Midyear Outlook

6/15/2009


Midyear is as good a time as any to pause and reflect, and the first half of 2009 seems especially worthy of review for the extreme swings in nearly all measures of the stock market.

The Dow Industrials dropped 25% from Dec. 31 to March 9, then rebounded 34% over 13 weeks — the fifth-fastest rebound from a market low in the Dow’s 112-year history. The Dow Transports slumped 39% to March 9 before rebounding 59%. The Russell 2000 Index of small stocks has staged the biggest 13-week rally in its history — yet is up only 5.7% for the year to date.

Industry-group leadership turned 180 degrees on March 9. The financial sector, down nearly 50% to March 9, has nearly doubled over the past three months. Other hard-hit groups like automobiles and parts, oilfield equipment and services, metals and mining, and hotels have gained at least 60%. Meanwhile, such defensive areas as health care, telecom, and utilities, which held up comparatively well during the market’s slide, have lagged since March.

Partly because of the shift in group leadership, low-quality stocks have rebounded to lead the market’s advance since March. Shares of money-losing companies have handily outperformed those of profitable companies, and those with weak balance sheets have outperformed those with strong balance sheets. In fact, based on five of the six category scores used in Quadrix® — Earnings Estimates, Financial Strength, Momentum, Performance, and Quality — the worst stocks have been the best performers since March. Top Overall Quadrix scorers have underperformed the worst Overall scorers but have nearly kept pace with the average stock, partly because Value scores have worked nicely since March.

Measures of market valuation have shifted markedly, reaching generational lows before surging because of higher stock prices and lower earnings. The average stock in the S&P 1500 Index of large, midcap, and small stocks trades at 17 times trailing earnings, up from about 12 in March but below the 15-year norm of 21. Based on expected current-year earnings, the average S&P 1500 stock trades at a price/earnings ratio of more than 18, versus about 13 in March. The valuation swings in individual sectors have been even more dramatic, with forward P/Es doubling from the lows in the consumer-discretionary, energy, financial, and materials sectors.

Investor sentiment has shifted dramatically. The CBOE Volatility Index, a measure of the volatility implied by S&P 500 option prices, has dropped below 29 from 52 in early March and 80 in November. Bullish newsletters now outnumber bears by 48% to 23% — nearly a mirror image of the 26% bulls and 47% bears at the March low. Surveys of institutional investors have also seen a jump in bullishness, and Wall Street analysts are forecasting a 30% jump in S&P 500 Index operating earnings for 2010.

Our game plan
While bulls and bears appear sharply divided, we see no reason to make an all-or-nothing decision on the stock market. The Dow Theory remains in the bearish camp, as the last confirmed signal was the move to new lows in March. But both the Industrials and Transports have staged significant rallies since March, so the pathway to a bull-market signal has been established. If at least one average can hold above a March low on a significant market correction and then both averages rebound above the closing highs established in the current rally, the Dow Theory will return to the bullish camp.

We may reduce our cash position on a market correction, though we are likely to keep a sizable cash position until we see a bull-market signal. As always, our cash position will also depend on the opportunities available in individual stocks.

While the average U.S. stock is no longer particularly cheap, many attractive values are available. Among S&P 500 stocks, more than 100 have trailing P/E ratios below 10 — down from 230 in March but well above the 18-year norm of 42. Some 77 stocks in the S&P 500 have P/Es between 10 and 12 — more than double the 18-year norm. Moreover, because low-quality stocks have led in recent months, many of the best values can be found among the fundamentally superior companies favored by Dow Theory Forecasts. Six such stocks, including three new additions to the Focus List, are reviewed below.

Midyear capital-gains favorites
Biogen Idec’s ($52; BIIB) fortunes are leveraged to three drugs: Rituxan (rheumatoid arthritis and non-Hodgkin’s lymphoma), Avonex (multiple sclerosis), and Tysabri (Crohn’s disease and MS). Over the next 12 months, Biogen will rely on these drugs to sustain its operating momentum.

