Barron's Cover

 | SATURDAY, AUGUST 13, 2011

Bargain Days

By ANDREW BARY | MORE ARTICLES BY AUTHOR

They've taken a beating lately, but quality stocks, helped by historically low interest rates, are appealing.

Stocks went on an extraordinary ride last week, as the Dow Jones Industrial Average swung more than 400 points in four straight sessions, but the net result was modest, with major averages ending with losses of less than 2% over the five trading sessions.

Barron's was bullish in an Aug. 8 feature story ("Attention, Shoppers. It's Time to Buy"), and we remain so because U.S. stocks, as measured by the S&P 500 index, are valued at around 12 times this year's earnings. The current S&P forward price/earnings ratio is back to 1980s levels, save for the brief period around the market low in early 2009. But back in the '80s, interest rates were much higher, so stocks arguably are a better relative value now.

The S&P 500 closed Friday at 1179, off 1.7% on the week and 6.3% on the year. And the Dow finished at 11,269, down 1.5% in the five sessions and off 2.7% this year. The S&P 500 now yields 2.2%; the Dow, 2.7%.

A range of blue-chip stocks, including Microsoft (ticker: MSFT), Merck (MRK), Intel (INTC), ExxonMobil (XOM) and JPMorgan Chase (JPM) trade for less than 10 times estimated 2011 profits, and most have dividend yields that exceed the puny 2.26% on the Treasury's 10-year note. With the Federal Reserve pledging to hold short-term rates near zero for the next two years, the dividend yields on stocks look appealing, especially since many companies should be capable of increasing their payouts each year.

"Investors have a great opportunity to build a defensive portfolio that will throw off a good income stream," says Michael Jamison, portfolio manager at Barrett Asset Management in New York. He cites stocks like IBM (IBM), Procter & Gamble (PG), Kraft Foods (KFT), ConocoPhillips (COP) and Kimberly Clark (KMB). Other fans of quality stocks include Jeremy Grantham, a founder of Boston investment manager GMO. Grantham noted in his recent investment commentary that quality stocks have bested lesser peers globally since April and that the trend could continue.

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Scott Pollack

With the economy weakening in recent quarters, investors worry that corporate profits may be headed lower, which would remove a key underpinning for the stock market. Barclays Capital strategist Barry Knapp is optimistic, arguing that profits will hold up in the coming quarters. He cites good earnings reports from the likes of Macy's (M), Kohl's (KSS), Nordstrom (JWN) and Cisco Systems (CSCO) last week. "I don't see any data points that suggest the economy is going to roll over."

Knapp looked at the profit picture during recessions since World War II and found that S&P 500 profits dropped an average of 15.7%. The biggest declines came during the past two downturns, including a profit collapse of more than 50% in the 2008-2009 recession.

Knapp thinks the economy will avoid a recession, but even if there is one, he figures that the profit drop will be modest at 10% or so. The huge earnings decline in 2008-2009 was largely a result of deep losses in the financial sector, which accounted for 64% of the earnings decline from the peak in 2007 to the bottom in early 2009. The energy sector also was hit hard as oil dropped from a high of $140 a barrel to a low of $40.

"IF WE GET A RECESSION IN 2012, I would expect S&P 500 earnings to fall to something like $90" from around $96 this year, Knapp says. That would hardly be catastrophic, given that the S&P 500 now would be valued at 13 times that bearish earnings level, rather than 11 times the current consensus for about $105 in S&P profits next year.

A replay of 2008-2009 seems unlikely from an economic standpoint, and American nonfinancial corporations are much healthier than they were then, sitting on more than $1 trillion of cash. Banks have been a focus on investor worries lately with financial stocks the worst performers in the S&P 500 so far this month -- and during 2011 -- given debt problems in Europe and ongoing domestic mortgage woes, but the industry is far better capitalized than it was before the financial crisis in 2007, reducing the risk of anything close to a repeat of the '08-'09 crisis.

