Wednesday, November 28, 2012

Stocks That Can Outperform in a Slow Growth Environment

Another month and another set of payroll numbers. The market likes them and the long slow haul of economic recovery. I want to analyze this recovery in the context of previous recoveries and see which stocks or sectors might do well with the conclusions drawn from the analysis.

A Weak Recovery

The US worker has a right to feel aggrieved because this cycle has followed a path of good recovery in corporate profitability which hasn’t been accompanied by strong employment gains

First let’s look at how bad this recession has been compared to previous ones using non-farm payroll data from the Bureau of Labor Studies.

Note the magnitude of the job losses in the last recession.  Moreover while the recent job growth has matched previous recoveries it is nowhere near strong enough to reclaim the jobs lost.

I want to demonstrate this pictorially.  I confess that when I put this together I wasn't expecting this result! The x-axis represents months since the payroll data turned positive (for two months in a row) after the recession. The y-axis represents the percentage of jobs lost in the recession that have been regained in the recovery.

The table is truly astonishing. The US hasn’t even recovered half the jobs lost in the recession and by this stage in the next worst recovery (2001) the economy had regained over 200% of the jobs lost.

Meanwhile corporate profits have snapped back nicely.

US Corporate Profits After Tax data by YCharts

It is impossible not to conclude that this recovery hasn’t been uneven and ‘unfair’ to those who believe in the concept of social justice.

However lest I stray onto political matters I want to discuss how this affects the types of stocks and sectors that investors should be looking at for this recovery.

Stocks For Sluggish Growth

I’ve always believed that consumer discretionary stocks were late cycle stocks. The idea is once employment gains start to materialize (after the initial growth phase) consumer spending will pick up accordingly.  However, as we have seen above, not all recoveries are equal in terms of job growth!  As a consequence I think something fundamental has happened in retail. US consumers (at least in terms of the mass) are now extremely price sensitive and inclined towards using the discount and dollar stores. I’ve written elsewhere in an article linked here that I think this story is a long term one.  Not only are the dollar stores like Family Dollar, Dollar General, and Dollar Tree (NASDAQ: DLTR) seeing increased footfall but they are also selling more and more products that were usually sold via traditional grocers.  Dollar Tree is my favored stock in the sector because it has the best underlying cash flow yield and the smallest number of stores. This implies it can finance growth in stores while trying to maintain its leadership in sales per store.

However the story isn’t just one of discount stores. The truth is that corporate profits are strong and if you have a job, borrowing rates are at historic lows and the Federal Reserve wants to keep it that way. So now we are seeing a curious bifurcation where the higher end and specialty stores are seeing good sales growth.  So I look at a stock like Whole Foods (NASDAQ: WFM) and think it has further to go. The stock is not cheap by any measure but then the market doesn’t worry about these things as long as growth occurs. I wouldn’t buy the stock right now but it should be on monitor in case it has a growth hiccup (and it will at some point) along the way.

The other aspect that I think investors should be aware of is that certain patterns of behavior seem to accelerate when they become socially and culturally acceptable. I’m a big fan James Q. Wilson and he often articulated this point.  For our purposes when it becomes socially acceptable to shop at an off-price retailer and every housewife is talking about the bargain she got yesterday then this trend will accelerate. I think the off-price retailers like Ross Stores (NASDAQ: ROST) have a great long term story. It is seeing good footfall growth and expanding the categories of products in its stores.  If it is becoming more acceptable for some people to buy clothing there then why not things like table lamps, food, cutlery, etc.

I also like financials. In particular I like something like Wells Fargo (NYSE: WFC) Let’s put it this way, corporate profitability is back and corporations are flush with cash so lending quality should be high. Similarly, US households have cleaned up their act and the credit companies are reporting very low levels of charge offs and delinquencies. Wells Fargo’s growing mortgage book should benefit from rising house prices which help asset quality.  Moreover the sub-prime debacle has led to all manner of regulations and adjustments to lending behavior which help to reduce long term risk. And finally this industry is political protected and everyone knows it.

Almost bizarrely, I also like companies tied to the employment cycle like Automatic Data Processing (NASDAQ: ADP).  Think about it. If we are headed for a long slow period of sluggish job growth than the employment based companies will do well because the cyclical nature of their earnings will be reduced. Moreover the likes of ADP have been operationally calibrated to make money in the current environment. Any uptick will see operational leverage kick in and it will drop into the bottom line pretty quickly. If ADP can generate 6.5% of its enterprise value in a difficult year just think what it could do when things get better?

The Bottom Line

I’d like to thank readers for sticking with this article and hope that they got some interesting ‘tells’ and stock ideas from it. The anemic state of job creation is very sad for many Americans and I’d hope that fact wasn’t forgotten when some of us more fortunate souls make moral judgments on the unemployed. This is a very difficult time.