Well readers, it's been a while. For myriad reasons, I have had to sideline my writing for the past few months. Unfortunately, my contributions will remain sporadic for the foreseeable future.
A lot has changed since my
last column in the spring. The residential real estate correction has accelerated. The
has belatedly paused its tightening campaign. The commodity trade has lost its appeal. Small-caps have relinquished leadership in the market to large-cap stocks. And despite an ostensibly resilient economy, the defensive sectors of the market have captured investors' attention in a big way.
In March, I wrote that I was moderately bullish going forward through the late spring. Since then I have been torn between conflicting trends in the economy and the financial markets. For the most part, share prices have churned, frustrating both the bulls and the bears. The only certain trade has been to avoid most economically sensitive stocks.
That's correct; despite an economy at full employment with decent real (if downshifting) growth and a neutral Fed, investors see an economic collapse in every data point. The Cult of the Bear has been taking in new doomsday members as fast as it can sign them up. Currently, a collapse of the housing "bubble"; next, a plunge in the global economy.
So sound-bite investors buy health care, staples and utilities and sell commodities (including energy), industrials and consumer durables. It's that simple. Unfortunately, investing is rarely that cut and dried.
Undoubtedly, there are major macroeconomic concerns:
- Residential real estate appears to be experiencing a hard landing. This will curtail mortgage equity withdrawals and the purchases that money represented.
- Sticky commodity prices, although tapering, will also dampen consumer enthusiasm.
- The current account deficit should continue to pressure the dollar.
- Geopolitical tensions appear to be on the rise, which is also clipping consumer confidence.
- Finally, the financial press, led by a roster of screeching CNBC anchors, attempts to turn every minor problem into a full-blown crisis. Watch them these days and you will need to double your Prozac dosage or move to Montana!
And yet, for all the actual and potential catastrophes, the financial sun seems to appear each morning. Economic activity, outside of real estate speculation, continues at a healthy pace. Nonresidential real estate appears to be picking up where housing left off. Initial unemployment claims remain subdued, and unemployment is low. Interest rates seem to have leveled off. Bond prices remain solid -- even high-yield paper has a firm bid. Foreign economies continue to march ahead, especially developing countries. Corporate profitability and free cash flow remain healthy.
Maybe, just maybe, the "necessary" hard landing in the general economy is not so assured after all. Both the economic bulls and bears need to recognize that we are in virgin territory here, with an uncertain outcome. This midcycle pause may be just that, and forgotten in 12 months, or it may be the start of something more severe. We just don't know yet.
This virgin cycle makes investing all the more difficult. Normally, the economic cycle progresses in a fairly predictable fashion. However, a housing "bubble" and the negative savings rate change everything. It does not eliminate the cyclical trade; rather, it complicates it. If we dodge a recession, many economically sensitive stocks are compellingly cheap. If the economy is receding this time next year, cyclical shares have yet to bottom.
What does it all mean to investors? Despite the conventional wisdom of staying all defensive, all the time, I think it makes sense to hold a balanced portfolio containing defensive as well as offensive/economically sensitive positions.
Over the past few months, I've booked some profits in energy, industrial, technology and consumer durable stocks, but I still have decent exposure there. I've also built up holdings in more defensive sectors, such as health care and financial services, and added some hedges in the portfolio, especially in the small-cap sector. Should the economy really slow, small-caps will get hit harder than large-caps because of their duration and domestic sensitivity.
I really don't know what the short term will bring for stocks. They might overreact to the current economic deceleration and earnings concerns this fall, or they might continue to work higher on some kind of Goldilocks scenario. If I were forced to predict, I would choose the former. One last leg down in the equity markets would create exceptional valuations in many sectors of the market and be an excellent buying opportunity.
Some oldies but goodies that could be worth picking up whether there is a leg down or not are:
-- This is the best combination of sustainable revenue growth (20% for 2006) and modest valuations (14 times my 2007 estimate) in the stock market today. Continued big market-share gains, strong unit/revenue growth and finally, yes, finally, margin expansion. Last quarter somewhat silenced the perma-hackers on Motorola in the press. A strong finish to 2006, with many hot new products, should put the bears into hibernation. When was the Razr going to die? My long-published target remains $30. It currently trades around $23.
