Betting on a smoky recovery

Thomas Lee of J.P. Morgan says a U.S. economic rebound could get a little dirty for investors who want to make money.

By Scott Cendrowski, reporter

NEW YORK (Fortune) -- When looking for stocks that will rise out of the current recession, Thomas Lee, J.P. Morgan's chief U.S. equities strategist and one of Wall Street's most bullish prognosticators, advises clients to buy for a "smoke stack recovery."

Lee, who in January predicted the S&P 500 index (SPX) to finish at 1,100 by year-end, says the combination of quick gross domestic product recovery and low industrial growth through the recession should lead to bigger gains in sectors like industrials, material makers and energy firms.

"This is going to be a very smoke stackey recovery," says Lee. He says investors should buy "companies that feed industrial production."

Lee's call is rooted in J.P. Morgan's bullish expectations of a strong U.S. and global recovery. The bank's economic research team expects U.S. GDP will recover to 2007 levels by the end of 2010. "[I]t now looks likely that the coming four quarters will see GDP gains that rival the strongest global performance of the past two decades," its worldwide research team recently wrote.

Companies that delayed new projects and countries that put off structural upgrades during the recession, Lee contends, will put money toward industrial production to keep up with increased spending and GDP growth.

Businesses are also better positioned to spend. As Lee points out, S&P 500 companies hoarded cash and cut expenses in the downturn. Nine out of 10 sectors in the index have lower expenses levels than they did in 2007. (The only exception is health care.)

And corporate borrowing costs have dramatically fallen. "Today, high-grade issuers are borrowing at levels even lower than they could in 2005," Lee says. "There are a lot of things that have positioned companies now in 2010 for much better earnings if the economy starts to recover."

How can investors buy into an industrial recovery? First, Lee recommends small and midcap stocks which rise fastest during a recovery. The Russell 2,000 index of smallcaps for example, has returned 63% since its March 9th low, while the Dow Jones Industrial Average has gained 42% since then.

J.P. Morgan Securities recently released its small and midcap "Money List" -- a group of recommended stocks based on risk/reward, industries, and balance sheets. Lee thinks the following shares should benefit from a smoke stack recovery:

Bway Holding Company (BWY)

The $1-billion company makes containers: metal paint cans, aerosol cans and plastic pails. Lee likes the stock because it trades at one of the group's cheapest price/earnings to growth ratios. It was 2.39 in the June quarter. Bway also raised its 2009 earnings expectations by 4% to $124 million in August as costs cuts worked amid declining sales.

Century Aluminum (CENX)

The $2-billion aluminum maker supplies four main customers for nearly 75% of its sales: Rio Tinto Alcan (the aluminum unit of Rio Tinto), Southwire, BHP Billiton, and Glencore International. The value of its stock has risen nine-fold since March. But Lee still sees opportunity as a strong U.S. recovery will hasten the need for materials.

Terex (TEX, Fortune 500)

Terex cranes and construction equipment can been seen at almost any construction site. The $9.9 billion manufacturer makes cement mixing trucks and surface mining equipment and is the world's No. 3 construction equipment maker. Terex said this summer that sales cold drop 40% to 45% this year amid the recession, but J.P. Morgan expects the stock to bounce back.

Lee cautions that every recovery slowly works its way through different economic sectors. Even so, he recommends retail investors buy strong operators before Wall Street analysts begin to turn bullish and upgrade their stocks. He notes that the number of "buy" ratings on S&P 500 companies are at their lowest level since 2003. "For a retail investor, that's important, Lee says. "They might anticipate [a recovery]." To top of page

More Galleries