Unloved and Underowned

By James J Puplava CFP and Chris Puplava, July 22, 2005

INTRODUCTION
by Jim Puplava

At a time when asset markets appear to be overpriced and value is hard to find, opportunities still exist in the financial markets. Three areas stand out in our opinion: healthcare, in particular pharmaceuticals, energy in all forms, and lastly telecommunications. All value is relative, but when compared to existing markets these markets look relatively cheap. The S&P 500 is selling at 20 times current earnings and 16 times forward earnings. At 45 times this year's profits, the NASDAQ is selling at nosebleed levels. Dividend yields are still nonexistent with yields at 2% for the S&P 500 and 1.5% for the Nasdaq. Given these high valuations and deteriorating fundamentals for most sectors of the market it is refreshing to find sectors like those listed above where valuations look relatively attractive and fundamentals look promising.

Despite the attractiveness of these sectors they remain largely unloved and underowned. Energy carries an 8% weighting within the S&P 500 and telecom is down to under 3%. Only healthcare, which is a broad sector, has a weighting comparable to S&P heavyweights such as technology (16.6%) and financial (22.2%). Looking at institutional holdings you will find that fund managers and large institutions have been sellers of pharmaceuticals throughout the first and second quarters. They have also been big sellers of energy. Yet the demand for energy keeps growing, the population keeps aging and the demand and uses for telecommunications keeps expanding. Despite predictions for lower oil prices over the last three years they have never arrived. For the first time in decades oil demand has reached parity with supply. The IEA keeps increasing its estimates for the demand for oil, Chinese car sales are up 24% this year, and everywhere you look outside Russia and the Canadian oil sands, production keeps falling. To me this spells opportunity. If I'm wrong in the near-term investors will still have attractive dividends that they can count on rather than rest their hopes on the promise of future growth estimates that may or may not materialize.

Speaking of earnings, this quarter it is anticipated that S&P 500 earnings will be up 9% versus expectations of only 6%. The reason for the increase is energy. Energy sector earnings this quarter are going to be a blowout. Refinery margins remain strong. If we look at a two-year chart of oil we see that oil prices were between $30-$35 in Q2 of last year. For this quarter oil prices have averaged between the mid-50's and high 50's with occasional forays above $60. The markets are going to be surprised at just how high these profits turn out to be. Listed below are what we feel are some compelling reasons to own these sectors.

SECTOR REVIEW
by Chris Puplava

Health Care Sector

With the Fed consistently raising interest rates (9 straight interest rate hikes), energy prices at record levels, and many S&P companies reporting earnings estimates below analyst expectations, a possible economic slowdown and sector rotation bodes well for the health care sector, which is improving profitability and poses attractive valuations. In periods of weak equity markets, the health care sector consistently outperforms the overall market (See chart below):

Source: BCA Research, U.S. Equity Sector Strategy, July 15, 2005

Great Valuation Discounts:

Bad news already priced into most companies.

The sector's price performance has been dismal over the past few years resulting over concerns about its earnings prospects due to a significant number of patent expirations and weak pipelines, not to mention a slew of lawsuits and drugs being pulled off the market (Merck: Vioxx, Pfizer: Bextra). Most of this bad news has been priced into stocks making them attractive buys on a valuation standpoint. For example, Pfizer's current P/E ratio is at 12.8, near its 5-year low of 12.5 and a far cry from its 5-year high of 45.4! Pfizer's Price/Cash Flow, Price/Book Value, and Price/Sales are also near their 5-year lows. The same valuations are seen with Merck, whose current P/E ratio (12.7) is also near its 5-year low of 10.0.

Source: Ford Equity Research

Improving Profit Margins & Earnings:

Pfizer outlined cost-cutting plans that would allow for double-digit share-net advances by targeting $4 billion in total annualized cost savings by 2008, which represents approximately 12 percent of Pfizer's current cost base. Pfizer Vice Chairman David Shedlarz said the company expects to accelerate the completion of a $5 billion share repurchase program initiated in October 2004. The repurchase is expected to be completed by mid-year, following the planned purchase of approximately $2.3 billion of Pfizer stock in the second quarter of 2005 alone, improving earnings per share. Other companies such as Merck are following suit to increase profit margins and improve their long-term outlook.