-- OK, infrastructure and resource extraction are late-cycle industries, at least in the U.S. In developing parts of the world, they are secular growth industries. At around $41 a share, the stock is trading for eight times my 2007 earnings forecast with midteens revenue growth. The nonresidential construction cycle is just entering its sweet spot. Also, I expect some big orders from the BRIC countries (Brazil, Russia, India and China) for coal-mining shovels and trucks. However, 2010 might look a bit squishy right now. Give me a break. The upside is to $65 at 13 times earnings.
-- At 6.6 times 2007 profits, the stock is still too cheap not to own, especially compared to
Royal Dutch Shell
. With a $9-$10 strip for natural gas, the Burlington deal isn't looking as dumb as I first feared. Hopefully, James Mulva learned his lesson and will start returning serious cash to shareholders. A P/E of 9 gets me a 30% trade. It's trading around $65.
Here are some new low P/E stocks in my portfolio that I believe can do well in the next rally:
-- Ugh, an airline. Hey, if Cramer can do it, so can I. UAL is the cheapest company in the airline group by a country mile on an EV/EBITDAR basis. It's kind of like Terex last year. Cost cuts and balanced system revenue give it a shot at reacquiring premium image and valuation. Management can't screw things up, since domestic airlines can't get their hands on new planes for years.
are tied up filling orders from foreign airlines, and nothing is left in the desert. Stop bitching about fares -- they are going higher and the airlines are making money for the next few years. On my $5 EPS estimate for next year, the stock would trade back to $40 from around $24 now.
-- Glad I met ya, especially at $32, when investors puked the stock on a made quarter. This leading managed care company "stumbled" last quarter and the stock plunged to 10 times my 2007 forecast. That's too cheap for 15% revenue and earnings growth, even if it takes a buyback and cost cuts to make the number. If it makes its numbers in 2007 and 2008 ($3.50 a share), the stock should retrace its high above $50. It's currently around $37.
-- The sell side is obsessed with the end of the drilling cycle, so the stock is trading for seven times 2007 estimates at $33 a share. Maybe it's not going to end. We will drill 25,000 to 30,000 natural gas wells this year in the lower 48 just to maintain flattish dry gas production of 18.5TCF. This compares to 10,000 to 15,000 just a few years ago! We might actually need that new rig capacity coming on line over the next 18 months. The drilling cycle might be protracted like in the 1970s, sparking record earnings for years to come. The company has embarked on a huge share repurchase program as the CEO puts our money where his mouth is. A 10 multiple for this "cyclical growth" company would result in a 50% trade.
This is a tricky time for investors. There are some very significant economic headwinds. A bad storm might be rising. However, some of that is already priced into stocks, especially those with economic sensitivity. Remain flexible, yet stay disciplined. Buying stocks that are down and cheap should provide some protection in a stormy market.
A final correction into the fall would provide an excellent buying opportunity, especially if that storm turns out to be like the first half of the 2006 hurricane season. But also stay cognizant of the risks to the economy. The Cult of the Bear should get more airtime on Burstingvision (formerly Bubblevision) as the economy continues to decelerate.
Gee, isn't investing fun?
At the time of publication, Marcin was long Motorola, Terex, ConocoPhillips, UAL, Aetna and Nabors, although positions may change at any time.
Robert Marcin is the founder of Defiance Asset Management, a private investment management firm. Client accounts managed by Defiance Asset Management often buy and sell securities that are the subject of commentary by Marcin, both before and after it is posted. Under no circumstances does this column represent a recommendation to buy or sell stocks. This column is intended to provide insight into the financial services industry and is not a solicitation of any kind. Neither Marcin nor Defiance Asset Management can provide investment advice or respond to individual requests for recommendations. However, Marcin appreciates your feedback;
to send him an email. Marcin is not required to update or held responsible for updating any portion of this column in response to events that may transpire subsequent to its original publication date.