TCS Daily


With A Little Courage, Plenty Of Blue-Chip Bargains Can Be Found

By James K. Glassman - September 24, 2001 12:00 AM

It is now time to think the unthinkable: buying stocks. In the five days after U.S. exchanges reopened following the Sept. 11 attacks on New York and Washington, the Dow Jones Industrial Average fell more than 14% - its second-worst week in history. The Nasdaq dropped by an even larger amount. Even in October 1987, when the Dow fell 22% on a Monday, it recovered enough to finish the week off 13%.

But there was no rally last week. Only three of the 20 most widely held U.S. stocks rose Friday, and shares of solid companies based around the world dropped as well: Nokia Corp. by a further 3%; BP PLC, 4%; L'Oreal SA, 5%, and Honda Motor Co., 8%.

In the midst of all this gloom, why buy? Because individual stocks, by conventional measures, are cheap and because broader markets, by traditional indicators, are oversold. Of course, "conventional" and "traditional" analysis is useless if, as a result of the attacks, the world has entered a new long-term period of retrenchment, fear and shattered consumer confidence. As I wrote in the Money Report section of the International Herald Tribune over the weekend, this time may be different. But if the old principles continue to apply, then current markets appear to present historic buying opportunities.

Economists at the Federal Reserve use a crude model to judge whether stocks are cheap or expensive: They compare interest yields on bonds with earnings yields on stocks. In recent years, stock yields have nearly always been higher than bond yields, an indication, according to the model, that stocks are no bargain. Now, the situation is reversed: Stock yields are a full percentage point below those of bonds.

The slowdown in the economy and a flight to such havens as government paper have driven 10-year U.S. Treasury bond rates down to 4.69%. Consensus estimates indicate that the earnings yield for the Standard Poor's 500-stock index is 5.69% - meaning that the typical large-capitalization U.S. company is expected to produce earnings over the next year that amount to 5.69% of its current stock price.

The last time there was such a large discrepancy between bonds and stocks was during another period of intense fear: the 1998 financial crisis, when Russia defaulted on its debt and Long-Term Capital Management, a huge hedge fund, collapsed. Over the five months from September 1998 through January 1999, stocks staged an incredible rally, with the S&P surging 33%.

In fact, the history of stocks is a tale of intense rebounds from conditions that appeared hopeless. The all-time worst stock-market week - a 15.6% loss for the week that ended July 21, 1933 - was followed by a 12% gain in August. For all of 1933, U.S. large-cap stocks returned 54%.

Another hopeful indicator is "investor sentiment." When investors sour on stocks, a resurgence in prices is often at hand. Over the past three weeks, one closely watched survey found that only 36% of investors were bullish, compared with 44% three weeks ago; another survey found that bulls had dropped over the same period from 31% of investors to 20%.

Let's assume, as I do, that the attacks do not mean the end of the economic world as we know it. Certainly, chances are that the global economy will slip into recession - we may already be there - but never has the U.S. economy, at least, been so prepared to combat economic decline. A stimulative tax relief, including rebates and lower withholding taxes, is already in the works, interest rates have been cut by 3.5 percentage points over the past eight and a half months, and the government has approved increased spending.

Even if we assume a normal recession, lasting three or four quarters, the economy should start to recover next spring - with the market rising far earlier. But long-term investors do not even need such guesswork. Again, if history holds, recessions always end, and recoveries always lift economies, and stock markets, to levels higher than those before the slowdown.

Under such a scenario, the main problem investors face today is an embarrassment of riches. Practically everything seems cheap. My own approach would be to hedge the apocalypse by concentrating on strong companies that have shown an ability to produce consistent, copious earnings and have solid balance sheets to help them ride out the storm.

An obvious choice is General Electric Co., probably the best-managed company in the world. Last week it announced that despite the horrors of the past month, its earnings will rise more than 10% this year. GE closed Friday at $31.30 a share, down by nearly half from its high of last year. Based on likely earnings for this year, GE trades at a price/earnings ratio of 22 with a dividend yield of more than 2%. Those figures are lower than the annual averages for the stock for every year since 1996.

Pfizer Inc., Merck Co. and GlaxoSmithKline PLC are examples of companies with superb balance sheets that are unlikely to suffer in any conceivable economic downturn yet have been dragged down by market pessimism. All are trading at or near their 52-week lows. Merck, for example, is expected to earn $3.14 this year and $3.43 next year, yet it closed Friday at $65.70, down from a high of $96. Merck's P/E ratio is lower than at any point since 1995.

And what about a wonderful company like Express Scripts Inc., a pharmacy-benefits manager that has been increasing its earnings at a rate of 30% a year? The stock has fallen by one-fifth this month even though the earnings outlook, as of Monday, had not changed for the year.

Another approach is to look for companies whose sales have been crushed because of the Sept. 11 attacks but which are likely to return to normal within a few years. Hotel and gaming stocks are clear choices. Shares of Starwood Hotels Resorts Worldwide Inc., which owns the Sheraton, Westin, St. Regis and W chains, hit an all-time low Friday, ending at $17.75, down from a high of more than $40. In 1999, Starwood earned $2.47 a share. If it can return to those levels, its P/E, based on the current price, is just 7. Starwood also carries a dividend yield of 4.4%, and Value Line Investment Survey ranked it the top hotel or gaming stock for "financial strength."

A more speculative play is AMR Corp., the parent of American Airlines, one of the stocks I bought last week, along with Walt Disney Co. and Cisco Systems Inc. AMR closed at $17.90 on Friday, down from a high of $89.90 in 1998 and $68.80 at its peak last year. Yes, AMR has big problems with the American public afraid to fly, but that should change. AMR is also relatively strong financially - the only airline rated "A" by Value Line - and some of its competitors are faltering. Also, in this new climate, regulators probably will allow mergers they would have rejected earlier, and AMR could be a beneficiary. Look how much AMR can earn: In 1998, its profit per share was $7.48, and between 1996 and 2000, per-share earnings averaged $5.32. At current prices, that would mean a P/E ratio of between 3 and 4.

Less risky are companies in businesses that should not be harmed by a conventional slowdown but have seen declines in share prices of 20% or more. These include American Italian Pasta Co., Home Depot Inc., Columbia Sportswear Co. - a $1.5 billion company with just $50 million in debt - the auto-parts company Pep Boys, Sony Corp., TotalFinaElf SA, the Netherlands-based international grocery giant Ahold Ltd. - which fell inexplicably along with everything else - and financial companies such as Merrill Lynch Co., which was trading at a P/E of less than 10 based on 2000 earnings, Bank of America Corp. and the British bank Barclays PLC, at a current P/E of just 9.
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