3 Picks for a Shaky Market

03/13/2012 9:00 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Uncertain times make it tough to swing for the fences. Instead, look for ways to play ‘small ball’ with stocks like these, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.

Remember the old saying, "the trend is your friend"?

It goes well with this one: "A rising tide lifts all boats." And when the trend turns against us? When the market plunges, run for an exit until you see blood in the streets (or hear the sound of cannon). Then it’s time to get back in on the cheap.

Yes, markets with strong trends are relatively easy to navigate.

But how about a market without a strong, discernible trend to drive stock prices? One that seems at the mercy of news? And that has rallied far enough so that while it’s not especially expensive, it’s not especially cheap either?

What do you do as an investor then?

I think that’s the kind of market we’re in right now: one without a strong trend in either direction, but that seems inclined—maybe—to drift higher in the absence of bad news. In this kind of market:

  • You can go for broke, swing for the fences, double down. You can make a big directional bet on the market and hope that you’ve called it correctly. If you’re right, you’ll make out like a bandit. Get it wrong, though, and you’ll feel as if you’ve been robbed by a bandit.
  • Or, you can play "small ball." You take what the market gives you, as its search for direction creates temporary bargains in individual stocks that you’d like to own for a while.

"Small ball" is time-consuming. It takes a whole lot more effort to invest this way than to simply load up on gold or to short Chinese banks.

But in a market that’s searching for direction, "small ball" can allow you to make some money while limiting your exposure to getting the big picture wrong. It has the added value that if, as I believe now, the trend of global stock markets will be a whole lot clearer in six months than now, you will have preserved your capital diligently enough so that you can take advantage of an easier market.

First, let me review where we are, in terms of the technicals of the market and its macroeconomic underpinnings. Then I’ll give you my three small-ball picks.

Rally Hits Stall Speed
Beginning on December 19, with the S&P 500 at 1,205, US stocks staged a major rally, reaching 1,368 intraday on February 21. That’s a gain of 13.5% in about two months.

And then the US market went into a stall, moving essentially sideways over the next week or ten days. And Wall Street analysts started talking about the need for this rally to take a rest. Stocks were overbought, and they needed to either pull back or at least move sideways to build up a new foundation for a further advance.

And, for a while last week, it looked as if investors might get exactly the downward trend some of these analysts had been forecasting.

After closing at 1,374 on March 1 (with an intraday high at 1,376), the S&P 500 fell on Monday and Tuesday, March 5 and 6, to a close of 1,343 (with an intraday low of 1,340). It looked as if stocks might indeed resolve the sideways move from an intraday high of 1,368 on the S&P 500 by moving into a correction.

But that wasn’t to be. The S&P 500 recovered pretty much all it had lost at the beginning of the week by the end of the week, closing at 1,371 on Friday, March 9, with an intraday high of 1,374.

Now I’m sure most investors—all those who are long stocks, anyway—aren’t about to lament the failure of a correction to arrive as promised by the drop in stocks at the beginning of last week. If you’re long stocks, you aren’t wishing for a trend quite that much.

But it does leave us with the same market with the same lack of a strong trend that we’ve had since the rally that began the year, stalled and began to move sideways in late February.

Of course, the rally stalled and started to move sideways because of more than just nervousness about the market’s technicals. News from Europe, China, and the United States also had something to do with it.

For example, as March began, it started to look as if the Greek rescue deal might come apart, because not enough Greek bondholders would agree to swap their old Greek bonds for new ones with a lower face value and a lower coupon yield. At the same time, investors got new data indicating that economic growth in the Eurozone would be even lower than forecast—even in relatively strong Germany.

In the US, the Federal Reserve said the economic recovery was weak enough that the central bank would leave intact its policy of keeping interest rates near 0% through 2014, but strong enough that the Fed wouldn’t add stimulus via a new program of quantitative easing in the near future.

And China cut its target for economic growth in 2012 to 7.5% from 8%, raising fears that China’s economy might be headed for a hard landing.

By the end of last week, however, those fears had receded, if not vanished:

  • Some 95% of Greek bondholders had agreed to swap their bonds.
  • The US jobs number showed a net increase of 227,000, and aggregate income grew.
  • The lower Chinese target for growth turned from a forecast of a hard landing to one more reason for thinking that the People’s Bank of China would lower the bank reserve ratio again—perhaps as early as this month—and then move to an actual interest-rate cut in June or so.

That left us with a still-overbought US stock market that hadn’t fallen enough for across-the-board bargain hunting—and where growth trends looked positive, but worries about growth hadn’t been put to bed.

NEXT: The Slow-Growth Problem

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The Slow-Growth Problem
One thing that worries me right now is earnings growth.

It’s looking as if fourth-quarter earnings for S&P 500 stocks grew by 6.1%—ending a string of eight consecutive quarters of double-digit earnings growth. And the Wall Street consensus is moving toward a view that investors won’t see a return to double-digit earnings growth until the fourth quarter of this year.

