BARRON'S: Time To Stock Up: Forget The Gloom -- Equities Haven't Been This Attractive...

By Andrew Bary

After two years of gut-wrenching declines, the stock market continues to be

battered daily by bad news about corporate malfeasance, the quality of corporate

accounting, executive options and what Federal Reserve Chairman Alan Greenspan

last week called the "infectious greed" that pervaded Corporate America in the

late 1990s.

But amid the blaring headlines, finger-wagging editorials and the cacophony of

televised blather, a crucial truth for investors may be obscured: Stocks haven't

been this attractive since the mid-1990s, before the bubble inflated. Sober

investors fortunate enough to be sitting on cash now have the opportunity to

invest in stocks at valuations that look pretty reasonable by historical

standards, especially given the low level of interest rates.

The benchmark Standard & Poor's 500 index, at 848, is down 26% this year and

stands 44% below its 2000 peak of 1527, marking the worst bear market since the

infamous decline of 1973-1974, when the index dropped 48%. As the headlines have

been screaming, the S&P and the Nasdaq are back where they stood in 1997.

The Nasdaq, at 1319, is off 32% this year and down 74% from its March 2000

high of 5048. The Dow Jones Industrial Average, at 8,019, has fared better than

the S&P and Nasdaq -- down 20% in 2002 and 32% below its high of 11,723.

The silver lining to these dreadful losses is that valuations also have

descended from the stratosphere. The Dow now trades for 16 times projected 2002

profits (see the table on page 18 for earnings estimates for all 30 Dow stocks).

The S&P, meanwhile, commands 17 times projected 2002 profits of $51 and trades

for about 18 times trailing 12-month earnings and 15 times estimated forward

earnings for 12 months to July 2003. As the table shows, the S&P's

price/earnings ratio is back where it stood at the end of 1995 and is comparable

to early 1990s levels.

There are justifiable concern about the earnings outlook, however. Just last

week, stalwarts such as Microsoft, Eli Lilly, PepsiCo, and Automatic Data

Processing came under pressure due to disappointing earnings, outlooks or

revenues. This raises doubts about the sharp profit gains expected in the second

half and in 2003. But at current valuations, many stocks no longer are

anticipating big earnings increases.

The S&P may have been cheaper at the end of 1994, when it traded for just 12

times forward earnings, but bond yields were much higher, with the Treasury

10-year note then at almost 8% -- way above today's 4.60% yield. (High interest

rates tend to depress equity valuations by making bonds more competitive.) At

the end of 1999, just three months before its peak, the S&P traded for 1469,

nearly 30 times trailing profits.

"I'm not certain that we've seen the absolute bottom, but we're in a bottoming

process," says Tom McManus, Banc of America Securities' chief equity strategist.

"People should be looking for bargains in the market."

Such bullish pronouncements by professionals are falling on deaf ears lately

as a disgusted investing public recoils from stocks after embracing them at

egregious valuations in 2000. Stocks now are viewed as dangerous, but the

reality, as McManus points out, is that "a lot of the risk has been taken out,

given the decline in stock prices."

Barton Biggs, the longtime bearish strategist at Morgan Stanley, recently

turned bullish. "In the long run, there is no investment medium like equities.

Never has been; never will be. No other asset class offers a comparable

combination of growth and liquidity," he wrote in a recent client note.

Biggs added that just as the ills of past stock-market eras were cured,

there's every reason to believe today's excesses will be corrected. Indeed, the

current problems involving accounting, options and other issues already are

being addressed, and appear less serious than those of the past, such as the

stagflation of the 1970s or the super-high interest rates of the early 1980s.

The buzz now is about the allure of high-grade bonds, but that may reflect a

rear-view approach to investing. Sure, once-disparaged bonds have done well in

the past two years, but low yields make it nearly impossible mathematically for

investors to generate high future returns.

Various models that seek to gauge the relative appeal of stocks and bonds now

are tilting heavily toward stocks. The so-called Fed model, originally cited by

Greenspan five years ago and the basis for a bullish Barron's cover story last

year ("Buyer's Market," Sept. 24, 2001), now suggests that the S&P 500 is 30%

undervalued. This simple model, which compares the yield on the 10-year Treasury

with the so-called earnings yield on the S&P 500, suggests fair value for the

S&P 500 of about 1200. Earnings yield is the inverse of the S&P P/E ratio based

on forward 12-month profits.

A more sophisticated model, long maintained by Morgan Stanley strategist Byron

Wien, is screaming "buy" because it suggests the S&P is 35% undervalued, its

most bullish reading since the early 1980s. Wien's model factors in Treasury

yields, forward S&P earnings, a 2% risk premium for stocks and a profit growth

outlook of nearly 10% annually. Some argue that Wien's earnings growth forecast

is too optimistic, given the historical 7% annual gain in corporate profits.

