By
John Kozey
:
Stock market investors could rejoice in capturing a 15% gain in
the S&P 500 in the first nine months of 2012. But a run like
that also generates unease about the prospect of a pullback. Here
are four reasons you might want to consider sticking to your guns,
and staying put in the stock markets - and the names of four
companies whose stocks may benefit from these investment
hypotheses.
Welcome to the fourth quarter of 2012. If you're like most
equity investors, you're looking forward to the next three months
with mixed emotions and a degree of trepidation. True, rallies
triggered by the aggressive actions on the part of the Federal
Reserve, the European Central Bank and other monetary policymakers
in recent weeks have propelled the S&P 500 index to a gain of
as much as 18% for 2012 as a whole. That's more than double the
return that many economists and other pundits had warned us that we
could expect, on average, in the coming years. It also is
considerably more than investors could have earned from investing
in most other asset classes. So, if equities seem to be just about
the only game in town for returns, the logical next question is,
what can we expect in the way of an encore?
The knee-jerk response would seem to be, "not much." It's hard
to imagine central bankers becoming still more interventionist, and
stock market gains already have been impressive. So owning equities
now might make one nervous, at least in the short run. But the
fundamentals suggest sticking with stocks, for the long run, as
long as you can maintain discipline and refrain from chasing
winners whose valuations have moved into nosebleed territory. In
fact, we see four reasons you may want to stay put in equities,
with the specifics depending on your particular investment
strategy, risk tolerance and style.
Reason 1 - Don't Fight the Fed
This is never a good idea - ask any veteran investor. Today,
it's even dicier. Yields on U.S. government debt and other fixed
income securities remain at artificially low levels thanks to what
can only be described as financial repression in the shape of an
insistence by Fed chairman Ben Bernanke that key lending rates will
remain near zero until at least 2015. This policy, known as the
"Bernanke Put", continues to force investors who would normally
seek fixed interest returns into the risk-on equity arena in
ever-growing numbers. Media reports proclaim that the strategy of
investing in stocks that pay out high dividend yields is overdone,
overcrowded or about to underperform. All three may be true to some
degree, but that's not to say that yield-starved investors are
paying attention; they still want some income, and if they can't
get it from bonds….
One way for investors to try to ride the slipstream of the Fed's
easy money policy is consider buying shares in those companies that
pay out an above-average dividend yield, while retaining an above
average amount of their free cash flow. (In other words, look at
companies with high yields and low payout ratios.) That's the way
to acquire a portfolio of companies that remain cash-rich while
still being generous to investors.
Microsoft (
MSFT
) is a poster child for this strategy. While the average yield on
the S&P 500 is 2%, Microsoft offers 3%. Moreover, the stock's
price has climbed 15% as of the end of September, a gain that is in
line with that of the S&P 500. Moreover, the company recently
boosted its quarterly dividend to 23 cents a share from 20 cents
previously. Nonetheless, even at that higher payout level,
Microsoft will still only use about a third of what StarMine
estimates will be its $3.08 per share of earnings generated over
the coming 12 months to fund dividends. StarMine's analysis of the
earnings forecasts produced by analysts who track Microsoft tells
us that the five-year compound earnings growth is expected to be
7.7%. That's about in line with the S&P 500 CAGR of 7.9% --
although, given that Microsoft generates a higher yield, it's
reasonable to expect that the long-term earnings growth would be
more subdued, and along the lines of many high yield and low payout
companies.
Reason 2 - Quality Still Matters
For the time being, try to put the idea of whether you are "risk
on" or "risk off" to one side entirely. Instead, think about
quality, and specifically, earnings quality. Those companies able
to boast that they have an above-average degree of earnings quality
- that is, that they are able to provide a degree of comfort to
investors that they will continue to generate solid returns over
the coming quarters - may lag the broader market during the kind of
"junk" rallies we saw in the second half of 2009. But during
unstable economic environments, and over a full market cycle, these
quality companies reasonably can be expected to demonstrate an
above-market performance.
