Front and Center
S&P's Broad-Based Analyses Provide Clarity on Global Trends
and Relative Values
by Ben Mattlin
In the past 10 years it has tripled in value,
outstripping the Standard & Poor's 500 index by more than 100 percentage points. It's a broad-based portfolio, spanning
the gamut of industries and market capitalizations, and even in recent market turmoil it has advanced six percent over the
last five years while the S&P 500 slipped 30%.
That portfolio consists entirely of S&P's five-star rated stocks, an ever-changing
selection culled by S&P's 80-strong squad of equity analysts--60 in New York, 10 in London, and 10 in Singapore. Headquartered
in New York, Standard & Poor's Equity Research Group is a multifaceted financial information provider, and since 1966,
has been a division of the publicly-traded media and education giant McGraw-Hill Cos. They apply a rigorous multi-layered
financial analysis to every company in the S&P 500 and many more that aren't, encompassing all 10 sectors and 160 industries
of S&P's proprietary Global Industry Classification Standard. "Our team is not only good at assessing industries and analyzing
financial data but stunningly effective at picking stocks," stresses Kenneth Shea, a former food and beverages analyst who
has spearheaded S&P's U.S. equity research department since 1998 and assumed the global directorship last year. "Leveraging
our tremendous stock selection track record is one of my top priorities."
Another priority is to expand the department's institutional client base. Ever
since Shea, 40, joined S&P in 1986 the department's "core constituency," has been dominated by retail investors and its
equity research overshadowed by the corporate debt rating service it actually predates. "When people thought of S&P, they
first thought of our credit rating agency and then the S&P 500 benchmark. And that was probably all," Shea acknowledges.
One reason S&P's equity research has had this Rodney Dangerfield-like problem
may be that historically, it was purely informational in purpose; before 1987, stocks weren't rated and recommendations were
never part of the picture. But on January 1, 1987, the firm elaborated on its motto of obliging "the investor's right to know"--a
saying supposedly favored by Henry Varnum Poor, who launched Poor's Publishing Co. in 1860, which in 1941 merged with the
Standard Statistics Bureau to become the Standard & Poor's Corp.--and offered opinions for the first time. Thus S&P's
Stock Appreciation Ranking System (STARS) was born. From five stars for "Buy" down to a single star to connote a "Sell," every
stock report from S&P began carrying a rating. "Everyone knows that in the long run the S&P 500 beats most actively-managed
funds," observes Chief Investment Strategist and frequent media presence Sam Stovall. "The point of our STARS system is to
offer investors a selection of stocks that are likely to outperform the S&P 500 and a selection likely to underperform."
STELLAR PERFORMANCE
The proof is in the performance: In STARS' 16-year history, its top-rated stocks
surpassed the benchmark's annual results 12 times. It's come up short three times, and once was a tie. Still, investors who
bet on S&P's recommendations clearly did better in the long run than practically anyone else, even index investors who
linked their fortunes to the S&P 500.
Yet equally important is the bottom of the STARS scheme--the stocks slated to
trail the S&P 500. In an era when many analysts are slammed for touting bad stocks, S&P analysts stand out from the
pack for never being shy about using the Sell rating. In a recent survey of the department's global universe of 1,400 stocks--1,200
in the U.S. alone--19% carried a Sell. Buy-rated stocks represented a modest 32%. "We call a sell a 'Sell,' and we always
have," says Shea with pride. "We can do that--and in fact can cover any stock that should be covered because we have no investment
banking or other obligations to the companies themselves."
THE LONG AND SHORT OF IT
At New York's C.E. Unterberg, Towbin, Fund Manager Lee Tawes "spent a good deal
of time looking at the S&P product and the people who work on it," Tawes recounts. "I was very impressed with both."
Tawes runs the UT/S&P STARS Long/Short Fund, a hedge fund launched early this
year, which takes long positions in a selection of S&P's four- and five-star recommended stocks and shorts a variety of
the one- and two-star stocks. Why use S&P's research? One answer is simply the breadth of coverage. Most other firms can
only follow a limited number of sectors and stocks on their own. More importantly, S&P's broad-based analyses make for
a higher degree of clarity on global trends and relative values. Because S&P analysts track every significant company
in their industries, they're able to present a kind of mile-high perspective on a vast array of stocks.
