If the last few months left you craving less risk in your portfolio, this episode is for you. In this week's Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Brian Feroldi explain what Verizon Communications ( VZ 1.36% ), Microsoft ( MSFT -1.97% ), and Adobe ( ADBE -8.24% ) have to offer risk-minded investors during a potential downturn.
Tune in for Brian's checklist of factors to consider when looking at stocks with a recession in mind, why dividend stocks tend to provide some much-needed stability during a crash, how Adobe managed to turn its business model around in the last few years, how Microsoft offers both growth potential and security, how Verizon got into commodities, and more.
A full transcript follows the video.
This video was recorded on Jan. 11, 2019.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, January 11th. We're talking about stocks for 2019. I'm your host, Dylan Lewis, and I've got fool.com's Brian Feroldi on Skype. Brian, what's going on?
Brian Feroldi: Hey, Dylan! Happy Friday to you!
Lewis: Happy Friday! Are you guys supposed to be getting snow this weekend?
Feroldi: I have no idea. My weekend is going to be filled with football. My New England Patriots have a playoff game. More importantly, my son's indoor flag football team has a tournament going on. So if it snows or not, I don't care. How about you?
Lewis: Oh, you just had to twist the knife there, Brian. You know that I'm from New Jersey, you know that I'm a Jets fan. I don't need to be hearing about the Patriots right now, all right? I get it. [laughs]
Feroldi: I'll make sure you know exactly what's going on with the Patriots, Dylan.
Lewis: It's bad enough with Chris Hill and Matt Argersinger! I don't need to be hearing it from you, too, Brian! It's a rough time of the year to be a Jets fan.
It's also a rough time of the year for the stock market. We've been looking at some pretty strong returns for the S&P 500 over the last couple of years. 2018 was the first year since the Great Recession that the S&P 500 logged a down year. That final result was down 4.38%.
Brian, I feel like heading into 2019, there are probably a lot of investors trying to forecast whether the bull market we've come to know is going to keep going, or if maybe this is the time to think about what they own and what's available for a little bit shorter term than they normally would.
Feroldi: Given the recent volatility, it can be a good time for investors to look at their portfolio and reassess their exposure. In some cases, if the recent downturn caused people a lot of anxiety or they lost sleep over it, it can be useful to go through and de-risk your portfolio by moving into some securities, out of others.
Lewis: We're going to talk today about some stocks that provide a decent amount of downside protection. We're going to cover a spectrum from slightly less risky to a little bit more risky, but we're doing it with the understanding that there are some people that maybe can't stomach a 30% or 40% sell-off, which is something that might happen with a lot of the growth stocks that we typically cover, especially some of these relatively young companies that aren't quite profitable yet. Today, our view is going to be a little bit different than we normally would be. We need to give the normal caveats here that this is not personalized financial advice.
I think we need to recognize that people will look at dips very differently depending on what their financial situation is. If you're a long ways from retirement, Brian, it's a bummer to have your portfolio dip, but that if you're looking five, 10, maybe even 20, 30 years out, it doesn't make much of a difference to you.
Feroldi: Not at all. That's why we at The Fool are always talking about the long term, thinking business owners. The stock market can really test your nerves over a quarter, even a year or multiple years. That's why we expound staying focused on the fundamentals of the business, thinking and acting with the long-term in mind. When times like this come up, when you see your portfolio get mashed, you need to be thinking, "It's time to get aggressive. It's time for me to be a net buyer, not to be a seller."
Lewis: On the flip side, there are folks that are either nearing or are in retirement. When they see their portfolio sell off 20% or 30%, it's a lot harder for them to look at that opportunistically. They know that they either are already taking distributions or will need to soon take distributions from those funds. And when you're in that position, you want your money to keep growing, but you're a lot more sensitive to losing money. Today, we're going to focus a little bit more on that other half. There are times where, in our growth-focused mind-set, Brian, we can get a little carried away, maybe spend a little bit too much time looking at the big growth opportunities that are out there that are also a little bit riskier.
