4 Stocks Picks For The Market’s Next Storm

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Despite the S&P 500’s massive rally this year, winning fund manager Steve Romick warns that soaring levels of sovereign and corporate debt to new highs could inflict major turmoil on the stock market. Romick has good cause to be worried, given as head of the $17 billion outperforming FPA Crescent fund (FPACX), he is 70% invested in stocks. To protect against that, Romick is buying equities with a five to seven-year investment horizon, which he argues will outperform, including American International Group (AIG), Jefferies Financial Group (JEF), Charter Communications (CHTR) and Comcast Corp. (CMCSA), per Barron’s.

 4 Stocks To Navigate The Storm

(YTD Stock Performance)

·     American International Group; 8%

·     Jefferies Financial Group; 15.6%

·     Charter Communications; 19.8%

·     Comcast Corp.; 10.8%

Source: Investopedia

Romick’s FPA Crescent fund, which he runs alongside Mark Landecker and Brian Selmo, holds equities, cash and bonds, reflecting the fund managers’ broader market views. Over the past three, five, 10 and 15 years, the moderate asset-allocation fund has beaten the average for its peer group, including funds which hold 50% to 70% of assets in stocks and the rest in fixed income and cash. FPA Crescent was buying up equities during 2018’s downdraft, yet still maintains a quarter of its assets in cash.

Upheaval in Corporate and Sovereign Debt

In an interview with Barron’s, Romick argues that while many have focused on the high debt facing consumers and banks, both cohorts are actually in better standing than before. Meanwhile, corporate debt and sovereign debt are the issues keeping him up at night.

“Sovereign debt levels are as high as they’ve ever been relative to gross domestic product around the globe,” stated the market vet, citing the highly leveraged U.S. Treasury, as well as state and local governments across the U.S. “This rapid debt expansion can’t continue forever. At some point, there will be a price to pay in the form of slower economic growth or recession. Buyers of sovereign debt could demand a higher yield. Corporate defaults could result from higher borrowing costs. The weak economy could cause lower cash flow. Figuring out the timing on sovereigns, in particular, is impossible,” he explained.

US Corporate Debt Surpasses $9 Trillion

Romick indicates that U.S. corporate debt is at its most elevated level in history, at over $9 trillion, with the highest leverage ratios outside of a recession and “some of the weakest covenants we’ve ever seen.”

While the risks of more high-yield, leveraged-loans are more understood, the investor indicated that there is a widespread lack of understanding with respect to investment-grade bonds. The market for high-yield bonds and levered loans grew from $1.3 trillion in 2008 to $2.4 trillion currently, nearly doubling. Meanwhile, the investment-grade market jumped fro $2.5 trillion to a whopping $6.4 trillion over the same period. The percentage of BBB-rated investment-grade bonds, just a level above junk, jumping from 32.5% to over 50% in 10 years.

As a result of lower rates and an accommodating lending market, “zombie firms” are surviving longer than they normally would, while a surge in M&A have levered up corporations to new highs.

All of this leaves little margin of safety in the event of a recession, wherein Ebitda declines and leverage ratios increase. He added that credit metrics are already worse than typical in a recession.

Volatility ‘Creates Future Opportunity to Put Capital to Work’

Taking into account negative headwinds, Romick expects equities to suffer as the market sees more corporate bankruptcies. High leverage, weaker covenants and a high level of absolute corporate bonds will result in a below-average recovery rate, per the market watcher. However, he sees this volatility as creating “future opportunity for us to put even more capital to work,” within a five-to-seven-year mind-set.

“We’d rather have our money out there and accept some volatility, rather than just keep it in cash,” he stated.

Insurance Play

Romick likes shares of American International Group, which his fund bought right after the last recession. The investor is upbeat regarding AIG’s new CEO Brian Duperreault and COO Peter Zaffino, both insurance industry vets. He expects new management to help move the company forward in its initiative to improve property and casualty underwriting. AIG shares have staged a comeback in 2019, up 10.8% YTD, yet still down 25% over 12 months. Romick views AIG’s valuation as attractive, pegging the stock’s tangible book value at $56 per share, versus its current price at $42.62

Telecommunications Buy

While many investors have ditched cable providers due to fears of widespread cord cutting and a shift to on-demand streaming, Romick likes Charter Communications and Comcast.

“We believe in the latent pricing power of broadband, which is necessary for the consumer to cut the cord in the first place. The average typical broadband customer is going to be perfectly happy paying, say, only $10 to $20 more per month—our estimate for video profitability. Otherwise, you don’t get your Netflix or your new Disney streaming or Hulu, or your videogames,” he explains.

Bank Stock

Romick is also bullish on broker dealer and merchant bank Jefferies, which he calls a quality business with good owner-operators. He notes that while Jefferies repurchased 13% of its shares last year, its stock fell 35%, leading it to trade at less than 80% of its book value and “at about a 30% to 35% discount to our conservative low-$20s assessment of net asset value.” The investor is upbeat about Jefferies earnings results which met expectations in 2018, as well as the reduction of its majority stake in National Beef.

Looking Ahead

Romick’s sober view of the markets reflects the new caution investors have in the wake of the fourth-quarter plunge. The big question will remain whether Romick – or any investor – can hand pick stocks that will prosper amid the next downdraft, avoiding getting pulled down by it.

Source: Investopedia

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