Assume 7% growth and his model shows the S&P is still 15% undervalued.

Talk to institutional investors and they sense opportunity, although many

bought prematurely in the past weeks. "There are good-quality companies that are

selling at prices and valuations that we haven't seen in five years. The overall

economy is improving. That's a good equation," says Michael Jamison, principal

at Jamison Prince, a New York investment manager.

Jamison points to blue-chip stocks such as General Electric, Bank of America,

Automatic Data Processing and American International Group. GE, at 27, clearly

faces challenges given the looming profit decline in its critical turbine

operations and questions about its opaque financial-services arm, GE Capital.

But GE is off more than 50% from its 2000 peak and now trades for 16 times

projected 2002 profit of $1.65 a share and yields 2.6%.

Insurance giant AIG, down 28% this year to 57, has come under pressure with

the rest of the insurance sector lately. It now trades for 16 times estimated

2002 profit of $3.50 a share. AIG still commands a premium to other big

financial stocks, but its P/E is down from late 2000, when it peaked at 40. AIG

also has generated 13% annual profit growth in recent years, and its formidable

chairman, 77-year-old Maurice "Hank" Greenberg, is optimistic owing to higher

prices in the property and insurance market and opportunities in the company's

jewel, its Asian life-insurance operations.

ADP got rocked last week, falling 10 points to 32, as the payroll-processing

company warned Wall Street that its amazing 41-year record of double-digit

annual profit gains would come to an end in the current fiscal year ending next

June. It now fetches 17 times projected fiscal 2003 profit.

"This is a time when investors can trade up in quality without paying through

the nose," says Steve Galbraith, strategist at Morgan Stanley, who recently took

a favorable look at the 10 companies in the S&P 500 with triple-A bond ratings,

including GE, AIG, ADP, ExxonMobil, Merck, Johnson & Johnson and Pfizer.

The accompanying table shows the valuation of the top 20 stocks in the S&P 500

index. Many of these stocks aren't cheap, but most do trade for less than 20

times estimated 2002 profits. Technology remains the priciest sector even after

its monumental decline, with industry leader Microsoft trading around 50, or 25

times projected 2003 calendar profit. Even Cisco Systems, down more than 80%

from its bubble peak, at 14, still trades at 30 times projected 2002 earnings.

Some investors have been nibbling at the beaten-down drug group, where nearly

all major stocks trade for less than 20 times estimated 2002 profits. Merck, at

42, fetches 13 times projected 2002 profit and yields 3.3%. To be sure, Barron's

has been bullish on Merck and other blue chips at higher levels ("Searching for

Good Value," Oct. 1, 2001).

 Industry leader Pfizer, at 27, trades for 17 times estimated 2002 earnings, or

where it was in 1998 despite profit having doubled. Pfizer may have overpaid in

agreeing to buy Pharmacia last week for $50 billion, or almost 30 times

projected 2002 profit. But Pfizer assured Wall Street that the deal wouldn't

reduce its projected mid-teens annual profit growth because of heavy cost

cutting. A cheap way to play Pfizer is through Pharmacia, which, at 38, is $3

below the value of the deal. The risk with Pharmacia is that the deal falls

apart, but the Street puts a high likelihood on a successful completion of the

merger.

Elsewhere, depressed supermarket stocks may face a growing threat from

steamroller Wal-Mart Stores, but their valuations may adequately compensate

investors for that risk. Safeway, at 28, and Kroger, at 19, trade for about 11

times forecast 2002 profits.

One of the best-run consumer franchises, PepsiCo, is down 30% in the past

month to 36 on fears about a slowdown in its powerhouse snack-food business and

a rotation by investors out of defensive stocks. There are concerns that the

company may have to reduce its revenue-growth target of 6% to 7% after it last

week reported revenue growth of just 3% in the second quarter. Earnings, up 14%

to 52 cents a share, matched expectations. Pepsi trades for 18 times estimated

2002 profit, an appreciable discount to Coca-Cola, which at 45, fetches 25 times

projected 2002 earnings. Pepsi, however, has executed far better than Coke in

recent years.

Fannie Mae and Freddie Mac continue to post strong profit gains yet get little

respect from investors. Fannie Mae, at 69, and Freddie Mac, at 56, trade for

just 11 times 2002 earnings amid amorphous concerns about derivatives dangers

and political risk.

The entire financial sector of the S&P 500 now trades at just 12 times forward

12-month earnings. The world's largest financial company, Citigroup, last week

reported a 13% rise in second-quarter profit in a tough environment. Its stock

is down to 36 from a peak of 59 -- a P/E of 11 times estimated 2002 profits and

10 times estimated 2003 earnings.

