Defensive Investing is One Key to Profits in Uncertain Markets
By Martin Hutchinson
Chief Global Investing Strategist
The world’s stock markets have taken to making sharp downward lurches recently, worrying even those investors who made good profits from the record market upswings. At some point, these lurches could turn into a genuine bear market, a reality that raises that age-old investor question: Is there anywhere to hide?
In short: How does one defend against a bear market – apart from just selling everything, then stuffing the money in your mattress and yourself under the bed? An experience that a friend and former colleague of mine had 20 years ago illustrates all too well that, on a particularly bad day, if you’re invested in the market, there’s really nowhere to run, and no place to hide.
This former colleague got one of the first largish payouts – a few million dollars, in fact – from cashing out his stock options after the investment bank we’d both worked for got sold.
His good fortune didn’t last, as I discovered when I ran into him one mid-October Tuesday afternoon. His white-as-a-sheet pallor had little to do with the autumnal lack of sunshine and almost everything to do with the fact that it was 1987 and that the U.S. stock market had crashed only the day before.
As it turns out, my sad former workplace compatriot had been buying U.S. shares on margin, and had been awakened at 1:30 a.m. London time by an insistent clerk wielding a $1.3 million margin call.
When I think back to that downturn 20 years ago – and compare it to the gyrations we’re experiencing right now – it’s easy to see that each downturn is different, meaning the places to hide are also correspondingly different. During the 2000-2002 downturn, for instance, the best places to hide from the bear-market reaper and his margin-call scythe would have been in small stocks, consumer-goods companies and firms in homebuilding-related businesses.
All those sectors would have been grand defensive plays: They hadn’t participated much in the tech-stock madness of 1996-1999, and there was a good chance that the Fed would cut interest rates, which would help housing in particular and consumer spending in general.
This time around, the whole economic backdrop is very different. The Fed won’t be able to cut interest rates much, and there’s actually some chance that we’ll see an increase, since – even with the figures massaged – inflation is barely under control. Housing will recover sometime, but there’s no sign that we’re anywhere near the bottom, meaning it’s far too early to buy. Consumer-goods companies, which have stable cash flows, have already been bid up to dizzying levels by the private-equity crowd, which sees them as particularly juicy potential buyout candidates.
Indeed, at this point, the entire financial-services industry – investment banks, commercial banks, credit-card companies, debt-rating agencies, and home-finance firms – is nothing short of, well, a screaming short. LBO deals are falling apart daily, the subprime-mortgage market is a ghastly wreck, and it’s pretty clear that a similar mess is simmering in the corporate bond market, especially with junk bonds.
Like subprime mortgages, the first bonds to go bad will be only the tip of the iceberg; the rest of the bond-market train wreck will unfold in agonizing slow motion, taking as long as two years to play out (sorry about the mixed metaphor there, but you see what I mean, right?). Service providers like debt-rating firms can expect a lot of litigation from investors who are feeling rather burned right now – one in particular is being asked some highly awkward questions about why it granted a AAA rating to some collateralized mortgage obligation bonds (CMOs) that were based on subprime mortgages.
Given the potential breadth of this devastation, it’s unlikely that U.S. consumers – many of them with houses that have lost value – will be spending enthusiastically, so consumer-products firms aren’t likely to do well, either. As with previous stock-market booms, tech stocks have been bid up enough to carry high valuations, so even though this boom wasn’t particularly tech-oriented, the shares of high-tech firms will drop more than most stocks when a market downturn comes along.
However, even within the United States, there is one sector that should do well: exporters. There may be a hiccup in world growth and even in the emerging markets generally, but it won’t be more than that. Meanwhile, thanks to the downturn, the U.S. balance-of-payments deficit will recede, which probably means the dollar will remain weak. Many exporting companies will find themselves beset by cheaper competition from China, India and others, but there are a few that won’t.
The Boeing Co. (NYSE: BA), for example, just reported excellent second-quarter earnings. It has only one real competitor: Airbus SAS, the commercial airliner builder that’s a subsidiary of European Aeronautic Defence and Space Co. NV, or EADS (EPA: EAD.PA). And Airbus operates out of the high-cost European Union.
Boeing is the single-largest U.S. exporter. And it’s a juggernaut in the aerospace sector, a major player in both the commercial and military aircraft markets that has grown both organically, and also through a series of shrewd acquisitions.
After initially making its name as the builder of some gorgeous biplane fighters for the U.S. Army Air Corps in the Depression-laden 1930s, it solidified its place in history by building the B-17 “Flying Fortress” and B-29 “Superfortress” heavy bombers of World War II vintage, and then built the B-52 Stratofortress jet bomber that continues to fly today.
