Jewish World Review June 19, 2002 / 9 Tamuz, 5762
James K. Glassman
Crawford Perspectives, a 25-year-old newsletter edited by a former Wall Street star, combines technical stock analysis with astrology. Yes, astrology.
The main story in the June issue carries a one-word headline: "Armageddon." It begins, "Some of the Most Powerful astronomic combinations in all of recorded history will be culminating in the next Three Weeks." Big trouble. Among the worries: "Saturn will 'trigger' the Eclipse point by conjunction on June 20." On the last page, a reiteration: "We expect this period to be the most significant of the decade, at least! Caution!!"
I don't mean to make fun of Arch Crawford, a bright, wry character whose record has been remarkably good at times. For instance, during the five years ended in 1997, Perspectives was the only newsletter to beat the benchmark Standard & Poor's 500-stock index. The last time Crawford issued this sort of warning was on Sept. 4, 2001.
This time, he has certainly caught the zeitgeist. The other evening, my dinner partner said she and her advisers decided to sell everything in her considerable stock portfolio and put the money into municipal bonds. She's not alone.
In a non-astrological moment, Crawford listed the problems: Valuations (that is, price-to-earnings ratios) are "unrealistically high," corporate insiders are overwhelmingly selling rather than buying, "scary tape action, dollar weak, gold strong, corporate officials leaving office, political brinkmanship, fear levels worldwide."
Yes, but whenever you hear this kind of talk, ask yourself: Are these worries a secret? Does anyone else who buys and sells stocks know that the dollar is weakening, that scandals have hit Wall Street and that the world seems a tinderbox? Of course they do. Believers in efficient -- or nearly efficient -- markets will tell you that such fear is already priced into stocks, or "discounted." What will influence the stock market next are unknown and unexpected events.
Trying to guess what will happen to the market in the near future by looking at historic movements on stock (or astrological) charts is a fruitless pursuit, like trying to guess the next roll of the dice at a craps table by analyzing the rolls that preceded it. But, while the market is eminently unpredictable, there are times when individual stocks -- companies you have always wanted to own anyway -- become attractively priced because of fear or miscalculation.
This phenomenon often occurs when you start hearing people make sweeping generalizations about the market or about sectors. For example, a few years ago, some observers were saying that small-capitalization stocks were finished. Why? One argument was that, in the wake of the financial crises in Asia and Russia, liquidity had become king. Since small-caps didn't have enough buyers and sellers to create stable markets, investors would shun them. Another argument was that, in a globalized economy, the little guys were getting squeezed out by the brand-name giants. The small-cap bears were wrong, of course; such stocks have been standouts lately. Over the past 12 months, the Russell 2000 small-cap index has risen by 14 percent while the Standard & Poor's 500 large-cap index has fallen by 18 percent.
Now, we're hearing the opposite -- that large-caps are finished. Here's a typical analysis I read last week: "Just as large trees run into the laws of gravity and old age that ultimately impede their growth, so do large companies." This generalization is just as wrongheaded. Some large companies thrive as they get bigger; some decay. For investors today, however, the point is that as the large-cap sector falls from favor, individual bargains sprout.
The summer of 2002 may be a very good time to start harvesting them. Begin with some of the biggest:
- Wal-Mart Stores, the largest retailer in the world and No. 1 on the Fortune 500 list with $218 billion in sales, has rallied from its post-Sept. 11 low, but it's still about 20 percent below its 1999 peak. Wal-Mart is not just huge, it's consistent: Earnings have risen every year since the business began in Rogers, Ark., in 1962. The company now has 4,300 stores, about a quarter of them outside the United States.
- Citigroup, which ranks seventh in revenue, second in profit and fifth in market capitalization (its value according to its stock price) among U.S. financial institutions, is a global behemoth with 200 million customer accounts in 100 countries. Its price has dropped more than one-fifth since January even though earnings continue to rise at a 15 percent annual pace and dividends were just boosted for the 16th consecutive year. Citigroup trades at a price-to-earnings (P/E) ratio of 14, compared with 43 for the average S&P 500 stock.
- By sales and earnings, International Business Machines is the largest U.S. technology company. Its stock has dropped from $123 to $73 this year, and its P/E has descended to 17, based on projected earnings for 2002.
- Procter & Gamble, with the largest market cap among consumer-products companies, has the best collection of brand names in the world (Tide, Crest, Folger's, etc.) and a long record of annual profit increases. The stock has risen this year, and earnings for the quarter just ending are expected to jump another 14 percent, but the stock still trades below 1998 levels.
- The largest drug firm, Merck, has dropped from a high of $95 in early 2001 to $52 on May 13. Four of the 25 biggest U.S. companies, by market cap, are pharmaceutical companies, and the entire sector has been clobbered in recent months, mainly because of worries about a lack of profitable drugs in their pipelines. Valuations have fallen "to the most favorable level since 1993-95," according to Barry M. Goggins of David L. Babson & Co., the Cambridge, Mass., investment management firm. Goggins still estimates that the profits of drug companies will rise at double-digit rates well into the future, so, "in this industry -- there are many good market values."
