Jubak's Journal Recent articles: • A golden way to play the dollar's fall, 4/6/2005 • Prepare for the global money crunch, 4/5/2005 • Say goodbye to easy money, 4/1/2005 More... | Jubak's Journal 10 stock picks for the new era The rules have changed as financial markets move into a new cycle. I searched and screened to find 10 stocks likely to thrive. By Jim Jubak In my last two columns I've bid a sad goodbye to the era of cheap money. I'll certainly miss it. The 25-year cycle that ended with 1% short-term interest rates in the United States and that produced a 420% expansion in the money supply since 1980 resulted in a 1,098% return from the Dow Jones Industrial Average ($INDU). But investors need to move on. Now that the Federal Reserve has hiked its target for short-term interest rates to 2.75%, and now that growth in the U.S. money supply has started to taper off, the financial markets are moving into a new cycle of unknown length. I'm ready. Here's my list of 10 stocks for the new era of more expensive capital and slower growth:
Even though the new cycle is still in its very early stages, we can draw a pretty good profile of the types of stocks wed want to own.
Cruising for cash cows Here's how I found my 10 stocks for a new era. Step One: Build a screen to find five U.S.-based cash cows with developing market potential.
To put together the first half of my list, I started with a screen I created back in October of 2003. That original "10 cash cows" portfolio has gained 25% from inception through the market close on Feb. 7 of this year. That beats the 15% gain on the Standard & Poor's 500 ($INX) stock index and the 8% gain on the Nasdaq Composite ($COMPX) index for that same period. I updated that list on Feb. 11 of this year, and while it has sputtered in this down market, Im comfortable that itll catch up in the long run. How did I pick these cash-cow stocks? To start with, these companies had to have cash on their balance sheets equal to 5% of the value of their assets. There's nothing like starting with a pile of cash if you're looking for evidence that a company can generate more of it. Then they had to show growth in free cash flow over the trailing 12-month period, and free cash flow had to amount to more than 5% of sales in each of the last three years. That way I could be certain that the money from sales was dropping to the bottom line in something like the financial equivalent of a flood rather than a trickle. To make sure that all this cash was being reinvested at a high return, I looked for a trailing 12-month return on equity that was greater than the average for the company's sector. I also required companies show a return on equity of 14.84% or better to avoid having sectors with low returns from equity dominating the list. That would put the company in the top 25% of all companies on this measure of profitability. And just to make sure that I leveled the playing field between companies that use equity and debt financing, I also required companies to show a return on assets of 6.61% or better, enough to rank them in the top 25% of companies on that measure, too. And then, finally, to adapt this screen to the job of finding cash cows with big exposure to China and the rest of the developing world, I looked for stocks with market capitalizations above $1.4 billion. That puts them among the top 25% of all stocks by market capitalization. That's important since, as a general rule, it's the biggest companies that have the most exposure to markets outside their home countries. That produced a list of 128 stocks including 3M What about cyclical raw materials? Step Two: Hand-pick five stocks that screening overlooked, paying special attention to non-U.S.-based companies and historically cyclical companies poised to tap into growth in the developing markets. Related news and commentary on MSN Money
Why not stop with the stocks that show up on my screen? All screens have biases and two are especially worth correcting in this case. Screening for investment opportunities always carries a bias toward U.S.-based stocks. Foreign financial reporting standards, time lags and sometimes just the difficulty in collecting the data almost always results in lots of promising overseas companies, even from developed countries, never making it through the screen. And a screen like my cash-cow screen, with its emphasis on consistently superior cash flows, eliminates exactly the kind of cyclical raw-materials stocks that are best positioned to cash in on growth in the developing markets of China and India. If growth in these developing economies is as strong over the next five years as now seems likely, cyclical stocks will be much more consistent performers in the future than they've been in the past. And using only past data will leave a portfolio for the next cycle underrepresented in these sectors. I don't know any easy way to do this except to look at the financials of promising companies one by one looking for those that almost, but not quite, make the cut. For example, BHP Billiton should have passed my screen with flying colors -- return on equity was 15.3% for the trailing 12 months and return on assets 7.6% -- except that the database I used was missing a figure for cash flow growth in the last 12 months. This miner of iron, copper, nickel and other metals is clearly well-positioned, with major operations in Australia, to tap into growth in China and India. And with substantial sales of oil, gas and coal, BHP Billiton has a buffer against the traditional boom-and-bust cycles for producers of metals. I'd add this stock to my portfolio for the next era. In other cases, companies that initially look like near-misses on the criteria of the screen turn out to be much less promising on deeper examination. Two other non-U.S.-based stocks I'd add to BHP Billiton are Total and Potash Corp. of Saskatchewan. Total, the French oil company that is now the fourth largest in the world, has relatively low exposure to mature oil and gas fields and better prospects for increasing production than peers such as Exxon Mobil A long-term core for a portfolio My final two stocks for the new-era portfolio are U.S. cyclicals with superior cash flows and better-than-average opportunities for investing that cash. Apache avoids the problem currently bedeviling the big oil companies -- where to invest all that cash generated by $56-a-barrel oil -- because of its relatively small size. While an Exxon Mobil looks in vain for a new field with enough potential oil and gas to make an impression on its huge top line, Apache has developed a very profitable niche in buying mature fields from the majors and, after investing in the latest extraction technology, squeezing new oil out of old rocks. Cleveland-Cliffs wasn't a model of consistency in the last cycle, but I think the company's recent decision to expand its iron ore business outside North America will enable the company to tap into a much steadier pattern of growth in the next era. These 10 stocks for a new era arent a complete portfolio for any investor, by any means. Rather, I'd use them as the long-term core of a portfolio with an annual review to make sure that nothing has changed in the companies or the global economy. (And I'd try to buy them on dips and sector corrections.) Around this group, I'd include an edge of more timely and more short-term opportunities. Energy and basic-materials stocks bought on dips. Agricultural and food stocks bought after erratic earnings results. Gold stocks bought when the dollar is rallying as insurance on inflation and a weak dollar. And financial stocks bought when news of financial shenanigans runs at full flood. One stock like that, American International Group Changes to Jubak's Picks Buy Goldcorp I'm going to take advantage of what I believe is a short-term dollar rally in a long-term bear market for the U.S. dollar to pick up some portfolio insurance at a reasonable price against inflation and a weaker dollar. Goldcorp New developments on past columns 4 ways to pad your portfolio for a crash On April 5, Corn Products International 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, Corn Products International, Newmont Mining, PepsiCo and Schlumberger. He does not own short positions in any stock mentioned in this column. | ||||||||||||||||||||||||||||||||||||||||||||||||||||
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