How To Take Advantage Of This Correction
We are currently seeing a correction in U.S. stocks of about 5% from the high reached by the major indexes a few weeks ago. What makes this correction noteworthy is that there were analysts pounding the table about ‘sell in May and go away’ as well as the need for a correction. These things usually occur when people don’t expect them, this correction has been the worst kept secret.
A 5% move doesn’t sound like much, but keep in mind that many quality stocks have underperformed on top of the correction. So a move by the market has exacerbated their under performance. A good example of this is McDonalds (MCD) which has underperformed the market by over 16% YTD and can be called as being in a correction.
The adage of “buy low, sell high” works especially well when the market itself forces stocks down for reasons not having much to do with the fundamentals of a company. If you are invested in Fossil (FOSL) or Chipotle (CMG), we did see significant news about their earnings that will force you to assess your position. The market showed no mercy on these high growth stocks gone wrong since the market had previously priced them for perfection.
But what if the companies you own didn’t have any earnings issue or any other problem recently? This is your time to buy additional shares at a lower price. This is the time to be very unemotional and logical.
How To Take Advantage
To make a correction work for you, it requires some planning as well as clear criteria to use to assess when to buy stocks you are interested in. The problem with taking advantage of corrections is that you might already be fully, or nearly fully invested. This may lead you to the choice of switching some existing investments for others that you deem a better opportunity.
My investment strategy avoids this dilemma because a sizable portion of my portfolio is invested in the highest yielding fixed income type of investments available now: low investment or near investment grade corporate debt (this is a kind way of saying “junk” bonds). This works especially well right now because the debt and fixed income markets are very strong, there isn’t any issue in selling to raise cash if necessary. There is normally a struggle or lack of correlation between stocks and bonds, but because we live in unusual times we aren’t getting the normal case.
This strategy is quite flexible, because if the correction never occurs or is shallow, I still earn a respectable return (about an annual return of 7%).
So, it will be possible to sell your strongest performing asset (debt) to buy struggling assets (stocks)..
Here’s a summary of my portfolio now:
- Corporate debt (preferred stocks): 30%
- Cash: 12%
- Stocks: 58%
Assessing The Opportunities
The question is how do you determine when to buy stocks you want to own? I already have a good idea about companies I want to own (either because I already own them or have researched them). To assess each situation, I use a combination of technical indicators and a fair estimate of the long term return on investment.
Using technical indicators, I use a very simple trending average that is well known: exponential moving average. Keeping it simple, the EMA will indicate the following about stock price movement.
200 day EMA: Stock price above indicates BULL, below indicates BEAR
50 day EMA: Stock price at this level indicates a BULL correction (assuming BULL case is still intact – meaning that the 50 day EMA is above the 200 day EMA).
If you want to be conservative, use the EMA calculated over a multi-year period using weekly prices (the more aggressive approach is to use the EMA calculated off of the daily price – I will use the former). In all the cases I will mention today, the stocks have been in a consistently upward bullish trend. Using these technical indicators, the first opportunity to buy a bullish stock on a pullback is when the current price reaches the 50 day EMA.
In terms of determining the long term return on investment, I utilize a simple model that I have discussed before. It estimates the long term return on a dividend investment as follows:
Average Annual Investment Return = dividend yield * long term dividend growth.
Since corporate bonds can earn 7% per year with little effort, I want a higher rate of return for taking capital risk. Ideally, I want to buy investments that offer a long term potential return of 15%/year, but I will start to add to my position at about 13%/year. This means that the addition of the dividend yield plus the dividend growth rate should be greater or equal to 13.
Patience pays off. I got some opportunities here for stocks that can be bought now plus a few others that I still think need to pull back more. In each case, I provide the details both about the technical indicators as well as the expected investment return.
Apple Inc. (Apple), along with its subsidiaries is engaged in designs, manufactures and markets mobile communication and media devices, personal computers, and portable digital music players, and sells a range of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company’s products and services include iPhone, iPad, Mac, iPod, Apple TV, a portfolio of consumer and professional software applications, the iOS and Mac OS X operating systems, iCloud, and a range of accessory, service and support offerings. It also sells and delivers digital content and applications through the iTunes Store, App Store, iBookstore, and Mac App Store.
