Time for Investors to Take Cover?

Farr, Miller & Washington's Michael Farr says costly oil and the yield curve possibly inverting are red flags, making him prefer defensive stocks

"This is a time for investors to be defensive." That's the warning from Michael K. Farr, president of investment firm Farr, Miller & Washington.

One of Farr's worries is that "with oil above $60 a barrel, people are making excuses as to why [it] can go higher without causing any significant economic disruption." That reminds him of the late 1990s, when dot-com stocks were soaring, and people were arguing that it was a new era of investing. "Sooner or later, cyclical stocks and cyclical industries complete their cycle, and the prices will come down," he says.

Farr also has concerns about inflation and the possibility of an inverted yield curve, which he notes has always led to recession. In this climate, he urges a defensive strategy, investing in only select stocks. Among his current choices are Bank of America (BAC ), drugstore chain CVS (CVS ), PepsiCo (PEP ), General Electric (GE ), and IBM (IBM ).

These were a few highlights from an investing chat with Farr presented Aug. 18 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at aol.businessweek.com/chats

Q: How do you see the market's prospects, oil prices and all?


Oil prices continue to be a serious concern. When oil prices were flirting with $50 a barrel, several experienced market watchers noted that sustained $50 oil inevitably led to recession. It's very interesting to me that with oil above $60 a barrel, people are making excuses as to why oil can go higher without causing any significant economic disruption.

I'm reminded of the late '90s, when concept stocks and the dot-coms seemed to defy gravity and reason, and the market made up excuses as to why things were different this time, why this was a new era of investing, and how things could continue to go higher unabated.

When explanations begin to surface that things are "different this time" and that "the old rules no longer apply," you should be afraid -- you should be very afraid...sooner or later, cyclical stocks and cyclical industries complete their cycle, and the prices will come down.

We're seeing inflationary signs. In addition to the price of oil, food prices are modestly higher, education is higher, housing is higher, health care is higher. Yesterday's producer price index -- the prices that manufacturers pay -- was unexpectedly high.

The Fed is committed to additional rate hikes, and in a most puzzling manner, bond yields refuse to move higher. The difference between the two-year and 10-year Treasury yield is now 0.21 of 1%. If the Fed Open Market Committee increases short-term rates at their next meeting by 25 basis points, they will cause the yield curve to become inverted. Every time the yield curve has become inverted, we have gone into recession.

This is a time for investors to be defensive. Individual stocks still represent value, but money is too hard to make to be the least bit speculative in this sort of investing environment. We're continuing to remain invested, but we're exceptionally cautious and encourage all investors to be more on their guard than normal.

Q: So how do these factors affect your own investment calculations? Any changes in portfolios?


We're more cautious than ever on the financial stocks. There are still those that we like, though we have modified our expectations for them. Bank of America is yielding 4.6%, and it's trading at 10 times earnings. Earnings are forecast to increase almost 10% per year over the next few years, and that's a rate superior to the average S&P 500 stock, and the multiple is significantly lower than an average S&P 500 stock. With the 30-year Treasury bond paying 4.4%, we think a position in Bank of America makes sense for our investors.

I think that you need to lighten up on those banks [that are] more reliant on the consumer, more reliant on mortgage revenues, issuing fees, and those that are providers of subprime debt.

Q: What individual defensive stocks do you recommend?


In addition to Bank of America, I like CVS, the drugstore chain. With the graying of America comes a higher demand for drugs. The pharmaceutical industry is heavily regulated and litigated, but stores like CVS will benefit from an increase in volume. They will especially benefit from an increase in volume on generic drugs coming off patent. Those sales are more profitable. We see CVS as a more defensive way to participate in that trend.

General Electric also appears to us to be defensive. GE is benefiting from the cycle in energy. They also are well on their way to recover in several divisions after the last recession and economic slowdown. Several of their long-term businesses that are very economically sensitive suffered.

As new long-term orders begin to fill the books, the forecast for GE's performance continues to improve. It's trading at a market multiple, the dividend is 2.6%, and earnings are increasing at around 10% per year, which again is a premium to the average S&P 500 stock. GE, therefore, is similar to an S&P 500 price with superior earnings power. I also want to throw in PepsiCo and IBM as good defensive stocks.

Q: Michael, what do you want to see happen for your strategy to change from defensive to offensive?


That's a great question. I think that the deficit needs to continue to shrink. The higher-than-expected tax receipts need to continue. The price of oil also needs to come down. And air needs to be released from the real estate bubble. In other words, we need a more stable footing for investors.

The inflated real estate market has provided a constant source of funds for the consumer. Home equity loans continue to increase, with ever more creative financial terms. Most of these creative financial terms are floating rate -- adjustable-rate. They'll go up if and when rates go higher.

The already overextended consumer will find that expenses are going up in all areas of his or her world, and bills will go unpaid. Credit-card debt is high, mortgage balances continue to increase, so somehow the consumer who has been resilient beyond reason needs to come back to reality. That slows the economy, that stops the need for rate increases, that stops inflation, and that makes me feel better.

