S&P (NYSEARCA:SPY) posted a new all-time high yesterday. As the ongoing bull market has become the second-longest in history and stock valuations have become stretched, it has become increasingly hard to identify bargains. Moreover, after an 8-year bull run, many investors are afraid that the next bear market may be just around the corner. Therefore, in this article, I will recommend two holdings for those who are afraid of an imminent bear market.
Dividend aristocrats typically outperform the market during bear markets. Therefore, most investors resort to this category of stocks when they are afraid of an upcoming market sell-off. However, thanks to the almost record-low interest rates, most dividend aristocrats have become pronouncedly overvalued, as their dividends are considered an attractive alternative to the prevailing record-low yields. Given that most dividend aristocrats, such as Coca-Cola (NYSE:KO) and Procter & Gamble (NYSE:PG), have stopped growing at a meaningful pace, their overvaluation results in significant downside risk in the event of a bear market. More specifically, these stocks are likely to incur compression of their P/E ratios from 23-25 to 16-18 in such a scenario. Therefore, they are not the ideal holdings for a scenario of a bear market, at least in my opinion.
Colgate-Palmolive (NYSE:CL) is my first recommendation for an attractive profit under the prevailing market conditions. More specifically, the CEO of the company recently announced that he would be willing to receive a takeover proposal from another company. Kraft Heinz (NASDAQ:KHC) is a potential acquirer, as it recently attempted to acquire Unilever (NYSE:UL), albeit without success. Colgate-Palmolive is very similar to Unilever, as both companies are solid consumer staples, with remarkable growth records thanks to their products, which are perceived as of premium quality by consumers.
While Colgate-Palmolive has an admirable historical record, it has somewhat reached a saturation point and hence it is now growing at mid-single digits. Therefore, it is only natural that its management favors a takeover proposal. Moreover, the CEO of Kraft Heinz has repeatedly emphasized that the company is looking for a major acquisition while both companies have refused to comment on the rumors of their merger. All in all, a merger between the two companies has good chances of materializing.
As the stock of Colgate-Palmolive currently enjoys a takeover premium and is somewhat overvalued, I do not recommend purchasing its shares. Instead I have sold the put options that expire in January and have a strike price of $70. These put options can be sold for about $3.0 and hence they can provide a 4.5% profit (=3/67) within the next 7 months for an annualized return of 7.7%. While this return may seem lackluster to some investors, it is actually a great return given the current stock valuations and the very low risk of the trade.
If Colgate-Palmolive is acquired, the above profit is guaranteed. If the company is not acquired but its takeover prospects remain alive in the next 7 months, the stock is likely to continue to carry its takeover premium and hence the trade will be profitable in that case as well. The only adverse scenario for the stock is the case in which Kraft Heinz acquires another company. In such a scenario, Colgate-Palmolive is likely to deflate due to the loss of its takeover premium. However, even in that case, the essential entry point of the trade is approximately $67, which is 13% below the current stock price. As this stock is characterized by remarkably low volatility, it rarely loses more than 13% within half a year. Therefore, even in the adverse scenario, the above trade is likely to prove profitable. In any case, it will be equivalent to buying the shares at a 13% discount to their current price, which is not a bad deal for such a stalwart.
Bonds of Yum Brands
S&P has historically returned 8.6% per year since 1960. However, as it has rallied for 8 years and is currently at its all-time high, it is only reasonable to expect that its return from its current level will be significantly lower than 8.6%. Even worse, there is significant downside risk due to its overvalued status, at least for the next few years. Therefore, the risk/reward profile of S&P does not seem attractive at the moment.
On the other hand, I am highly attracted by the risk/reward profile of the 20-year bonds of Yum Brands (NYSE:YUM). I have bought these 6.875% bonds slightly below parity and hence I receive an approximate 7% annual return from these bonds. As these bonds have appreciated to about 106, they currently offer an approximate 6.4% annual yield to maturity. This return is likely to be better than the future return of S&P from its current level.
Even better, these bonds are almost risk-free, given the business strength of the company and its enviable growth trajectory. The only reason that these bonds offer such a high yield is the fact that the management has been extremely generous in its shareholder distributions and has thus leveraged the balance sheet. However, if the company faces headwinds in the future, it will certainly reduce its share repurchases. If that measure proves insufficient, the company will even have to reduce the dividend. The only thing it will not do is to default on its debt. Therefore, even in the adverse scenario for Yum Brands, only its shareholders will be affected while its bondholders will continue to receive the above generous yield. All in all, the risk/reward profile of the above bonds is by far superior to the profile of S&P at the moment.
While most investors are usually attracted by a dividend yield in the range 3%-5%, they tend to show contempt for a bond yield that is in the same or even higher range. This is a paradox that remains to be explained. Of course the 20-year bonds bear the risk of rising interest rates. However, even though interest rates are rising from their record-low levels, it is highly unlikely that the average yield of long-term bonds will exceed 6.4% on average during the next two decades. Moreover, if the US falls into a recession, the Fed will stop raising the interest rates and hence the bonds of Yum Brands will appreciate in value. Thus they constitute a recession-proof investment with a markedly attractive annual yield.
The bottom line
Most investors incur heavy losses during bear markets due to their panic selling. This is natural, as they cannot tolerate watching their portfolio bleeding for many months in a row. Therefore, in order to avoid such a painful experience, they should position their portfolio so that it will exhibit strong resistance in the event of a bear market while it will keep offering them an attractive yield. The above two holdings offer an attractive return with very limited downside risk. This is an especially rare combination under the prevailing market conditions.
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.
Additional disclosure: I am long YUM bonds and CL via shorting its put options.