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3 strategies to beat the market in 2005
I clobbered the indexes in 2004 by looking for growth, anticipating trouble and watching long-term trends. The same strategies should pay in the year to come.
By Jim Jubak
As we begin 2005, the Wall Street consensus is that the year ahead will be OK. Not great like 2003, when the Standard & Poor's 500 ($INX) stock index was up 26%. And not terrible like 2002, when the S&P 500 was down 23%. But OK like 2004, when the index climbed 9.1%.
Great. 9.1% doesn't sound so bad.
But I think you can beat that return, just as it was quite 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 winds up unfolding anything like 2004 -- and the two years have some striking similarities, as well as a few significant differences -- 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%.
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 growth
First, 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).
2 places to look for growth
In 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 stock-picking challenge.
I'd look for this growth in two places:
Look 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. I've built a very simple screen to look for these names. Among the candidates it pulls up are big caps American International Group (AIG, news, msgs), Golden West Financial (GDW, news, msgs) and Paccar (PCAR, news, msgs), and smaller stocks such as Smithfield Foods (SFD, news, msgs), Wolverine World Wide (WWW, news, msgs) and Ball (BLL, news, msgs).
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 stocks in 2005 and to keep the cycle running near peak levels for another year. A stock like Deere & Company (DE, news, msgs), 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 to check out include Briggs & Stratton (BGG, news, msgs), Englehard (EC, news, msgs) and RPM International (RPM, news, msgs).
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 United States) won't significantly falter.
- U.S. interest rates will rise at the measured pace that the Federal Reserve has promised.
The likelihood that 2005 will follow this script is just about nil, in my opinion.
The very small spread between global oil supply and global oil demand -- and the increasing difficulty and expense of expanding supply -- makes energy prices very, very 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 Exxon Mobil (XOM, news, msgs) and BP (BP, news, msgs), and the minors Swift Energy (SFY, news, msgs), Apache (APA, news, msgs), Southwestern Energy (SWN, news, msgs), EnCana (ECA, news, msgs) and St. Mary Land & Exploration (SM, news, msgs), to name just a few. Don't forget the oil-service stocks and drillers, starting with Schlumberger (SLB, news, msgs) and including, but not limited to, National-Oilwell (NOI, news, msgs), Smith International (SII, news, msgs), Transocean (RIG, news, msgs) and Diamond Offshore Drilling (DO, news, msgs). For good measure, add a dollop of coal, too: Penn Virginia (PVA, news, msgs), Peabody Energy (BTU, news, msgs) and BHP Billiton Limited (BHP, news, msgs).
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, news, msgs), Inco (N, news, msgs) and Phelps Dodge (PD, news, msgs).
And finally, while I think the financial 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 United States will finish 2004 about where they started the year, despite the Federal Reserve'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 Federal Reserve. 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, news, msgs) and Capital One Financial (COF, news, msgs).
Keep an eye on the long term, too
And third, ignore the short-term trends of 2005 to keep adding to positions in stocks that will benefit from the long-term trends toward higher inflation, higher interest rates and greater uncertainty.
Stocks like these won't burn up the track in any one year -- unless we get some truly terrible global event -- but over the next decade they'll consistently add percentage points to your portfolio's return. I'm talking about gold stocks such as Newmont Mining (NEM, news, msgs), Placer Dome (PDG, news, msgs) and Glamis Gold (GLG, news, msgs), and land and real-asset stocks such as The St. Joe Company (JOE, news, msgs), Tejon Ranch (TRC, news, msgs) and Rayonier (RYN, news, msgs).
During the next few weeks, I'll be stripping away the end-of-the-year plays in technology and biotech that I added to Jubak's Picks in an effort (not especially successful, I might add) to get more bang for my portfolio out of the year-end rally. As I sell those, what you'll see emerge is a portfolio that looks very much like the one that I've described in this column. As the new year unrolls, I'll be looking 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, e-mailed me or contributed to one of my columns in 2004.
New developments on past columns
Fourth-quarter 2004 performance for Jubaks Picks
Its time for the end-of-quarter, end of-the-year and longer-term performance numbers on Jubaks Picks. The portfolio finished the year with a rush as the fourth-quarter return came to 14.9%, beating the 6.8%, 4% and 1.5% of the first, second and third quarters of 2004, respectively. For the year, Jubaks Picks returned 29.5%. That outpaced the three indexes I use as benchmarks in the quarter and for the year.
But the quarter and the year werent without disappointments or mistakes. I added technology and biotechnology stocks to the portfolio in the fourth quarter in order to take advantage of the end-of-year rally I expected. Well, the stock market provided the rally with the Nasdaq Composite ($COMPX) climbing 12.2% in the fourth quarter. But thanks to some boneheaded stock-picking on my part, the entire group of six stocks and one ETF that I added climbed just 4.5% on average (assuming you invested equal amounts in each). Three of the stocks, Analog Devices (ADI, news, msgs), Cell Genesys (CEGE, news, msgs) and Micron Technology (MU, news, msgs) wound up the year in the red. Put that disappointment together with the higher returns earned by lower-risk stocks such as The St. Joe Company, Schlumberger, Wolverine World Wide, Engineered Support Systems (EASI, news, msgs), Smithfield Foods and Main Street Banks (MSBK, news, msgs), and its clear to me that 2004 wasnt a year that paid a premium (at least to me) for risk-taking. My belief is that 2005 will also turn out to favor the steady over the risky. Heres how I did against the major indexes:
| Jubaks Picks vs. major averages | | Index | Fourth quarter 2004 | Trailing 12-month (2004) | | Jubak's Picks | 14.9% | 29.5% | | Nasdaq Composite | 12.2% | 8.7% | | Standard & Poor's 500 | 7.3% | 9.1% | | Dow Jones Industrial Average | 6.0% | 3.3% |
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Here are longer-term performance numbers for three years, five years (a period that begins near the peak of the bull market in 2000 and includes the bear-market collapse from that peak) and since the inception of the portfolio:
| Jubak's Picks vs. the indexes -- the long-run picture | | Index | 3-year return* | 5-year return** | From inception*** | | Jubak's Picks | +46% | -7% | +150% | | Nasdaq Composite | +12% | -47% | +63% | | Standard & Poor's 500 | +6% | -17% | +47% | | Dow Jones Industrial Average | +8% | -6% | +51% |
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*Close on Dec. 31, 2001, through close on Dec. 30, 2004. **Dec. 31, 1999, through Dec. 30, 2004. ***May 7, 1997, through Dec. 30, 2004. All returns for Jubaks Picks deduct costs of commissions.
As is my practice, I will update these performance numbers at the end of the next quarter in March 2005.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American International Group, Encana, Micron Technology, Newmont Mining, Penn Virginia, Placer Dome, Schlumberger, Smithfield Foods, Tejon Ranch and The St. Joe Company. He does not own short positions in any stock mentioned in this column.
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