Where to Invest in 2007

ByRUSSELL PEARLMANRESHMA KAPADIA

ROBERT SELLAR HAS

every right to savor 2006. While an autumn rally pushed the Dow Jones Industrial Average to all-time highs, the head of North American equities for U.K.-based Aberdeen Asset Management did even better, earning returns that put him among the top foreign managers of U.S. stocks. But when the cheerful New Zealander wants some perspective on the near future, he looks a little further back into the past 12 years, to be precise.

This year's sectors to watch are

Investment Banking

, whose deal-making is now global;

Chemicals

, boosted by cheaper energy;

Internet

, where ads and retail are here to stay;

Insurers

, which thrive amid disaster; and

Beverages

, since alcohol is recession-proof. In

Emerging Markets

, you can profit from the new global middle class.

Also See:

Growth Funds Poised for a Comeback

Last year and 1994 had a lot in common. Both years saw a steady rise in interest rates, with inflation emerging from the crypt to spook investors, while the economy showed signs of slowing down. Twelve years ago, as a broker at UBS, Sellar told his clients that when the economy plateaus, larger firms with lots of cash on their balance sheets and huge customer bases to keep earnings growing are likely to outperform. And in 1995 his instincts paid off: Large-company stocks returned 37%, making them the best-performing equity class.

Bigger promises to be better again for investors in 2007 even if another 37% bump in the Standard & Poor's 500 is only a pipe dream. To cope with a potentially murky economic outlook, large companies have advantages they didn't have 12 years ago: They're more efficient and profitable, and they have considerably less debt. The savviest of the big companies are generating more growth overseas, immunizing themselves against the swings of the U.S. economy. And best of all, even after their recent bull run, says Sellar, "large firms seem quite cheap."

To be sure, there are risks that can cloud any rosy picture. The combined effects of falling home values, high oil prices and security crises overseas put the brakes on GDP growth in the second half of 2006. If any of those factors escalates, it could hurt the economy enough to neutralize the large-cap firms' advantages. What's more, smaller, riskier stocks typically outperform in the third year of a presidential term, according to the investment research firm Ibbotson Associates, as the party in the White House pumps money into the economy to boost its prospects for the next election.

But with the U.S. facing big deficits and the Democrats taking control of Congress, such stimulus is unlikely in '07. That's one reason why Jeremy Grantham, head of the $120 billion asset-management firm GMO, has changed his mind about the prospects for high-quality blue-chip names. For years the influential quant-oriented investor has knocked the biggest U.S. stocks as overpriced, but today he, too, feels the valuations are relatively cheap although their prices have risen, their earnings have grown far faster. The price to expected 2007 earnings ratio on the S&P is just below 16, well under the index's average of 20 since 1988.

Yet even as the Dow breached 12000 last fall, individual investors weren't buying stocks. Spooked by the markets' rough spring, they pulled money out of U.S. stock mutual funds for six straight months through October. Those moves suggest that there's plenty of money waiting on the sidelines money that could flow back into stocks if the economy gets a second wind. That's hardly out of the question, suggests Charles Biderman, chief of TrimTabs Investment Research, which counts some of the country's biggest hedge funds as its clients. He points out that tax withholding from corporations is rising at a record pace, suggesting that the economy is better than recent reports indicate.

To find our stocks for 2007, we couldn't simply pick undervalued industries all 10 sectors in the S&P 500 gained ground in 2006. But other macroeconomic factors tightened our focus. The current leveling off of interest rates, for example, should help financial-services companies like brokerages and insurers. With the prices of oil and other commodities stabilizing, chemical manufacturers could see their profits surge. And as a "defensive" industry that has historically been impervious to economic ups and downs, beverages look especially attractive.

Within our sectors, we sought companies that had a market value above $10 billion and were expected to increase profits by at least 8% a year over the long term. In most of the sectors, we also looked for stocks whose P/Es were less than twice their long-term growth rates. We focused on globally diversified companies that can weather domestic woes; we also picked two foreign stocks that cater to the emerging middle class in markets overseas. It all adds up to a portfolio of 12 companies that are poised to thrive in the coming year, even if the economy hits choppy waters.

