5 Ways to Beat This Market
These are dark times for investors. Without rehashing the events of the past year, suffice it to say that every so-called "safe" investment has proved to be anything but, leaving investors with nowhere to hide. With stock and bonds, you likely face further drops. But if you move into cash, you face the pain of locking in losses and missing out on any rallies.
To make matters worse, investors' guiding light in normal times, the price-earnings ratio, is today about as illuminating as a firefly in a blizzard. "The traditional valuation metrics that you apply to individual stocks aren't going to work in this market," says economist Ed Yardeni, president of Yardeni Research.
The future of corporate profits is highly uncertain, plus analysts' profit estimates appear to be overly optimistic across the board. Or, as Yardeni puts it, "Analysts tend to be better attuned to how their companies are doing in good times than in bad, so in a recession, their expectations tend to lag the market."
From sunny Warren Buffett to former perma-bear Jeremy Grantham, there's broad consensus among experts that stocks are dirt cheap, or at least attractively valued. The trick for individual investors is to sniff out the best values. Here are five expert solutions.
1. Follow the dividends. Just because P/Es are unreliable doesn't mean picking stocks has to be difficult. You need to focus on only one figure in this market: a stock's dividend. So says Sam Stovall, chief investment strategist at Standard & Poor's. "Reinvested dividends have accounted for 40% of the total return of the S&P 500 for the past 70 years," he points out.
It's a simple approach to buying quality companies on the cheap, and the grunt work has already been done for you. S&P maintains a list of "Dividend Aristocrats" on its Web sites, composed of companies that have consistently hiked their dividends in each of the past 25 years. These won't be the stocks with the most pop when the market turns, he says, "but if you're building a long-term portfolio, you want to stick with high quality."
2. Think like Buffett. Warren Buffett has often said that he tries to be fearful when others are greedy and greedy when others are fearful. So if you want to channel the Oracle of Omaha, now is the time. Larry Coats, manager of Oak Value fund, says today Buffett is probably focused on companies that generate a lot of free cash -- that is, earnings plus depreciation and other noncash charges, minus the capital spending needed to maintain the business. "As management, you can't pay down debt or pay dividends with reported earnings -- it's cash that determines what you can do," he says.
Buffett-minded investors should also focus on any company that has built a strong "moat," or competitive defense, around its business. "A company's ability to control its own future is largely determined by its competitive position," Coats says. Industry leaders and solid brand names are prime hunting grounds.
Such well-positioned companies tend to run more predictably than others, so sophisticated investors can value them by estimating the cash they'll generate over the next several years. That's how Coats does it, and by that measure he likes Diageo, a liquor company that produces such well-known labels as Smirnoff, Johnnie Walker and Tanqueray. The stock (symbol DEO) closed at $53.68 on November 12.
He also likes Internet-hardware maker Cisco (CSCO), at its recent price of $16.55. For every dollar of Cisco's sales, "you can take 20 cents of free cash flow at the door and set it aside for shareholders," he says.
3. Smooth out the road bumps. No one can tell what 2009 will look like, but by 2010 the world will probably have inched closer to normal. So reasons Lew Altfest, president of L.J. Altfest & Co., a New York financial-planning and investment-management firm. He says you can still value companies on projected earnings as long as you look far enough into the future to smooth out near-term uncertainties.
Build a margin of safety around the stocks you buy today by sticking to large companies, Altfest recommends. He browses among the 200 largest companies in Standard and Poor's 500-stock index and compares the projected three-year earnings-growth rates of specific companies to others within the same sector.
Using this approach, he likes Avon Products (AVP), IBM (IBM), Nike (NKE) and Aflac (AFL), all of which are projected to expand earnings at a double-digit clip over the next five years. "That doesn't mean they couldn't go down more, but you'll be very happy in two or three years," he says.
4. Play defense. David Chalupnik, head of equities at First American Funds, says investors should remain defensive with their stock portfolios. He likes consumer-staple and health-care stocks, which have conventionally been regarded as good hiding places from which to weather a downturn. This time around has been no exception: Consumer staples and health care have been the best-performing sectors of the S&P 500 year-to-date, losing 18% and 26%, respectively.
He also notes that earnings estimates for such companies tend to be more reliable than those for more cyclical sectors. For example, Johnson & Johnson, the ultimate foul-weather stock, beat analyst estimates of profits per share by a few cents in each of the past several quarters. At a recent price of $57.92, the stock (JNJ) trades for 12 times estimated 2009 profits.
5. For value, avoid the pack. Ed Yardeni counters that the traditionally defensive areas have become too crowded. "It's a little late to be playing defense," he says. "Health care and consumer staples are the obvious places to be, but they're not cheap anymore."
He prefers the more-loathed sectors. "Materials, energy and industrials most likely hold the best values right now," he says. Many of those stocks have already seen huge drops in their prices and P/Es, as investors have anticipated that earnings will fall off a cliff. For example, aluminum maker Alcoa (AA) and steel producer U.S. Steel (X) are down 71% and 77%, respectively, year-to-date. At its November 12 closing price of $10.17, Alcoa trades for ten times estimated 2009 profits, and U.S. Steel trades for just three times projected profits.
He says that the sectors don't have much further to fall, even as analysts continue to catch up to the market by lowering profit estimates. Says Yardeni, "The cheapest oil in the world is in the U.S. stock market."