Friday, October 19, 2007

The Commemorative Correction

The Dow Jones Industrial Average was down over 360 points today. It hurt to be a shareholder today, but it was a pale shadow of the pain endured by investors 20 years ago to the day on October 19, 1987; a day when the stock market dropped over 20% and so deeply scarred the memories of investors that it is known by not one, but two, nicknames today – “Black Monday”, and “The 87 Crash”.

Of course, the stock market did not drop today because it is the anniversary of Black Monday – traders are not that sentimental. Bad news on many fronts provided ample reasons for traders to dump shares, including:

  • Standard and Poor’s downgraded more mortgage-backed securities, creating further doubt about the health of the credit markets.
  • Oil prices made a new all-time high, crossing above the $90 level for a short time before closing at $88.
  • Lackluster earnings reports and cautious words about the economy from companies such as Caterpillar, 3M, and Harley Davidson.

So, where does that leave us, as individual investors? Relatively calm, if we have been careful to buy “great companies at great prices”; as Warren Buffett would put it. We’re also not overly concerned if we have focused our mutual fund assets in the better managed funds that are available to us, with the right mix of stocks and bonds.

It is hard to tell which direction the stock market will go in the next few days or the next few weeks, but one thing that history teaches us is that the day after a substantial drop in the market indices is not the time to sell your shares indiscriminately. It is a time to calmly assess your financial situation and your risk tolerance, and to make some adjustments to your portfolio if it is out of sync with either of these. And, if you are in the fortunate position of having cash available to invest, it is a time to buy shares in a great company that is selling at a great price because of the drop (or correction) that you have just endured.

Selling all of your stocks on October 20, 1987 would have been a big mistake, and selling all of your stocks on Monday, October 22, 2007 when the US markets next open, will almost certainly prove to be a big mistake if you choose to take that course of action.

After all, the only reason that it is possible to earn higher returns as a stockholder than you can earn in a CD is because stockholders suffer through days like today, (and occasionally, those like Black Monday). This suffering is what accounts for what Jeremy Siegel calls “the equity risk premium” – or, in plain English, the compensation that an investor gets for making a good long-term investment, and then enduring the inevitable bad days that will occur while that investment comes to fruition.

Just remember:

The payment for the pain is the chance to make a gain.

Footnotes and Foreshadowing

I’ll go into more detail about how well-chosen investments reward us for our patience (and our pain) in my next column, where I will discuss my experience owning, managing, and selling a small rental property.

Tuesday, October 9, 2007

Uncork the Bullish Champagne... But Avoid the Hangover: The Case for General Electric and Johnson and Johnson, Part II

In part I of this column, I discussed how recent market developments will help large companies with strong credit ratings to replace private equity groups as the players best positioned to buy out smaller companies. In this column, I will go into more depth about a few of the characteristics that make Johnson and Johnson (JNJ) and General Electric (GE), two of the many companies that benefit from this trend, such good investments at current prices. These companies share the following outstanding characteristics:

  • Exceptional track records of making smart acquisitions (and smart divestitures)
  • They are well positioned to ride long-term macroeconomic and demographic trends
  • They have a long history of shareholcder-friendly dividend policies

Smart Acquisitions, Smart Divestitures

Both JNJ and GE have a long history of finding good businesses to acquire, and successfully integrating those businesses with existing businesses after each acquisition. As I mentioned in my previous column, GE took advantage of the liquidation of Enron to buy that company's wind power assets, which gives GE a strong position as the demand for green electricty continues to soar in response to forward-looking regulations. GE also made a smart move when it divested its slow-growing plastics business for $11 billion.

Johnson and Johnson recently purchased Pfizer's Consumer Healthcare business, adding an armada of well-known consumer staples brands to its already impressive fleet of products. Have a cut? sterilize it with Neosporin, and then dress it with a Band-Aid. Quitting smoking? Some Nicorette gum will help. Not so successful in your attempt to kick the habit? Then you'll need some Listerine to cover that up from your spouse. With so many staple products in its fleet, you would have to go out of your way to avoid generating sales for Johnson and Johnson on your next visit to the grocery store - never mind the money that they will make on your next trip to the hospital.

