Finding value in current markets

US equities

Last week, the U.S. stock market ended in positive territory, with the S&P 500 having a return of 1.51%. Among the best performing sectors, Office Electronics gained 11.01%, Wireless Telecommunication Services (6.97%), and Fertilizers & Agricultural Chemicals (6.95%). The worst performing sectors were Homebuilding (-1.13%), Construction & Engineering (-1.71%), and Health Care Distributors losing 1.97%.

This week ISM Manufacturing, Vehicles Sales, Factory orders, and Unemployment Rate would be the major economic figures to be released.

For investors seeking stocks with attractive valuations, we recommend companies that did not rally as much as the market. Among our recommendations, these companies are Aflac Inc. (AFL, $32.02, CSFB: Neutral) having a return of 0.34% since March 31st, compared with a 19.71% return for the S&P 500, The Allstate Corp. (ALL, $35.75, CSFB: Outperform) with a 9.16% return, and Northrop Grumman Corp. (NOC, $95.48, CSFB: Outperform) with 12.26%.

Aflac Inc. is under pressure due to weaker-than-expected sales in the U.S. Instead of having 10%-15% sales growth in the U.S., the company reported only 4% in 2Q, and 8.8% in 1Q. However, we believe investors have over-reacted, because AFL reported an impressive 11%-growth in Japan in 2Q, where the company made about 75% of its revenue in 2002.

Investors avoided Allstate because of a lack of new customers. However, in the last quarterly report, ALL's profit increased 71% y-o-y after the company raised its rates. We believe the insurer would continue to benefit from its pricing power in the near-term, attracting more investors.

It is not a surprise that Northrop Grumman underperformed the market because this is a defensive stock, having a beta of 0.27 vs. the S&P 500. Hence, we believe this company is suitable for portfolio diversification. On the business side, the company is involved in major new weapons programs and would benefit from an increasing defense budget next year.

The technology sector research firm IDC published the most recent server computer market share data, which placed International Business Machines Inc (IBM, $82.01, CSFB: Neutral) at the top spot, with USD 3.23 billion in sales, or 30% market share.

IBM has been increasing its market share form 28% a year ago on sales of $2.93 billion. Hewlett Packard Co (HPQ, $19.93, CSFB: Neutral) came in second with 28%, flat year on year. The industry's revenue totalled USD 10.6 billion, a 0.2% increase from a year ago, which may indicate that IT spending is on the way to a recovery, but is too early to talk about a rebound.

Another winner is Dell Inc (DELL, $32.62, CSFB: Outperform), which was able to increase its share of the server market to 9.9% from the previous year's 8.4%. Dell aims to grow its server revenue in order to help boost its total sales.

Sun Microsystems Inc (SUNW, $3.90, CSFB: Underperform) has been on the losing side with its share of the market declining to 14% from 17%, due to a year on year drop in sales of 19%.

This is due to the increasing popularity of servers using Intel architecture and Windows operating system over Sun's Unix based systems. Sun can claim to be increasing its market share for Unix based servers, where it sells 33% in terms of value, but we expect the shift towards Intel/Windows products, as well as increasingly Linux based servers to continue.

We see both our recommended stocks IBM and Dell well positioned in the race for market share in the server area, with IBM being able to leverage its leading position and Dell to transfer its successful business model from the PC into the server market. We reiterate our buy recommendation on both companies.

European equities

The DJ EUR Stoxx 50 closed the week 1.4% lower at 2556.71

• Update on 2Q results by Arcelor and CB placement by Adidas-Salomon
• We added The Swatch Group to our recommendation list

Early in the week, market's attention was on the release of the German IFO Index, which managed to post the fourth consecutive rise (90.8 for August, July 89.2, consensus estimates 90).

The expectations component continued to rise to 102.1 for August (July 100.2, consensus estimates 101.3), but more importantly was that the assessment of the current state of the economy increased more than expected after it fell in July. Although this is a positive development it remains to be seen if the improvement was influenced by the underlying economy or simply by the recent rally in equity markets.

