Q&A: What To Buy?

Jerry e-mailed to ask: "What stocks would you recommend buying during this downturn? XOM, COP, GE?"

This gives me a good opportunity to write a little about what I've been up to lately and what I'm thinking today. Of course, what I'm thinking today could differ significantly from what I'll be thinking tomorrow in this market.

As a quick reminder, I am not a day trader. Most of the positions I take are for the long-term though some are shorter-term opportunistic trades. In addition, I pursue a long/short strategy with most client portfolios. Part of the portfolio is long, and part is short. Where that split falls depends on the number of compelling short ideas I find as well as market and sector valuation (and the degree to which the government prevents me from shorting).

Obviously, the short portion of the portfolio has done well. I'd love to attribute that to my genius, but there isn't much you could have shorted recently and not done...it's because of my genius. Of course, a true genius would have held an even larger short position.

The long portfolio has been a mixed bag. It was designed to be defensive, and it had been up until this latest "baby and bath water" stage in which any semi-liquid security has been tossed overboard. The only things rising these days seem to be Treasury securities, gold, pessimism, some currencies, and the number of political ads on TV. The portion of our long portfolio that has done well is the exposure to cash, gold, the Japanese yen, and the Chinese yuan (renminbi). These positions have fortunately been the largest holdings in most portfolios. I wish they'd been larger still for they haven't offset the losses from the other long holdings.

With the decline in the market of the past 2 weeks, I've been gradually covering my short positions (SRS, QID, TWM). I have a few remaining (MS, BWLD, COF, AMZN, and HOG). I also still have some put options in some accounts on the QQQs. I anticipate closing most of these positions out in the near-term if the market doesn't spike higher (which would not be surprising). I'll probably keep the BWLD short a little longer as it hasn't come off its high too much, the valuation is still rich, cost (margin) pressures are building, and restaurant spending is a discretionary expenditure that is easy to rein in when times are tough. Buffalo wings are tasty, but I can put tabasco sauce on my tofu dogs and watch the game at home.

On the long side, I think the best long-term buys today are in some of the emerging markets and in the commodity space. Again, these should not be bought if you're looking to make a quick buck or if you're the obsessive type who monitors his investments every few minutes. They could easily fall significantly from here before finding a bottom, but if you are a true long-term investor, these are the areas I would focus on. Many of my long positions are in these two areas, and as I've indicated, I've been very gradually adding to them as they've come in, and I plan to roll the gains from the short positions into these areas.

As for emerging markets, I like China and Russia right now. You want exposure to China over the next couple of decades (probably longer) given their growth prospects and rising incomes, and you can get it today at a very reasonable price given the tremendous decline in their stock markets. There are some good, non-speculative, individual Chinese stocks to own, but most people would be better off with an ETF/fund (FXI, PGJ, GCH, CAF).

I also think Russia is looking interesting. That market has been blown apart from the "war" with Georgia and the decline of commodity prices on which Russia is highly dependent. Some degree of continuing conflict with its neighbors has already been discounted, and I believe the long-term outlook for many commodities is quite bullish. Russia is in a much better position than it was during its 1998 financial crisis. The Russians should have enough reserves to make it through the downturn as they are far less dependent on external financing than they were in 1998. Russian stocks are currently trading at some of the lowest multiples in the world right now - typically a good time to buy. One of the easiest ways to gain exposure to Russia is with RSX.

On the commodity front, I like many commodities long-term, but the supply-demand balance and time frame differs for each. In general, commodities are being knocked down of late due to declining demand from a contracting global economy as well as the general de-leveraging underway that is hitting all risky assets. These factors are currently overpowering the supply side of the equation. Longer-term, however, we need to watch what's going on with supply as well. Heading into this downturn, supply of many commodities was struggling to keep up with demand.

Currently, due to lower commodity prices, inability to access funding, declining demand, and higher costs, there is a steady flow of news detailing mine/project closures and postponements. In many cases, it's too expensive to start a new project even if you're able to scrape together the funding to do so. This will eventually lead to even lower supply. Once the global economy settles out and starts to grow again (and it will some day), I suspect it won't take long for investors to realize how serious the under-supply situation is. Some of the commodity names I'd recommend taking a look at include POT, MOS, DBA, DBB, SLV, GLD, NEM, GDX, TCK, RIO, BHP, AEM, PAAS, SSRI, NGD, and COW, but there are plenty of others interesting names as well these days.

