More Stocks to Watch for Downside Risk

by: Erik Dellith

From the labor figures, to the potential deal to help Italy, to the US credit downgrade by S&P, Friday was packed with information on the global economy. Although the US economy seems to be meandering along, there is reason to be concerned about future growth. Today, I discuss ways to identify stocks to avoid in the event that growth heads south.

Reflecting on the Economy

The number of non-agricultural payrolls from Friday’s Bureau of Labor Statistics (BLS) Employment Situation Summary came in slightly better than I expected, following Wednesday’s ADP report. Further, the BLS revised higher the payroll numbers for May and June. Despite being “good” news, these jobs figures still suggest that the US economy continues to plod along at a slow-growth pace.

Nonetheless, risks to the downside remain. Concerns over a double-dip recession not only exist, but also seem to be grabbing headlines. Simply note the current issue of the US edition of The Economist, or Thursday’s article from Floyd Norris at The New York TimesTime to Say It: Double Dip Recession May Be Happening”. I’m not ready to agree that we’re in a double-dip recession, though I admit that, given conditions in our slow-growth path, discerning the difference is difficult.

This economic weakness, both at home and abroad, has hit the US stock market. The current trend in the domestic economy, including the soft labor and real estate markets, and the on-going troubles in Europe suggest that conditions will not improve substantially anytime soon. That stated, investors probably should get accustomed to the recent rise in volatility in the financial markets.

Mark Hulbert recently wrote an article that also indicates that we should expect further declines in stock prices over coming weeks and, potentially, months. In light of the expectations for further broad-based declines, investors may be interested in gaining exposure to the ETFs that short the market, such as the ProShares UltraShort S&P 500 ETF (NYSEARCA:SDS).

I’m not ready to throw in the towel on all equity securities, as I believe that careful stock picking can still yield winners. Yet, investors should be careful with their exposure to companies that might get hit harder when the market slips.

Why would some stock suffer more? As I indicated in a July 17 article, titled "If Interest Rates Increase: Stocks to Watch for Downside Risk" the reasons vary: Perhaps the valuation is high, or perhaps the company has a lot of debt, or perhaps the stock has historically been more volatile than the overall market. Today, we re-evaluate this screen to highlight such companies.

Adjusting The Screen

Given the issues in the market, the first step in building this screen is to avoid the finance sector. The potential for further loan losses down the road, particularly if economic growth slides, makes me wary of this segment of the market. Other investors might disagree and state that this area could be a gem. Personally, I would prefer to see better signs of growth, especially in the labor and real estate markets, before I jump into this arena.

We continue to focus on high valuation, and look for stocks with P/E ratios, based on trailing twelve month (TTM) earnings, that are at least 50% above the averages for their respective industries. Running this screen on Saturday returns a list of 608 companies.

In the earlier article, we wanted to highlight companies that might get hit harder than others if interest rates rose quickly and substantially, as a result of a significant decline in the US credit rating. Since then, a deal has been reached on the debt ceiling and credit ratings agencies Fitch and Moody’s (NYSE:MCO) have left the nation’s top credit rating untouched. S&P, on the other hand, lowered the nation’s credit rating from AAA for the first time.

Some might quickly adopt a “sky is falling” mentality, but S&P’s move should have been largely anticipated. The company had after all, been warning of such a possibility for months. Moody’s and Fitch have also made cautionary comments, so do not be surprised if they make similar changes down the road. Still, S&P’s downgrade is minor (as far as credit adjustments go), and will likely have little impact on interest rates, as it will not necessitate a change in holdings at mutual funds and other asset managers that are required to hold high-grade paper.

The concern really is weakness in the macroeconomy, not just now, but also for the rest of this year and into next year. For this reason, we are going to change our screen slightly, to include valuations based on expectations for future earnings.

We turn our attention to the PEG ratio, which is calculated as P/E based on expected future earnings, divided by the estimate for the future long-term EPS growth rate. While a value-oriented investor might want to focus on companies with PEG ratios less than 1, we want to highlight companies that are richly priced, so we filter for PEG ratios above 2. This requirement reduces our list to 107 names.

