Non-Partisan Portfolio Bets

08/13/2004 12:00 am EST

Focus:

Richard Band

Editor, Profitable Investing

In his non-partisan assessment, Richard Band highlights those positions that will do well no matter which party sits in the White House. The editor of Profitable Investing says, "I’ll show you how to fatten your portfolioregardless of who wins the Presidential election."

"I can’t tell you who will capture the presidency. (It’s really too close to call.) What I can say with some assurance, however, is that the markets will celebrate the election ofeither candidate once the returns are final. Typically, Wall Street rallies ahead of the election of a Republican president and hesitates prior to a Democrat win. After the dust settles, though, the stock market nearly always throws a party—at least until the real business of governing gets under way the following January. Election Day reduces uncertainty, the hobgoblin of investors.

"In the end, though, as long-term investors, we want to keep our eyes focused on things that will make a difference in 2005 and beyond. In our view, both candidates will grapple with the same set of economic challenges in 2005, so you can make a tidy fortune if you understand what those are (and how they’re likely to be dealt with). Here are three looming issues that neither a President Bush nor a President Kerry can wish away:

Corporate profit growth will slow in 2005. Currently, we’re in the sweet spot of the profit cycle. According to recent estimates, the companies that make up the S&P 500 index logged a sizzling 25% increase in second-quarter profits, versus the year-ago period. As the Fed hikes borrowing costs, profits will continue to rise, but at a much more subdued pace—probably around 12%–14% in 2005. Stocks trading at sky-high P/E multiples on hopes of sky’s-the-limit earnings growth will fall back to earth.

The headwind from excessive debt will blow harder. Low interest rates over the past few years encouraged consumers to pile up a mountain of IOUs. American shoppers are devoting a near-record share of their income to the famous ‘monthly payment.’ More troubling yet, a large chunk of this debt is at floating rates. With rates on the upswing, consumers will find it harder to boost their spending in 2005. Delinquencies and defaults will begin to creep up.

The 'graying of America' will come into sharper focus. Commentators who noodle over the impact of the retiring Baby Boomers on the stock market often point to 2011 as the year to watch. (That’s when the first Boomers turn 65.) However, a parade of Boomers are already retiring and their numbers will only grow in 2005 and afterward. As Boomers start to put financial pressure on the pension system, the stock market will feel the heat.

"All three of these issues point to a more cautious environment for stocks once the election hoopla wears off. I’m not predicting a down year in 2005 (at least not yet), but I think investors will gravitate toward lower-risk stocks rather than the high flyers—and probably toward bonds as well. We’re already preparing for the road ahead by pocketing profits of more than 90% on our small-cap stocks while shifting cash into bonds, high-yielding blue chip stocks and even a low-risk ‘hedge fund.’

"For the stock segment of your portfolio, I suggest an emphasis on names with well-above-average dividend yields. Even if Congress tinkers with the dividend tax next year, stocks that throw off a liberal stream of cash will appeal to investors who may tire of waiting for capital gains. My #1 buy now is  Citigroup (C NYSE). The stock is trading at a mere 11 times this year’s estimated earnings. Seven long years ago,  the stock sold for as much as 16.6 times earnings. Meanwhile, Citigroup has grown into a far stronger and more broadly diversified company than it was back then. The stock is also yielding a lush 3.6%. Over the past ten years, the firm has boosted its dividend a sparkling 167%. If Chuck Prince and his team can do the same in the next decade, by 2014 you’ll be earning 9.6% a year on dividends alone (based on today’s share price). I can’t think of a better way to beat the stock market indexes over the long haul. Citigroup is now my second-largest single stock position after Pfizer (PFE NYSE). Pfizer is also trading at an abnormally low price-earnings multiple and a respectable dividend yield of 2%. We recommend that investors buy PFE at $37 or less. Counting dividends, both C and PFE should double your money over the next three to five years.

"With the bull market aging, it’s no longer enough just to buy the safest stocks we can find. The time has come, I believe, to build a hedge around our stock portfolio for 2005 and we have added Hussman Strategic Growth Fund (HSGFX) to our portfolio. Hussman fund invests in stocks but have the capability to hedge its holdings through short sales and the purchase of put options. At present, skipper John Hussman has the fund 100% hedged against a market decline, although he could change that stance in the blink of an eye if necessary. Over the past three years, HSGFX has beaten the S&P 500 index by a spectacular 16.5% annually. Most individual investors who dabble at hedging get the timing wrong. If you’re serious about growing your money during the remainder of this bull market (and protecting your gains when the bear returns), I urge you to consider HSGFX.

