Top 4 Stocks Likely To Outperform In The Next Recession

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Includes: DUK, JNJ, MO, VZ
by: Brad Kenagy

Summary

Recent reports from bankers note an increased possibility of recession in 2016.

The main focus of my search was to find companies that are attractively valued and have outperformed during times of great market stress.

Through a four-step process I identified four companies that are likely to outperform during the next recession.

In this article, I will be looking stocks that are likely to outperform during the next recession and are currently trading at attractive valuation. In a recent article by a fellow contributor, he noted bankers had raised their expectations to a 20% chance that a recession would occur in 2016. I also believe that the current bull market has peaked, as I noted in a September article I wrote, conditions that were present in 2000 and 2007, were again present at the end of August of 2015.

While I like the author's picks because they are from the top performers list during the crisis, there are two issues with his list and those issues are diversification and valuation. Of the five selections, three were gas/electric utilities and one was a water utility. To me this is too much concentration in one sector, even if that sector tends to outperform during a recession. The second item I noticed was that many people commenting were noting the valuations of the selections seemed stretched for companies with low growth. I will be using a process that will address these issues by identify stocks from a multiple sectors/industries that are trading at attractive valuations and have outperformed during great market stress.

My Process

To start my search for companies I will be building off recent research I conducted in my article: High Dividend and Low Volatility ETF Outperforms during Corrections. What I found was that over the past two years, the PowerShares S&P 500 High Dividend Low Volatility Portfolio ETF (NYSEARCA:SPHD) provided the best performance during corrections. Therefore, the underlying holdings of SPHD can be a good place to start when looking for individual ideas that can outperform during market corrections. I will be looking at four traditionally defensive sectors [Consumer Staples, Health Care, Telecomm. and Utilities] for stocks with an attractive valuation and that have outperformed during great market stress.

Test #1: Attractive Valuation

For each of the four defensive sectors I mentioned above, I looked at the underlying holdings of SPHD and compared the forward PE for each stock to the average forward PE for the corresponding sector SPDR ETF. I compiled forward PE data for each stock from FinViz, so I would be able to see which stocks were currently trading below the forward PE ratio of each sector ETF. The stocks that are currently trading below the Forward PE for their corresponding sectors are listed in the table below.

Consumer Staples

Forward PE

General Mills, Inc.

(NYSE:GIS)

17.99

Sysco Corporation

(NYSE:SYY)

18.55

Procter & Gamble

(NYSE:PG)

18.72

Philip Morris International

(NYSE:PM)

19.13

Altria Group Inc.

(NYSE:MO)

19.29

Kellogg Company

(NYSE:K)

19.38

Reynolds American Inc.

(NYSE:RAI)

20.15

Kimberly-Clark

(NYSE:KMB)

20.3

Coca-Cola

(NYSE:KO)

20.52

Consumer Staples SPDR ETF

(NYSEARCA:XLP)

20.6

Health Care

Forward PE

Pfizer

(NYSE:PFE)

12.99

Merck

(NYSE:MRK)

13.78

Johnson & Johnson

(NYSE:JNJ)

15.83

Health Care SPDR ETF

(NYSEARCA:XLV)

15.95

Telecom

Forward PE

Century Link

(NYSE:CTL)

10.44

Verizon

(NYSE:VZ)

11.98

AT&T

(NYSE:T)

12.63

Telecom SPDR ETF

(NYSEARCA:XTL)

14.55

Utilities

Forward PE

FirstEnergy

(NYSE:FE)

11.26

Entergy

(NYSE:ETR)

13.8

PPL

(NYSE:PPL)

14.58

Duke Energy

(NYSE:DUK)

15.43

CenterPoint Energy

(NYSE:CNP)

15.69

Ameren

(NYSE:AEE)

15.77

Southern Company

(NYSE:SO)

16.15

Utilities SPDR ETF

(NYSEARCA:XLU)

16.18

Click to enlarge

[Forward PE data for stocks from FinViz, Forward PE data for sector SPDRs from there fund pages]

Test #2: Outperformance

For the second test, I looked at the price performance of each of the above stocks compared to their corresponding sector ETF from the high in the S&P 500 (NYSEARCA:SPY) on October 9th 2007 to closing low on March 9th 2009. Only the stocks that outperformed their sector make it onto my final list for consideration. Out of the 22 stocks that passed my valuation test above, only 9 stocks outperformed their corresponding sector from the peak in the market to the bottom.

