Non-Cyclical Stocks: Investment Opportunities as Downside Risk Looms

Includes: ADM, CPB, GIS, SPU
by: Erik Dellith

What a difference a couple of months can make. Back in June, the IMF reduced its estimate for 2011 US GDP, to 2.5% from its April estimate of 2.8%. This move was understandable, as a string of unfortunate events, including the devastation in Japan, worked to disrupt the US economic recovery.

Similarly, it seems that the Federal Reserve’s July Beige Book report of economic conditions, more so than the previous report, provided the latest evidence that economic activity in the second quarter would be soft, suggesting that we should re-think our expectations for the year. Yet, I was still surprised with the GDP figure on Friday morning.

The BEA’s GDP report shows that the economy is still growing at an anemic pace, but that pace is more anemic than previously thought. Sure, the US economy expanded at a seasonally adjusted annual rate (SAAR) of 1.3% in the second quarter, but it is important to recognize two key factors.

The first of these is that this pace is lower than expected, which is bad enough by itself, but this leads us to the second factor that growth for the previous few quarters had been revised down.

The first quarter is now reported as 0.4% versus the earlier estimate of 1.9%, and the fourth quarter of last year now stands at 2.3% versus 3.1%. Not only is growth slower than many expected, but it is slower coming off of a lower base.

Weakened Consumer

Consumer spending accounts for roughly 70% of US GDP, so the recent slowdown is particularly disheartening. At the end of last year, consumer spending climbed at a SAAR of 3.6% (down from the previous estimate of 4%). This pace slowed to 2.1% in the first quarter of this year (also revised lower, from a previous estimate of 2.7%), and then basically came to a stand-still, edging ahead only 0.1% in the second quarter.

These significant downward revisions and the collapse of consumer spending in recent months point to a more difficult road ahead, particularly considering the protracted weakness in the labor market. Initial jobless claims may have dipped recently below the pivotal 400,000 benchmark (click here to read Doug Short’s recent article). But the pace of job addition has yet to ramp up. (Click here to read my article on stocks and the labor market).

I had been relatively hopeful that, even with the slow rate of hiring, the US would avoid another recession, as long as the American consumer kept going (or, at least, as long as those with jobs would keep spending). The downward revision in consumer activity, and the recent collapse in spending, increases the risk of another recession. Of course, some of the factors that contributed to the slowdown in consumer activity (weather, for instance) have since abated. However, other factors have risen in their place, not the least of these is the uncertainty surrounding the debate of the debt ceiling.

Indeed, the wild card in all this is the political mess of the US debt ceiling. Realistically, I fully anticipate that near-term US debt obligations will be met. The larger issue, though, is the credit rating and the adoption of a workable plan to reduce the national debt. There is concern that the ratings agencies will cut the credit rating of the US, which will undoubtedly raise interest rates and lead to larger interest payments and put more pressure on the federal budget.

There is also the recent announcement from Moody’s:

On July 28, 2011, Moody’s placed the ratings of 177 U.S. municipal issuers that are indirectly linked to the U.S. Government on review for possible downgrade.

Although Moody’s has backpedaled somewhat on its earlier threat to lower the US credit rating, risks remain. The overall US economy would likely withstand (for the most part) a modest credit downgrade, if that’s all there was. But the ripple effects of a federal downgrade could prove problematic, striking these municipalities and putting them under more pressure to cut spending (fire employees and cancel contracts with local businesses) and potentially raise taxes.

Clearly, such dynamics would hurt regional economies, and if enough regional economies are hurt, then the national economy takes a hit. Hence, a downgrade in US debt could lead to further declines in economic activity and a bleaker jobs picture.

Examining Non-Cyclicals

The US economy will likely continue to limp along through the rest of this year and into 2012, yet risks to the downside loom. This gave me reason to look for stocks that might depend less on general economic trends. That said, we begin with a look at the more than 275 companies in the non-cyclical sector.

Given the recent weakness in the equity markets, and the potential for further broad-market losses, we want stocks that should be less sensitive to these fluctuations. To accomplish this, we developed a stock screen that begins with a requirement that a stock’s beta, a measure of its sensitivity to market fluctuations, is low. Since the non-cyclical sector, by its definition, is not supposed to be very reliant on national economic trends, many of the industries in this sector have average betas that are less than one. Food processing, non-alcoholic beverages, tobacco, personal and household products are examples of such industries, and this is where we focus. (Alcoholic beverages and crops have betas that are equal to or higher than the market’s volatility, and thus have betas of 1.0 or higher.)

We want to focus deeper on less sensitive stocks, so we also require that a stock’s beta must be less than 80% of its industry norm. Executing these simple requirements on Saturday reduces our list to 31 names.

We also want companies that are deep in value territory. The screen’s next requirement, then, is that a stock’s P/E ratio must be less than 80% of the industry average. This slashes our list to 14 names.

Continuing with a focus on value, we turn our attention to the stock’s price tag based on expected earnings. Specifically, we want forward P/E ratios that are less than the industry median. On Saturday, this screen reduces our list to four companies, for further review.

Below is a brief closer look at these companies. Remember, this is only a starting point to help us identify potential positions; more thorough research is required to determine if any of these companies have the characteristics that would nicely fit your portfolio.

  • Since its beginnings in 1902 as a linseed crushing business, Archer Daniels Midland Company (NYSE:ADM) has grown into a food processing giant. Over the last three months, ADM shares have substantially lagged the S&P 500 Index. Not surprisingly, given the recent share-price weakness, ADM has a P/E of 9.4, relative to an industry average of 39, according to data from Reuters. But, it is important to keep in mind that the company has been growing sales faster than its peers: 17.6% over the trailing twelve months (TTM), versus an industry average of 9.4%. Nonetheless, analysts have been paring back their estimates. We should have a clearer picture of business conditions when ADM reports earnings on August 2.
  • Soup and sauce giant Campbell Soup Company (NYSE:CPB) has edged ahead of the S&P 500 Index over the last three months. Nonetheless, with a P/E ratio of 13.6, it remains considerably cheaper than its peers, which have an average P/E of 39, according to Reuters. TTM revenue has slipped nearly one percent, significantly lagging the industry’s average growth rate of 9.4%. Over the last month, analysts have, on average, lowered their estimates for next year’s earnings. Watch to see how expectations change after the company releases earnings on September 2.
  • General Mills, Inc. (NYSE:GIS) is a key player in the global manufacturing and marketing of consumer foods. Net, GIS shares have barely outperformed the S&P 500 Index over the last three months, losing about 3% relative to the broader market’s loss of about 5%. With a P/E of 13.8, GIS stock is priced at a bargain relative to its industry average of 39, based on Reuters data. TTM revenue growth, at 1.7%, seems to have barely budged when compared with the industry’s average gain of 9.4%. Meanwhile, analysts have been, on average, busy trimming back their estimates for next year’s earnings. We should have more information about what to expect next year, when the company announces earnings on September 21.
  • China-based SkyPeople Fruit Juice, Inc. (NASDAQ:SPU) focuses on fruit juice concentrate and fruit beverages, which it sells to whole sellers, supermarkets, hotels, etc., though it also sells to the end user. Shares were slammed in May, and although they have trended slightly higher since then, they are still down about 20% over the last three months, considerably more than the S&P 500 Index’s slip of about 5%. Its P/E is 2.7, well below its industry average of 39, according to Reuters. Its TTM revenue growth rate is 35, much faster than the industry reading of 9.4. According to Reuters data, only one analyst tracks this company and that analyst has not many any earnings revisions over the last month. The company is scheduled to announce earnings on August 15.

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