The best stocks for 2008
We've found ten stocks that will thrive despite - or even benefit from - the troubles facing the markets next year.
(Fortune Magazine) -- We'll say this for the U.S. economy: It can take a punch.
Consider the blows it has absorbed just this year. The worst real estate crash since the Great Depression. Pow! Oil prices up from $50 to $90 a barrel since last January. Bam! A subprime mortgage mess metastasizing into a full-blown credit crisis, with banks swallowing billions in losses and cutting back on loans. Baff!
Yet through all the punishment, the economy has barely flinched. "I'm floored by how resilient it has been," says veteran stock strategist Ed Yardeni of Oak Associates. "Had you told me at the beginning of the year this was going to happen, I doubt I would have been very optimistic."
That's why forecasting 2008 is so difficult. History tells us that oil shocks, real estate crashes, and banking crises are harbingers of downturns. Confidence has already plunged as consumers have been pinched by rising energy prices and falling home values.
October saw another bad omen: a decline in discretionary purchases such as books and electronics. Observes Merrill Lynch economist David Rosenberg: "You have to go back to the 1990-91 recession to find a time that this trend has been so weak heading into the holiday shopping season."
Despite all that, the U.S. economy expanded 3.8% and 4.9% in the second and third quarters, respectively - up from 2.4% and 1.1% during the same periods in 2006. That's right: For all the bad headlines, the American economy appears to be getting stronger.
How can that be? The short answer is globalization. Rapid expansion in the developing world - not just in China and India but in Russia, Brazil, and Turkey, for example - has created new markets for U.S. goods and services, and a weak dollar has made them relatively cheap.
As a result, 44% of the Standard & Poor's 500 companies' revenues comes from abroad, up from 32% in 2001. S&P expects that figure to rise to 50% in 2008. Says Bob Doll, who helps manage some $1.3 trillion as chief investment officer for BlackRock: "The boom in exports is almost as big a positive as housing is a negative."
The bottom line: We think the U.S. economy will slow in 2008 but narrowly miss an outright recession. We expect the overall stock market to bounce around, as it did this year, and deliver anemic single-digit returns.
Of course, some stocks will thrive even when the market as a whole is on the ropes. After interviewing dozens of analysts and money managers and poring over reams of Wall Street research, we've identified ten stocks we believe are poised for big gains in 2008.
Five of our picks are growth companies in noncyclical industries, on the logic that in a slowing economy, investors will pay a hefty premium for superior profit improvement. These five aren't cheap - they trade at an average of 22 times 2008 profits vs. a price/earnings ratio of 14 for the S&P, according to Baseline - but they're worth it. Analysts expect their earnings to increase an average of 29% next year, vs. 6% for the S&P.
We've also identified a handful of opportunistic investments - stocks positioned to exploit the ongoing crises in finance and real estate or to rebound once the panic lifts. These are not for the faint of heart, but the opportunity is just too good to let a little apprehension (okay, a lot) get in the way.
For the record, our past Investor's Guide selections have excelled. Our ten stock picks for 2006 returned an average of 26% that year, vs.13% for the S&P. And through Dec. 3, our ten stocks for 2007 have outpaced the S&P 14% to 6%.
Now on to Fortune's best investments for 2008:
Annaly is a hedge fund disguised as a real estate investment trust that makes its money by investing in mortgage-backed securities. Sounds like a prescription for disaster, right? In reality, there's probably no company better positioned to profit from the ongoing mortgage crisis than this one.
What distinguishes Annaly (NLY) from its out-of-favor Wall Street peers is the fact that it doesn't take credit risk, only interest-rate risk. It buys mortgage-backed securities issued by government-sponsored enterprises like Fannie Mae and Freddie Mac; in other words, it has no exposure to subprime mortgages.
The securities Annaly owns are all guaranteed by Fannie, Freddie, or Ginnie Mae, which means they're implicitly guaranteed by the U.S. Treasury. Yes, there have been troubles at Fannie and Freddie, but trust us when we say that the value of Annaly stock would be the least of your concerns if the federal government ever allowed Fannie or Freddie to default.
