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5 stocks for an up-and-down year
January's lesson? Falling margins could hurt in 2005, so I've selected some companies immune to the rising cost of raw materials.
By Jim Jubak
The stock market dug a deep hole for itself in January -- a month that, if history is any guide, foreshadows the rest of the year.
The Dow Jones Industrial Average ($INDU) was down 2.7%, the S&P 500 Index ($INX) 2.5%, and the Nasdaq ($COMPX) 5.2%.
Since 1950, the direction of the stock market in January, as measured by the S&P 500, has predicted the direction of the stock market for the entire year with only five significant errors, according to the Stock Trader's Almanac.
In odd-numbered years -- like this one -- the record has been almost perfect. January's gain or loss predicted the gain or loss for the year in every year since 1939, with the exception of just two years, 2001 and 2003.
Time to put the old portfolio in cash and forget about the rest of 2005? No way.
The stock market wasn't yelling "sell everything" in January. But it was signaling what to avoid and what to buy. In this column I'll show you how to follow the clues from January to pick "Five for '05."
To understand what January means for the stock market in general, you need to start with the reasons that January is so predictive of stock market returns in general.
January's predictive power
Yale and Jeff Hirsch, the editors of "Stock Trader's Almanac," point out that the predictive power of January really begins in 1934, when the 20th amendment to the U.S. Constitution went into effect. Up until that year, senators and representatives didn't take office until December of the year following their election (except in years when a president was inaugurated). The lame-duck session, with defeated members of Congress remaining in office, stretched on for 13 months after the November election.
Starting in 1934, however, the 20th amendment crammed January full of political change. The new Congress now takes office Jan. 3. The presidential inauguration was moved to Jan. 20 from March 4. In most years, the inaugural address, the State of the Union and the release of the federal budget follow in short order. Even if they don't all fit into January, the politicking about them starts in earnest during the month. So in most years, January sets the tone for economic policy, government-budget priorities -- and, most importantly, the national mood that heavily influences the rest of the year.
This January has been stuffed with worries. President Bush wants to make the tax cuts of his first administration permanent. Worry: Won't that make the deficit even larger? President Bush wants to change Social Security and introduce private accounts. Worries: Won't that make the deficit even larger? Won't that cut my benefits? And so on, with concern about the falling dollar, the huge trade deficit and the election and war in Iraq all making the list.
And this January has been noticeably short on responses that make us feel better about those worries. Part of that is the way the calendar has worked out this year. The President's State of the Union message, which is a bully pulpit for proposing solutions that can turn the worried into the at-least-momentarily optimistic, wasn't delivered this year until Feb. 2.
But part of the reason for that lack of positive response has been strategic. The Bush administration decided to keep its Social Security plan vague, for example, because his advisers concluded that would add to their ability to horse trade with Congress.
Short-term relief
It's relatively easy to turn about this atmosphere of worry in the short term. The rally that began this week is a prime example. The 60% voter turnout in Iraq, a calm statement on inflation from the Federal Reserve and the rhetoric of the State of the Union have all pushed worries to the background.
Related news and commentary on MSN Money
For the moment. It's much harder to turn around an atmosphere of worry in the long term, especially when those worries are rooted in real, tough-to-solve problems. A successful election in Iraq doesn't mean the war is over. The financial markets were relieved that Alan Greenspan & Co. aren't worried about inflation, but that doesn't mean the markets won't resume worrying about the dollar, the budget and the trade deficit soon.
The likely result for 2005 is a pattern of retreats and rallies that nets out to a meager return for the year in the major indexes such as the S&P 500 or the Dow industrials. (For another read on 2005, see my colleague Jon Markman's column, "February holds the key to investing in 2005.")
Play the retreats and rallies?
To better those returns, you could try to time these rallies, buying lower and selling higher over and over again. That's going to be a tough way to make a buck, since both retreats and rallies are likely to be relatively short. The January dip took the Dow down 2.7% and the S&P down 2.5%. I doubt that the February rally will produce a much bigger move to the upside.
I think you stand a much better chance of improving your returns if you use the evidence from the January drop to figure out what stocks to avoid and what to buy.
In a year when the major indexes aren't going much of anywhere, what you don't own is as important as what you do. It's clear from January what kind of stocks you don't want to own: the shares of any company that is showing falling margins as a result of rising raw-materials costs or competitive pressures.
So, for example, Caterpillar (CAT, news, msgs), on Jan. 27, reported a 32% increase in revenue for the fourth quarter of 2004 from the fourth quarter of 2003. Operating profit climbed 39% and earnings per share soared almost 60%. Yet the stock plunged 5% for the day after the company reported earnings just before the market opened. The culprit? An earnings disappointment of 7 cents a share as higher core operating costs of $412 million ate into profit margins. It certainly didn't help that the company said that it expected these cost pressures to continue for the first half of 2005. Caterpillar shares finished January down 8%.
