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Time To Invest In The Highest-Quality Companies

In my columns over the past six months, I’ve discussed many risks that the global economy faces. China, the world’s second-largest economy, is in the midst of an enormous overcapacity bubble in commercial, industrial and residential real estate.

In my columns over the past six months, I’ve discussed many risks that the global economy faces. China, the world’s second-largest economy, is in the midst of an enormous overcapacity bubble in commercial, industrial and residential real estate. Japan, the third-largest and second-most-indebted nation, is in a debt bubble, addicted to unsustainably low interest rates. Last, the U.S. is unlikely to maintain its recent rate of growth because it is being propelled by government intervention (QE2 comes to mind here).

Yes, I’ve been very skeptical about the health of the global economy. I don’t know if we’ll have inflation, deflation or both. It appears that problems in China and Japan will lead to higher global interest rates; after all, they are the largest foreign holders of U.S. debt, and as their respective bubbles burst, they’ll be forced to become net sellers. Over the next few years, global GDP growth will be lower than we’ve been accustomed to, as consumer deleveraging will be followed eventually by government deleveraging, which comes with higher taxation.

There is no place to hide. With every shelter you seek, you assume a different risk. Bonds will do great if we have deflation but will be decimated if we get inflation. There is gold, of course, but it is not a cash-generating asset, thus nobody really knows what it is worth. There are industrial commodities, but China is the incremental buyer, so even if we have inflation, prices may still decline with plummeting demand. If you have plenty of exposure through bonds or equities to the countries that have fared the best so far — the likes of Australia, Brazil and Canada — don’t expect them to be spared, as they have been the primary beneficiaries of the Chinese bubble.

Okay, before I depress you further: You don’t need to reserve a space in a cave stocked with canned food and ammo. But this is definitely the time to own the highest-quality companies. They need to have strong balance sheets so higher interest rates will not dent their profitability. Their businesses need to have a competitive advantage so they can raise prices for their goods or services in case inflation hits or maintain their prices in case of deflation. And, of paramount importance, they need to be noncyclical businesses.

For a company to be truly high quality, its business has to be insensitive to the health of the global economy. Interestingly, there is usually a premium that is built into high-quality companies’ valuations, as investors are willing to pay more for lower risk and the certainty of cash flows. Deeply cyclical stocks have traditionally traded at a discount to the market. That’s not the case today: Low quality is expensive, and high quality is dirt cheap.

So here are a few companies that we consider to be high quality — companies we own in our accounts. The first two are in health care. Though the passage of Obamacare is behind us and its impact has been relatively low on the industry, stocks did not get the message. Pfizer, the largest drug company in the world, is trading at less than 8 times earnings. It generates enormous cash flows, pays a 4.5 percent dividend (which it just raised) and will be debt-free in the not-so-distant future. But the market puts zero value on Pfizer’s enormous pipeline of drugs and the $10 billion it spends annually on research and development.

Medtronic, which makes pacemakers, is trading at 10 times 2011 earnings. If you looked at its stock chart for the past decade, you’d think Medtronic’s business has stagnated. It hasn’t. The company has grown sales and earnings, on average, 14 percent a year over the past ten years. Both Medtronic and Pfizer have a huge tailwind behind them: Baby boomers around the world will be consuming more, not fewer, drugs and medical devices five years from now, no matter what happens in China or Japan.

Cisco Systems and Computer Sciences Corp. Cisco — the maker of Internet plumbing — disappointed Wall Street last fall, and the stock was taken out back and shot. Today it is trading at about 11 times next-year earnings, or less than 9 times if we adjust the price for the $25 billion of net cash it has on the balance sheet. As we consume more and more data and video over the Internet, the demand for Cisco’s products will only increase, regardless of what happens to the global economy.

The most boring of this bunch is CSC, an outsourcing company for large corporations and the U.S. government. It is trading at 9 times next year’s earnings and has announced a stock buyback of close to 12 percent of its shares. CSC has a very stable and growing business as the trend of outsourcing continues.

For the complete II Magazine article, please click here.

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