With interest rates stuck near zero and a moribund central bank refusing to aggressively raise interest rates, stocks remain the best investment opportunity in town.
But that’s no guarantee that the market will keep going up. Nothing moves in a straight line. Chances are good we’ll see another market selloff before the end of the year. Besides the usual annual seasonal volatility, there’s the election. If anything, this election looks like a referendum on 2008. It’s not just the Obama presidency, but all his policies from bailouts to overly dovish central bankers.
So watch out. Be prepared for bigger swings in your portfolio. Even if we get another 10-percent decline in stocks, that’s still a lot to spook out investors and cause some headaches for leveraged traders.
But it’s also an opportunity, and one that shouldn’t go to waste.
I’ve been talking for weeks about creating a buy list for the next market decline. But let’s get specific. I’m looking for companies with strong moats.
In investing, a moat is some kind of competitive advantage that one company has over all its competitors. Moats can be wide, like a software company with proprietary technology. Think Google’s dominance of search engines.
A moat can be narrow, like Wal-Mart’s (WMT) cost advantage over other retailers. While the firm typically competes to win on price, it often loses out on quality or customer experience. As a result, their profit margins are narrow. Hence the small moat.
Some moats allow companies to continue expanding at a rapid rate for years. Other moats simply allow companies to generate lots of cash that they can’t reinvest in their core business, leaving lots of capital to give back to shareholders.
A company that can consistently generate substantial amounts of revenue above and beyond its costs has a moat. If that moat is something like a brand, where investors will pay up for the name versus a generic substitute, then the company can also keep hiking prices as the years roll by. That makes them insulated from inflation, since it’s consumers paying the higher costs instead.
For instance, at the right price, investors can pay up for The Hershey Company (HSY).
The company’s strong brand and position in the U.S. chocolate market give it a strong moat. That’s why shares are almost always conventionally expensive when using traditional investment metrics like the price to earnings ratio.
Now is a time to think about companies with strong moats. Those that have the proven earnings power to get through tough times, ideally rewarding shareholders in the process.
They should also have some kind of potential catalyst that can be a boost to earnings down the road as well.
For instance, Hershey has very little exposure to the international chocolate market. A push there could give their sales a huge boost. With a rise in the global middle class, millions of people escaping poverty can enjoy little luxuries like chocolate bars on a regular basis.
Just bear in mind, however, that there are times when shares will get even more expensive. That’s where a covered call writing strategy comes into play.
Going back to the Hershey example, shares vaulted back in July when Mondelez Foods (MDZ) made an offer to buy out the company. The offer fell through in August, sending shares back down again. That round trip return in shares could have bene offset in a few ways. Those who took profits got cashed out, and can now buy back shares where they were trading just a few months ago. Those who took a buy and hold strategy ended up about the same as well.
But investors who covered their position by writing a call option could have kept shares and gotten some extra income too. In today’s environment, it’s not a bad way to stay invested. Either markets will trend higher and you’ll get called away, or markets stay flat or go down and you raise some cash for the next opportunity.
What does matter is using the power of these economic moats to your advantage. That means being willing to pay up going in. It also means keeping an eye for the right companies to hit the right price. There’s no right answer there, either. You could wait for a company to trade at the historically high-end of its dividend yield if you’re looking for an income play. A few opportunities emerged in that space back in February when markets sold off.
For instance, investors could have bought a sector-dominating company like Intel (INTC) with a dividend yield of 3.7 percent. Today, Intel’s yield is 2.88 percent. That’s still better than the average S&P 500 stock, but not by much. It’s a company with a good moat, but you need more than that to get great returns. You need patience.
Or you could wait for a company with a promising new product to fall out of favor first. Wireless chipmaker Qualcomm (QCOM) has been out of favor since last year when it got hit with a $1 billion anti-trust claim by the Chinese government. But they paid the fine, are growing in China, and their latest Snapdragon chips are selling well. Shares also yielded almost 4 percent near the bottom earlier this year.
But remember, a moat isn’t a financial metric per se. Yet evidence of a moat can show up on a company’s statistics in terms of high profit margins or return on invested capital (ROIC). But it’s also a subjective, intangible quality reflecting a company’s brand and earnings power.
When looking for the next investment opportunity, look beyond the numbers and what a company does. Think about what it does differently than its competitors. Favorable differentiations play a huge role in long-term investment returns.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and is managing editor of Financial Intelligence Report. To read more of his work, GO HERE NOW.
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