DOES ANYONE REMEMBER WHAT A MARKET RALLY FEELS LIKE? The first half of 2003 certainly felt like one: stocks on the Dow Jones industrial average up some 13% and Nasdaq issues climbing a hearty 30% as of mid-August. We haven’t seen such a steady rise in the financial markets in almost three years. With uncertainty hanging in the air from a tepid economy, international upheaval, and ongoing terrorist threats, how can we be sure if the markets are ready to rebound or whether investors will be hurt by a severe market relapse?
We assembled four high-powered money managers to try to answer that question by evaluating the current economic picture and telling us what we can expect in the fourth quarter of 2003 and beyond. Members of our roundtable are Mary Pugh, CEO of Pugh Capital Management (No. 15 on the BE ASSET MANAGERS list with $609 million under management), a Seattle-based firm specializing in fixed-income portfolio management; Isaac Green, president and chief investment officer of Piedmont Investment Advisors, a Durham, North Carolina-based firm focusing on core investing—a portfolio-building strategy identifying quality stocks from each segment of the market; Randall Eley, president of The Edgar Lomax Co. (No. 9 on the BE ASSET MANAGERS list with $1.48 billion under management), a Springfield, Virginia-based mutual fund company that embraces value investing; and Raymond Stewart, president and chief investment officer of Rasara Strategies, a Briarcliff Manor, New York-based money management firm that focuses on value investing within the banking sector.
BLACK ENTERPRISE: Give us your assessment of the economy and market forecast for the second half of 2003 and into 2004.
RAYMOND STEWART: I’d characterize the economy as lethargic, at best. You’ve got unemployment at 6.4% versus 5.8%. You’ve got rising budget deficits. Even if the nation’s policy makers are successful, I do not see more than a 5% to 10% increase in year-end stock prices. Next year, I’d expect perhaps another 5% to 10% gain. I would really have to see a strong pick up in corporate earnings for me to become a little more sanguine about the outlook for the stock market.
MARY PUGH: Our outlook says we are going to see a W type of recovery, which means we’ll have some growth and then we’ll have a slow down in that growth. We won’t go back into a recession, but we will not experience substantial growth either. Our forecast for 2004 would be about 3% GDP [gross domestic product] growth, with interest rates of about 3.75% to 4.5% for the 10-year treasury [bonds].
ISAAC GREEN: Our outlook on the markets for the second half of this year and into next year is…that there is a lot of room for things to get better.
I think it’s possible that the market may correct in the third quarter of this year, based on spiking interest rates; but we don’t think the spiking rates are sustainable or merited. We think stocks are slightly undervalued right now, based on depressed earnings, and that there is meaningful room for the earnings of corporate America to appreciate, from their cyclical lows. So, if you consider that earnings can recover very strongly over the next few years, you could expect the market to start rallying over the second half of this year [and] first half of next year as it becomes clear that the economy is recovering. Then that rally can be sustained by the fact that as profits go up, optimism will go up.
B.E.: How much of a factor will psychology play in any recovery in the near future?
GREEN: In the short term, the stock market is nothing but psychology. It reflects the balance between greed and fear [and] optimism and pessimism. Psychology determines what the discount rate of the market is [or] how much of a risk premium do investors have to earn relative to risk-free investments in order to have an incentive to go into stocks. The more optimistic folks are, the less of a premium they require and, therefore, the higher valuation they are willing to pay for the market.
PUGH: Psychology works a little differently from the corporate bond standpoint, with respect to the equity side. If you step back to last year, psychology was a tremendous driver of the market and there were a couple of really significant events. We had Enron followed by Worldcom, Qwest, and Global Crossing. All these major corporations with accounting fraud issues really challenged investors in terms of whether or not they could believe their financial statements. That was significant.
Another major event last year was the July sign-off period in which CFOs and CEOs had to sign on the dotted line, [verifying] their financial statements. That actually was a point when both the equity market and the corporate bond market rallied for a short period because people were saying, “Okay, I can start to believe a little bit more.”