But Boeing made its biggest mark by changing the global airliner market forever with the 1958 introduction of its sleek Boeing 707 jet airliner. It further outdistanced its global rivals – De Havilland of Britain, Caravelle of France and Tupolev of Russia – when it unveiled Boeing 747 Jumbo Jet, the globetrotting civil airliner with its trademark humpback silhouette.
If a new company wanted to compete in the mainstream passenger aircraft market, it would have to start designing new models from scratch and put together a huge manufacturing and assembly operation – a very expensive and highly risky venture, and one that would take at least a decade to pull off. Although Airbus and its forerunners have been around in one form or another since the 1960s, it wasn’t until it launched the twin-engine, 150-passsenger A320 in the 1980s that the pan-European firm actually solidified itself as a real rival of Boeing.
At about the same time, the ongoing Boeing-Airbus slugfest all but drove two well-capitalized U.S. aircraft companies – McDonnell Douglas and Lockheed Corp. – right out of the worldwide civilian airliner business. McDonnell Douglas is now part of Boeing, while Lockheed merged with Martin-Marietta (formerly the Glenn L. Martin Aircraft Co.) to form Lockheed-Martin Corp. (NYSE: LMT).
But even after it gained a strong foothold in Boeing’s market and helped clear away two major rivals, it still took Airbus another 15 years to actually overtake Boeing to become the world’s No. 1 civil aircraft maker, as measured by actual orders – a milestone it didn’t reach until 2001. Airbus held that title until last year, when a series of well-publicized problems with it and its parent company helped knock it from the top spot.
The result: Boeing won the annual orders race for the first time since 2000, grabbing 55% of the global deals. It’s on a pace to set a sales record for the year. And even with some slight delays, the company is getting a lot of favorable news coverage from its innovative and highly hyped Boeing 787 “Dreamliner” passenger jet.
With such a treacherous competitive landscape, why would any other company even attempt to storm this market? Brazil’s Embraer-Empresa Brasileir de Aero (NYSE: ERJ) is the only company I can think of which might have an advantage in doing this, and there’s currently no sign that it intends to.
However, before you rush out and buy Boeing, one word of warning – the stock’s trading at more than 30 times earnings, so it’s vulnerable from that standpoint alone. Indeed, the announced delay of the Dreamliner’s maiden flight – a two-to-four week delay that Boeing insists won’t delay the first deliveries set for next May – was enough to spark a small sell-off after the company’s shares hit a record high this week.
Outside the United States, the picture is somewhat brighter. With a weak dollar, European manufacturers will find it difficult to compete. Besides, much of Europe – particularly Britain and Spain – have evolving real estate problems that appear similar to those facing the U.S. market. India is certainly worth a good look, though the market is a bit expensive at its current valuation of about 25 times earnings. Latin America has too much debt, making a lot of the plays there vulnerable to a domestic, or global, credit crunch. And China, as a market that’s currently trading at roughly 40 times earnings, is generally priced too high to be part of our search for defensive investments.
But elsewhere in East Asia there are some countries that don’t need to borrow so heavily (leaving them less vulnerable to a credit squeeze) and yet have decent-enough long-term growth expectations.
Japan – which suffered through a decade-long hangover from its 1980s excesses, but which has most recently has rebounded nicely – is one such country. South Korea and Taiwan also offer the kind of long-term growth opportunities that make them potentially terrific defensive plays. [For additional insights, check out our brand-new research report, Global Investing: The 3 Best Investments in Asia Today. It’s free].
Concentrate mainly on domestically-oriented companies, though, or exporters to Asia – if the U.S. and European markets slip badly, world trade may not continue its present rate of growth, but Japan, Korea and Taiwan each have an excellent chance of profiting from their hard work through increased domestic consumption. Investors can play these markets through conventional mutual funds, through the better exchange-traded funds, or ETFs, or through individual companies carefully chosen to capitalize on the trends we’ve outlined here.
Among the ETFs that focus on these geographic areas, the possible plays include the iShares MSCI Japan Index (NYSE: EWJ), and the iShares MSCI Taiwan Index (NYSE: EWT).
On a bad day, everything will drop: There’s just no escaping that harsh realization. Even so, as we saw in the 2000-2002 bear market, in a downturn lasting 18-24 months sectors and countries that are outside the main problem areas will not drop much – and may even continue to rise in price, making themselves the new leaders for the next economic upturn.
Ferret out those stocks and you’ll have gone a long way in achieving your goal of finding safe havens for your money.
Money Morning Managing Editor William Patalon III contributed to this report.