The ECB will meet this Thursday 4th September. Market consensus does not expect a further interest rate cut this month. The ECB's further action will likely be influenced by upcoming economic data and exchange rate developments.

Corporate newsflow was relatively thin this week; even more the focus was on the 1H results release from the two reinsurers Munich Re (MUV2 GR; EUR 93.20) and Swiss Re (RUKN VX; CHF 86.00). Whereas the headline figures from Munich Re disappointed and S&P's rating downgrade (from AA- to A+) just one day ahead of the results raised further concerns about Munich Re's capital position, the results from Swiss Re were solid, but benefited from gains in the investment portfolio.

However, since the beginning of the 1H, unrealised gains from the bond portfolio have been reduced and with 86% of investments in bonds the stock is clearly interest sensitive. This might have been among the reasons why the stock sold off over 3% on the day the results were released.

One of our cyclical stocks, Arcelor (LOR FP; EUR 11.75), also reported results. The figures came in on the weaker side and we would expect some short-term pressure. 2Q net income increased by 44% to EUR 166m vs consensus of EUR 216m. The management referred to the near term environment as still difficult and sees the 2H lower than the 1H.

On the positive side, 3Q steel prices could have been maintained although many expected them to decline. Arcelor - pursuing a price-over-volume strategy - follows its competitor's by reducing supply, which should help in stabilising prices.

The results show that the demand side of the equation remains weak, however the cost cutting and restructuring story of Arcelor remains intact. The stock trades on an EV/EBITDA of 4.1x for 04 against a historical range of 2.4 - 8.7x and we believe, once markets regain its focus of a likely recovery in the steelmarket, potential upside remains.

Adidas-Salomon AG (ADS GY; EUR 76.27) successfully placed a EUR 400m convertible bond with a conversion premium of 40%, a coupon of 2.5% and 15 years to maturity. Adidas had EUR 1.5bn net debt in 2002 with a gearing of some 132% stemming from the Salomon take over in 1997. The financing step lowers the risk of an interest rate rise and gives the company flexibility in terms of smaller acquisitions or share buy backs.

Given the shareholder friendly terms and the removal of the uncertainty, the market took it as a positive, Adidas increased by 5.5% for the week. We continue to believe that Adidas-Salomon will live up to its expectations when reporting 3Q figures. The 3Q is the most important for the company accounting for over 50% of the annual profit. We reiterate our buy.

We added The Swatch Group (UHR VX: CHF 136.00) to our recommendation list with a target price of CHF 158.00. Our investment case is based on: 1) valuation (at a P/E 04E of 13.4x and an EV/EBITDA 04E of 7.2x, the stock trades at the low end of the historical 20-40% discount vs the luxury goods sector) and 2) earnings and margin upside in the 2nd half of 2003 due to signs of improving demand and cost measures coming into effect.

IH 2003 results were in the range of LVMH's, but stronger than Richemont's or Bulgari's suggesting that Swatch had gained market share. Management sees encouraging signs of improving demand in July/August from the retailers and estimates inventories in the trade have more or less returned to normal levels. In addition the product mix strategy looks promising with more and more products being positioned at the higher end of the pricing range.

In general, we would look for a balanced portfolio with some defensive names such as Nestle (NESN VX; CHF 305.00), selected higher beta plays such as Siemens (SIE GY; EUR 56.40) and selected exposure to consumer goods such as Adidas-Salomon (ADS GY: EUR 76.27) and Swatch (UHR VX; CHF 136). Our call on dividend yield remains intact with the following counters:

Total (FP FP; EUR 139.70) 2.94%
ENI (ENI IM; EUR 13.76) 5.43%

Restructuring play in auto sector:
DaimlerChrysler (DCX GY; EUR 34.69) 4.32%

Restructuring/German play in engineering sector:
MAN (MAN GY; EUR 20.00) 3.00%

Value/Restructuring play in commodity sector:
Arcelor (LOR FP; EUR 11.75) 3.23%