Smart defence is best investment strategy

The financial sector’s exposure to the energy sector is driving banking stocks down world-wide. John Stephenson is portfolio manager and President and CEO of Stephenson & Company Capital Management Inc. in Toronto. His stock market outlook for 2016 calls for continuing volatility. Investors should hang out, until the dust settles, in stable income-oriented stocks with attractive valuations and strong cash flows with unique not-easy-to-replicate business models. He names three.

Investors have had plenty to fret about for the start of 2016 with crude oil plummeting and global stock markets continuing their dizzying declines. In January, the S&P 500 on an intraday basis took out its August 2015 low, before rebounding slightly. The sharp declines are part of a fundamental reassessment of global growth prospects, reflecting years of disappointing progress and the limits of central bank stimulus. A slowing Chinese economy and worries over global deflation have stoked fears that an economic slowdown in China would spill over to North America and Europe.

U.S. financials have been hammered after downbeat fourth-quarter earnings and on concerns over lower margins with the flattening yield curve and the lenders’ exposure to the U.S. energy sector that is being hurt by low oil prices. The S&P 500 financials sector is by far the worst performing sector of the market year-to-date with losses of more than 12 per cent. But the carnage in the U.S. banking sector is also sweeping the globe with Europe being especially hard hit. Shares of Credit Suisse, Deutsche Bank AG and Italy’s UniCredit SpA are all off by about a third so far this year.

Sovereign wealth funds need cash

Oil’s negative impact on the market outlook for 2016 is more than just that of a proxy for slumping global growth, it’s also a story of fund flows. Some of the world’s largest sovereign wealth funds are in oil-dependent countries that collectively control some $4 trillion of assets that have been invested in equities, bonds and other financial instruments around the world. With crude oil price tanking, many cash-strapped governments in oil-producing countries have been cashing in their chips by hitting the sell button on their investment portfolios, which in turn has pressured global bourses.

For many, the selloff in January and early February is a belated recognition of the persistent failure of global growth to lift off. Six months ago, the International Monetary Fund (IMF) projected the global economy would expand 3.8% in 2016. After two downgrades, that projection now stands at 3.4%. For others, the cause of the problem is clear—central bank intervention that has gone on for too long creating growing distortions in nearly all asset prices—from stocks to bonds to real estate.

Market outlook for volatility and uncertainty to continue

The volatility that we have seen in markets since August of 2015, while extreme, will likely continue for some time. The unprecedented actions of central banks in the wake of the 2008/09 global financial crisis have created broad distortions in asset prices of all types — from stocks to bonds to real estate.

These distortions are widely observable in the world around us, whether it is prospective homeowners entering into bidding wars for homes in Toronto and Vancouver where bidders are routinely bidding $300,000 over asking, despite the weak economic fundamentals of the Canadian economy or the relatively high stock market valuations vis-à-vis historical norms. But rather than being an isolated phenomenon this is a global phenomenon that has impacted assets of all types and distorted valuations and is a direct result of easy-money policies by central bankers. In short, if you make the cost of money cheap enough, people will spend it.

This “new normal” has created a situation of low growth, political dysfunction and rising inequality. Central banks in the wake of the financial crisis borrowed profits and growth from the future in the form of easy monetary policies. But now, central banks are out of ammo and others such as the U.S. Federal Reserve have started on a path toward normalization, but this path is untested and unprecedented. The unwinding of these extraordinary measures and the resultant distortions in asset prices they created will take time, likely resulting in volatility and uncertainty for investors as the continuing market outlook for 2016.

Stock gains to remain less robust

Stock strategists, a normally bullish group, have curbed their enthusiasm with forecasts for U.S. stocks ranging from a paltry three percent rise in 2016 (Goldman Sachs) to a more robust 11 percent increase in the Deutsche Bank stock market outlook. Nonetheless, all would be a step down from the robust gains of the past where the S&P grew 15 percent annually from 2009 to 2014, not including dividends.

Stocks will become attractive again once the expected returns become great enough to induce prospective buyers back into the market. With recent market volatility stocks are becoming more attractive but it will likely take expected returns north of 20% to induce investors back into the markets and drive them higher on a smoother more continuous basis.

