PICKING THROUGH LARGE CAPS.

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Author: Birinyi, Laszlo1

MAKING MONEY IN THE STOCK MARKET IS always difficult, but 2005 was one of the easier years in my experience. Investors who avoided large-cap stocks, particularly in drugs or autos, did well. And if they went for Apple Computer and Google, they looked like geniuses.

Gratifyingly, 2006 is off to a stronger start than last year and in three months has already achieved a 4.5% total return, half of what most commentators thought would take the entire year. But there's a paradox here. While the overall market is doing fine, no trends have emerged that you can ride.

Stock sectors that would appear to be great bets turn out to be problematical. Energy stocks are a day-to-day thing based on the price of oil--and that, in turn, is affected by geopolitics, weather and Wall Street predictions. Housing stocks aren't romping the way they did last year, yet they haven't fallen apart, either. These issues react to any number of indicators, including new home sales, existing home sales, mortgage rates, refinancing numbers and what builders say about themselves.

Investors jump from one stock to another, hoping to catch a new trend, only to bail out when the trend fails to materialize. One example is Dell Computer, which has been trading in a narrow range of around $30 for some time. When a respected analyst upgraded the stock in mid-February, it gapped up $2 to $31 on heavy volume but has since receded to $30.

As 2006 started, many commentators predicted a recovery in languishing large caps. This would have been good news for Dell, Wal-Mart, Intel, Johnson & Johnson and on and on. These are fine companies with good fundamentals. Things haven't worked out for them, though.

And the reason is the nature of today's buyers. Stock prices in 2006 are ruled by hedge funds and Wall Street firms trading for their own accounts (see my July 4, 2005 column). The big boys' program trading, where large numbers of shares are traded when a computer spots the slightest movement, ensures that short-term mentality dominates. Hedge funds generally report monthly, while Wall Street trading desks review their exposure daily. For the most part they have little interest in large caps--the General Electrics and the IBMs are likely to move only 10 or 20 cents on the majority of days, giving the hot-money crowd little payoff.

These short-term traders remind me of the old joke about the sardine market. The new sardine trader decides one day to eat one and spits it out in disgust. The old trader tells him that the sardines aren't for eating, they're for trading.

That's not to say that popular stocks are always bad stocks. In fact, your greatest gains this year are likely to be in stocks of interest to the professional traders. First might be, of all things, a large cap: Google (371,GOOG), which I realize (painfully so) is down largely because of some unfortunate management comments. In February Chief Financial Officer George Reyes said the search engine giant's growth rate would slow. Don't worry. Google stock will be back.

Even if Google's growth slows from ten times the speed of light to merely nine times, it is expanding rapidly. This is no ordinary dot-com. Google makes money--and a lot of it. While the price is a lofty 45 times likely 2006 earnings, those earnings are increasing at a torrid 35% clip. That gives it a price/earnings ratio equal to 1.28 times the growth rate. Some feel any P/E-to-growth ratio over 1.0 looks rich. But on this score Google is a lot cheaper than Cisco Systems, one of the best-performing S&P 500 tech names this year, with a PEG ratio of 1.6.

Other stocks to own aren't favorites of the quick-trading set. I am intrigued by (and have bought) New Century Financial (48,NEW), a real estate investment trust that handles mortgages, an unloved part of the market. But despite rising rates and plentiful worries about a housing bust, residential real estate never quite seems to crash as it is supposed to. Meanwhile, New Century just raised its dividend for the seventh quarter in a row and pays an astonishing 14% yield. None of the 15 analysts who covers the stock is recommending a sale, so I will stay with it.

Another dividend play is San Juan Basin Royalty Trust (41,SJT), which owns oil and gas properties. While this stock is tied to natural gas prices, with its monthly dividend it yields 8% today and will benefit if energy prices stabilize or go higher. It costs 13 times trailing earnings.

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By Laszlo Birinyi

Laszlo Birinyi Jr. is president of Birinyi Associates, a Westport, Conn.-based financial consulting firm. Visit his home page at www.forbes.com/birinyi.