Some recent numbers point to a rebound of sorts. Admittedly, I expected the speed bump from bad weather in the Midwest and the impact in the U.S. from the tragedy in Japan to take a bit longer to be resolved. With that in mind, I consider May’s increase in durable goods orders a positive sign, which is supported by the Federal Reserve’s recent report that industrial production, particularly in manufacturing, rebounded a bit last month. Moreover, the recent fall in some commodity prices has ameliorated the impact of the run-up earlier in the year.
Of course, the improvements in some areas do not mean that everything is coming up roses. New home sales remain weak, as does the labor market. Concerns about the situation in Europe have only exacerbated investors fears and contributed to stock market weakness.
Given the global reach of U.S. businesses, one cannot be surprised by the sensitivity of the U.S. equity market to international concerns. Rather unfortunately, it is unlikely that the European situation is going to be fully resolved anytime soon. An attempt to significantly reduce Greece’s debt level through spending cuts and tax increases will likely subdue the country’s GDP growth and hurt its tax receipts over the near to intermediate term. Even if the country receives some type of loan now to help it get through this current funk, Greece may find itself in a similar situation next year. As such, even if the U.S. economy otherwise continues to grow at its muted pace, one cannot help but anticipate that the financial markets will remain manically sensitive to every bit of good or bad news. Not surprisingly, some are calling for a summer crash. (For example, see Michael Gayed’s “The Junk Debt Dilemma and the Summer Crash of 2011” here.)
While this dynamic creates interesting trading opportunities, this type of environment is less than hospitable to longer-term equity investors. Indeed, many have replaced the mantra of “buy-and-hold” with “buy-and-trade” or something of the sort. Against this backdrop, I am more inclined to steer clear of the broader indices, but rather carefully choose specific securities. If a longer-term investor still wanted to play a key index, say the Dow Jones Industrial Average, one good way to do so is to invest in the SPDR Dow Jones Industrial Average ETF (DIA). Still, given the possibility for further weakness, such an investor might want to hedge the downside with a position in ProShares Short Dow 30 ETF (DOG). We can construct a stock screen to help us focus on specific securities.
Given the likelihood of a relatively unfavorable economic environment, we can exclude more cyclically sensitive sectors, like conglomerates. These are large, diversified businesses that have a hand in many different areas, and, as such, can be considered barometers of economic activity. For that very reason, we want to steer clear of them.
The labor market still has a long way to go to make up for all the jobs lost during the last recession. With job creation anemic, it is unlikely that consumer spending is going to skyrocket. More realistically, consumers will probably limp along, on average. As a result, we will also want to omit consumer cyclical stocks.
While the government has demonstrated its support for the big financial institutions, the smaller ones on Main Street USA have not been so fortunate, as 48 banks have failed so far this year. Given the protracted weakness in the housing market and the potential for consumer demand for additional loans to be relatively subdued, we want to stay away from financial stocks, too.
Right off the bat, those are the sectors that we generally would most like to avoid. Now, let’s think about the firms in the remaining sectors, and some of the characteristics we would like to identify.
While much research has been done on the optimal debt level, it might be prudent if we err on the side of caution and focus on companies that have relatively little debt, because of the likelihood of challenging business conditions. To accomplish this, we filter for companies where the debt to equity ratio is less than the industry average. Also, we want to focus on companies that have been reducing their own debt burden, so we require that the debt to equity ratio in the most recent quarter is less than it was in the previous quarter.
Similarly, we want some operating buffer. A slim profit can turn into a large loss when business conditions deteriorate. We would like to focus on companies that have wider profit margins than their competitors, as these companies have more room to work.
While the fundamental considerations of relatively little debt and wider profit margins help to identify companies that stand a better chance of successfully managing adverse business climates, other things equal, we also want to take steps to limit our exposure to the anticipated volatility of the equity markets. We accomplish this in two ways. First, we focus on “cheaper” stocks, as they have less room to fall than their over-priced peers if things go sour and more room to climb if conditions improve. Second, we look at a stock’s volatility relative to the market.
In terms of valuation, we focus on forward P/E ratios. We require that these ratios calculated on both current year EPS and next year EPS are below the industry medians. Also, we want to take into consideration these P/E ratios relative to analyst estimates for earnings growth, so, for this example, we require the PEG ratio to be less than 1.5.
Next, we turn to the stock’s volatility. We write in our screen that the beta of the stock should be less than one. (Beta is a measure of a stock’s volatility relative to that of the market. A measure of one means that the stock moves with the market; measures less than one indicate that the stock moves less than the market. Click here for a brief discussion of beta.) In this example, I hunt for stocks with betas less than 0.8.
As with other statistics, there is some importance in comparing a specific stock with its competitors. By their nature, some industries are generally more volatile than the overall market and have betas greater than one. Industries within the technology sectors are good examples. On the flip side, other sectors may be less responsive to fluctuations in the market and have betas less than one. Examples here can be found in the healthcare and utilities sectors. We want to focus on companies that are less volatile than their peers. To accomplish this, we restrict our search to companies with betas that are less than 90% of the industry average beta.
Running this screen on Saturday afternoon yielded 13 companies, for more-detailed research. Here is the list:
- American Science & Engineering, Inc. (ASEI)
- China Ceramics Co. Ltd. (CCCL)
- Church & Dwight Co., Inc. (CHD)
- China XD Plastics Co. Ltd. (CXDC)
- Dynamics Research Corp. (DRCO)
- DeVry Inc. (DV)
- Edgewater Technology Inc. (EDGW)
- GeoEye Inc. (GEOY)
- Haemonetics Corp. (HAE)
- ICF International, Inc. (ICFI)
- InterDigital, Inc. (IDCC)
- Metropolitan Health Networks, Inc. (MDF)
Rent-A-Center, Inc. (RCII)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.