While Focus Remains On The Eurozone, Fiscal Cliff Beast Lurks In The Shadows

Includes: AJRD, DVA, HSP, OSK, THC
by: Nicholas Puri (PuriCassar)

With weak data being released from countries almost daily, in conjunction with an overall negative backdrop of Euro Zone concern, it is safe to say that the outlook for the world economy is far from positive. With these headline-making statistics and concerns there is still one issue that has stayed relatively silent in comparison but has the potential to fully overshadow any other situations we are witnessing: the US "Fiscal Cliff."

The beast awakens

Investors and economic spectators will, without doubt, have heard mention of the Fiscal Cliff and its disastrous implications, but the focus still does not appear to be priced into the markets and opinion polls show that until recently, the general public has been largely ignorant to this impending situation. However, with specific deadlines looming for a solution to this crisis the markets will soon need to take note and investors must be fully prepared for what is about to unfold, in order to safeguard their investments and even capitalize on this unique opportunity.

Groundhog day for global markets

The Fiscal Cliff in essence is a group of tax changes and spending cuts being made by the US Government, which can cause a combined reduction of around 4% of US GDP. Should this go ahead without compromise and restructuring, the impact will likely cause the US to enter a deep recession; an unsupportable situation especially considering recent PMI data from the US shows a number below 50 and therefore a country in 'contraction' along with other weak indicators such as the current employment situation and consumer sentiment amongst others. The resulting effect on markets will be a deeper decline than experienced during the US Debt Ceiling Crisis of 2011 and the potential for a replication of the disasters witnessed in the recent Financial Crisis.

High government spend targets in the line of fire

Taking into account all effects of this impending Fiscal Cliff, we believe the most disastrous impact will be experienced as a result of the spending cuts and the dividend tax increase. As a result of this, our recent research focus has been shifted to two specific sectors: Defense and Healthcare; both of which make up a large amount of the US budget.

No light at the end of the tunnel for Defense

The defense industry is presenting signs of general weakness in light of upcoming negative impacts such as the potential sequestration in the government budget or any resulting compromise, as well as a reliance on current spending and clear threats of decline owing to the ending of the war in Afghanistan. In general the companies are highly leveraged and the larger companies still commit to large dividend payments. The incestuous nature of the industry means any cuts in US spend is felt throughout the industry leading to many companies being left unable to sustain through these conditions with their current balance sheet structure and company model.

US Health Care window dressed despite underlying issues

The Health Care industry has shown signs of being in even worse shape as a whole. Key metrics in the industry such as uncompensated treatment figures and covered hospital visits shows pressure in the industry in negative areas. Many companies within this industry are reliant not only on the resulting effect of government hand-outs, but also rely on the smooth running of the industry as it stands and run the risk of a strong decline in company operations should there be any sign of downturn or reduced funding.

Target companies

Scenario testing based on historic events as well as Fiscal Cliff models predicting potential outcomes for the US have given clear signals about which companies are at highest risk, combined with fundamental research of the company operations and balance sheets analysis. In terms of defense, highly leveraged and undiversified companies such as Oshkosh (NYSE:OSK) would be ideal candidates for a short trade due to overdependence on the US Government combined with the weak company structure. The same applies for GenCorp (GY) who in addition to their weak structure have also recently taken on more debt to fund more acquisitions such as Rocketdyne; potentially revealing their hand in an attempt to save the company at any cost - a red or black scenario for the future of GenCorp.

In terms of Health Care there are clear candidates again for short selling, which are Tenet Healthcare (NYSE:THC) who have high debt levels and a clear weakness to the Fiscal Cliff due to their running of hospital in states with weak budget management. The balance sheet also looks unhealthy with high debt levels, which combined with metrics such as uncompensated treatment (which is ever increasing) does not look promising. Other companies to watch for short selling are DaVita Inc. (NYSE:DVA) and Hospira Inc. (HSP).

Scenario testing on the above companies through a Fiscal Cliff related scenario model returned reductions in share price of between 20-50%.

Going long for growth during a downturn

For investors who prefer not to short securities, there are still companies who will rebound strongly out of this situation. Investors must be willing to take a short term 'hit' and a period of uncertainty but will return to an increasingly profitable position through the outcome. The companies to focus on are cash-rich entities, preferably those with a history of M&A activity in the markets. Through past analysis of these types of companies, they have shown the tendency to grow strongly in negative situations due to a diversified portfolio and the ability to acquire strong companies at value prices.

Without doubt, it is essential for investors to now begin to plan and reshape portfolios in anticipation of any outcome of US discussions, since we have seen from 2011 and various other scenarios that even the mention of uncertainty can have grave effects on markets and portfolio value. In times of highly fluctuating sentiment, it is essential to plan with a 'better safe than sorry' mind-set.

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.

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