Investment Strategy for a Challenging Market (Part II)

Industrial

While the outlook for U.S. construction equipment is still negative, there are reasons not to be too bearish on the sector: global uptrend in agriculture and mining. My top picks are Deere & Co. (DE) and Bucyrus International (BUCY), which will benefit from global exposure to these late, long-cycle trends.

In a previous article I discussed my positive view on agriculture. DE is the world's largest maker of agricultural equipment. Rising demand and high prices for commodities such as corn and wheat should continue to bode well for tractor sales, as farmers seeks to increase efficiency and enhance crop yields.

Meanwhile, the global commodities boom has prompted mining companies to boost production to meet demand.

My top pick is Bucyrus International (BUCY). The firm specializes in large-scale excavation gear used in surface mining and more recently high-tech systems for underground coal mining.

Joel Tiss, a machinery analyst of Lehman Brothers, sees BUCY’s earnings peaking in 2010. He wrote in a report that "the current mining cycle continues to have legs."

Currently the stock looks attractive as it is trading only at 15 times forward 2009 consensus EPS estimate of $6.00 per share- which can prove to be conservative given BUCY’s margin improvement and capacity expansion opportunities. Pay close attention to the company’s quarterly earnings release on February 14th.

Consumer

Retailers have suffered as consumers cut discretionary spending amid weak housing and credit markets and high food and gas prices. However, a few Wall Street analysts have started to upgrade retail stocks since many are trending below historical trough levels, and they believe that they present attractive longer-term opportunities when consumer spending bounces back. UBS analyst Brian Nagel said some retail stocks might recover early in a recession and upgraded office-supply retailer Staples Inc. and home-furnishings retailer Bed, Bath & Beyond (BBBY) based on that view. "Consider that in the early 1990s recession retail stocks started their recovery more than one year before negative earnings per share adjustments ended," Nagel wrote.

If investors wait for retailers to start beating analysts forecasts again, in other words, they might miss the first stages of an uptick in the retail sector. Instead, investors should be alert for periods when the Federal Reserve cuts rates, because retail stocks do well during times of monetary easing, he said. Overall, I believe that a combination of interest-rate cuts and a fiscal-stimulus package should provide positive bias for retail sector, until consumer data starts to point otherwise. Simple ways to long/short this sector is through the Consumer Discretionary SPDR (XLY) and Consumer Staples SPDR (XLP).

Outlook: Cautious

Business Services

Most media stocks are largely dependent on advertising spending, which diminishes across many categories when the economy is suffering. Therefore, expect to see further pressure on stocks in this sector, such as New York Times (NYT) and Sirius Satellite Radio (SIRI). A warning sign is Google (GOOG) missing analyst estimates in Q4 2007 due to decelerating ad sales.

Despite my overall negative outlook on the services sector, there is one exception. I believe that education is an attractive recession-proof play. My top pick is Apollo Group Inc. (APOL), a company that owns the University of Phoenix and Axia College brand names. With over 310k students, Apollo is the largest private postsecondary school in the U.S. In the first quarter, its earnings jumped 23% due to robust enrollment growth. During a conference call with analysts, Apollo’s President Brian Mueller said working people tend to flock to adult education companies like Apollo when their "wages are not high enough to provide them with a comfortable middle-class lifestyle." Furthermore, in order to be more competitive in the job market, more and more people have decided to pursue online education due to flexibility and affordability.

Outlook: Negative

Disclosure: The author has a long position in BUCY.