Brian Dress, CFA — Director of Research, Investment Advisor
In last week’s article, we explored with you the idea that the best offense in this market might be a good defense. We argued for the idea that stocks in the value area, with passive income through high dividends, might be ready for their place in the sun. This week we lean into that theme, as we outline our thoughts on three stocks that fit this bill: Kraft Heinz (KHC), Best Buy (BBY), and IBM (IBM).
Whether your portfolio is composed of stocks, bonds, or some combination, it’s likely that you are down significantly on the year. Through our conversations with investors, we know that many portfolios need a repair strategy. We think now is the time for investors to approach retirement planning with an active management approach, as finding stocks that outperform in the current market environment is a huge challenge! As active managers here at Left Brain, we can respond to a new investment dynamic where growth stocks are being repriced (downward). On the other hand, more predictable companies with durable cash flows that return capital to shareholders are in favor. The three stocks we will detail here are just a few of the stocks we think have potential to perform well in this volatile environment.
This week we saw yet another volatile period of market action, with the S&P 500 down 2.4% and the NASDAQ falling 2.3%. This was a marked improvement after a very strong session Thursday; the NASDAQ was down more than 5% after Wednesday’s trading. We are right in the thick of earnings season and we received constructive earnings reports from Meta Platforms (FB), Microsoft (MSFT), Chipotle (CMG), and ServiceNow (NOW). Conversely, reports from General Electric (GE), Alphabet (GOOG), Boeing (BA), and Amazon (AMZN).
One piece of news that stuck out for us was the fact that the AAII Sentiment Survey showed the most bearish reading since 2009, with nearly 60% of investors surveyed harboring bearish expectations on the next six months of market direction. Clearly investor sentiment is awful right now and contributes to our view that companies with stable and predictable business trajectories are the best way to position until sentiment and fundamentals improve. In this week’s (abbreviated) “What’s Working?” and “What’s Not Working?” section, we look for patterns in our ETF list to determine the areas of strength and weakness in the week’s market action.
What is/is not Working?
With markets again overall weak, the skew between positive and negative is stark, with our Best Performing ETFs up just a fraction, while the Worst Performing 20 ETFs in our list each fell between 6-9%.
The best performers this week were definitely dominated by emerging markets index ETFs, including China. Among our top performers were KraneShares CSI China Internet ETF (KWEB), EMQQ The Emerging Markets Internet & Ecommerce ETF (EMQQ), iShares China Large-Cap ETF (FXI). Note also that we saw strength in a couple of the more recently downtrodden sectors this week, including iShares U.S. Home Construction ETF (ITB) and SPDR S&P Semiconductor ETF (XSD). Finally, we saw continued strength in the US Dollar, with Invesco DB US Dollar Index Bullish Fund (UUP) up nearly 3% for the week and a brief reprieve in fixed income this week as rates ticked down slightly with iShares 10-20 Year Treasury Bond ETF (TLH) and iShares Core U.S. Aggregate Bond ETF (AGG) among the top performers.
This week was another difficult one for the traditional “risk on” categories. Our worst performing ETF in our watchlist again was the ARK Innovation ETF (ARKK) fund, which fell more than 9% as top holdings Teladoc (TDOC) and Tesla (TSLA) performed quite badly this week. Other “risk on” ETFs that struggled this week included AdvisorShares Pure US Cannabis ETF (MSOS), SPDR S&P Biotech ETF (XBI), and Invesco Alerian Galaxy Crypto Economy ETF (SATO).
Beyond the “risk on” group, we saw weakness in more defensive areas like VanEck Gold Miners ETF (GDX) and SPDR S&P Health Care Services ETF (XHS). This lends more credence to what we have been saying lately, that even defensive type sectors are facing losses from time to time. Certainly, a challenging time for all of us invested in the market!
In past quarters, you have seen us give you earnings updates during this time of the quarter, when we are furiously studying the barrage of earnings reports coming down the pike. This quarter we will be giving you a bit less of that, but one of the stocks we wanted to highlight this week did, in fact, report earnings on Wednesday this week.
Kraft Heinz is the first stock we wanted to highlight for you that fits our “portfolio repair strategy.” We are being explicit in our desire to invest in businesses that will perform in an inflationary environment. The main characteristics that we are looking for are predictable and dependable cash flows and the ability of a business to pass along higher production costs to customers, in the form of higher prices, without losing demand.
On Wednesday’s earnings call, CEO Miguel Patricio reported that the company’s organic net sales grew at an annual rate of 6.8% for the quarter, with the company’s prices up 9% and volumes down 2.2%. This data point shows us that the purveyor of such brands as Velveeta and Jell-O has pricing power in the current environment, which means KHC’s fundamentals are accelerating in a difficult time for nearly every industry.
