Association for Investor Awareness - Week of 05/27/2010

In This Issue:

The Way Ahead
Long-Term Investors Welcome Stock Corrections
Mutual Funds May Beat Index Funds From Here On
Finding Current Income
The Bottom Line

Our special report last month that warned about a stock market correction, proved to be very timely. We would have actually been happier, not to mention a bit wealthier, to have been wrong. Unfortunately, Mother Market never consults us before making her moves.

In any event, from April 29 to May 26, the Dow and the Nasdaq dropped an uncomfortable -10.7% and -12.6% respectively. Judging from the strength of the decline, it has further to go before it runs out of steam.

The Way Ahead

The biggest question for investors now is whether the decline is a normal correction, or the start of a bear market.

We think the drop is most likely a correction. It was to be expected following the heady run-up of the previous 12 months. The only surprise is the retreat didn't come earlier. The delay allowed many stock prices to move further ahead of the economy, which means they have more ground to give back before the scales are balanced again.

Fortunately, the economy is continuing to grow – and it is doing so at a higher pace than most analysts predicted. By the fall, we think the stock market will resume its advance in a classic catch-up move.

Consequently, we are recommending that investors buy high quality stocks that the correction has made more attractively priced. According to the Bespoke Investment Group ( 89.8% of the S&P 500 stocks are oversold.

Long-Term Investors Welcome Stock Corrections

Successful investors have a habit of making good use of corrections. That's because lower stock prices early in an investment program lead to much higher overall long term gains. The effect can be so large, we often tell young clients to start their accounts and pray for a two or three year bear market.

To maximize long term gains, focus on leading companies that are likely to deliver excellent profits for the next few years. Here are three sectors and six leading stocks within them that look particularly good:

Energy. Although the cost of energy and energy stocks declined due to the recession, the long-term outlook for them calls for much higher prices. Exploding demand from China and other industrialized nations all but guarantee many years of expanding profits for the world's leading energy companies.

In our opinion, the most promising energy producer is ExxonMobil (XOM). Not only is the company the most profitable of its type in the world, it also has lots of cash and only modest debt. Nevertheless, the stock is selling for an attractive 13.4 times earnings, and yields 2.90%. Dividends have been increased annually for 27 consecutive years. 

More aggressive investors with long-term time lines should consider BP PLC (BP). No, we haven't taken leave of our senses. We know the company is in the doghouse, and why. The oil spill in the Gulf of Mexico is an environmental tragedy.

However, we also know that BP's troubles in the Gulf are unlikely to have a lasting impact on its profits. In addition, the stock is almost certainly oversold by investors who have been paying more attention to the company's headlines than its fundamentals. The stock has been hit so hard it has an incredibly low P/E of 6.5, and an eye-popping 8.8% yield. All in all, we think BP is very attractive. The best way to get in is to buy a little at a time over the next few weeks.

We also recommend EnCana (ECA), which has excellent long-term prospects for growth in the North American natural gas industry.

As you may know, an extraordinary new technology allows vast quantities of natural gas trapped in shale rock to be extracted. The sudden increase in supply is driving natural gas prices through the floor, and industry stock prices are following them down.

However, there is more to the natural gas story. Countless energy users are starting to switch to gas from much more expensive oil and coal. The surge in demand can be expected to drive natural gas prices back up longer term. We think that's a recipe for success at EnCana. The stock has an attractive P/E of 9.1 and a 2.70% yield.

Consumer Staples. Thanks largely to the global economy and the millions of more affluent people it created, many consumer staple companies have become money machines. One of the best of the group is Colgate Palmolive (CL).

In 2006 we paid $44.95 for Colgate. The stock is now $77.98, a 73.5% gain – not counting dividends. We think the price will continue to climb for as far ahead as we can see, albeit with corrections along the way. Colgate has a forward P/E of 14.5 and is expected to pay a 2.7% dividend this year.

Another company that should perform well over the long-term is Coca Cola (KO), a Warren Buffett favorite. Coke produces much more than its namesake product. In recent years the company expanded into bottled water, fruit juices, energy drinks, teas and coffee.

All of Coke's businesses use the same distribution and marketing capabilities the company created for its carbonated beverages. The efficient operations keep margins high and profits growing. Thanks to the stock market downturn, Coke has an attractive forward P/E of 13.5. The company pays a 3.4% dividend.

Pharmaceuticals. During recessions pharmaceutical stocks are attractive because people need medications no matter what the economy may be doing. This time around we think drug companies are especially promising because the new healthcare bill will increase the size of their market.

We particularly like the outlook for Merck & Company (MRK). Last November Merck acquired its former rival Schering-Plough for $41 billion. The move vaulted Merck from the eighth largest global pharmaceutical company to the second largest.

Even more importantly, Merck is enjoying a spurt of new drug launches. Several additional products are nearing the end of the development pipeline and should come on the market over the next few years.

Merck's stock is down from its $41.65 high, just before the correction, to $32.42. We think the 22.2% discount is too good to pass up. The forward P/E is a modest 8.3 and the yield is 4.7%.

Mutual Funds May Beat Index Funds From Here On

When the stock market has a good run, it is common for index funds to outperform mutual funds. The difference in performance is understandable since index funds are always fully invested and they have almost no trading costs.

On the other hand, mutual funds always keep some money out of the market and out of action. