At the market's top in 2000, all investors seemed to want to talk about was technology stocks and their valuations. Now that the
has tumbled 3,000 points, all investors still seem to want to talk about is technology stocks and their valuations. Are we at a bottom yet? When will it be a good time to buy? What price can I expect
to hit at the bottom?
Those are good, sound, smart contrarian questions. The time to buy, contrarians believe, is when everybody hates the stock market or a particular sector or a specific stock. The time to sell, on the other hand, is when everybody is head-over-heels in love with equities.
When everybody hates a sector or equities in general, stocks will go up, because investors have already sold and are holding cash on the sidelines just looking for a chance to get back in. When everybody loves a sector or stocks, shares will have to go down because everybody is fully invested and there's no source of new cash to take prices higher.
But investors shouldn't be asking those questions about just technology stocks. The energy and drug sectors have been stalwart defensive supports of many portfolios during the technology meltdown but have taken big hits in the past few weeks. Investors who
that the economy is about to rebound without sliding into a true recession and who
that the June quarter marks the bottom for revenue and earnings at technology companies can certainly afford to ignore these potential buying opportunities. But anyone who's still uncertain about exactly where we are in the economic cycle ought to consider the contrarian case for buying energy and drug stocks while they're temporarily out of favor.
Energy Stocks: A Temporary Loss of Power
Any good contrarian investor will tell you that the time to buy is when everybody hates a sector. And the energy sector has certainly been pounded lately as the bad times just keep rolling.
Last week, the
Federal Energy Regulatory Commission
voted to expand to 10 other Western states the price controls it had slapped on to help the California energy crisis. Back at ground zero in the crisis, California announced that it would seek $9 billion in refunds from energy providers. All of that took another bite out of the stocks of wholesale energy providers such as
. That stock is down 11% in the past month through June 28, and 22% for the year to date, after soaring 373% in 2000.
Oil and gas producers and refiners have taken it on the chin because of slumping prices. The wellhead prices of natural gas fell 14 cents to $3.57 and are now down 13% from a year ago. Gasoline prices slumped to a six-month low on evidence that supplies were ample for the peak summer driving period. Stocks of oil and natural gas producers
are now down 17% and 13% in the past month. Even the integrated oil companies that make money at every point in the production cycle are showing signs of vulnerability.
, for example, dropped from $98.03 on June 4 to $88.74 on June 28.
Drilling and service companies haven't escaped, either. After all, if no one is ever going to make a buck on selling oil or gas again, all drilling activity is certainly about to come to a standstill. Or so you'd conclude from the way stocks in this sector have dropped this month:
, down 21%;
, down 25%;
, down 28%; and
, down 28%.
Is the Story as Bad as All That?
Certainly some wholesale energy producers will take a hit in California, but others such as
have already settled with the state and/or have put aside adequate reserves against such a settlement. Other stocks in the sector will actually benefit from the move to negotiated long-term contracts because these fixed-price deals will remove much of the current investor uncertainty about revenue and earnings growth.
Energy prices do seem headed down in the near term. For example, natural gas prices are likely to fluctuate between $3.50 and $4.25 per 1,000 cubic feet over the next three to six months, according to
, and that will lead to big declines in earnings growth at some natural gas producers. But efficient producers, such as Apache and Anadarko, are likely to escape the worst of the problem in the short run. Lehman, for instance, cut its 2001 earnings estimates for Apache by just 4% in its last June 4 research report and set a new 12-month price target for it of $72, only modestly down from the prior $75 goal.
So far, at least oil and gas production companies have not cut budgets for drilling and exploration. Lehman's recently completed study of oil and gas company exploration and production budgets shows that as of June these companies planned to increase spending by 23% in 2001, compared with plans in December 2000 to increase spending by 19%. The biggest increase, according to Lehman, is in international exploration and production budgets, now planned to climb 24% in 2001. That leads Lehman to favor drilling companies with big international exposure:
Transocean Sedco Forex
, Halliburton and Global Marine.
I've already written about my favorite energy play, Chevron, and I think it's now time to add it to Jubak's Picks on recent weakness. I'm looking for both multiple expansion and earnings growth from cutting costs after Chevron closes its acquisition of
sometime in the third quarter of 2001. I'm setting a target price of $110 by May 2002.