What makes Annaly's business model so compelling right now is the widening gap between its borrowing costs (which are sinking as the Federal Reserve cuts rates and banks offer Annaly better borrowing terms) and the yields on the mortgage securities it holds (which haven't fallen nearly as far). In the third quarter, that interest-rate spread more than doubled, from 0.32% to 0.67%. A third of a percentage point may not sound like a lot, but it's huge when you've got a $45 billion portfolio.
This widening spread is fueling massive earnings growth - 57% in the third quarter and a projected 53% in 2008, according to analyst estimates. Schneider Value Fund portfolio manager Arnie Schneider thinks more Fed rate cuts are coming, which would juice Annaly's earnings even more.
Best of all, Annaly isn't priced like a growth stock, as it boasts a 5.2% dividend yield and trades at a mere nine times estimated 2008 earnings. Says Schneider: "It's the perfect recessionary stock."
Let's dispense with the obvious. Warren Buffett, Berkshire Hathaway's illustrious chairman and CEO, is 77 years old. The line of succession remains murky. Berkshire's insurance businesses have benefited from unusually benign weather- namely, the dearth of U.S. hurricanes. And Berkshire stock has already risen 22% since August.
So why are we recommending Berkshire (BRK.B) now? Simple. Warren Buffett knows how to exploit panics. He bought 5% of American Express in 1963, following a financial crisis (involving vegetable oil, of all things) that had cut AmEx's stock price in half. He started buying up shares of Geico in 1976 when claim-cost miscalculations left the auto insurer teetering near bankruptcy. And he picked the pocket of financially troubled energy company Dynegy in 2002, paying $928 million for a natural gas pipeline that Dynegy had bought for $1.5 billion only months earlier.
With $40 billion in cash idling on Berkshire's balance sheet at the end of the third quarter, Buffett looks ready to plunge in should a financial company, bond insurer, or homebuilder with attractive land assets need a white knight. (Indeed, in early December, Buffett bought $2.2 billion in high-yield bonds from Texas power company TXU at a discount.)
"He's going to wait for the fat pitch and pounce," says ace value fund manager Jean-Marie Eveillard, explaining why Berkshire remains the biggest stock holding in his First Eagle Global fund, even though he believes Berkshire's market cap exceeds the value of its businesses. "The current circumstances in the economy and possibly in financial markets are exactly the kind of environment where Buffett will be able to see and seize opportunities."
Retail is tough even in the best of times. Still, if you look at the histories of America's retail category killers- Best Buy, Home Depot, Costco, Staples, etc.- there is always an inflection point at which the chain's geographic reach has not yet caught up with the proven success of its business model.
That's where Dick's Sporting Goods (DKS) is today, and it's why we think now is the time to invest in this emerging category killer. Though well established in the Midwest and Northeast - the company has grown from 61 stores to 341 in the past decade - Dick's has relatively few outposts in Southern and Western states like Florida and Texas and none in California.
Over the next seven years Dick's plans to more than double its store count, to 800. Another plus: It faces competition mostly from mom-and-pops; the top five U.S. sporting goods retailers account for only 17% of sales.
Dick's emphasizes a store-within-a-store sales approach. Each department has its own look and staff, which appeals to the enthusiast who purchases a lot of sporting goods. Then there is its innovative merchandising. Dick's has been phasing out its no-name, private-label apparel and equipment in favor of deals in which Reebok and Nike put their logos on products sold exclusively at Dick's (a strategy that analysts have dubbed "private brand" rather than "private label").
So now, for example, Nike swooshes can be found on Dick's hats, gloves, and outerwear. "What private brand does," explains Michael Baron, an analyst with Baron Growth fund, which owns 3% of outstanding Dick's shares, "is allow them to charge branded-product prices but with margins seven to eight percentage points higher." Through the first nine months of 2007, Dick's earnings per share rose 73% on sales growth of 28%. Another key barometer: Same-store sales rose at a terrific 8.6% clip in the third quarter.
What happens if the economy tanks? Industry experts say that sporting goods have proven resilient in the past. Indeed, in 2008, analysts expect a 19% increase in earnings per share. Says fund manager Thomas Ognar, who has 3% of his Wells Fargo Advantage Growth fund in Dick's: "People cut back on a lot of other things before not buying cleats for their kids."
There's a reason you won't find any major technology companies among our 2008 stock picks. More than 70% of tech purchases are made by businesses, according to tech tracker IDC, and spending is sagging. Cisco CEO John Chambers recently warned of "dramatic decreases" in orders from banks.
