Sizing Up 'Stay-at-Home' StocksDavid Bogoslaw
If you're a bit nervous about the declining value of the euro and the potential impact it may have on the revenues of companies with a significant presence in Europe, you may more draw more comfort from owning shares of companies that derive all, or nearly all, their sales from the U.S.
Be careful, however, of making blanket assumptions about U.S. companies with foreign exposure. Although the dollar has strengthened against the euro over the past month, it's still on the defensive against the Japanese yen and has been trading steady against the Canadian dollar, the Mexican peso, and the Chinese yuan of late on a trade-weighted basis, says William Cline, senior fellow and resident global trade specialist at the Peterson Institute of International Economics in Washington.
U.S. companies have a big stake in the health of overseas economies. Foreign gross domestic product growth of 3% generally translates to 5% growth in U.S. exports in terms of currency-adjusted value, says Cline. "If you get another 5% foreign GDP growth this year, then you have something like 10% export growth driven by activity levels outside the U.S," he says. The positive impact of higher exports would more than offset the negative effect of revenue lost on currency translations from abroad, Cline says.
The International Monetary Fund revised its GDP growth projections on Jan. 26, predicting 3.9% growth of the world economy in 2010 and 6% growth in emerging and developing economies. The IMF expects the U.S. economy to grow 2.7% this year, vs. just 1% growth in the euro zone.
Investors who prefer to avoid currency risks should keep in mind that it generally takes a couple of years for major swings in exchange rates to fully play through to affect a country's GDP, says Cline. He expects U.S. exports to remain fairly strong this year and predicts the dollar value of U.S. exports will rise by about 9% this year off a weak base in 2009. In terms of specific portfolio moves, it's probably wise for investors to steer clear of multinationals, which generally have heavy exposure to Europe and whose earnings might take a bigger hit from a weaker euro than companies that export to other regions, he says.
George Feiger, chairman of Contango Capital Advisors in San Francisco, sees foreign exchange risk as a red herring. It causes only short-term volatility and doesn't transform the fundamental value of a company's business since currency risk can be hedged away with foreign exchange derivatives.
"The real issue is that the emerging markets' economy is on average growing faster than [that of] the U.S.," he says.
While Contango invests in industry or indexed pools of securities rather than individual stocks, Feiger predicts companies with strong balance sheets—low debt, very little of which needs to be rolled over in the next three years—"will triumph over weak-balance-sheet companies in every industry." That's evident in Simon Property Group's (SPG) acquisition of General Growth Properties (GGWPQ:US), announced Feb. 16. Both own shopping malls, but Simon has a strong balance sheet while General Growth was in bankruptcy because it was overextended, he says.
Three sectors where companies tend to have more robust balance sheets are technology, energy, and health care, he adds.
The Standard & Poor's 500-stock index includes 95 companies whose revenues are generated entirely in the U.S., according to data from Bloomberg. They tend to be concentrated in six major industries: supermarket or drug store chains such as Kroger Co. (KR), department stores such as Target (TGT), commercial real estate such as Simon Property Group, health-care providers such as WellPoint (WP), telecommunications outfits such as AT&T (T), and energy and utilities concerns like Consolidated Edison (ED).
Jonathan Feeney, an analyst at Janney Montgomery Scott, in a Dec. 9 research note acknowledged the macroeconomic risk that some see in Kroger's stock but recommended aggressively buying the shares. "Kroger's core earnings power hasn't changed, and while the near-term outlook is challenging, Kroger has the best [comparable-store sales] and is the best-positioned traditional grocer vis-à-vis a continually thrifty consumer and a stronger mass merchant lineup," all at a similar valuation to the group.
On Dec. 8, Kroger reported third-quarter earnings of 27 cents a share, excluding a $1.62 impairment charge and an eight-cent loss on lower fuel margins. The company attributed the poor results, which missed analyst estimates, to "persistent deflation, unusually intense competition and the cautious mindset of customers," which overshadowed strong fundamentals such as good tonnage growth, market share gains, and cost controls.
The tough consumer environment prompted Kroger to cut its capital spending plans to less than $2 billion a year on average during the next three fiscal years, which is about $1 billion less than what it initially planned to spend during that period. The reduced spending should increase the company's free cash-flow yield by about 20 cents a share vs. prior expectations, and could result in share buybacks, the Janney note said.
As for broad-line retailers, UBS Equity Research upgraded Target to buy from neutral on Feb. 16 and raised its price target to $57 from $55 after upward earnings revisions and signs of improving consumer acceptance. In a research note, analyst Neil Currie said he was encouraged by better-than-expected comparable-store sales in December and "inline performance in January," particularly in consumable (single-use) goods.
"We believe consumers are positively responding to Target's more promotional perception storewide," the note said. An investor conference on Jan. 21 "highlighted its renewed focus on driving traffic and increasing the productivity and shopability of its chain." Target's credit operations remain a concern, but Currie said his revised 2010 earnings forecast of $3.68 a share (up from the previous $3.60 estimate) "reflects a conservative stance of very modest profitability."
Health care is another sector where there are plenty of large companies with little or no exposure to foreign countries. Analyst Jason Gurda at Leerink Swann & Co. likes most of the managed-care group more than hospitals and has an outperform rating on WellPoint and Cigna (CI), which generates 89% of its revenue in the U.S. Those ratings are based on a combination of attractive valuations and confidence that earnings expectations can be achieved, he says.
"[V]aluations are still being impacted by potential health-care reform and other regulatory risks, even though those are looking a lot less drastic than a few months ago," he says. "[The stocks] are still trading at significant discounts to where the group has traded historically."
One sector to stay away from if you prefer stay-at-home stocks is telecom, according to Christopher King, an analyst at Stifel Nicolaus & Co. (SF). "There's no growth left in U.S.telecom. The broadband and wireless [markets] are saturated. There are pricing pressures in both, particularly in wireless," he says. The easiest money to be made in telecom now is by "betting on increases in wireless penetration in emerging or frontier markets, whether Latin America or Africa."
Multinationals like Coca-Cola (KO) are probably getting enough growth from sales in Asia to be able to neutralize any currency translation losses from Europe, says Cline at the Peterson Institute.
And while it won't be easy for Europe to work out its debt problems, he's not sure those will continue to depress the euro. "The European Union's current account [the difference between total exports of goods, services, and transfers and total imports of them] is much closer to balanced" than that of the U.S., he says. "At some point investors are going to [realize] the U.S. has its own fiscal issues to deal with. All it takes is California to go belly-up for the euro to start looking good again by comparison."