The market cycles between financial assets and hard assets, although neither have been working over the past few months. I believe that commodities are still in a long-term bull trend and that the bull market will reassert itself at some point and run quite a bit further. My preference is to have "direct" exposure through ETFs as well as owning stocks that operate in the commodity space. I had hoped that the commodity-related stocks would have held up better, but in the current environment, everything liquid is being sold regardless of long-term prospects. The good news is that these stocks are offering amazing entry levels for the long-term investor, assuming we're not going back to living in caves and chasing our meals with clubs.

Let me turn to gold. I've been a big fan of gold for about 5 years now, and I think it makes sense for just about everyone to have some exposure here. Gold has performed well of late, and it's our largest single holding in most portfolios. I'm actually a little surprised that it hasn't done even better given the global financial stresses. The recent relative strength of the dollar is likely the key factor keeping gold from exploding, but the explosion in the money supply that's underway, the declining level of (already low) interest rates, the terrible shape of the U.S. government balance sheet, and the implosion of the financial system should be supportive, to put it mildly. At some point, I think there's a good chance of a gold mania.

As for gold vs. gold stocks, I own both. Currently, despite the price of gold hanging in there, gold stocks have been beaten up, and many are trading near their 52-week lows. If you have a longer-term horizon, you have a wonderful opportunity to put a basket of these stocks together and tuck it away. You could also buy GDX which would give you exposure to a basket of mining companies. In addition, owning actual gold coins somewhere offshore wouldn't be a terrible idea either.

As for XOM, COP, and GE specifically, my feeling is that there are better opportunities available. These names aren't likely to outperform the market when things eventually turn, and they haven't really provided much of a hiding place thus far. If you have a longer term time horizon I would focus more on companies that will be more leveraged to the upturn. If you like energy (I do long-term), take a look at PBR, CHK, APC, and XTO. Also take a look at the drillers, especially the offshore deepwater plays. It's probably a little early here still, but these will be strong winners again.

As for GE, anything with significant financial exposure is still off limits for the time being. I've had a net short position in financials (wish it had been bigger) during the decline. The problem has been that no one really knows what any financial company's balance sheet really looks like. If you don't know the quality of the balance sheet and you buy still buy the stock, you're simply gambling. I save my gambling for the poker table. And buying the larger banks because you think the government won't let them fail is a flawed strategy. True, Wells Fargo and Bank of America won't be allowed to fail, but as we've seen, you shouldn't expect the common shareholders to be bailed out.

One final note if you're picking individual stocks. Equity investors never worry much about the balance sheet or cash flow statement when times are good. Now that times are not so good, the balance sheet and cash flow statement are critical. If you're not going to look at 10-Qs and 10-Ks then you shouldn't be buying individual stocks. Companies with too much debt and/or too high a reliance on external financing are off limits. These are potential company killers. High debt with strong cash flow may be fine if the cash flow remains sufficient during the downturn.

UPDATE: I was a bit sidetracked from this post today due to the market. The market has now closed -- down another 675 points. Today's action isn't shocking given sentiment and the lifting of the short ban.

At this point, I have turned from bearish to neutral on the market overall. There is certainly more room for downside, but after a 40% decline in the market, normalized P/E is looking more reasonable, and I'm having a much easier time finding attractive long ideas. This market is either ready to implode or we're due for an explosive bear market rally.

At the end of the day, I closed out my short positions in MS, COF, HOG, and AMZN. Currently, the only short I have is BWLD. At these levels, I'll be putting some cash to work on the long side in some of the names mentioned earlier. Never a dull moment.

Disclosure: The Rubbernecker is long on long-term buying opportunities and short of shorts.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Agricultural Smackdown - South Asian Style

“Food is an important part of a balanced diet.” Fran Lebowitz

There was an interesting article in yesterday’s New York Times discussing the developing spat/misunderstanding between the U.S. and India about responsibility for the rise in food prices. The whole to-do started a couple of weeks ago with some comments by Condoleezza Rice and was exacerbated by President Bush a couple of days later (shocking).

