With Election Day now past, the market's attention has turned to the approaching "fiscal cliff". If President Obama and the Congress cannot come to agreement on a combination of tax increases and spending cuts to reduce the deficit, a series of drastic automatic cuts will go into effect in 2013. Both Obama and House Speaker John Boehner (the default leader of the Republicans in Congress) laid out initial positions on Friday, causing additional turmoil in the markets. After opening lower, the market rallied following Boehner's comments, which opened the door to "revenue increases" (though not tax rate increases). The markets then pulled back sharply following President Obama's speech in the afternoon.
I expect more turbulence of this sort as the parties engage in hard bargaining over the deficit reduction plan. The fiscal cliff is just the second coming of last summer's debt ceiling debate, which severely punished U.S. markets (the S&P 500 (NYSEARCA:SPY) dropped nearly 20% in just a few weeks). I do think it is likely that some compromise will come about. After all, the landmark 1986 Tax Reform act was also passed in a period of divided government (the White House and Senate were controlled by Republicans, while the House was controlled by the Democrats: the exact reverse of today's configuration). The Tax Reform Act was also very controversial, but equally necessary for the United States. However, just because a solution to the "fiscal cliff" is necessary does not mean it will be found quickly. I only expect a resolution after a game of "chicken" that will last until the very end of the year.
Even if the political parties do manage to find a compromise, the country will still face a combination of higher taxes and lower government spending in 2013, which will be a substantial drag on economic growth.
One natural reaction for investors could be to exit the market entirely and hold cash until the outlook is more certain. For investors with short time horizons, this might be the best strategy. Alternatively, shorting the market, or particularly vulnerable stocks, could be a worthwhile strategy. On the other hand, as another Seeking Alpha author recently pointed out, the market's valuation on a P/E basis is fairly modest at less than 14X (a roughly 10% discount to the historical average). Thus, a significant drop is far from certain.
Therefore, I think that investors with a longer-term focus should plan to stay long in equities despite the potential for volatility over the next several months. However, from a risk-management perspective it is important to be careful when picking stocks in the current environment. Below, I will lay out three strategies that I am following, which I expect to generate solid returns while mitigating risk. I will also present my top stock pick for each strategy.
1) Buy High-Quality Companies on Weakness: This is perhaps the most obvious strategy for long-term investors. Over a five year period (or longer), stocks will gravitate towards intrinsic value, so market turbulence can lead to good buying opportunities. With high quality companies, there is a very limited risk of bankruptcy even if the economy were to fall back into recession. Moreover, these companies can afford to invest through a dip in order to generate lasting advantages vis-a-vis weaker competitors, who may be forced to cut back during bad times. In short, these are companies that will not disappear and may even be able to improve their competitive positioning during a recession.
My top pick in this category is Apple (NASDAQ:AAPL). At $547, Apple is now trading more than 20% below its all-time high above $700 in September. Apple has over $120 billion in cash and investments on its balance sheet, which gives the company enormous flexibility to plow money into R&D to develop new products, while continuing to drive strong demand for its current product lines (primarily iPhone, iPad, and Mac). While my "buy" call timing was off last month (when I wrote that $610 was a good level to get into Apple), I stand behind my recommendation, and recently increased my position in Apple. Even after a recent round of estimate cuts, analysts still expect Apple to earn more than $50 per share in the next year, and I expect Apple to comfortably beat these estimates. Apple is less sensitive to U.S. economic growth than most companies because 1) much of its profit comes from the iPhone, which is heavily subsidized by carrier partners in the U.S., 2) many customers in the U.S. are well-to-do Apple enthusiasts, who are likely to buy Apple products regardless of the economic environment, and 3) Apple is deriving an increasing proportion of revenue from emerging markets. I expect Apple to rally past its recent highs over the next six months or so, and I still think the stock will test $800 in the April-June timeframe.
