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Preamble
The World Is A Scary Place
If headlines were to be believed, the world is in turmoil, the market is crashing, and recession could be upon us.
Sky News
Sky News
Bloomberg 2 August 2024
Bloomberg 8 August 2024
WSJ 5 August 2024
The S&P's macro outlook for the next 12 months is pessimistic. S&P's research pointed to 4 out of 7 risk categories with worsening trends.
S&P
According to their report,
Softer economic growth and still high interest rates will pressure low-rated corporates in consumer-related sectors and emerging markets. Over time, companies are refinancing more and more debt at noticeably higher rates, squeezing businesses' headroom. A worsening geopolitical landscape, a more severe economic downturn, a longer-than-expected period of high rates, and growing threats to global trade could derail our base case and lead to weaker business activity and market liquidity.
The fact that the United States has yet to cut rates and this being an election year will add to the volatility and uncertainty. Specifically about the US, their research pointed out some potential downsides for certain sectors:
On top of the downside risk posed by prolonged high financing costs, input-price pressures persist, and commercial real estate losses could worsen amid cyclical and secular headwinds. U.S. elections could lead to market volatility and policy uncertainty. The region's net outlook bias was negative 10.2% as of June 11, with telecom, consumer products, and chemicals having the highest negative bias. We expect the U.S. default rate to fall slightly to 4.5% by March after peaking in the third quarter.
Macro-Investing or No Macro-Investing?
In 2008, McKinsey published a paper on risk titled "Shaping Strategy in a Highly Uncertain Macro-economic Environment". The following chart that I took from the paper is scarily prescient. We just had a global pandemic, China's growth has slowed significantly, and oil prices have remained elevated for months.
McKinsey 2008
However, I have not heard of anyone who made a fortune in the past 4 years with the help of that McKinsey report.
As a fan of Howard Marks, I agree with his stance on macro-investing. In his 22 November 2022 memo, he wrote,
Macro events and the ups and downs of companies' near-term fortunes are unpredictable and not necessarily indicative of - or relevant to - companies' long-term prospects. So little attention should be paid to them.
Howard also said, in his book "The Most Important Things Illuminated", that
Being too far ahead of your time is indistinguishable from being wrong
There are too many unknowns when making macro forecasts. Even if forecasts are correct, and we can know these in advance, they will not guarantee investment success, as responses to these events from policymakers, investors, and business owners, are all unknowns.
Basic Premise That I Adopt
I accept that the world has always been, and will always be a place rife with volatility, unrest, uncertainties, and unexpected black swan events will happen from time to time.
Some investors may think it is better to hold cash than equities amidst the global unrest during periods of great uncertainty and volatility - war in Ukraine and the Middle East and increasing protectionism between the world's two largest economies. As of 8 August 2024, the S&P 500 earnings yield stood at 3.6% while the U.S. 3-month treasury offers 5.217%. No wonder Warren Buffett has been going into cash and has been a net seller of stocks for at least 7 quarters now, counting his almost 50% reduction in the Apple Inc. (AAPL) shares held by Berkshire Hathaway Inc. (BRK.A).
Other investors may think they should always stay invested since missing out on the best days of the stock market is a costly matter, which I totally agree with.
Fidelity
Rather than take an extreme either FOLE (fear of losing everything) or FOMO (fear of missing out) position, I opt for the middle ground, believing that it matters that investors stay invested, and it matters that on top of their 6 months emergency funds investors set aside a portion of their portfolio in cash or highly liquid short-term instruments (a.k.a. cash position) that they can tap into if necessary.
How much of your portfolio to place in cash is up to your personal beliefs, investment strategy, market outlook for the next 12 to 24 months, and risk tolerance. You can be like Warren Buffett who has more than 50% of Berkshire Hathaway in cash, or you can have more in equities.
Since I am clearly nowhere near Warren Buffett in terms of investment acumen and assets, my strategies and asset allocation cannot replicate his. However, as someone who had 87.5% of my liquid assets invested into equities as of June 2024, a reallocation of some of that into cash, short-term bonds, and real estate makes sense to me. This is not about timing the market, nor is it about a bearish take on the market. Rather, it is simply a matter of repositioning my liquid assets to have a larger war chest that allows me to better take advantage of potential corrections like the one that happened in the first week of August 2024.
Translating Beliefs Into Action To Sleep Well At Night
Although I take the occasional calculated risk, I generally position-size those to under 0.5% of my portfolio. One key characteristic of the companies that occupy 5% or more of my portfolio is this: they are hard to go bust.
And since I am managing my wife's savings in addition to mine, keeping the portfolio safe is paramount to me sleeping well (and safely!) at night.