"[I] spent a good deal of time looking at the S&P product and the people who work
on it. I was very impressed with both."
Lee Tawes, Portfolio Manager of the UT/S&P
STARS Long/Short Fund, C.E. Unterberg, Towbin
If strong performance is one differentiating factor of S&P equity research,
and its comprehensive scope is a second, and the third reason why institutions like C.E. Unterberg, Towbin subscribe to its
multifarious equity reports is: "The research is independent," says Tawes. "There isn't even the possibility of conflicts
with investment banking." Indeed, S&P has no investment banking operations and these days, avoiding even the appearance
of bias is a desirable goal for all institutions, whether or not they've ever been accused of a banking conflict. S&P
employees are also barred from owning any of the stocks under coverage. The analysts' only incentive, in fact, derives from
their stock-picking skills; annual bonuses are based on the performance of stocks they've rated.
A fourth, final critical consideration is how the broad, independent research
is constructed--the process behind the product. Every stock undergoes a three-pronged analysis. First, to quantify a stock's
"intrinsic value," Shea says the firm starts with the notion that a stock is worth the present value of its future free cash
flow. "It's like considering how much money you would generate if you were to rent out your house," he notes. "That's key
to finding the intrinsic value of the house going forward." S&P's cash-flow projections typically go out 15 years.
Second, analysts overlay a relative-value matrix on each stock's intrinsic value,
which they can do readily because the analysts tend to cover every company in the sector anyway. Weighing the stock against
its peers, Shea observes, is akin to "looking at your house in the context of other houses in your neighborhood."
The third component of S&P's equity research process requires analysts to
do a lot of due diligence to identify a stock's "private value," which involves pulling a company apart to find what it could
be sold for on the private market or if, for example, it was taken over in a leveraged buyout. "If your house burns down,
what would be the cost to replace it?" Shea asks.
These discrete perspectives are used to model every stock's intrinsic value, which
is ultimately compared to the stock's trading price to determine whether it should be bought, sold or held onto. Client Tawes
is "very comfortable with S&P's proprietary approach over the long run" and applauds the "rigorous financial analyses,"
especially the emphasis on S&P's proprietary Core Earnings which strips out stock options and pension-related income."
That's exactly what Shea aims for. "We try to improve upon the current financial
reporting system," says Shea. "By considering all the different layers of earnings transparency--stock option expenses, pension
costs, restructuring charges, non-operating gains, and so on, we add a degree of market intelligence." To be sure, there is
a quantitative element to this analytical approach. But Shea underscores that research is driven from the bottom up. The analysts,
seasoned or not, are tested on their ability to render these sorts of three-tiered analyses. The S&P equity research department
is "an analytical shop, not a quant shop," Shea asserts. "Analysts' opinions matter."
FREETHINKING ANALYSIS
Since 1987, Robert Gold has been one of those analysts. For the past five years
he's covered the medical devices group--some 25 companies ranging in market cap from $200 million to $55 billion, and heads
up the broader healthcare team of three other senior analysts. "We get guidance from the research director, the strategist,
and others who form the S&P Investment Policy Committee, but overall I have a great deal of autonomy," says Gold. "I pick
and choose stocks as I see fit."
For instance, informed by strategist Stovall's historical perspective on which
way markets tend to go coming out of a recession and war, Gold then coordinates his healthcare team members' views to decide
whether investors should overweight or underweight, or something in between.
Last October, Gold upgraded Boston Scientific Corp. (BSX) to a Buy. Based in Natick,
Mass., Boston Scientific is a maker of noninvasive medical devices for cardiovascular and endosurgery (i.e., oncology, urology,
gynecology, etc.) patients--therapeutic designations that "will not slow down in demand for the foreseeable future simply
because of the aging population," Gold observes. He likes long-term demand drivers, and is especially enthusiastic about the
potential for self-absorbing drug-coated coronary stents, which as of this writing await approval from the U. S. Food and
Drug Administration. Gold is optimistic. He says the new product represents a tremendous improvement over old-fashioned metal
stents, a market that currently accounts for more than $2 billion annually. Gold estimates that number will grow to $4.5 billion
by 2005.