What I Recommend

Markets will likely remain volatile through much of 2016, offering plenty of challenge for investors. Central bankers have been buying time since the financial crisis of 2008/09, making much of it up on the fly. With global growth slowing, political dysfunction the norm and asset prices out-of-whack with historic norms, a day of reckoning is coming for markets of all types. While some of the froth has come out of stocks since last August, investors should adopt a very defensive posture with their investments.

Companies trading at high valuations or those with balance sheet problems should be avoided. While it may be tempting to jump back into the market on the first signs of healing, caution should be the watchword of the day until the dust finally settles and markets are trading at multiples below their long-term averages.

Investors should hang out until the dust settles in stable income-oriented stocks with attractive valuations and strong cash flows with unique not-easy-to-replicate business models.

REIT focused on grocery-anchored retail centres

One company that has been rock-solid in my portfolios during these turbulent times is Slate Retail REIT (TSX─SRT.U).  Slate is a Canadian domiciled REIT with 100% of its assets in the U.S. It owns a portfolio of more than 60 grocery-anchored properties encompassing over 7.0 million square feet in secondary markets. Slate’s strategic investment plan is to capitalize on the large investment landscape in the U.S. by building scale through a roll-up strategy of grocery-anchored retail centres in large but secondary markets. The company has a current dividend yield of 7.85% and recently increased its dividend by three per cent. I have a Buy rating and a twelve-month price target of USD $17.00 per share on Slate.

Largest wireless provider has best industry margins

Another stock that is a defensive port in the storm is Verizon Communications (NYSE─VZ). Verizon is the largest U.S. wireless communications service provider in the United States. The stock also boasts a dividend yield of 4.40%, making it an ideal stock for conservative investors. The company has a very comfortable dividend payout ratio that should provide a strong runway for further dividend increases. The company has the best quality wireless network that helps it to drive industry-leading margins that should continue to surpass peers as the company typically provides fewer discounts and promotions than peers.  I have a Buy rating and a twelve-month price target of USD $55 per share on Verizon Communications.

Coke putting fizz back into its stock

It doesn’t get much more American and defensive than The Coca-Cola Company (NYSE─KO). It has become one of the favorite stocks for defensive income-oriented investors. The company has a solid 3.11% dividend yield and is playing catch-up with its peers as it has underperformed them over worries about a slowdown in volumes, a strengthening U.S. dollar and regulatory concerns over increased taxation on sugary drinks in several markets. But these worries have opened up a favorable valuation gap between Coca-Cola and its peers.  I have a Buy rating and a twelve-month price target of USD $47.50 per share on The Coca-Cola Company.

Tech stocks are latest selloff victims

Lately there have been revolving selloffs in oil, healthcare and most recent technology stocks. The most recent bout of bad news for stock investors came from LinkedIn Corp. and Tableau Software, which helped lead the NASDAQ down more than three per cent in a single day recently. LinkedIn Corp. posted a fourth-quarter loss and gave weaker guidance than investors were hoping for, sending it down more than 45% in a single day.

Tableau Software is a big data and cloud computing company that allows its customers, typically large corporations, to analyze vast reams of data quickly. Some bearish investors have been warning that valuations in the “cloud” computer sector have been sky-high with investors focused on fast revenue growth rather than profitability. If the pessimists are right, then these companies are very vulnerable to any suggestion that revenue growth might slow. Unlike other companies, they don’t have a profit lever to pull to make up for any drop off in revenue growth.

Tableau Software’s recent earnings were a real gut punch to investors causing the stock to tumble almost 50% in a single day after the earnings announcement.

Smart defence is best investment strategy

Ultra-loose monetary policy, including the adoption of negative rate policy in Japan and expectations of further easing in Japan, plus expectations for further easing in Europe, has heightened fears for global economic growth. In a market that can see single stock positions move as much as 40 to 50 per cent in a single day playing smart defense is the best strategy for investors.

There will be some incredible bargains for investors once central bankers and other policy makers coalesce around a cogent and workable long-term strategy to create economic growth. But until that time comes, investors should play it safe by waiting it out in stable steady income-oriented securities with exceptionally strong franchises.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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