Shaping a Portfolio–Highly Volatile Companies: Cyclicals, Leveraged, “Near-Death Experiences”

Cyclicality, Leverage, “Near Death”

The three kinds of companies have two things in common:  their earnings can swing wildly, and their stocks even more so.  They can be like playing with fire, so they’re not for everyone.  In fact, they’re not for most people, even though they usually lead the performance of a bull market in its first year or more.  So you might want to stop reading here.  Or you might keep on going just so you’ll know something more about how these stocks work, even if you won’t own them.

Cyclical companies are ones whose sales follow the business cycle up and down, like homebuilders, technology firms, metals miners or car companies.  Sometimes investors will try to distinguish firms that deal in pure commodities, like lumber or basic chemicals, from those with other sources of value-added by calling the former “deep” cyclicals.

There is also a kind of cyclicality within an industry.  Sometimes, the market leader has such a strong reputation for quality and service that the other market entrants end up being “overflow” producers–that is, they get orders only when the leader has run out of capacity and can’t supply new requests–despite having adequate quality and comparable prices.  Even though the industry as a whole may not be particularly cyclical, it can turns out to be a roller coaster ride for the second-tier firms.

“Leveraged” companies are ones who have structured themselves in a way that small changes in sales, positive or negative, create large changes in profits.  The leveraging comes in two forms, financial and operating.

Financial leverage means debt, either bank borrowings or bonds.

Operating leverage means high fixed costs (fixed costs are those that have to be paid, whether there’s any output or not; variable costs are those directly linked with the production of a specific item).

High fixed costs can result for a number or reasons:

1.  it’s the nature of the business, like a semiconductor factory,  a cement plant or a hotel;

2.  the company’s plant and equipment is no longer state of the art and costs more to run than newer assets;

3.  the plant and equipment isn’t configured in the best way.

Companies can mitigate the effect of leverage by entering into long-term arrangements, either formal contracts or informal agreements, that guarantee customers will always buy a certain portion of their output, though usually in return for a price concession.  Japanese blast furnace steel mills, for example, have traditionally done this with their automotive customers.  In most cases, I think, the industry leader does some form of this.

On the other hand, a company can choose to figuratively revel in its leverage and operate mostly/exclusively in the non-contract or “spot” market.  It argues that the higher prices in good times more than offset the lower prices in bad.  UMC, the Taiwanese semiconductor foundry, is a case in point.  Twenty years ago, most gold mining companies operated this way, as well, but they also made sure they had no debt.

I think of “near death” companies as ones that depend on the kindness of strangers, and which are destined to go into bankruptcy in a world ruled by justice rather than mercy (or, what amounts to the same thing, government support for “strategic” industries).  Computer memory chip makers would be a good example.  PALM (a family member owns shares), pre its rescue by Bono, might be another.  Too much leverage, management ineptitude, too much cyclicality are usually the causes of these companies’ problems.

When To Buy Them–and How Much

How much?  In large amounts, never, in my opinion (a value investor would probably be more enthusiastic, though).

For most people, never may still be the right answer.  For those with a relatively high risk tolerance, small amounts, among the top-tier companies, is probably best.

When to buy? These stocks are often the best performers during the first year or so of a new bull market.  Their performance is typically in inverse order to their riskiness/cyclicality. Why? As you will be able to see from any historical record, these stocks as a group are pummelled in a down market, with the most highly leveraged doing by far the worst.  The stocks are usually trading a steep discounts to asset value, with the second-tier companies at the lowest valuations.  As the cycle turns, however, these “worst” companies (more precisely, those who don’t go into bankruptcy first) get disproportionately large sales gains (the industry leader runs out of capacity, so buyers have to turn to the same #2 and #3 they shunned a few months before) and the threat of bankruptcy recedes.  So these stocks benefit not only from sharply increasing earnings, but also from a perceived decrease in risk.

Professionals typically buy the stocks of these volatile companies when they conclude that conditions can’t get any worse and sell them when they conclude that things can’t get any better.  In effect, this means they buy when there are no earnings and no backlog of new orders and sell when the company is raking money in and the future looks great.

