Three Stocks and Three Sectors for Tough Times

01/19/2010 9:44 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The global economic recovery won't be so great for industries with excess production capacity. What's an investor to do? Here are resilient sectors and stocks to keep on your radar.
Big industries—aluminum, autos, steel, memory chips—are awash in excess global capacity, with more scheduled to come online. (I've described the problems in some of these industries in recent posts such as "Ford's dilemma" for the auto industry, and "Alcoa delivers bad news for global profits" for the aluminum industry.)

Because the world hasn't begun to address the problems of excess capital and the excess production capacity that it creates under today's economic rules, the global economic recovery is going to turn out to be extraordinarily profitless in industry after industry as producers with excess capacity cut prices in an effort to buy market share.

This isn't a short-term problem. With the Chinese economy outpacing others in recovering from the depths of the downturn, China's "solution"—flood the economy with cash, build plants, and export the excess—has become a model to emulate. The mismatch between global supply and demand in many areas of the global economy will go on for years, and in some sectors, the excess of supply over demand will get worse before it gets better. (I spelled out the way that China's economic model contributes to this problem in the January 15 edition of Jubak's Journal.)

The problem is too big and too long-lasting to ignore. So what are investors supposed to do about it?

How about building a portfolio that avoids niches, industries, and sectors where global overcapacity will create a profitless recovery?

Well, duh! Of course. Simple.
 
How about some advice on what to avoid and where to put money to work? Sure, like most advice—such as "Never put anything smaller than your elbow in your ear" and "Buy low and sell high"—it isn't very useful without specifics.

Three Points of Protection

I'm going to start with three sectors that you should target now and in the next few years that will avoid the worst of these problems. (I'll even throw in a glancing reference to a niche or two with the characteristics you'll want to buy.) And I'm going to end by identifying three stocks that you should own (one is already in Jubak's Picks, one is in the Jubak Picks 50 portfolio, and one is a new buy) from one of these sectors.

To avoid the trap of excess capacity killing even modest profits, I think you have to look for sectors that have barriers that prevent excess capacity from driving down all prices as companies slit each other's throats to acquire profitless market share.

I can think of three big barriers like that:

1) Brands: In markets where consumers are willing to pay for a brand, the brand provides protection from excess capacity running prices so low that the producer can't make a profit. This isn't some new intellectual breakthrough on my part: It's right out of the Warren Buffett playbook. It's why he owns brands such as American Express (NYSE: AXP) and Coca-Cola (NYSE: KO). Because of their brand names, American Express is able to charge more for its cards, and Coke sells for more than no-name sodas (the ones my dad used to buy).

Unfortunately, there are fewer and fewer brand names that can withstand the onslaught of excess capacity. Cereal brand names such as Kellogg (NYSE: K) are losing the pricing war to store brands. The Washington Post (NYSE: WPO), another Buffett holding, has lost the news and ad battle to the excess capacity of the Internet. (Frankly, I think Buffett owns the Post company these days for its Kaplan testing and electronic education business.) Look at your own buying habits: How many brand names do you pay extra for these days?

2) Distribution and service networks: Adding production capacity is relatively fast and easy these days. But distribution and service? That's tough.

Give me access to cheap capital and I can be turning out Jubak's Cola—"The cola that talks back"—within a year and undercutting Pepsi and Coke on price. But getting the stuff into stores? That's the work of consistent investment running into the billions over a decade if you hope to compete with the system that puts PepsiCo's (NYSE: PEP) sodas, juices, water, and Frito-Lay snacks into every store from Buffalo Gap to Beijing.

Sure, you can make a cheaper tractor than Deere (NYSE: DE) sells—lots of companies do, and more are trying—but Deere's network of service centers and dealerships has been crafted over decades. Wal-Mart Stores (NYSE: WMT) is able to eat competitors alive every day not because it sells stuff for less, but because it has a purchasing and distribution system that lets it sell stuff for less and still make a five-year average gross margin of 24.5%. And the company never stops honing this competitive weapon. If I were a Wal-Mart competitor, I'd be up late almost every night worrying about news that Wal-Mart is going to increase the percentage of the goods it sells that it buys straight from manufacturers.

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3) Technology: I don't mean commodity technology like memory chips. Once a technology gets mature enough so that anyone can produce it, technology itself stops being a barrier that protects your profits. Steel and automobiles were once cutting-edge technologies, too. No, I'm talking about technology that's on the edge of what's new and where the company gets paid something extra for making something that's more powerful or smaller or faster or more complex than what existed yesterday. And I'm talking about companies that can produce a relatively constant stream of new technology products like that and are able to constantly push the envelope of what's possible.

