The Quiet Rally
Stocks continue a stealth rally, quietly moving to their best levels in five months. The market has recently been untroubled by bad news from Europe, even receiving some sparks of good news like another small downtick in the unemployment rate. Quarterly earnings season kicked off with a few decent reports while trading volume increased, an encouraging sign of buying by the big institutions.
Fresh pension funding usually adds liquidity in January, and new funds seem to be going into stocks rather than bonds, which outperformed stocks in 2011. It was not difficult to outperform stocks during the year, as stock returns were flat. Investors were fearful and favored defensive stocks like McDonalds, which was the best performer among the 30 stocks in the Dow Jones Industrial Average. (Bank of America was the worst.)
Investors tend to favor whatever worked in the recent past. There is some logic to this as stocks often continue their momentum but investors should attempt to distinguish between stocks that have performed above average because of fads or emotions and those that will benefit from changing business conditions.
Stocks like McDonalds and Proctor & Gamble usually do well in anxiety-ridden markets like 2011 but are often outshone by more cyclical or faster growing companies as investors regain confidence. There is nothing wrong with holding blue chip stalwarts like these even though their growth is slow and their valuations higher than more volatile stocks. With the Euro Zone possibly sliding into recession and the U.S. showing early signs of an economic pickup, investors should consider selective additions of domestic stocks in faster growing companies, accepting their accompanying greater volatility.
TransDigm (TDG-$98) is a Cleveland-based manufacturer of highly engineered components for airliners and military aircraft. Sales are $1.2 billion, growing recently at over 40%. Earnings growth is strong, although variable, with recent and forecast quarterly increases of 20%-30%. Earnings per share for its current fiscal year are forecast at $5.30, up 24%, with a resulting forward price: earnings ratio of 18.
The company has grown through acquisitions, resulting in substantial debt, a concern but also an advantage in today’s low interest rate climate, provided it can continue its growth. TransDigm is well positioned, as its market comprises almost all aircraft in service, of which 95% of its sales are of proprietary products for which it owns the design. Additionally, it is the sole source supplier for 80% of its sales.
Stocks in cyclical companies like manufacturers should be balanced with the income funds that I have been recommending for years. Some like Alliance Bernstein Global (AWF-$14) and Credit Suisse (CIK-$4) have gained other fans, whose buying has pushed their market values above their net asset values. Their dividends remain quite attractive and they should be held while new purchases should be directed to those still selling at discounts.
Franklin Trust (FT-$7), an old favorite, still trades at a 7% discount and pays 7% despite an 11% price gain in 2011. This idiosyncratic bond fund combines mild leverage with 30% holdings in utility stocks. Wells Fargo Multi-Sector (ERC-$15) offers an 8% discount and an 8% yield. Nuveen Multi-Currency Short-Term, a best buy, is selling at a 12% discount and yields 10%.
Beyond bond funds, CBRE Global Real Estate Income (IGR-$7) has a 13% discount and pays 7.5%. Eaton Vance Enhanced Income (EOI-$10) has a whopping 14% discount and yields over 10%. It holds big cap stocks and sells call options against them, an income strategy that works, but should be left to pros and not tried at home.
Those who hoped that 2012 would bring an end to uncertainty and volatility in the stock market will be disappointed. Those who accept these factors and take advantage of them will be rewarded.
Tony Crowell manages stock portfolios for individuals and their trust and retirement accounts with CROWELL•ROBERTS Investment Counsel, a registered investment advisor in Laguna Beach since 1993. [email protected] 949.494.1376/