Defensives and selected cyclicals are the preferred stocks (page 2 of 2)

Even though it is reasonable to expect a rate cut on March 20, it will most likely have a limited impact only. While we do not doubt that lower interest rates will eventually have a positive impact on markets we do not believe that it is valid in the current environment. What the market is focusing on are earnings and news about the high levels of inventories. Lower interest rates will help but like the inventory burn-down they need time until they materialise in a recovery of earnings. The increasing pace of earnings downgrades witnessed over the last two weeks explains the weakness in many stocks but also underlines that a significant recovery of earnings and hence stock prices will take longer than expected. The uncertainty about the extent and the duration of the current slowdown results in the fact that there are no buyers around that are willing to step in even though some stocks appear to offer value under a long-term perspective.

After the sharp deterioration of economic fundamentals in February we find it too much of a bet to place new money in growth sectors at the current point in time. This offers opportunities for sectors, which generate stable earnings (defensives) and sectors that benefit from lower interest rates (cyclicals). The point about defensives is that valuations do not give a reason to buy them after the strong rally in 2000. Historically, these sectors are a sources of funds in an environment of declining interest rates. Even though the pharmaceuticals, food & beverage and to some extent the insurance sectors offer some safety in the current environment we would be selective in committing new money to these sectors. Over the last few days we noticed that interest in defensives is declining while selected cyclicals came back in investors' favour. Cyclicals are the relative outperformers among European sectors year-to-date. We find the reasons for this in the beneficial impact of lower interest rates but also in the attractiveness of low valuations. Even though an aggressive call on these sectors might be a bit early we feel that investors should slowly start picking up some good-value stocks soon. Many companies might report disappointing 2000 earnings but this would not be a surprise. History has shown that the best time to buy these stocks was the time when earnings were the worst.

We view Rhodia (RHA FP; EUR 15.24) and Schneider Electric (SU FP; EUR 72.45) as our top-picks and intend to add some more if the price is right.

Schneider reported a good set of earnings for 2H00 with an increase of 32% in profits. The company benefited from its cost cutting program but also from the strong business activity in the USA. Schneider's management expects 2001 sales growth to be strong in Europe and moderate in the USA. The management is confident to integrate Legrand on schedule and expressed interests in parts of Honeywell that GE might have to sell in the process of the acquisition.

ING (INTNC NA; EUR 75) reported an increase in 4Q00 profits of 18%, which was in line with consensus. The insurance unit (approx. 60% of profits) delivered an impressive performance, growing 28% in Q4. The fact that the banking unit disappointed is not so dramatic as ING sold parts of its troubled ING Barings assets to ABN Amro. ING remains on track to become a focused financial services company. We think ING is currently traded below its fair value and believe that the current price offers an attractive buying opportunity.

Aventis (AVE FP; EUR 88.10) reported an increase of 51% in full year 2000 EPS, which was ahead of consensus. Aventis showed further improvement in its product mix with sales of strategic brands rising 48%. The company reiterated its intention to dispose its Agri business. The company has stated that EPS growth for the future core business should be between 25 to 30% over the next three years. The shares remain a deeply defensive play in an uncertain world and still trade at a 15% prospective EV/EBITDA discount to the Euro Pharma sector. While Aventis remains a solid long-term hold we consider its short-term upside limited for the time being.