That’s quite a retreat. As recently as August, Wall Street was calling for double-digit earnings growth in the fourth quarter of 2011, and for every quarter of this year.

At the beginning of March, projected earnings growth for the S&P 500 in the first quarter of 2012 had tumbled to a slight decline of 0.6%. That’s down from 0% projected at the beginning of February, 3% growth projected on December 30, and 8% growth projected three months earlier.

The drop in growth in 2012 isn’t as illogical as it might seem. Companies cut costs and then cut them again in 2010 and 2011. But now that process is coming up against its limits, and profit margins aren’t going to get the boost this year that they did in 2011. European economies are still slowing as they slip into recession, and that’s cutting revenues for US exporters.

Valuing stocks when earnings growth comes into question gets rather challenging. On March 9, S&P 500 stocks traded at 15.86 times trailing 12-month earnings per share. That’s actually down from the 17.92 times trailing 12-month earnings per share that these 500 stocks commanded on March 9, 2011.

Stocks have rallied recently (although they’re not especially far ahead of where they were at the high of 1,364 on April 29, 2011), but earnings have grown even faster, making them less expensive than they were in spite of the rally.

In fact, by some measures, stocks are cheap. On projected 2012 earnings, the S&P 500 trades at a multiple of just 13.1. That’s well below the historical average of 14.6 on projected earnings per share for this index.

Of course, if earnings growth is headed for a severe slowdown in the first half of the year, then the current forward multiple on the S&P stocks doesn’t say they’re cheap, but rather that Wall Street analysts and investors haven’t yet fully caught up with a worsening earnings picture.

(Not to go too far down another road, but methods of valuation that depend on interest rates or cost of capital to calculate a target price also face difficulties ahead if interest rates stop falling and begin to climb. Long-term interest rates can do that even if the world’s central banks remain committed to super-low short-term rates.)

Small-Ball Buys for This Market
So what am I looking for as possible picks as I try to play small ball in this market?

Companies that have recently disappointed investors and been taken to the woodshed by the market. I’m especially interested in stocks like that if, in the aftermath of the disappointment, growth forecasts for the company have been slashed to the bone.

For example, in my March 6 column "Why big money is turning to China," I suggested waiting until Home Inns and Hotels Management (HMIN) reported fourth-quarter earnings (on March 8) because the company might well disappoint. Sure enough, it did, and the stock finished March 9 12.6% below its March 5 price.

What was the company’s big sin? Not revenue. Revenue for the quarter came in at $208.1 million, above the consensus estimate of $191.2 million, and up 64% from the fourth quarter of 2010. At 12 cents a share, earnings badly missed Wall Street estimates of 28 cents.

The problem was a $2.8 million loss from Motel 168, a chain recently purchased by Home Inns and Hotels and that hasn’t yet been fully integrated into the company. A loss of $2.8 million might not seem like much, but total income for the quarter was just $5.2 million.

What other stocks might make good small-ball plays?

How about a biotech, such as OncoGenex (OGXI)? Short of a market meltdown that sends every investor screaming out of anything with a bit of risk, biotechnology stocks tend to march to their own drummers, going up on the progress of drug trials and corporate partnerships independent of what the market does.

OncoGenex has two drugs for treating prostate cancer in Phase II and Phase III trials. The stock sold off a bit (2.7%) from the March 1 high at $16.20 to the close on March 9.

Prostate cancer is a big disease with 200,000 to 220,000 new cases a year. Unlike many cancers, it is very treatable, with a near 100% survival rate when caught early. Still, nearly 30,000 men die of the cancer in the US every year. The race among drug companies is to find an effective treatment for those men who aren’t diagnosed early.

OncoGenex has just signed a partnership with Teva Pharmaceutical Industries (TEVA) that included a $60 million upfront payment and $370 million in potential milestones for the company’s advanced Phase III drug, OGX-011.

Or, how about taking a really long view on the natural gas glut and making a small-ball play on Ultra Petroleum (UPL)? The company has one of the lowest cost structures in the US natural gas industry.

Of course, that doesn’t mean that even Ultra Petroleum is making any money with natural gas at $2.28 per million BTUs, but unless natural gas prices fall an additional 25% or so, Ultra Petroleum doesn’t look as if it will need to raise significant new capital. That’s important, because in the natural gas industry these days, raising capital usually means selling off assets.

Oil has about six times the energy content of an equivalent amount of natural gas. So, all things being equal—which they never are—oil should sell at six times the price of natural gas. Right now, it sells for 47 times the price of natural gas.

Granted, natural gas can’t substitute for oil in many uses, but the price of natural gas is still too low. Any company that can survive to get to the other side of this price collapse with some natural-gas assets intact will be a long-term winner. (Ultra Petroleum is a member of my long-term Jubak Picks 50 portfolio.)

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

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