Seeking Alpha
Long/short equity, value, growth at reasonable price, income
Profile| Send Message|
( followers)  

By Mark Bern, CPA CFA

For those who are reading this article I probably don't need to explain why I chose to put "capital preservation" in the title, but I will just the same to justify the term in today's marketplace. While the U.S. economy seems to be chugging along, albeit at a relatively slow pace for a recovery, there is one very real potential black swan circling the global economy: Eurozone sovereign debt. Greece is running out of time to come to terms with its creditors before it must refinance 14.5 billion euros of debt coming due in March. Creditors offered to lengthen bond terms to 30-year terms at 4% but eurozone ministers turned it down. Greece countered with a request of 3.5% interest, which would result in larger losses for creditors. I can't say for certain but I did read that this could result in a 65% write down by creditors. If creditors say no, it could mean a hard default for Greece and a major blow to the eurozone financial system. But what does that mean to investors here in the U.S.?

First, if Greek defaults it will increase the perceived risk that other countries could end up in default such as Spain, Portugal, Ireland and Italy. Ireland would probably get some aid from the UK and Portugal, while larger than Greece, could probably be handled, but if either Italy or Spain were to tumble the game could be over. U.S. banks hold eurozone sovereign debt but claim that the net exposure is close to zero because of the credit default swap (a form of insurance) agreements the banks have entered into. The problem is that the banks bought the "insurance" from European banks and those banks across the pond are in far worse condition than American banks. If the sellers of the insurance become insolvent, the "insurance" becomes worthless and the U.S. banks are left holding the proverbial bag. I've seen several estimates of the potential exposure to the five largest U.S. banks but it appears fairly certain that it is at least $200 billion and probably more like $400 billion. With the insurers unable to meet obligations our major banks could have to write down as much as 50% of that amount, if not more. An average loss of $40 billion might be a problem, but I'm sure a loss of $80 apiece would create major financial problems in the U.S. financial system.

I don't expect the world to end. I actually expect that the creditors will come to terms with Greece, but probably not until the last minute. That seems to be the way of politics, doesn't it? I also don't expect that leaders of the eurozone will find a way to completely cure the problem, but I do expect them to find a way to delay it for at least another year or two. The governments will bail out the banks somehow and the banks will forgive some of the debt of the weaker sovereigns. Germany will find a way to spread the pain so that its citizens don't have to shoulder the entire burden. The worst financial crisis in history will essentially be made bigger but postponed until some time in the future. When governments purchase shares in a bank it won't count as an expense because the shares will be an asset carried book value until sold. The governments learned that one from the banks and their treatment underperforming real estate loans. The declaration will read something like, "Eurozone Sovereign Debt Issued Put to Bed, No Need to Panic, All is Well!" That may be a little too melodramatic but you get the idea.

There are other authors such as James Kostohryz in his recent article, "2012 Europe Outlook: How the Fiasco will Unfold" who will say there is no putting the crisis off much further. They could be right, but I'm not so sure but that politicians won't find a way to forestall the inevitable a little longer than those authors expect. On the other hand, the problem is real and it could affect us all; therefore the reason for preservation.

So, how do I define preservation? This time around I don't define it as Treasury bonds because while treasuries are likely to jump in a crisis due to the usual flight to safety, the party won't last long as investors realize that the U.S. is on the same path currently that Europe has taken. Once the worst is over in Europe, if there is a crisis, excess debt will be purged from the European economies and suddenly the euro (or whatever takes its place) will start to look good on a relative basis compared with the U.S. dollar. Plus, as the U.S. banks are forced to the brink, will our government let them fall or print more currency to bail them out? If the government does the latter, even in some form of disguised manner, the truth will eventually come out and the dollar will likely plummet. The dollar is only good as long as the euro, yen, Swiss franc, etc. are bad. Currency valuations are all relative to one another. As one strengthens another must fall.

So, the black swan is circling but it may not land for quite a while. Some of us conservative types are looking for preservation. If it's not Treasuries, what is it? There are a couple of different answers. Some say that it is definitely not equities, but I would have to argue that carefully chosen equities should be part of the equation. So, one answer is carefully chosen equities. The other answer is to diversify holdings out of U.S. dollar denominated assets. Another is to hold more hard assets such as precious metals. None of the answers above is correct by itself.

We may be looking at inflation in our future, in which commodities and equities would perform best. We may be looking at deflation coming, in which case it is better to be in currencies that are stronger relative to other currencies. Or we could end up continuing along our current path, but with rising inflation and no growth due to the lack of demand. Having lots of currency in circulation but no velocity could result in stagflation. In the latter case, owning equities in companies that have a well-diversified geographical operational foot print and non-discretionary products and services along with some precious metals and sovereign debt issued by emerging market nations that have little or no debt may be the best combination. Actually, that last combination may be best because we don't know which way this whole thing is going to turn out.

I'm sorry for the long justification and introduction, but I felt it necessary to state my case for what I am about to propose. In the remainder of Part I of this series I will define the types of equities that I believe will provide a high degree of capital preservation with relatively steady income. Then I will provide the first four equities I like for this portfolio out of a total of 16 that will be offered throughout the series. Investors could own all 16 equities or as few as eight equities as long as the companies are in different industries. I will specify the proper industry designation for each company.