I’ve looked over a number of articles discussing this issue and, as usual, most of them just pick and choose which quotes to offer or simply paraphrase what Rice and Bush (hereafter referred to as Brice) said. To paraphrase the paraphrasing, a good portion of the commentary has gone something like, “Brice blames rising food prices exclusively on the irresponsible growth in India and China and their lack of willingness to continue starving for the benefit of the West. To address this travesty, the U.S. is now developing a secret program to sterilize all of the women in both countries to ensure a continued orgy of steak, ale, Oreos, and Hummers for the best, brightest, sexiest, most shaved, and most smiled-upon people ever to grace the face of the planet – Americans.”

Let’s actually take a look at exactly what our beloved leaders said. First off, Rice was offered the following question at a recent Peace Corps Conference:

Many of us are in countries where the predominant source of food is grain, rice, et cetera. And I’m wondering about your thoughts about the US government’s thoughts about the skyrocketing prices of grain worldwide?

Her reply

We obviously have to look at places where production seems to be declining and declining to the point that people are actually putting export caps on the amount of food. Now, some of that is not so much declining production as apparently improvement in the diets of people, for instance, in China and India, and then pressures to keep food inside the country. So, that’s another element that we have to look at.

Now let’s look at exactly what Bush said a few days later.

Worldwide there is increasing demand. There turns out to be prosperity in developing world, which is good. It's going to be good for you because you'll be selling products in the countries, you know, big countries perhaps, and it's hard to sell products into countries that aren't prosperous. In other words, the more prosperous the world is, the more opportunity there is.

It also, however, increases demand. So, for example, just as an interesting thought for you, there are 350 million people in India who are classified as middle class. That's bigger than America. Their middle class is larger than our entire population. And when you start getting wealth, you start demanding better nutrition and better food, and so demand is high, and that causes the price to go up.

So…………they’re basically saying that declining production, trade restrictions, and the increasing demand for more and better food from a wealthier developing world are contributing to the rise in food prices. Sounds like a no-brainer to me. The problem with it, apparently, is simply that Brice didn’t explicitly state that these were SOME of the factors impacting food prices rather than ALL of the factors.
Because of this, we’ve seen an outpouring of hostility and disbelief from a portion of the developing world, most notably India, which is screaming that the U.S. is the real culprit behind rising food prices. Here’s an example from the NYT article,

…Pradeep S. Mehta, secretary general of the center for international trade, economics and the environment of CUTS International, an independent research institute based here, said that if Americans slimmed down to the weight of middle-class Indians, “many hungry people in sub-Saharan Africa would find food on their plates.”

He added, archly, that the money spent in the United States on liposuction to get rid of fat from excess consumption could be funneled to feed famine victims.

Explaining the food price increases, Indian politicians and academics cite consumption in the United States; the West’s diversion of arable land into the production of ethanol and other biofuels; agricultural subsidies and trade barriers from Washington and the European Union; and finally the decline in the exchange rate of the dollar.

Mr. Mehta just gave me my newest million dollar idea. Let’s re-package all of that cellulite into 8 ounce plastic containers and market it in the developing world as a high-calorie snack called YoGurth! Everybody wins!

Ok. Now let’s look at who has the upper hand in this argument. I’ve thought short and soft about this, and the winner is………..well, it’s a tie. We can debate the relative importance of each factor, but most of the points that both sides are making are valid.

• As wealth in India and China increases, demand for more and better food increases. This higher demand is one factor leading to rising food prices.

• The average American has enough fat to live off of for two entire years (note: this statistic has not been scientifically proven and was pulled from the author’s nether-region in the interest of editorial expeditiousness).

• Export barriers and tariffs may temporarily limit price increases internally, but they exacerbate global supply problems, lead to higher prices globally, and will likely result in lower domestic supply.

• Americans are the largest per-capita consumers of many things: oil, food, liposuction, therapy, fatuous TV programming, lust, gluttony, greed, sloth, wrath, etc.

• Some farm land has indeed been converted from food production to feed the ethically-bankrupt subsidized beast of ethanol.

What are the key points from all of this?
• The economies of China and India are growing quickly. It’s reasonable to expect them to want to improve their diets. Given that they’re moving from the starvation level to one of mere malnutrition, we Americans should take care not to speak too indelicately with our mouths so full.