Having set the stage for my picks, the next part will be on the types of stocks that I am holding, and the characteristics of those that I am buying.
Top Credit Quality = SWAN
Screening with the help of a company's credit rating is a quick and easy way to identify SWAN stocks - or "sleep-well-at-night" - that fit this "hard-to-go-bust" criteria. According to research from S&P, the higher their ratings, the lower their default rates which is defined as "the first time a payment default on any financial obligation whether it is rated or unrated - other than when it is due to a bona fide commercial dispute, and vice versa".
S&P
Interest rates are still high at the time of writing, and I am not holding my breath hoping for a rate cut in September 2024. Companies that had taken loans from 2022 to the first half of 2024 would have refinanced at higher rates that reduced their margins. Companies with poor credit ratings would be unable to refinance at favorable rates. Regardless of Jerome Powell's decision in September 2024 and beyond, companies with a strong credit rating will always stand to benefit.
Using the following criteria, I surfaced 77 companies listed on the NYSE or the NASDAQ with a credit rating of at least an A and a market capitalization of $500 million.
Fast Graph
From this list of 77 companies, I dig deeper to find companies that fit investors with three different investment profiles: dividend growth investors, income investors, and growth investors.
Dividend Growth Investors
Dividend growth stocks form a big part of my portfolio. Since 2021, after the aggressive buying in 2020 exhausted my war chest, I have been funding my stock purchases through reinvesting my dividends and proceeds from some profit-taking. I have not used any new cash to buy shares and instead have been building my war chest back again using the savings from my day job.
If you are like me, not needing to use dividends to pay for living expenses, and you enjoy seeing a growing paycheck every year from the companies that you own to help you fund and grow your equity portfolio, you will like these companies.
Dividend growth investors are not yield-chasers. They want these companies to grow that dividend to show they are capable of growing sales and free cash flow as these are clear signs that the business is doing well, and hence, they can sleep well at night.
In addition to that earlier screen, I included the following criteria:
a. Estimated Sales Growth for this FY to exceed 5%
b. Estimated 3-5 years of Sales Growth to exceed 5%c. Estimated Free Cash Flow to Equity Growth to exceed 5%. Estimated 3-5 years of Free Cash Flow to Equity Growth to exceed 5%
e. Paid a growing dividend exceeding 15 years
Fast Graph
Seeking Alpha's Dividend scores confirm that these are great dividend growth companies, scoring mostly A- and above for "Safety", "Growth" and "Consistency".
Seeking Alpha Dividend Scores
With over 50 holdings in my portfolio, I am not interested in starting new positions unless it is to buy an unrivaled company at a ridiculously low price. Since I already own QUALCOMM Incorporated (QCOM) and Visa Inc. (V), I am planning to add to these positions when dips bring their prices to fair value or lower.
You can read more about my article on QCOM here.
Disclosure: I own shares in QCOM and V.
Income Stocks
Income stocks comprise a significant part of my portfolio to generate funds for reinvestment, generating a five-figure sum annually. Needless to say, dividend cuts are unacceptable, hence in choosing stable dividend payers, I focus more on their dividend safety and yield, and less on dividend growth.
The list of 18 companies below have dividend yields at least twice that of the S&P 500 and have paid dividends for at least 21 years. The top 7 companies have paid a growing dividend for 21 years while the last one, Public Storage (PSA), has been growing its dividends more recently.
Fast Graph
Seeking Alpha's Dividend scorecard gave these companies high dividend consistency and safety scores.
Seeking Alpha
Disclosure: I own shares in JNJ and ADM.
Growth Companies
Income stocks cannot supercharge my portfolio. I need growth stocks for that. Investopedia defines a growth company as one where "its business generates positive cash flows or earnings faster than the overall economy."
I further fine-tuned my search criteria within the 77 companies to identify companies expected to generate more than 20% in operating cash flow and free-cash-flow-to equity for this fiscal year and the next 3 to 5 years, and I get the following 10 companies.
Fast Graph
I am two-minds about investing in insurance companies. Warren Buffett loves them since they provide him with the cash flow to reinvest. Yet, all it takes is a major catastrophe requiring high payouts to severely strain their balance sheet. NFLX is a wonderful company (I cannot live without it) but it is too pricey at the moment. MRK is an option to consider though investors of big pharmaceutical companies need to always keep an eye out for patent cliffs. This is also a business that requires a lot of R&D spend.
That leaves NVDA and AMZN, which I will touch on later.
Disclosure: I own shares in NVDA and AMZN.
5 Companies That I Will Add More On Dips
From the list of 33 companies spread over the three categories, I own the following: NVDA, AMZN, JNJ, ADM, QCOM, and V.
