This is the first of a multi-part series introducing 3 distinct success strategies I contend are key for 2014 equity investors:
- Understand the current phase of the business cycle and overweight to stock sectors that historically outperform;
- Identify contrarian stock values; "the most hated names of 2013"
- Maintain discipline when evaluating securities; don't chase hot tickets
In this article, we will overview the overarching 2014 investment premise underpinning these strategies. Next, we will walk through the 3 strategies and the reasoning behind them. Finally, I will suggest specific stocks that I believe are aligned with the strategies, and provide a quick recap why I like them.
In subsequent installments of this series, I plan to offer readers a deeper dive into each of these names; completing a ground-up fundamental analysis and ownership thesis for each security.
The 2014 Investment Landscape: Overarching Premises
First and foremost, I believe an investor must consider appropriate foundation premises before settling upon medium-term investment strategies that may capitalize upon them. For purposes of this article, I consider the medium-term to be 12 to 18 months.
Year 2013 saw a 30% increase in equity prices as measured by the S&P 500 total return. This was unusual, and indeed a pleasant development, for those who emphasized long stock investments.
Does the market advance of 2013 portend anything about the upcoming year?
Well, it was reported S&P 500 IQ provides the statistical answer to this question: 14 of the last 17 times the market advanced more than 20% in one year, the following year saw an annual gain of at least 15%. The average gain for all post-20% gain years is 11%. While this guarantees nothing, it does indicate a broad market decline this year is not aligned with historical precedent.
Buttressing this view is the fact that global economies are generally improving. As we begin 2014, the U.S. may be embarking upon a period of more robust growth, as evidenced by the most recent GDP figures. The EU countries appear to be emerging from years of recession. China continues its economic ascent. Even Japan is showing signs of life. Barring a black swan event, it would be difficult to paint a picture that worldwide economies are deteriorating.
Therefore, a foundation premise beneath our investment strategies is as follows:
Overall U.S. equity markets are more likely to advance than decline in 2014, pending a continuation of the economic momentum experienced domestically and by most developed nations as we begin the year.
Now let's develop some strategies sitting atop this premise.
3 Strategies to Capitalize Upon in 2014
Business Cycle Identification and Sector Rotation
I concur with the concept of equity sector rotation based upon the rhythm of a regular economic business cycle. By this I mean that as we progress through phases of the cycle, certain stock sectors tend to outperform others. My view is based upon 50 years of historical evidence.
Make no mistake: stock sector leadership patterns are by no means 100% accurate, partly because each recovery is different. Compounding matters is the fact that determining phase inflection points are often clearer in the rear-view mirror than in real time. Of course, specific stocks selection is also critical. However, none of these reasons are sufficient to discard the power of the strategy.
The general economic business cycle is comprised of 4 phases: Early-cycle, Mid-Cycle, Late-Cycle and Recession.
The American economy entered a deep recession in 2008-09; directly or indirectly dragging down much of the developed world with it. The U.S. emerged from this event in mid-2009, and has slogged through a lumpy, early-cycle recovery phase since that time. Early-cycle recovery tends to favor 4 stock sectors providing performance leadership: Financials, Consumer Discretionary, Technology, and Industrials. This period is also marked by highly accommodative Fed policies.
The mid-cycle phase is marked by clear evidence of economic growth and associated actions by the Fed to prepare the markets for subsequent interest rate increases. Typically, the leadership of interest-rate sensitive stocks tapers a bit, and the cyclical sectors begin to take over. Tech and Industrials continue to outperform, particularly the Industrials. However, leadership in 2 new sectors, namely Materials and Energy, begin to emerge as demand for equipment, machinery and capital goods accelerate. The need for energy and key raw materials likewise ramp up.
So where are we now?
I suggest early 2014 sees us on the cusp between early-cycle and mid-cycle expansion. Therefore, I will start to underweight Financials and Consumer Discretionary stocks, hold certain Industrials and Tech shares, and selectively begin to overweight Materials / Energy names.
I will list specific stocks I like towards the end of this article.
Contrarian Stocks or Value Traps?
After a one-year, 30% increase in equity prices, there are far fewer "bargains" out there than in January 2013. Therefore, another of my 2014 investment strategies includes accumulating shares of particular companies that no one likes. Separating sound contrarian stocks from value traps takes a combination of thorough research, fortitude, and a certain element of good fortune. Indeed, some stocks are cheap for a reason. Others take time to blossom under the weight of near-term overhangs headwinds. Remember, the prospective time frame for success is over a year, not a few months.
It's not too difficult to generate a list of "most hated" stocks. They are trumpeted throughout the media.
Picking through the rubble may be likened to a prospector sifting through yards of rock and sand to find a single gold nugget. These nuggets are oft mixed in with pyrite, or "fools' gold."
I've got 3 contrarian stock picks highlighted later in this article.
Stay Disciplined When Evaluating Securities
As the market rises, market psychology tends to find many investors "chase" stocks. Some had been underweight equities, and too heavy in cash: they try to play "catch up." Others get caught in the euphoria of bull markets, and begin to see a new normal for stock valuation metrics. The prudent investor fights the urge to "chase," and maintains his / her discipline when purchasing stocks throughout the full cycle of bull and bear markets.
