Wednesday, August 8, 2012

Which Stocks Are Working in this Market?

The markets have been very tough recently and, given that they are being driven by macro-economic factors, it would be remiss of me to discuss stocks without trying to understand what sectors and stocks are being affected and why. I think there are a number of themes in play, and I would like to shed some thoughts on what is going on while suggest some ideas that might work.
Firstly, some brief words on what is going on. I think there are two issues here.

Greek Drama and the Gods are not Pleased

The first relates to the Euro Zone debt crisis and Greece. Simply put, despite multiple attempts at restructuring, Greece’s debt is now unserviceable and the country is possibly headed for a disorderly default and an exit from the Euro. This would cause a significant problem at the ECB because it would face large losses on its balance sheet following its previous purchases of Greek bonds. In addition, the billions of loans made to Greece by the ECB, would now be worthless.

The problems don’t stop there. There are also the contagion effects of losses at banks that have exposure to Greek debt and the threat that fears will spread to other countries like Portugal and Ireland.

But, I hear you ask, why does Greece matter?

In a sense, it doesn’t. It constitutes a tiny portion of global GDP and, on its own, will not have an affect. When was the last time you read an earnings report that highlighted the importance of revenues from Greece? The real problem is the possibility of future contagion, but this can be mitigated with prompt action. Indeed, the ECB LTRO has succeeded in eradicating banking liquidity concerns in Europe, at least, for now.

The likely response to a Greek disorderly default, will be that the ECB will be pressured to print in order to re-capitalise its balance sheet following losses on Greek debt and loans. Whilst politically embarrassing, it is feasible.  However, my suspicion is that a deal will be done by, the EU and Greece, for an orderly default and exit, which should encourage the retention of market confidence, as uncertainty is taken out of the system. 

A Chinese Puzzle

The second issue is the growing realisation that China’s growth is slowing. I have contributed a more detailed post on this subject linked here. Since then, further evidence has suggested that fixed asset investment is slowing along with retail sales and industrial output. Economists have been scrambling to lower growth forecasts and the Government is trying to enact measures to stimulate growth.
The key takeaway here is that the composition of China’s growth is likely to change from being focused on fixed asset investment to more social spending and private consumption. The way to play China will change this year. That said I am also cautious on the quantum of China’s growth. As we have all learned, over the last few years, it takes time to recover from a property bubble.
It’s time to turn to specific sectors.

Why are US Technology Stocks Tanking?

Technology is one of the North America’s key export industries and Europe makes up a large portion of a typical tech US firm’s revenues. Usually, the Far East contributes less, but critically, a lot of tech companies are seeing a large part of their growth coming from the Far East. Since, tech is seen as a cyclical component of spending, it is natural that the sector will be sold off on concerns of the macro-economy.

In addition, tech bellwether Cisco Systems (NASDAQ: CSCO) gave horrible guidance and, talked of weak enterprise spending. I think the problems are more about Cisco’s challenges in its core divisions than overall weakness in tech spending, but when Cisco speaks the market listens. More on it linked here.

I think it is highly probable that some areas of tech will see a bit of softness in Europe as CEOs react to the economic uncertainty, but I also think this could clear up in the second half. There are many secular growth trends within technology (smart phones, cloud computing, security, big data etc.) and they are unlikely to go away in a hurry.

What’s Happening with the Dividend Plays?

The logic here is that if the global economy is headed for a slowdown caused by Europe & China, then US treasury yields are likely to remain at historically low levels for an extended period. This makes blue chip consumer staples more attractive because their dividends will be taken as a proxy for a ‘risk free’ investment in Government debt. Indeed, it’s noticeable how things like Johnson & Johnson (NYSE: JNJ) have been outperforming. The stock is interesting in itself because the factors that will drive its performance are largely driven by its execution. Something like General Mills, Procter & Gamble or Kraft is also worth a look.

However, any investor chasing this theme needs to be selective. For example, in 2008 a broad based dividend chasing theme would have guided investors into being overweight housing and banking stocks. Not good. The key thing is, as ever, to ensure that future earnings will be generated in order to pay dividends.

What about Commodities?

If you live by the sword, you usually die by it. Any Greek dramatist will tell you that.
Over the years, I have lost count of the number of times I have heard the ‘commodity super cycle’ argument. Its usual case is that the marginal increase in demand created by emerging market industrialization will create a long term boom for commodities. In particular, this argument is usually accompanied by talk of ‘peak oil’. It is a powerful argument, but if you hold it, you must recognise that any slowdown in demand coming from, say China’s fixed asset investment will also reduce the marginal demand for commodities.

I think that is what we are going to see that this year. It is not hard to see why the likes of Rio Tinto or Vale have been underperforming recently. Moreover, a stock like, mining equipment company Joy Global (NYSE: JOY), looks vulnerable in this environment. The services and equipment providers tend to be more vulnerable because their stock prices are dictated more by current pricing. Contrast this with, say an oil explorer, whereby the net asset value of its oil, will be determined more by longer term pricing.
If China’s housing and construction market is going to slow, then commodities will be hit. Joy Global will not be immune.

Biotech & Pharma, a Possible Safe Haven?

There is a good case for both, but I prefer biotech over pharma. I confess that I am slightly biased in this case because I spent a good part of 2008 running around London trying (ultimately unsuccessfully) to get a collection of biotech experts together in order to set up a fund. There are three biotech focused funds listed in the UK, they all generated mid teens returns in 2008.  The reasons for my interest are the same reasons why I like the sector now. With biotech, companies can offer a value proposition which is largely independent of the economy.

Take for example Vertex Pharmaceuticals (NASDAQ: VRTX). It has been soaring recently following successful data on a trial for a drug to treat cystic fibrosis. Of course, investing history is littered with biotech failures, but the central point remains. Success or failure with biotech companies has little to do with the Greek’s tolerance for austerity or China’s penchant for property speculation.
It is a similar case with pharma and larger cap biotech, but a lot of these companies are mature and, subject to significant risk concerning healthcare reforms and pricing. Nevertheless, there are still exciting things happening in the sector. For example, Gilead Sciences (NASDAQ: GILD) recently received two separate FDA panel recommendations. Its HIV pill Quad, received recommendation for approval and, its earlier HIV drug Truvada saw an FDA advisory panel supports its use to prevent HIV infections. The FDA usually follows the advice of its panels.

All of which, demonstrates that there are sectors that investors can look into, that will generate growth irrespective of the economic environment. For individual investors, stock picking can be fraught with difficulty in the sector. So why not consider a biotech fund like, say the Rydex Biotechnology Fund or Fidelity Advisor Biotechnology Funds?

What Next for the Markets?

Frankly, it is an uncertain outlook because economic growth is becoming increasingly dictated by political manoeuvres and policy responses. I think China’s slowdown may well turn out to be more pervasive and longer term, than European difficulties. However, in any case, there are sectors and themes that can generate relative outperformance and investors should stay diversified in order to capture the upside potential with them.

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