JNJ shares are fairly valued at best, so I am not adding to my position. My yield on cost on JNJ is around 8%, so I am holding my shares and collecting dividends. As for the others, I am planning to add on dips.
Both NVDA and AMZN have wide moats. Both have the operating and free cash flow growth needed to justify their premium valuation.
Demand for NVDA's GPUs and data centers is not letting up, from enterprises to countries. CFO Colette Kress reported the following at the Q1 2024 earnings call,
Data Center revenue of $22.6 billion was a record, up 23% sequentially and up 427% year-on-year, driven by continued strong demand for the NVIDIA Hopper GPU computing platform...
Strong sequential data center growth was driven by all customer types, led by enterprise and consumer internet companies...
From a geographic perspective, Data Center revenue continues to diversify as countries around the world invest in Sovereign AI. Sovereign AI refers to a nation's capabilities to produce artificial intelligence using its own infrastructure, data, workforce, and business networks.
The delay in the delivery of Blackwell Ai GPUs is just a small bump in the road. When a complete NVDA server rack costs $3 million and upwards, and the company expects to sell 60 to 70 thousand of these, it pays to get the product right at launch.
As for AMZN, some investors were disappointed with its decline in growth in North America and internationally.
Q2 2024 10Q
However, AMZN's crown jewel AWS is shining bright with accelerating growth. AWS matters most to AMZN as it is the most profitable segment; the $18.775 billion of operating income it generated in the first half of 2024 is 62.5% of its consolidated operating income for the same period.
With the secular shift of consumers shopping more via e-commerce strengthening since 2020, AMZN's dominance as the number one e-commerce business will serve it well. As its Prime membership increases, the revenue it generates through membership fees ($139 annually) and sales will continue to generate meaningful returns.
An investment in AMZN is also an investment into the AI-backed catalyst that is fueling so much interest worldwide. CEO Andy Jassey talked about AMZN's in-house chips in the Q2 earnings call which will help it to retain AWS customers and bring in new ones,
... our customers really want improved price performance all the time. And so that's why we went about building Trainium, which is our training chip and Inferentia, which is our inference chip, which we're on second versions of both of those, they will have very compelling relative price performance and in a world where it's hard to get GPUs today, the supply is scarce and all the schedules continue to move over time... I think that's going to have very good return profile just like Graviton has and I think it will be another differentiating feature around AWS relative to others... In the generative AI space, it's going to get big fast and it's largely all going to be built from the get-go in the cloud, which allows the opportunity for those businesses to continue to grow.
QCOM was harshly punished in June and July, falling 23.6% in under 2 months. That is unjustified. Despite losing Huawei's business and rumors of Apple replacing QCOM chips in 2025, the 34 Factset analysts who cover QCOM for a living maintained their adjusted earnings forecasts and raised their revenue forecasts. This is due to the increased visibility of their revenue. The 8% decline in IoT from a year ago is more than offset by the 12% growth in the Handsets and the 87% growth in the Automotive segments.
ADM "engages in the procurement, transportation, storage, processing, and merchandising of agricultural commodities, ingredients, flavors, and solutions in the United States, Switzerland, the Cayman Islands, Brazil, Mexico, Canada, the United Kingdom, and internationally." As one of the 4 largest agribusinesses in the world together with Bunge Global SA (BG), Cargill, and Louis Dreyfus Company (or ABCD as they are commonly known), ADM is an essential business in any economic condition. The investment thesis for ADM is straightforward. Everyone needs to eat.
V is a scalable, high-margin (net margin 53%), highly profitable business with a long runway as more people turn from cash to digital payment. V is an impressive dividend growth stock that has been growing dividends at double-digit rates since 2009, except for FY 2021. At a payout ratio of just 21%, V has plenty of room to boost the dividend payout.
None of these are especially cheap or in value territory at the moment though they are fairly valued, and I would rather pay a fair price for a quality company that can help me "sleep well at night" than a cheap price for a low-quality one.
Conclusion
A sleep-well-at-night portfolio helps investors to keep calm and prevent them from panic selling. This does not mean owning dodgy or boring companies with no growth potential. By sieving through the best companies listed on the American stock exchanges, identifying those with the lowest possibilities of defaulting, and understanding their traits and purpose in one's portfolio - be it to generate income or growth or both - and investing in those companies with a huge moat with revenue supported by strong tailwinds, one can sleep well through recessions and other bad times. These are companies I feel confident holding long-term and accumulating on significant dips.
Although I have identified 33 companies that, I think, are great businesses, I focused on the process of arriving at my list of SWAN stocks and discussed the 6 that I own. There are certainly others that I am interested in, and I intend to cover some of those in my subsequent articles.