*NOTE: For Telecom ETF performance, I had to use the performance of the iShares Telecom ETF (NYSEARCA:IYZ) because the start date of October 9th 2007, was prior to the inception of the XTL.

Consumer Staples

Return

General Mills, Inc.

GIS

-14.85%

Altria Group Inc.

MO

-26.29%

Consumer Staples SPDR ETF

XLP

-30.63%

Health Care

Return

Johnson & Johnson

JNJ

-29.66%

Health Care SPDR ETF

XLV

-39.72%

Telecom

Return

Verizon

VZ

-42.61%

AT&T

T

-48.26%

Century Link

CTL

-48.03%

*iShares Telecom ETF*

IYZ

-60.39%

Utilities

Return

Southern Company

SO

-27.88%

Duke Energy

DUK

-38.87%

First Energy

FE

-44.78%

Utilities SPDR ETF

XLU

-44.93%

Click to enlarge

[Price return data from ThinkorSwim platform]

Test # 3: Dividend Stability

For this test I looked at the dividend history for each of the above nine stocks and eliminated Century Link, and First Energy from further consideration because each has cut their dividend within the last five years.

Test # 4: Growing Underlying Business

For the seven remaining companies I looked to see if net income for each company has increased or decreased over the last five years. Looking at financials on Gurufocus for each company, I found that General Mills, AT&T and Southern Company have had lower net income than five years ago and thus I eliminated them from further consideration. After those companies were eliminated, the four final companies that remained were Altria, Johnson & Johnson, Verizon and Duke Energy.

Dividend Growth Potential

For each of my final four companies I looked at their dividend growth rates over the last five years and applied that to the current dividend to project out five years how much dividend growth potential each company has. As you can see, out of the four companies, Altria and Johnson & Johnson have the highest potential for dividend growth over the next five years.

Altria

Johnson & Johnson

5 Year Historical Dividend-Growth Rate: 8.26%

5 Year Historical Dividend-Growth Rate: 7.01%

Calendar Year

Est. Div/Share

Calendar Year

Est. Div/Share

2016 est.

2.45

2016 est.

3.21

2017 est.

2.65

2017 est.

3.44

2018 est.

2.87

2018 est.

3.68

2019 est.

3.1

2019 est.

3.93

2020 est.

3.36

2020 est.

4.21

2020 Div

3.36

2020 Div

4.21

2020 Quarterly

0.84

2020 Quarterly

1.05

Current Quarterly

0.57

Current Quarterly

0.75

% Dividend Upside

48.68%

% Dividend Upside

40.30%

Verizon

Duke Energy

5 Year Historical Dividend-Growth Rate: 3.05%

5 Year Historical Dividend-Growth Rate: 2.20%

Calendar Year

Est. Div/Share

Calendar Year

Est. Div/Share

2016 est.

2.33

2016 est.

3.37

2017 est.

2.4

2017 est.

3.45

2018 est.

2.47

2018 est.

3.52

2019 est.

2.55

2019 est.

3.6

2020 est.

2.63

2020 est.

3.68

2020 Div

2.63

2020 Div

3.68

2020 Quarterly

0.66

2020 Quarterly

0.92

Current Quarterly

0.57

Current Quarterly

0.83

% Dividend Upside

16.22%

% Dividend Upside

11.49%

Click to enlarge

[Table data based on data from Dividendchannel]

Dividend Yield

An additional benefit of using SPHD as my starting point of my search is that the companies within the ETF have an above average dividend yield. As you can see below, the average yield on my final four companies is 4.01%, which is twice the current 2% yield on the 10-year treasury, and nearly twice the 2.21% yield on the S&P 500.

