The Outlook from Standard & Poor's

02/28/2003 12:00 am EST

Focus:

Sam Stovall

Chief Investment Strategist, CFRA Research

There are over 350 research firms in the US, making stock recommendations. In 2000, 24% of all sell recommendations came from just one company – Standard & Poor’s. S&P equity research was just rated #1 on a one-year, two-year, and three-year basis, by the independent InveStars.com research service. Here Sam Stovall, chief investment strategist, provides his outlook for the market and Kevin Gooley discusses S&P's five favorite stocks.

Sam Stovall says, "I think there are some reasons out there to be optimistic about the future. I’m not saying we should be giddy about the future, but I certainly think the odds favor us closing to the upside this year, as opposed to us having a fourth year in a row with a negative return for the major stock averages. One reason is because we are expecting a rebound in the US economy. Certainly, once we get Iraq behind us, and given the stimulus package that’s working its way through Congress, as well as other stimuli that’s already been injected into the economy, we could see a nice little rebound for GDP, consumer spending, and business spending in the months ahead. In terms of real GDP, last year we saw about a 2.4% advance. We’re looking for a 2.9% gain this year, with that accelerating up to a 4.5% in 2004. So GDP is likely to be accelerating.

"Consumer spending will probably take a bit of a breather this year. After spending at a 3.1% rate last year, we’ll probably see about 2.4% this year. However, that should accelerate to 3% in 2004. This is due to acceleration of tax credits, and other stimulus working it’s way through the system. Meanwhile, history shows that consumers only stop spending when banks stop lending, and since we haven’t seen that yet, I think consumers will continue to spend. Business spending, which dropped almost 2% last year and 6½% the year before, is likely to increase about 5.9% this year. Actually, our feeling is that this 5.9% is only for replacement of items that they have not replaced over the last several years. So 2003 is likely to be a replacement year for many businesses. In 2004, we could see an acceleration to 12% for business spending.

"As for interest rates, we’re forecasting that the ten-year note, which averaged 4.6% last year, will average 4.2% this year, and then rise to 5.4% in 2004. So the bond market is likely to reflect an accelerating economy. As a result, we could see an uptick in longer-term interest rates, which could have more of a negative impact on bonds than on stocks. That’s why we believe there are better opportunities in equities than bonds, and certainly a better opportunity in equities than in cash. The dividend yield on the S&P 500 is now close to 2%, which is more than twice what you would get on an average money market. So we still think that equities offer the best possibilities.

"Also supporting our positive outlook is our expectations for an earnings recovery. Even though we had negative year-over-year earnings in 2001, we started to see some positive returns in 2002, I think we’re likely to see an acceleration of both operating and GAAP earnings in 2003. We look for an 18% increase in operating earnings this year. We’re also looking for about a 25% advance in top-down generated GAAP, or as-reported, earnings. Finally, I would never say to use history as gospel, but certainly you can use history as a guide. And at this point, history suggests we should do fairly well, because we are likely coming off the end of a bear market. Our price target for the S&P 500 for the end of 2003 is 1005, which implies about a 15% price advance over year-end 2002."

Adds S&P stock analyst Kevin Gooley, "The sectors that we do like right now are consumer discretionary, consumer staples, energy, and materials. Consumer discretionary and materials tends to be more economically sensitive, and we do expect the economy to do better as the year moves on. Consumer staples is a more defensive area, but is also showing good earnings growth. We like energy, of course, because of high oil prices. And even if prices do come down very sharply, these companies can still do well, as long as oil prices stay above $20 a barrel.

"Among consumer staples, we like Alberto-Culver (ACV NYSE). This is the company that makes well-know hair-care products and other health and beauty aids. It’s probably best known for its very first product, Alberto VO-5. They also operate a line of beauty supply stores, and that continues to grow and do quite well. They are benefiting from acquisitions, new store openings, and higher same-stores sales (stores that have been open for at least 12 months). Sales of health and beauty products should be bolstered by increased advertising and promotion efforts. They already have good brand awareness out there, but they continue to drive sales through promotions. The company has also been gaining market share. The way they have been able to do that is by pricing their products at very attractive price points. As a result, they have been able to pick up market share from their competitors.

"In the energy sector, our top pick is Nabors Industries (NBR NYSE). This is the world’s largest oil and gas drilling contractor, with more than 550 rigs. They operate in Alaska, Canada, and the lower 48 US states. They also operate internationally, in South and Central America, the Middle East, and Africa, which helps diversify their exposure. With higher oil prices, there should be strong demand for drilling services. This is the company that goes out and drills for oil and finds it for the big international oil companies. Their Alaskan and Canadian operations are doing particularly well, and should be one of the key drivers for earnings. They’ve been expanding their fleet of drilling rigs over the past few years, due to some very good acquisitions, giving them an even bigger presence in this market and helping to further drive revenue growth.

"In the materials sector, we like Nucor (NUE NYSE), the largest steel maker in the US. They also make the broadest range of products of any steel company in the US. Most importantly, they are also the most profitable. The reason is that they use scrap steel as opposed to the traditional integrated steel making method where you have to go out and mine for the raw material. That’s a much more expensive way of making steel products. Nucor’s process is far more cost-effective. We expect revenues to grow very sharply, due to volume from recent acquisitions, along with higher selling prices. The firm has acquired Birmingham Steel, Tricon Steel, etc. This should boost volume by some 28% this year, further driving top-line revenue. They will also see their fixed costs spread over a higher revenue base, so that their per unit costs will come down. That’s going to go directly to the bottom line and boost their earnings. They also have a very solid balance sheet, with strong cash flow generation.

"In the financial sector, our pick is City National (CYN NYSE). This is a company that operates more than 50 bank branches in 11 California counties. They are best known for their private banking franchise. They have built an enviable franchise in this business. Private banking is more of a personalized service, as opposed to dealing with different people for different parts of your financial needs. In this case, one person deals with you, and you get much more personal service. They have done quite well with this approach. One of the key elements of this bank is that they have been able to maintain good interpersonal customer relationships. People and business like the personal attention. Another reason we like this stock is that they have an improving credit risk profile. They have been charging off more of their problem loans, they have been adding to their reserves, and they have been very careful about managing their credit risk profile. Their trust business continues to grow and as their deposit base grows, they’ll see fees off that deposit base grow as well. This provides a steady flow of revenue.

"Our last favorite is in the industrial sector – Jacobs Engineering (JEC NYSE). This is an engineering, construction, and maintenance company, and they provide these services to private industry and federal government agencies. Their margins are expected to improve. They will be seeing some good synergies from some recent acquisitions, and costs reductions from eliminating duplicate operations. This will further boost profits. And they also continue to expand their geographic reach. So they are widening their markets. They also tend to have long-term, preferred contracts, which tend to reduce risk and provide a consistent earnings stream. So the nice thing here is that once they have established these contracts, they tend to be long term and provide a recurring stream of revenue. So you get a little more certainty on the earnings front. Also, bookings should pick up for clean fuels and military projects, and Jacobs is in a good position to benefit from growth in these areas."

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