Biogen plows its strong cash flow into research and development, spending an average of 32% of sales on R&D for the past five years. The pipeline includes 20 drug candidates in the late stages of clinical trials that could broaden Biogen’s portfolio.

In May, a Tysabri patient fell ill with progressive multifocal leukoencephalopathy (PML), a rare but often fatal brain infection. This marks the seventh PML case linked to Tysabri since its reintroduction in July 2006, and the third in 2009. Despite its side effects, Tysabri has gained acceptance among neurologists. Regarded as the most effective MS treatment available, Tysabri deters relapse at a higher rate than other drugs and possibly halts the disease’s progression altogether. Rivals are racing to develop an alternative, but none are expected to reach the market in the near term.

Biogen shares are up 10% in 2009, suggesting investors have become less skittish about new PML cases. After ratcheting expectations higher in the past month, Wall Street sees per-share profits rising 12% in the June quarter, 13% for full-year 2009, and 4% for full-year 2010. Trading at 12 times trailing earnings, a discount to the three-year average of 31, Biogen is a Focus List Buy and a Long-Term Buy.


As an outsourcing firm, Cognizant Technology Solutions ($27; CTSH) runs two lines of business: applications development and applications management. Generally, on-site teams work with clients to design software systems, while remote staffers help manage those systems and other applications vital to the demands of e-commerce.

Cognizant operates primarily in India, where it taps into a highly educated but low-cost work force. Cognizant faces considerable pricing pressure during recessions but has responded to discount requests by moving clients into less expensive, off-site service mixes. That strategy has held pricing, down about 2% in the March quarter, largely in place.

Cognizant carries significant exposure to financial services, an industry under consolidation. However, that segment (44% of March-quarter revenue) grew sales in the March quarter, as did health care (25%) and retail manufacturing and logistics (17%).

Management anticipates revenue will climb 10% this year, in line with the consensus. Wall Street expects per-share profits to grow 7% in 2009, an estimate that has been rising in the past month. A new addition to the Focus List, Cognizant is also a Long-Term Buy.


Anticipating that subscribers will upgrade to more expensive packages, Comcast ($14; CMCSA) is shifting toward a fully digital platform. New services will include access to 10,000 OnDemand choices and also triple the number of high-definition stations to 100. The transition won’t require new TV set-top boxes and has been successful in test markets. Comcast plans to roll out the initiative in more than half of its markets this year and expects completion by 2010. Despite these plans, management expects to reduce capital expenditures ($5.75 billion, or 17% of sales, in 2008) in both dollars and as a percentage of sales in 2009.

CEO Brian Roberts considers Comcast’s primary operations, video and broadband services, as intertwined. He says he does not expect a material impact from “cord cutters” — those who cancel cable subscriptions and watch video on the Internet. Comcast is working on a Web service that will stream cable-TV shows only to subscribers.

The consensus predicts 2009 per-share profits will increase 13% on 4% higher revenue. Over the next five years, profit growth is expected to average 11%. Already a Long-Term Buy, Comcast is being upgraded to a Focus List Buy.


CVS Caremark’s ($31; CVS) retail business has fared better than its competition. Same-store sales rose 3.3% in the March quarter, higher than Walgreen’s ($31; WAG) 1.3% growth and that of most U.S. retailers. Looking to push its advantage, CVS has launched a pilot program to enhance its beauty department and lure customers away from struggling department stores. Management reports that recently acquired Longs Drugs is smoothly folding into operations.

CVS survived a treacherous retail environment with a little help from its prescription benefit management (PBM) unit. Despite pressure on volumes as uninsured customers conserved on prescriptions, PBM sales rose 7% to $11.5 billion in the March quarter and are up 2% over the past 12 months. Never timid about pursuing new acquisitions, CVS looks to grow the health-care unit, though no deals are imminent.