Investors are fortunate right now to have two areas of the technology sector that are showing solid growth and that present significant barriers to the destruction of profits by global excess capacity. One is the next generation of networked information technologies. Desktops and laptops, storage devices, and even, increasingly, servers themselves, are on their way to becoming technology commodities (if they're not there already—have you priced a desktop lately?) where profits get crushed by global excess capacity. Dell (Nasdaq: DELL), for example, has run into this global buzz saw.

But networked technology—servers, storage, communication devices and software—that connects as a unified system with the cloud of computing that increasingly is the Internet, that's not a commodity. That's because getting all this stuff to work together requires building not just a product, but a system of suppliers and subsuppliers that can provide compatible pieces. And a service organization that can make sure that it all connects securely.

In a recent report, Forrester Research called for a six- to seven-year cycle of spending on what it calls the new information technology foundations for unified computing. Global spending on information technology, which fell 9% in 2009, is expected to climb 8% this year.

The other technology area with strong barriers to global excess capacity is the upgrading of wireless networks to handle the deluge of traffic that's overwhelming them from owners of iPhones, Nexus Ones, BlackBerrys, and Androids. Those customers are doing exactly what the companies that make and sell those devices want them to do: Downloading and sending vast quantities of music, video, and graphics, and running huge numbers of applications over their mobile devices.

Anyone who appreciates irony—well, anyone who appreciates irony but doesn't work at AT&T (NYSE: T)—had to chuckle when AT&T shut down iPhone sales in New York for a few days because iPhone users had overwhelmed its network. According to the Federal Communications Commission (FCC), wireless data use is up 700% over the past four years and is expected to grow 130% a year for the foreseeable future.

Three Safe from the Storm

The key to success in information technology isn't the cheapest price, but the ability to deliver a seamless networked service. I've got some names that you should own in this sector if you want to protect your portfolio from a profitless recovery created by global excess capacity:

  • One is Cisco Systems (NASDAQ:CSCO). This stock is already in Jubak's Picks (and I think you can still buy it and make money at current prices). Cisco is the IBM of the Internet: Companies can buy its gear and know that it will talk to the rest of the gear in their network (because Cisco probably sold them a good part of that gear and because everybody makes sure their gear works with Cisco equipment). Plus, Cisco has used recent acquisitions to continue its transformation from a simple, but globally dominant, seller of routers into a company that builds unified digital communications systems.

  • A second is Google (NASDAQ:GOOG). Yes, Google stands a good chance of getting kicked out of China with its 1.3 billion potential Internet users. But no company is better positioned for the long-term trend toward distributed computing over the Internet than Google. If you own it, hold for the long term, and pick up more on any China-related weakness. (See my update of Google on Tuesday in the Jubak Picks 50 portfolio on my blog.)

  • A third is Marvel Technology Group (NASDAQ: MRVL). The company has succeeded in driving its system on a chip solution from stand-alone hard drives to the network itself in such areas as networked storage and mobile devices. I'm adding Marvel to Jubak's Picks with a buy Tuesday. See my post later Tuesday in Jubak’s Picks for more details, including a target price.

These three areas and these three technology picks aren't the only ways to build a portfolio that avoids the danger of a profitless recovery. You can also look for smaller niches where it's just about impossible to build new capacity—North American transcontinental railroads come to mind. I doubt that anyone will ever build another. Which has something to do with why Buffett is buying Burlington Northern Santa Fe (NYSE: BNI).

You shouldn't by any means assume that the only companies with barriers to global excess capacity like those I've talked about live in developed economies. One of the reasons that I recently added AmBev (NYSE: ABV) to Jubak's Picks is because of the barriers created by its strong brands and distribution system in South America.

And finally, you shouldn't assume that the best-managed of the world's companies aren't aware of this problem. They're busy working on new ways to differentiate themselves and protect their pricing power in a world of so much excess capacity. But that's the topic for another column.

At the time of publication, Jim Jubak owned shares of the following company mentioned in this column: Cisco Systems.

Jim Jubak has been writing Jubak's Journal and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a 2008 book, "The Jubak Picks," and writer of the Jubak Picks blog. He's also the senior markets editor at MoneyShow.com.

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