Next:

Chemical Makers


In the recent bull market, chemical-company investors have felt like wallflowers at the party. As economies surged worldwide, demand for their products soared. But skyrocketing energy prices dented their profit margins because chemical companies rely heavily on oil as a basic ingredient and on natural gas to power their plants.

Still, during the lean years the best-run firms were laying the groundwork for a great 2007 by taking advantage of high demand to implement double-digit-percentage price increases. Today energy costs are dropping oil prices are down more than 20% since July, and natural-gas prices have fallen even further. But booming industrial economies in Asia and Eastern Europe are keeping orders high, so chemical makers shouldn't have to cut back on their prices. And if the U.S. economy stumbles, even that could be a boon to chemical stocks, notes Merrill Lynch chemicals analyst Don Carson. In 1995, when the Fed stopped raising rates to aid a sluggish economy, chemical firms significantly outperformed the broader market.

Midland, Mich.-based Dow Chemical is the nation's largest producer of plastics and so-called performance chemicals that show up in all kinds of finished goods, from Styrofoam to paint thinner. And more than 60% of its sales come from outside the U.S. "They have a mature U.S. market, but it's still a great business," says Aberdeen's Sellar, a longtime owner who started adding to his position last summer. Oil and natural-gas expenses account for nearly half of Dow's annual operating costs, but Dow's product price increases have more than offset them in recent quarters. Over the past nine months, the firm had $36.9 billion in sales and $2.7 billion in net income.

In October, Dow announced a $2 billion stock buyback. That's good news for shareholders, but perhaps better news is that the company's executives are buying shares for themselves. Since July, CEO Andrew Liveris and other top Dow executives have purchased nearly $4 million in Dow stock in the high $30s. The shares have risen to $41, but the insiders presumably expect better odds are those executives are not going to flip their shares for a measly 10% profit. And despite that uptick, Dow shares remain reasonably priced at 10 times expected 2007 earnings of $4.12 a share; the stock also throws off a 3.7% dividend yield.

Hardly a household name, Philadelphia-based Rohm & Haas is probably best known for a product few people think of as a chemical: Morton salt. It also supplies many paint manufacturers, including Sherwin-Williams, and makes dozens of resins and adhesives that wind up in everything from fishing lures to truck parts. And the company's most rapidly growing product line is its protective chemicals for electronics. Sales of these chemically based shields, which are used in products like cell phones and semiconductors, reached $1.2 billion during the first nine months of 2006, up 19% from the same period in 2005. That business should more than make up for any falloff in other sales stemming from rough times in the housing market or the auto industry. Total sales grew 5%, to $6.2 billion, in the first nine months of 2006, while net income grew 10%, to $559 million. And any dip in the prices of oil or natural gas will go right to the Rohm & Haas bottom line.

Rohm & Haas has a reputation as a good caretaker of shareholder money; it has resisted overspending on new factories or other equipment, something few other chemical companies can claim. Analysts expect the company to have sales of $8.7 billion. And over the next five years, earnings growth is expected to accelerate to 9% a year on average. The stock currently has a 2.6% dividend yield, and the company has increased its dividend payouts every year since 1983.

Internet Companies


In the late 1990s, when Yahoo and Amazon.com were superspeculative Internet pioneers without a dime in earnings, they were the companies that every investor had to own. So now that they're large, profitable enterprises, it's perversely logical that people hate their stocks. Over the past year, Amazon has slipped 6%, while Yahoo is down 29%. Investors have decried Amazon's inability to raise its single-digit profit margin. And not a day goes by when someone doesn't call for Yahoo boss Terry Semel to be fired, as the firm loses market share to Google in Internet-based searches and online advertising. Thanks to such sentiment, the stocks are now just too cheap to ignore especially given that both firms are increasing sales at a considerably faster rate than most other large companies. And in 2007 both firms should clear away some roadblocks that have held them back.

