Investing in 2005: Focus on Quality Stocks

As 2004 was drawing to a close, manyfinancial analysts were commenting onwhat a "lackluster" year it was for thestock market. That assessment might seema bit strange, considering the S&P 500 closed the yearup nearly 9%—despite high oil prices, rising interestrates, and continued trouble in Iraq.

Perhaps analysts have once again become greedy.Some see anything less than double-digit gains asinsignificant; others point to the stock market's long-termhistory and ask, rhetorically, what exactly iswrong with a 9% gain?

Amid these contrasting viewpoints are the overridingquestions: What's ahead for the stock market in2005, and what types of investing strategies should beemployed? The answers depend on whom you talk to.

Optimist vs Pessimist

Kiplinger's

The analysts polled by predict that2005 will be a "catch-up time for stocks" and thatinvestor confidence in the health of the economy willgrow as the year progresses. Those factors, the analystsnote, should help push stocks upward. As such,they argue that "gains of more than 10% are achievablein the coming year."

One optimist in particular, Bank of New YorkChief Investment Officer Kevin Bannon, says the marketcan gain 15% in 2005. His forecast "is based onthe assumption that corporate profits will increase10%" during 2005. Also, even if interest rates continueto rise, "investors will be willing to pay a bit morefor each dollar of earnings?because higher rates willsignal an improved economy."

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Taking a slightly more conservative approach, theforecasters polled by say that stocksshould continue their "lackluster" performance for atleast the first half of 2005. The analysts point toexpected interest rate hikes and the US trade and budgetdeficits, and see few catalysts "that could drivestocks up in the next few months." Their take is thatthe S&P 500 will once again return single-digit gainsin 2005, probably around the same 9% performanceturned in during 2004.

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If you're wondering which forecast to bank on, itmight be worthwhile to consider past performances. Inthat case, C. Kim Goodwin, chief investment officer forequities at Boston's State Street Research & Management,beat out 65 other strategists in 's2004 market forecast. According to the magazine,Goodwin was 1% over the Dow, 0.75% over the S&P500, and less than 0.1% off the Nasdaq.

How does Goodwin see 2005? She says thatstocks' year-end rally will continue through the firstquarter of the year, but she is concerned the rally willsputter as interest rates continue to rise. She's taking aconservative approach, pegging the Dow to riseapproximately 4%, the S&P 500 up just under 5%,and the Nasdaq to rise just under 3%.

Quality Approach

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The forecasters polled by suggestinvestors "continue to migrate into quality stocks" for2005. They define these companies as having consistentearnings growth and strong balance sheets, accompaniedby low debt and healthy cash flow. According tothe magazine's forecasters, corporate profits rose 19%in 2004, but are expected to rise only 11% this year.That increases the importance of investing in qualitystocks. As interest rates rise, "solid, cash-rich companiesare likely to outperform cash-poor ones."

Kiplinger's

Where will you find these companies? Forecasterssuggest focusing on mid to large cap stocks. Small caps,they reason, may have outperformed large caps in recentyears, but are likely to lose steam this year. Sectors theyfavor include energy, technology, industrial cyclicals, andhealth care. The forecasters polled by agree.They expect the strong moves already made by energystocks to continue. "Tight supplies of oil and natural gasand a shortage of drilling and refining capacity will fuelthe bullish climate."

Technology stocks, while they won't repeat their1990s' performance, are due for a recovery. Andhealth care stocks, particularly sectors such as medicaldevices and health care services, should continue performingwell in 2005. In addition, the stocks of someof the largest pharmaceutical companies are relativelycheap right now, so there could be opportunities withthe likes of Pfizer and Eli Lilly.

Elite Stocks for ‘05

Kiplinger

Beyond simple sector speculation, the forecasterspolled by 's gave their top picks of stocks toown in 2005. For starters, consider Emerson Electric.The St. Louis-based company is well managed and regularlydumps low-return businesses while expandinginto more profitable lines. According to forecasters,45% of the company's sales were outside the UnitedStates. "Emerson's ability to ring up sales in variouscurrencies should enhance profits." The company hasalso increased its dividend for 49 consecutive years.

Next is Lyondell Chemical, a Houston-basedpetrochemical manufacturer that also has a stake inoil refining. The company was also preparing tomerge with Millennium Chemicals, resulting in aneven broader product line. Forecasters say the stock isa bit of a gamble, but it also provides a generous dividend,making it worth the risk.

In the health care sector, forecasters point toMinneapolis-based Medtronic, the world's largestmaker of implantable medical devices. "The companygenerates some $2 billion a year in cash-free flow, soit can spend generously on research" to develop newdevices. Currently trading at 20% below what it didin 2000 and at only 25 times estimated 2005 profits,forecasters say this is a good opportunity to invest ina great company at a reasonable price.

Symantec and Yahoo! are the tech companies forecasterssay will do best in 2005. Symantec is the worldleader in security software. And with the number ofworms and viruses floating around cyberspace up from1000 a year ago to more than 4500, the need to createsoftware defenses should continue for years to come.

Why Yahoo!? Forecasters point out that, unlikemany failed dot-coms, Yahoo! makes money.According to PricewaterhouseCoopers, online ad revenuehas taken off, climbing 40% during the first halfof 2004. As a result, the company "has a $3-billioncash horde that it can use to buy or launch new revenue-generating services."

International Flavor

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Kiplinger's

With the US dollar weak, forecasters say it's agood time to look more closely at internationalstocks, if you haven't already done so. Forecasterspolled by suggest increasing your assetallocation for international stocks from the 14% recommendedlast year up to 18%. points outthat there are hundreds of foreign stocks that trade inthe United States. Forecasters have pinpointed fivethey consider are worth owning in 2005.

Nokia, the Finnish wireless phone maker, seemsrevitalized after losing half its value between the springand summer of 2004. At $17 a share, the stock has fallena great distance from $63 in 2000. But according toanalysts, the company has cut prices, revamped itsproduct line, and added market share. It might be agreat bargain for 2005.

Britain's HSBC Holdings operates in 76 countries,but analysts say its key is in China and Asia-Pacificbusiness, which "generates about 40% of its profits."They point to the growth in Asian consumers' wagesand consumption, noting that "HSBC will be in thefront" of that growth.

Also based in Britain is Diageo, which is not exactlya household name, but after selling Burger King in2002 and most of General Mills in 2004, the companyis poised to become a pure seller of distilled spirits."Among its products are eight of the world's top 10brands of premium spirits, including Johnnie Walkerand Smirnoff."

Analysts note that Germany-based SAP, a manufacturerof software that helps large businesses operatemore efficiently, has been "quietly adding to its 56%market share." Considering the improved outlook forcorporate technology spending and the high cost ofswitching brands, SAP is considered an attractive buy.

Kiplinger's

Lastly, China National Offshore Oil Corporationis China's leading producer of oil and natural gas.According to , the company has a government-granted monopoly, giving it the "right toacquire—at no cost—a 51% interest in any offshorediscovery in the South China Sea." And with a list ofeager foreign partners that are willing to meet thoseterms, positive things are expected in 2005.

Quality Revisited

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It's worth restating the importance of focusing onquality stocks in 2005, particularly as core holdings inyour portfolio. points out that aNovember 2004 study by the National Association ofInvestment Clubs found that 40% of investors "thinkit's a good time to move into less risky investments."That figure is up from 34% in early 2004.

Are the masses always right? Not always, butwhen it comes to investing in quality stocks for 2005,they probably are.