"Bonds? Yes, despite all the chatter about rising interest rates, I’m convinced that yields at the long end of the maturity spectrum won’t climb much, if at all, from here. Meanwhile, look at my favorite sector of the bond market right now: tax exempt municipals.  Floated by state and local governments, munis pay interest that generally escapes federal income tax. In addition, most states waive state and local income tax on interest paid by munis issued within the state. Why are those characteristics especially alluring right now? Federal income tax rates today are probably the lowest you and I will see for the rest of our lifetimes. The muni market has already caught the scent of higher taxes ahead. In recent months, the ‘spread’ in yields between municipals and taxable bonds of a similar maturity has begun to widen. For taxpayers in the 28% or higher brackets, however, munis still deliver a higher after-tax return than high-grade taxable bonds—particularly if you go out to maturities of ten years or more. For example, a ten-year Treasury note was quoted the other day at a yield of 4.4%. For a taxpayer in the 35% federal bracket, a ten-year muni nets 33% more income after tax than the T-note. At the 30-year maturity, the muni yields 47% more, after tax.

"What specific vehicles should you choose? Basically, there are three ways to play, each with its own advantages. First, if you think you’ll be holding your bonds to maturity, I wouldn’t hesitate to buy individual bonds. As a buyer of individual munis, you can concentrate your holdings in your home state, for the double or triple (federal, state, local) tax-free benefit. You’ll also save on the management fees of a mutual fund. Just make sure you buy top-quality bonds that won’t default.

"Next, we would look at funds, where you will enjoy wide diversification and—perhaps even more important—instant liquidity. Individual munis are hard to sell at a good price on short notice. If you think you might simply want to ‘park’ some cash in munis until, say, an irresistible opportunity pops up in the stock market, reach for a fund. Among fund families with muni offerings, Vanguard towers over the rest. No sales charge, no redemption fee and ultra-low overhead. Your main decision is what maturity range to select. For most, I suggest Vanguard Intermediate-Term Tax Exempt Fund (VWITX), with a 5.9-year average maturity. The fund yields 4.1% tax-free, the equivalent of a 6.3% corporate bond for a person in the top tax bracket. Buy at $13.50 or less. If you can stomach somewhat wider fluctuations in the share price, though, it may be worthwhile to put at least a token amount into Vanguard Long-Term Tax-Exempt Fund (VWLTX). Long-dated munis are exceptionally cheap relative to Treasuries and other taxable bonds. The fund yields 4.6%, more than a ten-year Treasury note without any federal income tax on the interest! Pay up to $11.40.

"Finally, unlike mutual funds, closed-end funds trade on a stock exchange, where you buy or sell them through a broker (just like ordinary shares of stock). Since you’re buying from an existing shareholder, rather than the fund itself, closed-end funds can trade at a sizable premium—or discount—to the value of the fund’s portfolio (known as 'net asset value' or NAV). I prefer to buy closed-end funds when they’re quoted at an abnormally wide discount to NAV. That way, I can purchase $1 of assets for less than a buck. In recent weeks, dozens of closed-end muni funds have fallen to enticing discounts. Here is a shopping list of closed-end municipal bond funds.

"Among intermediate-term funds, we like Federated Premier Intermediate Muni (FPT NYSE), yielding 6.1% with a 10.8% discount to NAV and Neuberger Berman Intermediate Muni (NBH ASE), yielding 6.3% with a 10.5% discount. Among long-term funds, we like Morgan Stanley Quality Muni Securities (IQM NYSE), yielding 6.5% at a 12.2% discount, Salomon Bros. Municipal Partners Fund (MNP NYSE), yielding 6.4% with a 12.9% discount, Seligman Select Municipal Fund (SEL NYSE), yielding 6.8% with a 13% discount, and Van Kampen Advantage Muni Income (VKA NYSE), yielding 7.7% with an 11.7% discount.

"We also have two picks among single-state funds. Do you happen to live in California or New York? Take a close look at the funds below that focus on those states. For a top-bracket earner, MuniYield California Insured (MCA NYSE) yields 6.8% and trades at an 11.6% discount to NAV. It is paying the equivalent of a corporate bond yielding 12.2% after federal and state tax. Van Kampen New York Quality Municipal (VNM NYSE) yields 6.5% and trades at a 12.2% discount to NAV. It is yielding a tax-equivalent 12.3% for a top-bracket investor living in New York City.

"Overall, we’re moving our portfolio in a more cautious direction. I’m building additional safety and profit into your portfolio by focusing on investments that will do well whether it’s Bush or Kerry who takes the prize. In the universe of blue-chip stocks, Citigroup and Pfizer offer some of the highest ratios of reward-to-risk. For a hedge against potential stock market weakness (and gains if the bull continues to run), sign up with the switch-hitting Hussman Strategic Growth Fund . Finally, play offense against the IRS, with the one tax shelter Washington doesn’t dare to shut down—municipal bonds. They’ll stand you in good stead this year and for years to come."

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