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Barclays credit analyst Jonathan Glionna wrote in a client note Friday that the country's four largest banks� Citigroup(C), Bank of America (BAC), JPMorgan Chase and Wells Fargo (WFC) -- have $471 billion of tangible common equity, nearly double their total in June 2007, reflecting retained profits since then and the sales of common stock and other capital-raising efforts. Big bankers may grumble about regulatory overkill and excessive capital requirements that are dampening returns and stock-market valuations, but higher capital levels should enable big banks -- with the possible exception of Bank of America -- to avoid any dilutive equity sales. The capital cushions also reassure investors and creditors. American banks are much better capitalized than most of their European brethren, whose shares were crunched last week.

Financial stocks now are the cheapest sector of the S&P 500 (see table), trading for under nine times projected profits in the next 12 months and for less than book value, both attractive valuations. All the major banks, life insurers and property and casualty insurers are trading around or below book value with outliers like Citigroup (C), at 30, trading for less than two-thirds of tangible book value, a conservative measure that excludes goodwill from any acquisitions. JP Morgan, at 36, trades for seven times estimated 2011 earnings with a nearly 3% dividend yield that CEO Jamie Dimon is intent on increasing.

Most regional bank stocks, including Fifth Third Bancorp (FITB), Suntrust Banks (STI) and Comerica (CMA), trade below book value, while MetLife (MET), a leading insurer, trades at 33, roughly 70% of book. Property-and-casualty stocks like Travelers (TRV) and Chubb (CB) carry lower risk than life insurers because their portfolios are heavy in bonds that have appreciated with the sharp rate decline this year. Bank stocks were dampened by the Fed's rate announcement last week because another two years of near-zero short rates may further pressure bank interest margins, but that risk seems captured in low stock valuations.

Defensive groups like electric utilities have held up best in the market slump. Battered financials now trade, on average, below book value.

S&P 500 Index Sector	―Percent Change― MTD YTD		P/E NTM	Dividend Yield	Price/ Book
Utilities	-4.2%	1.1%	12.2	4.6%	1.3
Telecom	-4.4	-6.9	14.2	5.8	1.7
Consumer Staples	-4.8	-0.5	12.9	3.2	3.1
Technology	-7.4	-4.4	11.0	1.1	2.9
Health Care	-8.1	-0.6	10.0	2.5	2.1
Materials	-9.9	-10.6	10.2	2.3	2.1
Consumer Disc	-10.2	-4.8	12.1	1.6	2.6
Industrials	-11.2	-11.8	10.7	2.5	2.2
Energy	-12.6	-2.9	8.8	2.1	1.7
Financials	-12.7	-19.1	8.6	1.8	0.8
S&P 500	-9.3	-6.8	10.5	2.2	1.8
NTM-Next 12 months Sources: Bloomberg; Barclays Capital

Many drug stocks, including Merck and Pfizer (PFE) trade for 10 times earnings or less while yielding 4% or more. Electric-utility stocks have been relatively good performers recently and they offer a good alternative to bonds with dividend yields of 4% or more -- plus the prospect of modest annual increases in the coming years.

THE UPSIDE POTENTIAL of cheaply valued technology stocks was illustrated by the pop in Cisco Systems last week, which rose $1 to $16 after its quarterly results for the period ended in July beat expectations. Here's a company with $5 a share in net cash and investments on its balance sheet and it was trading under $14 at its low last week. Even now, Cisco trades for under 10 times fiscal 2012 profits, and for under seven times earnings, excluding its cash. The tech sector in the S&P 500 trades for just 11 times forward earnings.

Knapp looks at the so-called earnings yield on S&P 500, which is the inverse of the price/earnings ratio. It's now at 8% based on 2011 profits and 9% based on forward earnings projections. He compares the earnings yield with the real, or inflation-adjusted, yield, on 10-year Treasuries, which is now about zero. Ten-year TIPS, or Treasury Inflation Protected Securities, now provide yield above inflation. The current spread of about nine points between the forward earnings yield and the real Treasury yield is at its highest level since the early 1980s, which strongly favors stocks.

Risk-averse corporate and public pension funds have been moving away from stocks in recent years and into bonds and so-called alternative investments like hedge funds. That's been a good move, but the funds now are in a bind because bond yields are so low that it imperils their ability to hit return targets that often are as high as 8% to 9% annually. That could mean a shift back into stocks.

Investors understandably have been rattled by the recent market action, but that shouldn't obscure the value in stocks. It's true that stocks have had a bad 10 years, but they had come off a poor decade in 1982, just before a historic bull run began.