GUIDE 2005: The 20 Best Bargains in the Market
Monday, December 13, 2004
By Yuval Rosenberg and David Stires
Every investor loves a soaring stock price. Problem is, we often chase those hot stocks after they've reached the ozone. Yes, most of us would do well to use the discipline of a value investor and learn the fine art of rooting around in remainder bins. If you can separate the unfairly maligned and the turn-around prospects from the stocks that deserve their outcast status, you can make quite a pretty penny. With that in mind, we tracked down top value managers, big-picture strategistsand threw in a couple of growth gurus for good measureand got them to recommend cheap, unloved, overlooked, or simply underappreciated investments. We asked them for their single best pick right now. We can't guarantee you'll sell high, but here are some ideas on how to buy low in 2005.
ALTRIA GROUP MO
DAVID DREMAN Scudder Dreman High Return
They say that breaking up is hard to do, but Altria Group (the former Philip Morris) has decided it's the best path to happier shareholders. Altria's stock is up some 14% over the past 52 weeks. But despite a commanding market share, it trades at 11 times 2005 earnings, lower than some weaker tobacco rivals. With the stock weighed down by three major lawsuits against cigarette maker Philip Morris, CEO Louis Camilleri has acknowledged that once the litigation picture improves, the company plans to split into two or three units to unlock shareholder value. Call it the RJR strategy: First diversify into consumer goods, proclaiming it the solution to your tobacco woes; then unload those same divisions some years later on the theory that you'll do better if you focus on your core strength. A 180-degree turn it may be, but profits have been dwindling at Altria's Kraft Foods as a result of low-carb diets and high commodity prices. And whatever your feelings about cigarettes, the truth is they make money.
The spinoffwhose timing is uncertainis one reason contrarian David Dreman continues to like Altria stock. "The sum of the parts is worth more than the whole," says Dreman, who runs more than $11 billion in various funds (including 17.3 million shares of Altria as of Sept. 30, 2004) and has averaged returns of nearly 15% a year over the past ten years at Scudder Dreman High Return Equity. The market effectively treats the U.S. operations of Philip Morris as worthless, he notes, even though the division earns about $4 billion a year. Analysts say that Altria could fetch $75 a share or more if the businesses are broken up.
RICHARD BERNSTEIN Merrill Lynch
"If I could buy a Bentley for the same price as a Volkswagen, why wouldn't I buy the Bentley?" That's how Rich Bernstein, chief U.S. strategist for Merrill Lynch, explains his market outlook for 2005, namely that high-quality dividend-paying stocks remain the best bets. Lower-quality stocks, Bernstein says, have gotten expensive, reaching valuations similar to those of higher-quality companies. The longtime bear still expects low-single-digit returns in 2005. And he notes that the S&P 500 has eked out annualized gains of just 2% from June 30, 1998, through November 2004. In that kind of low-return market, Bernstein says, dividends become ever more important.
That's one reason Bernstein advocates the utilities and consumer-staple sectors in 2005, with health-care and pharmaceutical stocks earning honorable mention. Investors have been shunning utilities and consumer staples. But he predicts that earnings growth won't flag in those sectors as much as it will elsewhere, and risk-weary investors will turn to them for safety.
One stock he recommends is Ameren, a St. Louis-based power utility that serves customers in Missouri and Illinois. The shares have a P/E of 16 based on estimated 2005 earnings, slightly above average for a utility. But Bernstein is enamored of Ameren's electrifying 5.25% dividend yield, which he says is reason enough to buy (though he thinks the stock has room to rise too). "People should be thinking about very modest returns and the most certain way of getting those modest returns," Bernstein says. "If you get a 5% dividend yield, you're basically there."
BERKSHIRE HATHAWAY BRKB
WALLY WEITZ Weitz Value
In uncertain times for the stock market, who better to trust your money with than Warren Buffett? The legendary investor has been building up cash of latehis Berkshire Hathaway concluded its third quarter with a $38 billion hoard and another $23 billion in fixed-maturity securitiesmeaning that Buffett is primed to pounce if he spies a bargain. "The thing he does even better than running the company day to day is identifying and having the courage to commit to very big opportunities," says fund manager Wally Weitz, who has made Berkshire a top holding.
