The Right Stocks for Tough Times

After a powerful rally that erased the worst memories of the market meltdown, things are starting to look bad again for stock investors. With the economy stubbornly resisting every effort to make it speed up, investors are starting to lose confidence in corporate America and are turning to the safety of Treasury bonds to preserve their capital.

Yet while there are plenty of good arguments for why you should play defense with your money right now, that doesn't mean you need to pull everything you own out of the stock market. Many stocks have fallen to a point at which they're very attractive, and some have characteristics that will help you defend your money from a downturn.

Questioning growth
Some of the best long-term investments have come from high-growth stocks. When times are good, promising companies turn opportunities into profit, and bring shareholders along for the ride. Countless stocks, from Starbucks to Amazon.com to Netflix, have soared as companies tapped into what turned out to be huge trends early on, reaping big rewards along the way.

But when the economy slows, growth stocks become a riskier proposition. The best companies still find ways to grow, but many experience big falls as their sky-high past growth rates drop to more modest levels. Investors start to question whether strong growth will come back, keeping share prices down and making them less attractive investments than they were in better times.

The best combination for right now
So if growth stocks aren't the right play for today, what is? One strategy is to look for companies trading at low valuations. These cheap stocks give you a margin of safety you won't find with many stocks; even if times stay tough for a while, their share prices already reflect quite a bit of pessimism.

Another possibility that many are using today is to pick stocks that pay substantial dividends. In many cases, these stocks have demonstrated an ability over time to earn consistent returns for investors throughout entire economic cycles. That kind of history can make you feel more confident about their ability to get through the current downturn.

To try to find stocks with both of these traits, I ran a screen for stocks with earnings multiples of 10 or less, selling below their book value, and paying a dividend of at least 3%. Here are some of the stocks I came up with:

Stock

Current P/E

Price-to-Book

Dividend Yield

CAPS Rating (out of 5)

Anworth Mortgage (NYSE: ANH  )

6.6

0.95

14.8%

**

Capstead Mortgage (NYSE: CMO  )

8.6

0.99

12.2%

**

KKR Financial (NYSE: KFN  )

4.4

0.95

6.2%

**

MFA Financial (NYSE: MFA  )

7.4

0.91

10.5%

***

Pennant Park Investment (Nasdaq: PNNT  )

6.1

0.89

10.6%

*****

Paragon Shipping (NYSE: PRGN  )

4.1

0.40

5.4%

*****

Cincinnati Financial (Nasdaq: CINF  )

8.5

0.92

6%

****

Source: Motley Fool CAPS.

The key thing to remember, though, is that you can't just stop with screen results. Further research is necessary to make sure you have the whole story. For instance, Anworth, Capstead, and MFA are all REITs that use mortgage-backed securities to drive profits. KKR has a somewhat broader portfolio that includes corporate loans and commercial real estate securities but uses the same general interest rate spread strategy. The combination of low short-term rates and a steep yield curve have given these companies the best conditions they could hope for, pushing dividend yields upward. But an eventual return to a more normal interest rate environment could force a dividend cut and put a damper on these stocks.

Pennant Park is a business development company that helps privately held companies get financing, typically in the mezzanine phase of their existence. With roughly $625 million in investments, the company is leveraged at about 180% of net assets. But the company recently raised $40 million in a public offering to boost capital.

Paragon is in a business known for dividends: bulk shipping. Although you may be more familiar with competitors DryShips and Navios Maritime, Paragon's stronger balance sheet and cheaper valuation make it an attractive play.

Finally, property and casualty insurer Cincinnati Financial has a history of making it through tough times. It has raised its dividend in 49 straight years, and the stock has traded in a fairly narrow range over the past year, giving investors some stability in a turbulent market.

Get the best
As you can see, there's more to picking stocks than just running a screen. But the combination of good value and great payouts make for attractive investments even when the economy is struggling. Even though there's more to these companies than meets the eye, digging into them is worth the effort.

Avoiding bad stocks in a bear market is key. Michael Olson has found several stocks that could easily lose your money.

Fool contributor Dan Caplinger plans for the worst, so he isn't surprised by a problematic economy. He doesn't own shares of the companies mentioned above. Amazon.com, Netflix, and Starbucks are Motley Fool Stock Advisor picks. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is in the right place at the right time.


Read/Post Comments (2) | Recommend This Article (8)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 25, 2010, at 12:44 PM, ContraryDude wrote:

    Well I have to say that I like your logic! in fact, my real llife IRA portfolio looks a lot like your picks in this article. My "top picks" in CAPS correspond to my real life investments. You will see MFA, PNNT, KFN, and AINV (which you may to want to consider adding to this list, except P/E = 13, too high for your screen).

    I also have previously owned shares of PRGN, but I am not liking the shipping sector right now, and they cut their dividend substantially in the past 12 months. Previously, PRGN had a yield of more than 12%.

    Overall, great article!

  • Report this Comment On August 25, 2010, at 2:27 PM, humbledutch wrote:

    I think, that under the present circumstances, financials and real estate are kind of vulnerable.

    I would classify these fit for good times, not rough.

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