Wednesday, July 25, 2012

Global Uncertainty

With Europe in a recession, China slowing down, and US sputtering, the global economy outlook is tepid at best. In environments like this, I recommend sticking to high quality stocks that have strong balance sheets, yield support, and are best of breed in their sector. What do these mean?

Strong Balance Sheet

When the economy hits the gutters, corporate revenues, and thus profits, typically decline for the majority of businesses. In this scenario, it is important that the company is not carrying too much debt, as debt servicing costs remain relatively constant. A company with minimal debt can attack its operating costs and survive the downturn, but a company loaded with debt will be forced to divert a bigger and bigger slice of the shrinking revenue pie towards servicing that debt.

In the worst of scenarios, the company could even declare bankruptcy, which would wipe out shareholders. 

There remain 4 companies in the entire United States with top tier credit ratings, AAA, which makes them more credit worthy than the US government. They are:
- Exxon Mobil
- Microsoft
- Automatic Data Processing (ADP)
- Johnson & Johnson

There are many other companies with strong balance sheets. It is easy to look for them by filtering with debt/equity ratio.

Yield Support

Another important characteristic to look for during these times is yield support. Yield support refers to the levels as the stock drops where the dividend yield reaches a certain level that brings in buyers. Yield support often determines how much the stock can fall when shit really hits the fan. 4-5% is often used as a level where stocks find support, but since 2009 I've actually been using a better indicator.

For each of my investments, I've been looking back at 2009, and looking at what the dividend yield was back then, and using that as a worst case scenario. The interesting thing with this method is that over the last few years, I actually found a few stocks that are trading near the yield levels they saw in March 2009.

For example, Intel (INTC) yielded 4.7% in March 2009 at its bottom (where it traded for $12 per share, and paid 56 cents annual dividend, 0.56 / 12 = 4.7%, and was 57% lower than its 07/08 peaks). Since then, there has been a few times each year where it has neared or gotten to a 4% yield. Each time has been a good time to buy more shares.

Another example, UPS, also bottomed in March 2009 around 4-5% yield. It traded around $40 and had a $1.80 annual dividend, good for 4.5% yield, and 50% loss from its peak in 07/08

United Technologies (UTX) is another example, having bottomed at around $40 and having a $1.56 annual dividend, good for a 3.9% yield, also 50% lower than its 07/08 peak

Compare these with high flying non-dividend stocks like Chipotle Mexican Grill (CMG) or Lululemon (LULU) which dropped 73% and 94%, and you begin to see how yield support can protect your capital during the storm.

Best of Breed

The last desirable trait is segment leadership. Very often, the leaders in an industry will not fall as hard as the runner ups. This is because as leaders, they often are in better economic condition to withstand a downturn. Leadership businesses often also have stronger brand support, which can protect its revenues.

Take for example Nike (NKE) which lost 43% from $70 to $40 during the 08/09 recession, versus Adidas (ADS) which went from $50 to $21 for a loss of 58%.

Or Mcdonalds (MCD) versus Yum Brands (YUM) which owns Pizza Hut and KFC. The former lost 33% going from $67 to $45, and the latter lost 48% going from $42 to $22.

So, until Europe sorts itself out, China picks up some steam, let's just play defense for a while, and stick to best of breed stocks that have a strong balance sheet and good yield. After all, to make money, you need to make sure not to get wiped out first.

No comments:

Post a Comment