Stocks that could reward you for fiscal cliff risk

Many investors are avoiding buying into companies they think could get hit, and that's creating some big potential bargains.

By John Reese Dec 13, 2012 2:47PM

Ball on Roulette wheel, close-up copyright Adam Gault, Digital Vision, Getty ImagesWhile history's greatest investors have come in a variety of shapes and sizes, one quality that the vast majority have had in common is that they are contrarian thinkers. They don't follow the crowd, they don't listen to the pundits, and they don't let the headlines of the day drive their investment decisions.

 

Right now, the headlines and the pundits and the crowd seem to have one thing on their minds: the fiscal cliff. And the conventional wisdom seems to be that, if the U.S. does go off the cliff (which will trigger a number of significant tax hikes and budget cuts in 2013), stocks will get hit hard -- particularly certain types of stocks, like dividend plays and defense companies. Be cautious, the thinking goes -- very cautious. 


But what if we don't go off the cliff, or we do, but the impact on the stock market isn't as severe as expected?


Despite what you may have heard, those are both legitimately possible scenarios. And if they do play out, the stocks that are supposed to get hit hard could instead take off. If you're willing to take on some macroeconomic risk in your portfolio, you might want to take a look at some of these types of stocks. 


Recently I used my Guru Strategies -- each of which is based on the approach of a different investing great -- to find some of the most fundamentally and financially sound stocks in "cliff-sensitive" areas of the market, like the defense sector, dividend stocks, and small caps. Again, keep in mind that these stocks come with a good amount of macroeconomic risk in the short term. But also keep in mind that that risk has been known for some time, and may well be baked into prices already. If you have a long-term horizon, picks like these could provide some nice upside within a well diversified portfolio.

 

General Dynamics (GD): The Virginia company ($24 billion market cap) is one of the U.S.'s largest aerospace & defense firms, making everything from battle tanks and battleships to armaments and munitions to nuclear submarines and military information technology systems.

 

Defense companies could be hit hard if the U.S. goes off the fiscal cliff, which calls for drastic reductions in defense spending. But General Dynamics has a long history of strong performance, and its size would give it a big advantage over smaller firms even if those drastic defense cuts did go into effect. In addition, the fiscal cliff fears have made it quite cheap -- it trades for just 9.6 times projected 12-month earnings, which is based on projections of only minor growth next year.

 

My Joel Greenblatt-based model is high on GD. Greenblatt used a remarkably simple, two-variable strategy that looked at earnings yield and return on capital. With an earnings yield of 14.4% and a return on capital of nearly 50%, GD rates quite highly.

 

Intel Corporation (INTC): This California computer-chip giant is paying a very healthy 4.4% dividend yield. But if legislators don't address the fiscal cliff, dividend taxes will jump significantly, which has led to speculation that dividend stocks' shares will get hit hard. The reality may be far different, however. A recent study by O'Shaughnessy Asset Management found that, historically, high-dividend stocks have actually done best when dividend taxes were highest, believe it or not.

 

Plus, Intel has more than just that dividend going for it. It has a long-term growth rate of more than 26% (I use an average of the three-, four-, and five-year earnings per share (EPS) growth rates to find a long-term rate) and trades for just 9 times trailing 12-month EPS; that makes for a stellar 0.34 Price/Earnings-to-Growth ratio (PEG), one reason my Peter Lynch-based model likes it. The model I base on the writings of OSAM's James O'Shaughnessy, meanwhile, likes Intel's size ($103 billion market cap), solid $3.82 in cash flow per share, and that 4.4% dividend yield.

 

Northrop Grumman Corporation (NOC): Like General Dynamics, Grumman is a large ($17 billion market cap), well diversified aerospace and defense firm. In the past year, it has taken in more than $25 billion in sales.

 

Grumman shares are cheap, trading for 8.8 times trailing 12-month (TTM) earnings, and 9.2 times projected 12-month earnings. My Lynch-based model likes Grumman's 18.6% long-term growth rate, 3.2% dividend yield, and that 8.8 TTM P/E, all of which make for a strong yield-adjusted PEG of 0.40. (For slow and moderate growing firms, Lynch added dividend yield to the growth rate in determining a PEG.)

