Each January SmartMoney surveys the stock market to find the most promising stocks worth grabbing for the coming year. This year there’s a multitude of worthwhile candidates — from giant industrial conglomerates to highly profitable technology firms.
But we share a knot in our collective stomach, worried that the ugliness of 2008 could linger into the new year or beyond. Still, investing pros offer one answer to the paradox: Create a portfolio of stocks that have a wider range of risks than usual — from the safer, recession-resistant businesses with good dividends but small price swings to those stocks that carry higher risk but the potential for high return.
“It’s the barbell approach,” with higher-risk stocks balanced by the safer ones, says Ed Crotty, who manages about $1 billion in assets as chief investment officer of Davidson Investment Advisors.
Stock investing of any sort is scary these days. Nearly 11 years’ worth of market gains have been wiped out in just 13 months. And there’s the possibility of more suffering, especially if the credit crisis reaccelerates or the world sinks into a depression.
But those who want to dip their toe back into the market can take comfort that they’re not alone. Some savvy long-term investors are taking the barbell approach as they quietly pick up stocks beaten down in the market morass. Many of the companies are big-name firms with strong growth records.
Perhaps most important, the market has been in bad shape before and recovered. Since World War II there have been 13 bear markets, when stocks have fallen by 20 percent or more. According to the Leuthold Group, a Minneapolis-based authority on market behavior, stocks rebounded an average of 34 percent within a year of the bear market and 51 percent after two years.
Business-school textbooks will tell you that a stock price should reflect the company’s future earnings. Sure enough, when investors feared this fall that a serious recession would cripple corporate profits, they rushed to sell.
But not every company’s fortunes depend on whether the U.S. economy is shrinking or growing. And the good news for investors is that some of these defensive investments are selling at their lowest valuations in years — and paying decent dividends.
DUKE ENERGY AND SOUTHERN CO.
Since 1960, nationwide demand for electricity has declined in only two years-1982 and 2001. Yes, the economy was bad in those years, but electricity consumption still rose again in the following years-even when the broader economy hadn’t recovered. That kind of steadiness pays off: Over the past six slowdowns, utility stocks averaged a nearly 5 percent annual return, according to Merrill Lynch.
Even if 2009 turns out to be one of those years in which electricity demand falls, analysts say the depressed stock prices leave a margin of safety. “At this point the valuations are just downright silly,” says Lasan Johong, a utilities analyst for RBC Capital Markets.
A decade ago Duke Energy invested in opening power plants that would produce electricity and sell it to the highest bidder. But these days the Charlotte, N.C.-based company still gets more than three-quarters of its more than $1.5 billion in annual profits from its heavily regulated, highly dependable electricity business in the Carolinas and the Midwest. Even though Duke has nearly $13 billion in debt, its debt-to-total-capital ratio is about 41 percent, on the low side for the industry.
Another southern utility, Atlanta-based Southern Co., also continues to plug along. The electricity generator serves 4.4 million customers in a territory that stretches from Georgia to Mississippi.
Since 1973, a period that includes four recessions and eight bear markets, Southern has generated an annualized 12 percent return for shareholders. “It has the best management team in the industry,” says Brian Youngberg, a utilities analyst at Edward Jones. Under CEO David Ratcliffe, the company has locked in lower coal costs and maintained good relationships with state regulators, Youngberg says.
Microsoft is looking a lot like a utility these days. Customers come back year after year to purchase software upgrades of Windows, Office and its other seminal programs, just as homeowners and businesses routinely pay their electricity bills. Even if there’s a recession, Chief Financial Officer Chris Liddell told investors in late October, the company expects to increase revenue 7 to 10 percent a year and profits 7 to 12 percent a year.
Microsoft’s valuation is also utility-esque, trading at less than 10 times expected 2009 profits. Microsoft has no debt and $20 billion in cash on its balance sheet, giving it plenty of ammunition to buy other companies and boost its future growth.
JOHNSON & JOHNSON
Thanks to the market sell-off, investors can buy J&J at its lowest valuation in decades, as measured by the ratio of its price to cash flow. In the first 10 days of October, J&J shares lost nearly 20 percent as short-term traders feared the company’s profits would be slammed by currency fluctuations. That’s because the New Brunswick, N.J.-based company gets more than half its sales from overseas; when it brings that money back to the United States, its profits are hurt by a strengthening dollar.
But some experts think the worries might be overblown. “Is their business any different now than it was six months ago? The answer is, not really,” says Christian Andreach, a portfolio manager of the Manning & Napier Pro-Blend Maximum Term fund and a buyer of the stock. J&J has a yield of about 3 percent and a streak of 46 consecutive years of raising its dividend.
A LITTLE VOLATILE
Now that many consumers and companies are sharply reining in their spending, some say investors’ fears of a steep downturn were justified. But have the stocks of some quality companies suffered more than their businesses will? These firms, with healthy balance sheets and good business models, could take off when the economic outlook improves.
MEDCO HEALTH SOLUTIONS
Long a growth market, prescription-drug sales slowed down considerably in 2008, according to the health care research group IMS Health, and 2009 might not be much better. That hurt pharmacy benefits manager Medco Health Solutions, a Franklin Lakes, N.J., firm that fills more than 560 million prescriptions a year for insurers, government agencies and corporations. Medco’s shares also took a beating on worries that an Obama administration might hurt profit margins by mandating lower prices on prescription drugs.