What we are really looking for in a business now is the generation of Free Cash Flow, which allows companies to keep solid balance sheets and return cash back to shareholders in the form of dividend payouts and share buybacks. In KHC’s case, the company is executing on both sides of that equation: since 2020, management has reduced the company’s leverage ratio from 4.5x in 2020 to 3.1x now, and has returned KHC’s credit rating to investment grade, which reduces borrowing costs for future bond sales. In terms of capital return, we also see things positively for Kraft Heinz, with the shares carrying a dividend yield of 3.7% at the current stock price.
KHC shares have gained 21% year-to-date, which is obviously impressive in the context of the broader market. However, at the same time, there is plenty of upside remaining in KHC, as that stock is down more than 50% (blue) over the last 5 years (versus +75% in the S&P 500; orange). KHC is one of the stocks in our recovery basket.
Our second “recovery stock” is Best Buy
Best Buy was just like many other big box stores during the 2010s, with its business under siege by online retailers (mostly Amazon). For a time, customers used to visit Best Buy’s showrooms to view electronics in person, then bring out their phones to purchase the product on Amazon! Best Buy has gotten wise to this over the years, offering price matching and beefing up the company’s online retail presence. Another growth lever for Best Buy has been the expansion of its service business the “Geek Squad” and the company now offers a subscription product for ongoing service. We like the fact that this gives Best Buy a predictable revenue stream going forward.
We like the way business is trending from the qualitative point of view, but the numbers are also compelling here. First of all, BBY shares trade at a 9x price/earnings ratio, which is extremely low, even for a company in the consumer discretionary sector. At the same time, Best Buy delivered sales growth in excess of 9% in Fiscal Year 2021. Given these inputs, we think the stock trades quite cheaply, so there is a potential for multiple expansion here in the coming month, in addition to the earnings growth already in evidence.
But capital appreciation is not the only potential source of return here. At the current share price, Best Buy shares have a dividend yield just a shade under 3.8%. With the relatively low valuation of BBY shares and the dividend yield on offer, we think there is potentially a high floor on this stock. Even if shares fail to appreciate, investors have the opportunity to collect the generous dividend.
International Business Machines
Of the three stocks in our “recovery portfolio”, IBM may be the most unloved one over a long period of time. Since the beginning of 2012, IBM shares have lost 27% in value (ex-dividends), while the NASDAQ Composite Index has gained nearly 350% over that period! For a company engaged in the technology space, it is hard to have lost value over the last decade, but they’ve accomplished the feat. “Hated over the last decade” is actually the type of stock that seems to be working in the current environment. While the NASDAQ is down more than 20% this year, IBM shares have fallen just 2%. Couple that with the company’s dividend yield of 4.9% at the current stock price, IBM shares have been a good way to preserve capital in this bear market.
We took a look at last week’s earnings report. The company has slowly shifted its business model away from mainframe computers of the past, toward contemporary technologies, like hybrid cloud computing. The 2019 acquisition of Red Hat, an open-source software producer, gave the company a new growth engine. In the 1st quarter of 2022, IBM had revenue growth in its software of 15% and in consulting of 17%. Overall, the company’s sales contracted, mainly due to the spinoff of the company’s managed infrastructure business, Kyndryl.
Last quarter, IBM generated nearly $3 billion in Free Cash Flow on revenues of just under $15 billion and the company’s cash flow trajectory has been consistent in recent years. We like CEO Arvind Krishna, who comes from the company’s hybrid cloud computing division. He appears to be the right manager to bring IBM to the cutting edge, which is not something we could have said even two years ago.
IBM currently trades at a market multiple of 21x price/earnings. We don’t expect to see multiple expansion, but we do think if earnings continue to accelerate that the shares could do well in the coming years. The generous dividend yield provides a strong incentive for investors to be patient. You can expect IBM to be a stock that finds its way to our research shortlist in the coming weeks.
Takeaways from this Week
With markets (both stock and bond) continuing to struggle, we are looking for a strong playbook for portfolio recovery. The thread that ties all these three stocks together (KHC, BBY, and IBM) is that they are cash generative businesses, have generous dividend yields, and reasonable valuations, while having at least some growth and pricing power. This is the profile of the stocks that are working best in a difficult market environment.
Over the past few years, many investors have become committed to the concept that “growth stock” means a business growing at 30-40% (or higher) and losing money. We are encouraging investors to start looking in the so-called “value investing” bucket for companies growing steadily in single-digits or low double-digits. We still are looking for accelerating fundamentals, but predictable cash flows are the flavor we like best currently and we will continue to lean into that theme for 2022. Couple stocks like the three above with energy and materials, two other sectors with pricing power and Free Cash Flow, we think there is a strong playbook for portfolio repair in 2022.
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