Salomon analysts address portfolio changes in "disaster recovery" report

By Ronda Fears

Nashville, Tenn., Sept. 27 - In the aftermath of the Sept. 11 disaster, investors have been struggling with what to do now. Acknowledging the difficulty in assessing the situation so soon, in a new report Thursday Salomon Smith Barney convertible analysts identified several groups to target for shelter amid the turmoil, where to shy away from, and some ideas for possible gains.

"As the events of Sept. 11 made a difficult investment environment far more challenging and uncertain, convertible market investors have been presented with an increasingly more complicated investment landscape," the Salomon convertible analysts said in the report. "With the lowering of GDP estimates and the subsequent decrease in expected earnings growth, future stock performance and therefore convertible performance has been materially dampened for the next few quarters. While the year-to-date strength of the bond market has had a positive impact on convertible market returns, the recent collapse of the high yield market presents the convertible market with a difficult challenge in maintaining the asset class's superior relative return profile.

"With new issue volume expected to be slight at best, non-existent at worse, the convertible market must seek excess returns from more defensive industry groups and possible supply/demand imbalances."

Salomon strategists are calling for a price target of 1200 on the S&P 500 for 2001 and 1350 in 2002. If achieved, this would be an 18% increase from current levels but down 9.1% for 2001 and an annual price return of 12.5% for 2002. If you assume the convertible market's historical 78% return participation rate to that of the S&P 500 holds true, the convertible analysts the 9.1% decline for the S&P 500 would equate to a convertible market return of 7.1% for 2001, while 2002 would put the convertible with a price return of 9.8%.

"We believe over the next six to nine months, a supply/demand imbalance may add additional positive performance to the convertible market thereby either accentuating any positive returns from the stock market or buffering any decline if the equity markets where to continue to fall," the Salomon analysts said in the report.

"The primary impetuous to this imbalance is the pending convertible issues which have upcoming puts. According to our calculations, over the next nine months there are 19 issues with total proceeds of $11.8 billion, which possess a high degree of probability of being put by investors. If we assume the equity markets continue to either trend sideways or down over this time frame, the new issue calendar for the convertible market will remain dormant. Without new supply coming into the market, dedicated convertible investors will have no avenue to invest the proceeds received from the retirement of these issues. Regardless of whether the puts are satisfied in stock, convertible investors will in all likelihood sell the stock received and be left with extra cash. With the current market value of the U.S. convertible market at approximately $186 billion, this $11.8 billion in funds or, 6.3% of the total, could add 10 to 20 bps of positive return to the group."

As for what to do with your money now, the Salomon convertible analysts suggest, based largely on the firm's position with the underlying stocks, to look for Raytheon and L-3 Communications to potentially benefit from any increased defense spending.

With regard to portfolio changes, the Salomon convertible analysts suggest reducing cyclical exposure from their previous recommendation of modest overweight to underweight. "Particularly in the airlines and leisure sectors appear most vulnerable to a persistent downturn," the report states. "On the positive side of this group would be the more defensive metals & mining and paper sectors."

The financial sector remains steady, the analysts said, and they continue suggesting an overweight position in the group. "While the brokerage group and banks with direct exposure or lower-quality balance sheets are somewhat susceptible to continuing downdrafts, we believe abundant provision of liquidity and aggressively lower rates has helped limit the risk and should support the better quality names," the report states. "In insurance sector's exposure to this disaster has been largely priced in and relative downside risk has subsided recently."

Now is the time to increase a position in energy, the analysts suggest. "While the group possesses a high degree of leverage to the military response, the recent sell off has positioned the group in such a way as to offer relatively low downside risk. More important is the fact that since these stocks are sitting on top of their 52-week lows, potential upside is even more promising than in the energy sector represented within the broad equity market."

On a selective basis, the Salomon convertible analysts suggest increasing technology and telecom exposure. "Opportunities at the sub-sector levels within technology may be poised for improvement in relative earnings visibility, particularly in the data storage sector which will ultimately benefit from companies heightened need for an increased capacity off-site back-up facility," the report states. "Also, Salomon Smith Barney's telecom team believes that their sector may benefit from an increased level of network usage over the near and median terms."

Names highlighted in the telecom group were Worldcom, Quest Communications, Broadwing, Global Crossing and Verizon. End

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