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Stock Strategist

Pockets of Opportunity

Our best stock ideas for the new year and some names to keep on your radar screen.

After the furious market rally for most of 2009, are there still pockets of opportunity left for investors? For the most part the market looks fairly valued, but some stocks and sectors still look cheap enough to pique interest. We'll take a look at the best ideas in a few sectors, along with some of the major trends to watch over the next 12 months.

Technology
Macroeconomic concerns aside, technology companies must constantly deal with disruptive trends. Next year doesn't look like it will be an exception. We see two major trends on the horizon that could upend existing business models: cloud computing and the growth of smartphones.

However, the big disruptive trends also provide the biggest opportunities. Cloud computing providers that are able to establish a dominant platform will capture a significant share of enterprise IT spending over the next decade. Similarly, companies that can build dominant mobile platforms ( Apple's (AAPL) iPhone and  Google's (GOOG) Android are leading contenders) have a gigantic opportunity.

Overall, our analyst staff thinks that both hardware and software stocks are overvalued at current levels. But if the market should pull back, the team's best ideas are large-cap firms with moats. These companies, like  Microsoft (MSFT), Apple, and  Hewlett-Packard (HPQ) have the resources and talent to adapt to the fast-changing tech landscape.

Basic Materials
It's hard to ignore the impact that falling global demand has had on the basic materials sector. For example, lower demand for electricity has led to 50 million tons of excess coal inventory, by our estimation. This is equal to about 5% of annual production and has kept prices low, hurting large coal producers like  Peabody Energy . The speed of the economic recovery, along with other factors like the weather, will dictate how fast prices come back.

There are also concerns in the sector about how government spending will play out next year. The federal highway bill has encountered gridlock in Washington, and no one is sure if any future stimulus packages will include chucks of infrastructure spending. These decisions will be major drivers for firms that provide materials for the construction industry, like  Vulcan Materials (VMC).

At the moment  Monsanto  looks like the best buy in the sector. We think that concerns over the firm's Round-Up fertilizer business are overblown and that investors should focus on the company's core strengths.

There are a few other high-quality stocks to keep on your radar screen for 2010 in case there is a pullback in stock prices. These include  Nalco , Peabody Energy,  Arch Coal (ACI),  Potash Corp (POT),  Agrium , and  Compass Minerals (CMP).

Industrials
Industrial companies face several challenges in 2010. Global capital spending, one of the mainstays of the sector, has been subdued for two years now. Getting companies to open their wallets and spend on some of these projects is one of the largest challenges facing industrials companies. In fact, the U.S. stimulus has actually hindered this spending domestically as companies postpone spending in hopes of receiving stimulus funds down the road. In Asia, there has been a more positive response to stimulus spending, as it was larger as a percentage of overall GDP and allocated to more beneficial sectors.

There is also a lot of concern about how government intervention will impact industrial companies. Cap and trade, card check, and the proposed elimination of the overseas tax deferral provision in the U.S. tax code could all be bad for business.

Despite the potential issues, many industrial firms may enjoy significant snap-backs in the coming years, as current levels of production aren't sustainable. Specifically, auto, truck, and home manufacturing are currently sitting at generational lows. In autos, 2009 will likely see production of about 8.6 million units. Including imports, auto sales will amount to around 10 million units this year. This is the lowest since the 1960s, a period with significantly less drivers in the U.S. With normalized demand likely between 12.5 and 15 million units and the current fleet at its oldest in some time, future years are likely to enjoy greatly increased production. In trucks, it's the same story. This year will feature less than 100,000 class 8 truck builds in the U.S., as opposed to normal demand of about double that. Though the industry suffers from overcapacity at the moment, the fleet is older than it's been in decades. Older trucks are much less efficient than new ones, so if energy prices stay high, truck demand could snap back in a hurry.

In housing, this year will feature about 530,000 starts, by far the lowest since 1959 (first year with data). The industry has been undershooting potential demand for two to three years now, with this year maybe even a million less than potential demand. Bottom line, the glut that peaked in 2005 is being absorbed. Prices are low, and several of the empty homes sitting out there are in areas where nobody wants to live. If next year features a similar level of starts as 2009, 2011 could be explosive.

Intermodal operator  Pacer International  and logistics firm  UTi Worldwide (UTI) both look cheap right now. Worries over transport volume and the global economy have beaten down these stocks, but both firms have been oversold.

In the event of a significant pullback, investors could do worse than owning truck manufacturer  PACCAR (PCAR), homebuilder  NVR (NVR), or  Toyota (TM). In the transportation space,  UPS (UPS),  FedEx (FDX),  C.H. Robinson (CHRW), and  Expeditors (EXPD) could be interesting if investors get another shot at decent pricing next year.

