Friday, August 1, 2008

Rethinking Recession-Proof Stocks

Conventional Wisdom: Rethinking Recession-Proof Stocks

By Joshua Lipton | 30 July 2008

The conventional wisdom says to buy defensive stocks when the economy slows down. But with factors other than U.S. growth to thank for solid global growth, and with rapid advancements in technology, it may be time to rethink what it really means to invest defensively.

Or is it?

The tried-and-true strategy for stock-market investors during tough times is to move to companies making products people need: consumer staples like toothpaste and toilet paper, medicines and utilities. Forbes.com recently checked in with some market pros to see whether this time-tested game plan still holds up. Our big picture professionals by and large continue to favor the traditional game plan, though they also argue that defensive investing requires a bit of fine-tuning in the current climate. Let's start with a sector that screams "safety first"— consumer staple stocks, which provide cover during down periods in the economy and markets. Douglas Cliggott, chief investment officer at money manager Dover Management, believes consumer goods companies are still reasonable investments.

"They sell products people buy, whether they're excited or concerned about economic prospects," Cliggott says. But there is some concern that consumer-goods firms could get their profits pinched, as they struggle with higher energy and raw materials costs. Cliggott acknowledges the risk. He argues, though, that companies selling products around the world can diversify away some of these potential problems.

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"A lot of raw materials costs are in dollars, and sales are in currencies that are rising against the dollar," he says. "There is cost pressure. But there is less cost pressure for them than a firm that is primarily dollar-sales based. So it doesn't eliminate the issue. But it mitigates it." In the sector, Cliggott favors Procter & Gamble (nyse: PG).

"P&G has broad global exposure, tends to sell products people need, like diapers and toothpaste, as opposed to gadgets people want, like iPods and iPhones," Cliggott says. "Most importantly, it now has an implied earnings growth rate of less than 7%, which means its current share price is based on a medium-term EPS growth rate of less than 7%. But, during the past 10 years, P&G has averaged EPS growth of about 10.5% per year."

Cliggott is a bit more lukewarm right now on another traditional safe haven: health care, given what he calls that sector's "extremely clouded outlook." Specifically, Cliggott isn't a big fan of the large cap pharmaceuticals, citing relatively thin new drug pipelines. Cliggott isn't the only one feeling cautious. Standard & Poor's fundamental outlook for pharmaceuticals is now "neutral".

While recession-resistant drug stocks have generally outperformed during past economic downturns, S&P analyst Herman Saftlas thinks the 2008 outlook for drug stocks is clouded by uncertainty, given the impact of November's elections and research and development productivity issues. On the plus side, he does think companies with well-defined growth prospects and generous dividend yields should hold up relatively well over the coming quarters.

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But the health care sector is big and broad, including not just drug stocks but also medical device makers and managed care companies. Robert Doll, vice chairman and chief investment officer of global equities at BlackRock (nyse: BLK), acknowledges the concerns, given the uncertainty about the elections and pipelines, but he still likes health care. "The stocks are cheap relative to earnings, so you need to ask yourself: Do you think those concerns are priced into these stocks? We do."

Doll favors the stability of the sector, and prefers to play the service companies, like the HMOs, because they have better pricing power and healthier balance sheets, he says. His picks here include Express Scripts (nasdaq: ESRX), Medco Health Solutions (nyse: MHS) and Aetna (nyse: AET).

Chuck Carlson, chief executive officer of Horizon Investment Services and editor of DRIP Investor, agrees. He favors managed care names like Humana (nyse: HUM) and Coventry Health Care (nyse: CVH). Carlson is less enthusiastic about another go-to defensive sector: utilities, a sector that investors ran to in 2007, attracted to steady earnings, decent dividends and solid demand. In the past 12 months, the Utilities Select Sector SPDR (amex: XLU) is up more than 8%.

"They are OK," says Carlson. "But they are pricey. They had a good year last year. Now they are stretched." Brad Sorensen, director of sector research at Charles Schwab, currently weights the utilities sector as "neutral," staying cautious, he says, because of valuations. Instead, Schwab is bullish on tech. Some pros disagree with that strategy. Jim Stack, editor of Whitefish Montana's InvesTech Research and Portfolio Strategy, points out that information technology is one of the highest risk areas in a bear market.

In a recession, Stack notes, an easy way for businesses to save money is by cutting back on technology upgrades ( See: "Forbes Gurus: Best Investment Ideas For 2008"). Schwab currently rates the tech sector "overweight" because of, at least partially, its exposure to overseas markets. "We believe that, with the weaker dollar and stronger economies worldwide, that helps them maintain profitability," Sorensen says.

Even if the U.S. economy slows down or there is even a mild recession, Sorensen argues, tech will continue to hold up well because the sector generates so much of its revenue outside of the U.S. That thesis changes if the U.S. economy takes a more pronounced nose dive. "We would then reduce our allocation to tech," Sorensen says. "But we don't forecast an extended, severe recession in the U.S. that would cause global recession." [[It's already doing so! See Horror Movie In Britain And Eurozone and Another Bout Of The Asian Flu?: normxxx]]

"They [tech companies] will have earnings that hold up," Robert Doll says. "These companies learned the lessons the hard way in the tech bubble. They now have healthier balance sheets and excess cash flow." Doll likes IBM (nyse: IBM), Hewlett-Packard (nyse: HPQ) and eBay (nasdaq: EBAY) in the tech sector.

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Jim Swanson, chief investment strategist at MFS Investment management, says he would play tech through the software side. "Remember, that's linked directly to job creation," Swanson says. "In the emerging markets, job growth is high, running at 5% or so. A lot of them are hired in tech industries, and they need software." Pullbacks, viewed strategically, are a time to load up on stocks you want to own for the long term.

"Don't disengage," says Carlson. "There will be another bull market. So position your portfolio for that." Carlson says that now is when the smart long-term investor, the one willing to roll up his sleeves and do some work, should be able to find quality stocks at attractive valuations. "That may not pay off instantly," he says. "But, when the market does turn, you will be in the stocks you want to be in. Don't bury your head in the sand. Work hard and be in the best stocks possible. That will pay off. Maybe not now, but it definitely will later."

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Another non-traditional defensive area, which was coincidentally a great buy during the last recession, is energy. Doll likes the sector. "We don't need oil prices screaming higher," Doll says. "If prices consolidate some of the gains, that is still OK for oil stocks. It's a global cyclical." His picks in the sector include Exxon Mobil (nyse: XOM) and ConocoPhillips (nyse: COP).

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Normxxx    
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