Bargain hunting in a stormy market
Fears of further rate hikes have rattled global markets - and created some enticing opportunities.
(FORTUNE Magazine) -- Murky. That's probably the best way to describe the outlook for the stock market these days. The May-June selloff sliced 5% from Standard & Poor's 500, and that was a portfolio paper cut compared with the mauling inflicted abroad.
Stocks fell 18% in Japan, for example, and 22% in Brazil. The big question now: Is the selloff a buying opportunity for brave investors or a warning sign for everyone that worse is yet to come?
Our own view is more the former than the latter, but conflicting signals do abound. Corporate earnings growth remains strong - on pace to rise 9% this year, according to analyst projections - and interest rates are still historically modest. On the other hand, margin debt - the lifeblood of the stock speculator crowd - is at its highest levels since 2000, according to the New York Stock Exchange.
On the economic front, new Federal Reserve chairman Benjamin Bernanke has made several comments that investors have taken as signs that he's not ready to stop raising interest rates. Whereas pundits once painted Bernanke as an inflation dove, today's conventional wisdom is that he's more likely to err on the side of raising rates too much than too little.
It was this specter of continuing rate hikes that sparked the global stock market downturn.
Investors' concern: Higher borrowing costs typically crimp consumer and corporate spending, slowing the economy. And, notes Rudolph-Riad Younes, manager of the $19 billion Julius Baer International Equity fund, any rate-induced weakening in the U.S. economy could slam the brakes on growth around the world. China, for instance, sends 40% of its exports to the U.S. "We are the locomotive of the global economy," says Younes.
Some of the declines overseas were probably inevitable. Emerging markets have been returning nearly 40% a year since October 2002. Not surprisingly, those gaudy returns attracted billions of dollars from go-with-the-flow investors.
In May, according to AMG Data, 87% of the $11 billion invested in equity mutual funds went into global or international funds. "This is the signature 'stampede' of the performance-chasing herd flocking into the hottest-performing asset category," Leuthold Group senior analyst Eric Bjorgen wrote in an April research note. "We have seen time and time again, these kind of trends rarely end well." As he predicted, the hot money departed at the first sign of trouble, pulling $4 billion out of emerging-markets funds in late May and early June, deepening the declines.
Despite the global jitters, we're modestly optimistic.
For one thing, the correlation between Fed tightening cycles and stock market declines isn't quite as strong as people assume. According to Bjorgen's research, since 1969 the S&P 500 posted positive 12-month returns following three of the last seven Fed tightening cycles (excluding the current one).
Second, the hot money now fleeing all kinds of interest rate sensitive stocks - from foreign banks to U.S. homebuilders - pays little attention to the valuations left behind. As a result, the price/earnings ratios and dividend yields on some of these stocks now more than amply reflect any recession risk.
Finally, for all the hand-wringing over inflation, it's worth remembering that it wasn't so long ago that deflation was supposed to be the big, long-term, economic risk. Zachary Karabell, Alger Funds' chief economist, still thinks it is.
The twin pillars of the world economy are globalization and rising productivity, he says, "and they're both deflationary." Karabell dismisses the current scare, noting it's hard to have a true inflationary spiral without wage pressure. And labor costs are rising at an annualized rate of only 1.6%.
Panic sellers aren't known for being selective, which can make selloffs rewarding for investors willing to buck the trend.
With that in mind, here are five stock market plays in sectors that have been hit particularly hard by the recent downturn.
Okay, we were wrong last August when we said the worst was over for homebuilder stocks. Since then KB Home (Charts) and D.R. Horton (Charts) have cratered more than 30% (even as the companies themselves continued to post 25%-plus earnings growth).
There's no question that higher mortgage rates have cooled demand for new homes. That said, the current valuations of these stocks make no sense - a sentiment shared by Legg Mason Funds' value ace Bill Miller, who's been buying homebuilders like mad.
D.R. Horton, KB Home, and Pulte Homes (Charts) are all trading at just four or five times the previous 12 months' earnings, making them the cheapest stocks in the entire S&P 500. Profits would have to decline 50% or more to justify such valuations, and there's simply no reason to think that's going to happen.
Housing starts have already shown signs of bouncing back, rising 5% in May, and average home prices are still rising. So if you have the nerve for a truly contrarian play, consider the Dow Jones U.S. Home Construction index (Charts), an exchange-traded fund that consists only of homebuilder stocks.
Generally speaking, Merrill Lynch foreign-stock strategist Michael Hartnett thinks investors should hold off before putting new money into emerging markets. "There are too many people looking for an autumn rebound than an autumn re-test of recent lows," he warns.
One exception, in Hartnett's view, is Turkey, where he thinks the stock market's 45% drop since February has been excessive, particularly in light of the sound fiscal and monetary policies Turkey has embraced in recent years.
Adrian Mowat, J.P. Morgan's emerging markets strategist, has been advising institutional clients to buy Turkish bank stocks and industrial companies. For individuals, probably the best way to buy Turkish stocks is via the Turkish Investment fund (Charts), a closed-end fund managed by Morgan Stanley.
A U.S. mining company with big operations in Peru and Mexico, Southern Copper (Charts) has been hit by a double whammy. Not only has it faced an inflation-triggered decline in global copper prices from $4 to $3 a pound, but the company has also been hit by labor strikes at two Mexican mines.
The good news for investors is that at $75 a share - down 27% from its early-May high - the stock now trades at seven times earnings and boasts a dividend yield of 11%. Not bad for a company that's still expected to boost earnings 56% this year.
Here's a classic example of a bargain left behind when hot money runs for the hills. Since May 8, ADR shares of Cemex (Charts), the big Mexican cement producer, plummeted 22% to $55. At nine times earnings, Cemex now trades at a 35% to 50% valuation discount to rivals such as LaFarge. Citigroup analyst Stephen Trent has a 12-month price target of $78 for Cemex, calling the recent selloff "an outstanding opportunity."
Based on trailing earnings, Diamond Offshore (Charts), one of the world's leading deep-ocean drillers, doesn't look cheap. But Diamond's 21% stock price decline presents an opportunity to grab a terrific growth stock at a sharp discount.
With oil holding at around $70 a barrel and global fuel demand showing no signs of abating, day rates for drilling rigs are skyrocketing. Diamond's profits are expected to triple in 2006, which means that, at $76 a share, the stock is trading at 29 times trailing earnings but just 14 times projected 2006 earnings.
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