Long-Term Industry Support Factors:

Rapidly Aging Population: The U.S. population is expected to age rapidly through 2030, with projections that 22% of the population will be eligible for Medicare compared to roughly 14% now.

Prescription Drug Trends: Strong drug volume being driven by increased prescriptions by doctors to patients they see, emphasizing preventative medicine supporting drug demand.

Increased R&D Spending: To counteract expiring patents and strengthen their pipelines for new drugs, many of the big drug companies are stepping up their R&D expenses. Pfizer plans to invest approximately $8 billion in R&D in 2005, compared with $7.7 billion in 2004.

Source: BCA Research, U.S. Equity Sector Strategy, July 15, 2005

Energy: Oil & Refining

The International Energy Agency (IEA) report said oil demand will rise 2.1% next year, with consumption increasing by 1.75 million barrels per day (bpd) and China's demand growth is expected to rise 7.2%. On the supply side, OPEC decreased crude oil production by 60,000 bpd to 29.3 million bpd produced in June, with higher supplies from Iraq and Nigeria being offset by lower production from Iran, Saudi Arabia, Kuwait and United Arab Emirates. World production of crude oil in June totaled 84.6 million bpd, a decline of 155,000 bpd over last month.

Russia has been contributing to the decline in crude oil production as well. The Russian Economy Minister said this week that Russian oil production would grow 3.5% this year, which amounts to half the average growth rate of the last five years. Some of the factors contributing to the decrease in production are a lack of incentives, lack of transportation capacity and laws that penalize managers who increase production. For example, Russian oil companies do not have an incentive to increase production with high oil prices because any profit made over $28 per barrel goes straight to the government. The result is that Russian companies are conserving their capital instead of risking it on ventures that may have no economic value.

Coupled with the declining supply is a rising domestic demand from our motor fuel consumption. The National Commission on Energy Policy said that if automakers improved gasoline fuel efficiency from the current 27.5 miles per gallon (mpg) to 44 mpg, our fuel consumption would still rise by 3.7 million bpd.

Furthering the problem of rising demand for oil and decreasing supply is the lack of refining capacity here at home. Michel J. Economides paints a disturbing picture in his May 2005 World Energy Monthly Review, "Refineries: A Disaster Waiting to Happen." He points out that the U.S. hasn't built a refinery in about 30 years, with the number of U.S. refineries falling from about 325 in 1980 to fewer than 150 today, and refining capacity of roughly 20 million bpd falling to 17 million bpd over the same period. The aging refineries pose a significant concern to current refining capacity where old equipment is corroding and increasing the likelihood of failure. He points out that the return on capital between 1976 and 2000 was a mere 5%, supporting the obvious problem of the age in the refinery sector.

Telecom Services:

Like the pharmaceuticals, telecom stocks have faced depressed stock prices and pose strong buying opportunities. Telecom stock prices have fallen from a long list of structural challenges that are reflected in both low short-term and long-term earnings forecasts. Additionally, like pharmaceuticals, telecom companies are less cyclical than the wide-ranging market and are ripe to outperform the broad market in the light of slowing overall earnings growth. Telecom service stocks have outperformed during flat to falling forward earnings estimates for the overall S&P 500 in nearly every period, even more so in periods of falling treasury yields.

Further support for a strengthening of the telecom services comes accelerated consumer spending and pricing power in recent months, which is even further supported with recent consolidations that may stem downward pressure on pricing and protect profit margins.

Today's Market... please review Market Monitor for closing prices and Dogs of the Dow update.

Have a pleasant weekend,

Jim & Chris Puplava

Chart courtesy: stockcharts.com, BCA Research, and Ford Equity Research

James Puplava

© 2005 James Puplava

Contact Information

James J. Puplava CFP
PFS Group
PO Box 503147
San Diego, CA 92150-3147
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