But analysts say consumers can cut back only so much on prescription spending without risking their health. And now that Medco is trading at about 15 times expected 2009 profits, that risk, along with concern about Obamanomics, could be fully reflected in the stock.
Dentsply, one of the largest manufacturers and distributors of disposable dental equipment, makes drills, X-rays, braces and nearly everything else you see from the dentist chair. Investors sold off the stock over worries that patients will postpone cosmetic dentistry or cut back on regular dental appointments in the U.S. and abroad (about half of Dentsply’s sales are from outside the U.S.).
William Jellison, Dentsply’s chief financial officer, said that the world’s economic downturn has indeed slowed the dentistry industry’s growth from its current 4 to 5 percent annual rate, but he adds that it’s still growing as the population ages and more people “are retaining their teeth.” Joe Milano of the T. Rowe Price New America Growth fund estimates Dentsply earnings can grow 10 percent in 2009 “unless we have the Great Depression.”
Its products have become so iconic that when many of us hear the word apple, we think iPod or iPhone before we think of the fruit. And that kind of brand recognition has allowed the Cupertino, Calif., technology company to charge hefty prices for its products even as it sells more of them. Analysts note that the firm has a nearly 20 percent operating profit margin, no debt and $24 billion in cash. “They have the premier brand and grow in ways that others can’t,” says Chris Armbuster, analyst at the Al Frank Fund, which owns Apple shares.
Veteran tech investors still have nightmares about seeing their Cisco Systems shares plummet during the technology bust in 2000. When Cisco’s shares dropped 30 percent in the fall, investors again feared the worst. But according to some analysts, this time is different. In the tech bust, Cisco found itself with excess routers and other products it couldn’t sell because many of its customers had loaded up on its equipment. That crushed the company’s profits and forced it to sell brand-new equipment at major discounts.
Today sales growth is slowing around the world, but inventories are in better shape. And with a cash hoard of $27 billion, or $4.60 a share, the Redwood City, Calif., company has flexibility to buy smaller firms and expand its businesses or-gasp-initiate a dividend. A Cisco spokesperson says it has discussed starting a dividend, but that for the time being it will use the cash for acquisitions or other ways to fuel growth.
HIGHER RISK AND RETURN
The stock market seems to be pricing many companies as though the credit crunch and recession fog will never lift. Call us crazy, but surely some financial firms and energy companies won’t go out of business in 2009. In fact, they might even thrive once the economy gets past the current mess. These riskier picks could offer high rewards.
ANNALY CAPITAL MANAGEMENT
Annaly Capital might be one of the few housing-related companies to make more money as the housing market gets worse. The New York-based real estate investment trust, or REIT, profits from borrowing money at low interest rates, then buying mortgages that pay out a higher interest rate. Most of the mortgages Annaly buys are insured by Fannie Mae and Freddie Mac, the now notorious agencies at the center of the housing bust.
Investors naturally wonder what will happen to Annaly if the mortgages it holds go bad and Fannie and Freddie can’t guarantee the debt. But some analysts say that while nothing is certain, the government’s takeover of the two agencies last September is a de facto guarantee that the government will cover the mortgages. The lower price “just gives value investors like us an opportunity to get involved,” says Armburster, of the Al Frank Fund, which has been buying the stock.
Lowe’s stores sit at the intersection of Recession Road and Housing Bust Boulevard. Fewer homes are being built, so the stores sell less paint and lumber for new construction, while consumers are feeling the pinch of the slow economy and cutting back on spending. But many analysts also think the Mooresville, N.C.-based home-improvement retailer is a good bet at about 16 times expected 2009 profits. Lowe’s also owns nearly all of its stores, giving it the flexibility to sell and lease back some of its properties if it wants to raise cash.
One of the few things that tops the collapse in the stock market is the recent free fall in the price of oil. That plunge has sent investors fleeing from Transocean, the world’s largest operator of offshore-drilling platforms. Its stock has fallen $163 last May and trades at less than five times expected 2009 profits. Oil-service firms traditionally trade at price/earnings multiples below most stocks, due to the industry’s historic volatility. However, Transocean is at its cheapest since 2001.
The worldwide slowdown has dented demand for GE’s products, such as aircraft engines and washing machines. Worst of all, the credit crunch has hammered GE’s finance business. The Fairfield, Conn.-based company borrows money in the short term to fund itself and help its own customers finance big-ticket GE purchases. In the worst-case scenario, the credit crunch could make it difficult for GE to refinance $330 billion of long-term debt.
GE’s stock appears to be priced as if the worst case is not just possible but probable. The stock has fallen by half since we recommended it last year, reaching valuations not seen since the early 1990s. But that dire scenario is unlikely, say analysts. GE has raised more than $15 billion in cash from a stock issue and from an investment by Warren Buffett. Meanwhile, GE and other firms can take short-term loans directly from the U.S. government, clearing up some of the credit worries, says Dan Genter, president of investment management firm RNC Genter Capital Management.