The Drug Sector's Drug Problem
Investor opinion on the drug sector certainly does swing from one extreme to another. When investors focus on these companies' tremendous earning power -- and their relative immunity to an economic downturn -- the stocks soar. Investors seeking a safe haven during 2000, for example, sent
up 41% that year,
up 46% and
up 44%. (All three stocks had been down in 1999 during the huge run-up in technology shares.)
But then investors flip-flop and worry about things like drugs losing patent protection, less-than-full pipelines of new drugs and sluggish sales of compounds touted as blockbusters. They worry about earnings growth, in other words.
Those are the problems behind Merck's revenue and earnings warning on June 22. The company said it was expecting second-quarter earnings of 77 cents to 79 cents a share instead of the Wall Street analyst consensus of 81 cents a share. Not much of a miss, I'll grant you, but enough apparently to make investors remember their worries about growth. And Merck's warning took down other drug company stocks with major products coming off patent. Eli Lilly fell on the perennial worries about the expiration of patent protection on Prozac, for example, and
, which has its own patent issues, fell as well. Year to date, the three stocks have declined 30%, 20% and 28% respectively.
Drug stocks that don't have this perceived "growth problem" stumbled as well on Merck's warning.
Johnson & Johnson
, which is riding a big sales recovery in its stent business, fell 2% on the week, for example. But Johnson & Johnson is still up 19% in the past three months, and as you'd expect, it trades at a huge premium to its "growth problem" peers. At recent prices, Johnson & Johnson commands a multiple of about 28 times projected 2001 earnings per share while Merck earns a more modest multiple of 22 times projected 2001 earnings.
It would seem that investors have a choice of paying up for superior growth potential -- Johnson & Johnson -- or taking a chance with a cheaper stock that has investors worried about its prospects for future growth.
But I think there's a third alternative. The drug companies with the best sales forces -- and that means Merck, Pfizer and
-- will fill their drug pipelines by acquiring drug companies with promising drugs or drug candidates, but which don't have the sales forces to market these drugs to their full potential. That's been the pattern in the industry over the past decade; look at Pfizer's acquisition of
for a high-profile example. I don't think we're finished with that wave of consolidation quite yet.
We know who's going to be doing the acquiring. But we want to own shares of the companies being acquired because those get the premium in any deal. Who's a likely target?
has been linked to Merck as a possible acquisition for weeks now. But the company's continued manufacturing and management problems -- President Raul Cesan
resigned Wednesday, and it was
cited by the
Food & Drug Administration
again last week -- make that deal less likely. The FDA is holding up approval of Clarinex, Schering-Plough's successor to its allergy blockbuster Claritin, until the company gets its plants in shape. The patent on Claritin expires in 2002, and because the drug represents about 40% of Schering-Plough's profits, any uncertainty over when Clarinex will gain approval is a likely deal-breaker.
Until recently, the big drug company with the weakest sales group and the best pipeline,
, didn't look like a potential acquisition candidate. But that all changed on June 18 when the FDA failed to approve Zelnorm, one of the company's most promising drugs. Novartis had billed Zelnorm, a treatment for irritable bowel syndrome, as a potential $1 billion drug. The news has sent Novartis stock down from $38.04 at the close on June 15 to $34.84 on June 28.
But look at the goodies in Novartis' cupboard. There's Gleevec, a leukemia pill approved by the FDA last month. Starlix, for diabetes, went on the market in February. Zometa, for excessive blood calcium, and Xolair, for asthma, are on track for FDA approval within the year. Elidel, for skin inflammation, and Zomaril, for schizophrenia, are likely to get approval in 2002. All that and analysts are still projecting just 10% earnings growth for 2001 and 14% for 2002. Merck, with all its problems, still looks likely to produce 10% growth in 2001 and 2002. To me, Novartis looks like an underachiever that will either get its act together or wind up on the block -- either way, the stock goes up. Not a bad set of alternatives. And the stock is well worth watching over the next few weeks.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Apache and Global Marine.