Berkshire's insurance business got whacked by this year's hurricanes, and its stock dipped after New York attorney general Eliot Spitzer announced his probe of the insurance industry. (Berkshire has not been implicated thus far.) Still, the businesses are solid, and Weitz says Berkshire's share price represents a discount of "at least 20% or 30%" to the company's underlying business value.
Forget the facile comparisons between Weitz and Buffett (two straight-arrow value investors based in Omaha). Weitz's record stands up pretty well on its own. His flagship Weitz Value fund has averaged 17% annual gains over the past decade and has beaten the S&P 500 by nearly ten percentage points a year over the past five years. Weitz himself has been husbanding his money; as of the end of the third quarter he had 24% of the fund's assets in cash. But he's still happily holding on to Berkshire. "I think it's a pretty compelling value," he says.
SUSAN BYRNE WESTWOOD Holdings Group
More than anything else, energy prices have been troubling the collective mind of Wall Street in 2004. Crude-oil prices that topped $55 a barrel helped the energy sector gain 31% through November, and many money managers say the oil patch is still the place to be. "If you're looking for free-cash-flow-generating, dividend-increasing machines, it's got to be the oil companies," says Susan Byrne. Those are just the kinds of companies Byrne looks for at Westwood Holdings Group, the Dallas firm she founded in 1983, which has more than $4 billion under management, about 15% of which is in energy stocks.
Byrne says that despite the sector's gains, oil stock valuations still don't reflect the price of crude. "If it stays at $35, they're very undervalued," she says, "and if it stays at $45, they're just ridiculous." (For more, see "Three Ways to Make Money in Energy Stocks.") One of Byrne's favorites is ChevronTexaco. The integrated oil and gas giant trades at a discount to rivals in part because it has been carrying heavy debt. But ChevronTexaco has used its gushing greenbacks to retire its obligations, and as of the fourth quarter of 2004, Byrne says, the company's cash on hand equals its debt. And ChevronTexaco offers a higher dividend yield, currently 3%, than many of its competitors. Byrne expects the company to use its cash to make the payout even richer, adding to its appeal.
RON MUHLENKAMP Muhlenkamp
Ron Muhlenkamp typically stuffs his portfolio with battered stocks that most investors won't touch. During the tech boom in the late 1990s, Muhlenkamp was scoring with dowdy, smaller bargains like Stanley Furniture. The payoff: The fund has returned 17.9% annually over the past ten years, outpacing the S&P 500 by six percentage points a year.
So it might seem surprising that his top pick now is Citigroup. Yet it makes sense: The $100 billion financial giant has taken hits from Enron, WorldCom, and other scandals. But Muhlenkamp says those problems are largely in the past, and CEO Charles Prince is improving corporate governance and risk management. "Citigroup is a good company and a great franchise," he says. What's not to like? Shares trade for just 11 times next year's forecasted earnings, a sharp discount to the S&P 500's P/E of 16, and sport a juicy 3.5% yield. Citigroup simply is, if you'll pardon the phrase, a cash machine, earning an estimated $21 billion in 2004. And Muhlenkamp expects profits to grow 12% a year, nearly twice the market's rate. "Even if the P/E doesn't change," he says, "a 12% return will be pretty good."
BILL D'ALONZO Brandywine
An avid hunter, Bill D'Alonzo has traveled as far as Alaska, Argentina, and New Zealand in search of game. But D'Alonzo has bagged some of his most valuable prizes hunting for stocks from his Delaware office. Like any smart hunter, D'Alonzo likes to thoroughly understand his prey. He looks for stocks whose earnings are growing at 20% a year or more but are not burdened with inflated P/E multiples. He seeks out companies that will exceed Wall Street expectations and bring a "sizzle factor"a management change or other catalyst that will get investors excited. His team not only researches prospective investments but also examines competitors, suppliers, and customers.