To me, it looks like now is the time.

Where Would I Look?

First, let me say I’m only beginning to do the research anyone would need before actually buying one of these, but I think three areas (the “usual suspects,” for me) are potentially interesting:  hotels like HOT, MAR or IHG and casinos (I own WYNN already); semiconductor fountries, especially TSMC ; and industrial machinery companies like CAT or DE.

Usually I get worried about a stock symbol that spells a word–this isn’t a joke–because I think it shows top management is spending more time trying to be cute than running the business.  But CAT is the start of the company’s name, and the management that picked HOT isn’t there any more.  I do have unresolved/unresearched worries about both, though:  CAT’s financing operation and HOT’s timeshares.

If you’re sticking to a plan of index funds + sector funds + individual stocks, you may decide that the cyclical area is too much trouble to deal with directly and find a sector fund to get exposure here instead.

What the Risk-Averse–That’s Almost Everyone– Should Avoid

“Risk averse” doesn’t mean conservative.  It means expecting to be paid for taking risk and not embracing risk as an end in itself.  Anyway, even the deepest value investors I’ve known would say to avoid industries in secular decline.  That would certainly include airlines and newspapers.  I’m sure you can come up with more.

I was listening to CNBC the other day and heard a reporter say a certain group of equity-oriented hedge funds had lost money over the past six weeks or so because they were long (i.e., they owned) high-quality companies and were short (i.e. had borrowed and sold, effectively betting the stock would underperform) low-quality companies.  He didn’t know, but you should, if you’ve read this far, that the hedge funds in question were betting the market would continue to go down.  Why?  because low-quality, leveraged, cyclical companies outperform in the early stages of an up market.

Shaping a Portfolio–Pent-up Demand

“Pent-up” Demand

In weak economic times, individual consumers and corporations become afraid they’ll run out of cash and postpone purchases, creating unfulfilled or “pent up” demand for these items when times get better.

For what might be thought of as capital goods, that is, expensive stuff with a long lifetime, like a new house, a car, a refrigerator, or a new corporate headquarters, a data center, overhaul/replacement of the point-of-sale computer system–these purchases just don’t get made in bad times.

For smaller-value, more frequent purchases, like food or clothing, software upgrades, a new coat of paint–either these purchases aren’t made, or buyers “trade down” to a cheaper substitute.

Trading Down

Trading down is in the eye of the beholder, in many cases.   For the Macy’s customer, trading down may mean Target.  For the Target customer, it may mean Wal-Mart. For the Wal-Mart customer, it may mean the Salvation Army store. Some people may just wear what they own now and buy nothing.  So even though common sense says the high end of the chain loses but there may be someone at the low end who actually benefits from bad times, that beneficiary may be harder to find than you think.

Cutbacks in spending affect maintenance as well as new purchases, urban legends to the contrary.  While some may repaint their houses instead of moving, they are dwarfed by the number of people who will let the old paint job last another year (or two).   It’s the same with supposed purchases of “little luxuries” like a new tie or a lipstick.   Businesses will also stretch their preventative maintenance schedules for things like paint and sealants, and patch up old PCs as they break, or recycle them multiple times, rather than upgrade beforehand or buy a new PC or blackberry for a new employee.

Travel, entertainment and advertising are corporate areas that tend to be particularly hard hit.  Salesmen may make three trips a year to visit clients instead of four, fly coach instead of first class, stay in less luxurious hotels and have smaller entertainment allowances.  Conventions may be smaller, in cheaper venues–or not happen at all.  Marketers who believe advertising has created enormous brand value for them, may figure they can cut back for a short time without damaging the brand.

Each Downturn Is Different

Each downturn has its own peculiarities.  I’ve been a bit surprised that Starbucks and bottled water have been such early casualties of this recession, not that I’m a devotee of either, but because they’re relatively inexpensive.  I’d known that luxury goods companies have a much larger number of “aspirational buyers” than is usually appreciated, so this is not a great area to be in during a downturn, but the sales decline here has been pretty remarkable.  On the other hand, I hadn’t expected business purchases of new blackberrys to be up.

