Picking Stocks as GDP Forecasts Are Cut

by: Erik Dellith

Earlier this month, I discussed the weakness in the labor market and manufacturing, and how forecasts for US GDP growth would likely be trimmed. On Friday, we saw this happen, as the IMF reduced its forecasts for US growth for 2011 and 2012. Even though some of the headwinds may be abating, it is still important to consider these downside risks and this slowing growth when looking for stocks.

Easing Growth

Words you really don’t want to read: “greater-than-anticipated weakness in U.S. activity and renewed financial volatility from concerns about the depth of fiscal challenges in the euro area periphery pose greater downside risks.” This is how the IMF recently described some of the headwinds to global growth. Conditions do not seem favorable in the US or parts of the euro zone. Unfortunately, even in the better-performing parts of the world, there are issues: “Risks also draw from persistent fiscal and financial sector imbalances in many advanced economies, while signs of overheating are becoming increasingly apparent in many emerging and developing economies.”

Focusing on the US, the IMF has lowered its growth forecast for the US for this year from 2.8% to 2.5%. The IMF research points out what many have already been saying: growth has been hit by higher commodity prices, weather, and the Japan earthquake, which threw-off supply chains. These are all transitory factors, and we’ve already seen signs of amelioration. Commodity prices have since pulled back a bit; the price of oil, for example, is under $93. Further, gains have been made in easing supply-chain bottlenecks in Japan. Of course, even with these improvements, this does not necessarily mean that growth is going to skyrocket and propel hiring. As these kinks get worked out, growth should pick back up. With that in mind, the IMF’s expectation that US GDP growth will be a touch faster in 2012 (2.7%) seems reasonable.

With economic growth in the mid-2% range, it is unlikely that the labor market will experience significant improvement. Based on quarterly GDP figures from the BEA, we see that the economy has grown at an average pace of just about 2.6% since the first quarter of 2010. During that time, the economy has added, on average, approximately 100,000 jobs a month, based on data from the BLS. At that pace, the economy will require about five and a half years to make up for the remaining jobs that were lost during the last recession. This does not include jobs for new entrants into the labor market.

We need to take into consideration the likelihood of this subdued growth when picking stocks.

Security Selection

With economic growth easing, we need to be careful to focus on companies that can continue to grow their business even during tough times. To highlight such companies, we start by building a screen that focuses on companies that have recently posted revenue and earnings growth that is better than average for their respective industries. We focus on sales performance over the last quarter to capture some of the recent slowing.

Regarding earnings, we focus on companies that have grown EPS in the most recent quarter and over the trailing twelve months faster than the industry medians. We want to focus on companies that will likely keep growing, so we also filter for companies where the estimate for next year’s EPS is higher than the estimate for this year’s. Similarly, we also require the long-term earnings growth rate to be faster than the growth rate the companies have posted over the trailing twelve months.

Running this screen on Sunday evening returned a list of 26 companies. This list is still a bit too big for us to handle, so we add some more criteria to narrow it down to a more manageable number.

We can add a valuation metric, to minimize the likelihood that we are left with over-valued stocks. We take into consideration the EPS estimates for this year and next, and require that the forward P/E ratios are less than the industry mean.

This reduces our list to only ten names, which we can then research further to determine if any would make a good addition to our portfolios. Here is the result from Sunday evening:

  • AMCOL International Corp. (NYSE:ACO)
  • Harleysville Group Inc. (NASDAQ:HGIC)
  • Horace Mann Educators Corp. (NYSE:HMN)
  • Zhongpin Inc. (NASDAQ:HOGS)
  • Meadowbrook Insurance Group Inc. (NYSE:MIG)
  • Murphy Oil Corp. (NYSE:MUR)
  • Primoris Services Corp. (NASDAQ:PRIM)
  • Silvercorp Metals Inc. (SVM)
  • Tower Group, Inc. (NASDAQ:TWGP)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.