In fact, the drug sector is not the only place for values; attractive large-caps abound. "There's been a dramatic change," said Henry J. Herrmann, chief investment officer for Waddell & Reed, a mutual fund house based in Kansas City, Mo., that has a reputation for being cautious and taking the long view. "Valuations are a lot more favorable. . . . My view is that if you think about value, you need to think about large-caps." The Waddell & Reed Large-Cap Growth fund includes three drug companies and three tech firms among its top 10 holdings. Herrmann is high on big tech companies at these prices: "Technology still has some challenges to face, in my opinion, but the average tech stock is down approximately 65 percent from its March 2000 highs. As I said, I'm a buy-low, sell-high type."
Is there something special about large-cap companies? Do the best of them have an edge over the best of the mid- or small-caps? It seems that way. In 1993, Jensen Investment Management in Portland, Ore., launched a mutual fund on a simple premise: to fill it with companies that persistently increase their earnings but that carry prices that gave them what the late financial guru Benjamin Graham famously called a "margin of error." Jensen's managers use computer screens: Start with stocks that have delivered returns on equity of at least 15 percent for each of the past 10 years. (Out of a universe of 10,000 companies, only 110 currently meet that test.) Now trim the survivors by requiring that the stocks trade at a discount of at least 40 percent to their "intrinsic" value, based on projected cash flows. (That leaves just 27 stocks.)
Of these, 22 are large-caps, four are mid-caps and just one is a small-cap. The median market cap of a Jensen stock is $22 billion, compared with $8 billion for the S&P 500 stocks. It seems that big companies are where you find that golden nexus between profitability and value.
Robert Zagunis, one of Jensen's four principals, stresses that the fund did not intend to wind up in Morningstar's "large-cap growth" box. That's just where the firm's philosophy took it. The fund's companies "don't grow their earnings extraordinarily fast," says Zagunis. By contrast, many smaller companies show swift early growth, and their prices rise sharply on "too much wishful thinking." No firm can grow at 30 percent forever, and as growth slows for small-caps, their prices tend to fall.
Jensen's largest holding is MBNA, a financial powerhouse with a market cap of $28 billion and assets of $120 billion. MBNA issues credit cards (especially "affinity" cards tied to groups such as sports teams and environmental organizations). Unlike other lenders, it makes money in good times and bad, in part because it has tight credit standards. MBNA's average customer has an annual income of $70,000 and a 17-year history of paying bills on time. The company's own record is similar: Earnings have risen in each of the past 10 years -- overall, from 23 cents a share to $1.92, an annual average of 23 percent. The Value Line Investment Survey, which rates MBNA A-plus for financial strength, estimates yearly profit growth will continue at more than 20 percent for the next five years. Yet the stock has tumbled from $39 a share in March to just $32.13 on Wednesday, for a P/E ratio of merely 16.
For the year through June 12, the Jensen fund is down 6 percent -- but that's still 5 percentage points better than the S&P 500. Over the past three years, average annual returns are 9 percent, compared with minus-7 percent for the benchmark. And Zagunis is admirably calm. His fund's turnover rate is one of the lowest among all mutual funds -- just 20 percent annually since 1997, meaning that Jensen holds the average stock for five years. "If you don't have a long time frame," says Zagunis, "you shouldn't be in a stock."
In fact, the only major change to the portfolio this year was the addition of Johnson & Johnson, which Jensen began buying about a month ago. Zagunis says he's liked the company for a long time -- it's the model of growth consistency -- but spurning it "was a question of valuation." Now, after dropping 15 percent since March, J&J, at a P/E that's one-third lower than that of S&P, looks well-priced. Other large-cap holdings at Jensen include Fannie Mae and Freddie Mac, which finance home mortgages; Procter & Gamble; drug companies Pfizer, Merck and Abbott Laboratories; Gannett, the media chain; and 3M. Jensen also has an admirably low expense ratio of 0.95 percent and a sane policy of passing on capital gains immediately to shareholders -- so they don't get an unpleasant surprise at tax time.
By the way, Jensen's only small-cap is Dionex, a high-tech firm that makes systems for chemical analysis. Other techs in the portfolio: Adobe Systems, the software maker and a favorite of mine as well, and Zebra Technologies, which makes sophisticated bar-code readers. "We love technology," says Zagunis. "The problem has always been price and consistency."
When I asked him whether the sluggish stock market worried him, he replied, "We have a hard time with generalizations about the market." What a great answer! Like nearly all successful investors, Zagunis strives to become a partner in great companies for the long haul. "The market," as super-investor Warren Buffett told Forbes in 1988, "is there only as a reference point to see if anybody is offering to do anything foolish."
And foolishness -- at least according to folks like Herrmann and Zagunis -- is popping up all over the large-cap sector these days, increasing the attractiveness of some of the best brand-name companies in the world.
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JWR contributor James K. Glassman is the host of Tech Central Station. Comment by clicking here.
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