Also, the leadership of major corporations got the message that they really needed to focus on paying down debt, and that is a trend that started to gain traction. All of those things came together, initially because of the problems, to create a horrible market. But then, as a result of the realization that a lot of it was being dealt with—not necessarily overnight, but over time—we started to see the psychology change. From October to November of last year everything crystallized to its worst point and then started to rebound, both in the equity market and in the bond markets.
ELEY: However long this current stock market rally goes, whatever economic growth we see over the next year or two, it is not likely to be nearly as strong as in past recoveries because you are not going to get increased capital spending or substantially increased employment.
I expect this year and next year [for] the market to perform in a milder manner than we saw in 2001 and 2002. However, I think that’s because of the political machinations that are going on—the lowering of interest rates and fiscal spending—but somewhere the federal government will stop doing that and then we’ll all have to pay the piper … maybe into 2004, maybe 2005 before the old bear market resumes.
B.E.: Given the likelihood of a return of a bear market, what should investors do?
GREEN: I think investors have to make long-term decisions about what parts of the market they are going to have their money invested in, what their personal asset allocation is, based upon their individual return objectives and risk tolerances. With those determinations made, investors are well served to stick to that asset allocation and only make minor adjustments in response to any wild gyrations of the stock market in the short term. If you are going to be active about it at all, be active in a contrarian fashion.
ELEY: My suggestion, which is a relatively safe strategy that can get you some of the higher returns through stocks over time, is to hold something in the area of a 40% to 45% position in stocks, but make sure they are stocks you believe are relatively low risk, with the remainder being in fixed-income [vehicles].
STEWART: With the caveat that I’m a specialist, just looking at the banking sector, I think diversification among different asset classes is the key, say about 40% to 50% domestic equity. Then you’ve got other asset classes that you might want to consider, such as real estate or real estate investment trusts. You might want to also look at non-U.S. equity investments, and if you think inflation is coming back, diversify into gold and precious metals.
PUGH: As we talk about asset allocation, we have to think about earning lower than average returns and what that means for you in terms of being able to meet your needs. That would influence your asset allocation process. If you have a higher need for higher returns, you’re going to do a different type of diversification than you would if you were more comfortable that that 5% to 7% type of returns were going to meet your needs over the longer term.
Just one other thing: I think
the type of environment that we are in, and will be in, is most suited to active managers, whether they are on the fixed [income] side or the equity side. I think that there is the ability to differentiate and incrementally add returns through that active process.
B.E.: Is there anything else investors can do to increase their returns?
STEWART: I tend to look for companies that have fairly strong cash flows and fairly good dividend payouts. I look toward things that I had a degree of familiarity with and things that I tend to utilize quite a bit. I am sure an investor can look to the [utility] company where he is paying the bill and if it’s publicly traded, I’m sure he’ll see a 3%, 4%, or 5% yield. Compare that to say keeping your money in a money market fund [yielding 1%].
GREEN: I have heard people talking about making back the losses, rebuilding their portfolio. You can’t go back and recover that [money]. The best thing you can do is just forget what happened in the past, look at what you have right now, and be very prudent and very judicious in how you handle it.
We are responsible for the stewardship of our own investments and good stewardship doesn’t mean being overly focused on risk and, therefore, not taking any risk and not getting any return. It also doesn’t mean being overly focused on return and taking too much risk. It means striking a balance between risk and return, and that is best accomplished through diversification.
PUGH: On the fixed income side, an intermediate maturity approach would generally be appropriate. If they are talking about a 10-year horizon, that would be fine if they are buying bonds outright because they can hold them to maturity. Depending on their tax bracket, taxable municipal bonds are a good place to look because they are trading relatively close to the yield of the treasury. I also like mortgage-backed securities. They have very high credit quality. They tend to yield a lot more than treasuries or agencies, so you’re picking up incrementally, typically 1% to 1.5%.
B.E.: What are some of the other promising sectors for investors?
PUGH: The sectors we like [within fixed income] in terms of fundamentals, positive improving fundamentals and best relative spread value, would be the cable sector. It’s a business that generates a lot of recurring cash flow from cable subscribers. They are seeing significant interest with respect to their digital cable and cable modems, as a growth area. We’re also seeing significant debt reduction with those companies that are improving their credit profile.
