As we begin 2005, the Wall Street consensus is that the year ahead will be OK. Not great like 2003, when the S&P 500 was up 26%. And not terrible like 2002, when the S&P was down 23%. But OK like 2004, when the index climbed 9.1%. Great. That 9.1% doesn't sound so bad. But I think you can beat that return, just as it was possible to beat the index in 2004. And you don't have to use fancy software, cutting-edge algorithms or proprietary trading strategies to do it. If 2005 unfolds anything like 2004, you should be able to beat the index by applying just three basic investment strategies. The strategies are pretty easy to understand, although finding the right stocks can take a deceptively large amount of work. But that's what I did in 2004, and the return certainly justified the effort: Although I haven't crunched the final numbers, the return on Jubak's Picks for 2004 will be better than 29.5%. There are no promises that this combination of strategies will clobber the index by the same amount in 2005. And I don't claim that this combination will beat the index every year. I think it's likely to work best in years when earnings growth is modest and the market has a lot to worry about even when it's rallying. That's a pretty good description of 2004, so I think there's a good chance of using this strategy to beat the index again in 2005. So what are the three parts of this index-beating strategy? And how do you apply them for 2005?
Look for Double-Digit Earnings GrowthFirst, understand what the Wall Street consensus values, and buy a core of stocks that will deliver it. For 2005, I think that means buying stocks that will deliver double-digit earnings growth.
When anything -- diamonds, oil, left-handed power pitchers -- is in short supply, the price climbs. In next year's stock market, double-digit earnings growth will be the scarce commodity. The U.S. economy is expected to grow next year, but at a slower rate, with GDP growth dropping to 3% in the first quarter of 2005 from an actual 3.9% in the third quarter of 2004, and a projected 4% in the fourth quarter of 2004. The projected slowdown will hit both the consumer and business sectors. Consumer-spending growth is projected to drop to 3.2% in the first quarter of 2005 from 5.1% in the third quarter of 2004, while business-investment growth is projected to plunge to 5% in the first quarter of 2005 from 13% in the fourth quarter of 2004, when companies were spending to take advantage of expiring tax breaks. Corporate profits and earnings will slow with the economy. Growth in corporate profits hit a 20-year high of 28% year to year in the first quarter of 2004, and has been on a downward trend since. Growth in earnings per share for the stocks in the S&P 500 is likely to come in near 20% for 2004, but is currently projected to drop to just 10.6% in 2005 (a big drop early in the year, picking up in the last half, according to Thomson First Call).
Two Places to Seek GrowthIn an environment of slowing growth, companies that can deliver predictable growth at a rate above the 10.6% benchmark for the S&P 500 will get a two-stage boost. First, earnings growth itself will lift the price of shares. Second, the scarcity of double-digit earnings growth in the period should boost the multiple -- the price-to-earnings ratio -- that investors are willing to pay for this growth. Simple enough. But finding the stocks that will deliver double-digit growth when the economy as a whole is slowing is a huge challenge. I'd look for this growth in two places: among stocks that Wall Street already projects to grow earnings per share in 2005 at better than the 10.6% S&P benchmark growth rate and that currently trade at a price-to-earnings ratio below the 21.3 P/E of the S&P 500.
Among the candidates my screen pulled up were big-caps American International Group ( AIG), Golden West Financial ( GDW) and Paccar ( PCAR), and smaller stocks such as Smithfield Foods ( SFD), Wolverine World Wide ( WWW) and Ball ( BLL). And look for growth among the cyclical stocks that Wall Street projects will fall just short of that 10.6% benchmark in 2005. I think Wall Street is underestimating the power of a cheap dollar to boost sales at these companies in 2005 and to keep the cycle running near peak levels for another year. A stock like Deere ( DE), with its projected 8.6% earnings per share growth in fiscal 2005, and its big exposure to the fall and (in 2005) rise of U.S. farm exports, fits this description exactly. Other stocks like this include Briggs & Stratton ( BGG), Englehard ( EC) and RPM International ( RPM).