One recent pickup that D'Alonzo expects to show some sizzle is Covance, a $1-billion-a-year contract research firm for pharmaceutical and medical-device companies. Covance, based in Princeton, N.J., has increased its operating margins from 6.4% in 2001 to 14.1% in the third quarter of 2004. But shares suffered in recent months following the company's announcement that CEO Chris Kuebler would be succeeded in 2005 by COO Joe Herring. D'Alonzo isn't worried about the management transition, because Kuebler will stay on as chairman and Herring has been well groomed for his new post. And analysts expect the company, which trades at a 2005 P/E of 21, to step up earnings by 22% next year, making shares look cheap. Particularly in the wake of Merck's Vioxx recall, D'Alonzo adds, Covance may benefit as drug companies look for added credibility while they race to replenish their pipelines. "The Vioxx situation," he says, "makes involving a third party in the development process more appealing."
ELECTRONIC ARTS ERTS
SPIROS "SIG" SEGALAS Harbor Capital Appreciation
Sometimes you can find a value opportunity in a growth stock. That's good news because the past few years have not been kind to fans of fast and furious equities. Still, Sig Segalas, veteran manager of the $6.8 billion Harbor Capital Appreciation fund, argues that growth shares could be poised for a comeback. Corporate earnings expansion is expected to downshift in 2005, and Segalas says that slowdown will provide "unique opportunities" for investors who can sniff out exceptional earnings potential. Come to think of it, that sounds suspiciously like a value philosophy. Whatever you want to call his approach, Segalas zeroes in on stocks whose profits he thinks will jump 15% or more over 12 to 18 months, ideally those with strong defensible characteristicsa powerful brand, for example, or superior technology.
One favorite is Electronic Arts, which could be dubbed a growth stock in a value moment. EA, for those of you without kids, is the leading videogame maker and home to titles such as Madden NFL 2005 and The Sims 2. Based in Redwood City, Calif., Electronic Arts has a balance sheet to fantasize about: It has no debt and $2.5 billion in cash. And, Segalas says, with three new videogame platforms on the horizonSony's PlayStation Portable and PlayStation3 as well as Microsoft's new Xboxthe company will pump up profit margins in coming years and see earnings explode. Before that new-product cycle kicks in, though, profits may stagnate as the company sells games for aging systems and incurs development costs for the next-generation consoles. That, says Segalas, spells buying opportunity right now. "For a halfway-patient investor," he says, "I think the stock goes over $60."
FOREST CITY ENTERPRISES FCE.A
MARTY WHITMAN Third Ave. Value
Real estate stocks have been soaring, with the typical real-estate investment trust (REIT) rising 22% a year since 1999. But veteran value hound Marty Whitman is entranced by one stock that now fetches a restrained P/E of 12 times projected profits: Forest City Enterprises, a real estate holding company with about $1 billion in sales. Founded in 1921 as a lumber dealer, the Cleveland company has expanded to include everything from offices and hotels to apartments and master-planned communities. The company typically targets fast-growing parts of the country where real estate costs are high. Forest City is currently redeveloping the Los Angeles subway terminal and building a skyscraper for the New York Times Co. "It's the biggest blue chip you've never heard of," says Whitman, whose small-company stock fund has returned an impressive 15.3% annually over the past ten years.
Unlike most real estate firms, Forest City is structured as an operating company rather than as a REIT. That means it doesn't have to pay out all profits as dividends. While that causes a relatively low yield, it also allows the company to reinvest more earnings in the business. Forest City generates robust cash flow. And its eclectic portfolio stabilizes operating results, making the stock a strong performer. Says Whitman: "They've been superior to any other real estate firm in building value over the years."
FREDDIE MAC FRE
JIM GIPSON Clipper
The lead manager of the Clipper fund, Jim Gipson, offers Douglas MacArthur's well-worn quote, "Old soldiers never die, they just fade away," to make the case for embattled Freddie Mac, the $37 billion mortgage-finance giant. Gipson says its two intertwined controversiesthe mortgage lender's accounting and how it should be regulatedare slowly receding, giving investors a prime opportunity to buy at an unusually attractive price.