Take Sunnyvale, Calif.-based Yahoo, which has 130 million unique visitors to its pages every day. Online advertising is Yahoo's primary revenue source, and worldwide it's expected to grow at nearly a 20% annual clip, to more than $50 billion in 2010, from $28 billion now. But Yahoo has fallen well behind rival Google in making money off the bleeding-edge technology in web advertising. So-called paid search systems can make a company's ads appear after an Internet user searches for something similar to the product or service advertised (imagine a user seeing a Starbucks ad after searching for "latte"). In 2006 Yahoo spent hundreds of millions of dollars to build a new system that uses this technology. The good news: It's finally rolling out now, and Yahoo should see its sales and profit accelerate in 2007, according to Merrill Lynch Internet commerce analyst Justin Post. And while it doesn't get the buzz of Google's YouTube, Yahoo also has a nicely designed Internet video system, an asset Post feels is not reflected in the stock price.

For 2007 Yahoo is expected to earn $879 million, or 60 cents a share, a 30% jump from the $669 million, or 46 cents a share, it projects for 2006. Yahoo's P/E of 45 looks dauntingly high. But Allison Thacker, who owns Yahoo as portfolio manager of the RS Internet Age fund, thinks the company ought to be measured by (take a deep breath here) enterprise value divided by EBITDA (earnings before interest, taxes, depreciation and amortization), a metric that better reflects the valuation of media companies that have big capital expenditures. By that measure, says Thacker, Yahoo trades more like a newspaper company, but "it is going to grow profits three to four times faster than a newspaper. When you balance the risk and reward, Yahoo is a value."

Up north in Seattle, Internet retailing pioneer Amazon.com has been taking a technological gamble over the past year. It poured hundreds of millions of dollars into "technology and content" investments to add video- and audio-downloading services to its online store; the company is also rolling out software and web sites designed to serve small businesses. Amazon hasn't been specific about how well these investments will pay off, much to the consternation of investors, who have watched its profit margin fall over the past year to a measly 2% from 7%.

But the long-term revenue picture looks much stronger. Amazon sold $6.7 billion worth of goods in the first nine months of 2006, 22% more than during the same period the year before. And Amazon's margins will also improve. Bill Miller, portfolio manager of Legg Mason Value Trust, says the market is assuming Amazon's profit margin will be low forever ignoring the fact that management has said its technology spending will slow down in 2007. Indeed, profits are already expected to rise 62% in 2007, to $300 million, or 70 cents a share, from $185 million, or 43 cents, in 2006.

Insurers


Hurricanes and other natural disasters cost property-casualty insurers billions of dollars in claims and according to Peter Vanderlee, a manager of the Legg Mason Partners Appreciation fund, they're great for business. Just look at the aftermath of 2005's troika of meteorological destruction: Katrina, Rita and Wilma. Yes, insurers paid out $50 billion to victims, but they still managed to record nearly that much in profits. And in 2006 they used the previous year's catastrophes to justify price increases of as much as 60% on some policies most of which went right to their bottom lines, as the year's storm season proved to be mild. Yet the investing masses haven't seemed to notice, and the valuations on several large insurers remain cheap.

St. Paul Travelers has been a major beneficiary of the price increases. For the first nine months of 2006, its net income more than doubled, to $3 billion, or $4.23 a share, from $1.4 billion, or $2.07 a share, over the same period in 2005. The absence of major disasters certainly helped the company's profits, but St. Paul also had a quite successful year investing its premium income. Many analysts expect earnings to flatten out in 2007, but Vanderlee disagrees. He sees the company boosting revenue at an 8% annual pace and notes that St. Paul has historically avoided the temptation to cut prices to attract new business. At nine times expected 2007 earnings of $5.54 and with a 2% dividend yield, the stock looks like a steal.