From an investor’s point of view, what I’ve written to this point is mostly information to be filed away and used when the next downturn occurs.  We’re trying to position ourselves to make money as the next upturn plays out.

Figuring the Upturn

For me, the main issue is this:  every downturn causes some behavior changes.  Some people will try Dunkin Donuts’ coffee because it’s cheaper and maybe never go back to Starbucks. Some will discover Target or Wal-Mart and switch allegiance from Macy’s. …or buy a Hyundai or Kia instead of a Toyota or Nissan and stay with Korean cars.  Others will switch back to their former favorites the instant they can afford to.  The big question is what will happen this time.

Remember, too, that we don’t need to have a comprehensive view of what the coming economic upturn will look like.  We’re looking for areas where we may be able to one or two stocks to supplement a mutual fund portfolio tilted toward economy-sensitive industries (namely, materials, consumer discretionary, technology and industrials).

Also, there are a lot of idfferent ways to make money.  Not everyone is going to have the same information or insights.  So there’s no “correct” answer.  There are just your peresonal guesses, the criteria you’re going to use to evaluate them and what needs to happen for you to confirm your beliefs/what would get you to change your mind.  (Please let me know if you have any good ideas.)

What I Think

For what it’s worth, this is what I think:

I think the overall economic recovery in the US won’t be as explosive as recoveries have been in the past.

I expect that white-collar workers below the age of, to pick a number out of the air, forty will have been relatively unaffected by the recession and will have no worries about going back to spending as usual.  One exception to this will be recent college graduates, who will be able to find jobs/find better jobs for the first time since they got their diplomas.  Their spending will also be strong, maybe stronger, for slightly different reasons.

In contrast, I think Baby Boomers will have been badly shaken by their loss of wealth so close to retirement age.  In addition, publicity about the underfunding of pension benefits–both by government and private corporations–and about what happens if your pension fund runs out of money won’t do anything to improve the BB mood.  My guess is that they will travel, replace their Buicks and do little else.  It may be harder than usual for the BB to find work in some industries, since the competition will be hordes of enthusiastic under-employed twenty-somethings.

Unemployment has been centered on construction and manufacturing workers.  I think the job loss in this area is much greater than officially reported, because of the presence of undocumented foreign workers in construction.  When construction resumes, who will be rehired first?  The mix between foreign and citizen will have an impact on the profits of companies that serve this market.

I don’t have any insight, either, into what the prospects for manufacturing industry are.  Among publicly-quoted companies, many have heavy exposure to housing and at least some have financing subsidiaries, where problems may still lurk.  I also think that what ultimately happens with the auto firms has the potential, for good or ill, to influence the multiple investors are willing to pay for US-based manufacturers.

What does all this boil down to?  I think we’ll have surprisingly strong growth in industries geared to the under-forty or under-thirty segment of the population.  I think this means video games, social networking, smartphones and action movies.  Travel-related (translation: hotels) may also do well, and get an added assist from the BB.

Shaping a Portfolio–Dividend-paying Stocks

A Traditional Way of Allocating Assets

One traditional technique for individual investors to allocate assets is to establish a cash reserve and then allocate enough money to government bonds or other fixed income that interest payments will cover living expenses.  Any remaining money would go into riskier assets, like stocks.

The idea is that the bonds provide a reliable, regular stream of income.  They are subject to two risks, though, assuming you hold to maturity: inflation may erode the purchasing power of interest and principal; and the principal must be reinvested at the end of the term of the bonds.  The stocks, on the other hand, may not provide much income but, because they are ownership interests in corporations strong enough to be publicly traded, they provide superior growth potential as well as some protection against inflation.

How Today Differs

Today, for the first time since the Great Depression and the years immediately after World War II, we are in the unusual position that stocks provide pretty much the same income as government bonds.  Even after the market advance since the early-March lows, and factoring in the dividend cuts by financial companies, the dividend yield on the S&P 500 is still about 2.5%.  If we consider only dividend-paying stocks in the S&P 500, the average yield is about 3.25%.  This compares with the 10-year Treasury bond, which yields 2.87% and the 30-year, which yields about 3.75%.