 

My Greenblatt-based model also likes Grumman, thanks to its 18% earnings yield and 43.1% return on capital. And my Kenneth Fisher-inspired strategy is high on the stock as well. Fisher pioneered the price/sales ratio (PSR) as a way to gauge value, and Grumman's PSR of 0.66 comes in under this models 0.75 upper limit, a good sign. The strategy also likes Grumman's $3.85 in free cash per share and 7.1% three-year average net profit margins.

 

ConocoPhillips (COP): Houston-based Conoco is an integrated oil and gas firm that has operations in more than two dozen countries. The $71-billion-market-cap firm has taken in more than $60 billion in sales over the past year. It's another high-dividend play (4.5%), but it's cheap, trading for just 10.5 times TTM EPS.

 

My O'Shaughnessy-based model thinks Conoco is worth a long look. It likes the firm's size, its impressive $11.35 in cash flow per share (about eight times the market mean), and that stellar dividend yield.

 

Main Street Capital Corporation (MAIN): This Houston-based investment firm offers long-term debt and equity capital to lower middle-market companies and debt capital to middle-market firms.  Main Street has three things going against it in terms of the "cliff" fears: It's a small-cap ($915 million); it's a financial; and it's a high dividend stock (6.2% yield).

 

But Main Street has even more going for it. My Motley Fool growth model (based on a strategy outlined by Fool co-creators Tom and David Gardner) gives it very high marks, in part because of its impressive growth. The firm upped EPS nearly 63% and revenue 34% last quarter (vs. the year-ago quarter). It also has tremendous profit margins, which have been rising (95% this year). And it's cheap -- Main Street's "Fool Ratio" (the same as Lynch's PEG ratio) is just 0.21.

 

My Lynch-based model also likes Main Street, thanks to its 38.8% long-term growth rate, that 0.21 PEG, and its 63% equity/assets ratio.


John Reese is founder and CEO of Validea Capital Management and Validea.com, a premium investment research site, and the author of "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies". 

 

I'm long NOC, GD, MAIN, INTC, and COP.

3Comments
Dec 14, 2012 7:34AM
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Every indicator suggests plowing forward will result in going backward. Consider how blind marketing and mass marketing was destroying brand value for years before the CEO got off the golf course and figured out he was killing the company by following others. In 1983, 99% of businesses bought into a similar business plan. By year-end most were destroyed, failed, force-acquired or in bankruptcy. The fact is, there are indeed- businesses positioned and structured for cliff survival. We can't see them because Wall Street Analysts and Economists are in the way. How do you analyze and forecast in an environment you are clueless in? How do you stop your massive unfounded ego from blinding you to critical nuance facts? One thing is for sure, Wall Street won't survive the cliff or shift. It can't. 99% of publicly traded entities are structured for financial play, not tangible actual performance. They won't make it either. I'd rather have a shirt being made here but perhaps on back order by demand, than the promise of one being shipped overseas only if maker and fake front office can agree on terms. There's more to that example than you think.  
Dec 20, 2012 3:55PM
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Here's a link to a video version of our study mentioned above -- -- uncorrelated dividend tax rates vs. dividend-stock performance.
Dec 14, 2012 2:08AM
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Wake up America

If the president gives into any of these outrageous demands from the Republicans

In their implacable obsession to make the rich, richer on the back of the middle class, many of us, friends, relatives, and neighbors that are hard core Democrats are saying we will for ever lose our Democrat Base. Its also obvious the Rolling Over of the Democrats one more time on the ridiculous, insidious, and inflexible demands from these fastidious people, wanting more bartering in their favor will terrible undermined the chances of Mrs. Clinton to run for president, and gain the presidency in 2016! We have suffer enough economical stagnation for many years  from the dismal political, and erratic socio-economical policies of Bush, and their dismal abuse of the people, in wars, unpaid taxes, lack of proper Big Business, and Banks regulations, disastrous economical expenditures that had brought us to this present fortuitous situation, to this living travesty of the present Fiscal Cliff. The loud voice from all the Democrats around here is that, we nearly lose the country to Bush economical debacles of 2008, we are ready to suffer some more pains not to tolerate any more further abuses of the House of Representatives Tea party, and Republicans in their relentless discard from the millions people’s hunger, and their perpetual discord putting our USA in chains against our wishes for food, and jobs any longer! This time it be much better, to win than losing our honor one more time.

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