12/23/2003, BusinessWeek Online: Interview with Sarat Sethi

Basic Materials for Basic Investing

Sarat Sethi of Douglas C. Lane & Associates likes paper, chemicals, steel, and such, partly because of the declining dollar.

Despite worries over a weakening dollar, it does make U.S. exports cheaper, and that's one reason to like basic materials stocks. That's the opinion of Sarat Sethi, analyst and portfolio manager for investment firm Douglas C. Lane & Associates, who points to companies in paper, steel, chemicals, and gold, among others.

Companies in this area also offer high yields, with dividends averaging about 3%, vs. 1.6% for the S&P 500 as a whole. Names he mentions in basic materials include Dow Chemical (DOW ), International Paper (IP ), and Eastman Chemical (EMN ). Dow is also one of the core stocks for his firm, which holds 50 to 60 stocks and likes to keep them three to five years. Others include Exxon Mobil (XOM ), Coca-Cola (K ), and Cisco (CSCO ).

On the market outlook in general, Sethi expects 2004 gains not to exceed the single digits and stresses that the way to make money is to focus on specific sectors and stocks.

These were a few of the points Sethi made in an investing chat presented Dec. 18 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Sarat, are you running along with the bulls? Someone in the audience comments: "I believe we will see the Dow to 11,000 in January." Are you that optimistic?
A: I think we've reached a pretty fair value. Next year we'll probably see some additional volatility, but we don't expect more than mid-single-digit returns on the indexes. We do think there are ways to make money, but that's in playing specific sectors, and within those sectors, specific stocks.

Q: So it seems you're concerned about valuations? Is there anything else providing a headwind to the market?
A: I think, basically, we've reached a stage where many of the companies are getting to be pretty fairly valued, and in terms of catalysts, we need to see continued earnings growth, as well as a steady decline of the dollar, without any major strength in selling. One of our forecasts is that interest rates will start backing up, and that could provide a headwind.

Q: Can you be specific about some of the specific sectors and stocks on which you can make money, as you said?
A: When you look at the stock market, and you look at the specific sectors, 3% of the S&P is in basic materials, and what I mean is paper, steel, chemicals, gold, etc.

Having said that, when you look at the steady decline of the dollar (over 20% in a year), and you see the strength in our economy -- as well as economies overseas, such as China -- you have a few things happening all at the same time. You see that there's increased demand here in our country, and with the dollar weaker it makes imports more expensive, and our exports a whole lot cheaper.

The basic materials companies have higher-than-average dividend yields, with the S&P yielding about 1.6% and most basic materials around 3%. In a taxable portfolio, the advantages of holding these types of dividend stocks are greater. And with our belief that 2004 will not see huge returns on the indexes, having stocks that provide you a good yield as well as potential for capital appreciation we think provides a good holding for the future.

Q: What do you think of technology? It's certainly the future, but if you could choose, would you pick biotech?
A: We think technology is an important part of any portfolio, but we're not going to go back to the late '90s in terms of valuations or opportunity. You need to pick your spots carefully in technology and look for companies that provide a longer-term competitive advantage.

Following that thought, stay away from hardware companies, companies that have a saturated market, and those that have lower barriers to entry. Biotech as well is an important part of any portfolio, but it's extremely speculative and volatile, so it shouldn't be a big part of any portfolio unless you're willing to take the risks that come along with the rewards, which could be quite high. The key to being invested here is to also be invested in other [sectors] in a diversified manner, in order to create long-term gains.

Q: Among the tech stocks, opinion on JDS Uniphase (JDSU )?
A: Sure. We like JDS Uniphase. The stock has come off quite a bit from its highs, but the long-term future of bandwidth is huge, and their opportunities in that area are big. Our portfolios have about a 1% position in them. Again, it's a stock that's a good holding but will benefit only once we start using up the capacity out there.

Q: You recommended looking at dividend stocks -- please name a few of these high-yielding stocks.
A: We [make the] caveat that a good dividend doesn't mean it's a good company, so you still must look at the fundamentals of the company. If the company has covered the dividend, or grown it, that's a good sign.

Having said that, in the basic-materials section, Dow Chemical (DOW ) is a good one. International Paper (IP ) is another. A company we like, and we think the dividend is secure, is Eastman Chemical (EMN ).

On the utilities side, Dominion Resources (D ) is good. Verizon (VZ ) is great -- we like them in part because of the wireless piece. So those are some examples of good companies with high dividends.

Q: What is your opinion on pharmaceuticals? Pfizer (PFE )?
A: We think there's a great opportunity in the pharma sector. There are still many molecules to be found, but you need to be wary of companies that are getting too big. They may be very well run, but you need to separate these from their long-term potential.

