Is Intel the next GM?

By Jon Markman

One of the big lies of the stock market is that investors should buy great companies once and hold them a long time.

That's been true for so few companies in the past three decades that you can count them on a hand or two. The far better strategy -- exemplified by the revival of the Dow Jones industrials ($INDU) this year -- is to buy great companies only after they stumble so badly that everyone agrees they'll never recover. And then hold them until they do cough to life.

Exhibit A in this category is General Motors (GM, news, msgs), which was considered just about the worst company in the world last year. Earnings were plunging, bankruptcy rumors were flying, rivals were laughing, management was reeling and there were calls for a government bailout. Now look at it. GM's condition had grown so bad that it attracted the attention of vultures -- speculators that buy large stakes in near-dead companies and try to pick out the edible pieces. Their insistence on big changes helped GM become a terrific contrarian investment, and its 70% move higher this year has led all other stocks in the Dow.

It's crazy and counterintuitive, but that's the market for you.

Lucky for us, it just so happens that there are several large companies among the Dow industrials that are just about where GM was last year: left for dead by most sane investors, with shares down 30% to 50% over the past six years. If you're patient and don't mind taking risks, they just might turn out as well over the next 12 months -- particularly if they attract impatient superspeculators who will demand big changes in a hurry.

That's why I think you should consider the potential for upside in embattled chip giant Intel (INTC, news, msgs), insurer American International Group (AIG, news, msgs) and retailer The Home Depot (HD, news, msgs) right now, all of whom are miles away from their all-time highs at a time of celebration for their Dow index peers. If you buy them as a group right now, you can look forward to the opportunity for a 20% return or more over the next 12 months.

The positives of negative sentiment

Let's start with Intel. Ugly does not begin to describe the shape of the world's largest maker of semiconductors. It's got too many people, too many factories, too little innovation and too little energy. Its top managers, promoted from within, are mostly a bunch of pansies who have tried to nip and tuck the company into shape with cosmetic changes when the company really needs open-heart surgery.

Intel late last month spent a few days explaining to analysts a refresh of its product line, and the projection screen had more characters than a Hispanic telenovela. The concept of keeping it simple was apparently never explained to Intel's product managers. However, out of the alphabet soup of multiprocessor chips, flash chips, server chips and wireless protocols emerged a sense that the move to a new architecture called "Core" on 65 nanometer wafers should accelerate growth over the next year.

Plus, of course, there is the fact that the primary provider of chips for Windows-based personal computers will benefit greatly from the long-delayed release of a new Vista operating system from Microsoft (MSFT, news, msgs). Tens of thousands of consumers and companies, including myself, have put off buying new PCs in the past year while waiting for the Vista release. It's really happening now, so the time to buy a company like Intel is now -- before the marketing hype begins. (Microsoft is the publisher of MSN Money.)

I'd like to see the board of directors get more aggressive and put Intel Chief Executive Paul Otellini on a short leash, as his restructuring plan so far has been painfully slow. The company expects a 10,000-person reduction in head count and other initiatives will cut costs by as much as $2 billion next year.

An aggressive set of vulture investors would encourage the company to at least double that total. If the cost-cutting move works at least as well as a similar effort a year ago by fellow tech giant Hewlett-Packard (HPQ, news, msgs), operating margins could improve by as much as six percentage points and gross margins could improve by as much as 2.5 percentage points in 2007. That would boost earnings per share significantly, energizing engineer morale and providing investors with proof that the company can make the tough decisions to grow efficiently again.

Most analysts came away from the Intel meeting unconvinced, so sentiment is still negative -- and that's a good thing. The best possible scenario for investors is to buy shares of a company at the forefront of a major new product cycle when expectations are low. Valuation is now very close to the bottom of its historic range just as the personal computer market is about to get a shot in the arm. I think Intel can rise as high as $27 over the next 15 months as sentiment rebounds from low levels in conjunction with an advance in earnings per share to $1.35 in 2007 and an expansion of the price-to-earnings multiple to 20. That would be an advance of 35% from the current quote.

Warts, but no storms

American International Group is a different case altogether. The subject of a scandal involving longtime Chief Executive Maurice R. "Hank" Greenberg last year and battered over the spring by fears of another terrible Caribbean hurricane season, the big property-casualty and life insurance company has warts all over its once-pristine story. But this is another situation that can improve dramatically given enough time.

Since the hurricane season turned out to be a dud, earnings estimates for insurance companies across the board are rising, but they have probably not advanced enough. Interest rates are back in retreat, bonds are rising in value and investment sentiment is slowly improving, so I think AIG and many of its industry peers will surprise to the upside over the next couple of quarters. AIG has plenty of growth opportunities in Asia, where it has a commanding lead over competitors and will generate tremendous growth from a rising middle class.

The market doesn't believe AIG can achieve the 15% earnings growth it has shown in the past, so there is a much greater likelihood of upside than downside surprise at this valuation level: a low, low 10 times estimated 2007 earnings, vs. the 20-times to 30-times multiple that AIG has enjoyed in the past.

A slump's victim

And finally, take a long look at Home Depot for the potential for a big move higher in 2007 and the chance to be a leader in the Dow industrials. The do-it-yourself retail leader suffered along with the slump in homebuilders, as the purchase of fewer homes obviously leads to fewer trips to the big orange stores for landscaping materials, paint, lumber and tools. Home Depot's price-earnings multiple has sunk to the once-unimaginable level of 12 times 2007 estimated results, which is less than a third the level of confidence it has enjoyed for most of the past decade. It doesn't take a lot of improvement in quarterly earnings to get investors excited when expectations are that low.

Home Depot invited analysts and investors last week to see its new "rapid refresh" approach to rebuilding store traffic and boosting sales, and many still came away skeptical. Again, that's s good thing. If you want to buy a leader when many believe it has completely lost its touch, then buy Home Depot now for a move toward at least a 16-times-earnings multiple and a price in the low $50s over the next 18 months. That would be a 35% move from the current quote.

Technology, financials and homebuilding retail have all stunk up the joint over the past few years, but don't count them out. Buy the great companies when they look more like chumps than champs, and be patient. It worked for GM and it should work for these three, too.

Fine print

Last month, in my column "Why YouTube is ready for prime time," I estimated that YouTube.com would be valued as high as $1 billion in an IPO. As it turned out, Google (GOOG, news, msgs) topped my offer by more than 50%, giving the company $1.65 billion in Google stock this week in exchange for the keys to the front door. That sounds like a lot, but keep in mind that it is really "funny money" -- stock, not cash. The founders would do well to recall that Broadcast.com founder Mark Cuban, who made a similar deal with Yahoo! (YHOO, news, msgs) back in 1999, became the world's most entertaining billionaire by selling his shares as soon as he could.

To learn more about Intel's new products, read here. Read more about American Insurance Group's rich set of products here. For more on Home Depot and its new "rapid refresh" program, check here.

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Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Jon Markman owned shares of Home Depot.