A Stable Portfolio for a Shaky Economy
With prospects for a recession growing, it's time to make a shift from small stocks to blue chips.
The whims of markets change constantly. One year the crowd favors technology companies, and then the mood shifts and the next year investors embrace shares of banks. A particularly odd pattern emerged in 2002 when investors rushed to buy shaky small companies.
While little-known stocks climbed, the stocks of rock-solid giants, such as General Electric and Johnson & Johnson, lagged. During the four years ending in 2006, companies rated A+ by Standard & Poor's—businesses with steady growth and stable earnings—returned 9.7% annually. At the same time, erratic performers with ratings of C and D returned more than 18% annually.
To be sure, many small companies had been overlooked in the 1990s, and their shares may have been making up for lost time. But much of the rally in small caps must be attributed to the mood of investors. With the economy doing well and small companies growing nicely, people felt confident enough to take flyers on risky stocks.
Then in 2007, the confidence began to erode. Earnings growth stumbled. Nervous investors changed their ways, bidding up prices of safe companies and avoiding unstable businesses. Today, with the outlook for economic growth bleak, the market is likely to continue favoring the safest blue chips, says Robert Millen, portfolio manager of Jensen Fund. He recommends buying familiar giants, including Procter & Gamble, 3M Company, and PepsiCo. Such rock-solid companies are not likely to stumble any time soon.
Millen is no recent convert to the gospel of blue chips. For years, he has favored several solid stocks with healthy growth prospects. To find the highest-quality stocks, Millen applies a clear test: a company must have recorded a return on equity of at least 15% for 10 consecutive years. Of the more than 10,000 publicly traded stocks, only about 200 clear the hurdle. “To achieve high returns on equity consistently, a company must dominate a niche or hold some long-term advantage, such as key patents,” says Millen.
Millen sticks to his formula. If a company in his fund misses the mark for one year, he immediately sells the shares. He will not buy back the stock until the company has passed the 15% growth test for another 10 straight years. Why so rigid? Predicting future performance is always difficult. But Millen says that if a company has posted a decade of strong profits, then future results are likely to be healthy.
Secondly, after screening for returns on equity, Millen favors companies that are generating lots of extra cash. Companies in his portfolio use cash to boost share prices by raising dividends, buying back their own stock, and making acquisitions. Dividend increases are a particularly strong signal. Corporate boards are reluctant to raise their dividends unless there is enough cash on hand to support the payout. So when a company increases its dividend year after year, investors can expect that the business is healthy and able to pay its bills.
The most reliable performers are companies that have long-term contracts with their customers. These companies receive steady income year after year. “When a company already has some revenues locked in, you can have a good idea what its earnings will be in the future,” says Millen. Two companies that meet his criteria are Automatic Data Processing and Emerson Electric.