Apple Price: $567.20
50 EMA: 302.13
200 EMA: 454.39
Dividend Yield: 1.9%
Earnings Growth: 19% (courtesy Yahoo! Finance)
Expected Investment Return: 21%
Apple is a very reasonably priced stock anyway you look at it. However, I don’t fight the market if it chooses to consistently undervalue the company. I will follow the technical indicators to get the best possible price. Because of the huge move the stock has made so far this year, the stock could still be considered in BULL mode over 100 points lower from here because the long term 200 day EMA is about $450/share.
I could make the case to buy it here purely on the numbers, but I will wait until the summer doldrums kick in to try to get a better price.
McDonald’s Corporation franchises and operates McDonald’s restaurants in the global restaurant industry. These restaurants serve a menu at various price points providing value in 119 countries globally. As of December 31, 2011, of the 33,510 restaurants in 119 countries 27,075 were franchised or licensed (including 19,527 franchised to conventional franchisees, 3,929 licensed to developmental licensees and 3,619 licensed to foreign affiliates (affiliates)-primarily Japan) and 6,435 were operated by the Company. McDonald’s menu includes hamburgers and cheeseburgers, Big Mac, Quarter Pounder with Cheese, Filet-O-Fish, several chicken sandwiches, Chicken McNuggets, Snack Wraps, French fries, salads, oatmeal, shakes, McFlurry desserts, sundaes, soft serve cones, pies, soft drinks, coffee, McCafe beverages and other beverages.
MCD Price: $91.75
50 EMA: 92.49
200 EMA: 74.81
Dividend Yield: 3.1%
Earnings Growth: 10% (courtesy Yahoo! Finance)
Expected Investment Return: 21%
MCD has pulled back to its 50 day EMA quite nicely. With a 10%/year earnings growth rate plus a 3% dividend yield rate going forward, it’s a buy here.
Lorillard, Inc. (Lorillard) is the manufacturer of cigarettes in the United States. Its Newport is a menthol flavored premium cigarette brand. During the year ended December 31, 2011, the Newport brand accounted for approximately 88.4% of its sales revenue. In addition to the Newport brand, its product line has four additional brand families marketed under the Kent, True, Maverick and Old Gold brand names. These five brands include 43 different product offerings. During 2011, it shipped 40.7 billion cigarettes, all of which were sold in the United States and certain the United States possessions and territories. Lorillard produces cigarettes for both the premium and discount segments of the domestic cigarette market. It sells its products primarily to wholesale distributors, who in turn service retail outlets, chain store organizations, and government agencies, including the United States Armed Forces.
LO Price: $127.49
50 EMA: 115.98
200 EMA: 90.82
Dividend Yield: 4.9%
Earnings Growth: 11% (courtesy Yahoo! Finance)
Expected Investment Return: 16%
LO is unusual in that it is bucking the domestic trend of lower cigarette volumes. It’s actually growing its volume and share and is second to none in its shareholder friendliness. It’s a better buy versus Altria (MO) right now. Analyst estimates from Yahoo! Finance indicate that earnings will grow over 11% per year going forward, but I would be conservative with a number at 8%. Even at an 8% earnings growth rate, the stock has come into buy territory. The stock price has not reached its 50 day EMA yet, so I wouldn’t buy all at once.
Kinder Morgan Partners (KMR)
Kinder Morgan Energy Partners, L.P. (KMP) is a pipeline transportation and energy storage company in North America. KMP owns an interest in approximately 29,000 miles of pipelines and 180 terminals. The Company operates in five business segments: Products Pipelines, Natural Gas Pipelines, carbon dioxide (CO2), Terminals and Kinder Morgan Canada. The Company’s pipelines transport natural gas, refined petroleum products, crude oil, carbon dioxide and other products. Its terminals store petroleum products and chemicals and handle products, such as ethanol, coal, petroleum coke and steel. The Company is also a provider of CO2.
KMR Price: $71.39
50 EMA: 71.06
200 EMA: 60.42
Dividend Yield: 6.7%
Earnings Growth: 8% (courtesy Morningstar)
Expected Investment Return: 14%
KMR is the sister to the more well known limited partner KMP. It’s essentially the same company, same assets but due to a different structure, the dividend is paid in shares instead of cash. KMR is priced at a 10% discount to KMP, so the indicated yield now is about 6.7%.
Recent analyst reports offer an earnings growth rate of 5%/year. Morningstar has reassessed the earnings growth rate based upon the recent El Paso (EP) acquisition, and they believe an 8% earnings growth rate is warranted. If you buy these numbers, you can buy it here at the 50 day EMA.