Unlike bond interest, there is the possibility that dividend payments can rise.  And because the Fed has responded to a horrible economy by temporarily lowering short-term rates to effectively zero, we are arguably at a high point for fixed income.  This, at a time when we are also, arguably, at a low point for stocks.

Unlike a few weeks ago, it may not be possible today to match the yield on the 30-year bond without reaching into the riskiest end of hte S&P 500.  But stocks like MMM, PG or INTC all yield about 3.5%, well above the 10-year bond.  Yes, these are mature companies that may not produce sizzling capital gains.  But if the dividends are secure, they seem to me to be a better choice than treasuries.

What about corporate bonds instead?  Yields here are much higher than treasuries.  (Remember, in reading what follows, that I’m a stock person, not a bond person).  Yes, that’s true and there is also some overlap between the riskiest end of the S&P 500 and investment-grade corporate issuers.  But I think the overall riskiness of the issuers of corporate debt, especially below investment grade (“junk” or “high-yield”), is substantially higher than for the S&P, and the instruments are substantially less liquid.  So you really better know what you’re doing in this arena.

What Could Go Wrong

What do I think could go wrong with buying 3.5%-4% dividend yield stocks?  Three points:

1.  The worst case is that operating weakness may force the company to reduce, or even eliminate, the dividend.  Dividends are supposed to be paid out of profits.  Also, the money may be needed to repay debt or to fund the operation of the business.  But you can do homework to see if this is a reasonable possibility.  Analyzing the flow of funds is the best approach.  But you can also check with services like Value Line for their statistics on how well covered the dividend is.  By the way, this is the issue with ultra-high dividends–the market is saying it doesn’t believe the payout is sustainable.

2.  The total return on a higher-than-average dividend stock may be below that of the market.  If we assume there’s no free lunch, then there’s a price to be paid for straying from the combination of dividend and cpaital change that the index is presently offering.  For the first extra unit of dividend, you may have to only give up one unit of chapital appreciation.  For the second, you may have to give up 1.2 units, and so on.  This may not matter to you.  But what I think is the most interesting aspect of today;s situation is that you don’t drift far from the market yield to do better than a 10-year bond.

3.  This one is a little bit out of left field.  I’m not sure how serious a worry it is.  As I’ve written elsewhere, it’s been more than twenty years since dividends have been close to 3% on the S&P 500 (this may be another way of saying it’s been that long since stocks have been so weak).  In any event, having a large dividend yield hasn’t seemed to me to have provided any cushion at all against a stock’s fall.  That could be changing, on the way back up.  But if company directors get it into their heads that dividends are a stock attribute that investors don’t want, sort of like huge tail fins on a car, then they may begin to think the payout could be better used by the company elsewhere and cut the dividend even though they don’t need to.

Shaping a Portfolio for 2010 (IV)–Individual Stocks (ii)-Where to Look

I’ve always found it much easier to figure out what’s likely to go wrong than what’s got a good chance of going right.

A company owes $1 million to its banks; interest expense is $70,000 a year.  But the company only generates $20,000 a year in revenue.  Trouble!

A company has a great new portable communication device.  Is it Blackberry or XM Radio?   or a company invents a social networking concept.  Is it Facebook or Friendster?

This is especially true with stock market upturns, which start in an atmosphere of fear and pessimism, where there isn’t much help for thinking positive thoughts.  Because the ongoing recession is accelerating the demise of newspapers and local television, media gloom is unusually intense today.

Despite the fact that looking for sources of economic strength won’t be as specific at this stage of the business cycle as one might like, and although the attempt may smack a bit of wishful thinking, here are the areas I think are important to focus on now to prepare for a stock market upturn.  I’m going to list some ideas now and develop them in subsequent posts.