Feroldi: Yeah. Growth stocks and consumer-facing stocks are obviously a lot more fun to talk about, but there's certainly a spot in anyone's portfolio for safer companies that have lower risk profiles.
Lewis: Before we get into the companies that we're going to discuss, why don't we break down exactly what investors should be looking for? True to form in doing a show with you, Brian, we have a checklist, we have a guideline that we're going to be basing a lot of our analysis off of. One of the big things when I'm considering things that can weather a recession or a prolonged downturn is, how does what the company offers fit into what consumers are doing with their buying decisions?
Feroldi: Yeah. When a downturn comes, you need to think through the business model of the company. Companies that have products that are in demand no matter what's going on, that can depend on their revenue and net income staying stable even during downturns, are obviously going to fare much better during a recession than companies that are much more cyclical. When you're thinking through the stocks that you own, it can be a good practice to think about what would happen to their revenue and profits if the economy was to slow down.
Lewis: I think one of the clearest examples for something like this is, you look over in the retail space, a company like Tiffany & Co. They're probably going to struggle a little bit more during an extended period of economic hardship because people just aren't buying luxury goods the same way they would if they have more disposable income and times are particularly good. On the flip side, the bargain companies, companies like TJ Maxx, those types of businesses might do a little bit better because they're offering discounts to the people that are coming into the store.
Feroldi: That's a good way to think about it. Even in the tech space, some companies rely on a strong economy to grow, whereas other companies do not. Their products will be in demand no matter what's going on. So even within the tech sector, you can find companies that are far more resistant to downturns than others.
Lewis: We also want to look a little bit at the books here. We're going to call this one financial security. This comes down to having a relatively low debt load and having some cash on hand to pay bills. This is something we've talked about the importance of quite a bit with you on the show in the past, Brian.
Feroldi: Yeah. Definitely, debt can be a killer when your business is heading south. Another factor I'd throw in there is, make sure that the company is consistently profitable and it's pumping out cash flow. Some of the companies we're going to talk about do have a substantial amount of debt, but as long as their business is highly resilient, you can feel good that they can be able to fund their needs throughout any downturn.
Lewis: Something else that we'll want to see with these businesses is something that leads to growth, it's a clear sustainable competitive advantage in a market that is growing. You'll hear very often that people should be looking at some consumer staples in this type of market. A lot of people throw out the Procter & Gambles, the Cloroxes, maybe even some of the tobacco companies of the world. I think the thing that you have to keep in mind there is, are the markets that those companies are serving growing? Sometimes, the answer is no. You're paying for security that...I mean, I guess there's a higher floor, but there isn't much of a ceiling in terms of where those companies could go.
Feroldi: Yeah. Companies that are selling into a market that is naturally growing, even during a downturn, are obviously going to have a much better chance at maintaining or even growing their revenue and profits than one that is in a declining market.
Lewis: Another big thing for us is looking at how these companies have endured past downturns. I think this is particularly important for companies that have dividend programs in place. You go back to the financial collapse of 2007, 2008. How did this company do? If the management is still in place there, how did they make decisions? How did the company weather that period?
Feroldi: The Great Recession was obviously extremely painful, but one of the great things for investors is, you can go back and look at how your companies performed during that period. If your company's revenue and profits were pretty steady, you can feel good that you have a good company. If, on the other hand, their revenue and profits declined significantly, that can give you a sense of the company's risk profile.
Lewis: Something that I think we need to recondition ourselves for with this show is, we'll very often look at a company's valuation and care about it, but also see that a high valuation is indicative of a potentially large total addressable market, and the fact that there's a lot of demand for this company to meet with the products they're going to be rolling out there. Of course, in a downturn, people are going to be more sensitive to the valuation multiples that companies sport. If you're looking at those nosebleed valuations, those are the companies that are going to be really hit by any major sell-offs in the market.
