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12 stocks for the recovery's next phase
Manufacturing usually leads the market out of a recession, but the primary gauge of activity suggests a peak is near. When it comes, look at these dozen stocks.
By Michael Brush
Our nations factories contribute just a small share of our economy, but they pack a powerful wallop when it comes to telling investors what kinds of stocks to own.
A look back over four decades shows that whenever manufacturing peaks, certain types of stocks move dramatically out of favor, while others rise up as the new stars.
Given that manufacturing is at its highest level in 20 years by one all-important measure, it looks like we might be close to a peak -- and ready for a fresh round of musical chairs in the market.
If so, it will soon be time to lighten up on stocks in technology, banking, mining, metals, paper and packaging. Instead, you should own:
- Consumer staples companies
- Health-care stocks
- Utilities
- Defense and aerospace companies
- Reinsurers
| Post-peak stocks | | Company | Sector | P/E | 3/2 price | | Sara Lee (SLE, news, msgs) | Consumer staples | 15.8 | $21.96 | | Lockheed Martin (LMT, news, msgs). | Defense | 19.8 | $45.64 | | Allied Defense Group (ADG, news, msgs). | Defense | 7.7 | $18.68 | | Orbit International (ORBT, news, msgs). | Defense | 14.6 | $8.25 | | Pfizer (PFE, news, msgs) | Health care | 166.6 | $36.65 | | Merck (MRK, news, msgs). | Health care | 15.9 | $47.75 | | Johnson & Johnson (JNJ, news, msgs) | Health care | 22.5 | $52.87 | | Urologix (ULGX, news, msgs) | Health care | NA | $8.11 | | Max Re Capital (MXRE, news, msgs) | Reinsurance | 9.6 | $23.25 | | PXRE Group (PXT, news, msgs) | Reinsurance | 6.6 | $27.53 | | Sempra Energy (SRE, news, msgs) | Utilities | 9.8 | $32.40 | | DTE Energy (DTE, news, msgs). | Utilities | 13.1 | $40.25 |
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Checking the pulse of manufacturing is easy, thanks to the Institute for Supply Management (ISM). Each month, the ISM asks 400 manufacturing companies how business is going. Then it crunches the numbers to create its monthly purchasing managers index (PMI), one of the most widely-followed economic indicators.
For anyone trying to figure out what stocks to buy, the PMI can offer uncanny guidance, says Franois Trahan, chief investment strategist at Bear Stearns who recently studied the power of this unlikely predictor for determining which areas of the market will do the best. In our view, this index is an all-in-one macro tool for sector positioning, says Trahan.
Manufacturing is a strong leading indicator
Why do certain sectors take over as market leaders when manufacturing growth starts to slow? Simply put, manufacturing is a great leading indicator, and a peak in the PMI signals slower economic growth ahead. In this climate, money managers start to hunt for financial strength, dividends and solid debt ratings. They want stocks with evidence of quality just in case economic growth peters out down the road.
Early in an economic expansion, low-quality and high-risk stocks do the best because they have been beaten down so badly during the recession, says John Hussman, an economist who manages the Hussman Strategic Growth Fund (HSGFX). On the flip side of an economic peak, its just the opposite.
Another hallmark of the winners? They all tend to sell things people keep buying even if economic growth slows. Health care is a perfect example, says Hussman. "You dont stop going to the doctor because you are in a recession. You dont stop buying staples and food.
No one can ever tell when the PMI has peaked until after the fact, so using this market tool involves some guesswork. But Trahan wouldnt be surprised if the PMI were close to peaking. Thats because its at its highest level in more than 20 years. For February, the PMI was at 61.4, down slightly from Januarys 63.6 level. The economy is thought to be growing anytime the PMI measures above 50. That level means half the respondents in the ISM survey said things were better than in the prior month.
Another early warning sign: The "new orders" component of the PMI began slipping in January -- and new orders and "production" declined in February.
The "inventories" component is in bearish territory, with a rating of less than 50. All this suggests a top for the PMI may be at hand. "A peak is on the horizon, and investors should start thinking about the portfolio implications of a declining PMI," Trahan says.
Value managers will have the better eye
To find some of the best stocks in the sectors that come into favor after a PMI peak, listen to value managers because they pay a lot of attention to quality stock measures such as strong financials, dividends and good debt ratings. We got help from one of the best in the business: John Buckingham. His Prudent Speculator newsletter is ranked No. 1 for long-term returns by Hulberts Financial Digest. Buckinghams newsletter picks were up 100% last year, and his Al Frank Fund (VALUX) was up more than 96% in the last year. We also pulled some ideas from the top holdings of Hussman, who has a strong value component to his stock picking.
Meantime, we looked for issues where insiders are purchasing shares in their own companies. Thats a good buy signal because it is such a rarity these days. Solid upward earnings estimate revisions fit into our formula, as well. Heres a quick look at what we found.
Health care stocks may be a bargain
Major pharmaceutical companies have sunk to their lowest valuations in three years. Theyre down thanks to fears about weak product pipelines, threats from generic drugs and rhetoric about high drug prices from politicians hungry for election-year whipping boys.