Debt is still a concern, as a manageable debt level could turn burdensome if business conditions deteriorate. For this reason, we filter for companies with a total debt to equity ratio that is 50% greater than the industry norm. Including this specification reduces our list to 18 companies.

Finally, we retain our focus on stocks that are particularly susceptible to market fluctuations. This is especially important as investors react to news of the credit downgrade. While Monday morning may be difficult for equities, it is also important to consider the impact of potential downgrades, both for the US and for other countries, in the future. As such, we want to limit our exposure to stocks that react very aggressively to market gyrations.

Specifically, we look for stocks that have a beta greater than 1.5, as they have been 50% more volatile than the overall market. It is important to remember that beta is based on an historical number; simply because a stock has performed a certain way in the past, does not guarantee that it will be the same in the future. Still, it is the best measure we have, so we use it.

Obviously, these parameters can be adjusted to fit your own personal preferences. On Saturday, the requirements we use here leave us with a list of five names, for further review.

Here is a brief, closer look at these companies:

Energy XXI (Bermuda) Limited (EXXI) is involved in oil and natural gas exploration and production. Over the last six months, its shares have dropped about 15%, relative to the S&P 500 Index decline of about 10%. Nonetheless, the company remains richly valued: Its P/E ratio stands at 150, relative to an industry average of just over 13, according to data from Reuters. In an industry where the average stock, with a beta of 0.8, is less volatile than the overall market, EXXI is exceptionally volatile, with a beta of 2.3. Analysts have been upping their estimates lately. We should have a better idea of business conditions when the company reports earnings on August 10.

The Greenbrier Companies (NYSE:GBX) is involved in the manufacturing of railroad freight car equipment. Over the last six months, GBX shares have lost more than 30% of their value, much more than the decline in the S&P 500 Index. Yet, its P/E ratio, at 257, continues to eclipse the industry norm of 15, according to Reuters. Its industry is more volatile than the overall market, as the average beta is about 1.4. Yet, GBX is more than twice as volatile, with a beta of just about 3. Over the last month, analyst estimates for this year have generally trended lower, though estimates for next year are mixed. The company is slated to announce earnings for this year on September 30.

Parker Drilling Company (NYSE:PKD) provides drilling services, include land and barge rigs, around the world. PKD shares have gyrated wildly over the last six months, but net, are up about 25% relative to a decline in the S&P 500 Index. With a P/E ratio of 113, its shares are priced at a considerable premium relative to its peers, which have an average P/E of 8.7. Stocks in oil and gas drilling industry are more volatile than the overall market. This is seen in the industry average beta of 1.3. Yet, PKD is particularly volatile, with a beta of 2.3. Analysts have not changed their estimates much lately, as the company just reported earnings on August 4.

Pulse Electronics Corp. (NYSE:PULS) in involved in the design and manufacturing of electronic components, including power supplies, converters, and radio frequency magnetic components, as well as ignition and valve coils for the auto market. PULS shares have lost about 25% over the last six months, more than decline in the S&P 500 Index. Yet, its stock remains priced at a premium relative to its industry: PULS has a P/E of 200 versus an average of about 17 for its peers. Further, its volatility also considerably exceeds that of its peers: PULS has a beta of about 3.2, relative to an industry norm of 1.2. There seems to be little analyst coverage for this stock, and, according to data from Reuters, those few analysts have not made any changes to their estimates of late. We should have a clearer picture of business conditions when the company announces earnings on August 9.

United Rentals, Inc. (NYSE:URI) is an equipment rental company, providing products ranging from general construction and industrial equipment such as forklifts and backhoes, to general tools such as pressure washers and water pumps. URI shares have been hit particularly hard lately, losing more than 40% of their value over the last six months, considerably outpacing the losses of the S&P 500 Index. In an industry where the average P/E is 18, URI is particularly richly valued with a P/E of nearly 170. Its beta of 2.4 is especially high, given that the industry, with an average of about 0.8, is less volatile than broader market. Over the last month analysts covering URI have been revising their estimates downward for this year, but are mixed for 2012. The company plans on announcing earnings next on October 17.

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