Stress-Test Your Portfolio

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After a big market run-up, look for dependable performers that wont get whipsawed in the next downturn.

WHATEVER THE STOCK

market has given you over the past year—losses, gains or a mild swearing problem—it has provided a valuable look at how things hold up when conditions turn ugly. Bank regulators and heart doctors call that a stress test. They use simulated strain to tell whether a bank like Citigroup needs a cash injection or Harry needs a bypass. Stock investors, however, have gotten an unscheduled, real-world test of what to swap into if they fear another downturn.

“All cash” isn’t the answer for two reasons. First, savings accounts and the like provide meager returns in the best of times and downright pitiful returns now, so they tend not to preserve buying power over longtime periods. Second, stocks might head higher. In recent months in this space, I’ve opined that stocks look a bit pricey relative to earnings, dividends and plenty else, and that for earnings to grow much, they’d have to return to bubbly levels when compared with the size of the economy. The numbers still tell me that, but then again, wild gyrations in economic measures over the past year have left the data as dirty as a New Jersey governor’s race, and even with clean data I often guess wrong on the short-term direction of the broad market.

Benjamin Graham, the man Warren Buffett says taught him how to buy stocks, had a simple way to guard against that. In his 1949 book The Intelligent Investor, he proposed “a fundamental guiding rule that the investor should never have less than 25 percent or more than 75 percent of his funds in common stocks.” That seems especially prudent now. Investors who follow that advice look for stock bargains even when they suspect the market will tumble.

If this is your dilemma, favor stocks that outperformed during the recent downturn. Also, if you search for cheap stocks by comparing share price with some measure of company income (sales, earnings), asset value (book value) or payments to shareholders (dividends), be sure to consider how reliable the measures proved amid market chaos. Sales for the S&P 500 index, for example, fell 20 percent from their peak in the second quarter of 2008 to their trough in the second quarter of 2009, much less than the top-to-bottom decline for stock prices of 57 percent. So the price/sales ratio performed faithfully, showing when stocks looked cheap. Price/earnings wasn’t much help, because earnings briefly disappeared altogether in the fourth quarter of 2008. Book value held up superbly, falling just 14 percent from peak to trough, but there’s a catch. Company asset values arc based on accountants’ opinions as to what buyers would pay for those assets, which is difficult to say during a spending slowdown for cranes and cargo ships and all but impossible to say for exotic financial instruments. Dividends held up admirably, falling just 17 percent from their high quarter to their low one. All told, use a variety of measures, but lean heavily on pricc/sales and dividend/price (a.k.a. dividend yield), and for many but not all companies, price/book.

As for stocks that have emerged as foul-weather outperformed, more than 60 companies in the S&iP 500 produced year-over-year sales growth in each of the past four quarters. About half of these have recently grown their earnings faster than their sales. A handful have increased their dividend payments, too.

Of course, improving financials aren’t much comfort if a stock’s price is whipsawing. Investors might want to favor companies that have also given investors a smooth ride of late. Congratulations to Amazon shareholders, whose stock price has increased from $80 to $120 on rising sales and profits during the past two years, while the S&rP 500 lost about 25 percent, but my condolences to those who sold when the stock fell to $35. Teva Pharmaceutical, an Israeli pillmaker, provided a third of Amazon’s gains and a modest dividend with almost no stock-price drama.

I recently searched among 900 large and midsize U.S. companies for ones that consistently increased sales and profits over the past year, raised their dividends and produced a share- price gain over the past two years. I favored companies whose stock- price charts look relatively smooth and whose shares seem reasonably priced compared with earnings.

For a company best known for Chee- rios, a cereal first produced during World War II, General Mills isn’t afraid to try new products. At last count it had plans to introduce 150 items over six months. Many include foods engineered for tweaked nutrition stats, like high-fiber yogurts and soups as well as gluten-free cake mixes. Defensive investors rushed into the stock in late 2008, chasing the price up, but it’s lower now and profits have climbed, leaving shares at a discount to the market.

Owens &c Minor was founded as a drug wholesaler 125 years ago, when antibiotics were mostly theory, the first vaccines were just being developed and a young Sigmund Freud was writing “Uber Coca,” touting cocaine as a medicinal marvel. Today the company distributes medical and surgical supplies, more than 200,000 products in all. It’s about 10 percent the size of industry giant McKesson based on stock market value, with larger profit margins and faster growth. Third- quarter sales increased 14 percent on a recent acquisition and higher demand from long-standing accounts.

Family Dollar Store’s sales have doubled in less than a decade. The discount retailer, long popular with low-income shoppers, has seen a rise in traffic among middle- and high-income customers looking for bargains, according to company research. Sales, profits and the stock price have benefited, and analysts say the key for management is to retain its higher- income customers once the economy rebounds. For now the company is enjoying some of the perks that come with larger size and financial success, like deeper discounts from suppliers, better retention of store managers and the ability to expand its lucrative private-label offerings.

Raytheon is something of a rarity in that it continues to buy back shares, retiring more than 1 percent of them last quarter. The weapons maker boasts consistent sales and profit growth and more cash than debt, but its shares carry a modest price/carnings ratio. Investors perhaps worry that budget deficits in the U.S. will crimp growth in defense spending, but more than half of Raytheon’s sales growth of late lias come from international markets. Raytheon isn’t a Dividend Aristocrat—a Standard & Poor’s name for companies that have increased payments each year for 25 years—but it’s close enough. Since the 1960s, it has boosted the dividend more than two dozen times. Today’s payment seems easily affordable at about one-quarter of yearly profits.

J&J Snack Foods sells soft pretzels, frozen slush drinks, fruit pops, cookies and more. It’s a relatively small company with broad distribution, reaching 90 percent of supermarkets, half of movie theaters, and many stadiums and theme parks. The company’s supermarket business is growing quickly at the moment, more than offsetting weakness at theme parks and such. Sales for its fiscal year ended in September increased 4 percent, and profits jumped 48 percent. J&CJ is debt-free with a cash stockpile equal to more than 10 percent of its stock market value and another 10 percent or so coming in each year as Operating cash.

Finally, Church Sc Dwight has turned the countless uses for Arm Sc Hammer baking soda into countless products bearing the brand: room fresheners, laundry detergents, deodorants and more. The company also sells condoms and pregnancy tests under the brandsTrojan and First Response. In its third quarter, Church Sc Dwight turned 2.5 percent sales growth into a 14 percent increase in earnings per share. Management says next year’s product launches should be the strongest in years.

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