–4%+ dividend-paying stocks

–pent up demand.  In bad times, people postpone purchases of big-ticket items and trade down to less expensive versions of what they do buy.  This creates a reservoir of demand which tends to be satisfied in a hurry, once consumers believe their jobs are safe.  What will the characteristics of this demand be in 2010?  There are consumer stock beneficiaries, industrial stock beneficiaries.

–highly leveraged companies/”near death experiences”.  Hotels are a good example.  At (about) 50% occupancy, a hotel may have no cash at all; at 60%, it will break even on its financial reporting books; at 70%, it’s rolling in money.

–non-bailout banks, especially with emerging markets exposure

–smartphones, netbooks

–winners (if you can find any) from the relentless evolution of the internet

–secular growth stocks

–Korean automakers (maybe).  Good news=market share gains in the US; bad news=Korean capitalism isn’t like the US variety

Shaping a Portfolio for 2010 (IV)–Individual Stocks (ii)-Where Economic Energy ISN’T

Any discount broker will provide some stock screening capabilities.  I think Fidelity’s are particularly good, although I don’t profess to be an expert on the subject.  This is probably the first stop for value investors.  I can’t offer much insight on how to proceed, but typical screens are for price to cash flow, price to book and price to earnings.  Simple screens are probably more effective than complex ones.

For a died-in-the-wool value investor, this may be enough.  But I’ve always thought that before buying a stock, you make up two lists.  One is what could go right, the second is what could go wrong.  A good stock is one that has the largest number of entries on the former list and the smallest number of entries on the latter.

That brings me to the subject of this post–What’s likely not to work in the upcoming bull market?  Remember that just as in a down market, everything goes down, in an up market (just about) everything goes up.  So what follows is about areas I think have the potential to underperform, that is, go up less than the market.  Also, especially in the US market, hidden gems in conceptually bad areas have a really good chance to work as stocks.  So my thoughts here shouldn’t be enough to dissuade you from buying a stock you have researched and really believe ink, just because it’s in a “bad” sector.

Areas I’m Going to Avoid

1. Banks that have received government bailout money.  These stocks have been strong performers as fears abate that they will be forced into bankruptcy.  I have no idea when this period of outperformance will end.  But I worry that these banks are being forced to concentrate their lending in their home markets, meaning that competition will be fierce and therefore margins low.  This will be very good for borrowers, but not for bank profits.  Standard Chartered, a bank that specializes in emerging market, has already reported that it is seeing traditional competitors withdrawing from the developing world.

The other side of this coin is, of course, the opportunities opening up in markets the big US and European banks are leaving.

There’s a second, although of itself pretty lame, reason to avoid this group.  Typically, in the transition from a down market to an up market, the leadership group changes.  This happened, for example, to the mega-cap “Nifty Fifty” in 1973-74, the oil stocks in 1981-82 and the internet stocks in 2001-2002.

2. Healthcare, especially providers of equipment and services.  For a long time the “conceptual” case for this group of stocks  has been that the aging of the Baby Boom will provide ever increasing demand for medical care.  There may be rays of hope in this arena, and drug companies are probably ok.  But I think the move toward more comprehensive medical insurance will bring with it calls for better use of medical dollars.

Also, I think that, although we don’t talk much about it, Americans don’t like the idea that corporations make a lot of money from citizens’ illnesses.  I think we respect people who are caregivers and have no qualms about their earning a good living.  But corporations?  –no.

Others may be able to navigate successfully through this heavily regulated industry.  But I can’t see myself as anything but the “dumb money” here.

3.  Consumer staples.  Again, there are doubtless great companies in this sector, like Procter and Gamble.  And there are niche areas like chewing gum or, in a better economy, chocolate.  Typical behavior in this relatively mature area has been that consumers trade down to cheaper (and less profitable) brands or to private label during bad times and trade back up when the economy gets better.  My worry is that the Baby Boom doesn’t trade back up and private label makes permanent deep inroads into the staples’ most profitable products.

I’m adding this on Apri l 15th.   I hadn’t mentioned companies in secular decline, which I think even value investors would regard as to be avoided –like newspapers, local tv stations, airlines, music companies, traditional book publishing…