Shares plunged in 2003 amid the accounting scandal that culminated with Freddie admitting it misstated earnings by billions of dollars in an attempt to show steady growth. But Gipson, whose large-stock value fund has posted a stellar ten-year 16.7% annualized return, says a stock resurgence is on the horizon. New CEO Richard Syron, a 61-year-old economist and former regulator, has made cleaning up the accounting mess his top priority and plans to have up-to-date financial results by March 2005. Gipson says the push to abolish the company's regulator and create a more aggressive agency is also fading (though Freddie could hit a few bumps if sister Fannie Mae encounters more trouble). In the meantime Freddie continues to generate a hefty 20% return on equity, significantly higher than the average S&P 500 company. The result, according to Gipson: "A very profitable company selling at under ten times 2005 estimated earnings."
TWEEDY BROWNE Global Value
Heineken is a champagne stock selling at a beer-budget price. So say the managers of Tweedy Browne Global Value, a top foreign-stock fund that has gained 12% a year in the past ten years. With $10 billion in sales, Heineken is the world's third-largest brewer, marketing its Heineken, Amstel, and other brands in more than 170 countries. The company has been clobbered by everything from the weakening dollar to smoking bans in bars in the big American market. Its share price has been on a gradual slide for several years.
Though the Tweedy Browne managers don't expect Heineken's U.S. troubles to disappear anytime soon, they argue that investors have overreacted to the headlines. They point out that the Americas account for only 12% of the company's total sales volume. Meanwhile CEO Thony Ruys is expanding into emerging markets in Russia (where beer is making inroads on vodka), China, and Africa. Like many other deep value managers, the Tweedy Browne team invests when a stock is priced at a steep discount to what it figures another buyer might pay for the company in a takeover. Given Heineken's recent woes, the stock sells for about 15 times forecasted 2005 earnings. That ratio might not seem like something to get hopped up about, but it's below that of peers such as Anheuser-Busch, which has a P/E of 17. And given Heineken's growth prospects, the stock is a relative bargain. The Tweedy Browne managers believe the shares are priced at 30% less than their true worth.
INTERPUBLIC GROUP OF COMPANIES IPG
DAVID WILLIAMS Excelsior Value & Restructuring
Corporate restructurings can be painful, but they've proven profitable for David Williams, manager of the $4.2 billion Excelsior Value & Restructuring fund. By homing in on stumbling companies in the midst of reorganizations or in consolidating industries, Williams has beaten the S&P 500 in ten of the past 12 years and averaged annual gains of about 17%, more than five points better than the S&P 500.
One current favorite is Interpublic Group, the world's third-largest advertising and marketing conglomerate. Interpublic's stock has been bludgeoned by a brutal industry downturn, bungled acquisitions, and a continuing SEC investigation into a past earnings restatement. Shares plunged from more than $34 in early 2002 to as low as $8 in early 2003. Yet Williams and other value mavens have been snapping up shares. Its P/E of 21 makes it look a bit pricey, but Williams predicts that earnings will continue to improve as the industry recovers from its slump and management reduces costs and restores margins. As that turnaround finally takes hold, Williams says, the stock should see significant gains. "It might be as high as $18," he says, "if everything works out well."
JOURNAL REGISTER JRC
JOHN ROGERS JR. Ariel
Forget bulls and bears. John Rogers says investors should emulate Aesop's tortoise, which is why he picked it as his firm's emblem and "Slow and steady wins the race" as its motto. Rogers considers only stocks trading for less than 13 times the next year's earnings, or a market capitalization at least 40% below his estimate of the company's value. By definition, the approach requires patiencehe typically holds stocks for three to five years. But it works: The Ariel fund has increased 16.4% a year over the past decade, outperforming the S&P 500 by more than four points a year.
