Focus on defensive, income paying stocks

US Markets

• Recommendation update
Defence stocks have been hit in the 4th quarter. We believe this is mainly due to sector rotation. Investors are taking profits in order to invest in other sectors. Furthermore, in letting in the UN arms inspectors, Iraq has to an extent appeased the stock markets. Besides, according to Morgan Stanley & Co., defense stocks have the tendency to underperform the S&P500 in the fourth quarter. Budget timing means the biggest awards are less likely to occur in the last quarter of the year, so there are few positive triggers to buoy the sector. We remain positive on this industry, maintaining our BUY recommendation on General Dynamics Corp. (GD, $78.80, CSFB: Outperform). Firstly, we think the risk of a war on Iraq remains, and we believe the defence sector could benefit from it. Secondly, companies with military-related business should remain beneficiaries of the Bush administration. Finally, the group presents strong fundamentals and a low correlation with the S$P 500 on a five-year basis.

Boeing Co. (BA, $31.50, CSFB: Outperform) announced that the first launch of the Delta IV has been delayed. The launch was initially planned on Saturday November 16th. The next launch window has been planned for next Tuesday. The Boeing Delta IV Medium+ (4,2) rocket will deliver the W5 commercial telecommunications satellite to space for Eutelsat S.A. of France. The Delta IV family is composed of five launchers, able to launch any size, medium or heavy payload into space (source: Boeing Co.). We believe, if the launch were a success, this would increase BA's space & communications business, which accounted for approximately 17% in FY01. Nevertheless we do not think a potential success next Tuesday would significantly affect the stock price. This is more a long-term story, and the company could fully benefit from its new launchers in 2-3 years. However, a failed launch could be detrimental to the stock price.

Also, Boeing is in talks with SPEEA union (Society of Professional Engineering Employees in Aerospace) to renew a three-year contract, expiring on December 1st. It would give employees annual pay raises of 4% and require them to pay more for some health insurance plans. Union's leaders, who represent 18,000 engineers, recommended accepting the terms. We believe a smooth agreement would be considered a non-event and the stock price would not react strongly. We maintain our buy recommendation, due to attractive valuations, even if the risk of UAL's bankruptcy remains strong.

It was an eventful week for the technology sector, with Dell Computer (DELL, CSFB Rating: Outperform) releasing its figures. Expectations were quite high and so even if the company actually met analysts' forecasts, the market viewed it as a disappointment. One positive point for Dell was that the company had been able to increase its sales in a weak environment with most of its competitors still struggle. The resulting decline in DELL's share price shows us that expectations might still be too high with regards to the technology sector. Dell has been able to perform during the last quarter, thanks to growing sales in the server business, where revenue increased by 27%. The fact that businesses are scaling down on IT projects helps Dell, which is offering low-end server solutions, based on the Microsoft Windows operating platform. From this perspective DELL is a suitable partner for Microsoft (MSFT, CSFB Rating: Not Rated) in its strategy to provide operating platforms for all different kinds of computers, from desktops via servers to handheld devices. We believe Microsoft is on its way to expanding its dominance in the software market.

However, the Federal Trade Commission will be watching Microsoft's expansion closely. For this purpose Microsoft has started to implement a task force, in order to ensure that the company is complying with the settlement that had been agreed with the US administration.

But there is still the European Commission to contend with. We cannot assume that the outcome will be similar to the settlement with the US administration, as the case here is slightly different with no offer for a settlement having been made. A ruling on the case is not expected before the end of the year.

We do not expect the case to be a major issue for Microsoft, as it is very unlikely to make a difference if Microsoft's bundling of software is just for convenience or if it gives MSFT an unfair advantage over its competitors.

We remain positive on Microsoft and believe that the growth story has not yet ended. We have a Buy recommendation on the stock and a 12-month price target of $70.

Philip Morris Cos Inc (MO US, US$38.06 CSFB: Not Rated) announced last week that they are retracting their FY03 EPS growth estimates of 8-10% given just two months ago. The stock has been beaten down 13% to US$38.06 in a matter of one week. We believe that the market is valuing MO solely on its Philip Morris USA business, which currently accounts for only 28% of its operating income and 20-23% going into FY03. The principal issue remains tackling the widening price gap between the discount brands and MO's premium brands such as Marlboro and NOT as most investors would believe the legal risk profile. In terms of its international tobacco business and Kraft foods, MO is firing on all cylinders. MO is a quality cheap stock with a solid balance sheet and strong free cashflow, which we believe should serve to maintain its lofty dividend yield of 7%. It is our view that this would be a good time to time to buy MO. We are attaching a US$46 dollar target price based on a conservative 8.5x 2004 earnings and a stop-loss level of US$31.


European Equities

• The Euro STOXX50 closed the week 3.5% higher

• We continue to be cautious on Allianz as it is the insurer most geared to equities in Europe

• Vodafone is our preferred exposure in the telecom sector and triggered by its good set of figures, the stock moved to a new trading range between GBP 1 - 1.20

Although sentiment seems to have improved during recent weeks, we believe economic reality remains difficult. The macroeconomic picture did not change for the better, the prospect of war - although temporarily diminished - still looms and cost cuts may not be enough to offset limited revenue growth from stalling economies. We would like to see improvement in sales and operating performance before we turn more positive. In the meantime, we suggest using any rally to lighten up positions in aggressive growth stocks and focus more on low beta, dividend paying defensive stocks.

