The turmoil and volatility of the last few months has been maddening even for the seasoned investor. The massive run ups, sell offs and reversals can be an emotional whipsaw. It is in times like these that I find it most helpful to take the long term view. One exercise I like to employ is to pretend I am leaving for a deserted island for five years and have to position my portfolio before my departure. Since I will have no access to any outside information, let alone the ability to change my allocation during my absence, it forces me to think prudently and focus on the long term fundamentals of the overall market as well as attractiveness of the individual equities.
One of the themes I have come back to over and over again in my articles is the good value available in large cap, blue chip stocks that provide good yield and solid dividend growth. I have also produced several articles that have highlighted the high probability that yields on government debt will rise significantly over time due to the size of our debt as well as feckless fiscal and monetary policies. Given these two strongly held positions, I think an easy and profitable long term pair trade is to buy the four S&P stocks with better credit than the U.S. government while shorting a U.S. 10 year treasury. Here is how I would allocate a hypothetical $3mm portfolio.
Automatic Data Processing (ADP)
Automatic Data Processing, Inc. provides business outsourcing solutions. The company operates in three segments: Employer Services, Professional Employer Organization (PEO) Services, and Dealer Services. (Business Description from Yahoo Finance)
Key Valuation Metrics (ADP at $49, $500K allocation in hypothetical portfolio)
- ADP yields 2.9% and has grown its dividend payouts by an average of 11% annually over the past five years.
- In addition to its AAA credit rating, ADP is a low beta (.65) stock due to its stable earnings and revenue streams, and has almost $3 of net cash per share on its books.
- It has beat or met earnings estimates for 12 straight quarters.
Exxon Mobil (XOM) –
Exxon Mobil Corporation engages in the exploration and production of crude oil and natural gas, and manufacture of petroleum products, as well as transportation and sale of crude oil, natural gas, and petroleum products. The company manufactures and markets commodity petrochemicals, including olefins, aromatics, polyethylene and polypropylene plastics, and other specialty products. (Business Description from Yahoo Finance)
Key Valuation Metrics (XOM at $75, $500K allocation in hypothetical portfolio)
- Exxon provides 2.6% dividend yield and boosted dividend payouts by an annual rate of 8% over the last half decade.
- Exxon has a forward P/E of just 8.7 which is a 25% discount to its five year historical valuation.
- XOM is selling at less than 7 times operating cash flow. It should easily be able to use its cash flow to increase dividends and repurchase shares throughout the foreseeable future.
Johnson & Johnson (JNJ)
Johnson & Johnson engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. (Business Description from Yahoo Finance)
Key Valuation Metrics (JNJ at $64, $500K allocation in hypothetical portfolio)
- JNJ has a 3.6% dividend yield and has grown its dividend at a 9% clip over the last five years.
- Johnson & Johnson has met or beat earnings estimates for a dozen straight quarters and has a forward PE of just over 12.
- It is selling at near the bottom of its five year valuation based on P/S, P/E, P/B and P/CF.
Microsoft Corporation develops, licenses, and supports a range of software products and services for various computing devices worldwide. (Business Description from Yahoo Finance)
Key Valuation Metrics (MSFT at $26.50, $500K allocation in hypothetical portfolio)
- Microsoft now yields 3% after a recent 25% boost to its dividend. It has averaged 12% growth in its dividend payouts over the last five years.
- MSFT has a five year projected PEG of just .93 which is a 25% discount to its five year historical average.
- It is selling at the very bottom of its five year valuation based on P/S, P/E, P/B and P/CF.
ProShares UltraShort 20+ Year Treasury (TBT)
The investment seeks daily investment results, before fees and expenses and interest income earned on cash and financial instruments, which correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Bond Index. The fund invests in derivatives that Proshare Advisors believe should have similar daily return characteristics as twice (200%) the inverse of the daily return of the index. (Business Description from Yahoo Finance)
Key Catalysts to higher interest rates (TBT at $2.07 a share, $1mm allocation in hypothetical portfolio)
- With one side of the aisle refusing to consider defense cuts or elimination of tax deductions, and the other denying the need to reform entitlements or the power of public employee unions; any agreement to meaningfully tackle the budget deficit does not look forthcoming anytime soon.
- The policies of the Federal Reserve will eventually ignite inflation at some point in the future, driving up interest rates.
- The ability to attract foreign investors for our rapidly growing debt for around 2% is not a sustainable trend.