Beware of falling margins
January said, in my reading, stay away from the shares of companies that face the prospects of falling margins in the first half of 2005 (especially if the stocks had a great run in 2004 or trade at price-to-earnings ratios well above the market or sector average.) These stocks are going to have a tough time rising above worries that higher costs will produce falling margins.
Two stocks in Jubak's Picks fall into this category for 2005. Middleby (MIDD, news, msgs), a maker of cooking equipment for restaurants, is very sensitive to increases in the price of steel. In its conference call after its third-quarter earnings announcement, the company flagged rising steel costs and noted that it "cannot pass the full steel pricing onto customers." That will make it tough for the company to continue to improve operating margins, which rose to 17.8% from 16.4% in the quarter. "From a gross margin and operating margin perspective, we anticipate that rising steel prices will have a negative impact upon margin improvement in the short term." Wall Street is projecting that earnings growth in 2005 will fall to 21% from 40% in 2004. Both are below the company's five-year annual average of 47%.
I think this is a great little company with very solid long-term prospects, especially internationally. But I'd expect the shares to stay under pressure through the first half of 2005 at least. Patient investors might want to use the weakness in the first half of 2005 to build a position in this stock at a good price -- shares trade at just 16.5 times trailing earnings -- for the long term. Investors trying to beat the market indexes over shorter time periods, say for the year, will sell these shares. The Jubak's Picks portfolio falls in the latter group, and I'll be selling Middleby with this column.
Donaldson (DCI, news, msgs) faces the same cost pressures from rising steel prices. The company has moved aggressively to cut costs by shipping production to Mexico and China, but at best that will only keep gross margins flat in 2005. Again, a great company for the long term. But in the short term, Donaldson is a sell in this market. Especially since it is trading at a price-to-earnings ratio of almost 26 on trailing 12-month earnings. That's relatively expensive. I'll be selling these shares out of Jubak's Picks with this column. (Note: The company's 6-cent-a-share dividend will be paid to shareholders of record on Feb. 18.)
So, what am I buying?
If I'm selling this kind of stock, what am I buying?
Stocks like Hartford Financial Services (HIG, news, msgs). This seller of life insurance and annuity products doesn't face rising raw materials costs; thanks to recent product launches, it is six to 12 months ahead of major competitors. Its products are well-suited to the current economy. Even after the latest Fed rate hike, interest rates remain relatively low. That makes annuities an especially appealing product for anyone looking toward retirement. It doesn't hurt that Hartford Financial Services is the market leader among sellers of variable annuities. I'll be adding shares to Jubak's Picks with this column.
In the same vein, I'd pick credit card issuer MBNA (KRB, news, msgs), thrift and mortgage lender Golden West Financial (GDW, news, msgs), defense communications specialist L-3 Communications (LLL, news, msgs) and Internet media goliath Yahoo! (YHOO, news, msgs). None of these face significant raw materials costs or pricing pressure from competitors.
Right now, besides Hartford Financial Services, I think MBNA and L-3 Communications are trading near decent buying points. I'd like to see both Golden West Financial and Yahoo! get cheaper before I buy. I'm adding Hartford Financial Services, MBNA and L-3 to Jubak's Picks with this column. I'll wait on the others in my "Five for 2005."
Changes to Jubak's Picks
Sell Middleby
Middleby (MIDD, news, msgs), a maker of cooking equipment for restaurants, is very sensitive to increases in the price of steel. In a conference call after its third-quarter earnings announcement, the company flagged rising steel costs and noted that it "cannot pass the full steel pricing onto customers." That will make it tough for the company to continue to improve operating margins, which rose to 17.8% from 16.4% in the quarter. "From a gross margin and operating margin perspective, we anticipate that rising steel prices will have a negative impact upon margin improvement in the short term." I think this is a great little company with very solid long-term prospects, especially internationally. But I'd expect the shares to stay under pressure through at least the first half of 2005. I'm therefore selling these shares out of Jubak's Picks with a 6% loss since I added Middleby at $53.34 on Aug. 20, 2004. (Full disclosure: I will sell my shares of Middleby three days after this column is posted.)
Sell Donaldson
Donaldson (DCI, news, msgs) faces the same cost pressures as Middleby from rising prices in the same commodity, steel. The company has moved aggressively to cut costs by moving production to Mexico and China, but at best I believe that will keep gross margins in 2005 flat with those in 2004. Again, I think this is a great company for the long term. But in the short term, I think Donaldson is a sell in this market. Especially since Donaldson trades at a price-to-earnings ratio of almost 26 on trailing 12-month earnings. That's relatively expensive in this market. I'll be selling these shares out of Jubak's Picks with an 11% gain since I added them to the portfolio on Oct. 14, 2003, at $28.60. Note: The company's 6 cents a share dividend will be paid to shareholders of record as of Feb. 18. (Full disclosure: I will sell my shares of Donaldson three days after this column is posted.)
