Cautious optimism, or upbeat despair? Wall Street can’t seem to decide. One firm says it’s time to embrace risk. Another says to hunker down for an earnings tumble. Both arguments make sense, and headlines aren’t helping to decide the matter.
Early this past week, FedEx (FDX) reported weak quarterly results and gave awful guidance—just the sort of transportation sneeze that can signal economic flu. Later in the week, however, data on unemployment claims, home sales, and regional factory activity suggested that jobs remain plentiful, and housing and manufacturing are stabilizing.
Below, we offer seven stocks for the economically agnostic. Acronym lovers can think of the theme as GARR, growth at reduced risk, or maybe SWAG, safety without avoiding growth. We turned to three pickers. Microsoft (MSFT) and Johnson & Johnson (JNJ) come from a growth fund manager who says to carefully watch measures of quality, like returns on equity and cash flows. Encompass Health (EHC), Diamondback Energy (FANG), and Facebook (FB) made an investment bank’s list of fast growers with historically low price volatility—factors that it says are likely to shine now. Another firm says it’s time to swap its list of favorite defensive names for its favorite cyclicals. Just in case, we’ll take one from each list: Comcast (CMCSA) and Delta Air Lines (DAL).
But hold on—why not just ignore the gloom-seers? One smart strategist or another has pooh-poohed the U.S. economic expansion during each of its record 10 years, now going on 11. Ultralow interest rates have played a key role, and just this past week, the Federal Reserve cut its key federal-funds rate. Don’t fight the Fed, right?
Recessions are inevitable, however, and the consequences can sting. The last recession was so severe that earnings underlying the S&P 500 (.SPX) index briefly turned negative, but even in an average recession, earnings can fall by close to a quarter. With the index trading around 3000, underlying earnings of close to $160 put it at just under 19 times earnings—only slightly pricey. But a drop to $120 in earnings would leave the index at a more problematic 25 times earnings, or, more likely, stocks would begin sliding long before earnings got to that level.
The Federal Reserve Bank of New York tracks the difference between 10-year and three-month Treasury yields to forecast recessions, and at the end of August, its negative reading put the chance of recession over the next year at 38%. That was up from 10% a year ago. Against that backdrop, an early-September jump in the 10-year yield looked like good news. Raymond James strategist Tavis McCourt sees it as driven by improving economic data, and predicts that a recent shift from defensive to cyclical stocks will continue.
But one measured bear, Barry Bannister at Stifel, argues that the recent lift in yields is merely a result of stimulus in China, which has now faded. In his view, the Fed is running out of power to boost economic growth and thus stock prices, and recession could hit next year, with stocks weakening around the fourth quarter of this year. For now, he favors traditional havens like utilities, staples, and real estate investment trusts, even though he acknowledges they’re expensive.
We went a different route, seeking growth stocks for concerned bulls. Rob McIver, co-manager of the Jensen Quality Growth fund (JENSX), says his selection process starts with identifying companies with many years of returns on equity over 15%, and strong and steady cash flows, with the goal of controlling risk. Over the past decade, the fund has returned just over 13% a year, on par with its peers, but volatility is well below the category average, according to Morningstar. Jensen says Microsoft is a good example of the companies he looks for. It’s growing organically, particularly in the cloud, and its cash flow allows it to spend richly on stockholders. This past week, it announced an 11% dividend increase and $40 billion of fresh funds available for stock buybacks.
Johnson & Johnson faces challenges, from lawsuits claiming its talcum powder causes cancer to a potential share of drug-industry liability over opioid deaths. Yet its earnings per share are seen rising 5% this year, 6% next year, and 7% each of the following two years. “It’s unusual for any diversified business to be firing on all cylinders at the same time,” says McIver. But the risks for J&J appear priced in and then some, he says. Shares go for 14.6 times forward earnings projections, down from a five-year average of 16.3 times.
Francois Trahan, U.S. stock strategist at UBS, has studied stock attributes that have worked well during past periods when surveys have signalled manufacturing weakness, as now. Growth stocks with low trading volatility have come out winners, he finds. His firm this past week pinpointed such companies that its stock analysts like. Three of these have at least 25% upside potential, judging by their recent prices relative to UBS’ targets.
Encompass Health, formerly called HealthSouth, is one of the country’s largest providers of inpatient rehabilitation services, following things like joint replacements and strokes. Baby boomers are approaching peak years for needing such services, but at the same time, the high-cost health-care industry faces potential for falling reimbursement rates. It bodes well for Encompass that so many of its patients are already on Medicare, where reimbursement rates have been relatively contained. Earnings per share are expected to rise 23% cumulatively over the three years through 2022.
Diamondback Energy is an oil producer, and its shares jumped, then settled back down, after a recent attack on Saudi oil production that drove crude’s price higher. Longer term, the company has faster production growth than most oil drillers, and healthy returns. If crude prices hold at about $55, Diamondback’s free cash flow could top $1 billion by 2021, making for a free cash yield of over 6%.
At a glance, Facebook doesn’t seem like much of a grower, with earnings per share expected to decline 13% this year. But that is due to higher costs, as the company works to address concerns over privacy, voter manipulation, and more. More telling is that revenue is expected to climb 26% this year. The company is benefiting from a gradual shift of advertising dollars to the internet from traditional venues. It must improve its relationship with Washington, D.C., if it is to avoid a costly regulatory crackdown. This past week, CEO Mark Zuckerberg donned a suit and tie to visit lawmakers and President Donald Trump, who tweeted a handshake pic, calling the meeting “nice.” If that’s not a bankable enough indicator, note that revenue estimates for next year have been rising.
Back to McCourt at Raymond James, who says to go for cyclicals. If he is right, Delta should benefit. His firm sees 18% upside there. Shares go for a lowly eight times this year’s projected earnings. Another jump in the oil price could raise jet fuel prices and cut into earnings growth. Then again, if oil rises on higher demand amid a shift to faster economic growth, it will presumably mean that more business travellers are hopping from airport to airport chasing deals.
Back in May, McCourt issued a list of defensive favorites with growth potential if the economy picks up. One of those is Comcast. As a cable company it faces cord-cutting risk, and as owner of NBC it must navigate the upheaval of a shift to streaming, including to its planned Peacock service, launching in April. Declines in video for the cable business, however, are being more than offset by gains for broadband, and cost cuts. NBCUniversal is expected to grow profits for the full year, and the theme-parks business is following Walt Disney’s success, expanding in Orlando, adding hotels, building a new park in China, and securing intellectual property for rides through a deal with Nintendo. Earnings are seen growing at a double-digit pace over the next three years—peppy for a defensive pick.
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