2: Buy Companies With High Exposure to Stronger Markets: Geographical diversification is usually a good thing, but unfortunately many multi-national companies are heavily exposed to Europe. If U.S. economic growth (already very mediocre) stalls, these companies will be faced with broad weakness in two critical geographies. However, some companies have good international exposure without a presence in Europe, and these are good investment candidates. While GDP growth in China has slowed to an estimated 7.5% annual rate in 2012, indicators have recently suggested that demand is picking up once again. Moreover, 7.5% growth is phenomenal compared to the rest of the world. Other countries in Asia are also in better shape than the U.S. and Europe. For example, while South Korean growth has been slowing in recent quarters, the government has acted to boost demand through fiscal and monetary policy (whereas the U.S. and Europe are now moving toward deflationary fiscal policies).
My top pick in this area is Hawaiian Holdings (NASDAQ:HA), parent company of Hawaiian Airlines. Two years ago, Hawaiian derived less than 10% of its revenue from international markets, while last quarter, international revenue (primarily from Japan, Australia, and South Korea) was up to nearly one-third of the company total. This is set to grow further as the company began service to Sapporo, Japan last month, and will start service to Brisbane, Australia and Auckland, New Zealand in the next four months. (Importantly, Hawaiian has no exposure to Europe.) Furthermore, the company has identified another 11 potentially viable markets in Asia and Australia for future growth.
If the U.S. market is hit by a slowdown, Hawaiian has the ability to re-shuffle capacity to Asia. Thus, while United Continental (NYSE:UAL) CEO Jeff Smisek is worried that the fiscal cliff will derail his company as businesses cut back on travel spending, Hawaiian has more flexibility to adapt by growing in markets where demand is still relatively strong.
3: Buy Companies Naturally Hedged Against a Weak Economy:
Even companies focused on weak markets can thrive if they offer products that are not sensitive to overall economic growth. People operating on tight budgets may cut back on consumption, or they may simply trade down. Thus, generic brands gained substantial market share during the 2008-2009 recession, and have been able to maintain those gains even as the economy has slowly recovered. Discount retailers have also performed well, whereas stores traditionally catering to the middle class have struggled, for the most part. Identifying companies that present a cheaper alternative to more "traditional" purchases could be a very valuable investing strategy today, particularly if those companies can retain customers when the economy returns to growth.
My top pick in this area is Zipcar (ZIP). Zipcar is the leading provider of "car sharing" services; the company owns cars that are parked in disparate locations in major cities and on college/university campuses, and rents them by the hour. Whereas traditional daily car rental agencies primarily aim to serve customers who already own a car but are traveling, Zipcar markets itself as an alternative to car ownership for students and city-dwellers. For most individuals who only need access to a car on an occasional basis for errands or day-trips, Zipcar is generally much cheaper than owning a car. The company has over 750,000 members and is growing at over 15% per year. In a weak economic environment, an increasing number of people are likely to give up the convenience of owning a car and join Zipcar instead. Zipcar has shown a high monthly retention rate historically (97-98%), so there is a good chance that Zipcar could keep many of these new members even after the economy returns to growth.
Conclusion: The three criteria I touched on here (high-quality companies, companies with high exposure to stronger markets, and companies naturally hedged against economic weakness) can be used both separately and in tandem to drive good investment decisions. For instance, Apple (a high quality company) also has high and growing exposure to China, a stronger market. Hawaiian (a company with high exposure to stronger markets) is also naturally hedged against economic weakness because oil prices (a key input) are likely to fall in a recession scenario, and also because hotel/resort operators in Hawaii typically offer big discounts to fill their rooms when leisure travel is weak, thus lowering the overall cost of a vacation.
While I have identified three companies that I find very attractive at the current stock prices, I encourage investors to do their own research to identify solid, "recession-proof" companies. There are certainly many other opportunities that fit one or more of the three strategies discussed here. Good luck out there, and be careful!
Disclosure: I am long AAPL, HA, ZIP. 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.