As an optimistic person, I usually don't bother reading the commentary of doom-and-gloom analysts who predict darker times while they ring the death knell for the markets. Nevertheless, no prudent investor should be blind to the prospect of a serious market correction. With our uncertain geopolitical future, the ever-present threat of terrorist actions, soaring oil prices, and a more restrictive monetary policy, who knows when the next precipitous market decline might come?
When it does, where can equity investors seek shelter -- aside from cash and bonds? Screening can narrow the field by weeding out firms that won't measure up in a down market. Among those that do make the grade, screens can thin the pool further by pinpointing those candidates most likely to swim when others around them are sinking. Which traits will best serve as life vests for these sorts of stocks?
Performance: For a variety of reasons, some companies aren't very highly correlated to the market and tend to zig when other stocks zag. While these stocks usually lag in a strong market, they often emerge as leaders in a weak one. Knowing how a stock reacted to the last bear market may provide insight into its behavior during the next one.
Yield: In a rising market, investors often overlook relatively paltry 2% to 3% dividend yields as they hunt for bigger game. Let's not forget, though, that dividends represent 42% of the Standard & Poor's 500's total return since 1926. Whenever stocks tumble, these payments will help cushion the fall.
Valuation: It may be cliche to assume that higher priced stocks have further to fall, but trite sayings are often grounded in truth. In tough times, bargain-priced stocks should hold up better than their racier cousins. With that in mind, companies trading at excessive valuations should be avoided.
Profit margins: Earnings -- still a driver of stock prices, though we at the Fool often endorse free cash flows -- are essentially a function of two things: sales and margins. In an economic slump, flagging revenues may be inevitable, making margins the last line of defense. All things being equal, a company with higher margins will be better equipped to keep an even keel in rough waters.
Balance sheet: There is nothing inherently wrong with debt, provided it is deployed judiciously. Leverage can be a problem, though, when cash flows become insufficient to meet obligations. Companies saddled with mountains of debt and weak interest coverage may have dug holes too deep to climb out of in a troubled economy.
Beta: Beta is a core measure of a stock's volatility compared with the broader S&P 500 -- which by definition has a beta of 1.0. High-beta stocks have more sensitivity to market fluctuations, while low-beta stocks typically exhibit smaller price swings. A stock with a beta of 1.5, for example, tends to rise 50% more than the S&P during a rising market and fall 50% harder when the market is dropping. By itself, beta can be a misleading statistic, but it can be a useful gauge in conjunction with other factors. I looked for below-average betas.
Beyond the numbers
Targeting companies that scored well in the areas above helped reduce the stock universe down to a workable group, but there is another important element in the process. Computers (at least not mine) cannot think or interpret the data, so rather than rely exclusively on screening, I tempered the process with a little common sense, intuitive judgment, and top-down analysis. In other words, I made another round of cuts based on qualitative factors (i.e., which industries will be least affected by a sluggish economy). The end result closely resembles the methodology used to determine which teams compete for NCAA football's Bowl Championship Series (BCS) trophy -- part computer, part human, lots of guesswork.
And the winners are:
|Ticker||2001 return||2002 return||Yield||Price/earnings (TTM)||Operating margins (TTM)||Interest coverage||Beta|
(2) Bank of America
(4) Procter & Gamble
(6) Waste Management
The common denominator
These blue-chip companies all operate in consistent, stable, and mature industries, and most represent the dominant force in those industries. During the tumultuous years of 2001 and 2002, when most companies were looking for a place to hide, this group posted solid gains. This list is by no means all-inclusive, but I'd say each of these stalwart companies stands a better than average chance of holding its ground when the next bear is on the prowl.
What do Ben Graham, Bill Miller, and Warren Buffett have in common? They are all value investors. You can be too -- take a free trial of the Motley Fool Inside Value newsletter.