AOL Time Warner
: Sell on accounting worries, or buy because investors have overreacted?
: Sell because it was in bed with Enron, or buy because these loans are immaterial to Citigroup's bottom line?
: Sell because CEO Bernie Ebbers is going to have to dump millions of shares to meet margin loans, or buy because the stock is ridiculously cheap?
These are the kinds of questions running through investors' minds as the stock market struggles through a crisis of confidence. I don't think it's possible just to ignore the whole problem -- especially if you're a long-term, buy-and-hold-oriented investor who has built the core of a portfolio around these kinds of blue-chip names. Even deciding to hold on is, after all, a decision. And in this environment, when a stock can lose 10% or more of its value overnight, holding on to the wrong stock can be quite expensive indeed.
In this column I'm going to tell you how I'd approach this tough market for 10 blue-chips. My scorecard for a group that includes
, AOL Time Warner,
, and WorldCom is five buys, four waits and one sell. Which stock got which score? Read on and see if you agree. (All ratings are for long-term investors who will hold for five years or more.)
Crisis Not Over
I don't think the crisis of confidence that ravaged the stock market for the first half of last week is over. The list of companies that distorted their results with off-the-book partnerships and other financial maneuvers won't stop with
PNC Financial Services
won't be the last huge company to file for bankruptcy. The list of companies facing currently unquantifiable asbestos liability will continue to grow. And the market hasn't even started to focus on problems in consumer credit and the funding shortfalls in corporate pension funds.
The list of problems seems endless, and the credibility of the players -- from CEOs to regulators to investment banks to accounting firms -- is effectively nil.
It's no wonder that many investors -- including the big institutional players of Wall Street -- have adopted a sell-first-and-ask-questions-later strategy. The issues are so complex in many of these cases that in the time it takes to figure out what the real numbers are, or how big the liability really is, a stock can lose 10% of its value or more.
, for example, fell to $34.65 on Jan. 29 from $45 on Jan. 25 on rumors of accounting problems. And that's after the stock had already tumbled from $57.25 on Jan. 25. Or PNC Financial, which fell to $55.71 on Jan. 30 from $61.59 on Jan. 29 on news that it had set up "independent" partnerships to get bad loans off its books.
Of course, some of the companies that the stock market is punishing so severely right now will turn out to be, if not innocent, at least not significantly guilty. The stock market always moves from reaction to overreaction at both the top and bottom. Some stocks in the last weeks have sold off because they're in a tainted industry. Others have taken a whack because of guilt by association. Others have suffered just because they haven't been especially adroit at explaining themselves.
In other words, the ills afflicting the market represent both danger and opportunity. Danger, because the excesses at many companies are real. (The risk management controls at
J.P. Morgan Chase
really did break down, and the company really did lose control of its lending to Enron and Argentina, for example.) And opportunity, because solid, conservative companies such as Duke Power have sold off because of guilt by association with problems at competitors.
All an investor has to do to safeguard capital is avoid the companies with real problems. And all an investor has to do to make money is buy the stocks of companies that have been unfairly punished.
Well, clearly not. The current market -- and Enron -- has demonstrated that investors should throw out the idea of "too big to fail." And enough very sophisticated investors have egg on their faces to show how hard it is to separate the winners from the losers. Pension funds, which have the cash to hire the best investment managers in the business, lost $1.5 billion by investing in Enron, according to
The New York Times
And some of these corporate situations are indeed too complex for anyone to figure out with any degree of certainty. I'm not sure that any Wall Street analyst can explain the financial side of General Electric, for example.
Don't Just Ignore the Dangers
But investors, especially long-term buy-and-hold-oriented investors, can't simply walk away from the stock market's current mix of danger, opportunity and uncertainty. Some of the most blue-chip members of long-term portfolios are caught up in the current crisis of confidence. And investors who hold these stocks have to do something.
My recommendation isn't perfect. But then again, this is clearly a stock market with imperfect information available to investors. My suggestion is that investors handicap stocks caught in this crisis on a one-by-one basis, trying to judge the risk that a bomb will blow up and devastate the share price and weighing that against the potential gain if the bomb turns out to be a dud.
What would such a handicapping system look like? Well, let me show you how I'd do it using the list of 10 stocks that I named at the beginning of this column. I hope you won't take my brief discussion of each stock as gospel -- it's intended as a starting place for your own analysis.
And please remember that even if you do agree with my assessment of risk and reward, you can still come to a very different conclusion on whether to own the individual stock in question because your own attitude toward risk and reward is different from my own.
. In its most recent earnings report, American Express said it expects that its exposure to problems in Argentina and at Enron will be immaterial. And the company estimated that it would have enough excess capital to maintain its current debt rating. To make sure it does, the company is suspending its program to buy back shares. But the market isn't behaving as if it believes American Express management. And why should it? This is the company that took a $826 million charge in the second quarter of 2001 to write down the value of its junk bond portfolio. And there's nothing that guarantees American Express has a better handle on risk going forward than it did in the past. But balance against that the very real upside that will result from an economic recovery, pushing volumes back up in its asset management, credit card and travel businesses. Your decision on this one comes down to your call on the economy. I believe that the economy has started to come back -- and that swings the risk/reward tradeoff on this one toward reward. I handicap American Express as a buy.
