Monday, September 24, 2007

Uncork the Bullish Champagne... But Avoid the Hangover: The Case for Investing in Safe, Steady Companies like General Electric and Johnson and Johnson

When Ben Bernanke and the other governors of the Federal Reserve lowered the discount rate last Tuesday, it sparked a massive rally. Bankers, hedge fund managers, and individual investors in the stock market and real estate markets alike breathed a collective sigh of relief. Those of us who tend to invest aggressively when good news arises have already started buying stocks again, thinking that the Fed will bail us out if things should go wrong. And yet, even in the wake of a Fed rate cut, it pays to observe how the investing landscape has changed since the giddy heights of Dow 14000 back in July, and to adjust our investment strategies accordingly.

This is especially important when we stop to consider that the Fed would not cut rates by 50 basis points right now, with inflationary risks looming, if they did not believe that we are in danger of entering a recession. In this column, I will provide two recommendations that I believe are poised to outperform the market, over both the short-term (the next 6 months) and the long-term (5+ years), and explain why companies such as GE and JNJ are poised to replace all but the best-run hedge funds as the new kings of the buyout boom.

What has changed?

The first thing that has changed in the investing landscape is that the buyers of debt who helped to keep the leveraged buyout boom going; mostly pension funds and hedge funds; are now asking for (gasp) a significant premium over treasury interest rates to buy the debt that funds these deals. Back in July, the credit spread between junk bonds and treasuries were at historic lows, but they have widened significantly since then, making it more costly to take companies private by issuing junk bonds, so called because of the low credit ratings associated with this debt.

Buyouts of publicly traded companies (and the prospect of buyouts) had provided a significant boost to share prices over the last few years. Buyouts leave fewer companies for investors to purchase shares in, reducing the supply of shares as the demand for shares remains steady. Buyouts have also caused small and medium-sized companies to outperform their large-cap peers as investors scramble to buy shares in the next buyout target before the deal is announced. A slowdown in buyouts by hedge funds changes the market landscape significantly.

Who are the new buyout kings?

OK, you say, enough about the big picture – how does this affect me, and why does this shift make GE and JNJ look more attractive?

Good question. The declining fortunes of hedge funds, the kings of the current buyout boom, benefit the buyers of large companies that pay dividends and have strong credit ratings, due to three important characteristics possessed by these companies:

  • Safety: If the current economic slowdown gets worse, buyers of stocks will tend to prefer large companies with strong credit ratings and dividends because these companies have a demonstrated ability to survive recessions, and pay growing dividends to compensate shareholders for the risk of holding stocks in a recession. As Kelly Wright observes, growing dividends are one of the best attributes an investor can seek in an investment.
  • Value: Large companies (for example, GE and JNJ) have lagged the S&P 500 over the last 5 years, partially because they are too large to be viable targets for buyouts. As a result, GE and JNJ are selling at low PE ratios relative to their historical averages. With the “buyout premium” that was underpinning the share prices of smaller companies fading away along with the mania of the buyout boom, companies like GE and JNJ will no longer be at a disadvantage compared to smaller companies.
  • Opportunity: With great credit ratings and abundant free cash flow, large companies like GE and JNJ are well positioned to become the kings of the new buyout boom. Both companies have demonstrated skill at buying companies to add to their business. For example, GE entered its strategically important renewable energy business when it purchased Enron’s wind farms during the liquidation of that former high-flyer.

Neither of these companies will make you the coolest person in the room when the subject of investing comes up at the cocktail party, but investing isn’t about proving how smart you are, it is about having a comfortable (and preferably early) retirement and being able to meet your own essential needs, as well as those of your family.

In my next column, I plan to dig into what makes JNJ and GE outstanding in terms of their strategies for future growth, and in terms of their valuation.

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