Hartford Financial Services has been able to raise prices too. Over the first nine months of 2006, the company made $1.9 billion, or $6.43 a share, up 23% from a year earlier, thanks to increases in property premiums. But Hartford also has a more diverse range of products than some of its competitors, says Michael Barron, who started buying the stock for his Quaker Capital Opportunities fund early last year. Hartford sells variable annuities in the U.S. and Japan, and while those products aren't often great investments for consumers, they are incredibly profitable for insurers. They generated $1.3 billion in fee income alone for Hartford over the past nine months, and that doesn't include the investment income they generate on the "float."

Hartford announced a $300 million stock buyback in October and raised its dividend 25%, and the firm is so profitable that some analysts expect more shareholder-friendly actions soon. But like St. Paul, the company trades at just nine times expected 2007 earnings.

Beverages


In good times, people drink. And in bad times, people still drink (though perhaps for different reasons). Small wonder that alcoholic-beverage companies are attractive when the economy falters their steady earnings gains don't suffer. In the near term Diageo, maker of Smirnoff, Johnnie Walker and Guinness, remains a compelling stock. And we emphasize "remains": Diageo might sound familiar to SmartMoney readers because the U.K.-based distiller was a pick in our annual "Where to Invest" story in both 2004 and 2005.

The stock has returned 67 and 41%, respectively, since those picks. But even after those hefty returns, it's still a sound investment, with steady growth in markets around the globe. In the U.S., beer is putting the fizz in Diageo's growth, as consumers respond to the snazzy marketing of its Red Stripe and Guinness brands. Globally, Diageo's wine and spirits lines are growing at an 8% annual clip, and no market is hotter than Asia, where the company's sales rose almost 23% over the past year, to nearly $2 billion.

While Diageo has increased its marketing spending worldwide, it has kept its operating margin above 20% for five years running because it has been able to slightly raise its prices every year without driving drinkers away from the bar. Diageo intends to increase prices again this year. Analysts expect the company to make $2.9 billion in the current fiscal year (which ends June 30), or $4.25 a share, up 11% from 2006. Diageo trades at 18 times expected earnings, not expensive given its track record. And it carries a hefty 3.1% dividend yield, which, at the least, ought to buy shareholders a pint or two of Guinness.

Anheuser-Busch is not growing as fast as Diageo, mostly because the U.S. market for beer has been, well, flat. But foreign markets have helped the St. Louis-based brewer maintain some momentum: Sales are up 5% worldwide. And like Diageo, Anheuser-Busch has pricing power: This fall it pushed across a U.S. price increase of 1 to 2% on Budweiser and other beers without losing any keg sales, and it's likely to do the same in February. The increases can stick because other beermakers don't want to engage in a price war with a leviathan like the Bud crew, says Deutsche Bank beverage analyst Marc Greenberg. Nonetheless, the stock, at 17 times earnings and 13 times cash flow, is priced below its 10-year average one reason it's been bought over the past year by several prominent value investors, including Warren Buffett.

Investment Banks


At first glance, you'd think shares of Goldman Sachs and Lehman Brothers would be priced even higher than they are. After all, the companies are just wrapping up years in which they've posted record profits. But they owe much of their success to the spectacular skill (or luck) of their in-house trading desks, which have had a remarkable run of moneymaking bets. Other investment pros can't help thinking that the winning streak will end, and that has kept the investment bank stocks trading at reasonable values.

But I-banks have a lot more going for them in 2007 than just trading. For one thing, everyone wants to make a deal: By early November, the total dollar value of announced mergers, worldwide, for 2006 had topped $3 trillion, the highest figure since 2000. Also, private-equity groups are on the prowl to buy companies, and increasingly, investment banks are arranging the debt. And these business lines can keep the U.S. banks growing if the domestic stock market takes a dive because the banks are now players in foreign merger consulting and debt underwriting. "We like the guys who can make money in up or down markets," says Aberdeen's Sellar, who is heavily invested in the group.

