by Reshma Kapadia & Russell Pearlman
For many Americans , 2010 was the year of frustration. In poll after poll, they expressed their dismay about the economy, budget deficits, even how the TV show Lost ended. But where they may have channeled their angst most was toward the U.S. stock market. True, the Dow enjoyed a nice run-up in the fall, but a look at mutual fund statistics shows Main Street wasn’t a part of this party. Indeed, Joe and Jane Investor weren’t even interested. Fed up with Wall Street flash crashes and roller-coaster volatility, investors took $77 billion more out of U.S. stock mutual funds than they put in. Even as the market marched a hefty 14 percent higher during three months late last year, investors fled the market.
For a small but growing number of savvy investors, however, uncertain times almost always offer some opportunities. And 2011 will be no different, they say. This group argues that the pessimism that has engulfed the nation has kept ordinary investors from seeing some fantastic stock bargains—most notably, large U.S. companies. “The S&P 500 is cooking right now in terms of earnings,” says John Buckingham, manager of the $110 million Al Frank fund, who has been buying large firms such as Comcast ( CMCSA ) and Coca-Cola. Certainly, history is on the side of pros who make the boldest moves in dark times. Things seemed dire for both the economy and the markets in spring 2009. But the market looked incredibly cheap, and the people who abandoned stocks then missed out on a six-month, 50-plus percent rally.
Of course, Wall Street is still a hard sell for many investors, if only because their portfolios are still nowhere near the premarket crash levels of 2007. “No return for 10 years and two big declines; I think that has people less interested in these stocks,” says George Sertl Jr., a manager of the $276 million Artisan Opportunistic Value fund. But large-company stocks, from General Electric ( GE ) to McDonald’s, are trading, on average, at a price/earnings valuation of 14.8, the lowest they’ve been since the financial crisis (and before that, since 1990), according to stock-research firm Birinyi Associates. The more well known the company, the cheaper its stock seems. “One would expect companies with age-old traits like leading market share and strong balance sheets to trade for more than the market, and they don’t,” says Douglas Cohen, head of Morgan Stanley ( MS ) Smith Barney’s Strategic Equity Portfolio Group.
The nation’s high jobless rate crimped American spending habits. But based on some economic data released in the fall, the American consumer just might be on the comeback trail. Firms targeting U.S. shoppers or the emerging consumer class abroad are catching the eye of fund managers.
With the real estate market still in the dumps, Americans may be stuck with their existing abodes for some time. The longer people stay put, the more likely it is they will spend money fixing up the place, which bodes well for home-improvement retailers, including Lowe’s ( LOW ).
The recession hasn’t been easy for most retailers, particularly those that have been tied to the housing market. But during the recession, Lowe’s tried to limit the damage. It cut back on opening new stores, opting instead to invest in existing locations, relaunch its Web site and find ways to schedule workers more efficiently. The measures seemed to have worked. While its profits faltered, Mooresville, N.C.–based Lowe’s boosted market share every quarter during the downturn. Many analysts say the company can continue to increase market share and its cash flow as the economy improves.
Still, no one is banking on a speedy recovery. In November, Chief Executive Robert Niblock said consumers were still unwilling to take on bigger discretionary home improvement projects. But fund managers like Sam Peters, comanager of the $4 billion Legg Mason Value Trust fund, says that Lowe’s, trading at 16 times expected 2011 earnings, remains a good way to play the housing recovery—even if it doesn’t happen tomorrow. “You’ve got a 2 percent dividend yield, and that starts to be enough for us,” Peters says. If earnings are growing, Niblock told investors, Lowe’s will continue to increase its dividend and possibly buy back its own stock.
While thrifty fashionistas are roaming the aisles of T.J. Maxx and Marshalls, fund managers are doing their own bargain shopping on the stock of TJX, the parent company of the two retailers. The pair have been the beneficiaries of an emerging retail trend: People still want style; they just aren’t as willing to pay full price for it as they were two years ago. “TJX is a great place for that,” says Chuck Akre, of the Akre Focus fund, which owns the stock.
The Framingham, Mass.–based retailer, which has stores spread throughout the U.S., Canada and Europe, has weathered prior downturns well—it has reported only one year of same-store sales declines in its 33-year history. During this downturn, it has increased profits and free cash flow considerably. Analysts say that type of consistency is hard to find in a retailer in the current climate. Part of the profit growth comes from TJX’s continual improvements to ensure that the right stores get the right type of merchandise at the right time.
