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Picking Them While They're Down Takes Nerves of Steel

March 23, 1997|TOM PETRUNO

So you agreed wholeheartedly with Warren Buffett and Alan Greenspan a few weeks ago, that U.S. stock prices were simply too rich.

Well, they're not quite so rich anymore. Some might even be downright cheap.

If you want to follow the cardinal rule of successful investing--"buy low, sell high"--the continuing slump in the stock market is a gift. The only question now is how much bigger a gift investors might be given in the weeks and months ahead.

At the very least, this is a good time to get a shopping list together, whether you're looking at individual stocks or mutual funds.

So far, the pullback in big-name stocks has been relatively modest. The blue-chip Standard & Poor's 500 index has lost 4% from its peak reached on Feb. 18.

That is the equivalent of $2 off a $50 stock--hardly a big deal, especially considering the magnitude of the worries facing investors: higher interest rates, a strong dollar (bad for multinational companies' earnings) and a Federal Reserve Board chairman who apparently believes stocks are generally overpriced.

But in the broad market, and particularly among the thousands of small-company stocks that make up the majority of issues traded, price declines so far this year have in many cases been dramatic.

Some of the mutual funds that focus on smaller stocks have lost 15% or more of their value this year, compounding losses that began last summer and continued through the fourth quarter.

If you want to know what a bear market looks like--because we haven't had one in blue-chip stocks since 1990, ancient history for most investors--just get a load of the devastation in smaller stocks.

For many mutual fund managers, the last five months or so have been "a daily grind of feeling that you can't do anything right," says L. Keith Mullins, growth-stock analyst at Smith Barney Inc. in New York.

To be sure, some of those fund managers, and individual investors, were playing the dangerous game of "momentum" investing: chasing hot stocks ever higher, paying little or no attention to underlying valuations. No price seemed too high--50 times earnings, 60 times, 100 times--as long as the stocks were still rising.


But once the stocks began to decline in last summer's sharp market pullback, momentum investing was finished. What's more, those investors have compounded their own problems, as many have tried to exit formerly hot stocks all at once, only to find the door isn't wide enough.

To make matters worse, money managers complain that many Wall Street brokerages that are supposed to be active "market makers" in small growth stocks traded on the Nasdaq market--home to most smaller issues--have been increasingly reluctant to step up and trade those issues, causing a decline in market liquidity at exactly the time it is needed most.

That, however, is not a new phenomenon; Nasdaq stocks' liquidity always erodes in weak markets, because brokerages naturally become less willing to expose their own capital to risk of loss.

In any case, the liquidity issue is one more reason why some investment pros are skittish about jumping into the market now, despite the feeling that smaller growth stocks are becoming terrific bargains as they continue to slide.

Consider the case of Xylan Corp., a Calabasas-based computer-networking company. Its stock peaked at $76 last May 20 amid the frenzy for small technology stocks. The price plunged to $39 by mid-July as the market tanked, then rallied back to $58 by October.

But since then, Xylan's stock has been in a sustained downtrend. Buyers at $50, $40, $30 and even $20 probably now feel foolish: The stock closed at $18.75 on Friday.

What's it really worth? Even at $18.75, the stock isn't exactly cheap. Analysts expect the company to earn about 67 cents a share this year. That gives the stock a price-to-earnings ratio of 28.

"Even though a lot of these stocks have come down, they're still at high P/E multiples," notes David Ryan, manager of the New USA Growth fund in West Los Angeles. He worries that, because so many institutional investors plowed into smaller growth stocks last year, it will take a long time for them to unload in a market where liquidity has dried up.

That could be a recipe for even cheap stocks to get a lot cheaper, Ryan and other pros warn. And it won't help matters that the Fed appears virtually certain to begin tightening credit again, with a quarter-point rise in its key short-term interest rate expected to be announced Tuesday.

The other major concern is corporate earnings growth. As usual as the quarter draws to a close, the market has been hit in recent weeks by company announcements that earnings won't meet expectations. The latest bomb to fall: On Friday, Eastman Kodak released a terse statement saying sales for January and February will be flat, as higher product sales were offset by price cuts and the negative effects of the strong dollar on foreign sales.

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