Still, if there's one tech niche that should be immune to a slowdown, it's videogames. Fueled by the success of the Nintendo Wii and Microsoft Xbox 360 consoles, videogame sales rose 39% in October, according to the NPD Group, after a 64% rise in September. "I can't tell you if corporate spending falls off a cliff or hangs in there in 2008," says Eric Fischman, portfolio manager of the MFS Emerging Growth fund. "But I can tell you with a high degree of confidence that videogame sales are going to be up."
Fischman's top game pick is a turnaround story - Electronic Arts (ERTS). The stock has stagnated since 2004, with earnings falling and critics charging that EA was too reliant on aging franchises like Madden NFL. But things started to look up in early 2007 when ex-president John Riccitiello returned as CEO after a three-year stint with a venture capital firm.
Riccitiello reorganized EA into four divisions (trimming 4% of the workforce in the process) and spent $860 million to acquire BioWare and Pandemic, two smaller game studios known for producing the kind of innovative action-adventure and role-playing games (such as BioWare's hit Baldur's Gate) long missing from EA's lineup. "By themselves, BioWare and Pandemic won't make us market leaders in either action-adventure or RPG, but it takes us from nowhere to being in the top two or three," says Riccitiello.
EA has also worked hard at playing catch-up in the red-hot Wii market. It's now the No. 2 developer of Wii games, behind only Nintendo. The result: Analysts expect earnings to rise 76% next year. "Compared to where they were a year ago," says Fischman, "it's like night and day."
Once the darlings of biotech investors, Genentech shares have been in a prolonged slump since topping out at $96 in 2005. But the company itself remains a standout, and recent news provides the opportunity to buy the shares at a discount.
On Dec. 5, the stock was pounded, plunging 10% in a few hours. The reason: An FDA advisory panel voted against expanding the use of Avastin - a blockbuster Genentech (DNA) drug already approved to treat colon and lung cancer- for breast cancer.
The market overreacted. The advisory panel didn't dispute the core claim that Avastin is effective in fighting breast cancer, notes Sanford C. Bernstein & Co. analyst Geoffrey Porges. "What you heard from the panel," says Porges, "is not that this drug doesn't work in this indication but that we had an imperfect study, one with a lot of missing data." (As it happens, that study was enough to persuade the European authorities to endorse Avastin for breast cancer.)
Genentech has two Avastin studies in the works that are more comprehensive and that Porges believes will help it win FDA approval, eventually leading to a doubling of Avastin annual sales, now $2.5 billion, by 2011.
He arrives at that estimate via a recent Bernstein survey of 108 oncologists. The survey suggests that 80% of oncologists are already prescribing Avastin to treat some later-stage breast cancer, and that that percentage would rise to nearly 100% once there is FDA approval (which Porges now expects to come in early 2009).
The survey also indicates doctors' utilization of Avastin will double, from between 15% and 20% of their breast cancer patients today to between 35% and 40%. Says Porges: "I'd say the valuation upside is even more compelling now than it was before, though you might have to wait until the second half of next year to get that return."
Even with the FDA setback, Genentech is still expected to grow earnings 18% next year. And it's not as if Avastin is the only thing Genentech has going for it. There are early indications that its cancer drug Rituxin holds hope for treating autoimmune diseases like multiple sclerosis and lupus.
Tom Marsico, the growth fund manager whose eponymous firm owns 3.5% of the biotech's shares, is excited about Herceptin - considered a miracle drug for certain types of breast cancers - and Lucentis, which treats macular degeneration and might one day be used for vision loss related to diabetes. "What you're really investing in here," says Marsico, "is the premier pharmaceutical company in the world as far as innovation is concerned."
CEO Jeffrey Immelt has been leading a successful makeover at General Electric, though you wouldn't know it from GE's flaccid stock price. Our bet is that in a stormy market investors will gravitate toward the ultimate blue chip and finally give Immelt the credit he deserves.
Since replacing Jack Welch six years ago, Immelt has sold off laggard operations such as insurance and plastics, putting more emphasis on manufacturing and infrastructure businesses. The timing has been excellent. Though achieving double-digit earnings growth will always be a challenge for a company so big and diversified, GE (GE, Fortune 500) seems well positioned to slough off whatever economic challenges may exist in the U.S.