Feroldi: Yeah, the growth companies that we like to talk about often sport very high valuation multiples, and those are some of the first stocks that get hit the hardest when investors flee for safety. We don't typically talk about valuation when we're talking about high-growth SaaS stocks, for example, but in the case where you're thinking defense first, valuation is much more important.
Lewis: The simple reason there is, the downside is pretty much baked in, to a certain extent. For a company like Apple ( AAPL -1.17% ) that trades at maybe the low teens in terms of earnings, maybe even lower, given some of the recent sell-off, they can only go so much lower because so little is currently priced into the stock. Totally different story for a company that is not yet profitable and has 30%, 50% sales growth currently baked into the valuation.
Feroldi: I think that's 100% true. Companies like Apple, which are big and stable, will naturally be a little bit safer for investors.
Lewis: Speaking of Apple, it's a good queue-up for last one, and that's limited exposure to struggling markets. China is one of the big ones to focus on here, but looking back at that show that Evan and I did on Apple last week, talking about Tim Cook's letter, that was one of the really big first signals that the economic deceleration in China was being felt by U.S. companies in a major way. You want to be sensitive to the markets that companies are serving and how those markets are doing. That's going to have an outsized effect on what goes on with the stock.
Feroldi: I think that's 100% correct.
Lewis: All right, with that out of the way -- that's a lot of boxes for a business to check. It's going to be hard for them to do it. But it's a guide to look at businesses, and that's how we're going to be looking at things on this show today.
We're going to go through three different companies, Brian. We have, I would say, a reasonably safe pick, a company that offers solid growth with a decent amount of safety, and then a business that is relatively stable, more growth oriented, but certainly a little bit riskier. We're going to tackle that in ascending risk.
Why don't we start out with our safest one? That's Verizon Communications.
Feroldi: I'm sure this is a company that almost everybody listening is familiar with. They're the No. 1 wireless provider in the U.S. They also provide wireline to lots of customers. I'm sure lots of people have heard of their internet offering, which is called FiOS, which provides video and internet. This is a company with 117 million wireless customers. The cellphone has basically become a utility for consumers today. They pay it the same way they pay their electric bill or their water bill. So even during a downturn, you can feel really good that Verizon's core wireless business is going to hold up extremely well, because consumers are so willing to pay for their cellphone.
Lewis: Yeah. This is the company that boasts the best wireless network nationwide if you look at most industry data. I think that's particularly big for Verizon because the wireless industry is incredibly cutthroat. It's brutally competitive. But they're able to charge more than a lot of their peers because they offer the best service, because they have the most consistent coverage across the country. That gives them that premium pricing, and I think it gives them a little bit more stability, insulates them from a lot of the competitive pricing that we see from the Sprints and T-Mobiles of the world.
Feroldi: Yeah. Verizon is seen as the gold standard network. They've done a great job with their marketing to convince people that their network is No. 1 and you should stick with them if you want the best service, no matter where you are.
Lewis: To your point about the role that phones play in people's lives, this is something that a lot of people need to have. Depending on where you are in the country, the coverage is super important, especially in some of the more remote areas where you can't bank on being near a major metro area and all of the network benefits that come with that.
One of the strongest signals to me that business is doing well is the fact that their postpaid churn is 0.8%. You compare that to some of the companies that have steadily discounted to try to acquire customers, that's about half of what their churn is. It's clear that the premium pricing, better coverage model seems to work. They hold on to customers rather than having to spend a ton of money to acquire them only to lose them down the road.
Feroldi: Yeah. I'm sure that postpaid churn rate is going to surprise some listeners. I don't know about you, I tried to change my cellphone provider a couple of years ago to one of the discounted offerings. My wife basically said no. I went with it and she convinced me to come back because she wasn't willing to give up using Verizon. Verizon's competitive position is very strong.
Lewis: Looking back at 2007 and 2008, the stock did decline, as did the market, but their decline was lower than the broader sell-off we saw in the market. That's a signal of, this is a company that tends to weather these downturns a little bit better than a lot of high-price growth stocks. For them, curiously, sales actually increased throughout the recession, which you don't see very often.