Rogers's favorite bargain is Journal Register, a small newspaper publisher with 27 dailies including the New Haven Register, Connecticut's second-largest daily. Although the stock is up slightly since he purchased it, Rogers figures that it's still about 30% undervalued. With roughly $400 million in sales, the New Jersey company pursues a "clustering" strategy, owning and operating several papers in the same market. The idea is to spread sales and back-office functions across several publications, keeping profit margins high. Acquisitions have driven up debt, depressing the share price. But with its ample cash flow, Rogers says, Journal Register will start to pay down its debt. That means, he says, that the company's shares should move out of the discount bin.
LLOYDS TSB LYG
DAVID HERRO Oakmark International
As he considers the state of today's global markets, David Herro says that Europe, one of the most troubling regions from an economic perspective, is also the most appealing from an investment perspective. At first blush that notion might seem incongruous, but it's right in keeping with Herro's value-based approach. As manager of the $4.5 billion Oakmark International fund since 1992, Herro combs foreign markets for high-quality businessesthose earning above-average returns and using free cash wiselytrading at low price/cash flow ratios.
These days he likes what he sees in blue-chip European multinationals such as Diageo and Nestlé as well as in financial services companies such as London-based Lloyds TSB Group. The fifth-largest bank in Britain (not related to renowned insurance exchange Lloyd's of London), Lloyds TSB Group stumbled badly in the bear market, hurt by its acquisition of an insurance company, Scottish Widows, in 2000.
Lloyds has made some progress of late by divesting foreign operations and improving core British operations. As a result, earnings per share increased 6% in the first half of 2004. Herro argues Lloyds' share price has been punished because investors fear that growth will be limited and the dividend, which yields an astonishing 7.5%, may have to be cut. Herro sees things much differently: "You get a bank that gets 20%-plus return on equity, has a great retail franchise, and has a new management team which has realized that this company may have rested on its laurels a little bit." Most important, he says the powerhouse dividend should be secure.
ROYAL DUTCH PETROLEUM RD
SARAH KETTERER Causeway International Value
Each week Sarah Ketterer and her co-managers at Causeway International Value screen 3,400 companies in 24 countries to uncover cheap, dividend-paying ideas. Their global bargain approach has steered their young fund to a 16.4% annualized gain over the past three years, trouncing the Morgan Stanley EAFE index by six points a year. Ketterer's buy signal is now flashing on Royal Dutch/Shell, whose shares plummeted in January after the company announced that it had overstated reserves by 24%.
The good news, says Ketterer, is that the scandal has finally spurred the world's No. 3 oil and gas player to simplify its awkward structure. Subject to shareholder approval in April, Royal Dutch/Shell will merge its two interlocking but separate entitiesRoyal Dutch Petroleum of the Hague and London-based Shell Transport & Tradinginto a single company with a single board and chief executive officer. The long-contemplated move addresses criticisms that the structure not only confused investors but fostered the transparency and accountability problems that led to Shell's huge reserves revision. That should allow Shell to wipe out what Ketterer calls the "unjustifiably large" discount to peers such as BP and Exxon Mobil. While those stocks fetch about 15 times projected profits, shares of Shell's two holding companies go for about 11 times expected earnings. Using a very conservative estimate of $30 for a barrel of oil, Ketterer calculates the stock could run up by 20%. And of course the 4% dividend yield doesn't hurt either.
BOB OLSTEIN Olstein Financial Alert
Tupperware used to be known for the belching sound made by its containers, but the kitchenware maker has experienced some hiccups of its own. U.S. sales sagged after the Orlando-based direct seller put its products in Target stores, undercutting its main distribution channelthose famous Tupperware parties, which account for some 90% of North American revenues. Party bookings and recruiting of sales representatives sagged, and profits sank from $90 million in 2002 to $48 million in 2003.