Health Care
The biggest challenge the health-care sector is facing is the uncertainty surrounding reform. As we see various proposals finalized, the impact on the sector could vary widely--from drastically negative implications in the event of a complete overhaul of the system and the implementation of broad public plan (a very remote chance, in our opinion) to slightly positive as inflow of newly insured individuals offsets slight pricing concessions.

A less prominent theme for the 2010 health-care sector is its recovery from a surprisingly weak performance during the latest recession. Health care has often been viewed as a recession-proof sector, but its reputation got tarnished in the latest downturn--as health-care companies' budgets froze, hospital spending tanked, and individuals postponed their doctor visits and, in some cases, reduced their medication consumption.

Undoubtedly the biggest opportunity for health-care firms is the potential pool of 25 newly insured individuals. This could drive demand within every sector of health care--from drugs (both branded and generic) and devices to diagnostics and insurance. Another tailwind is that as the economy recovers, the pent-up demand for many postponed procedures as well as new medical equipment should provide a strong boost to health-care stocks.

Pharmaceutical companies in general remain severely undervalued, as the multiples remain compressed due to the great uncertainty overhang. Even if the reform outcome is not as favorable as expected, solely based on greater clarity of earnings trajectory, these stocks might receive a boost. We like well-diversified pharma companies, such as  Johnson & Johnson (JNJ) and  Novartis (NVS), that are shielded from pricing pressure in drugs by a strong presence in other less-targeted areas. In devices, we like  Stryker (SYK) and  Thermo Fisher (TMO), as both should see strong momentum from recovery in hospital spending, as well as other secular trends.

Although it is not attractively priced at the moment, we'd snap up wide-moat robotic surgery company  Intuitive Surgical (ISRG) if the shares were to weaken during the year.

 

Energy
Natural gas price uncertainty is our biggest concern in the energy sector. Lower industrial demand and a supply/inventory overhang could very well extend into 2010. Companies reduced spending in 2009, and we expected to see gas production fall in the back half of 2009 as the lower activity flowed through production, but it hasn't happened. Instead, several shale gas plays have seen costs fall considerably and drilling efficiencies improve, driving down the cost to bring on new supply. There is concern that renewed spending in 2010 and greater efficiency out of shale gas plays could further damage any hopes for a supply contraction in 2010.

Industrial demand (which was in secular decline and experienced a sharp cyclical decline in the recession during late 2008) and renewed growth from power generation demand (which has been the biggest source of secular growth for gas demand and is the largest single source of demand) for gas will be needed to drive gas prices higher, especially if supply doesn't right-size itself. Coal plants being de-commissioned could be a demand catalyst as 2010 progresses, especially if they are replaced by greater utilization of gas-fired power plants.

We've been concerned about government intervention in the energy sector for all of 2009, and that will continue into 2010. The president's initial budget proposal put the energy sector directly in its cross hairs. Long-held tax breaks could disappear--like intangible drilling costs (IDCs) and royalty relief in the Gulf of Mexico, and other forms of accelerated deprecation could be eliminated. Permitting and regulation could increase costs--horizontal wells could be made more expensive if permitting gets pulled under the clean water act, while federal lands could become more difficult to access and gain permitting. New taxes could appear, including windfall profits taxes. Carbon legislation could wreak havoc on stationary CO2 emitters like refiners and could have yet unknown negative impacts on other oil and refined products players. It could also potentially benefit those in the natural gas business. It could also have mixed effects on utilities depending on their exposure to different fuel sources within their generation fleets.

We see pockets of opportunities in utilities, E&P, integrated oil and gas, and pipelines. Overall we think valuations have become much fairer as we enter 2010, reducing our overall enthusiasm toward the energy sector. Utilities appear unusually attractive compared with other segments of energy.  Westar Energy (WR) and  Mirant Corporation  both look attractive. If they got cheap enough, we'd love to own  Southern (SO),  Nstar , and  National Grid (NGG) in that order.

Consumer
The consumer faces plenty of headwinds heading into 2010. High unemployment, lower house values, and limited access to credit will make it hard for spending to rebound to pre-recession levels. At the same time, consumer-facing firms could see cost pressures from rising commodity prices due to emerging-market growth.

In the face of these pressures some of the largest consumer firms, including  Wal-Mart (WMT) and  Target (TGT), are adjusting their merchandise mix. They are focusing on adding less expensive goods to their shelves, betting that people are unwilling to splurge on luxury items. To be sure, some firms are betting that spending is going to return, but we think that these players are setting themselves up for disappointment next year.

Right now, our best ideas in the sector include grocer  Supervalu , home-improvement warehouses  Home Depot (HD) and  Lowe's (LOW), and  Macy's (M). But any consumer company that has built an economic moat could become interesting if prices came down enough.

Joel Bloomer, Eric Chenoweth, Elizabeth Collins, Brett Horn, Eric Landry, Travis Miller, Alex Morozov, and Toan Tran contributed to this article.

Morningstar.com Ideas Week
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