If your time horizon is 10 years, today’s market almost certainly presents a terrific buying opportunity. However, what if capturing that opportunity requires holding stocks through another 35% dip in a market where each day the market moves up, or down, equal to what used to take place over the course of a year. Today’s volatility, combined with unstable economic prospects, might mean that it really is (dare I say it?) different this time.
- 10 Things To Own
PHARMACEUTICALS – Traditional pharma companies, like their biotech brethren, have been able to keep raising prices even in the midst of a recession. A renewed focus on cost controls has enabled the industry to boost profit margins. Industry earnings have more than doubled during the past decade while the stock prices for stocks in the industry have been cut in half. Non-cyclical earnings support high dividend yields and make this steady growth group a reasonably safe place to invest while waiting for the broad market to turn up.
NATURAL GAS EXPLORATION – Natural gas prices have fallen, but not as much as crude oil and demand for relative clean natural gas supplies may rise if the new Obama administration were to push for fleet vehicle use of condensed natural gas vehicles. We’re also heading into the part of the year where a cold winter can quickly decimate heating oil inventories, and these companies have real assets in the ground that make it much cheaper to buy future supplies than it is to drill for them.
ENERGY SERVICE – Despite significant improvements in drilling technology, gas well productivity has fallen from 150 cubic feet per day to below 125 cubic feet per day. Lower productivity means that the global rig count is increasing even though energy produced (and inventories) are on the decline. These are legitimate companies selling services that are required in order to keep our homes warm and electricity running. At roughly 8.5-times earnings, it means that investors are receiving an 11.7% return on an investment that has excellent built-in inflation protection.
CONSUMER STAPLES – Procter & Gamble, Coca-Cola, PepsiCo, CVS Caremark, and Wal-Mart Stores comprise roughly 45% of the holdings in the Fidelity Consumer Staples fund. Wal-Mart is one of a very few stocks which is actually up this year. If we knew that the market is headed lower, we’d go to cash. Unfortunately, perfect foresight is in short supply. Until things turn, however, we think that traditionally defensive holdings will outperform the broad market, yet still provide upside in case the cash flows out of equities reverse and the market starts moving in the right direction.
SOFTWARE – Software companies like Microsoft and Oracle are cash cows with quasi-monopolies, little debt, and products that are not particularly cyclical. Though software companies traded at ridiculous valuations during the tech bubble, now they sell for less than half their 2000-era prices while industry earnings have more than doubled. The current industry Price/Earnings ratio is 11X, more like where you’d expect a steel company to be valued, but software companies in the Fidelity fund have double-digit projected earnings growth, nearly 33% historical earnings growth, sales growth of nearly 25% and extremely high growth in cash flows. If leveraged financial companies are at "Ground Zero" in this crisis, the software companies are about as far out in left field as you can get.
IT SERVICES – We had been comfortable owning this sector because going into the Fall we were of the opinion that the recession (which was finally, officially recognized today by the National Bureau of Economic Research) was about to end. Shearson Lehman ended instead, and the rest is financial history. We felt like any turnaround would likely involve, and perhaps be led, by companies in the technology sector. Indeed, some of the main holdings in our fund (Visa, Accenture, and Automatic Data Processing) have held up reasonably well. What has changed, mostly, is that the market crashed and the recession will be longer and deeper than we’d originally envisioned. Moreover, many customers of the companies in this sector are financial companies needing to cut back in every conceivable area of spending. While normally a recession is a time when IT services companies pick up new customers as companies automate functions in order to cut costs, I fear that "this time is different" and the bloodied customer base puts the top line (revenue) growth for these companies at risk. We would like to sell this fund "on a bounce," but we may not get that luxury.
HIGH-YIELD BONDS – We’ve often described "junk bonds" as the canary in the mine that signals its safe to re-enter the stock market during a recession. Unfortunately, day after day during the Spring and Summer the canary went down into the mine but never came back up. Worse, at the height of the panic in October, junk bonds were selling off as much as stocks. That, fortunately, is no longer the case. The result of the carnage is that the sector now offers stock-like returns without taking stock-market type risks. The high yield exchange traded fund owns bonds which, if simply held to maturity, will return 18%. That’s better than stocks have historically returned. This is either way too cheap, or bond defaults are headed to levels not even experienced during the Depression. (And if defaults are headed that high, then the stock market sell-off has further to go.) We will likely own more high-yield bonds as time goes by, but we’ll reclassify them as "stocks" because they failed to preserve capital when the sell-off unfolded.
PREFERRED STOCKS – Like high-yield bonds, preferred stocks are trading as if their dividends are going to be eliminated, which is unlikely given the massive bailout that these companies have just received. Like the government, and Warren Buffett, we own preferred stocks which are fixed, unlike a common stock dividend which can be cut in order to conserve cash flow. When we bought the preferreds, the financial sector was rallying. We chose to invest in the recently bailed out financials, not through the common stock (which has subsequently crumbled), but by investing higher up in the capital base, where we won’t be diluted by the capital raising efforts that are now required of companies in the financial sector. We hope to achieve equity-like returns while taking less-than-equity market risk. Furthermore, with double-digit dividend yields, we will be paid to wait while the market takes time to stabilize.
CASH/MONEY MARKET FUNDS – We still have a little dry powder waiting on the sidelines. Despite years of being told not to "time the market," this year market timing is about the only thing that worked. Diversification didn’t work; everything went down. Not even corporate bonds zigged when the market zagged. Everything got zapped. We used a portion of our stash of cash to buy energy service stocks when the market dipped into "incredibly cheap" territory. That was about 9,600 on the Dow, a level we’re still hoping to see again. From this point, we’ll wait until the market proves itself before putting any more cash to work, especially since it’s our last bit of dry powder. We’re watching several indicators to evaluate when we should put this last bit of capital to work, and even then I suspect it will be for a quick rally and then we might be taking money off the table once more. I could pontificate about the indicators we’re watching, but Chris just called and is putting cheese on my hamburger so I think I’ll Pilot my way home and save that topic for another day, and another blog.
Today was "trading day," but we haven’t been able to operate with our normal regimen of monthly trades since mid-July. The volatility is too great. We’ve had to make several mid-month corrections to the portfolio since the daily price swings can make or break a month. No trades were made today. We’ll stick with these 10 things to own, at least until tomorrow. Both our typical fund portfolio and the individual stock model have positions in the types of investments I’ve described. If I am any more specific, the regulators will probably insist that I fire myself, so I’ll stop here and go grab a burger.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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