Finding winners among the losers in a bear market

“In the stock market — or in any widely traded market — there’s an inevitable fact of life: bear markets happen. It’s a topic I’d just as soon avoid. After all, some readers consider me a perma-bear.” So confesses Carlyle Dunbar, a former editor of Investor’s Digest of Canada and a long-time observer of the markets who is now based in Oakville, Ontario.

But bear markets do occur. After more than five years — old age for a market’s primary move —, stock valuations have become extreme. But the age of our raging bull, along with the high valuations, prompts this chat, even if it’s way premature. Why? Because there’s no sure answer to when a bear market begins.

As bulls go, the current one has few danger signals. Although it may be aging, it still looks fit. In this situation, your portfolio needs some big-cap stability. That’s because risk is lower for shares of large companies. Add in a solid dividend stream and you have income that’s likely to ride out a down market.

But the loonie is heading lower. Moreover, Canada’s stock market lacks dynamic support from resource industries. Translation? It’s time to turn to Wall Street.

Health care and information technology stand out

There, two sectors stand out: health care and information technology. But because neither sector is significant in Canada, there’s all the more reason to look south. Moreover, there’s more choice and better choice at that.

The pointer to these two sectors is their performance relative to the broad market which they’re leaving behind. These are long-term trends, dating from as far back as 2002. Still, health care stocks started to speed up their superior growth in 2012; information technology, a year later, despite the chaos surrounding Obamacare.

In the short run, Wall Street’s health care names are up 15 per cent this year, while info tech has climbed 14 per cent. By comparison, the S&P 500 Composite Index is up just seven per cent.

Of the 25 biggest U.S. info tech stocks, there are buy signals for 20, according to analysis from Investors Intelligence, in New Rochelle, N.Y. Meanwhile, over in health care, current price and relative strength trends are bullish for 22 of the 25 largest companies.

Four stand-out info tech companies

Of the biggest info tech plays, four now stand out. Their price strength and superior performance reflects strong fundamentals. The four leaders are Apple Inc. (AAPL–NASDAQ), Microsoft Corp. (MSFT–NASDAQ), Intel Corp. (INTC—NASDAQ) and Facebook Inc. (FB–NASDAQ).

With its amazing product line, Apple, in this sector, sets the pace. But consider this: the company’s cash flow has risen 58 per cent in five years, outpacing both sales and net income. Moreover, its net margin (after-tax profit per dollar of sales) has averaged 21 per cent, while its asset turnover (sales per dollar of assets) has risen in each of the past five years to 1.7 times in 2013.

These four companies generate strong cash flow, although at 25 per cent of revenue, Apple’s is the lowest on the totem pole. Margins for the four are also high. Microsoft, for example, makes $0.27 in after-tax profit on every dollar of sales.

For Intel, says S&P Capital IQ, a division of Standard & Poor’s Financial Services LLC, its buy recommendation reflects its view of improving fundamentals, attractive valuation, as well as Intel’s plan to return more cash to shareholders.

Meanwhile, Facebook, despite doubts about its ability to build income, has also bagged a buy from S&P Capital IQ. Facebook, say the Capital IQ boys, boasts considerable competitive advantages, including wide access to both user data and information.

Six health care stocks with strong price patterns

Among the biggest stocks in health care, six of the top 10 boast especially interesting price patterns, along with strong fundamentals.

Here, there’s a familiar name: Johnson & Johnson (JNJ–NYSE), the biggest health care stock by market valuation. Not only does this company average a 21 per cent return on equity, but its net margin from a wide spectrum of products averages 18 per cent.

Moreover, its products, says S&P Capital IQ, are largely immune from economic cycles. “We view JNJ as uniquely situated with unmatched depth and breadth in growing global health care markets with solid positions in drugs, medical devices and consumer products.”

The other five big health care names with strong price patterns are Merck & Co. (MRK–NYSE), Gilead Sciences Inc. (GILD–NASDAQ), AbbVie Inc. (ABBV–NYSE), UnitedHealth Group Inc. (UNH–NYSE) and Biogen Idec Inc. (BIIB–NASDAQ).

Because it was spun off share-for-share from Abbott Laboratories (ABT–NYSE) in January 2013, AbbVie lacks a track record. Moreover, compared to the other four names above, AbbVie’s balance sheet is weak, with equity equal to only 15 per cent of assets. But its balance sheet has been growing stronger. Then, too, AbbVie’s return on equity in 2013 was 104 per cent. And you can’t do much better than that. Moreover, its net profit, also for 2013, was 22 per cent.

UnitedHealth Group has appeal because of its leadership in America’s fragmented managed care market — a market that consists of health maintenance organizations, point-of-service plans, preferred provider organizations, as well as managed fee-for-service programs. UnitedHealth Group also has the biggest enrollment in health insurance plans.

Meanwhile, Gilead Sciences, with a strong buy from S&P Capital IQ, is diversifying its product lines. Although its major product has been HIV drugs, it’s making progress developing drugs for cancer treatment and hepatitis.

Avoid utilities and telecoms

Utilities and telecoms are the two U.S. sectors to avoid now. Lagging the market, they’re almost in a free fall in relative strength. My advice: Wait to buy. Badly losing sectors at the end of one bull market often share the lead higher in the next bull.

With U.S. telecom stocks, one problem is the absence of major phone systems from the S&P sector index. Verizon Communications (VZ–NYSE) and AT&T Corp. (T–NYSE) are both among the biggest stocks in the info tech sector index.

Bull market drives down Canadian dividend yield

Now, let’s review the data on the Canadian stock market’s valuation. The S&P/TSX Composite Index recently traded as high as 42 times earnings. But at last report, it stood at 28. Still, that’s unusually high, even after a big boost from second-quarter corporate earnings.

To add to the suspicion that markets are reaching extremes, mid-cap stocks (the S&P/TSX Completion Index) now trade at 50 times earnings. But those earnings have been dropping since the end of 2011, while the small-cap index has logged a loss since April.

For a reality check, look at indicated annual dividend payments on the S&P/TSX Composite.

Earnings are accounting judgments, but cash dividends are real. Adjusted to the index, the dividend was $425 at the end of August. But with the index at 15,626, that dividend sum provided a yield of only 2.7 per cent.

Because dividend yields drop in bull markets, this is low — almost as low as it was just before the crash of October 1987!

 

 

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846