. This is one of my favorite plays in global finance over the long term, but in the short run I have to handicap it as a hold. The stock took a hit recently on the news that it had structured partnerships with PNC Financial that allowed that company to move bad loans off its books. The legal impropriety here is on PNC's side, and many Wall Street analysts are making the argument that what AIG did was a legitimate extension of how an insurance company helps a client lay off risk through insurance policies. But the issue of AIG is that the company's financial structure is so complex that Wall Street can't be sure that there isn't a surprise waiting around the bend. I expect that worry will keep the stock depressed for a while, and investors could get a chance to pick up this one even more cheaply later in this quarter. I say wait on this one.
AOL Time Warner
. This stock has moved from one of Wall Street's most loved to one of Wall Street's most kicked. Part of that is pretty easily understood. By buying Time Warner, AOL became a much stodgier stock, and growth investors haven't forgiven the betrayal. Add to that the company's stubborn repetition of promises of fast growth that turned out to be empty and you'll see part of the stock's problem. But something else is troubling the shares. In an era when Wall Street is suddenly saying it values clear financial statements, AOL Time Warner has moved to provide less detail about its divisions. That's especially troubling to some analysts, because AOL Time Warner sells so much to itself, with one division buying services from another. That leaves investors to worry that the company is using sales among divisions to make its numbers look better than they would otherwise. I think this is a real worry -- but one that will recede with the recovery of the advertising market. AOL Time Warner's huge clout should make it one of the first media companies to recover and gain it more than its share of new spending. Like American Express, I think you should handicap this one depending on your view of the economy: The more firmly you believe in the economic recovery, the more this is a buy.
. Wall Street says it's worried about Cisco's past aggressive accounting. Did the company use loans to customers to pump up revenue growth and finesse the costs of acquisitions to hide problems with the return it was earning on the capital invested in those deals? I think the real issue, though, is that Wall Street is worried that Cisco will never be able again to produce growth rates like those in the past. The stock is certainly fully valued if it can't. With capital spending in telecommunications gear still sinking, we won't have a read on Cisco's potential growth until the second half of 2002. I'd call this one a wait until we get more data.
. These guys were up to their eyeballs in the Enron debacle -- arranging loans and helping to set up and sell the partnerships that sent Enron down the tubes. But so far at least, unlike J.P. Morgan Chase, Citigroup seems to have successfully managed its exposure. You don't have to admire this team, but you do have to admit that they used the varying Citigroup entities to limit financial and probably legal exposure. It could all still blow up on them, of course, but at the moment it looks like the fears that Enron will drag Citigroup down are going to prove unfounded. I think the risk/reward here leans toward buy.
. I know that Duke Energy is in many of the same businesses as Enron -- energy trading, wholesale power marketing, natural gas pipelines -- but there's one huge difference. Duke Energy is a real company with real assets. And I don't think any investor would have too much difficulty in understanding how Duke makes its money. The stock has never traded at the kind of multiples commanded by Enron before its crash -- but as we now know, that was a good thing. The stock has fallen another 13% this year on guilt by association with Enron. With the company well-positioned to take advantage of higher energy sales and prices in an economic rebound, I handicap this one as a buy.
. The worry here is that because no one on the outside understands the financial side of GE's business, no one can be sure that the company doesn't have substantial undisclosed exposure to Enron or Argentina or the airlines or -- well, who knows what. Now if Jack Welch were still in charge, I don't think this would be an issue. Wall Street would simply take Jack's word that everything is fine. But Jeff Immelt is a relatively unknown quantity and analysts are skeptical that the new guy can match Jack's record on growth. I think the deck is stacked against Immelt -- GE earnings got a boost during Welch's later years from its overfunded pension plan, and that trend is now likely to reverse. I think I'd wait on this until time shows if we need to worry about the books at GE Capital, and until the next quarter or two shows the trend on pension funding.
. In some ways Merrill Lynch is the opposite of Citigroup. I don't think they were nearly as deep in the Enron mess as Sandy Weill's team, but they have sure come out looking a lot worse. Thank the more than 100 members of upper management who invested in the off-the-books Enron partnerships while Merrill Lynch was busy selling Enron stock and debt to clients. Talk about clear conflict of interest. But Merrill actually has far less exposure to Enron's bad debt than J.P. Morgan Chase or Citigroup (as far as we know), and the stock's 14% decline from Jan. 12 through Feb. 1 seems overdone. Merrill Lynch, with its concentration in the equity side of the investment business, has been among the hardest hit of Wall Street brokerage firms. But any revival of this side of the market would also work disproportionately in Merrill Lynch's favor. And the company has been among the most aggressive on Wall Street in cutting costs. (Of course, it was among the most bloated going into this market.) I'd say the potential return justifies the risk on this one, and I'd give it a buy.
. On the downside is Pfizer's asbestos liability. On the upside, Pfizer has four new drugs set to come to market in 2002 that will give the company's vaunted sales force something more to sell. The asbestos liability is real, but I think monetarily minor; the new drugs are potentially a major addition to revenue. This one comes down on the buy side.
. Everybody last week was worried that Bernie Ebbers would have to dump millions of shares on the market because the banks would call in the loans he'd used to buy the stock. OK, the sales wouldn't be good for WorldCom, but they aren't my major worry about the stock. The telecommunications industry continues to spiral downward and each bankruptcy -- like that of Global Crossing -- creates another competitor with lower costs than the surviving nonbankrupt companies. It's unclear to me where this all stops. Certainly, further price declines in the telecommunications sector won't do anything good for WorldCom. I call this one a sell.
Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EST. At the time of publication, he owned or controlled shares in the following equities mentioned in this column: AIG, AOL Time Warner, Citigroup, and Johnson & Johnson.