One sector that has kind of hairy fundamentals but really provides the best relative value and the widest spreads is the auto sector. The auto industry faces a number of challenges, and they include tremendous excess capacity, under-funded pensions, and high fixed costs. However, we believe that you are compensated for that with respect to risk reward.
BE: What do you consider to be the best sectors on the equity side?
STEWART: When you look at the banking industry’s relative contribution to broader market segments, you’ve got a group that over the past 25 some odd years has had a compound average annual earnings growth of around 10%. Couple that with a dividend return of somewhere between 2.5% and 3.5%, you’re talking about [growth of] anywhere from 10% to maybe 14%. Yet and still, if you look at the degree of investor participation within that sector, it is, for the most part, low. It’s not a high-tech industry. It’s a basic, boring, stable industry.
ELEY: The industry sectors we are finding the most values in right now are utilities, industrials, and materials. [These sectors] have a higher than normal dividend yield with utilities yielding right now about 3.1% [compared] to the roughly 1.7% yield of the S&P 500.
That provides for great safety in a slow-growth environment that may include another recession in the next two or three years. The industrials are just straightforward valuation. You’re talking about very low P/E (price-to-earnings) ratios.GREEN: We’re looking for, we like, the sectors that are going to benefit from improvement in the economy. We are tending to start to take our profits from the more defensive sectors. We like, in particular, the health care sector where we think the pace of innovation is heating up and the pace of demand is clearly going up. Within that [industry], we like pharmaceuticals and biotech. In spite of the large run up it has had, we continue to like the technology sector. We think that is one of the key growth engines of the U.S. economy. We think the capital spending cycle is approaching a turning point that will restore true fundamental health to the sector. Finally, the consumer discretionary sector has a broad array of stuff, from big-ticket items like autos to media [and] telecommunications. We think that media, telecommunications, and some of the specialty retailing are going to do well in a recovery and represent an attractive investing opportunity.
B.E.: What about the changing tax laws? Is there anything positive that investors can look for?
ELEY: A part of the tax changes was an increase in the amount of funds that could be [placed] into tax-deferred or pension-type plans like 401(k)s. I’m a real believer in putting the maximum [contribution] into those accounts.
PUGH: I want to piggyback on that. If you didn’t do anything else, if the company has a match, an individual can double their investment. Whether your investment strategy is to be 100% in bonds, 100% stocks or whatever the split, you automatically double your savings. What better opportunity is there out there? That is something everybody should do if they are not already doing it.
B.E.: How has the housing boom affected the market and do you think that it’s a bubble that is going to burst soon?
ELEY: The fact is the housing boom has to come to an end. Whether or not it will burst or whether the air will be let out slowly, one way or another it’s going to happen. Now, it doesn’t mean that housing prices have to fall, but housing prices can stall for quite a few years. That is something that has happened before.
STEWART: I don’t think that it’s clear whether or not we are going to see a bubble. I think that we cannot or should not expect to see a continued upward valuation in housing prices from current levels. Whether or not they are going to fall precipitously, I can’t really say. But definitely, I do not think that they are going to go much higher over the next six or seven years.
GREEN: Given how much housing prices have gone up, it’s really imprudent now to look at your housing as an investment or to treat it as an investing activity. It’s [now] a financial activity. You should really make your decisions and frame your thinking about housing around how much risk you can take with your housing. Can you extend yourself for a high-priced house because you think it’s going to go up a lot and make a lot of money? Well, if you’re wrong and the economy is bad and you’ve got a high mortgage payment and you can’t make it, you’re in a lot of trouble, especially if that house is not worth what you paid for it. I think it’s very important that investors or individuals look at their housing as one of the basic staples of life and treat housing as much as a staple [of life] and expense as they do as an investment. Think of it as one of the areas for lowering their risk
RANDALL ELEY, The Edgar Lomax Co.