Boston Scientific (2002 revenue: $2.9 billion) is not without competition, however.
The threat from rivals such as Johnson & Johnson doesn't faze Gold. "This will be a great opportunity for Boston Scientific
because it's so focused on its cardiology business," he maintains. Fortunately, other products should help boost earnings
per share from last year's $0.90 to $1.30 in 2003. After that, Gold anticipates 2004 EPS of $2.50. At a recent $43, the stock
has already surged 21% from his October upgrade at $35.60. His target, that is, his "intrinsic value" per share, is $46.10.
Gold claims that, for him, understanding the scientific background of a company
is secondary to finding an attractive relative value--relative to its peers and its larger sector. Frank DiLorenzo, his colleague
who follows some 28 biotechnology stocks nationwide, might agree. "My education was in finance, not anything medical," says
the analyst, who finds this background helpful in rendering S&P's complex proprietary valuation methodologies. Of his
counterparts at other firms who cut their teeth in healthcare technology, he shrugs, "It's good to have a different perspective."
DiLorenzo favors profitable companies to those depending on products still under
development; profitable companies are better suited to his valuation metrics, he says, and carry less risk. "If you can get
a good, established company that's in a temporary correction but maintains strong fundamentals, that's my ideal opportunity,"
he says. "Of course, it's also got to have attractive prospects for the future."
Not that his favorite companies are all large; good things sometimes come in small
packages. One example is the Foster City, Calif.-based Gilead Sciences (GILD), which develops treatments to fight a variety
of infections. It makes AmBisome, an antifungal product, and Viread, which is used by people who have HIV. Last year, the
company won approval for a hepatitis B therapy called Hepsera. About a month before that, in August 2002, DiLorenzo upgraded
the shares to Buy as undervalued at $30. By April 2003 they had shot up 47% to $44. He contends they could get as high as
$50. The company posted EPS last year of $0.35 on revenue of just $469 million, and DiLorenzo forecasts EPS will grow to $0.81
this year and $1.24 in 2004. "With good drugs on the market and more in the pipeline," he says, referring in part to Coviracil,
an HIV-fighter currently under FDA review, to which Gilead won the rights when it acquired Triangle Pharmaceuticals in January
2003. "Gilead remains a growth opportunity," says DiLorenzo.
RISK AND REWARD
Sharing DiLorenzo's somewhat cautious view of the need to balance risk and reward
is computer hardware analyst Megan Graham-Hackett. She shies away from "making a big bet on a single product in development"
and favors companies that are "executing well and have a strategy for the future that makes sense," she says. Graham-Hackett
interviews end-users--that is, computer makers' customers--to gauge demand trends. She then compares their input to management's
strategy. Among the questions she considers: What are customers interested in seeing done in the future? Does management's
strategy address these desires? Does the company have the resources to execute management's strategy effectively?
To answer that last question, she looks to several historical factors. "I get
indications," she says, "from management's past performance in executing strategies, return on equity, the payoffs as best
we can estimate from research and development, and the company's technological position," she says. "Does it stay on the leading
edge? Also, do its products foster customer loyalty? Will it be able to take a bigger share of the total technology pie when
the sector improves?"
Though it's somewhat outside her usual coverage, her sense of hardware trends
and, to a degree, consumer electronics led her to a five-star endorsement of network components-maker Cisco Systems (CSCO).
Graham-Hackett took notice late last year when Cisco posted market-share gains that outpaced her expectations. Subsequent
conversations with enterprise network and information technology professionals--potential Cisco customers--furthered her interest.
She began to get the distinct impression Cisco was likely to continue gobbling up market share. "People wanted a vendor with
a broad product portfolio, which Cisco has," she recalls, "and Cisco has a reputation for being highly reliable. Many of the
end-users thought they would be better off replacing their old equipment with Cisco products."