Philip Morris is down to 42 from 57 in the past six weeks and now trades for

less than nine times estimated 2002 profit of almost $5 a share. Philip Morris

has been hurt by renewed legal concerns and weak second-quarter domestic

cigarette shipments, but the company is expected to generate 9% profit growth

this year and it remains a financial powerhouse. Big MO, as it's called for its

ticker symbol, is expected to increase its dividend by about 10% next month to

$2.56 a share, providing a 6% yield, and also plans to buy back $6 billion of

stock this year, a hefty chunk of the company's current $91 billion market

value. The effective value of the tobacco operations is very low because the

company's 84% interest in Kraft Foods is worth $25 per Philip Morris share.

Also roiling valuations was S&P's controversial July 9 decision to boot seven

foreign companies from the S&P 500, effective last Friday, in favor of U.S.

companies, including Goldman Sachs and Prudential Financial. The most notable

departures were Royal Dutch Petroleum, the Dutch side of the huge Royal

Dutch/Shell Group, and Unilever, the Anglo-Dutch consumer products giant. Royal

Dutch has tanked on the news, falling 10 points to 46, amid heavy selling by S&P

index funds.

"This is an opportunity to buy Royal Dutch, because being removed from the S&P

isn't a fundamental event," says Fred Leuffer, an oil analyst at Bear Stearns.He

notes that Royal Dutch now trades for 15 times projected 2003 profit of $2.75 a

share; ExxonMobil, its closest rival, commands 18 times 2003 earnings.

Financially solid Royal Dutch pays a dividend yield of 3.5% and is likely to

increase its semiannual payout again in September, continuing a long trend of

dividend hikes. Royal Dutch was hurt by concerns last week about power-trading

activities and $7 billion of outstanding contracts, but Leuffer doubts there are

huge losses lurking there. His price target for Royal Dutch is 65, and he sees

downside support for the stock at 40.

Unilever also could be a bargain, having fallen 12 points to 53 following the

S&P news. It trades at a modest 15 times projected 2002 profit, a discount to

Kraft Foods, which commands 18 times estimated earnings. Unilever pays a 2.6%

dividend.

Another intriguing sector is retailing, which has been rocked lately amid

concerns that consumer spending is set to slow. Those concerns deepened after

Whirlpool and Maytag issued cautious second-half outlooks. While Wal-Mart fell

five points to 47 last week, it isn't cheap at 25 times projected 2002 profit,

though it remains an industry juggernaut. Cheaper stocks include the

well-managed Target; at 32 (down from an early-year high of 46), it trades at

less than 20 times projected 2002 profit. Federated Department Stores, at 33,

fetches around 10 times estimated 2002 profit.

Looking back to 1960, Morgan Stanley's Galbraith found that corporate profit

growth has exactly matched the annual gains in the S&P 500 of 6.8%. This

translates into a doubling of the S&P's price about every 10 years. The annual

total returns on the S&P have been above 10% since 1960 because dividends

started at more than 3%. If corporate profits rise 7% annually for the rest of

this decade, S&P annual returns should average about 9%, based on the current 2%

dividend yield and assuming no change in P/E multiples. At that rate, however,

the S&P won't get back to its 2000 peak until 2010.

While P/E ratios have come down, earnings finally appear to be moving up.

Earnings growth turned positive in the second quarter for the first time since

the fourth quarter of 2000. After the avalanche of June quarter earnings reports

last week, S&P operating profits are on track for a 2% gain in the period,

according to Thomson Financial/First Call. Year-on-year earnings growth is

expected to accelerate to 15% in the third quarter and 27% in the fourth

quarter. Chuck Hill, director of research at First Call, says the third and

fourth-quarter projections probably are "too high," although Banc of America

Securities' McManus says less robust second-half growth already is being

anticipated in the market.

The 14% forecast growth in 2002 S&P operating profits, to an estimated $51.45,

is inflated by the end of goodwill amortization this year; excluding that

benefit, profits are expected to be up around 7%. Next year, S&P earnings are

seen rising nearly 20% -- perhaps overly optimistic but probably more than stock

prices are discounting.

The growing movement to expense stock options, led by such companies as

Coca-Cola, Bank One and Household International, also threatens to damp reported

profits. The Senate recently turned aside a proposal to require such expensing

amid pressure from technology companies, the biggest options issuers. But the

pressure is building on companies to follow Coke's lead and adopt the practice

anyway.

Lehman Brothers strategist Jeff Applegate has estimated that option expensing

would reduce estimated S&P 500 profits to about $44 this year from $51. If

option expensing becomes widespread, one of the main issues is whether investors

will value companies based on that noncash expense, or strip it out. Applegate

thinks a case can be made for the latter, but that remains to be seen.

Assessing the market scene, Morgan Stanley's Biggs recently said, "Many former

cheerleaders for the New Era suddenly have become raucous doomsayers for both

the economy and equities. Beating their breasts, they are predicting that deeply

disillusioned publics in Europe and America will forsake equities for a decade."

When such gloom is thickest, it may be time to be taking risks in stocks.

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