One way to identify high-quality investments is via the StarMine
Earnings Quality Model, which measures the degree to which past
earnings are likely to continue into the future. Independent
petroleum refiner Tesoro (
TSO
) currently scores 92 out of a possible 100 when measured by this
model; the company's Returns on Net Operating Assets ((RNOA)) of
26.7% for the quarter ended June 30, 2012 dwarf the 11.2% RNOA
generated by the energy sector as a whole. Profit margins - one of
two drivers of RNOA - at Tesoro have remained steady at around 4%
(versus 19% for the energy sector). It is the other driver that
accounts for Tesoro's high score: the company's asset turnover is
6.6 times, compared to 0.5% for the sector.
The bad news? Tesoro's share price has been on a tear this year,
and at around $43.24 today, it is up about 85% so far this year.
Most recently, news that Tesoro will purchase a package of refining
and marketing businesses from BP,
discussed previously
on AlphaNow, has given the stock an extra boost. StarMine
calculates that the company's five-year compound EPS growth now
stands at 13%, while the market price implies a growth rate of
-0.6% over the same period. Translated, that means that in spite of
the stock's recent price rally, it still appears to offer solid
value.
Reason 3 - Value: Who Can Resist a Bargain?
Despite the stock market's gains this year, there appear to be
plenty of values still to be found. This group includes several
insurance companies; in an industry characterized by consolidation,
some members are still a bargain. Reinsurance and underwriting
company Validus Holdings Ltd. (
VR
), up 22% so far this year, offers long-term investors a few
characteristics calculated to appeal to long-term investors,
including a 3% dividend yield. The company hasn't reported a loss
for a full year since its founding in 2005, despite the very
difficult first quarter of 2011, during which it, along with its
peers, faced liability claims from earthquakes in Japan and New
Zealand as well as floods in Australia. For those investors with a
penchant for stocks offering low price/earnings ratios, the Validus
forward 12-month P/E lies at 7.2, roughly the same level as it has
been for the last two years. Validus trades at a mere 0.9 times its
forward 12-month price to book value. That means investors are
being paid almost twice the current U.S. 10-Year Treasury yield to
wait for an industry upturn. StarMine rates the company in the top
83 percent of relative valuation as compared to its industry
peers.
Indeed, as the table below demonstrates, Validus's scores on an
array of StarMine models range from average all the way up to
excellent.
Reason 4 - Growth is Always Sexy
Companies that show that they are able to increase both bottom
line earnings as well as top line revenues are always popular among
investors, especially when the broader economy is merely plodding
along. Finding a company generating good returns with a valuation
that hasn't gotten ahead of itself is a tougher proposition. Even
during such a modest recovery as the one the U.S. seems to be
experiencing today, growth companies worthy of the moniker are
likely to be trading around their highs of the year; on that front,
DIRECTV (
DTV
), up 24% so far in 2012, doesn't disappoint.
According to StarMine SmartEstimates, the satellite television
company should see its earnings grow by 19.5% and revenues climb
6.9% over the coming 24 months. Analysts put DIRECTV's five-year
earnings compound growth rate at 12.8%, well above the current
S&P 500 projection of 7.9%. The illustration below provides
more insight into DIRECTV's above-average sector and industry
ranks.
So far, we have focused on the potential for generating
investment returns in this article. But investors may also be
pondering other important investment objectives: risk in the form
of attractive risk-adjusted returns, investment time horizons, the
specific investor's need for liquidity and their particular tax
considerations. The four stocks we have discussed above are only
examples of the kinds of companies that represent each of the
factors that, collectively, argue in favor of investors staying put
in stocks through to the end of the year. Investors will need to
factor in and weigh their own objectives when building a portfolio.
In an era during which pundits still predict that single-digit
returns will be the most that we can hope to glean from the equity
markets, what is crucial for all of us is to recall that one of the
factors most likely to put a crimp in our final returns are the
costs of strategies that lead us to move in and out of markets.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
See also
AllianceBernstsein Holding LP's CEO Discusses Q3
2012 Results - Earnings Conference Call
on seekingalpha.com