But it’s not just about keeping costs down. Analysts see strong prospects as the company expands abroad, particularly by adding Marshalls stores in Canada. CEO Carol Meyrowitz recently told analysts TJX’s long-term plans call for 4,300 stores—up from 2,800 now—not including potential openings in new markets. The retailer’s strong balance sheet, with $1.4 billion in cash, can help fund that expansion.
While the stock has more than doubled from the lows of late 2008, fund managers still find it attractive, since it trades at just nine times expected fiscal 2012 free cash flow. And with that free cash expected to increase at more than 10 percent a year over the next five years, Akre says, “it’s remarkably cheap.”
Yum Brands ( YUM ) , the company behind such fast-food staples as KFC, Pizza Hut and Taco Bell, gets about half its profits in emerging markets, one of the few companies in the S&P 500 to do so. “For anyone interested in global growth and a play on China, Yum is a go-to name,” says Morgan Stanley’s Cohen.
Louisville, Ky.–based Yum has been in China for 20 years, and KFC is the top Western quick-service restaurant in that country. Yum’s China business is also more lucrative than its domestic operations. As a result, analysts expect Yum’s profits to improve as that business keeps growing. The firm admits KFC isn’t doing as well in the U.S., so Yum has been restructuring its domestic business, selling some company-owned restaurants to franchisees to free up cash to reinvest in areas with better growth potential, says Derek Deutsch, manager of the Legg Mason Clearbridge Capital fund, which owns Yum stock.
To be sure, a slowdown in China likely would hurt Yum’s stock price. But some managers say Yum still has room to grow. Analysts expect Yum’s profits to rise 12 percent, to $1.3 billion, in 2011. With just 3,500 outlets in China, analysts see plenty of growth ahead. There is one quick-serve restaurant for every 2,000 American city dwellers, but in China, the ratio is one for every 140,000 urbanites. “Yum is likely to be the McDonald’s of China,” Deutsch says.
They say death and taxes are the only certainties, but fast food, garbage and Law & Order reruns come pretty close. These profitable companies produce such staples of everyday life, and analysts say their stocks are reasonably priced.
It’s a worry that makes cable investors shiver: cable companies losing revenue as customers flee to satellite firms, phone companies and other upstarts that can also beam Nickelodeon, ESPN and other cable favorites into the house. But at least so far, that’s not happening. Yes, Philadelphia-based Comcast ( CMCSA ) has lost some cable customers over the past 12 months. But the remaining ones make up for the losses. The average Comcast bill for video customers is nearly $130 a month, an increase of 10 percent from a year ago, and sales are up 7 percent companywide. Despite the competition, Comcast will increase its profits over the next few years, says Tim Hartch, comanager of the $360 million BBH Core Select fund.
For its part, Comcast blames the weak economy for losing cable customers. But even in this environment, the company is a cash cow. In the first nine months of 2010, Comcast generated nearly $4.3 billion in free cash—the money left over after the firm paid all its bills and made investments in equipment—an increase of 17 percent from the same period in 2009. Comcast is trying to wrap up a $14 billion deal to take control of NBC Universal. That deal, which still needs approval from government regulators, would give Com cast control of not only the peacock network but also several profitable cable channels and the Universal Pictures film studio. Comcast’s move often gets pilloried on NBC’s sitcom 30 Rock, but many investors think the cable company got a good price. Many pros think the company can continue to generate plenty of cash, making shares a bargain at 14 times 2011 expected profits.
A weak economy might trim the amount of stuff we throw out, but it doesn’t change the fact that Americans produce a lot of trash and someone has to clean it up. Phoenix-based Republic Services ( RSG ) takes out the garbage in 42 states, operating nearly 200 landfills and 78 recycling facilities. In the areas where Republic operates, the firm effectively has “little monopolies,” says Jeff Rottinghaus, manager of the recently launched T. Rowe Price ( TROW ) Large Cap Core fund, because very few trash haulers compete head-to-head in a geographic area. That has given Republic the ability to keep its prices stable, or even raise them, in the aftermath of the Great Recession.
Republic bought one of its biggest rivals, Allied Waste Industries, in 2008 and has been paying down debt ever since—more than $1 billion over the past 18 months. The company could get a boost if the housing industry rebounds (construction sites produce a lot of garbage), but even without a bounce, analysts expect the firm to earn more than $720 million in 2011 on sales of $8.4 billion. Republic also has a respectable 2.8 percent dividend, which looks particularly good when compared with the 10-year Treasury bond yield, says Legg Mason’s Peters. The stock is also one of Warren Buffett’s favorites; the investment guru’s firm, Berkshire Hathaway ( BRK.B ) , owns more than 10 million shares of Republic, nearly 3 percent of the company.
