Credit Crunch: Eight Industrial Stocks to Avoid

by: Alan Brochstein, CFA

For quite some time, pundits have lauded the three-legged stool theory supporting our stock market. In what seems to some like a nanosecond, the subprime mortgage market has put a chainsaw to that thesis. The reality is that subprime lending is only the tip of the iceberg reflecting the more pervasive problems of too much capital and too low of risk-free rates around the world. Investors have, quite simply, taken on way too much risk, which allowed homeowners, companies and nations (yes, nations) to act in dangerous ways. As all of this rapidly unfolds, it is extremely important for investors to work diligently so that they are not left holding the bag.

The three legs of the stool supporting stocks for quite some time have been the strong consumer, the insatiable LBO bid and the inexorable growth in certain Asian (as well as other emerging) countries. I believe that it is safe to say that most recognize that the first two legs are broken, so I will spend a bit more time on that last one. First, though, a picture tells a thousand words:


I could have selected any number of consumer-related stocks that show investors running for the hills, but Jamba (NASDAQ:JMBA) is special. Not only is it a great commentary on the state of the consumer, but it also represents some of the investment follies of recent years. This company was a blind pool acquisition company. When they bought privately held Jamba, the stock became a hedge-fund favorite, with lots of hype. I think that it is quite interesting that same-store sales were negative in the most recent quarter. This may have obviously surprised some (based upon the massive hit the stock took), but the company sells a product that is quite expensive relative to the cost of recreating it at home. It lacks the addictive qualities of the products of the Seattle-based company that many believe was a model for the growth potential. Bottom-line: consumers are rapidly paring back discretionary purchases. Even if you don’t agree with my juicy little example, all you have to do is quickly look at Coach (NYSE:COH) or Best Buy (NYSE:BBY) or even venerable Wal-Mart (NYSE:WMT), which sells a lot of discretionary items as well despite its reputation as a provider of staples. Bottom-line: Consumers are tapped out. The home-equity extraction game is up, there are signs that they are shifting to credit cards (revolving debt up way more than retail spending of late) and the economy is fully employed. In other words, it was as good as it gets, and now it looks like it may be time to pay the piper. If banks (and investors) restrict credit availability to Joe Consumer in an attempt to reign in overall risk in their lending portfolios (which they should), we are headed for a “big R” recession.

The second leg, the LBO bid, is certainly gone. When it would have ended was always a guess, with most, including me, assuming, incorrectly, that it would take a bad deal (there have been lots of those) to force lenders to stop funding any and all deals (and with little covenant protection). No, the credit crunch that began with the tiny sub-prime mortgage sector quickly curtailed the funds available to the deal-makers. The corollary is that all of the cash coming into the market (mostly via debt) is gone. So is the recycling, whereby investors redeploy the proceeds from their tendered shares. So is the speculation (and investment in) regarding which company would be next. The impacts are significant and multitudinous. The bad deals will certainly come back to haunt lenders as well. This tailwind is now a headwind.

The final leg of support for our stocks is the international growth theme. This one has lots of angles. The one that hasn’t been given enough thought in my opinion is that the capital crunch could slow growth in rapidly growing emerging economies (as well as the developed ones). As investors reign in their loose standards, they may think twice about having their money parked in some overseas company. Sure, China and India are great long-term stories, but they have benefited greatly from flows of capital and could slow down in the short-run. Inflation in China is bothersome to local officials, and they are trying to slow their economy. The flight of capital could certainly help that process. It’s deeper though. The developed economies have all been booming (relatively) as have their stock markets. Take a look at those charts, though, as they are rolling over rapidly. A final perspective is that outsourcing and supply base optimization has helped domestic companies greatly. That is one of the reasons why S&P 500 operating margins are at such high levels. It doesn’t help that China seems to have an affinity for toxic exports. The low-hanging fruit has been harvested, leaving outsourcing as much less a driver than it has been. Bottom-line: international trade expansion has been a huge driver for our stock market, and it can’t be taken for granted any longer.

So, if you take a stool and saw off its legs, what is left? A pile of stool! If you don’t want to fall into that pile, you need to be very careful how you invest. Personally, I think that cash (or shorting) continues to look like a great strategy. For those who must be invested or who aren’t quite as worried as I am about the potential for a recession and/or a major pullback in the market, I would at least consider caution in a few areas. I have already addressed Financials. I would be very careful with Industrials. This is an area that has benefited from the LBO boom as well as international expansion. These companies tend to use debt extensively. Here are a few names that stand out to potentially avoid in this “shoot-first, ask later” environment. I used StockVal to identify companies in the sector with the following characteristics: Domestic-based, Debt/Cap > 35%, PE > 20% above 5-year median, Price >50% above 2006 low, Price/Tangible book > 4.

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While focusing on these 8 stocks to double-check the risks makes sense, don’t miss the bigger conclusion: The environment is rapidly changing, and if you own a stock that has benefited from the LBO mania or emerging market growth, you risk a reversal as capital is reallocated globally. Be especially careful if that company has a large debt-burden or grows primarily by debt-financed acquistions.

Disclosure: None