If we see higher risk assets further over-valued, do not chase the move, but rather sell into price ...
Debating for the Bulls...
11/04/2005 12:00 am EST
I greatly enjoyed hosting a special bull/bear debate for alumni of past San Francisco Money Shows. On the bull side was Ryan, Beck & Co.'s Joe Battipaglia , one of Wall Street's most respected advisors. Here's an overview of his market and economic outlook, plus some current favorite stocks.
"I think the economy is actually going to fare much better than many others think. I believe it will be propelled by three things. One, the consumer is in the best financial health they have been in quite some time, and will continue to use that as a springboard for consumption. You need to focus on the personal balance sheet of America, which is at a record. You need to focus on the fact that we are still creating jobs at a rate of two million a year. And disposable income, year-over-year, has expanded by over $440 billion. So while the mood might be dour, I believe the consumer will carry on the historical contribution of about 70% if the economy.
"The next part of the economic stool is corporate spending. In the past, companies ran pretty lean with cash and would borrow money to expand their businesses, both domestically and internationally. They are not doing much of that now. The reason is that their cash flows are so huge and the cash they are sitting on is enormous. Standard & Poor’s estimates that the S&P 500 companies are currently sitting on approximately $664 billion in cash. When you compare cash to debt, it’s 40%, which is essentially a record. It is one of the lowest ratios of cash to stock market value that has ever been seen.
"So companies will use their business opportunities to aggressively expand their companies and spend that money. They will use that cash to raise their dividends. They will buy back their stock. They will prompt private equity companies to try and buy them out. That’s why Mr. Kerkorian, Mr. Ichan, and an endless list of private equity firms are running out to buy companies now. This can’t be because the economy is about to roll over and die. It can’t be because inflation is going to be virulent with 15% interest rates. No, what they are seeing is good opportunity in the market. So, the investment side of this equation goes into a renaissance over the next three years. The last part of the economic equation for you is, of course, government. And does anybody really think that government spending is going to slow down next year?
"As for stocks, I would point to the model that the Fed uses for valuation purposes, which suggests that the stock market is at its cheapest level in 20 years. In other words, by the measure of looking at earnings yield compared to the real rate of return on bond, the premium you are getting in stock prices is about 5%. That’s is the widest it has been in 20 years. So the market on that basis is cheap. The catalyst for the market to go up can come from a variety of things. It could come from a break in oil prices, it could come from the economy showing its durability, or perhaps it will be the end of Fed tightening that unleashes a bull market. But whatever the eventual catalyst, stocks are now fundamentally cheap.
"I do believe that there is a transition here. While there are places in small cap-land to make money, in general, larger stocks will give you better performance than small stocks. I expect growth stocks to outperform value stocks. I would avoid China like the plague. For all its financial might, in terms of holding Treasuries, their infrastructure speaks to me of a bust in that economy. Unlike the Japanese who took 15 years to right themselves because of a longer tradition of capitalism, the Chinese have no such tradition. So when that economy implodes upon itself, it could be chaotic for a while. Not for global markets who buy goods from there, but from the investments and valuations within that country.
"It goes without saying that you need to avoid complacency in portfolio management. You have to look at those stocks that have been great winner for you, that are a disproportionate percentage of your total, and find out whether or not they are ticking time bombs. The recommendations we make are usually in our managed account portfolios and we have the discretion to buy them and sell them as events occur. We have disciplined price targets for what level will we buy and sell. You need to have a similar discipline. So these recommendation are ‘homework assignments’, not necessarily the answers to the question of what you should buy.
"Having said that, here are some of the stocks that I particularly like right now. Microsoft (MSFT NASDAQ) is on the verge of having a new operating system on the market that will energize their bottom line for the next three years. It will let them widen out their operating margins for the first time in quite a while, and will add hugely to the cash they are already sitting on. In our opinion, this makes the stock a value opportunity in a growth category.
"Take-Two Interactive (TTWO NASDAQ) is a video game company that recently missed its quarterly results. The stock has been slammed as a result. However, they are essentially debt-free, are a big cash-generator, and will benefit from the new version of Microsoft’s X-box. Here, you are buying a company against the trend. But when nobody wants to buy is usually a good time to step into a stock like this. Nevertheless, I caution that it is volatile and risky situation.
"Palm (PALM NASDAQ) makes hand-held computing devices. This is a company with a new product that is quite lively. The margins are widening out, which gives them greater financial results and greater cash flow. It was disappointing in the last quarter, with a little spillover expected from Apple, but this has made the stock cheaper and more attractive.
"AstraZeneca PLC (AZN NYSE) does not have the same profile as companies like Merck and Pfizer. It is certainly not as ‘overvalued’ as Genentech or Amgen, which have become increasingly volatile as of late. The company has a nice, wide product portfolio. I think it belongs in a growth portfolio.
"Capital Title Group (CTGI NASDAQ) is an insurance company – title insurance for homes. This is an industry that is already dominated by four companies, and Capital Title will be the fifth. It is involved in a ‘roll-up’ strategy. Their business is concentrated in Arizona and California and they are expanding in Texas and Florida. This stock is not about housing starts and housing turnover. It is about who is aggressive in going out and getting business. I think the management team is terrific in accomplishing that. The stock is currently trading at about 5 times expected cash flow, which makes it cheap relative to its peers."
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