My Retirement Portfolio Just Backed Up The Truck On 6 High-Yield Stocks – Seeking Alpha

Posted: March 5, 2020 at 12:47 pm


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(Source: imgflip)

What an interesting few weeks it's been for investors.

Outside of single-day corrections (like Oct 19th, 1987 when S&P fell 20% in a single session), we've seen the fastest correction since the Great Depression.

That included an 11% decline in the S&P 500 and a 13.6% crash in the Dow during the final week of February. That was the worst week since 2008 and the 5th worst of all time.

Then on Monday, global central banks came out and said they would slash rates and provide "ample liquidity" to avert or at least mitigate a recession caused by the COVID-19 virus. That sent stocks up 4.8%, their best one day gain since 2008.

The bad news is that with 94,301 cases in 82 countries, this is now a pandemic that has escaped initial hopes of early containment.

The good news is that, as seen by China's daily new cases falling to a steady 100 per day in the past week, the COVID-19 virus is NOT a doomsday bug that will likely sweep the globe and kill millions.

(Source: Johns Hopkins) orange = China cases

China was the 51st most prepared country in the world for an epidemic according to a study by Johns Hopkins.

Yet even in Wuhan, where this outbreak began, Just 1 in 10,000 people have contracted the virus.

Of course, that doesn't mean that the global economy won't feel a short-term impact from this. Already over 220 S&P 500 companies have warned that supply chain disruption and lower demand from overseas (mostly China itself) will impact Q1 and thus 2020 earnings.

China's efforts at containing the outbreak, which appears to be succeeding, involved quarantining 60 million people and placing travel restrictions on 600 million.

(Source: Bloomberg)

The result of basically shutting down the country for a few weeks has been the sharpest contraction in manufacturing and services ever recorded.

The Harvard Business review just put out the following note:

Reports on how the Covid-19 outbreak is affecting supply chains and disrupting manufacturing operations around the world are increasing daily. But the worst is yet to come. We predict that the peak of the impact of Covid-19 on global supply chains will occur in mid-March, forcing thousands of companies to throttle down or temporarily shut assembly and manufacturing plants in the U.S. and Europe. The most vulnerable companies are those which rely heavily or solely on factories in China for parts and materials. The activity of Chinese manufacturing plants has fallen in the past month and is expected to remain depressed for months." - HBR (emphasis added)

How long will the supply chain disruption last?

According to David Iwinski, a local Chinese business consultant, We think August, September, this will be a memory.

The good news is that the maximum impact from supply chain disruption is likely to be mid-March. China reports that 96% of state-owned companies are already back to 91.7% capacity.

In other words, March 2020 is likely to see a temporary and peak hit to the US economy and companies. After that, a gradual recovery through September is likely, based on the best available data we have today.

We're already seeing signs of a supply chain recovery out of China. According to National Retail Federation CEO Matt Shay

A number of the larger companies have started to indicate that the signs that theyre getting from the Chinese market are some of the production is coming back online."

But this brings me to the reason for this article, the first emergency rate cut since 2008.

(Source: FOMC)

Monday the market was pricing in 100% probability of a March 50 bp rate cut. The Fed delivered that two weeks early. Stocks initially rallied 1.5% and then proceeded to decline a startling 5% at their peak in a matter of hours.

Bond yields cratered at a rate that even veteran bond traders found startling. The 3-month yield, which tracks the Fed Funds rate (and anticipates what it does in the future) fell 20%... in a single day. Today it's down about 25% more.

The 10-year yield, the proxy for long-term term rates, fell to an intra-day low of sub 1% for the first time in history.

(Source: CNBC) as of 2:15 PM EST 3/4/2020

The bond market is now anticipating even more rate cuts (since the COVID-19 pandemic is likely far from over). This explains why stocks are soaring (apparently due to Biden winning Super Tuesday) yet bond yields continue to fall.

Note the 3-month yield is falling the fastest, uninverting the yield-curve which is now at +28 bp and implying about 26% probability of a 2021 recession according to the Cleveland Fed/Haver analytics model.

Mark Zandi, Moody's Chief Economist, estimates that COVID-19 supply/demand shocks raise the risk of a 2020 US recession to about 40%, up from 20% a few months ago.

Normally, recession risk is higher the longer the time frame. However, since supply shock recessions are brief, mild and only last as long as the shock, in this case, the opposite is true.

Recession risk is higher this year than next year because the pandemic is likely to be over by the end of 2020.

(Source: CME Group)

Basically, bond yields are falling because bond investors are pricing in an 83% probability of at least one more rate cut this year.

But some, like JPMorgan, have far more dramatic expectations:

"I would not be surprised if within the next few months the Fed went back down to zero." said David Kelly, chief global strategist at JPMorgan Funds.

