THIS TIME, THE CREAM ISN'T rising to the top.
The historic rally that has lifted the Standard & Poor's 500 index by 50% from its March lows has been led by economically sensitive and lower-quality stocks, including such sectors as financials, basic materials, retailers and industrials. By contrast, high-quality stocks like Abbott Laboratories (ABT), ExxonMobil (XOM) and Procter & Gamble (PG) generally have lagged, with many showing outright losses so far this year.
The rush by investors for cyclical, economically sensitive stocks has only increased as the outlook for the global economy has brightened. But now a shift may be at hand. While it's tough to time changes in investor sentiment, quality stocks soon could start to shine.
Several factors are working in their favor, including relatively low price-to-earnings multiples, decent growth outlooks and strong financial positions. The run in economically sensitive stocks has left many of them trading at very high P/E ratios for 2009 and even 2010 -- to the extent they have any profits at all this year. Investors now can grab best-in-class companies such as Berkshire Hathaway (BRK.A), Microsoft (MSFT) and Wal-Mart Stores (WMT) at attractive prices and for little or no premium relative to their lesser brethren.
Jeremy Grantham of GMO, the Boston investment-management company that evaluates a wide range of domestic and overseas asset classes, argues that U.S. blue-chip stocks now represent one of the best investments in the world.
Barron's has picked a dozen quality stocks that look ready to rally. As the nearby table shows, the stocks trade for an average of 12 times projected 2010 earnings, excluding Berkshire Hathaway, which tends to get valued based on its book value rather than reported profits.
Each of our dozen could rise 20% in the next year, and most have secure dividends of 2% or more. The major market indexes may rise more grudgingly in the months ahead, following the biggest rally since the late 1930s. The S&P 500 now is valued at about 15 times projected 2010 operating profits, a premium to most of the blue chips on our list. And if the economy unexpectedly weakens, quality stocks are apt to offer greater downside protection than most of the market averages.
The bull case for the cyclicals, including many financials, rests on hoped-for 2011 or 2012 profits, but those might not materialize if the economy sputters. The investment outlook for Caterpillar (CAT), Ford (F), Dow Chemical (DOW), Paccar (PCAR) and a range of other economically sensitive stocks hinges on distant earnings. New investor favorite Ford, whose shares have more than tripled this year to 8, isn't expected to earn much money until 2011. And who knows what the economy and global auto market will look like then?
"The easy winner of the cheapest-equity sub-category is still high-quality U.S. blue chips," Grantham wrote in a recent market commentary. "They were really trashed on a relative basis by the second-quarter rally in junk. I understand a rally in junk after the record decline, but this was excessive and based apparently on unrealistic hopes for a strong, sustained economic recovery."
In fact, it's one of the biggest issues now confronting professional investors: Should one stick with the stocks that have been doing best -- the cyclicals -- in the hope that the rally continues, or start buying quality issues?
Numerous measures illustrate the outperformance of economically sensitive and lower-quality stocks. The Morgan Stanley index of cyclical stocks is up 48.6% this year, led by Ford, Goodyear Tire (GT), Freeport-McMoRan (FCX), Sears Holding (SHLD) and Ingersoll-Rand (IR). The Morgan Stanley Consumer index, by contrast, is up 7.5%, held back by double-digit percentage declines in Safeway (SWY), Abbott Labs and P&G.
Given its high-quality composition, the Dow Jones Industrial Average is one of the worst-performing U.S. market indexes this year: It has gained just 6%, while the S&P 500 has risen 11%; the technology-heavy Nasdaq, 27%; and the S&P 400 Midcap index, 21%. The energy sector has badly lagged the big gain in oil prices, as Dow components Chevron (CVX) and Exxon actually are in the red.
Here's a rundown of the dozen stocks on our list:
Due to its diversified business mix, Abbott has been one of the better investment stories in the tough pharmaceutical sector in recent years. Abbott shares, however, have fallen 17% this year, to 44. A key issue is Wall Street's fears about the slowing growth of Abbott's top drug, Humira, which is used to treat auto-immune diseases like rheumatoid arthritis. Humira generates nearly 20% of Abbott's $30 billion in annual sales and accounts for most of its revenue growth.
But Humira isn't fading. Sales of the drug could rise 20% this year and 15% or more in 2010. Unlike many drug stocks, Abbott still is a growth story, with profits expected to rise 11% this year to $3.69 a share and another 11% to $4.10 a share in 2010. Abbott looks reasonable at 11 times next year's projected profits. Morgan Stanley drug analyst David Lewis sees the stock hitting $55 within a year.
As a classic defensive stock, AT&T (T) has lagged in the market rally along with rival Verizon Communications (VZ). For both companies, the story has been growth in wireless revenue and profits offset by erosion in their formerly core wire-line phone operations. Wall Street worries about a saturated wireless market and continued wire-line losses as consumers "cut the cord." There were signs in the second quarter that wire-line losses may be moderating while AT&T benefits from its exclusive relationship with Apple's iPhone.
Valuation is low. The stock, at 25, trades for 12 times projected 2009 profits of $2.08 a share, but earnings are penalized by about 40 cents for non-cash goodwill amortization from acquisitions. AT&T's P/E based on its "cash" earnings, excluding the goodwill impact, is just 10, and the stock yields 6.4%. The dividend looks secure. Morgan Stanley telecom analyst Simon Flannery carries a price target of 32.
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