The question I get asked most these days is, “What will be the effect of war with Iraq on the economy and the stock market?”
It’s a fair question, but it is also disturbing. That’s why I was grateful when I received this important variation on the theme from a reader in Baton Rouge, La.:
“Is there room for a moral component in a discussion of investing in a time of war?” the anonymous reader asked, adding: “Even if this war turns out to be quick and successful in every way, it’s going to involve the death of a lot of human beings. This question is a consequence of my seeing some of the ‘experts’ on financial news shows cheerfully prattling on about how to maximize returns based on a war. I have to say, it turned my stomach. (And please don’t assume I’m a knee-jerk anti-war, anti-capitalism type. I’m not.)”
Well, I’m not either. And this is how I answered:
“Yes, yes, yes. Morality counts. . . . I also agree with you that a discussion of the economic effects of war is, in one sense, unseemly.” Still, imminent war dominates the markets; it affects every portfolio, every retirement plan, every decision to invest — or not to. We can’t ignore the economic and financial effects of war, and we shouldn’t feel shabby considering them. But keep the right perspective. Money, as they say, isn’t everything.
While the most likely reaction of the markets to the start of military action is a rise in stock prices, it’s far from sure. Yes, stocks soared after the bombing started in the 1991 Gulf War, but history rarely repeats itself precisely — especially if investors think it will.
As Michael Driscoll of Bear Stearns, the New York investment firm, recently wrote:
People are awfully cavalier about the potential for war with Iraq and the commonly held view that stocks will rally and oil prices will plunge as soon as bombs start dropping. That scenario is too pat. The only thing I know for certain is the market will do its best to screw up the most people possible.
Jeffrey Saut of Raymond James & Co. is even more adamant. “There is . . . little doubt in our mind that the consensus ‘call’ that once the war begins the economy and stock market will do just fine, will likely prove false.”
Byron Wien of Morgan Stanley takes a more nuanced view. In a long, perceptive essay (U.S. Investment Perspectives, Feb. 26), he wonders, even if the war goes well from the start, whether there is “enough latent buying power for a strong rally.” Since individual investors have been shell-shocked by the long bear market and the accounting scandals, he doubts they will drive a rally, but institutions might. Certainly, the cash is waiting in the wings.
“I believe most investors think that the rally will be short-lived and the indexes will head back down after a brief victory run-up,” Wien wrote. “The surprise would be if the market begins a climb of longer duration and greater scope. My assessment of the various conflicting factors leads me to conclude that a better-than-expected outcome is probable.”
Wien is convincing, but no one can possibly know what will happen to Iraq or to Wall Street. In conditions of uncertainty, investors have two choices. One is to sit on the sidelines — that is, to sell stocks or at least stop investing in them, putting new money into bonds or cash until clarity arrives. The other is to admit ignorance of short-term events, both geopolitical and financial, but to continue to invest sensibly for the long term, seeking attractive opportunities caused in part by excessive fear.
The second option, as you may have guessed, is the one I favor, but, as I wrote last week, bonds are a perfectly rational alternative.
Look at the latest research by Ibbotson Associates (cited in the February issue of AAII Journal, the publication of the American Association of Individual Investors). Ibbotson found that over the 15 years that ended Dec. 31, 2002, an all-stock portfolio comprising the companies of the benchmark Standard & Poor’s 500-stock index returned an annual average of 11.1%, while a mixed portfolio — 50% stocks and 50% high-grade corporate bonds — returned 10.6%. An investment of $1,000 in the all-stock portfolio became $5,370, while the same amount in the 50-50 portfolio became $5,010 — not much difference when you consider that the all-stock portfolio produced a much scarier ride, with two-thirds more volatility.
Bernstein Investment Research and Management, in a report last year titled “Sleeping with Enemy” (the “enemy” being volatility), studied stock and bond portfolios over 40 years and concluded that a combination of 60% stocks and 40% bonds carries a “superb risk/return tradeoff.”
Still, deciding abruptly to dump your stocks to buy bonds today, after a huge bear market in stocks and a huge bull market in bonds, seems risky in itself. A long-term strategy of using bonds to balance stocks makes sense for risk-averse investors, but panicky shifts because of what’s happening in the Middle East do not.
But back to stocks. One of the most attractive opportunities appears to lie with brand-name, blue-chip companies that have shown they can increase their earnings and dividends over time. Investors don’t often get the chance to become part-owners of such firms on the cheap.