Feroldi: Right. Back when the recession was just picking up, in 2008, that's when the smartphone boom was starting to take off. Verizon definitely benefited from that. Their revenue actually grew through 2008 through 2009 through 2010. As you mentioned, its stock got walloped, but that was the Great Recession. There were very few places that you could hide in the stock market. So the stock did decline, but it was actually a lower peak-to-trough drop than the market in general. Verizon is considered to be a low beta stock, which means that its stock price doesn't move up or down very much when compared to the market in general.
Lewis: Another encouraging sign here, they're one of the companies that continued to hike their dividend during the financial crisis. The dividend is what attracts a lot of people to Verizon. They're a steady payer. They've grown their payment over the last couple of years, and consistently doing it. Granted, they enjoyed the smartphone boom and maybe had a little bit more in the coffers than they would have absent that trend. But that's a sign you want to see, particularly from a dividend payer, when you're looking back at how they performed over downturn periods.
Another sign of them being a solid stock to own if you're worried about a lot of volatility, a lot of risk in the market, is that they trade at a low valuation, 12X trailing earnings, 12X forward earnings. That pretty much says it all about the growth outlook for this business.
Feroldi: Yeah, this company is growing its earnings at a mid-single-digit rate. It's about 6% over the last five years. That's about what investors expect moving forward. But the type of investor that's attracted to Verizon is an income investor. They're holding this stock because they want to get their hands on the company's dividend yield. The dividend yield is currently 4.4%. Like you said, it's been paid for literally more than 30 years. The type of person that owns Verizon's stock, is attracted to it, is really there for the dividend. That type of investor is less likely to sell when the market goes down, because they're not in the stock for capital appreciation, they're in it for the dividend. So as long as the dividend remains solid, I think the stock will hold up very well in any sort of bear market.
Lewis: For all the strength that we've outlined with Verizon, there is one thing that they don't quite check in terms of being riskless. That's the fact that they carry a lot of debt relative to the amount of cash that they have on hand. One hundred and fourteen billion dollars in debt, which they are trying to pay down against $2.5 billion in cash. Not exactly what you'd love to see.
Feroldi: Their balance sheet is debt-heavy, but that's just the nature of the industry that they're in. They're building cell towers, they're investing hugely in their equipment. It's very expensive to maintain a network and constantly upgrade it. Verizon is a company that you would expect to carry a huge amount of debt. It doesn't concern me because the business is so stable, it's so dependable. People are going to pay their cellphone bill every month, basically no matter what. So the debt is something for investors to think about, but I'm not very concerned about it.
Lewis: Yeah. If they were dealing with really crazy customer churn or running into issues where their network wasn't performing as strongly against peers, I would be a little bit more worried about the debt load. They continue to use debt to build out their network, invest in 5G, which is where the industry is going, and all these initiatives that should bode well for the business long term. Of course, that means that they're going to be carrying quite a bit of debt on the balance sheet in the meantime.
Feroldi: Yeah, correct. The long-term bull case for owning this stock is, you have the internet of things coming up, which is saying that billions of devices are going to come online and be connected to network. There's the upcoming rollout of 5G. And then, the business itself is so sticky, customers are so loyal. You have that dependable base. Then, if you layer in internet of things and 5G on top of that, I think it's reasonable to expect that their estimated growth rate of about 5% or 6% of earnings is achievable.
Lewis: All right. For folks looking for steady dividend payments, solid yield, likelihood that they won't be losing a ton in terms of actual share price depreciation during a rough period of the market, Verizon is a good company to look at.
For people that are willing to handle a little bit more volatility, we have a midrange company. This is a name that we have talked about fairly recently on the show. It's a stock that offers, in my opinion, really solid growth, but is so strong in what they do, so well built out, that they won't get crushed by anything for an extended period of time. That's Microsoft.