Buy MBNA
MBNA (KRB, news, msgs) is big -- it's the world's largest independent credit card lender and the leading issuer of affinity cards. And size counts in the credit card industry right now. Lower costs for marketing and to manage credit risk give an edge to the bigger card issuers, and MBNA's size also puts it first in the race to create new products. For example, now that the Supreme Court has ruled that Visa- and Mastercard-issuing banks can also offer products from American Express (AXP, news, msgs) and Discover, look for a battle to break out as new product offerings attempt to take market share from Visa and Mastercard. MBNA is already out of the gate with its American Express-branded card. It doesn't hurt, either, that MBNA has a history of getting credit quality right: only 4.4% of accounts were delinquent at the end of 2003, down from 4.9% in 2002. MBNA calls any account delinquent if the minimum payment hasn't been received by the date on the statement, a pretty tough standard. The shares trade at 13.4 times projected 2004 earnings per share. Our StockScouter rates MBNA shares an 8 out of a possible 10. I'm adding MBNA to Jubak's Picks with an October 2005 target price of $32.50 a share.
Buy Hartford Financial Services Group
Hartford Financial Services (HIG, news, msgs) is No. 1 in the individual variable-annuity market with around $12 billion in sales in 2004. The company actually looks likely to pick up share in 2005, thanks to an aggressive cut in withdrawal guarantee fees to less than half the industry average and a restructuring of some of its key annuity products that widen the range of available money managers. The company's auto-insurance segment has been busy adding new independent agents to sell its products, with a gain of about 20% in 2004. And the company's exclusive deal with AARP has been generating policy growth of close to 10%. Wall Street projects earnings growth of 17.5% in 2005 after earnings growth of 24% in 2004. The stock currently trades at 9.9 times trailing 12-month earnings per share and just 9.3 times projected 2005 earnings per share. Our StockScouter rates the shares a 9 out of a possible 10. I'm adding the shares to Jubak's Picks with an October target price of $77.
Buy L-3 Communications Holdings
L-3 Communications Holdings (LLL, news, msgs) makes the high-tech components for the communications gear required by the modern battle field. For example, the company's high transmission rate, jam-resistant communications components and systems are in use on battlefields in Iraq and Afghanistan. The Navy's Aegis-class destroyers use L3 Communications voice and data switching systems. Organic revenue growth should be about 15% in 2005 and earnings growth is projected to top that at 19%, but the company could do even better than that. L-3 Communications has pursued an aggressive acquisition strategy aimed at building up leading positions in significant niche markets in the defense and home land security sectors. Even before the fiscal 2006 budget is approved, L-3 Communications has built up a $4.4 billion backlog of funded orders. The stock now trades at 22 times 2004 earnings per share (18.5 times projected 2005 earnings per share) and has officially ended its January retreat by crossing above its 50-day moving average. As of February 4, Im adding the stock to Jubaks Picks with a July target price of $90 a share.
New developments on past columns
10 winning stocks for a stuck-in-a-rut market
Shares of Wolverine World Wide (WWW, news, msgs) split 3/2 on Feb. 1. A day later, the company announced fourth-quarter 2004 earnings of 52 cents a share (pre-split), beating Wall Street estimates by 4 cents a share. Revenues rose almost 9% for the period, coming in at $307 million -- above the Wall Street consensus of $300 million. In its conference call, the company raised its guidance for 2005 to earnings of $1.79 to $1.86 a share on revenue of $1.04 to $1.06 billion. The Wall Street consensus had been at $1.76 in earnings per share on revenue of $1.06 billion. As of Feb. 4, 2005, I'm raising my target price on Wolverine World Wide to a split-adjusted $27 a share from a prior, split-adjusted $24.
10 hated stocks you'll love in 2005
Maybe things are starting to look up for Micron Technology (MU, news, msgs). On Jan. 31, investment house First Albany said that the current quarter, to be reported on March 23, is on track. Chip production is set to increase by 20% instead of the 10% to 15% announced in the company's most recent guidance to investors. A big help has been Micron Technology's partnership with Intel (INTC, news, msgs), which has helped speed new memory products from Micron Technology through the product qualification process at Intel. First Albany also noted that the stock now trades at just 1.3 times tangible book value. As of Feb. 4, I think it's worth sticking with this chip stock despite the clear lack of momentum in the technology sector until that earnings report. I'm keeping the stock in Jubak's Picks, but I'm cutting my target price to $15 by June 2005 from the earlier $17.50 by October 2004. (Full disclosure: I own shares of Micron Technology.)
Editor's Note: A new Jubak's 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 of the following equities mentioned in this column: Donaldson, Micron Technology and Middleby. He does not own short positions in any stock mentioned in this column.
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