3 Sectors to Play the Coming Rebound

 |  Includes: ABT, BP, CVX, GLD, MSFT, NOK, PBR, TOT
by: Sebastien Buttet

Stocks have been lousy for about a couple of months and for good reasons:

  • Uncertainty about the survival of the Euro and fear of contagion if (when) the sovereign-debt crisis spreads to Ireland and Spain,

  • The Japanese economy slowing down after the earthquake and tsunami,

  • Congress' inability to reach a deal to lift the debt ceiling,

  • Weak economic numbers in particular for the housing and labor markets.

That being said, echoing the Goldman Sachs' call of 1500 for the S&P500 by 2012, I believe that stocks will keep going higher in the second half of the year for two important reasons:

  1. Some shocks that triggered the selling are transitory and thus unlikely to persist. The Japanese earthquake was truly "unforecastable" and the Nippon economy will recover at least in the short-run.The Fed predicts better numbers for the economy for the second half of the year and monetary policy is still very accommodative.

  2. Rational investors make their decisions by looking at the opportunity cost of holding equity. Let's review a few investment alternatives: Yields on Treasuries are meager; yields on taxable high grade corporate bonds are about 4%; the yield on equity (the inverse of the P/E ratio) stands at about 7.5%. Companies have clean balance sheets and top of the line numbers are improving. In other words, equities are cheap compared to other assets and should be bought.(Note: I did not include gold in my asset comparison as few investors own gold as a core holding).

I propose three different sectors for the coming rebound:

  1. Big Pharma: Stocks in this category are large caps with dividend yields of about 4%. Valuations of the stocks have been decimated due to the patent cliff coming in the next few years. We believe that the patent cliff is already priced into the stocks. Our favorite in the space is Abbott Labs (ABT) with a double digit EPS growth rate, a forward P/E of less than 12, and a dividend yield of 3.7%. Abbott reports results for the second quarter on July 7 (Click here for previous research report on Abbott).

  2. Energy (Integrated Oil): With the price of crude shooting up above $90 per barrel, integrated oil stocks have done extremely well. One U.S. stock that trades at a very reasonable value, with a high dividend yield relative to competitors is Chevron (CVX). More adventurous investors can find even better value in international stocks. Our favorites in the space are Total (TOT), Petrobras (PBR), and BP (NYSE:BP). Market prices have come down so much that I believe reasons not to own them are largely priced into the stocks. Of these, my favorite stock is Total with a dividend yield of 5.9% and a P/E of less than 8. For investors familiar with options, we would advise writing a LEAP put. Total closed at $55.88 at the end of Tuesday's trading session. Investors can collect $6.50 by selling a put that expires in January 2013 and with a strike price of $50. This strategy provides downside protection and yields an annual rate of return of about 8% assuming no margin is used (i.e. the put is cash secured).

  3. Old Tech: Microsoft (MSFT) has been a value trap for a decade now. Under the leadership (or lack thereof) of Steve Ballmer, EPS have doubled, but the stock did not go anywhere. Microsoft has missed the internet revolution (either search or display ad) but looks serious about becoming a strong player in the mobile business after it partnered with Nokia (NOK) and bought (overpaid) for Skype last month. Microsoft is trading toward the low-range of its band and if multiples expand just one bit, the stock could easily trade above the $30 range, a 20% plus gain from current valuation.

Disclosure: I am long ABT, PBR, TOT, MSFT.