Pick a pocket of US stocks

PORTFOLIO POINT: US equities remain attractive, but investors should be carefully selecting individual stocks rather than buying indices.

Amid the news flow of last week, Eureka readers would have seen reference to a bullish Goldman Sachs call to buy US equities, with risks to future growth “exaggerated”. The 40-page investment note by Goldman’s London-based strategist Peter Oppenheimer was received with equal measures of agreement and derision by the analyst community; the latter especially so in the wake of another piece of news about Goldman: that the investment bank’s employees allegedly refer to clients as “muppets”. But either way, Oppenheimer’s work certainly hit a nerve with traders and investors watching for an inflection point in the bond market, which could either spell doom or gloom for equities, depending on whom you ask.

However, for those watching equities, not bonds, Oppenheimer’s call seemed a little late to the party. Although his point on a narrowing gap between bond and dividend yields in the US is very valid (graphs are available in Friday's Research Watch), stocks in the S&P500 index have already rallied pretty hard in the meantime, from a low of 1,074.77 on October 4, to Friday's close of 1,397.11: a rally of 23%.

In Oppenheimer’s defence, it’s hard to time the market. I got bullish on US stocks on July 18 (see Beat the market doldrums), which is all well and good now, but my call came right before the market fell 17% to a low of 1119.28 on August 8. Had you waited a few weeks after my move – which was predicated on the argument that US bearishness was unfounded (though just because the market is irrational, doesn't mean it should be ignored) – you would be laughing, but had you acted instantly, you would have been waiting until January to recoup your losses, at least in US dollar terms.

Timing isn’t easy'¦
Source: Stock Doctor

Then again, this time in my defence, Aussie equities have done a lot worse and when currency considerations are taken into account, July was more or less just as good a time to diversify into US equities as was the market bottom in October, when our dollar fell back to below parity at $US0.95. And had you sold out of the ASX All Ordinaries on July 18 last year, you would have avoided a 4% loss to Friday's close (or a 16% loss from July 18 to the low of August 26).

With the wisdom of hindsight then, what is the best approach now with similar calls in the market to buy or sell the S&P500? Firstly, your thinking should go well beyond the index. Just as I don’t advocate holding a broad index of Australian stocks in current conditions – the gap between outlooks across the mining, banking and industrials sectors are just too wide – I don’t advocate holding a US index either, if you can afford the time and brokerage to go deeper into the world’s biggest equities market and pick stocks yourself (for a selection, see Ten-gallon stock tips).

The biggest charge against US equities bulls is that US profit margins are unsustainable and that forward earnings forecasts price such margins in (see chart below). Yet by stock-picking, rather than index-hugging, you can avoid this issue, choosing instead stocks that do have sustainable revenues, earnings and margins. In that vein, had you bought cash-rich and fast-growing Apple (NASDAQ:APPL), one of my picks on February 3, at $US459.68 per share, you would have enjoyed a 23% gain to Friday's close of $US596.05 per share, not to mention an all-time intraday high of $US609.65 on March 21.

Bubbling US profit margins'¦
Source: GMO LLC

The process of working out what’s sustainable and what’s not, however, is easier talked about than done. Still, beyond trawling company accounts, by using macro trends as a guide you can narrow down your range of stocks considerably.

First, investors need to identify which industries to consider and which to avoid. America is a big place and what drives the performance of one US stock will be irrelevant to another. The 'risk-on/risk-off’ mentality that dominated trading for much of 2010 and 2011 has broken down, says Morgan Stanley, which this month published research on cross-asset class correlations. (Interestingly, Morgan Stanley does not appear to be bullish on US equities as a whole, but the bank does like US corporate credit over the next three to six months.)

Source: Bloomberg, Quantitative and Derivative Strategies, Morgan Stanley Research

Source: CBOE, Bloomberg, Morgan Stanley Research

Second, investors need to drill down into stocks that have the right fundamentals, and not just of price (whether measured in terms of PE ratio valuation, discount cash-flow valuation or discount dividend modelling), but also in terms of risk – things like debt to equity, net tangible assets to equity and the performance of operating free cash-flow – as well as management and environment. Having said that, many brokers were recommending Enron and Lehman Brothers on the basis of fundamentals.

Third, investors need to consider how holdings of overseas stocks fit into their overall portfolio strategy. Owning a US (or European or Japanese) company shouldn’t be just about hedging the Australian dollar or diversifying beyond the ASX. To deserve a place in your portfolio, the stock should stand on its own merits. How does it stack up against its Australian peers? Does it over-expose you to a particular sector when you include similar Australian equities holdings? Is its probable lack of dividend income and definite lack of dividend imputation credits (pretty much unique to Australia and New Zealand) justified by likely capital growth?

In finding which industries, or sectors, to consider or avoid, this is arguably the most important – but subjective – part of the equation. Though it’s true to say that there are great stocks in all sectors at all times, finding a good stock in a bad industry can be like finding a needle in a haystack; better just to get a needle from somewhere else. And though there are plenty of disasters in even the most promising of industries – experienced investors in green energy, biotech or IT stocks can attest to that – a rising tide does generally lift all boats, even the rubber dinghies. Even if your stock-picking skills are based on a dartboard and pair of dice, if you stick to the right macro trends and ride the wall of money, you can generally extend and pretend as well as the most rigorous bottom-up value investor.

As for the macro trends I’m observing, part of my continuing attraction to US stocks in general is because America still enjoys a dominance in industries that I believe will do well in the next six, 12 and 24 months, unlike the Australian market in general, which is over-exposed to the industries that I believe will not do so well. The industries that I believe will do well are, in no particular order: oil (but not gas), electric vehicles, Chinese consumer discretionary goods, cloud computing, mobile telephony (especially in emerging markets), generic pharmaceuticals (but not brand-name pharma, though there are exceptions), and, at least in the long-term, agriculture and fertiliser. The industries that I expect to not do well are, again in no particular order: mining and mining services, Chinese real estate and construction, consumer and commercial banking (almost everywhere thanks to what could become a second Asian financial crisis), capital goods and heavy equipment, shipbuilding and thermal coal.

I’ve written about these sectors in more detail before and next week I wish to expand on this sectoral outlook within the context of the historic megatrends we are passing through, as I see them. In the meantime, however, the broad views I’ve put forth over the last year or so working at Eureka appear to be playing out. The US market has rallied, China has entered a slowdown, oil prices have spiked, and food looks likely to resume an upwards trajectory.

I’m still moderately bullish on the US – companies have maintained low debt and a savings glut still exists when measured by real interest rates – but think it’s time to get granular and start picking stocks, not investing in indices, if you’re not doing so already. Similarly, with regards to China’s slowdown, you should really reconsider exposure to mining and mining services in light of the macroeconomic data. Chinese electricity, cement and steel production is tanking, the HSBC flash purchasing managers’ index was down for the third month in a row last week and the ruling party's facade is showing signs of cracking (see China's Ides of March).

Exact timing, again, is hard to get right. But the trends speak for themselves.