Right now Goldman Sachs sits at the top of the investment bank heap. Already considered the most prestigious, the whitest of the white-shoe firms, the bank has a better profit margin and return on equity than any competitor. Goldman arranged $800 billion worth of mergers from January through October of 2006 one-quarter of all big deals worldwide making it the market-share leader. Advising deals and other consulting services also bring in a lot of money. Profits companywide rose to $6.4 billion, or $13.02 a share in the first nine months of 2006, from $7.90 a share in the same period a year earlier. In September management announced a hefty stock-buyback program. If it's completed, Goldman will spend more than $9 billion and buy up to 11% of its shares. If this means Goldman's top execs think the shares are cheap, we can hardly disagree: The stock trades at just 11 times expected 2007 earnings.

Situated just a few blocks from Goldman in downtown Manhattan, Lehman Brothers has gone from Wall Street laughing stock to fierce competitor, largely by diversifying away from its past dependence on fixed-income trading and underwriting. CEO Dick Fuld has transformed the firm into a moneymaking machine whose return on equity is second only to Goldman's among investment banks. One key to its success: the acquisition of profitable wealth-management firms such as Neuberger Berman.

Over the past nine months, Lehman's sales rose 44%, to $33.5 billion, and profits rose 25%, to $3 billion, or $5.09 a share, from the same period a year earlier. Leo Grohowski, chief investment officer of U.S. Trust, has been especially excited to see Lehman's name pop up in the screens for both the value and the growth-oriented portfolios he oversees that means he's poised to get big performance at bargain rates. Grohowski expects the company to increase profits as much as 15% a year over the next several years, but today the stock trades at only 11 times 2007 expected earnings of $6.94 a share.

Emerging Markets


Foreign stocks keep racking up great returns, undeterred by a brief slump last summer. And right now international fund managers see a particularly attractive opportunity in consumer-oriented companies that are relatively immune to any potential U.S. slowdown. The most promising of these companies have the same consumers in mind: the emerging middle class.

Rapid global economic growth, especially in Asia, Eastern Europe and Latin America, has improved the fortunes of millions of people who now have discretionary income to spend on everything from electronic gadgets and mortgages to snacks and fast food. "The growing middle class will be the main engine for the next decade," says Pauline Dan, executive director of equities for Manulife Asset Management in Hong Kong. "These consumers will be equivalent to the U.S. baby boomers in terms of overall market impact."

China Mobile, the world's largest wireless provider, is already benefiting. Investing in China isn't without risks: The country has a relatively undeveloped financial system in which reporting and governance standards often fall short of investors' expectations. But Dan says China Mobile has built a reputation for good transparency for example, it issues quarterly earnings reports, something few Chinese companies do. The company is on track to generate 15% earnings growth, along with strong enough cash flow to boost dividends. It already commands more than two-thirds of the Chinese cell phone market; with its service ubiquitous in coastal cities, the company is now forging into the countryside, where mobile penetration is only 20%. China Mobile is expected to close 2006 with more than 300 million subscribers that's greater than the population of the U.S. And there's more growth ahead. Each year about 50 million people in China become affluent enough to afford a cell phone, as they enter the lower-middle class, adds Frederick Jiang, manager of the Ivy Pacific Opportunities fund.

Central and Eastern Europe are also experiencing a boom. After spending half a century enduring the chill of Communist planned economies, the region is "being defrosted" as the countries join the European Union or become candidates for membership, says Rudolph-Riad Younes, comanager of the Julius Baer International Equity II fund. As countries like Hungary, Poland and Slovakia become outsourcing hubs for their Western neighbors, standards of living are rising. Coca-Cola Hellenic Bottling, a nonalcoholic beverage bottler that serves the region, is positioned to benefit. Most Eastern Europeans are still thinking twice about big-ticket consumer items like flat-screen TVs. But they're eager to indulge in modest splurges like Coke, bottled water and juice, says Jim Moffett, manager of the $2.75 billion UMB Scout International fund. Economists have seen evidence of a direct correlation between increasing wealth and soda consumption in the world's emerging markets it happened recently in China. That's why analysts expect 16% earnings growth this year from Coca-Cola Hellenic. And at 14 times 2007 earnings, the stock is by no means a splurge.

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