• We’re never going to out-run the Indians and Chinese if they ever invade us. It’s in our own best interest to fatten them up.

• It’s hard to get the full story from the press. They write with the short attention span of the average American in mind and therefore feel the need…………….what were we talking about?

• YoGurth – Saturate Your Diet with the Taste of America!

• The fertilizer stocks are still looking good. Still a buyer of POT, AGU, and MOS.

An Entry From My Dromediary About POT and MOS

Commodities are clearly in the midst of a bull market. On a daily basis, we're being deluged with stories of rising gasoline prices, rice shortages, soaring demand for steel, etc. These high prices will certainly encourage the development of new supply in time. A nearer-term impact will be product substitution when feasible. If steak costs too much, buy chicken instead. If the price of rice is too high, substitute potato. If the cost of cocoa soars.....bad example. I'm still buying cocoa.

The following example of the substitution effect is from a recent article in the Financial Times. It has me seriously thinking of swapping my Accord for some sled dogs.

Farmers in the Indian state of Rajasthan are rediscovering the humble camel.

As the cost of running gas-guzzling tractors soars, even-toed ungulates are making a comeback, raising hopes that a fall in the population of the desert state’s signature animal can be reversed.

“It’s excellent for the camel population if the price of oil continues to go up because demand for camels will also go up,” says Ilse Köhler-Rollefson of the League for Pastoral Peoples and Endogenous Livestock Development. “Two years ago, a camel cost little more than a goat, which is nothing. The price has since trebled.”

The shift comes not a moment too soon for a national camel population that has fallen more than 50 per cent over the past decade, to about 450,000, according to government figures.

Market prices for these “ships of the desert”, which crashed with the growing affordability of motorised transport, are rising again as oil prices soar.

A sturdy male with a life expectancy of 60-80 years now fetches up to Rs40,000 ($973), compared to Rs5,000-Rs10,000 three years ago, according to Hanuwant Singh of the Lokhit Pashu-Palak Sansthan, a non-profit welfare organisation for livestock keepers. Entry-level tractors cost around $4,000.

As far as I know, there are no camel futures or ETFs, and I'm not suggesting you mail order a caravan of camels in the hope of reselling them for a tidy profit . Remember, you have to pay for shipping, feed them, and pick up after them. And then there's the spitting. Oh, the spitting!

The point, as usual with commodities, is that the end of the bull for any particular commodity will eventually come from falling demand, rising supply, or both (2 years spent getting an MBA for that insight). Product substitution is just one factor to keep an eye on. In the short-term, we're more likely to see it in the agriculture space than metals or energy, given their relative fungibility.

If you really know what you're doing and have a great handle on the fundamentals of different agricultural commodities then you can do very well in the futures market. This can also be a bit dangerous since not all crops move together and significant retracements should be expected.

My preferred way to gain exposure to the agriculture space has been through the fertilizer space, which has been enjoying and is likely to sustain favorable supply/demand fundamentals. With these firms, we don't have to worry too much about product substitution. Yes. Different crops have different fertilizer needs, but there's nothing in the immediate future likely to totally replace potash and nitrogen use.

This past week, I added to positions in Potash (POT) and Mosaic (MOS). Both of these stocks have pulled back roughly 15% in the past 10 days as investors began rotating out of the the commodity space in general. I believe these names (and AGU which I also own) are in a secular (rather than cyclical) bull market. Their earnings growth is terrific, their valuation looking into 2009 is attractive (low double-digit P/E for both), and they're generating a ton of free cash.

Key fertilizer supply is constrained and demand continues to grow given the rising populations and dietary demands of the developing world. The rising prices of agricultural commodities is increasing the demand for fertilizers in order to maximize crop yield and also increasing the ability of farmers to pay higher fertilizer costs. These are the types of names that institutions will want to own given their fundamentals, valuation, and stock performance. This share demand support is likely to limit downside barring a significant adverse change in fertilizer supply or demand.

My strategy with these names has been to lighten as they've gone parabolic or become too large a portion of the portfolio and to add when we get these 10-20% pullbacks. A core position has been maintained regardless of price action. Should the stocks continue to fall in the coming weeks, I fully expect to keep adding.

The author currently has no camel position.