Defensives and selected cyclicals are the preferred stocks

US Stocks

In the last couple of weeks, we have been using financial ratios to see how a commonly held list of stocks compares with each other; the list consisted of both technology as well as non-tech shares.

In this final installment, we have consolidated them, and added a fourth category, which is the past 5 quarters inventory turnover rate:

-R&D to net sales
-R&D to operating cash flow
-Cash return
-Inventory turnover

In terms of inventory build-up, it is interesting to see the two companies with the largest deterioration in turnover rate were biotechnology companies, namely, Amgen and Biogen. Others that showed slower signs of turnover are - Cisco system, Broadcom Corp., and Lucent Technologies. But we do not see an across the broad weakness, perhaps the decline will only come in the first and the second quarter of this year.

The top twenty stocks from each category are as follows:

Microsoft Inc. (MSFT $56 11/16)
Boeing Co. (BA $60.10)
Intel Corp. (INTC $29 5/16)
General Electric (GE $44.57)
Computer Associates (CA $29.65)
Eastman Kodak (EK $43.98)
Cisco Systems (CSCO $22 3/16)
IBM (IBM $102.30)
Oracle Corp. (ORCL $16 7/8)
3M (MMM $111.33)

The above stocks should be considered as long-term buys.

US Technology Stocks

On a week on week basis, the NASDAQ Composite Index declined 6.4% to 2117.

With a recovery in economic growth rates in the US still an uncertain event, business confidence remains weak and has continued to prompt corporate decision-makers to hold tight onto company wallets. With corporate "purse-strings" drawn excessively tight, a menacing "IT-liquidity-crunch" virus has been spawned and has spread like "wild fire" across companies in the US.

This latest virus has the ability to delete or dramatically scale down corporate IT spending programs and subsequently amplify to erode earnings potential for technology companies all along the food-chain. And, Oracle (ORCL US, $16.875, CSFB rating downgraded to Buy) has been it's latest large-sized public victim.

Last week, ORCL warned that it would miss 3Q01 EPS ($0.10 versus $0.12 expected) and revenue ($2.67 billion versus $2.92 billion anticipated) estimates due to weak business sentiment that caused several deals to be delayed at the last minute. Though the lower growth scenario was not completely unexpected, investors were nevertheless shocked by the magnitude of the decline. ORCL highlighted it's software sales, which were approved by the customer's mid-level management, failed to get final approval from top-level executives on concerns about the economy. The surprise shortfall was due mainly to weaker sales in the US (57% of total sales), with sales in Europe (29%) and Asia Pacific (14%) remaining healthy.

With sentiment weak across all technology issues and near-term demand visibility limited, we remain cautious ahead and recommend taking a conservative approach to accumulating technology stocks. For the week ahead, we expect sentiment to remain depressed and we believe ORCL's stock price has the potential to trek lower towards $14.00. As such, we have revised our recommendation on ORCL to a near-term HOLD.

For those who followed our suggestion of exploring a 3-tiered accumulation on ORCL (CS Weekly, dated 26-Feb-01), we recommend to HOLD and wait for further price stability before considering to accumulate more.

T1 = 1st tier buy level
T2 = 2nd tier accumulation level
T3 = 3rd tier accumulation l

Europe

Hopes of an early US rate cut by the FED proved to be wrong dashing the market's only hope to find a bottom. 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.