Buckingham is telling his readers to snap up drug stocks because he says they're quite simply very cheap. He likes Pfizer (PFE, news, msgs) under $38, Merck (MRK, news, msgs) under $51 and Johnson & Johnson (JNJ, news, msgs) under $54. This is a strategy that we used in 1993-94 during the Hillary Clinton health-care scare, Buckingham says. And, in some cases, the strategy produced 300% gains.
The stocks are so low that these companies pay a relatively decent dividend of 2% to 4%. Meanwhile, they produce billions of dollars in annual free cash flow, and they have solid financial strength to boot -- exactly the things investors will be clamoring for if signs emerge, via a peaking ISM report, that economic growth is slowing.
But what about those weak product pipelines? They go through cycles like everything else, and if they dont have a blockbuster drug this year, next year they will, says Buckingham. Johnson & Johnson, for example, will file for more than 50 new products or line extensions over the next five years, says Morningstar analyst Heather Brilliant.
The much smaller Urologix (ULGX, news, msgs) looks like it has good days ahead, too. CEO Fred Parks plunked down $245,000 for his companys stock in September, and two directors bought $168,000 worth at around $7 in late February. Minneapolis-based Urologix sells devices used for non-invasive surgery to reduce enlarged prostates. A recent increase in Medicare reimbursements for the procedure should boost sales. The surgery is usually done on men over age 65; in other words, patients whose bills are typically paid by Medicare.
Defense and aerospace
The Armys recent cancellation of the $38 billion Comanche helicopter program had investors selling Lockheed Martin (LMT, news, msgs) shares for fear that other programs, such as Lockheeds F-22 land based fighter jet, may get chopped, too. I consider that far more unlikely, says Paul Nisbet, a defense sector analyst at JSA Research in Newport, R.I. Lockheed is also developing the F-35 Joint Strike Fighter jet. Nisbet says the two programs provide a solid revenue base for this defense contractor. Lockheed Martin pays about a 2% dividend.
Another defense company on Buckinghams buy list is ammunition maker Allied Defense Group (ADG, news, msgs). It has a book value of $18.47 and recently traded for around $19. He also holds 15% of the shares of a tiny defense electronics company called Orbit International (ORBT, news, msgs). Defense and aerospace stocks like these do well when economic growth slows, but a Democratic victory this year could be trouble. Buckingham isnt too worried about this. The world is going to remain a dangerous place, as much as we would like everything to be hunky dory, he says.
Utilities
The two top utility picks by Morningstar analyst Venkatesh Vadlamani are Sempra Energy (SRE, news, msgs) and DTE Energy (DTE, news, msgs). Sempra's San Diego Gas & Electric subsidiary provides power in the San Diego area, one of the fastest-growing regions of the country. Its 6% annual population growth is the kind of thing that makes it easier for a utility company to produce healthy profit growth. The company also has an energy trading division, and it expects to be a player in the burgeoning liquefied natural gas market with two proposed receiving terminals on the Gulf of Mexico near Lake Charles, La., and on the Pacific Coast of Mexico.
DTE Energy owns the Detroit Edison and Michigan Consolidated Natural Gas companies. Detroit Edison uses coal, which is a relatively cheap power source in these days of record natural gas prices. The company gets tax credits for burning coal in a more environmentally friendly way. Sempra pays a dividend of 3.2%, and DTE pays a 5.1% yield.
Consumer staples: predictable is good
Selling everything from deli meats and cake to Hanes underwear and Wonderbras, Sara Lee (SLE, news, msgs) has a collection of product lines known for slow-but-steady growth of 2% to 5% per year. Thats pretty boring when the economy is hot. But investors will warm up to Sara Lees predictable sales, healthy free cash flow, and 3.4% dividend if signs of economic slowdown appear. Buckingham suggests buying Sara Lee under $21.50.
Reinsurers offer strong earnings
Of all sectors, reinsurance companies should do the best following a peak in the PMI, according to the research by Bear Stearns Trahan. Max Re Capital (MXRE, news, msgs), a Bermuda-based company thats moving aggressively into reinsurance, has a pattern of solid earnings estimate revisions and insider buying. Top managers began buying company shares last May, and they continued all the way through late February when CEO Robert Cooney shelled out $106,000 to purchase 5,000 shares at around $21.26 apiece. The stock is now at about $23. He now owns some 195,000 shares indirectly and another 667,000 shares directly.
PXRE Group (PXT, news, msgs), another Bermuda-based reinsurance company, may start attracting momentum investors because it is getting nice earnings estimate revisions. At the same time, the stock is cheap -- not a quality you see often in potential momentum stocks. At $26.90, it is trading at a decent discount to book value of $29, and it has a price-to-earnings ratio of around 6.
These are not exciting companies for the average investor when the economy is in an uptrend, says Buckingham. But once we level off and money sloshes around from technology into safer havens, it will be different. Theoretically, what is safer than a stock trading with a P/E of 6?
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