Pfizer has a great pipeline -- a great company, and we own it, but we're scaling it back. Pfizer is a $200 billion market-cap company -- they would take a tremendous amount of growth to keep earnings growth in the long run.

A better bet might be a value play, like Schering Plough (SGP ), which has a new CEO and might get turned around. The other area in health care that we like is medical technology -- we think the potential there is unlimited. We like Medtronics (MDT ) in that area.

Q: What are for your views on Cisco (CSCO ), Sarat?
A: Cisco's a core holding of ours, and we like them. I think the company is very well positioned for growth. It has a fantastic balance sheet, no debt, close to $20 billion in cash, and many products that have the potential for multibillion-dollar sales. I think it should be part of everyone's portfolio, but with the caution that you should still be diversified and not overexpose yourself.

Q: What are your criteria for selecting a core holding? And what are some you haven't talked about yet?
A: We look at companies where we like the management, we like the products, we think they're in a good business, where, longer-term, they're going to create value for shareholders. We want to hold them for at least three to five years.

Our turnover is 15%, maybe 20% a year, so on average we're holding stocks four or five years. When we look at that, our core holdings, for example, are companies such as Exxon Mobil, Coca-Cola, Cisco, Dow Chemical. But there comes a point, where in the case of Dow, when they start reaching peak earnings, you're going to have to cut back.

These are not companies to buy and hold for 20 years, they are ones you hold in a cycle. Our portfolios contain 50 to 60 stocks, and when one becomes more than 4% to 5% of the portfolio, we start trimming back.

Q: Any thoughts on Harley-Davidson (HDI ), Carnival (CCL ), or any other "baby-boom" plays?
A: When you look at companies like that, that are dependent on discretionary income, the valuations...can get skewed, especially when times are good.... Our view is that a lot of money now, especially on the discretionary side, gets spent on entertainment -- the family aspect. A lot of our attention is spent on finding stocks that will benefit in this area. We look at a media stock, such as Time Warner (TWX ), where people will spend money to see movies, cable on demand, etc. Or Disney (DIS ), where people will go to spend time with their family and the like.

Q: Give your view on Lucent Tech (LU ).
A: We think Lucent's a great restructuring play.... They've restructured out of this downturn, pared back the balance sheet, and have a good product line. However, when Lucent competes with some of the newer tech companies, they're at a disadvantage because of their pension plan and post-retirement benefits, which can be a burden to the overall value of a company. While the company's not there yet, for an aggressive investor there's an opportunity that Lucent, with its relationships in the service-provider area, can actually survive and increase shareholder value.

Q: More on tech -- how about Oracle (ORCL )?
A: Oracle's an interesting play, because all through the downturn they didn't get hit as hard as everybody else, and now the company, which has a good balance sheet and good products, is trying to find a place to grow. But the market's not convinced that they'll be able to sustain a double-digit growth rate.

Time will tell, as they spend more time on R&D, whether they'll be able to develop new products that will gain customer attention. Oracle's having an analyst meeting next month, and I'll be there. It'll be interesting to see what insight they could give investors as to their strategy.

Q: Do you have any holdings -- or recommendations -- among the small- and midcap stocks?
A: One of the companies we like in that area is Jacobs Engineering (JEC ). They provide services to all kinds of industrial companies. It's very well run, with an international focus, and could do very well over time. Sonoco Products (SON ) is also excellent -- they make things like Pringle's boxes, your Maxwell House cans, the list goes on. They're well run, with a dividend close to 4%, and as the economy picks up, they'll have good operating leverage. They've got good sales overseas and strong ties with its customers, such as the Gillettes of the world.

Q: Any thoughts on Qualcomm (QCOM )?
A: They're a core holding of ours -- we have held them for many years. As the world moves more toward wireless, both data and voice -- not just in the U.S. but China and India, etc. -- Qualcomm has huge potential to grow its earnings. It's always a rich stock, it always has been, but more and more people are seeing value in its intellectual property and the position it has. Its balance sheet is excellent, it has a lot of cash. We like the company, and we like its products.

Q: A quick last question, Sarat -- what's the best strategy as we move into 2004?
A: I think the best strategy is to look at your portfolio, make sure you're diversified, exposed to the right sectors, the right stocks.

And don't fall in love with stocks. Don't make it emotional. Make sure that you're planting seeds now, such as in basic materials and consumer staples, so that these can grow and be fruitful later on. If you've got weeds, get rid of them, or prune them back. The idea is to keep the garden growing, but make sure you maintain it.