Together, the retail and PBM segments have sustained CVS’ operating momentum, and the stock’s Quadrix Momentum score exceeds 90% of U.S.-traded companies. CVS has a good track record of managing Wall Street profit expectations, meeting or exceeding the consensus in the past nine quarters. Consensus estimates, which have trended higher recently, project growth in per-share profits of 7% for both the June quarter and full year. Now upgraded to a Focus List Buy, CVS Caremark is also a Long-Term Buy. Walgreen is rated Neutral.


In May, IBM ($108; IBM) reiterated guidance for earnings per share of at least $10.00 in 2009, and stood by a per-share profit goal of $10 to $11 for 2010. Even if IBM’s revenue pulls back sharply in a worsening economy, management is confident about hitting its targets by margin expansion, share repurchases, and acquisitions. Helping matters, the company is geographically balanced, and two-thirds of profits are recurring. Consensus estimates project per-share earnings of $9.12 for 2009 and $9.95 for 2010, suggesting IBM is positioned to post upside surprises if demand for technology services improves.

IBM expects services and software to drive growth. The software segment generated 21% of revenue and 43% of income in 2008. Within the software unit, IBM sees growth driven by initiatives to help midsized companies design efficient systems. The segment also seems poised to take more market share in the middleware business. Backstopping growth, about 70% of software revenue enjoys annuity-like consistency.

Shares have risen 28% in 2009 compared to a 4% gain by the S&P 500 Index. Yet the stock trades at just 12 times expected current-year earnings, a 29% discount to the average profitable S&P 500 company. IBM is a Focus List Buy and a Long-Term Buy.


Whether it is deep sea or deep space, Oceaneering International ($52; OII) helps customers reach distant environments. In March, Oceaneering won a $180 million contract to design NASA spacesuits, but the company gets 90% of its revenue from selling equipment and services to offshore oil and gas drillers.

In 2009, Oceaneering will likely find growth in its Remotely Operated Vehicles (ROVs). Accounting for nearly half of operating income, the ROV fleet should expand at least 8%, and most of these new vehicles already have contracts. Further out, prospects looks bright for the other segments. Oceaneering controls 30% of the global market for subsea umbilicals, for which orders are expected to leap 60% over the next five years.

Deepwater markets have proved less vulnerable in the downturn because of their massive scale and contract lengths, which frequently exceed five years. This year, management expects per-share profits of $3.10 to $3.60.

Oceaneering is not a bargain at current prices but trades at a reasonable 14 times trailing earnings, a 30% discount to the five-year average. Oceaneering is a Focus List Buy.

MIDYEAR CAPITAL-GAINS FAVORITES
———— Current Year ————
————— Next Year —————
———— Quadrix Scores * ————
Company (Price; Ticker)
Est.
EPS
($)
EPS
Chg.
(%)
Est.
P/E
Sales
Chg.
(%)
Est.
EPS
($)
EPS
Chg.
(%)
Est.
P/E
Sales
Chg.
(%)
Est. LT
EPS
Growth
(%)
Momen-
tum
Value
Quality
Overall
Biogen Idec ($52; BIIB)
4.14
13.3
13
4.9
4.33
4.5
12
4.9
10
94
72
94
97
Cognizant Technology ($27; CTSH)
1.54
6.7
18
10.1
1.65
7.2
17
12.9
18
89
65
99
94
Comcast
($14; CMCSA)
1.03
13.3
14
3.9
1.16
12.1
12
3.5
11
87
91
85
92
CVS Caremark
($31; CVS)
2.60
6.7
12
12.3
3.00
15.3
10
7.0
12
90
79
81
93
IBM ($108; IBM)
9.12
2.2
12
(8.2)
10.00
9.6
11
2.5
12
59
73
93
90
Oceaneering Int’l
($52; OII)
3.31
(7.6)
16
(5.9)
3.47
4.8
15
7.0
NA
80
54
96
93
* Quadrix scores are percentile ranks, with 100 the best.

 


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