Feroldi: Who would have thought? Microsoft is an enormous business, one of the biggest businesses on Earth, but it's actually a growth company. This business is so big, it's so dominant, it has so many products. Over the last couple of years, they've made a big switch in their business model where they went from selling licensed software to basically moving as much as they could into the cloud. That move is the gift that keeps on giving. This is a company that's posting double-digit earnings growth over the last couple of years.
Lewis: Yeah. They have this wonderful and well-established portfolio of products, and they're investing in a lot of long-term growth verticals as well. Software is what they're known for, but you look over at what they're doing on the cloud side, in terms of infrastructure with Azure, that's a huge growth opportunity for them. They're one of the big players there. They're making up a lot of ground on the leaders in that space.
Feroldi: Their Azure product is growing gangbusters. It's out there competing with the likes of Amazon and Alphabet. It's good to see that they're growing alongside with the industry in general. And then there's their products like Office 365, which have Excel and Word and PowerPoint. And then there's Windows. Those are dependable cash cows for this business.
They do have a couple of growth avenues outside of the cloud. They also own Xbox. Their Microsoft Surface platform is gaining in popularity. Microsoft's been acquisition heavy over the last couple of years. They bought LinkedIn, the professional social network. They just bought a company called GitHub, which is a code-sharing and collaboration platform. When you combine their steady-Eddie dependable business with their growth, this is a company that's growing nicely.
Lewis: I mentioned before that they're somewhat insulated from major downturns. They did sell off 50% if you go back to the financial collapse. It's possible that they will be eating some losses if the market were to turn down. But I think the strength of what they offer is there, and it's so resilient that people should be reasonably comfortable knowing that this is a company that will rebound pretty quickly.
Going over to valuation, they're growing, and the valuation reflects that. You look back at trailing earnings, they're looking at 42X trailing earnings. It gets a lot more palatable, though, when you look on a forward basis.
Feroldi: They're trading at about 20X next year's earnings estimate. Their estimated growth rate over the next five years in earnings is about 12%. Those are reasonable numbers, especially for a dominant company like Microsoft. But Microsoft's strength is really its balance sheet. This is a company with $135 billion in cash. It does have $87 billion in debt, but that's a net cash position of almost $40 billion. They have plenty of capital to invest, to buy other businesses, to buy back stock, to continue paying their dividend and grow it. Microsoft is actually a pretty decent dividend payer. Its yield is about 1.8% right now, which is pretty similar to the S&P 500, but their dividend has grown consistently since they started paying it in 2003.
Lewis: One of the things that we didn't talk about in our criteria earlier, but maybe is worth mentioning when we look at the cash and debt, is having cash on hand during a downturn puts you in a position to be pretty opportunistic as well. If there are companies out there that fit well into what you're trying to do, it puts you in a position to acquire. It also puts you in a position to buy back some of your own stock. In their position, they have $60 billion or $70 billion in net cash. That's a nice thing to have if the market turns south.
Feroldi: Especially since the rest of their business is so dependable. This company could absolutely get as aggressive as it wanted to if a downturn were to come and take advantage of a weak stock price. It'll still be adding billions in profit every year. It has plenty of financial resources to do basically whatever it wants.
Lewis: All right, Brian, climbing up the risk ladder, we've got our last stock. I think this is probably for folks that have a little bit of a longer time horizon. It's a steady business, but there's a lot of growth priced into it. That's Adobe Systems, maybe a name that a lot of people interact with, but haven't quite thought about investing in.
Feroldi: Adobe is a company that I've known about for years, and I never dug into it. But once I started to really understand this business, this is a $110 billion company. It's huge. It's a top-tier software company. It's actually one of my favorite stocks in the entire market right now.
Most people are familiar with Adobe's -- what's called its Creative Cloud SaaS offering. That's where it has products like Photoshop, Illustrator, Premiere Pro, Acrobat. A lot of those products are basically the gold standard in the creative community. Millions of designers and videographers and animators are trained and use those products. They can't do their job without them. It's an extremely dependable business.
