Sunken Treasure?

By Daniel Kadlec

If stocks are finally near the bottom, which is the emerging consensus, a lot of market truisms fall neatly into place. Sure enough, in the end bear markets leave no places to hide. "Safe" havens like Coca-Cola and Philip Morris crashed more than 20% as the Dow plunged in June and July. Sure enough too, the collective wisdom of the market understands recessions better than the economists. Last week's revised figures show the economy contracted in not just one but three quarters last year. That deep pullback helps explain why the market began tanking in 2000, when economists were insisting the R word was overblown.

And, it turns out, we really do sell when we should buy: more than $30 billion flowed out of stock funds in July, the biggest one-month exodus since the 1987 crash. Selling stocks when prices are so low is "insane," says Morgan Stanley global strategist Barton Biggs. That scared money missed the Dow's 1,000-point rebound.

Throw in unusually high levels of short selling (a bet that stocks will fall) and frenzied institutional selling that drove the Dow to its closing low of 7702 on July 23, and you have a classic snapshot of how bear markets are supposed to end. Some market gurus now say the average stock is undervalued by 20% or more. Even if the major indexes haven't hit rock bottom, individually "many companies likely have hit their low," says Donald Straszheim of the economics firm Straszheim Global Advisors.

The analysts don't always get it right, of course, and many stuck far too long with stocks that plunged. This could be yet another false bottom. Three times since the Dow's descent began in January 2000 the market appeared ready to turn higher, only to suck in investors and saddle them with more losses. And a bottom does not signal an uninterrupted ride to higher ground. "After 20 years of a bull market, the bottoming process could take a long time," cautions Wallace Weitz, manager of Weitz Value fund. "The Dow could trade in this range [7700 to 10,000] for years."

Still, optimists are getting easier to find. Investors generally are encouraged by tough new laws on corporate fraud. Widely admired General Electric gave investors reason for hope last Wednesday, when it joined a growing list of companies that plan to treat stock options as an expense. Accounting rules don't require this, but not doing so has helped executives hide the truth about their companies' profits. And Stanley Works has scrapped plans to relocate in tax haven Bermuda. Though the decision sent its stock lower, it's likely to lead other companies to reconsider that ethically shaky strategy and is a sign that pressure on ceos to do the right thing is starting to work.

Want to put a face on the case for investing now? Try Warren Buffett's. In the past few weeks the fabled Omaha, Neb., investor has provided hundreds of millions in financing to telecom firm Level 3 Communications and energy firm Williams Companies. He bought a jewel of a natural-gas pipeline from Dynegy at the fire-sale price of $928 million. More illuminating: Buffett advertised himself as a buyer, telling the Wall Street Journal that "if I got a call this afternoon and somebody offered me A, B or C--securities, assets or a business--and it looked like a good idea, we could sign up a deal tonight. We move fast, and we always have cash."

Only a slip back into recession--the dreaded double dip--could take stocks much lower, says Straszheim. For that reason, he and others worry about the latest tea-leaf readings. Gross domestic product grew at an annual rate of just 1% in the second quarter, down from a 5% clip in the first quarter. And the recovery in manufacturing appears to be slowing. Such worries helped erase part of the market's recent gains, as the Dow fell 230 points on Thursday and an additional 193 points on Friday.

At moments like this, one common mistake is to hunt among fallen angels in the $2 range. Such stocks often end up in the zero range (see box, next page). Another mistake is to focus on companies that fell the most from their highs. In many cases the old high had no basis in reality and won't recur in your lifetime. The handiest measure of a stock's value is its price-to-earnings (P/E) ratio--price per share divided by earnings per share--compared with that of other companies in its industry and with the market and historical averages. But there are other useful calibrations. Here's how the pros evaluate five industries:

BANKING On the basis of earnings, a lot of bank stocks trade cheaper than the S&P 500's P/E of 18. But astute investors note that for the first time in a while, quality banks trade at less than two times book value. Book value is especially useful with banks, whose primary assets are cash and marketable securities. There's no fudging those values, which are adjusted daily. "They have some warts, with their exposure to bankruptcies in this climate," says value investor David Schafer, chairman of Schafer Cullen Capital Management. But he likes the group. Banks trading at less than two times book include Citigroup, Washington Mutual and FleetBoston.

DRUGS These stocks have traditionally commanded an above-market P/E because of their stable businesses and rich profit margins. People need medicine no matter how the economy performs. But lately there have been worries over patent expirations and a slim pipeline of new drugs. So the P/E for some has slipped below the market. "Pills are cheaper than hospitals," notes Bill Nygren, manager of the value-oriented Oakmark Fund. He expects the group to return to above-market growth. Among the cheapest are Merck and Bristol-Myers Squibb.

BASIC INDUSTRY This highly cyclical group includes Dow Chemical, aluminum producer Alcoa, rubber company Goodyear Tire and metal benders like Caterpillar--outfits that make what sells well in an economic recovery. Because their earnings are volatile, a better way to value such companies is by looking at sales, says John Manley, market strategist at Salomon Smith Barney. Over the past 30 years, he says, this group has traded at a 10% discount to the price-to-sales ratio (price per share divided by sales per share) of the S&P 500. The discount today is 30%.

ENERGY This industry has been scalded by the Enron scandal. The most compelling values are in natural gas (where Buffett has been buying). Typically, gas-company P/Es are slightly above the S&P multiple. Today the group trades at a 50% discount, Manley notes. Big oil companies don't look cheap, but domestic producers are trading below the market average, including Amerada Hess. Electric utilities are best valued by their dividend yields. Secure yields of 4% to 6%--as with FPL and Public Services Enterprises--are out there.

DEFENSE A nation preoccupied with national security is one whose military spending will rise for years. "This is a paradigm shift," says Richard Bernstein, chief U.S. market strategist at Merrill Lynch. "We're going back to a cold war mentality." He looks at defense stocks relative to tech stocks because most defense spending is in aerospace, surveillance and other high-tech areas. Such defense stocks usually trade at a 20% discount to tech overall, but today the discount is 55%. Boeing, Northrop Grumman and General Dynamics trade at deep discounts. This is a war you can win.