In subsequent articles we will discuss a couple of ways to own sovereign debt denominated in currencies that are likely to hold their value better than the U.S. dollar. I will also submit the next four equities to choose from for the portfolio. I will discuss why I believe investors should consider investing at least a small portion of the portfolio in hard assets as an inflation hedge. I will also submit the third set of four equities to choose from for the portfolio. I will also include the final four equity offerings along with a conclusion and maybe more detailed answers that arise in the comment sections of the previous articles.

My first equity offering is Procter & Gamble (NYSE:PG). I like leaders and companies in dominant positions within their industries. I like companies with sustainable business models. I like companies that are strong enough to not only survive during economic downturns, but strong enough to acquire competitors and complimentary brands to increase market share during difficult times. P&G meets all of those qualifications, in my opinion. The company offers consumer staple products, things we use every day and consume regularly. Many of the products PG produces and distributes are considered necessities that we can't live without; toilet paper comes to mind, as do toothpaste, soap, detergent, cosmetics, batteries, shaving items, etc. The company has more than 250 brands sold in over 180 countries around the globe. And the company is extremely well managed. The stock dropped less than the overall market did during the crash of 2008-2009. And, for me, the real proof in the pudding is that the earnings barely skipped a beat while the economy all around seemingly tumbled into the depths of near-depression. The company has also increased its dividend in every year for 55 consecutive years. With a payout ratio of 49%, over $3.5 billion in cash and a long-term debt-to-capital ratio of 25% the company has adequate flexibility to continue to expand operations, promote its brands and increase the dividend.

Year

2006

2007

2008

2009

2010

2011

EPS

$2.64

$3.04

$3.64

$3.58

$3.53

$3.93

Div. / Share

$1.15

$1.28

$1.45

$1.64

$1.80

$1.97

EPS = Earnings-per-share; Div. / Share = Dividend per share.

My second equity offering is Johnson & Johnson (NYSE:JNJ), which is the world's largest and most diversified healthcare company. The company pays a dividend yielding 3.5% annually and has increased its dividend for 49 consecutive years. Healthcare was one of the brightest spots during the last recession as even employment in the industry rose throughout almost the entire recession. JNJ reported earnings per share that improved every year during the recession. In fact EPS increased every year thought the last recession of 2001-2002 also. This company just keeps churning out new record earnings every year. My point about earnings is simple; as long as earnings continue to increase, share price will inevitably follow, even in the event of a temporary sell-off. JNJ stock sold off far less than the overall market did in 2008-09. This is one of those stocks that you can buy, lock it in the safe and forget about.

Year

2006

2007

2008

2009

2010

2011

EPS

$3.76

$4.15

$4.57

$4.63

$4.76

$5.00

Div. / Share

$1.46

$1.62

$1.80

$1.93

$2.11

$2.25

My third equity offering is Wal-Mart (NYSE:WMT), the largest retailer in the world. When the economy slows and people lose their jobs more often than not Wal-Mart ends up with new customers. As the economy slogs along at a mediocre pace of recovery, employment remains an issue in many households. The longer the economic growth remains too slow to add sufficient jobs to bring down unemployment to normal levels the more likely many people will remain loyal Wal-Mart customers. Overseas sales growth has been exceptional for the company (15.3% in the latest quarter) even as domestic growth has slowed. Again, EPS have risen in every year right through the last two recessions and dividends have increased for 39 consecutive years. The yield is currently 2.4% but I expect increases to average in the low double digits for the foreseeable future. The payout ratio is only 30% and likely to grow slowly over the next few years by about 1% per year if management continues apace.

Year

2005

2006

2007

2008

2009

2010

EPS

$2.63

$2.92

$3.16

$3.42

$3.66

$4.07

Div. / Share

$0.58

$0.65

$0.83

$0.83

$1.06

$1.21

My fourth equity offering is El Paso Pipeline LP (NYSE:EPB). Don't confuse this with El Paso Corporation. This is a pure pipeline play and that is what I'm looking for in this instance. Why do I like a pure pipeline play? I like the purity of a pipeline company at this juncture in time for two reasons. The first is because demand has been low for natural gas as the economy continues to struggle to recover. That means that demand is more likely to go up from here than down, especially over the long term since the use of natural gas is likely going to increase because of the low cost relative to other fossil fuels. The second reason is that revenue of the pipeline company is not dependent on the commodity price, but rather the quantity of the commodity that runs through it. The more gas that gets pumped through its pipelines, the higher the revenue for EPB. The company has been in business in its current form since just 2007. Compared with its peers, EPB has fared much better in terms of growth during the recessionary period from which the country recently emerged. EPS have increased every year since inception as have dividends. That can't be said about any of its competitors. Only three other pipeline MLPs weathered the recession with only small earnings setbacks: Williams Partners (NYSE:WPZ), Plains All American (NYSE:PAA) and Enterprise Products (NYSE:EPD). But I like the future growth prospects of El Paso Pipeline better as I expect the company to growth both earnings and dividends at rates nearly 50% faster than the other three. Even mighty Kinder Morgan (NYSE:KMP) could not maintain earnings per share during this last recession. Owners of EPB would have fared better as the shares now stand 50% higher than 2007 highs and the future holds more of the same.

Year

2007

2008

2009

2010

2011

EPS

$0.13

$1.22

$1.64

$1.9

$2.15*

Div. / Share

-

R1.01

$1.34

$1.55

$1.87

*Estimated

I hope you'll stick around for the rest of the series. I plan to remain very conservative in my picks and explain my reasoning for each one. Thanks for reading!

>> Click to view Part 2

Source: Building A Capital Preservation And Income Portfolio, Part 1