Pepsico ( PEP ) ‘s business of selling soft drinks and snacks isn’t particularly sexy; one of its big pushes is introducing a thicker version of Quaker oatmeal. But those products keep selling regardless of economic conditions. The Purchase, N.Y.–based firm’s profits were $4.9 billion in the first nine months of 2010, up 10 percent from the same time frame a year earlier. That steady growth, combined with the stock’s cheap valuation—14 times this year’s expected earnings—makes it an attractive target of many so-called value investors.
PepsiCo, of course, isn’t content with just a thicker oatmeal. It’s expanding its business in emerging markets, particularly China, which the firm expects to be the single largest beverage market by 2015. PepsiCo also is still digesting the recent $8 billion acquisition of two of its largest bottling firms. PepsiCo CEO Indra Nooyi told analysts that the move will allow Pepsi to introduce new drinks faster.
The company also undertook another big acquisition recently: its own stock. PepsiCo bought back more than $4 billion worth of its shares in 2010. The repurchases, combined with a dividend hike, have helped push PepsiCo’s dividend yield to nearly 3 percent. Owning PepsiCo shares is a “blue-chip anchor” in a portfolio, says Channing Smith, director of equity strategies at asset management firm Capital Advisors.
Hefty cash piles? Check. Growing overseas businesses? Check. Fund managers say large technology firms have many of the traits investors want right now—and best of all, some bargain stock prices. The sector trades for half as much as it did 15 years ago.
Some fund managers say San Jose, Calif.–based Cisco ( CSCO) is smack in the middle of some of the biggest trends in technology. Increasing Internet usage in emerging markets and booming sales of gadgets such as the iPad translate into more demand for Cisco’s equipment. Companies’ shift toward “cloud” (or Internet-based) computing and their increasing adoption of smart grids in the future should boost demand for Cisco’s network connections, putting the company “in the middle of this network tsunami,” says Smith, of Capital Advisors.
That said, the company faces near-term challenges after key government customers curtailed spending more than expected in the fall. That raised questions among some investors about whether Cisco was losing market share in parts of its business or, even worse, seeing signs of another economic slowdown. While Chief Executive John Chambers says that Cisco’s growth over the next several quarters will not be as fast as he would like, he calls the weakness an “air pocket” and says Cisco’s positioning for the major transitions under way in the industry hasn’t changed. Although the near term could be bumpy, Smith says Cisco’s long-term opportunities are underappreciated by investors. For a company trading at 11 times 2011 earnings, with $40 billion in cash, that is contemplating a dividend, “investors are getting a great buying opportunity,” Smith says.
Even must-have technology stocks sometimes falter. For several months in 2010, Google ( GOOG ) shares languished as investors wondered whether the Internet giant was about to hit a wall, in terms of growth. Well, never mind. Google recently said its emerging mobile business is on track to generate more than $1 billion in annual revenue and that its display-advertising business of video and images should contribute $2.5 billion.
The Mountain View, Calif., company’s core search business also keeps plowing ahead. Analysts expect that business to grow, in part because only 14 percent of global ad spending is online, according to advertising-research firm ZenithOptimedia, even though people spend an increasing amount of time online. Some groan that Google spends money on unusual projects, such as developing driverless cars, but a firm spokesperson says some of the previous projects have paid off. The company is expected to increase profits 17 percent this year. The valuation—18 times expected 2011 earnings, after excluding the $104 a share the firm has in cash—makes some analysts downright giddy. “I love Google,” says T. Rowe’s Rottinghaus.
Oracle ( ORCL: 31.84*, +1.57, +5.18% ) is known for its dealmaking, and no wonder. The software company has made more than 60 acquisitions since 2005, including last year’s $7 billion purchase of Sun Microsystems. With close to half its sales coming from the lucrative, and steady, maintenance-software business, Oracle’s profit margins are already higher than those of many of its peers, says Andrew Miedler, senior technology analyst at Edward Jones. Bringing in ex-Hewlett-Packard CEO Mark Hurd, Miedler says, is a “significant” positive as Oracle pushes into the computer-hardware business.
