The markets closed the week before last with all three indexes firmly in a correction, down more than 10% from the 52-week high.
Of course, the selloff could get much worse and even the best names could fall further, but there’s one very important difference between what I call “forever stocks” and the thousands of other shares traded on the exchanges.
Whether a recession comes sooner or later, these are the names with strong competitive advantages that will not only survive the downturn but take market share as less efficient companies struggle.
That means you don’t have to time a market downturn perfectly. Any investment in forever stocks can be a great long-term buy.
The Strategy That Doesn’t Depend On Market Timing
To say it’s a volatile market is an understatement. The VIX volatility index has jumped to an average of 18.4 over the last three months, 27% higher than the average over the three years to 2018. The market has fallen a percent or more 27 days this year, more than in 2016 and 2017 combined.
The economy is sending mixed signals and investors are on pins and needles for any development in the trade war. The Federal Reserve expects U.S. economic growth to top 3.1% this year. While GDP growth is expected to cool over the next two years, it’s still expected positive at 2.5% and 2.0% through 2020.
Against rising rates, historically low unemployment is supporting consumer spending that continues to drive the economy.
In a volatile market with a recession an eventuality, it’s important to get back to the idea of forever stocks. These are companies with competitive advantages in their industry, strong brands and the financial power to not only survive during a downturn but take market share from weaker peers.
What to Look For In Forever Stocks
Finding these best-of-breed names means looking at both qualitative and quantitative strengths.
Quantitative advantages are relatively easy to measure and include metrics like the operating margin and return-on-assets.
While most investors focus on bottom-line profitability, I like the operating margin as a more accurate measure of management’s ability to drive profits. Following the operating margin gives you profitability without the distortion of leverage and taxes.
Qualitative advantages in brand strength and management can be more difficult to assess but can be compared on a relative basis. The longevity of management and stewardship ratings as well as a comprehensive strategic plan in investor reporting can point to companies with qualitative advantages over peers.
Beyond the competitive advantages, investors also need to look at relative price measures like price-to-earnings. Shares of these best-of-breed companies can get bid up for a premium on their strengths so investors should avoid paying too much. These are long-term investments so there’s no need to jump into a stock until the opportunity to buy-in at a good valuation presents itself.
Emerson Electric (NYSE: EMR) is a diversified industrial equipment provider but has set itself apart in automation solutions, one of the fastest-growing segments in the industry. Shares are down 24% since September highs largely due to the heavy exposure to oil & gas customers.
Despite recent weakness, the company was still able to book earnings growth of 7% year-over-year in the most recent quarter and is expected to grow EPS by nearly 9% over the next year. Emerson is using its unique distributed control system, Ovation, to expand throughout the power markets into data analytics and security.
CEO David Farr has been leading the company for nearly two decades and grew the automation business from almost nothing to the largest installed base in the industry. He’s known for being brutally honest with investors, giving a clear assessment of the company’s strengths and weaknesses.
Shares trade for 17.9 times earnings and the company has one of the strongest operating margins among peers at 16.3% over the past year. Shares pay a 3.2% yield, and new technology could help drive the Commercial & Residential Solutions over the next few years.
Alibaba Group (NYSE: BABA) is the leader in e-commerce, cloud solutions and entertainment media in China. The company is growing cloud revenue at 90% year-over-year and booked overall revenue growth of 54% in the most recent quarter.
Shares have followed the rest of the Chinese market lower since June, losing 30% of the market cap, and trade for 30 times trailing earnings. That’s less than a third the multiple of 98 times earnings for shares of Amazon. Alibaba’s operating margin of 28% is nearly six times the 5% margin reported by U.S. e-commerce leader.
Alibaba signed a partnership with the Russian Direct Investment Fund, the sovereign wealth fund of Russia, to revitalize the country’s consumer internet and e-commerce platforms. E-commerce in Russia is still just 2% of total retail sales but expected to grow at 30%+ annually and could be a profit machine for Alibaba.
The company’s founder, Jack Ma, recently announced he was stepping down from the executive chairman role, leaving some uncertainty, but the company is thought to be exceptionally well-run. The Alibaba Partnership, a group of 36 core managers, results in a peer-run business with less bureaucracy.
Sanofi (NYSE: SNY) is one of the most diverse drugmakers in the industry with just 10% of sales from its strongest product. The company books revenue in five segments from Rare Diseases (34% of revenue) followed by Multiple Sclerosis (24%), Oncology (18%), Rare Blood Disorders (13%) and Immunology (11%).
In the five years through 2016, management has taken the company from underperforming the industry average on new product sales per R&D spending to a market leader. The company also leads the industry average in success of drugs in Phase 2 and Phase 3 drug trials.
Shares trade for 14 times earnings, well below the industry average, and the 16% operating margin is above most peers. Almost two-thirds (65%) of the company’s pipeline is in first-in-class drugs, providing a long runway for patent protection and growth.
Risks To Consider: Even best-of-breed companies will see their shares weaken in a recession but should emerge stronger over the long-term.
Action To Take: Take advantage of the recent selloff to pick up long-term investments at opportune prices for a portion of your portfolio you can hold through the next recession.
— Joseph Hogue
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Source: Street Authority