The industrial and infrastructure businesses - which include aircraft engines, locomotives, water-treatment and desalinization plants, green energy (wind turbines and solar panels), and not-so-green energy (coal power turbines and coal gasification) - have all been reaping the rewards of the global economic boom. Half of GE sales now come from overseas.
The infrastructure divisions now account for 34% of total GE revenues, and they're growing at a 17% annualized rate. Better yet, from a shareholder perspective, these businesses are exactly the kind of "late cycle" performers that are awarded higher valuations when economic growth slows.
"Power, water, wind - all those infrastructure businesses are coming together a lot faster than anybody anticipated," says Bob Turner, founder and chief investment officer of Turner Investment Partners, a growth-fund shop with some $27 billion under management (including 8.6 million shares of GE as of Sept. 30).
About half of GE's earnings come from lending and investing, a fact that has weighed on the stock. But Immelt- who's quick to point out that GE has no exposure to troubled assets like collateralized debt obligations (CDOs) - sees GE's financial services exposure as an asset in today's market.
"These are classically the times where our financial service businesses do very well," he says. "This is a great time to be triple-A rated. We have a good cost of funds and availability of funds, and there are things that might have been trading for a 10% or 15% return six months ago that are going to be a 25% to 30% return today."
Goldman Sachs analyst Deane Dray argues that GE's business mix merits a P/E of 17 - a 10% premium to the S&P 500 and up from 15 today. Based on Dray's 2008 earnings estimate of $2.45 a share, a 17 P/E translates to a stock price of approximately $45- which also happens to be Turner's GE target. "You've got the best company in the world growing earnings 12% and a stock with a 3% dividend yield," says Turner. "You could be looking at a 25% return."
Normally we wouldn't recommend a stock that has doubled since the start of '07. But as we said, in a slowing economy, you want to own companies that can demonstrate superior earnings growth regardless of what's happening around them. Jacobs Engineering is such an enterprise.
Jacobs (JEC, Fortune 500) is one of the fastest growers in an exploding industry: construction and engineering. The company is hired to design and build oil refineries, biodiesel plants, hospitals, bridges, and water-treatment centers.
"These are the strongest markets we've seen in 30 years," says Jacobs CEO Craig Martin. Earnings jumped 39% in the fourth quarter of the fiscal year ended Sept. 30. That makes the company's 26 P/E look reasonable, especially since Jacobs should maintain a 35%-plus growth rate into 2008: It has a $13.6 billion backlog of orders (up 39% from the year before).
"From a global standpoint, the amount of infrastructure spending that's going to occur in coming years is staggering," says David Scott, manager of the Chase Mid-Cap Growth fund, which counts Jacobs as a top-five holding. "As the premier company in its field, Jacobs sits squarely in the middle of that boom."
Question: What do you call it when an $8 billion asset writedown translates into a $30 billion loss in market cap? Answer: an overreaction. Yes, Merrill's shares deserved a punishment for the firm's mortgage-related bungling. But the public flogging has far exceeded the transgression, which is why smart investors should buy this stock before everyone else comes to their senses.
Even if Merrill (MER, Fortune 500) writes down another $6 billion in the fourth quarter, as S&P analyst Jeff Sexton recently predicted it will, stocks are valued on future earnings. There's little reason to believe this will have a big effect on 2008 profits, which analysts estimate at $7.68 a share. That means Merrill is trading at a mere eight times 2008 earnings (with a 2.4% dividend yield).
Why are we so confident that the mortgage debacle won't bleed into 2008? Two reasons. The first is Merrill's new CEO, John Thain, formerly CEO of the New York Stock Exchange and Goldman Sachs co-president. Thain used to run the mortgage desk at Goldman, and it's hard to believe he would have taken the Merrill job if the problems were worse than they appeared to be. "You know he did his due diligence," says Anton Schutz, manager of the Burnham Financial Services fund.
The second reason is that financial panics are almost always overblown. In the case of CDOs and other mortgage-backed assets, the problem for Merrill, et. al was not that the mortgages underlying the securities all went bad.
What happened is that the secondary market for these securities evaporated, forcing the institutions holding them to mark down their value. When this market bounces back, as surely will happen, Merrill stands to post sizable gains as it writes up the same assets it was forced to write down. "I've seen my share of credit crises," says Larry Puglia, manager of the T. Rowe Price Blue Chip Growth fund and himself a former bank analyst. "And absolutely that could be the case."