A Foot in the Future, A Foot in the Past

But, you say, consumer staples are a boring, old-economy business. What is forward-looking about acquiring consumer staples brands? Quite a bit. In Jeremy Seigel's The Future For Investors, the author examines the long-term returns of companies in the Standard and Poor's 500 index, and draws the following conclusions:

The consumer staples sector has been marked by unusual stability. Most of the largest firms in this sector have been around for fifty years or more, and provided investors with superb returns.

Unusual stability and superb returns are a winning combination in my book. Additionally, if you consider that any healthcare reform legislation that comes out of Washington D.C. in the next few years is much more likely to negatively impact the makers of pharmeceuticals and medical devices, rather than the makers of consumer staples brands such as Listerine and Nicorette, then this acquisition makes even more sense. By adding additional consumer staples brands to the company with this acquisition, Johnson and Johnson has reduced its exposure to the political uncertainty that is a fact of life in its core health care businesses. And regardless of what sort of health care reform comes out of Washington, demographic trends assure that Johnson and Johnson will do well as the United States moves from spending 16% of GDP on healthcare to 20% of GDP on healthcare in the next 20 years.

GE Places Bets on the Future of Energy and Water

Speaking of staples, few things are as essential as energy and water - and GE is no slouch when it comes to looking toward the future and finding ways to align itself with long-term trends in these areas. It is well positioned to benefit from the current (and worsening) energy shortage by selling the world's most fuel efficient locomotive. On the power-generation front, GE will benefit regardless of whether we get more of our electricity from nuclear, coal, or wind energy - after all, they build equipment needed to generate electricity from all of those sources. Even the looming world water shortage will benefit GE as the foremost leader in desalination technology, which converts sea water into drinkable water.


So how does all of this smart planning benefit you as a prospective shareholder? Both GE and JNJ sport higher-than-average dividend yeilds of 2.7 and 2.5% respectively, and have a long history of increasing their earnings and dividends over time. It is rare to find such a combination of strong performance, high dividends, and good prospects for the future in one company, much less in two companies at the same time. I own a few shares of each of these companies for the long term, and you could do worse than to buy a few shares for yourself. My 12-month price target on GE is $52, and my 12-month price target on JNJ is $75.

Monday, October 1, 2007

Dow 14000 - The Pros Sustain the Close

Today the Dow Jones Industrial Average closed above the psychologically important 14000 mark. The last time that this number was in the news, it marked the end of a rally in the stock market. This time, it looks like the 14000 level will mark the beginning of a rally, rather than the end of one. As I stated previously in Dow 14000 - The High Water Mark?:

...when a market average such as the Dow passes through 12000, and then 13000, confidence and buying momentum build. And when the next much heralded number, 14000, becomes a barrier that the market can reach, but that the Dow average cannot close above, then that is a worrisome sign for the stock market.

The last time that the Dow average crossed the 14000 line, it closed below that number as traders rejected the new valuation for the 30 Dow stocks. Today, the Dow charged through the 14000 mark on high volume and closed above this number for the first time ever, providing a buying signal as strong as the sell signal that was provided by the rejection of this level last July.

And while we are taking a stroll down the (admittedly short) memory lane of previous columns posted to this blog, I should mention that the "festival of falling knives" that caused so many investors so much pain between the end of July and mid-September appears to be over. Only 40 companies had their shares hit new record low prices for last 52 weeks today, well down from the record of 1,107 new low prices which was set on August 16, 2007.

Certainly, investors have plenty to worry about, from fears of recession to the uncertainty that comes with a prededential election on the horizon, but for the moment we can take solace from a Federal Reserve that is apparently more eager to avoid a recession than to support the dollar or to contain inflation, and from a stock market which is rebounding from a substantial correction. Now is a good time to buy rationally priced assets, using the screen that I described in Avoiding the Pitfalls of Growth Investing, parts I and II, especially if you are investing with a time horizon of a year or more.

In my next column, I will discuss the reasons why you should hold your stocks for over a year, and why the shares of General Electric and Johnson and Johnson look so inviting at the moment.