Tupperware is still recovering from the blunderit pulled out of Target in September 2003but those woes haven't scared off Bob Olstein, the veteran manager of the Olstein Financial Alert fund. Olstein built his reputation as a financial sleuth in the 1970s with the well-known newsletter The Quality of Earnings Report. He established his own firm in 1995 and has returned nearly 10.5% annually over the past five years. The key, he says, is steering clear of catastrophic losses. "I'm more interested in not getting in trouble than in hitting home runs," Olstein says. To achieve that he digs through corporate numbers to determine the true financial health of prospective investments, keeping a close eye on cash flows. He likes what he sees at Tupperware. The company is steadily rebuilding its party sales. As a result, Olstein says the shares could be worth as much as $24. In the meantime, there's an enticing 4.6% dividend yield.
TURKISH INVESTMENT FUND TKF
RUDOLPH-RIAD YOUNES Julius Baer International Equity
Talk about a Turkish delight. Since Rudolph-Riad Younes recommended the Turkish Investment fundwhich now holds stakes in 20 of that nation's companiesin our 2004 Investor's Guide, shares have gained more than 70%. Yet Younes thinks the $63 million closed-end fund, managed by Morgan Stanley, should continue to climb. "I really believe Turkey is one of the most interesting investment ideas over the next ten years," he says.
Younes, who has co-managed Julius Baer International Equity since 1995, considers both macroeconomic and company-specific factors in picking stocks for his diversified portfolio, which now bulges with nearly 270 names. The fund has generated a 12.7% annualized return over the past ten years, which places it in the top 1% among international stock offerings. Why his taste for Turkey? The country continues to make economic progress as it strives to join the European Union, Younes says. And whether or not it ultimately enters the European Union is less important than moving toward an "open, corruption-free, and dynamic economy"something he says the country is doing. As long as that remains the case, the Turkish Investment fund should continue to post strong gains.
WASHINGTON MUTUAL WM
BILL NYGREN Oakmark Select
Washington Mutual, Bill Nygren's longtime favorite stock, has taken a beating lately. After riding the housing boom to become the nation's largest mortgage bank, with nearly $20 billion in sales, the Seattle thrift has been hammered by rising interest rates, which have crimped profits. It's a testament to Nygren's knack for sniffing out bargains that despite WaMu's woes, the stock is actually up 6% this year. And with a rich 4.5% dividend yield, WaMu pays out wads of cash.
Nygren has delivered a five-year annualized return of 14.5%, placing his large-stock value fund in the top percentile in its category. And the Chicago manager remains a huge WaMu fan. Shares are still selling for less than 60% of what he figures an acquirer would pay for them. Meanwhile the company, he says, is transforming itself from a mortgage lender into the leading nationwide retail bank for the middle class. WaMu's retail bank, he notes, is growing at a double-digit rate. And he thinks CEO Kerry Killinger's plan to cut $1 billion in costs from the mortgage banking business will boost that division's profits. Trading for 11 times estimated 2005 profits, the stock looks cheap. Nygren thinks WaMu shares could hit $60 in a couple of years.
TOBIAS LEVKOVICH Smith Barney
Too much, too fast. That's how Tobias Levkovich, chief U.S. equity strategist at Smith Barney, describes the market rally sparked by November's elections. Yet while Levkovich anticipates a near-term pullback, he displays tempered optimism about 2005, projecting that the S&P 500 will end the year at 1225 or higher, a 3% bump from the current 1189.
Levkovich is gravitating toward large-cap stocks these days. What's more, says Levkovich, "we think the areas that are kind of out of favor, where the earnings revisions have come down, where valuations are starting to be compellinglike pharma and mediaare far more interesting." In media, for example, Levkovich points to a steady rebirth in ad spending. And while product-liability issues (read: Vioxx) and concerns about drug reimportation have pounded pharma shares, the stocks' valuations "are similar to what we saw in 1994 during the big health-care reform push," Levkovich says, adding, "These stocks look very poised for outperformance."
He recommends drugmaker Wyeth, which trades at around 15 times earnings. (Citigroup owns more than 2% of its shares.) The stock has been hurt by liability worries related to the diet drug combination fen-phen, but Levkovich says Wyeth has already set aside large reserves to cover those costs. He also points to a solid drug pipeline and the potential for future stock buybacks or dividend hikes. "The cash flow," he says, "is still phenomenal."