We're on record as saying that $95 a barrel is not a sustainable price for oil. Yet The Hottest Fund Manager in America - a.k.a. CGM's Ken Heebner- now has us hedging our bets.
For those unfamiliar with Heebner, understand that his stock picking over the past eight years has been genius (as it has been for much of his 30-year career). He made a bundle short-selling tech and telecom stocks in 2000. He bet big on homebuilders in 2001 only to get out just before they crashed. He plowed his homebuilder profits into energy stocks in 2005 and eventually doubled down on commodities with a big bet on copper.
The result: His CGM Focus fund was up 66% through early December - while juicing his returns with short positions on Indymac and Countrywide Financial, mortgage lenders whose stocks have been circling the drain.
With that kind of track record, we listened when Heebner laid out an argument that $100 oil is not only coming but will be here to stay. "There is still strong growth in Latin America, China, India, and a host of smaller countries like Poland and Thailand," he says.
That means a need for some 1.5 million more barrels of oil a day. The problem, Heebner explains, isn't just finding another 1.5 million barrels; it's finding them even as some of the most productive oil fields in the world are declining.
Heebner, who is a fanatical researcher, questions the conventional view that OPEC has enough spare capacity to fill much of that void. Heebner cites one Saudi Arabian source whom he declines to name who asserts that output at Ghawa r- a legendary Saudi field that produces about 6% of the world's oil - is declining at 9% a year. (The Saudi authorities vociferously dispute this.)
"So I'm connecting all the dots," Heebner says. "It's a tight situation to start with, but add to that a loss of a million barrels a day for the Saudis, and suddenly it gets very interesting on the upside for the price of oil."
That brings us to Petrobras (PBR), Brazil's largest oil company and the stock Heebner thinks is the best way to play oil right now. With petroleum prices so high, a big risk for oil companies is that host countries will demand a bigger and bigger share of the profits in the form of taxes or royalties. "One way you can avoid this," says Heebner, "is if the government owns half the company you've invested in. That's Petrobras."
Petrobras is cheap enough, at 16 times earnings, that it can be a winning investment even if Heebner is proven wrong about $100 oil. The company just announced a huge find offshore from Rio de Janeiro, a field said to have up to eight billion barrels of recoverable oil. (See correction.)
We have no idea whether the Florida real estate market has hit rock bottom. What we do know is that eventually it will bounce back. Demographics demand it, with the Census Bureau projecting a 33% population increase for Florida- the equivalent of six million new residents- between now and 2020.
And when Florida real estate does rebound, investors will be kicking themselves for not recognizing today's $28 stock price for St. Joe Co (JOE).- Florida's largest private landowner - as a rare opportunity. The stock traded as high as $82 in July 2005.
At $28, says Third Avenue Real Estate Value fund manager Michael Winer, whose firm owns 20% of St. Joe shares, "this is a fire-sale price that basically assumes the Florida market will never come back."
The way to value St. Joe isn't on its current earnings (which are awful) but on its land holdings. The company owns 710,000 acres of Florida real estate, mostly in the Panhandle region, 310,000 of which are situated within ten miles of the coast. The stock market is now valuing St. Joe's property at the equivalent of $3,700 an acre. Winer says a "fire-sale value" would be $5,000 an acre. Keefe Bruyette & Woods analyst Sheila McGrath puts the fair value at $7,200, "at least."
Moreover, St. Joe's Panhandle stronghold looks as though it will recover faster than the overall Florida market. In Panama City, for example, the number of home sales increased 4% between October 2006 and October 2007, vs. a 29% decline statewide.
McGrath sees another bullish indicator in the just-begun construction of a new airport in Panama City that, unlike the old one, will support commercial jets. The airport will give a huge boost to the local economy, she contends, much as the opening of Fort Myers's new airport in 1983 boosted real estate and tourism in southwest Florida. "In the short term, there is some headline risk," she says. "But all in all, I think St. Joe is ridiculously cheap."
Correction: An earlier version of this story mislabeled the ticker and stock data for the oil company Petrobras. The correct ticker symbol is PBR, not PZE (which is a Petrobras affiliate). Return to story.