The year subsequent to 30% market gains is most certainly a time to remind ourselves of the virtues of sound valuation and associated portfolio management.
There are many ways to evaluate securities. There are no silver bullets. I tend keep the number of stocks in my portfolio limited; and review them routinely and comprehensively. Nevertheless, I emphasize certain key valuation metrics in an attempt to "keep my hat on straight:"
- Price-to-Cash Flow (preferably < 10x)
- 2-year PEG ratio (< 1.5x)
- Return-on-Equity (preferably > 15%)
- Debt-to-Equity (within industry peer parameters)
- Revenue growth (exceeding earnings growth)
- Strong or improving margins
- Management continues to "guide up"
Experienced investors know that the aforementioned are just starting points. It's a way to "sift" stocks as part of an overall evaluation and selection process. Numbers tell a story, but numbers are not THE story. Understanding the business, and management's ability to set objectives and achieve them is paramount to crunching numbers.
Now let's get to the rubber to hit the road.
One Man's Take: Specific Stocks for 2014
Following is a short-list of a few stocks I believe fit the aforementioned outlined strategies. I own all of them for my personal account. In subsequent parts of this series, I will analyze each of them in depth; so that you as the reader may agree or critique my rationale. It may also become a platform for your own detailed review and analysis.
Cycle and Sector Rotation Stocks
INDUSTRIAL SECTOR -- Eaton PLC (ETN) and Union Pacific Corp (UNP): two "best-of-breed" companies, one competing in the global capital goods markets and the other a stalwart of the U.S. transportation industry are clear choices. Both are well-positioned for future growth internationally and domestically. Each leads its peers in margins and cost efficiency. These stocks pay rapidly growing dividends. Eaton is successfully amplifying synergies after its November 2012, $13 billion acquisition of Cooper Industries: the largest in the company's 101-year history. Union Pacific is building upon its position as the railroad titan for the western two-third of the U.S. The corporation's geography and assets leverage its span with proprietary interchanges with Mexico and Asian markets.
MATERIALS SECTOR -- International Paper (IP): the former Dow component is the epitome of a global "smokestack" company, ready to capitalize upon a worldwide economic expansion requiring the manufacture of paper and packaging materials. IP is well underway in its execution of a multi-year plan to re-tool the business. A 2012 buyout of competitor Temple-Inland was an exclamation point in the transformation journey for the company.
ENERGY SECTOR -- Energy Transfer Equity (ETE): My favorite midstream energy company combines a renewed asset base and potentially explosive growth in its service markets. In 2008, Energy Transfer was a sleepy, Texas-centered commodity NGL trading and pipeline company. Today, it's one of the United States' largest domestic midstream / downstream enterprises. Energy Transfer Equity is the MLP General Partner.
TECHNOLOGY SECTOR -- Apple (AAPL): Arguably the best technology manufacturing, distribution and retailing company on the planet, Apple has a globally-recognized brand, legions of loyal customers, high margins, a fortress balance sheet and generates lots of cash. A solid dividend and a strong share repurchase program mark its transition from a rapid-growth company into a mature Tech play. I believe the stock is undervalued by several measures.
Caterpillar (CAT) -- This just may be the most hated stock on the NYSE. Year 2013 marked a period when just about everything that could go wrong did: three missed earnings reports; declines in all business lines, especially heavy mining equipment; and little prospective enthusiasm for 2014. Yet the stock has risen 7% since an abysmal third-quarter earnings release. The stock has experienced lower-than-average volume for months.
Intel (INTC) -- Some commentators contend Intel has not, and will never recover from the dot-com bust days. Oft-maligned for slow entry into the handset device and tablet markets, and an over-dependence upon PC chipsets, Intel changed CEOs in 2013, marking an end of one era and the start of another. The balance sheet is pristine, the dividend yield is greater than most Utility sector stocks, and margins remain high. Even though investor sentiment and valuation remain low, this stock quietly garnered 2013 total returns on par with the S&P 500, thereby making its inclusion as a contrarian play questionable. I believe it's still a good stock for 2014.
Annaly Capital Management (NLY) -- Possibly, this stock is hated as much as Caterpillar. Year-end tax-loss selling exacerbated an already-dismal 2013 stock performance. Investors bailed on Annaly in droves after interest rates spiked in May, then never looked back. Despite trading about 20% below net book value, the general investment community continues to view NLY with unrelenting gloom. Early in 2013, investors fretted that mREIT net interest margins were too low. Later on, many feared that as interest rates rise, the mREIT stock must continue to go down; even as the short-long spread widened thereby increasing the spread. The ability of management to hedge, leverage capital, and diversify into commercial mortgages was discounted.
Good investors marry premises and strategies with careful security analysis and portfolio management. In the first part of this series, we reviewed 3 distinct 2014 strategies: understand the current phase of the business cycle and associated stock sector rotation, seek select contrarian stocks after a huge 2013 run-up in prices, and maintain equity valuation discipline.
In future installments of this series, we will perform a deeper dive into the short-list of specific stocks mentioned that meet these strategies.
Disclaimer: This article is not a recommendation to buy any securities. It is for information purposes only. Please do your own due diligence before making any investment.
Good luck with all your 2014 investments. I look forward to writing you all as the year progresses.