Seeking Alpha
Long only, contrarian, special situations, value
Profile| Send Message| ()  

I would like to open this article with a theoretical question. Let's say you have owned a business over the past five years. Times have been tough. You have managed to keep revenues within 3% of where they were five years ago, but costs have soared some 35%. So as the owner of this enterprise, what would your focus be on? If you are like most people with business experience and/or common sense, you would concentrate on bringing costs back in line with revenues. Unfortunately, both of those traits are in short supply with our current political leadership. The entire focus so far in trying to resolve the "fiscal cliff" has been on how to raise tax revenues with no thought on how to reduce spending. It is also the reason I believe we are going to go merrily off the fiscal cliff together.

I believe investors are being very complacent here in thinking the fiscal cliff will be resolved in an orderly fashion by the end of the year. I think the incentives for both sides to take negotiations right up to the year-end deadline and probably into 2013 are strong. When this gets factored in by the market, it will trigger a significant equity sell-off.

Let's take a look at two of the main players in this Shakespearean tragedy: Speaker of the House Boehner and President Obama. The speaker seems open to raising tax revenue if it can be achieved by capping, modifying or eliminating deductions and not by raising tax rates. He has been shy on the details of how this would be done, and has not specified an amount he is willing to raise revenue. I think we can assume that this number is at least the $800B that was on the table last year when the "Grand Bargain" fell apart.

Boehner is in a difficult position. He has to give some ground, as his side lost the election even as they retained control of the House. In addition, he is also aware that the other side reneged on spending cuts in both 1986 and 1990 budget agreements when taxes were raised. Any deal that does not include substantial and verifiable cuts in government spending and entitlements would be political suicide for the Republicans at this point. It would be better to go off the fiscal cliff rather than accept any deal that does nothing about our current spending excesses. Yes, he would get blamed by the majority of the population and the media for the resulting recession. However, the cuts and tax revenues triggered by the sequester would substantially close the budget deficit, and it would also cripple the rest of President Obama's second-half agenda. In addition, the mid-terms of 2014 are a long way off, and voters might be more focused on the escalating costs and negative job growth implications of Obamacare by then.

President Obama, on the other hand, is riding high on the back of his re-election. He acts as if he believes the mainstream media's drumbeat that he has won a "mandate," even though he received almost precisely the same percentage of the vote (50.73%) as Bush did in 2004, when little talk of a mandate was being thrown about. His opening gambit ($1.6T in new tax revenue, a minor $400B cut from entitlements, $50B in new stimulus, extension of the $120B payroll tax holiday, another year of enhanced jobless benefits, and control of the debt ceiling from Congress) drew guffaws from the other side, and is going to do nothing to lower temperatures between the two sides in Washington.

That leaves a huge gap between both sides, and also with the Simpson-Bowles' recommendations ($1T in tax revenues, $3T in spending cuts) that needs to get resolved over the next month. I think both sides are going to dig in here, and the market is vulnerable to a 5% to 15% sell-off. In my portfolio, I am being extremely cautious until we get better clarity on the resolution of this issue. I am currently around 65% long, 5% short and 30% in cash. Ordinarily, I would be increasing my short positions right here. However, this is a special situation where any positive sound bite from the politicians could drive the market hundreds of points higher and catch me leaning the wrong way.

What I am doing is making a shopping list of stocks I want to pick up and add to existing positions for that 30% allocation currently sitting in cash. I am particularly focused on high dividend stocks that I believe will become one of the prime areas that will be dumped hard in any sort of market sell-off. Here are three cheap dividend stocks I am looking to add to existing positions should this market pullback occur. Two I have recently covered, so I will just give a quick value synopsis, and the third I will cover more in depth.

Microsoft (MSFT) - $27. I would love to add to my current position if Microsoft trades at a $25 handle. The stock is cheap at just over 8x forward earnings, has over $50 billion in net cash on its balance sheet, and pays a 3.4% dividend. For more on why I am positive on MSFT, click here.

Corning (GLW) - $12. I will add to my position if the stock gets to the $11 a share level. Corning provides a 3% yield, sells at 9x forward earnings and has around $2 a share in net cash on its balance sheet. For more on why I like GLW, click here.

I also like energy MLPs, as the tax treatment of these MLPs looks like it will remain stable compared with the traditional income sectors (Utilities, Pharmaceuticals, etc.) that face dividend tax hikes in 2013. In addition, I think the next couple of years will bring higher inflation, and possibly even some stagflation. This means investors will want some hard assets that throw off significant yield and grow operating cash flow.

One of my favorites in this space is Calumet Specialty Products Partners (CLMT), which refines and sells specialty petroleum products in North America. I have owned it since it was at $25 a share, but it is still a buy at just under $31 currently.

Four reasons to buy CLMT at $31 a share:

  • CLMT yields 8%, and has increased its payouts over 30% over the past four years. The company recently acquired a small refinery in Montana that should increase cash flow and hopefully accelerate distributions in the years ahead.
  • The stock is selling for just over 8 times forward earnings, a discount to its five-year average (11.2).
  • CLMT sports a five-year projected PEG of under 1 (.62), which is unusual for an 8% yielder. It also has a low beta (.53).
  • Insiders have been net buyers of the stock over the past year (about 250K worth in 2012).
Source: Merrily Going Off The Fiscal Cliff Together