Q: What do you think of Cisco Systems (CSCO )? A: We think, for the first time in several years, Cisco's valuation looks very compelling for accounts under our management. Future growth opportunities for Cisco will come from products that facilitate wireless networks in the home and in the office. We think Cisco is an above-average company that deserves an above-average multiple.

Q: Beyond Cisco, how do you view the tech sector generally? Any names?


We like Oracle (ORCL ). Oracle trades at a discount to the market, as well as a discount to its peers in spite of above-average growth prospects and returns on capital.

We're also warming up to Microsoft (MSFT ). Microsoft has been a rather boring stock for the last five years, but they're on the cusp of several very large product launches, the most significant being an upgrade to the Windows operating system.

Another tech stock we like is Nokia (NOK ). We think the company has an attractive valuation, has defensible products, and is at the right price. It's a good core position to a technology portfolio.

Q: And dare I ask about Google (GOOG )?


The follow-on offering at this level is intimidating. If they earn $7 a share, that sets the price-earnings multiple at around 40 times, which is pretty much in line with Yahoo! (YHOO ) and eBay (EBAY ).

The whole issue with Google then becomes the growth rate -- can they continue to grow earnings north of 30% a year, and for how long? If you believe that they can continue to increase earnings at north of 30% a year for the next five years, then I think I'd probably feel comfortable owning some of these shares.

The problem is that that's a remarkably difficult task for any company.... The competition with Yahoo and Microsoft is to be taken seriously. Few companies want to become the full focus of Bill Gates's attention, and Google is close.

Q: Do you believe the health sector will do well for the next 12 months? What do you like there?


Twelve months is too short-term for our investment discipline. Longer-term, we continue to like Johnson & Johnson (JNJ ), Waters (WAT ), Stryker (SYK ), and Pfizer (PFE ). I'd probably be buying some UnitedHealth Group (UNH ) on a pullback and maybe some Medtronic (MDT ).

Q: How long do you think small-cap stocks will lead the way?


I wonder if it might not already be the beginning of the end. We saw that group underperform significantly today. They've done very well for quite a while, and keep in mind that I'm making comments about the entire sector of small caps. On a company-by-company basis, there's still value to be found. But in general, it looks like their year-over-year comparisons are becoming more difficult, and a lot of the easy money has been made. Given our cautious outlook on the economy and the market in general, we prefer the safety of the large caps.

Q: Boeing (BA ) -- buy, sell, or hold?


Aerospace has been improving lately. Boeing is not a stock I own. The shares are up almost 35% since the beginning of the year. I would guess that they have further room on the upside. I prefer United Technologies (UTX ), again with a below-market multiple and an above-market growth rate, with a 1.8% dividend. These shares are more comfortable in our portfolios. General Electric is also another way to participate in that improving environment in aerospace.

Q: You pointed to consumer staples as defensive -- what stocks would you recommend?


Well, I mentioned a couple -- PepsiCo is one. I also like Colgate-Palmolive (CL ) and Procter & Gamble (PG ). If I could see a little bit of price weakness, I'd be comfortable in Sysco (SYY ).

Q: Back on your energy thoughts -- I have held oil stocks the past five years. Is the time right to sell?


I like to hold any stock as long as humanly possible. Oil shares as a part of a portfolio over the very long term have made sense. While they do not fit with our investment philosophy, they can be a very successful holding -- and have been for many people for many years.

As levels continue to be more speculative, it may make sense to sell some shares and diversify some parts of those positions. Portfolios get riskier when they become more concentrated in individual names, so it may be a good time to take some money out of those shares and diversify into other holdings. I probably would not sell them entirely.

Q: Is Apple (AAPL ) worth buying now?


I've been wrong on Apple for a long time. It's not a computer used in the workplace. It's used in education, and their great success has come from the iPod. This is a company that managed to reinvent itself at a time when the chips were really stacked against it.

While the shares appear to be very expensive at these levels, I would be willing to pay a premium for the innovations if I were convinced that they will continue. In sum, if Apple has another iPod up its sleeve, it's worth owning. If it doesn't, well -- the trick in owning Apple is knowing what's next.

Q: Michael, how would you sum up your investment philosophy? Do you tailor it to the times, as per your defensive stance now?


In the years that I have been privileged to talk with the BusinessWeek Online audience, I almost always hear myself saying that these are difficult times, that the current markets always seem to be difficult.

There have been times when I have been markedly more cautious over the years than in others. My fear level is at around 6 out of 10 right now. I'm cautious, I still see bright places, but over those years, our steady investment discipline of not paying too much for well-managed companies with superior earnings and superior prospects for future earnings has paid off very well for our clients.

So what we do is what I encourage all investors to do: Be dogged in your research and dispassionate in your approach. Diversify, look for quality, and be prepared to invest for the long term. Time, quality, and discipline mitigate risk and beget success. Everything going on in the market today has in some form occurred before, will occur again, and through it, good, patient people have profited. You can, too -- stick to your discipline and stay the course.

Before it's here, it's on the Bloomberg Terminal.