Sell Europe, buy Hershey in the New Year

Hard times may be coming, and chocolate makes people feel better.

By InvestorPlace Dec 19, 2011 1:15PM
 (© image100/Corbis)By Jon Markman, Editor, Trader's Advantage

The past three presidential election years have been very hard on risky assets, and two of them were completely brutal.

The most recent was 2008, and if you don't remember the global financial crisis that occurred that year, you were either too young, drunk or in jail. The one before that, 2004, ended with a 9% gain but was flat or down for three-quarters of the span. And the one before that, 2000, featured the bursting of the technology bubble, with the Nasdaq 100 collapsing by 40%.

So it's no wonder that I am looking at the upcoming election year, 2012, with a jaundiced eye.

My mostly skeptical outlook is not way out of consensus, but most surveys show that the majority of investors are either neutral or mildly bullish. They are expecting a rebound from the 2011 quagmire as the U.S. economy slowly recovers, the Europeans find a solution to their credit troubles and emerging markets fulfill their destiny as growth engines that can charge higher even if the West falters.

To find consistent success as an investor, it usually pays to have a variant perspective. That is to say, a view that is outside consensus by at least a stone's throw -- which the consensus will eventually arrive at.

So in the current environment, it won't work to be neutral or mildly bullish. You either need to be very positive, arguing that all the pessimism of late is completely misguided and that stocks will roar forward over the next year as the economy improves more than expected. Or you need to be very negative, arguing that the majority of investors do not yet recognize the world of hurt that lies ahead -- and that stocks will be sold hard as earnings deteriorate.

My research suggests that the majority of investors underestimate the trouble that lies ahead for Europe as it enters a deep and prolonged recession amid the deleveraging of its banks and governments. Further, it looks as though emerging markets will get dragged down in the wake of Europe's decline because of the impact on exports and the tightening of credit by French and German banks. And my studies indicate that the U.S. won't be able to withstand the loss of buying power overseas -- and that will drag down earnings of most companies.

At the same time, I think companies that depend most on government subsidies, such as alternative energy producers, will experience the biggest difficulties as their fundamental business declines and their sugar daddies close credit lines.

So, just to make it easy, the simplest trades next year will likely be short iShares Europe (IEV), short iShares Emerging Markets (EEM) and short solar energy equipment producers like First Solar (FSLR).

What should investors be buying? You can pair these trades against a long purchase of iShares Consumer Staples (XLP), as this sector tends to do fairly well, if not actually great, when times get tough. Other safe bets should be corporate bond funds, such as Vanguard Corporate Bond (VWESX) or the exchange-traded fund iShares Investment Grade Bonds (LQD).

As others make their choices for "best stocks for 2012," I'm focusing on a U.S. food maker or low-cost vendor for my long pick. There are many good ones, like General Mills (GIS), Kraft (KFT) or Dollar Tree (DLTR). But I'll go with chocolate maker Hershey (HSY), which produces something that isn't quite a staple but actually makes people feel better in difficult times. That Hershey product is, of course, chocolate.

Your first thought might be, "Hershey only makes chocolate, and I'd hardly consider that a staple that I must have." Well, try explaining to my daughter that chocolate isn't a household staple.

Hershey is the largest candy maker in North America, controlling 43% of all chocolate sales. It also makes cookies, snack bars, baking ingredients and beverages.

Its product portfolio consists of over 80 brands, including Hershey's, Reese's, Kit Kat and Bubble Yum. Headquartered in Pennsylvania, it's a $13 billion international powerhouse whose products are sold in 60 countries. It generates over $5 billion in annual revenues and employs 14,000 people.

Milton Hershey founded the company in 1894 when he decided to shift focus from his Lancaster Caramel Co. to chocolate instead. He built a milk-processing plant a couple years later and eventually refined what later became known as the "Hershey process," a trade secret for manufacturing chocolate candy with milk. This type of chocolate is the taste that most Americans know, though it's hardly the only chocolate taste available in the world.

More than 30% of Hershey shares remain owned by the Milton Hershey School Trust, which funds a private school that Hershey and his wife founded in 1909. The company is in good hands with Chief Executive John Bilbrey at the helm. He took over recently after serving in various management roles since 2003. He's a former executive with Danone (DANOY) and Procter & Gamble (PG), and is reported to have a deep understanding of the business.

Hershey has averaged earnings growth of 33% over the past three years and is the best operator among its peers, having achieved inventory improvement in six consecutive years. It has done a particularly good job of reining in costs and improving efficiencies, leading to $180 million in annual savings. Another $80 million in cost cuts is targeted over the next three years.

Despite its long and storied history, Hershey plans to stay aggressive in its growth plans. It's looking to expand overseas, where it currently generates only 15% of its revenues. I like this upside. Earlier this month it acquired Canada's Brookside Foods and, according to management, looks to double its non-North American business from about $500 million to $1 billion by 2015.

Brookside's expertise lies with chocolate-covered fruit, fruit juice and nuts, for which it holds several patents. According to Thilo Wrede, an analyst with Jefferies, this purchase will be immediately accretive to earnings and further expand Hershey's product portfolio.

Investors have been rewarded this year -- the stock is up nearly 25%. You may be interested to know that it also performed well in 2008, 2004 and 2000. Chocolate really does make people feel better: It's not quite a drug, but it has properties that promote a mild sense of well being. Consider it an affordable luxury for difficult times.

In sum, Hershey is a best-of-breed operator that deserves and gets a premium valuation. Even in a tough environment, it could appreciate by 10% or more. If you're willing to be patient, split your purchase into thirds. Buy a third at year-end, a third at $56 limit and a third at $54 limit.

Jon Markman operates the investment firm Markman Capital Insights.  He also writes a daily trading newsletter, Trader's Advantage, and a long-term investment service, Strategic Advantage.

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