John Dorfman—Value Stocks a Safe Harbor from Poor Earnings Reports

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Microsoft Corp. rocked the stock market when it announced that per-share earnings for the December quarter will be 2 or 3 cents shy of expectations.

The same day, Chase Manhattan Corp. and J.P. Morgan & Co. warned their fourth-quarter earnings would miss estimates “substantially.”

These were followed by earnings warnings from Compaq Computer Corp. and Whirlpool Corp. that again tripped the market.

And then General Motors Corp. and Eastman Kodak Co. were the bearers of bad news.

How can you cushion your portfolio against damage from earnings disappointments? There’s no sure way, but a few steps may reduce the frequency and severity of the damage.

First off, you should prefer value stocks to growth stocks. The latter suffer far more when earnings fall short of expectations.

Second, consider buying stocks with above-average dividends. The dividend provides an anchor of value if the market turns nasty. My market view (a sophisticated term for my guess) is that we will have a good rally in January, but the rest of 2001 will be fairly unpleasant.

Third, it may help to choose stocks that have shown high profitability (as measured by return on equity and return on assets) in the past. That way, if the company’s business sags, there’s a better chance the results will still be written with black ink, not red.

With these considerations in mind, I used Bloomberg stock-screening software to look for stocks that are reasonably valued, had a return on equity of at least 17 percent in their latest fiscal year and carry a dividend yield of 4 percent or more.

Five favorites

Here are five stocks I like that meet those criteria.

TRW Inc. is a conglomerate or as they say nowadays, multi-industry company based in Cleveland. It gets about 70 percent of revenue from automotive products (air bags, antilock brakes, chassis, electronics, engine components and seat belts, among other things). The other 30 percent comes from aerospace and defense products such as satellites, defense communications equipment and lasers. TRW sports an attractive dividend yield of 4.4 percent and an alluring price-earnings ratio (stock price divided by the past four quarters’ per-share earnings) of 7.

In 1999 it earned a 20 percent return on stockholders’ equity.

Its main drawback is a heavy debt load. Debt was recently about 250 percent of equity.

Also, the auto-parts business is vulnerable to a recession or slowdown.

But in general, I like conglomerates (because they can be profitably disassembled or restructured) and I like defense stocks, so TRW looks pretty good to me.

Allegheny Technologies Inc., based in Pittsburgh, has a stronger balance sheet than TRW, with debt recently 57 percent of equity.

Its 1999 return on equity was close to 24 percent and it sells for only 9.5 times earnings because it is perceived (rightly) as a cyclical stock that rises and falls with the tides of the economy.

The company makes stainless steel and various metal products such as titanium, tantalum and nickel and cobalt alloys. The dividend yield is 5 percent.

Again, this one could have problems in an economic slowdown. But the stock, down to $15.88 from $26.81 in May, seems already to discount a fair amount of bad news.

Banking opportunities

Next come a pair of banks, First Union Corp. and Wachovia Corp. I’m not totally objective about First Union Dreman Value Management, with which I’m affiliated, owns some First Union shares, as does my wife.

That said, I think First Union shares are a steal for long-term holders at about 9 times earnings.

The stock has been knocked down to $27.19 from more than $65 in July 1998.

Trouble in assimilating a couple of major acquisitions contributed to the decline. The company, based in Charlotte, has suffered six quarters in a row of unfavorable earnings comparisons.

But I think it will set things right, as it was considered a skillful assimilator of acquisitions in the past. First Union yields 7.1 percent in dividends and had a 1999 return on equity of 19 percent and return on assets of 1.3 percent.

Wachovia, based in Winston-Salem, N.C., also strikes me as a bargain.

It has historically had good profitability (for example, in 1999 it earned 1.5 percent on assets and 18 percent on equity), but it sells for only about 11 times recent earnings and yields 4.7 percent in dividends.

Probably the most speculative stock in the group is American Capital Strategies Ltd.

It’s based in Bethesda, Md., and lends money to small businesses and often takes an equity stake as well.

Its average customer has been in business for 41 years and has $97 million in annual sales. On average, American Capital Strategies has a 31 percent equity stake in the businesses to which is lends money.

Its dividend yield is 8.8 percent, and its 1999 return on equity was 42 percent.

Obviously, it is risky to invest in a business-loan company at a time when the economy seems to be slowing down. But American Capital’s loan-quality checks are pretty good, according to analysts who follow the company.

All 11 analysts have “buy” ratings on the stock.

That fact actually gives me some pause, as I usually like to be on the other side of the popularity equation. However, this company is small enough to still provide room for it to be “discovered” by institutional and individual investors, which for me takes some of the curse off the 11-0 recommendation tally.

One more thing I like about American Capital Strategies is that its insiders have been frequent buyers of the stock.

John Dorfman is president of Dorfman Investments in Boston and a columnist for Bloomberg News.

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