Beyond the Creative Cloud products, Adobe has actually been moving into what's called a digital experience unit. That's where it provides cloud-based marketing and analytics tools to enterprise customers. It can help with creating marketing campaigns, analyzing them, increasing your presence in the e-commerce market. They actually have a sizable business that serves specifically business and enterprise customers.
Lewis: Something that's fascinating with this stock in particular is, we go back and look at the history, the stock did not fare particularly well during the 2007, 2008 recession. The stock fell about 65% from its 2007 high. But you look at how the company performed this past year, when the S&P 500 sold off about 4%, they posted 29% gains.
Feroldi: Yeah. The comparison between now and 2008 is not apples to apples. A couple of years ago, Adobe switched its business model from doing a licensing model to forcing all of its users to go to a software-as-a-service model. Previously, during the last downturn, if somebody wanted to delay upgrading to the latest Premiere or the latest Photoshop, they could do so. Now, they're subscribing to Adobe services. That's a recurring bill that they're paying every month, regardless. I believe that if a downturn was to come, Adobe's financial statements would actually hold up much better than they did during the last downturn.
But even during the last downturn, the numbers weren't horrible. Their sales dropped 13%. That's not great, but considering the market environment they were in, that's not terrible, either. They were still profitable, although their net income did fall in half. But I believe that if a big recession was on the horizon, their business model now would allow them to hold up much better.
Lewis: For all of us characterizing them as a high-flying growth stock, their valuation doesn't look all that different than Microsoft's on a trailing basis. They're at about 45X earnings, on a forward basis 25X earnings. They aren't as built out and established as Microsoft is. But to your point earlier, they are the de facto software for all of these enterprise clients that are doing anything in the creative space.
Feroldi: Yeah. A few years ago, when they made the switch to a purely cloud-based, as we spoke about on our software-as-a-service show, it did cost them revenue and profits in the near-term. Their revenue and profits did hit when they switched their business model. However, if you fast-forward to today, their revenue is growing at a 20% rate, and their earnings are growing even faster than that. Over the last five years, this is a business that's put up earnings growth of 48% annually. That's just huge. That rate is projected to fall to 22% over the next five years, but if you compare that to their valuation of about 25X next year's earnings estimates, that's a very fast growth rate for basically a slight premium to the market. I think Adobe's stock will probably hold up pretty well if it can deliver on its growth targets.
Lewis: Brian, I didn't realize this as we were planning out the show, but now that we've talked about all three companies, I see another thing that was not included in our criteria, and that's steady payments, routine purchases. All of these businesses, whether it's Verizon with subscribers paying a monthly payment to them to use their network, or Microsoft with its software products, or Adobe with their software products, all of these have recurring revenue streams in one way or another. They are not banking on one big product release to make numbers.
Feroldi: Yeah, that's correct. When you can count on recurring revenue vs. a one-time sale, it's the gift that keeps on giving. Your financial statements become much more dependable, and Wall Street generally rewards that with a more stable stock price.
Lewis: Brian, you did a write-up recently on Adobe. If anyone wants that in written form rather than in audio, that's available.
Feroldi: Yes, absolutely. It's right on fool.com.
Lewis: Listeners, if you want that, shoot us an email over at email@example.com. We'll make sure to send that your way. Brian, anything else before I let you go?
Feroldi: I would just say to the listeners, if a market downturn does come, do your best to stay calm and think bargain hunting as opposed to freaking out.
Lewis: I appreciate that. I also appreciate you not sneaking a "go Patriots" plug in there at the end. I hope that --
Feroldi: Go Patriots!
Lewis: [laughs] There it is! I hope that you enjoy your Saturday and Sunday. I hope that your son wins, and your other team loses.
Feroldi: Yeah, thanks!
Lewis: [laughs] Thanks for joining me, Brian!
Feroldi: Great to be here, as always!
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you want to reach out and say hey, like I said, you can shoot us an email over at firstname.lastname@example.org. Or, of course, you can tweet us over @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can check out the videos from this podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for his work behind the glass today. For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!