The bank's US economics research team told clients Tuesday they now see a 50% chance of a return to zero this year." - CNN (emphasis added)

That brings me to the six high-yield stocks I bought during Tuesday's emergency rate cut meltdown.

Why do I believe so strongly in these six companies that I chased them down 28 times via limit orders so far?

(Source: imgflip)

As I've already explained, recession risk is being badly mispriced by the stock market right now, with financials and media companies being valued as if they will see permanent negative growth.

Reward/Risk Ratio

I am now paying under six times earnings on these companies which according to the Graham/Dodd fair value formula implies about -6% CAGR forever. My average cost basis implies -5% CAGR long-term growth.

Now, let me debunk the notion that today's low rates mean quality financial companies such as these can't grow.

Here is how UNM, OZK, CMA, and LNC have performed over the past decade when financial regulations have been stricter and interest rates their lowest in history.

Quality Financial Companies Can Overcome Low Rates

(Source: Ycharts)

Whether you look at book value, EPS or dividends, all four have performed admirably which is why I trust their competent management teams to overcome temporarily reduced rates.

By no means do I expect short term or long-term rates to ever go back to 4%, 5%, or 6%. The bond market is pricing in long-term inflation of about 1.6% to 1.8% over the next 10 to 30 years. That lines up with most economists (and the Fed's) 2% GDP growth forecast for the US and 2.5% long-term interest rates (10-year yield).

Even IF COVID-19 leads to a mild supply shock recession, that contraction will likely be brief and interest rates will likely rise as soon as it's over.

The time to buy quality financials is when the market hates them most, to the point of allowing you to buy a blue chip insurer like UNM at under 4 times earnings.

A 24.3% earnings yield -risk premium on UNM represents a 6.6 times greater reward/risk ratio than the S&P 500's 3.7% average since 2000.

Private equity companies are paying about 12 times earnings/cash flow for illiquid companies, often ones that require 5-10 year turnarounds.

The average Shark Tank deal is for 7.0 times earnings/cash flow, again for small, private companies with far higher growth uncertainty.

So let's take a look at the fundamentals of these six companies, to see why buying them for an average PE of under 6 is not just a great deal, but what Chuck Carnevale calls "buying opportunities of a lifetime unless the business models completely implode."

(Source: Dividend Kings Valuation Tool)

Fundamental Stats On These 6 Companies

Fundamentally, what I'm trying to do with these six companies is to be greedy when others are fearful so I can, in the words of Joel Greenblatt, buy "above-average quality companies at below-average prices."

(Source: imgflip)

Except that I'm not buying at just below-average prices, I'm buying these companies at an average discount to their approximate market-determined fair values of 52%.

That makes them anti-bubble stocks, as seen by the fact that, according to Graham/Dodd, the founders of company analysis and value investing, they are priced for -6% CAGR long-term growth while analysts expect them to grow 9.2% CAGR over time.

Am I worried about a short-term interest rate collapse? Absolutely not. Not only because it would be temporary (time arbitrage is the game all value investors play) but because even if they don't grow as expected, I'm likely to earn strong returns. All while enjoying fat, safe and growing yields.

What A Potential Buying Opportunity Of A Lifetime Looks Like

(Source: F.A.S.T Graphs, FactSet Research)

For example, here's the kind of return potential generated if UNM grows as expected and returns to the mid-range of its historical fair value (PE of 9.0).

UNM has a great track record of meeting or beating EPS forecasts, within a 10% and 20% margin of error over 12 and 24-month periods.

But the idea behind anti-bubble stocks is that you don't require any growth at all in order to make good and often market-beating long-term returns.

VIAC Long-Term Total Return Potential If It Grows At Zero

(Source: F.A.S.T Graphs, FactSet Research)

UNM Long-Term Total Return Potential If It Grows At Zero

(Source: F.A.S.T Graphs, FactSet Research)

FL Long-Term Total Return Potential If It Grows At Zero

(Source: F.A.S.T Graphs, FactSet Research)

LNC Long-Term Total Return Potential If It Grows At Zero

(Source: F.A.S.T Graphs, FactSet Research)

CMA Long-Term Total Return Potential If It Grows At Zero

(Source: F.A.S.T Graphs, FactSet Research)

OZK Long-Term Total Return Potential If It Grows At Zero

(Source: F.A.S.T Graphs, FactSet Research)

Keep in mind that these are the returns potential if each of these companies grows at zero for the next five years.

Now contrast these return potentials to the expected returns of the S&P 500 based on 6% to 8.5% CAGR long-term growth expectations (depending on the asset manager model).

Original post:
My Retirement Portfolio Just Backed Up The Truck On 6 High-Yield Stocks - Seeking Alpha

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March 5th, 2020 at 12:47 pm

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