Cash-Rich Companies Look Ready to Buy

Corporate cash is earning next to nothing, and the itch to improve that through buys could start a rally.
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NEW YORK (TheStreet) -- Unnerved by high unemployment rates and sluggish economic growth, shareholders have been pulling cash out of stock mutual funds. But that is exactly the wrong move to make, according to a growing chorus of fund managers who say stocks are selling at bargain levels.

"A lot of companies are priced as if the world is ending," says Robert Olstein, portfolio manager of

Olstein All Cap Value Fund

(OFALX) - Get Report

.

The bullish managers say the glass is half full. While the country has plenty of problems, the economy is growing and corporate profits climbing. Eventually investors will stop worrying about the recession and bid up share prices to higher levels.

Olstein compares current conditions to the market of 1974, a period when the economy was sluggish and stocks slumped. At the time, the

S&P 500

sold for a depressed price-earnings ratio of 7. Investors who bought at those low levels scored big gains the next year when the markets jumped.

Today the market multiple is 10 based on next year's earnings. But Olstein says stocks are especially good values now because yields on 10-year Treasuries are only 2.5%. Treasury yields were 8% in 1974. When interest rates are lower, share prices should be higher because stock dividend yields are relatively attractive compared with fixed income.

What will cause investors to start buying? Olstein says the rally will be triggered by corporations who now hold a record $1.8 trillion in cash on their balance sheets. With yields on money market instruments negligible, the corporate cash is earning next to nothing. To get better results, corporations will start buying back their own shares and acquiring other companies. That will boost share prices.

Olstein prefers cash-rich companies, and a favorite holding is

Microsoft

(MSFT) - Get Report

, which has $36 billion in cash. The shares trade for a forward multiple of nine and offer a dividend yield of 2.6%. The annual cash flow is $24 billion, an impressive figure for a company with a market capitalization of $214 billion. "Why would you own a bond instead of Microsoft?" Olstein wonders.

He also likes

Dr. Pepper Snapple

(DPS)

, which sells for a forward multiple of 12 and pays a dividend yield of 2.9%. The company's beverage products generate reliable sales and have potential to grow abroad, he says.

Another bullish manager is Richard Skeppstrom, portfolio manager of

Eagle Large Cap Core

(HTCAX)

. To demonstrate how undervalued stocks are, Skeppstrom cites a group of about 30 blue chips that account for most of his fund's assets. The stocks include

Wells Fargo

(WFC) - Get Report

, office supply company

Staples

(SPLS)

and

EMC

(EMC)

, an information storage provider. At the height of the bull market in 2000, the portfolio names sold for a multiple of 24. In the next decade, the share prices drifted down, but the earnings grew at a 9.4% annual rate. As a result, the multiple has dropped to around 12. "There was nothing wrong with these stocks," Skeppstrom says. "People just paid too much at the start of the decade."

Now the blue-chip stocks are priced to deliver decent returns for the next 10 years, he says. If the earnings growth rate remains close to 9% and the P/E stays flat or rises slightly, the stocks could deliver double-digit returns.

What happens if the economy stays sluggish for the next decade? Earnings growth could slip to 5% and the P/E multiple could drop to 8, Skeppstrom says. But even under the bearish scenario, he figures stocks would deliver an annual return of 3%, including reinvested dividends. That would beat the returns of investors who bought and held 10-year Treasury bonds.

Among the very cheapest stocks are the bluest of the blue chips, says John Eisinger, portfolio manager of

Janus Global Select

(JORNX) - Get Report

, which seek high-quality businesses that dominate niches. A favorite holding is

Johnson & Johnson

(JNJ) - Get Report

, a company that has long delivered rich returns on equity. "The average price-earnings ratio for Johnson & Johnson for the past 20 years is a little over 20 times, and now the multiple is around 12," he says.

He also likes

Cisco Systems

(CSCO) - Get Report

, which has a forward P/E of 11. With data traffic growing, demand for Cisco's networking equipment remains strong, and the company can grow at a 10% annual rate, Eisinger says.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.