The market is getting strange. 8 stocks to ride it out

  • By Jack Hough,
  • Barron's
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Currency got weird just before the U.S. Civil War. Banks issued their own designs, exchangeable for gold, and some used popular imagery to make customers want to keep their paper. The 1980s television series Ripley’s Believe It or Not! once featured a three-year note from the Central Bank of Troy, N.Y., with a portrait of Santa Claus and his reindeer.

If someone had told the Ripley’s folks that more than a quarter of government debt worldwide would carry negative yields one day, they might have struggled to believe it. Santa notes are one thing, but lenders paying borrowers? That’s a financial freak show. Yet, here we are. And with the world’s debt exceeding 320% of its economic output, growth looking weak, and central banks getting creative, there could be more and greater money-related oddities to come.

The path for investors through this bizarre landscape is straightforward, however. Stocks remain attractive relative to bonds. U.S. bonds are a better deal than what’s on offer in the rest of the developed world, especially if yields are headed lower. A typical 60/40 mix of stock and bond index funds is a strong enough hand. For stockpickers, one Wall Street firm recently recommended fast growers whose fortunes aren’t closely tied to economic cycles, and companies that generate plenty of free cash to spend on dividends in a yield-starved world. Some picks in a moment.

First, there’s good news for political partisans: U.S. financial signals are sufficiently mixed to allow both sides to talk their book. Stocks have shined this year, recent wobbles notwithstanding, and the longest economic expansion in U.S. history continues. Manufacturing might already be in recession, but the larger consumer economy is strong, with unemployment low and confidence high.

When will stocks crash? Any day now, or not for years—there is no reliable way to know. It bodes well in either event that banks are stronger now than leading up to the housing bust a decade ago. But forecasters looking for hobgoblins will find them; student loans, for example, are a larger portion of household debt now than subprime mortgages were back then.

No need to get fancy here: A 10-year Treasury yield of 1.7% isn’t anyone’s idea of generous, but it is 2.3 percentage points more than what Europe is paying. The Federal Reserve won’t want to let that differential make the dollar too strong. Futures prices suggest the near-certainty of at least a quarter-point cut in the federal-funds rate in September, and better-than-even odds of two more cuts by year’s end.

Pimco, the giant West Coast bond manager, says negative U.S. Treasury yields are a possibility, if not a probability. It cites not only cooling growth but also longer lives, which are creating a glut of retirement savings. Bank of America Merrill Lynch sees a risk of the 10-year yield dropping below 1% within a year. The record low is 1.37%, reached in 2016.

Falling rates are stimulus, economists say, but remember: That term can describe both a cup of coffee and a cattle prod. As already-low yields slide closer to zero, the result might be a pickup in mergers and home buying, or a melt-up in risky assets. Bitcoin, too volatile for a currency and too abstract for an investment, but just right for gamblers, has tripled in price since March, to about $12,000.

Back to that 60/40 portfolio. The bonds will do nicely, fulfilling their traditional purpose of protecting against the flakiness of stocks. They could rise in value if yields broadly fall, or they could fail to keep up with inflation, recently 1.7%. But investors can mix in corporate bonds; an index of high-quality corporates recently yielded double the inflation rate.

Stocks, meanwhile, are just the thing for a melt-up, or more likely, a long stretch of so-so growth. Savers who will need to spend their money soon should skimp on stocks, as always. For those with a decade to wait, a 5.7% earnings yield on the S&P 500 index (.SPX), which funds a 2% dividend, is a powerful advantage over Treasurys or even quality corporate bonds—even before considering that companies tend to increase their earnings over time, and that the people who run them can adjust tactics for changes in rates, growth, and more.

Put it together and the response to a world of Ripley’s-worthy extremes can still be as simple as a mix of cheap index funds, whether open-ended, like Schwab Total Stock Market (SWTSX), or exchange-traded, like Vanguard Total Bond (BND).

What about gold and Bitcoin? No harm in dabbling, but don’t think of either as long-term protection against financial collapse. Any thought experiment in which other stores of value fail almost certainly involves a Mad Max world where soft metal and internet money will come in less handy than food, friends, and firearms. We are more optimistic than that.

Strategists at Bank of America highlighted the firm’s favorite “idiosyncratic growth” stocks this past week—companies whose prospects aren’t too tethered to economic shifts. Separately, the strategists noted that stocks with high dividend yields have historically done best in the first six months of an interest-rate-cutting cycle. Here is a closer look at four of the firm’s growth picks, plus four sturdy high-yielders that our own screen turned up.

Amazon.com (AMZN) is like an information-age mutual fund. Or maybe it’s more like an algorithm. The company offers investment exposure to e-commerce, which can continue to gain market share from stores for years, and Amazon Web Services, a cloud business that is still growing like a start-up, with revenue up 37% in the latest quarter. There’s also a streaming service for movies and shows, a fast-growing advertising unit, and a dominant voice-assistant franchise.