Oracle’s shares have a lower valuation than some rivals’ because some investors fear it could trip up with one of its acquisitions. But analysts say Oracle is still well positioned, due to the fact that its products make customers more efficient. Redwood Shores, Calif.–based Oracle might use some of its $12 billion in cash to boost its small dividend, says Don Kilbride, manager of the $4.1 billion Vanguard Dividend Growth fund. Oracle declined to comment.
Many economists pin the slump on the newfound thriftiness of consumers. But companies are flush with cash and are beginning to help the industrial economy—along with the profits of manufacturers—rev back up. “It’s almost like they are living on another planet,” says one strategist.
Tracing its roots to the aerospace industry of the early 1900s, United Technologies ( UTX ) now makes everything from heating and air-conditioning units—hot products in emerging markets—to the jet engines and spare parts facilitating global trade. While some businesses, like fire safety and security, are going strong, others, such as commercial construction products, are still stuck in a slump. But the Hartford, Conn., firm’s diversity is a source of comfort for investors seeking a way to play a global recovery. “Their business mix shelters them better than most,” says Lewis Piantedosi, lead manager of Eaton Vance ( EV ) ‘s large-cap growth team.
United Technologies, which routinely gets high marks for its focus on controlling costs, restructured during the downturn to boost profitability and cash while continuing to invest in its business. “It continues to grow, and grow in the right way, by keeping its balance sheet strong and consistently buying back stock,” says Scott Lawson, a portfolio manager at Westwood Holdings Group ( WHG ). Analysts say the company’s habit of consistent buybacks differentiates United Technologies from other companies that repurchase shares sporadically—and risk doing it at the wrong time.
That said, not everything about the company’s business is consistent. One downside of getting 60 percent of sales abroad is vulnerability to currency fluctuations. A slowdown in China’s building boom or a double-dip in the global economic recovery would hurt the company’s prospects. Chief Financial Officer Greg Hayes tells SmartMoney that some of the currency impact is muted because 40 percent of the firm’s sales are derived locally. And while real estate prices in China might decline, he doesn’t expect much of a slowdown in the company’s Chinese businesses. “We still see growth,” he says, noting that China is building 5 million low-end housing units and needs many more as the country continues to urbanize.
In just the past several months, 3M ( MMM ) , perhaps best known for Scotch tape and Post-it notes, has snapped up a biometric security firm that can read fingerprints, a company that makes temperature-adjusted hospital gowns and a China-based maker of tape. While these are very different businesses, the company says the deals fit into its portfolio of about 50,000 products across a slew of industries.
The St. Paul, Minn.–based global manufacturer has refocused on innovation, boosting its research and development budget by 6 percent in 2010, as it tries to generate 40 percent of sales from products launched in the past five years. Peter Nielsen, manager of the Sextant Core fund, thinks the shares could rise at least another 20 percent. “Even if growth in the U.S. is anemic, this is a way to invest in a firm that has fairly strong growth potential,” he says.
To achieve some of that growth, executives tell analysts, 3M will continue to tap its strong balance sheet for acquisitions and investments, to push into areas like software and electronics. Executives say 3M also might boost its stock buybacks, even as it continues to pay a dividend it has consistently increased since the 1950s. “It’s not a sexy story, nor a shoot-the-lights-out type of stock, but a nice steady anchor to a portfolio,” says Eaton Vance’s Piantedosi.
United Parcel Service
With about 6 percent of the country’s gross domestic product delivered by United Parcel Service ( UPS ) , the Atlanta-based company is often seen as a proxy for the U.S. economy. But it looks like the folks with the dark brown trucks are a step ahead: While the economy has been sluggish, all the shipping company’s divisions, encompassing areas such as international package delivery and logistical operations, are on track to post profit increases of more than 50 percent from year-ago lows.
The snapback in global trade is one reason for the gains. But UPS has also restructured its U.S. business and invested in its hubs to make them more autonomous, lowering labor and other costs. Those investments should pay off even further as the economic recovery boosts volume, says Kevin Sterling, BB&T Capital Markets transportation analyst. On average, analysts expect profits to increase 18 percent, to $4.1 billion in 2011. Some analysts expect the company to put its $4 billion in cash toward acquisitions to gain more market share abroad, boost its share buyback and even increase the dividend it has paid since 1955. Chief Financial Officer Kurt Kuehn tells SmartMoney that the most likely type of acquisition would push UPS further into new areas like developing markets or into industries where it could use more expertise.
To be sure, any slowdown in the global economy or protectionist moves made by the U.S. or other countries could hurt business, and UPS’s stock has already risen 20 percent since the summer. But at 16 times expected 2011 earnings, it still trades below its long-term average.