Since her upgrade last November at $10, shares of Cisco, which books some $19
billion in annual sales, jumped 30% through April 2003.
Graham-Hackett's colleague Tina Vital, an energy analyst who heads the energy
and utilities group, similarly questions her industries' quirks. Vital worked in the oil industry through most of the 1980s
before going back to school for her MBA, and she digs for answers with an academician's zeal. "The emphasis here is to arrive
at the truth," she stresses, "not to hustle for high-paying deals."
Vital points out that while many oil and gas companies' earnings are sensitive
to commodity price changes and geopolitical volatility, the "super major" integrated oil companies' tend not to be. They diversify
risk by operating in many different parts of the world and subsectors of the petroleum business. Yet the stock market has
tarred them with the same brush. That, she says, is about to change. Vital has a Buy on the Irving, Texas-based Exxon Mobil
Corp. (XOM). With $205 billion in revenue reported last year, it is the world's largest publicly-traded integrated oil company.
Among her reasons, she cites: "the stability of its earnings growth, its strong balance sheet, its top-tier assets, the enterprise
value of its invested capital and high return on equity." All this, she says, should give it a premium valuation but so far
hasn't. "Go for the quality," Vital insists. "It's a safe haven, and a very good buy." She anticipates EPS will rise from
last year's $1.61 to $2.07 this year. At a recent $35 a share, she sees 20% upside potential.
SPOTTING TROUBLE
The ethos of searching for truth seems to pervade S&P's equity research operations.
Consider Analyst Stephen Biggar's increasingly negative view of Detroit-based lender Comerica (CMA). Biggar, who monitors
major regional banks, also coordinates the firm's financials group. Last year, when the credit ratings of many regional banks
were being reduced, it was largely related to rising commercial loan defaults, he says. Biggar pegged Comerica as especially
troubled. "It was not only having negative growth but suffering some of the most dismal cuts in its credit quality," Biggar
reflects. He looked into the bank holding company's balance sheet and discovered a big piece of the problem. Three-quarters
of Comerica's debt portfolio was in commercial loans, while most equivalent lenders have closer to a 50-50 split between commercial
and consumer loans. Comerica, which posted $3.7 billion in sales last year, was in trouble.
Biggar maintained a bearish view of the company throughout last year and then,
on October 1, 2002, with the shares off 15% for the year, management cut its earnings guidance and Biggar downgraded the stock
to one star: Sell. Through April 2003, Comerica has fallen another 23% to under $38. Despite his forecasted jump in EPS from
last year's $3.40 to $4.25 in 2003, largely due to growth in deposit activity, Biggar continues to rate Comerica a Sell. "It's
a poor fit with the current environment," he contends.
STAYING IN THE LOOP
In addition to analysts' individual company and sector reports, clients receive
S&P MarketScope, which is a kind of electronic newswire incorporating S&P analyst real-time opinions, strategist Stovall's
monthly Equity Insights, and an ever-expanding variety of other updates. "Everything is posted on their Web site," says client
Tawes of Unterberg, Towbin. "But if I have a question, I never have trouble getting the analyst on the phone."
"The point of our
STARS system is to offer investors a selection of stocks that are likely to outperform the S&P 500 and a selection likely
to underperform."
Sam Stovall, Chief Investment Strategist, Standard & Poor's
In keeping with S&P's new emphasis on serving institutional clients, it offers
them the data-crunching capabilities of Compustat, the soft-dollar broker S&P Securities and customized moel portfolios.
With six analysts added last year and more on the way, research chief Shea anticipates needing additional analytical muscle
to serve a more demanding and growing institutional client base. "To do what we already do even better," he says.
Shea also has an eye on pending legislation that might require investment banks
to distribute third-party research along with their own. "We would be a logical source of such independent opinions, and may
need to cover companies we don't yet follow," he says. "Investors today want financial transparency, market intelligence,
and independent opinions more than ever before. The opportunities for Standard & Poor's Equity Research are terrific,
and I've never been more excited about the future." ™
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