Last of the Bargains 

08/05/2009 2:55 pm EST


Allan Nichols

Equities Strategist & Editor, Morningstar InternationalInvestor

Novartis and France Telecom are solid values in an increasingly frothy market, argues Allan Nichols in Morningstar StockInvestor.

I have been concerned for some time that the current stock market rally has run ahead of fundamentals.
The market is acting as if this recession was just a blip and that we are now back to normal. I think that while the worst is over, it will still be a slow recovery, and the previous business environment was not normal.

This decade has seen some of the largest operating margins and lowest interest rates in a long time. I don’t see these as sustainable.

In addition, banks will remain concerned about their balance sheets and will likely keep lending tight. This will slow the growth of the entire economy, particularly for smaller and faster-growing companies.
Finally, there is a real risk of inflation returning, and even if it does not, interest rates will need to rise to avoid creating the next bubble.

Markets aren’t expensive, but if economic growth will be slower than the markets expect, don’t be surprised to see a pullback in stock prices. One of the biggest drivers of this market advance has been a return to risk. The biggest movers have been emerging markets (Morningstar’s median price/fair value estimate ratio for emerging-market stocks has gone from 0.68 in January to 1.01 in June) and low-quality stocks. That has left the best values in our favorite types of stocks: high-quality companies with moats.

Novartis (NYSE: NVS; Zurich: NOVN.VX) is a leading pharmaceutical firm based in Switzerland. Besides having one of the stronger pipelines among large branded drug firms, it also owns Sandoz, the second largest generic drug firm in the world, and has sizeable positions in vaccines, diagnostics, and consumer products. These additional areas provide relatively sustainable revenue and earnings growth for this wide-moat firm. Novartis has already been through the worst of its patent expiration period. With its strong pipeline and diversification, it should actually grow over the next several years, unlike many of the other large pharmaceutical firms. [Shares closed at $45.47 in New York Tuesday, for a 3.8% forward dividend yield—Editor.]
France Telecom (NYSE: FTE, Paris: FTE.PA) is the largest fixed-line and wireless telephone company in France, and also provides high-speed Internet access. It also has significant operations in the UK, Spain, and Poland, as well as smaller operations elsewhere, particularly in eastern Europe and Africa. While fixed-line phone service is declining worldwide, the other businesses are growing fast enough to offset the revenue declines in its fixed-line business. This narrow-moat firm remains a slow but steady grower with a very nice dividend. I think the dividend is not only sustainable, but likely to slowly increase. It is currently yielding 8.8%. [At New York's Tuesday closing price of $25.17, the annual yield stood at 7.9%—Editor.] We think this will provide a buffer for the stock should the market pull back again.

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