| Stock (Exchange: Ticker) |
Price at |
12-Month |
| Exxon Mobil Corp. (NYSE: XOM) |
$36.68 |
$43.00 |
| Merck & Co. Inc. (NYSE: MRK) |
53.72 |
62.00 |
| Eastman Kodak Co. (NYSE: EK) |
28.16 |
33.00 |
| *AS OF AUGUST 19, 2003 SOURCE: ZACKS.COM; RANDALL ELEY | ||
Exxon Mobil: “When you look at the balance sheet … [and] income statements for the last 10
years, Exxon is a powerhouse. It’s an earnings machine. Their credit rating is much better than most companies. There would have to be a series of the most improbable events [for] Exxon to not be making money and a sufficient return on its investment over the next 10 years.”Merck: “Here is a company in the healthcare sector where stocks have been generally priced at higher P/E ratios, lower yields and yet Merck is carrying a [dividend] yield of 2.3%. I think that can go up in light of the preference in the most recent tax law being given to dividend returns.”
Eastman Kodak: “We’re not looking for extraordinary growth in the future. It’s just that the stock is so depressed because earnings have been going down. [If] earnings stabilize, you would have a big pop in the price of the stock.”
ISAAC GREEN, Piedmont Investment Advisors
| Stock (Exchange: Ticker) |
Price at |
12-Month |
| Exxon Mobil Corp. (NYSE: XOM) |
$36.68 |
$42.00 |
| Applied Materials, Inc. (Nasdaq: AMAT) |
20.08 |
25.00 |
| AOL Time Warner Inc. (NYSE: AOL) |
16.00 |
25.00 |
| *AS OF AUGUST 19, 2003. SOURCE: ZACKS.COM; ISAAC GREEN | ||
Exxon Mobil: “We think that Exxon Mobil is very high quality, very stable [and] very rich in cash. If oil prices spike and that derails the economy, Exxon Mobil is also a very strong financial company that would weather that storm very well and outperform the market.”
Applied Materials: “It’s the dominant manufacturer of semiconductor equipment. They produce the equipment that other companies use to manufacture chips. This is a blue-chip name within the technology sector that makes a backbone product and, as confidence in technology builds, we think Applied Materials will participate quite nicely.”
AOL Time Warner: “We think that AOL Time Warner is a company that has great franchises, both on the media and entertainment side, and substantial participation in the Internet business. The current price of the company fairly captures the value of the media and entertainment assets.”
MARY PUGH, Pugh Capital Management
| Bond | Coupon | Maturity |
| Ginnie Mae | 5.5% | 2033 |
| Comcast | 8.38 | 2013 |
| Ford | 7.25 | 2011 |
| SOURCE: MARY PUGH | ||
Ginnie Mae: “Basically, the mortgages represent a very high-quality sector of all the securities. [I chose] Ginnie Mae mortgaged-backed [securities] for both the attractive yields that they have provided, and also the government guarantee and the monthly cash flow.”
Comcast: “The cable sector is one that we see as having improving credit fundamentals. We’re picking Comcast because they have an incredible franchise in their cable assets, a strong management team, [and] improving credit.”
Ford: “Ford is challenged by a non-competitive cost structure, declining market share, and it operates within an industry that has global excess capacity so it’s not necessarily a beautiful picture. Having said those negative things, we actually think that you are well compensated for those risks. It is an investment grade credit.”
RAYMOND STEWART, Rasara Strategies
| Stock (Exchange: Ticker) |
Price at |
12-Month |
| Popular Co. Inc. (Nasdaq: BPOP) |
$37.10 |
$46.00 |
| Sovereign Bancorp Inc. (NYSE: SOV) |
18.23 |
21.00 |
| Marshall & Ilsley Corp. (NYSE: MI) |
31.07 |
36.00 |
| *AUGUST 19, 2003 SOURCE: ZACKS.COM; RAYMOND STEWART | ||
Popular Co.: “My first pick is formerly known as Banco Popular. It’s a $36 billion banking company serving the United States, Puerto Rico, and parts of the Caribbean. Earnings have tended to grow at this company around 14% per annum over the past five years.”
Sovereign Bancorp: “[It has] 19 operations in Pennsylvania, New Jersey, and various parts of New England. It doesn’t pay much of a dividend [but] it has been growing earnings at around 12% per annum over the past several years. It could also end up as a merger or consolidation target.”
Marshall & Ilsley: “[It is] a diversified financial services company with operations in commercial banking, trust and investment management, and data processing. I’m looking for the stock to trade in the $36 target range in the next six to 12 months.”