Where Will Wall Street Be Wrong?Second, understand what might go wrong with the consensus and buy a core of stocks to profit from the inevitable deviation of reality from Wall Street projections. The Wall Street consensus on earnings growth and stock market return for 2005 rests on these assumptions:
- Energy prices won't go so high that they drag down growth.
- Growth in China (the other critical engine of global growth besides the U.S.) won't significantly falter.
- U.S. interest rates will rise at the measured pace that the Federal Reserve has promised.
The very small spread between global oil supply and global oil demand -- and the increasing difficulty and expense of expanding supply -- make energy prices extremely sensitive to the slightest disruption in supply. It's wishful thinking to believe that this violent and chaotic world of ours will manage to get through an entire year without something -- Russian politics, terrorism, Saudi politics, hurricanes, Nigerian politics, the war in Iraq, Venezuelan politics -- producing another spike in oil prices that will leave oil prices permanently higher even when it retreats. On weakness, buy the majors such as ExxonMobil ( XOM) and BP ( BP), and the minors Swift Energy ( SFY), Apache ( APA), Southwestern Energy ( SWN), EnCana ( ECA) and St. Mary Land and Exploration ( SM), to name just a few. Don't forget the oil-service stocks and drillers, starting with Schlumberger ( SLB) and including, but not limited to, National-Oilwell ( NOI), Smith International ( SII), Transocean ( RIG) and Diamond Offshore Drilling ( DO). For good measure, add a dollop of coal, too: Penn Virginia ( PVA), Peabody Energy ( BTU) and BHP Billiton Limited ( BHP). The uncertainty about how far China will trim its growth rate (and whether its bankers and economists will make a mistake and send growth tumbling instead) will make it difficult to duplicate the successful raw materials plays of 2004. Later in the year, if China's growth policies are no longer roiling the commodity markets in copper, nickel and iron, it would be worth revisiting stocks such as Southern Peru Copper ( PCU), Inco ( N) and Phelps Dodge ( PD). And finally, while I think the market's trust in Federal Reserve Chairman Alan Greenspan is touching, it's wise to remember that not all global financial markets are within Greenspan's control. The huge U.S. budget and trade deficits mean that interest rates are hostage to the willingness of overseas investors to hold dollars. In 2004 through December, the U.S. Treasury increased the supply of U.S. Treasury debt by $400 billion, but foreign investors bought up $800 billion in Treasury notes and bonds.
That's one major reason why long-term interest rates in the U.S. finished 2004 about where they started the year, despite the Fed's increase in short-term interest rates from 1% to 2.25%. If foreigners, at this point largely Asian central banks, decide to temper their love affair with the dollar, U.S. interest rates will go up, with or without the Fed. If a cheap U.S. dollar and the consequent price increase in everything we import fail to stem our appetite for imports, those higher prices will give U.S. companies the ability to raise their own prices. That feeds into inflation, and higher inflation could provoke the Federal Reserve to move at a quicker-than-measured pace. Profit from this by buying financials that have the ability -- due to their product mix and their management skills -- to increase the spread they collect on their loans, mortgages and credit cards if interest rates go up. I'd look at adjustable-rate mortgage specialists such as Golden West Financial and credit card giants such as MBNA ( KRB) and Capital One Financial ( COF).
During the next few weeks, I'll strip away the end-of-the-year plays in technology and biotech that I added to Jubak's Picks in a not very successful effort to get more bang for my portfolio out of the year-end rally. As I sell those, what you'll see is a portfolio that looks very much like the one I've described in this column. As the new year unrolls, I'll look to add stocks like the ones I've described here to the portfolio when the price is right in an effort to beat the index in 2005. Looking ahead, 2005 promises to be another interesting -- and let's hope profitable -- year. Thanks to everyone who read Jubak's Journal, emailed me or contributed to one of my columns in 2004.