What separates Amazon from other tech titans is its knack for methodically trying many new businesses and quickly moving on from failures. Its smartphone, launched five years ago and killed after only a year, is already a distant memory. A less-disciplined company might still be trying to make a go of it. Shares at a glance look worrisomely expensive at 77 times this year’s earnings forecast, but free cash flow is more than double earnings—and expected to more than double from here in three years. The result is a valuation of 15 times the 2022 free cash consensus. Not so scary.

Arista Networks (ANET) sells switches and routers to cloud players, including the biggest tech companies. The stock recently fell back to where it traded in late 2017, even though earnings per share rose 42% last year and the consensus calls for 21% growth this year. The issue is that the company has recently been growing revenue at a mid- to high-teens rate, in keeping with its long-term guidance, but investors had assumed its guidance was conservative. Disappointment comes easy when stocks trade at 33 times forward earnings estimates, but over the past year, Arista has been marked down from that level to a more appealing 24 times earnings. There are packaged-food companies that sell for a similar multiple and don’t have half of Arista’s growth potential.

Equinix (EQIX) is a real estate investment trust, and those typically are bought for income rather than growth. In this case, however, the real estate is a platform of interconnected data centers, where tenants, many of them big companies, pay premium rents to connect directly and safely with their customers, vendors, and cloud and network service providers. The shares trade at 24 times this year’s projected funds from operations and yield 1.8%. Revenue is expected to increase at a steady 10% a year in coming years. Compare that with American Tower (AMT), another communications REIT focused on the wireless industry. It goes for a richer 28 times funds from operations, with slower revenue growth and a lower dividend yield.

Investors don’t care much for one-hit drug companies, unless they were recently no-hit drug companies. Merck (MRK) has a dominant drug for lung cancer called Keytruda, which first broke $1 billion in revenue in 2016 and last year did more than $7 billion. This year, Wall Street is looking for $10.7 billion, which would make Keytruda an estimated 23% of Merck’s total revenue. The long-term potential could be $20 billion a year. There are other things to like about Merck, like a fast-growing vaccines business that includes Gardasil for human papillomavirus, the most common sexually transmitted disease, and a lucrative animal-health unit covering livestock and pets. Shares go for 17 times this year’s projected earnings, with earnings per share growing at a low-double digit pace.

High dividend yields are easy to find, but many come from industries at risk of long-term decline, such as tobacco and department stores. Semiconductors, on the other hand, are in what is sure to be a temporary slump. Broadcom (AVGO) is a chip-company roll-up that has turned to adding software, including through the purchase of mainframe specialist CA Technologies last year, and a deal announced this past week to buy the enterprise side of Symantec (SYMC), a cybersecurity company, for $10.7 billion.

Deal making and dividends can be awkward companions, raising the possibility of cutting one to fund the other. But Broadcom generates more than twice as much free cash as it needs to pay its 3.8% dividend, and has a record of buying steady businesses and cutting overhead to boost profitability.

Our cover story last week discussed why the U.S. has far too many stores, and could go through a decade of elevated store closings. That’s bad news for many chains, but some stand to pick up new business. Goldman Sachs estimates that $7.5 billion in sales have been put up for grabs from closings and bankruptcies this year. It sees department stores and traditional grocers as most vulnerable, and calls Target (TGT) among the best-positioned companies to benefit.

One sign that Target is capitalizing on others’ woes is a more-than-5% jump in same-store sales of apparel in the first quarter of this year, while the overall U.S. apparel industry was roughly flat. Target competes in the same categories as Dressbarn, Gymboree, Sears, Bed Bath & Beyond (BBBY), and many other shrinking competitors. Shares of Target recently went for 14 times forward earnings estimates, a one-third discount to Walmart (WMT).

Verizon Communications (VZ) is growing earnings per share at a low-single digit pace. While 5G cellular service is already trickling out, it won’t contribute meaningfully to growth for a couple of years. Even then, it is unlikely to transform Verizon into a peppy grower. The reason to favor the stock is that wireless price competition appears benign, and the shares are affordable at 12 times this year’s earnings forecast. Plus, the dividend yield of 4.3% is well supported by free cash flow.

Weyerhaeuser (WY) is another real estate investment trust and the largest private owner of timberland in North America, with 12.2 million acres. Lumber prices seesawed during 2017 and 2018, doubling and then halving. This year, rainy weather delayed housing construction in key U.S. markets. One result is that Weyerhaeuser is left with a dividend payment that exceeds its earnings.

But free cash flow is a better gauge of dividend safety for timber REITs, argued Stephens analyst Mark Connelly when he upgraded the stock to Overweight from Equal Weight this past April. He estimates that dividends will take up less than 60% of free cash flow this year, or less than 70% assuming a sharp further downturn in margins and volumes.

That leaves the shares with a 5.4% dividend and perhaps a double tailwind. Falling rates could give home building a lift. They could also send more investors out to the timberlands in a hunt for yield.

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