As the market slides on fears the

Federal Reserve

will hike interest rates sooner rather than later, investors have been quietly dumping casino stocks for hotel stocks, but by doing so have made the gaming sector worth another gamble.

At the close of trading on April 20, the evening before the hotel and casino sectors released first-quarter earnings, casino stocks were up 26.2% year to date vs. a gain of 4.6% for the hotel sector. But since then casinos are down 14.3%, while hotel stocks are up 0.3% -- and even insiders are getting into the act. On May 10,

Starwood Hotels

(HOT)

CEO Barry Sternlicht bought 143,185 shares of his company, according to filings with the

Securities and Exchange Commission

.

Heading into earnings, hotel stocks were fairly valued based on historical multiples and earnings expectations were still quite low. In contrast, casino stocks were pushing the high end of historical valuations, with earnings expectations driven higher by a series of positive preannouncements.

Hotels got hot by boosting guidance. Starwood,

Marriott International

(MAR) - Get Report

,

Hilton Hotels

(HLT) - Get Report

and

Four Seasons

(FS)

all beat Wall Street expectations and guided earnings higher for the rest of the year, citing an overall pickup in travel demand.

In contrast, while many casino operators beat Wall Street's lofty expectations, most left guidance unchanged and have been punished by investors and analysts alike. Look at

MGM Mirage

(MGG)

, which announced record first-quarter earnings that were up 218% from a year ago, but was downgraded by CIBC World Markets and Merrill Lynch after it didn't raise guidance.

"Most companies did not raise their guidance for the remainder of 2004," said William Schmitt, CIBC's analyst, in his downgrade. "In our view, this means they are either forecasting conservatively or they consider the first quarter an anomaly."

No Fundamental Change to Gaming Outlook

But with gaming industry fundamentals improving, especially in Las Vegas where convention business is driving big gains to revenue per available room, a key metric called revpar, some analysts feel the downgrades were myopic moves that ignore the long-term growth story.

"The coming summer is shaping up to be better than last year's, not worse," said Daniel Davila, gaming analyst at Stern Agee and Leach, a brokerage firm. "Fundamentals have, in almost every case, improved, suggesting the downgrades have no real merit other than gaining the notoriety associated with moving the market."

In Davila's view, many casino companies declined to boost guidance so they can continue to outperform the low bar set by Wall Street. Ultimately, he feels the gaming industry's track record when it comes to growth is tough to ignore.

"We took a basket of gaming stocks and measured the actual first-quarter earnings against First Call and they exceeded by an average of 15% -- yet the stocks sold off," said Davila. "Since 1970, the Sept. 11 period was the only decline in gaming revenue you see in Clark County, Nev. And that's through a rising and falling interest rate environment, through wars and recession."

Hotels Good, Casinos Better

Because both industries are cyclical, they benefit from the economic recovery and will continue to do so with business travelers, convention-goers and vacationers boosting revenue and earnings growth. In the most recent consumer price index report, housing costs were up 4% and are expected to rise in the coming months. A big part of the housing increase is due to rising room rates at both hotels and casinos, where increases are sticking.

As a result, both sectors are likely to perform well in the coming year, using increased demand and higher rates to drive earnings. But unlike the straight hotel operators, the hotel-casino operators have gambling, entertainment and retail businesses to boost earnings even more when times are good and insulate them when times sour.

Case in point: In the wake of the World Trade Center attacks, the entire travel industry entered a deep recession, but the gaming industry recovered first. The Dow Jones Hotel Index took three-and-a-half months to reach the level it sat at prior to Sept. 11. It took the casino index just six weeks to do the same thing.

And with many casino stocks off by double-digit percentages in just three weeks, valuations have finally come back to earth, while hotel stocks are pushing their historical multiples.

After gaining 5% since April 20, Hilton is valued at 25.4 times expected 2004 earnings, which is slightly higher than the company's 10-year historical multiple of 22.5, according to data from Baseline. Meanwhile, MGM Mirage has dropped 10% over the same span, leaving its price-to-2004 earnings multiple at 17.5, less than its 10-year historical average of 21.1%.

"Some of these stocks showed positive returns for 2001, 2002 and 2003," said Dan Ahrens, fund adviser for The Vice Fund, a specialty fund that invests in gambling, tobacco and alcohol stocks, among others. "The fundamental story hasn't changed, but the thing that might have happened is that valuations got a little too aggressive and things needed to correct slightly."

Ahrens said he took advantage of the pullback to add to his positions, citing the long-term growth potential of the gaming industry. Specifically, Ahrens said he likes

Harrah's Entertainment

(HET)

and MGM Mirage among the large-cap gaming companies.

"Las Vegas is booming, it's crowded all the time, they're still expanding and the recent events are nothing more than a short-term buying opportunity," said Ahrens.

The lack of forward-looking guidance may have spooked gaming investors into dumping their pricey shares in favor of hotel stocks. But investors looking to capitalize on the rotation out of gaming should buck the trend, look for rising fundamentals in the sector and keep a keen eye out when stocks slide again.

"The momentum investors went toward hotels because that's where the downgrades told them to go," said Davila. "The only reason cattle move into the pen is because that's where they're herded, and if they're not herded there, they'll go their own way."