“When truth and faith are lost,” says Robert W. Smith, manager of the T. Rowe Price Growth Stock Fund (PRGFX), “you get a compression of price-to-earnings multiples. In terms of valuations, investors stop differentiating between companies with great growth prospects and those with average growth prospects. . . . This creates opportunity because you can pay average prices for superior growth companies.”
Among Smith’s top holdings at the end of 2002 (most recent report) was Freddie Mac (FRE), whose dividend has risen from 19 cents a share in 1992 to 88 cents today, with earnings rising each year at double-digit rates. But Freddie, which provides funds for home mortgages, trades at a P/E of 7, which is less than half its average for the decade. Also in Smith’s top 10 are Citigroup (C), the world’s second-largest financial firm, which trades at a P/E of 11, about one-third lower than its average for 1997-2001, despite consistently rising earnings, and Target (TGT), the innovative retail powerhouse, which is bucking a tough environment but is still boosting earnings as it has in the past. Target trades at a P/E of only 15, also about one-third below its average of the past five years.
Other stocks in the T. Rowe Price Growth Stock Fund that may be blue-chip bargains include two prestige managed-care companies, UnitedHealth Group (UNH) and WellPoint Health Networks (WLP). The Value Line Investment Survey gives each its top rating (“1″) and projects each will increase its earnings over the next three to five years by an annual average of more than 20%. United has a P/E of 20; WellPoint, 15. The average P/E of the S&P 500 stocks is 28; of the Dow Jones industrials, 21. By the way, Smith’s fund charges an expense ratio of only 0.77% and has beaten the S&P by an annual average of 2 percentage points over the past five years.
Another indication that a stock may be inexpensive is a high dividend yield. Value Line recently used computer screens to find 14 high-yielding stocks that also carried “low risk” (a safety rating of at least “2,” which is above average) and a record of strong dividend growth (in most cases more than 10% over the past five years). Many of the stocks fit into the blue-chip bargain category as well.
A standout is Altria Group (MO), the new name for Philip Morris Cos., which makes cigarettes (Marlboro, Benson & Hedges) and owns 84% of the world’s second-largest food company, Kraft (Maxwell House, Jell-O). Altria trades at a P/E of less than 8 and yields 6.6%. Clearly, tobacco companies carry risks, but profits have been rising year after year, and the dividend has gone from 21 cents a share in 1986 to $2.56 today.
Other companies on the Value Line list include ConAgra Foods (CAG), the No. 3 food company (Swiss-based Nestle S.A., is first), with a dividend yield of 4.5% and an “A” rating for financial strength; Charter One Financial (CF), whose profit has grown at an annual average of 20% for the past five years but, nonetheless, has a P/E of 12 and a dividend yield of 3.1%; and General Electric (GE), now yielding 3.2%, with a “1″ rating for safety and projected dividend growth of 12% annually for the next three to five years.
A good source for smaller prestige growth companies is the portfolio of one of my favorite mutual funds, First Eagle Fund of America (FEAFX), whose co-managers, Harold Levy and David Cohen (each holding his job for more than 13 years), concentrate on mid-cap stocks. First Eagle, according to Morningstar, “deserves more attention” for its consistent market-beating performance.
Top holdings include Yum Brands (YUM), which owns KFC, Taco Bell, Pizza Hut, and other restaurant chains and carries a P/E of 12 after losing nearly one-third of its value in the past six months; American Standard (ASD), air conditioning, plumbing and auto brakes, at a P/E of 13; General Dynamics (GD), nuclear subs, business jets, and tanks, also at a P/E of 13, and a dividend yield of 2.1%; and Ball Corp. (BLL), cans, jars, and aerospace technology, at a P/E of 19.
I am ending with two defense stocks, but don’t think you can make a fortune just by betting on arms makers. General Dynamics (GD) stock has dropped 35% over the past 12 months, and Lockheed Martin (LMT), the world’s largest defense contractor, is off 20% — while Ball is up 17% in a year and has more than tripled since late 2000.
Investing on the brink of war is far from simple. It’s best to stick to the basics: a broadly diversified portfolio of sound, growing companies at low prices. Stocks that meet those criteria are more abundant today than they were a couple of years ago.
— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. Of the stocks mentioned above, he owns General Electric. This column originally appeared in the Washington Post.