October 2002 B.E. Stock Update
Last October’s roundtable participants demonstrated that they can pick stocks with the best of them. Our stock pickers — Clark Grain of Zenith Investment Club, Marcus Plump of Millionaires-Thru-Christ Investment Club, Okorie Ramsey of Awareness to Action Investments, Bernadette Johnson of Black Women Investment Corp., and Baunita Greer of the NAIC New York Chapter — were all representatives of leading investment clubs. The leader of the pack was Johnson with picks that produced a whopping 36.78%. Grain, on the other hand, trailed his peers with an abysmal portfolio return of -9.13%.
| Zenith Investment Club | ||||
| Company (Exchange: Ticker) | Recent Price* | Price at Recommendation†|
Total Return | Current Value of $1,000 Investment |
| Automatic Data Processing (NYSE: ADP) | $37.19 | $34.75 | 7.02% | $1,070.22 |
| Freddie Mac (NYSE: FRE) | 48.30 | 61.01 | —20.83 | 791.67 |
| Fannie Mae (NYSE: FNM) | 63.09 | 73.01 | —13.59 | 864.13 |
| Portf olio Performance |
—9.13% | |||
| Current Value of $3,000 Investment | $2,726.02 | |||
| Millionaires-Thru-Christ Investment Club | ||||
| Company (Exchange: Ticker) | Recent Price* | Price at Recommendation†|
Total Return | Current Value of $1,000 Investment |
| Procter & Gamble (NYSE: PG) | $87.84 | $88.00 | —0.18% | $ 998.18 |
| Exxon Mobil (NYSE: XOM) | 35.61 | 32.29 | 10.28 | 1,102.82 |
| Coca-Cola (NYSE: KO) | 44.89 | 48.36 | —7.18 | 928.25 |
| Portfolio Performance | 0.97% | |||
| Current Value of $3,000 Investment | $3,029.25 | |||
| Awareness to Action Investments | ||||
| Company (Exchange: Ticker) | Recent Price* | Price at Recommendation†|
Total Return | Current Value of $1,000 Investment |
| Costco (Nasdaq: COST) | $36.96 | $31.85 | 16.04% | $1,160.44 |
| Starbucks ( Nasdaq: SBUX) | 26.95 | 18.63 | 44.66 | 1,446.59 |
| Wellpoint Health Systems (NYSE: WLP) | 82.09 | 66.31 | 23.80 | 1,237.97 |
| Stock Pick Average | 28.17 | |||
| Current Value of $3,000 Investment | $3,845.00 | |||
| Black Women Investment Corp. | ||||
| Company (Exchange: Ticker) | Recent Price* | Price at Recommendation†|
Total Return | Current Value of $1,000 Investment |
| Harley-Davidson (NYSE: HDI) | $46.76 | $42.83 | 9.18% | $1,091.76 |
| Oracle (Nasdaq: ORCL) | 11.86 | 9.01 | 31.63 | 1,316.32 |
| CISCO Sytems (Nasdaq: CSCO) | 19.26 | 11.36 | 69.54 | 1,695.42 |
| Stock Pick Average | 36.78% | |||
| Current Value of $3,000 Investment | $4,103.50 | |||
| Baunita Greer/ NAIC New York Chapter | ||||
| Company (Exchange: Ticker) | Recent Price* | Price at Recommendation†|
Total Return | Current Value of $1,000 Investment |
| Pfizer (NYSE: PFE) | $33.07 | $29.75 | 11.16% | $1,111.60 |
| Amgen (Nasdaq: AMGN) | 68.16 | 42.22 | 61.44 | 1,614.40 |
| Target (NYSE: TGT) | 38.56 | 31.50 | 22.41 | 1,224.13 |
| Stock Pick Average | 31.67% | |||
| Current Value of $3,000 Investment | $3,950.13 | |||
| SOURCE: YAHOO! FINANCE TOTAL RETURN REFLECTS STOCK APPRECIATION AND INCLUDES STOCK SPLITS AND DIVIDENDS *AS OF AUGUST 4, 2003 †AS OF AUGUST 5, 2002. | ||||