The European Commission cut its growth forecast for the Eurozone for this year from 1.4% to 0.8%, which is the slowest pace in nine years. In addition, we believe that after the publication of the ECB's monthly report for November in which a lower medium-term inflation was predicted, a rate cut - probably 50bps - on their next meeting on 5th December will be a given and what the market expects.

It was an important week for financials. While many of them were reporting huge quarterly losses, investors preferred to focus on forecasts for improved earnings based on hopes of diminishing future provisions and improving equity markets. Although valuations of banks look attractive (banks trade on a PER 03 of 13x compared to the market 18x and implied growth of the banking sector is 1.1% whereas they delivered 11.3% on average over the last 10 years), we remain cautious on the sector, as we would like to see clear signs of improving economic data and equity markets.

UBS (UBSN VX; CHF 70.55) reported earnings ahead of expectations with a 4% increase in 3Q03 net profit to CHF 942 million. This compares to a consensus of a drop in net profit of 8.4% to CHF 827 million. The strong credit quality of UBS is remarkable. The company had to take 3Q02 provisions of only CHF 95 million, which compares very favourably to the much higher than expected provisions announced by BNP (BNP FP; EUR 42.68), Deutsche Bank (DBK GY; EUR 49.44) last week and Commerzbank (CBK GY; EUR) and Allianz's (ALV GY; EUR 102.99) Dresdner unit which also reported this week.

Allianz (ALV GY; EUR 102.99) reported a 3Q net loss of EUR 2.5bn and a 9month net loss of EUR 924m compared to CSFB's estimates of EUR 2.1bn and EUR 532m respectively. The 3Q loss has to be attributed mainly to the write down of the value of the investment portfolio and losses at its Dresdner Bank unit. Dresdner Bank contributed a loss of 972m to its parent 's result as provisions for bad loans climbed to EUR 1.8bn. Allianz also set aside USD 750m for asbestos-related claims and EUR 550m to cover claims related to the flooding in Eastern Europe earlier in the year.

Being the insurer most geared to equities in Europe, we would still be cautious, as Allianz remains dependent on the performance of equity markets not only via its insurance but also via Dresdner Bank, which faces a depressed investment banking environment and a highly competitive German lending market.

AXA's (CS FP; EUR 14.15) 3Q02 revenues grew 1% to EUR 16.8bln, which was seen as somewhat disappointing by the market. AXA's management said that the slumping stock market made it impossible for the company to predict operating performances for its businesses and hence remained 'cautious on 2002 operating earnings growths'. We see this as a clear sign that the company is abandoning earlier guidance and is preparing the market for a disappointment. AXA, through its Alliance Capital fund management arm, is more exposed to equity markets than most other insurers. This is why AXA remains one of the most leveraged plays on the equity market and as such a good stock for trading the high volatility going forward.

We believe that telecom stocks have seen their worst days and are now in their bottoming phase. The major operators have addressed their high levels of debt with restructuring measures and asset disposals over the past year. Additionally, these companies have now shifted their focus to profitability after the expansion phase is mostly terminated. This is a good combination for profits to grow in the medium term. With most of these companies now being priced like low growth companies such as utilities the current downside risk is reduced considerably. We would still be cautious with companies such as France Telecom (FTE FP; EUR 12.56) and Deutsche Telecom (DTE GY; EUR 11.58) as both of them still have relatively high debt. Deutsche Telecom reported a record net loss of EUR 20.6bn after writing down over EUR 22bn in its US unit and the unit's mobile phone licences.

Our preferred exposure to the sector remains Vodafone (VOD LN; GBP 1.155), which reported an impressive set of figures, well ahead of expectations. Proportionate EBITA (incl. pro rata figures from non-controlling stakes) came in at GBP 6.203bln versus expectations of GBP 5.59bln. EPS was at p3.3 versus expectations of around p 2.7-2.8. Vodafone generated GBP 2.9bln in free cash flow in the first six months of its fiscal year, which is more than in the previous fiscal year. Net debt could be reduced to GBP 10.7bln from GBP 12.2bln. The excellent result was achieved due to a good performance in markets such as Japan and Italy where EBITA margins came in much stronger than expected at 32% and 49% respectively. Vodafone now generates about 14% of its revenue from data services with Japan leading this development. We believe that the data services business is a key growth area for telecom operators in the coming future and Vodafone seems to be best positioned to benefit from this trend. Vodafone expects 10% customer growth and 15% EBITA growth next year, which is more than twice CSFB's forecast. With free cash flow of GBP 4-4.5bln now possible for the whole fiscal year Vodafone's FCF yield would arrive at 6%-7%, which is almost twice the sector's average of 3.5%. On that basis Vodafone appears to be cheap and we would expect that the results helped the stock to break the resistance level at GBP 1.10 and lifted the stock's trading range one level higher to the GBP 1-1.20 range from the GBP 0.80-1 range that the stock established in the past few months.