Thursday, February 24, 2011

How to Invest in a High-Risk Stock Market

How should an investor respond to today’s high stock-market risks? Those who feel compelled to remain fully invested should seek to minimize potential damage by rotating away from the areas with the greatest price appreciation off the March, 2009 lows toward areas that are relatively undervalued.

Large capitalization stocks with attractive dividend yields are still undervalued. Their price performance has lagged that of small company stocks in particular, and their valuations are extraordinarily attractive in RELATIVE terms. (Stocks overall are, of course, historically quite OVERVALUED). These large-capitalization companies often have strong cash flows, dominant competitive positions, and international operations with better growth prospects than those of small-capitalization companies that operate only in the U.S. In addition, international operations would provide a hedge against potential further declines in the U.S. dollar.

Examples of attractive large-capitalization stocks are Abbott Laboratories (ABT) and Microsoft (MSFT). Abbott currently sells for 10 times estimated 2011 earnings per share, has a dividend yield of 4.1%, and just raised its dividend for the 39th consecutive year. (Disclosure: I own shares of Abbott.) Microsoft sells for nine times estimated current-year earnings, after making an adjustment for its large cash holdings. Microsoft also generates substantial cash flow in excess of its normal business needs, which facilitates dividend increases and share repurchases.

When one can buy shares in outstanding businesses at approximately ten times earnings, especially when there is significant excess cash flow and current (and rising) dividend income, one should do it. If there are macro concerns, then one can hedge the overall portfolio against declines by purchasing inexpensive put options on market indexes that would rise in value if stock indexes decline.

Investors who do not feel compelled to remain fully invested have a key advantage over fully-invested investors. They don’t HAVE to be in the market all of the time. They can take a patient approach that Warren Buffett likened to a baseball player batting without strikes being called. (As a baseball fan, I can relate to that. And as a mediocre baseball player in my youth, I can REALLY relate to that!) They can wait for a “fat pitch” before swinging. With stock-market risks currently at a high level, having to stay fully invested today would be like standing at the plate facing ace pitcher Cliff Lee and having balls and strikes called.

So now is an ideal time to hold cash despite earning no yield in the short term. That way, there will be resources available to scoop up bargains after the next major market decline. Alternatively, maintaining a portfolio of undervalued large-capitalization stocks and hedging with index put options would also provide desired resources after a market decline, as the options could be sold at a profit and reinvested in newly-depressed common stocks.

Thus, for either category of investor, now is definitely not the time to be complacent about equity prices. But with straightforward strategies for protecting capital in the next decline and being poised for the next major rise in equity prices, one could have a deserved sense of equanimity.

Steve Lehman

S & P 500: 1305
Russell 2000: 803

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