Finding Your Portfolio's Core

Investor beware? Learn all about a down market with our recession survival guide.

Are you ready to give up on the stock market? With the constant drumbeat of negative economic news, oil prices through the roof, and the financial sector crashing and burning, it's easy to lose confidence in equities.

Many stock investors are simply heading for the hills. Mutual funds that invest in long-term equities have seen net cash outflows of more than $54.4 billion in the past three months. After a minor surge of optimism in December, stock mutual fund investors simply threw in the towel in January.

Stock Mutual Funds

Nov

Dec

Jan

Net Inflows / (Outflows)

($10.9)

$1.3

($44.8)

Source: Investment Company Institute monthly reports. Numbers in billions.

Worries that the economy is already in recession are creating an ominous-looking feedback loop. One negative news report builds on another, leading to a downward spiral of consumer confidence, with no clear end in sight. What's an investor to do?

Remember the core
Instead of losing sleep every night over your portfolio, I suggest you get back to basics with a lesson from a fitness coach: Strengthen your core. Core strength comes from the big muscles that make everything else work: the back and abs. These muscles support your spine and keep the whole body balanced. Without a strong core, the body would collapse like a high-multiple highflier going into the tank.

Your investment portfolio should have a core as well: three to five stocks that have an overwhelming likelihood to grow and prosper, regardless of the state of the U.S. economy. Banking crisis? So what? Housing meltdown? Phooey! These stalwart companies share a few common characteristics:

  • Trusted brands that consumers will continue to use, no matter what
  • Huge positive cash flows. Companies that can go about their business without depending on the whims of capital markets.
  • Global diversity to withstand the ups and downs of local economic events.

I'm not talking here about finding the next 10-bagger. Growth has its place, but with a recession looming (or already here), it should only make up a modest portion of your portfolio. We're talking about survival, which means you need a core you can depend on. Consider that Warren Buffett's stock portfolio ended 2007 with 32% invested in just three consumer-product companies. (You can discover which ones in the Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual letter to shareholders.)

The beauty of these companies lies in the increased likelihood that they'll avoid Wall Street's herd mentality. While irrational exuberance can occasionally drive the valuation of these companies a bit too high, the best consumer-product companies have valuation floors that are hard to argue with, even during recessionary times. Sometimes, it pays to play it safe.

P/E Ranges

Current

10-Year Low

Procter & Gamble (NYSE:PG)

    20.2

    19.1

PepsiCo (NYSE:PEP)

    20.1

    18.3

Coca-Cola (NYSE:KO)

    22.4

    18.5

Colgate Palmolive (NYSE:CL)

    24.1

    17.1

Source: Capital IQ. P/E ratio represents trailing 12 months.

The lowest P/E valuation any of these companies has seen in the past 10 years is 17 times trailing-12-month earnings. Why so high? These firms' brand strength makes earnings growth consistent and predictable. Their cash flows far exceed their operating needs, spilling mostly into dividends and share repurchases that can be adjusted as needed. And their global diversity insulates them from currency fluctuations and local economic disruptions.

In short, these consumer-product companies are giant cash-flow machines that also deliver clockwork earnings growth.

Are these stocks cheap right now? Well, it's hard to call any stock that trades above a 20 P/E multiple today genuinely cheap, especially compared to the S&P 500's 2008 estimate of 14.3. But on a relative valuation basis, they're getting close to their 10-year lows, convincing me that these firms have far more upside than downside.

Which of these companies would I favor at this point? It's hard to go wrong with any of the four. Warren Buffett has long stated he will never sell his Coke shares. That's a pretty solid endorsement for the shares at virtually any price (within reason).

Colgate-Palmolive looks the most pricey of the four, thanks to its winning performance last year. PepsiCo has seen its snack business cool off in the U.S. recently, but international growth is taking up the slack. And in terms of predictable results, it's hard to match Procter & Gamble. Last year, the company delivered 12% revenue growth, and despite input cost pressures, earnings grew 15%.

Why not make it easy on yourself? Take one-third of your portfolio, and divide it equally among these four companies. Then sit back and take it easy -- you deserve a good night's sleep.

Further Foolishness is our core philosophy:


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