Dividend Yield

Altria

3.83%

Johnson & Johnson

2.97%

Verizon

4.68%

Duke Energy

4.57%

Average

4.01%

Click to enlarge

Altria

Altria is a solid choice for a stock that can outperform during a recession because its products and brands, which include Marlboro and Copenhagen are well known and are still purchased during a recession. As the following table shows, Altria was able to grow revenues during the great recession and I see no reason why if another recession occurred that Altria would not be able to continue growing revenues. In addition, over the next year, Altria has a potential catalyst of the proposed Anheuser-Busch/SABMiller merger. Altria owns 27% of SABMiller, and as they noted in a press release in November, "at closing, Altria expects to receive an approximately 10.5% stake in the new, combined company and approximately $2.5 billion in cash." If the deal is approved Altria has a large stake in a stable business and will have additional cash available to return to their shareholders. In the third quarter earnings release, Altria noted that they initiated a $1 billion share buyback program that they expected to complete by the end of 2016. With the potential for an addition of $2.5 billion in cash to the balance sheet, Altria could see larger scale share repurchases after the deal is completed.

MO Revenues

2008

2009

2010

15957

16824

16892

Click to enlarge

[Table data from Gurufocus]

Johnson & Johnson

Johnson & Johnson is a solid choice for a stock that can outperform during a recession because it is one of only three companies that has the coveted AAA rating. In addition, with 53 years in a row of dividend increases, an investor can be almost 100% certain that no matter what the market environment is like Johnson & Johnson will be increasing their dividend. When its great credit rating and dividend growth history is combined with its underlying businesses and widely recognized brands, Johnson & Johnson can withstand most market stresses better than the majority of companies out there. As you can see, the following chart from the most recentearnings report shows that Johnson & Johnson has a diversified set of businesses, led by its pharmaceuticals and medical devices segments with the consumer segment coming in third. With the pharmaceuticals segment being the largest, it is important to look at potential drug approvals in 2016. As you can see in the second chart below, Johnson & Johnson has a number of potential approvals in 2016.

[Chart from JNJ earnings report referenced above]

[Chart from JNJ earnings report referenced above]

Verizon

Verizon is a solid choice for a stock that can outperform during a recession because the company is domestically oriented and that means there is no currency risk like there is with companies that have international sales. In addition, Verizon had been making dividend payments to Vodafone (NASDAQ:VOD) for its 45% stake in Verizon Wireless, which was a drain on cash flows. Now that Verizon owns 100% of Verizon Wireless, they do not have those dividend payments and thus have more control over their business if a recession were to occur. Going forward, Verizon is sitting in the sweet spot of the trend to mobile, with the largest and best network Verizon is able to provide customers with a quality experience when using a smartphone. As the following chart from a recent earnings presentation shows, growth in 4G LTE smartphones has grown steadily over the last five quarters. In the event of a recession, customers will cut services like cable TV, internet, etc before they cut their smartphone. With technology that is available now unlike the last recession, customers can watch TV or stream pretty much anything they want as well as do pretty much anything else on their smartphone, which makes it the last item that a consumer would cut from their budget during a recession in my opinion.

[VZ 4Q 2015 earnings report]

Duke Energy

Duke Energy is a solid choice for a stock that can outperform during a recession because of its scale as the largest utility in the United States and of its impressive record of 89 consecutive years of paying a quarterly dividend. With a large portion of its business coming from the regulated utilities segment [chart below], Duke Energy is a stable company during any environment. Going forward, Duke Energy is looking to expand its renewable portfolio, expand its use of natural plants and with its recent proposed acquisition of Piedmont Natural Gas (NYSE:PNY), expand its presence in natural gas distribution. In addition, Duke is in the process of moving away from coal, in a recent settlement, they announced that they would stop burning coal at the plant within seven years and in May 2015, Duke announced that they would be retiring its coal plant in Asheville N.C. and replace it with a new natural gas plant. In the press release, the company noted "the new 650 MW plant will allow it to capitalize on low natural gas prices, cut its carbon dioxide emissions by ~60%, and be ~35% cheaper to operate than the 376 MW coal plant, based on current natural gas prices." This shows that by building the natural gas plant Duke will be able to enhance its profits and improve their carbon footprint.

[Duke Energy investor presentation]

Closing Thoughts

The four companies I presented represent diverse options to consider, if the bankers mentioned in the first paragraph are correct and a potential recession is around the corner. I believe provides through my process I have identified four quality stocks that are currently trading at an attractive valuation and I believe will outperform during the next recession.

Disclaimer: See here.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.