Favorable For Large-Cap

When it comes to market cap, large stocks are the primary beneficiary of a slower-growth economy and investor flight to quality. "At this stage in the cycle, the supply of earnings growth is starting to shrink, so paying for predictability in growth makes sense," says John Waterman, chief investment officer of Rittenhouse Asset Management, a conservative large-cap growth manager in Radnor, Pa. "We think the market will begin favoring companies that show consistent earnings growth and have strong balance sheets," Waterman says.
Whether consumers finally quit spending is a crucial issue, he adds. "Your stance on that matters a lot in where you put money within the large-cap space." Investors foreseeing consumer caution might consider conglomerate GE, with products in industrial and commercial markets that can buoy earnings regardless of what consumers do. Waterman also mentions certain types of health-care companies, including HMOs, pharmacy benefit managers, medical device companies and diversified organizations such as Johnson & Johnson.

Consumer-wary investors will probably want to avoid retail and consumer discretionary stocks, Waterman adds. Those shares were already falling by early autumn on initial fears of a consumer retrenchment. But they could rebound quickly if people's purse strings don't actually tighten, perhaps because of surprisingly gentler prices at the pump. Some investors, including Buffalo Funds, have been scouting for bargains when these sectors sell off.
    Another idea for 2006 is mid-cap. The companies are decidedly safer than small-cap names, yet have the ability to grow faster than large stocks. "Mid-caps are in the sweet spot in the market," says Buffalo's Gasaway. They're increasingly paying dividends, too, he says. "These are successful businesses that generate lots of cash, at least the ones we own."
    Sectors to watch include technology. Grant Sarris, another Buffalo Funds portfolio manager, says, "Tech stocks have underperformed for a few years but their earnings growth has been reasonably solid, cash has been building on their balance sheets, they're no longer diluting shareholders by granting too many stock options, and in some cases they're buying back stock." Proponents also argue businesses have reigned in technology expenditures for years and that has created pent-up demand.
    And energy? Even if prices remain high due to climbing global demand and limited refining capacity on the supply side, energy companies aren't known for executing optimally. "They're notorious for squandering capital," says Morningstar's Lyons. Better perhaps to invest in companies that are likely to benefit from a Big Oil spending spree.
    "As the global leader in the oil services industry, Schlumberger will be the first stop for most of the major integrated oils as they look to develop existing reserves and discover new ones," says Bill Fries, a portfolio manager and managing director at Thornburg Investment Management Co., in Santa Fe, N.M. "Schlumberger is going to have surprising demand for its services."

Opportunities Abroad

Because of the prominent role that the United States commands on the global economic stage, one's view of domestic growth necessarily colors one's outlook for the world. Fries says, "Because there is more of a global economy than ever, and because of the large consumer economy in the U.S., what happens here is pretty relevant to what goes on around the world." He's looking for 3% U.S. GDP growth in 2006 (down from the 3.6% he anticipated earlier this year) and between 7% and 9% in China. Even if the numbers are a tad lower than in recent years, that's still plenty of grease for the wheels of international commerce.
    Multinationals whose fortunes ride on global conditions could prosper in the new year, says Guang Yang, a portfolio manager and executive vice president of Templeton Global Equity Group. Yang's portfolios are 50% overweight non-U.S. compared to benchmarks and include holdings such as Denmark's Vestas Wind Systems, a wind power turbine manufacturer that has raising prices as the renewable energy movement gains momentum globally. He also touts Endesa, a Spanish utility deriving about 40% of revenues from outside its home market, a big slice from Latin America.

One of Yang's top holdings is South Korea's Samsung Electronics. "Samsung is a global IT [information technology] company that happens to be in Korea," he says. "Its products are very competitive globally, yet it's one of the cheapest IT companies in the world, trading at about 12 times earnings [when interviewed]. "
    Besides thinking globally, international investors should buy local businesses in foreign countries. For one thing, owning companies catering to the local trade provides diversification from multinationals affected by global markets or generating significant U.S. dollar-denominated revenues. It's also a way to capitalize on the growth of a nascent economy. Two widely held financials are Kookmin Bank in South Korea and OTP Bank, a Hungarian bank that's a play on Eastern Europe, according to Lyons. "Both are involved in lending and mortgages, two things that should do well when an economy prospers," he says.
    To Fries, the emerging markets are where you want to be, "in part because they have farther to catch up. Places like China, India, Eastern Europe, Russia, and even Latin America offer the best opportunities," he says. Think about what's happened to cell-phone proliferation in Russia as a case in point. Couple years ago, 40% of the population had cell phones. Today it's probably 65%, Fries estimates, although he adds that the penetration rate in nonurban areas remains quite low so there's still opportunity.
    Yang over-allocates to South Korea, which he believes will continue to prosper despite the Korea Composite Stock Price Index's 32% run-up this year (through October 24) and on the heels of double-digit returns in 2003 and 2004. "Many good companies in South Korea are still trading at large discounts to their global peers, and they're growing faster," Yang says of the Chinese trade-partner. "South Korea has more way to go."

Despite the Internet Age, gathering information on small foreign companies remains a challenge. "That's why in emerging markets, it's essential to have an experienced manager with an exacting research bench that's willing to go the extra mile," says Lyons.
In the developed markets, Europe appears attractive for reasons including cheap valuations. "One manager tells me that many European stocks are three-quarters the price of U.S. stocks, and that even though they may be growing more slowly, they represent better value," says Lyons.

Also favorable for European stocks is the corporate restructuring that's going on there. Like many U.S. companies did some years back, European businesses are cutting costs, implementing technology, divesting noncore subsidiaries, focusing on return-on-equity and generally shaping up. "That has just started to pick up in a big way in Europe," Yang says.
    Meanwhile in Japan, it's the same old story: Things are improving. Finally. Slowly. Maybe. At any rate, Fries eyes opportunity in financial services. The Japanese are big savers, don't forget. "They have large cash balances," he says. "That's an area to pay attention to."

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