Play Defense with 3 Large Caps

11/24/2011 7:00 am EST

Focus: FUNDS

Caution is well advised right now-there's more possibility of risk ahead for Europe, as well as the US, says Channing Smith. In Part One of his interview with MoneyShow.com, Smith advises investors to put some money into top-performing blue chips, and keep some cash on hand as global developments unfold.

Kate Stalter: I'm on the phone today with Channing Smith of Capital Advisors.

Channing, you use a number of strategies for your clients. Most of our listeners today are individual investors. What are the best approaches you see for them right now, given some of these volatile markets we've been seeing?

Channing Smith: Well, I stress to investors to take a cautious stance.

The past couple of months have been an extremely difficult investing environment. Global markets have been held hostage by headlines out of Europe, and this is despite a parade of consistently better-than-expected economic indicators and continued strength in corporate earnings out of the US.

But our market outlook continues to be one of caution. We're as tired as everybody else, talking about the challenges in Europe, but it's driving the market action right now. And as a result, we're trying to position the portfolio accordingly for the potential outcomes in Europe.

In our equity portfolios, Europe has forced us to keep about 10% to 15% cash. What we're doing on the equity side is really emphasizing high-quality blue-chip stocks that have strong balance sheets, strong free cash flow, better earnings visibility, exposure to faster growing emerging markets, and have good dividend yields. Our view is still that the US stock market is probably one of the best places to be right now.

The stock market should be priced off earnings and future earnings growth, which remain robust; however, we have this European financial turmoil that has the potential to morph into a banking crisis that could impact the equity markets. We're seeing that today.

One of the key developments that we've seen over the last couple of weeks, and it's obvious to everyone, is that Italy has been dragged into this sovereign debt crisis. Their government bond yields have been rising to levels which are really troubling, and this changes, really, the entire picture.

Our opinion on how investors should invest, because the risk to equities are considerable should this situation deteriorate more: I think investors-you know they hear the news-and what they really need to focus on is, what are the solutions.

The risk that we see, that this disorderly unwind of Eurozone debt morphs into a banking crisis, and we really want to focus on three things:

  • We need to see a wide-ranging plan out of Europe to address the Greek bonds, which we really haven't seen yet.
  • Secondly, we need to see a plan to recapitalize the systematically important banks out of Europe, and we haven't seen this yet.
  • And then lastly, we need to see a comprehensive plan to address sovereign debt issuance at feasible rates on a go-forward basis.

I think what the market is doing now is just hoping that the ECB will come in and kind of save the day and print money and buy all kinds of bonds. Unfortunately, the Germans are against this, and the new ECB head is against this, so we don't think it's quite as easy to accomplish as investors think.

One of the key points that came out that a lot of people missed was that Italy came out and said they wouldn't be issuing their preliminary GDP demand, but instead they'll issue final GDP demand on December 21, and this is not a good sign. It means that probably Italy is decelerating or probably falling into recession.

What investors need to realize is, we need more clarity on this. Stocks are a good place to be, but be very cautious. Invest in blue-chip stocks.

In our growth fund, Capital Advisors Growth Fund (CIAOX), what we're looking at are stocks like Johnson & Johnson (JNJ), Pepsi (PEP), and Procter & Gamble (PG). These are very strong blue-chip companies, with very strong financials, that have exposure to these emerging markets, and really don't have the volatility of the overall market.

Secondly, what we would suggest is that investors keep some dry powder. We're seeing this market deteriorate today. We are below key moving averages, the credit spreads are widening, and these are metrics that we look at in combination with our fundamental analysis. And these are showing negative momentum in the market.

So until we get a little more certainty on what's going to happen in Europe, investors need to take a very cautious approach to this market.

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Kate Stalter: It sounds like, when you say keep some powder dry, that you're talking about perhaps keeping some holdings in cash. Would that be correct?

Channing Smith: Yes, you know cash should be looked at as an asset class. If you were to invest in short-term securities, you're getting a couple of basis points. But just keep money in cash, have a list of stocks that you want to buy, and then take advantage of that. That's what we're doing.

And the other thing that we're doing is also game planning and creating scenario analysis. So, should we see a disorderly unwind, you have to figure out: What are you going to sell first? What will be impacted the most? And then what do you want to be in? Stocks that have less volatility-which we think are the blue-chip names.

But one of the things that we like about blue chips is-if you look on a valuation basis, for example, Pepsi or Procter & Gamble-the valuations of Pepsi and P&G are at levels we haven't seen in decades. So these are names that we feel comfortable in.

We're getting a nice 3% to 4% dividend yield, which is much greater than the ten-year Treasury at around 2%. These dividends will grow throughout time. They have grown throughout time. So, if you get inflation, you're going to have some defense against that.

In the past investors, would say, "I'm just going to go to fixed income." What we would say in fixed-income markets-especially in Treasuries-they're fraught with risk, especially over the long term, if you go out on a long-term basis.

So, it's a very difficult market. It's a very tricky market. Investors need to focus on buying just quality, having plans in case the market goes different directions, but it's a time to be very cautious.

We're excited to see the economy in the US has recovered somewhat, but let's not get too excited. We expect 1% or 2% growth. The GDP number in the third quarter was good, but if you really dig into the details, a lot of that was at the expense of the savings rate that came down. And we still have unemployment that's close to 9%, underemployment that is 16% or 17%, and we can't really count on the consumer, which is two-thirds of the economy. We're going to see some of the fiscal spending start to come off next year.

So, we're probably going to see a 1% to 2% environment and that's not great. Europe is likely to be in recession. So, we're saying buy equities, but be very selective in what you pick.

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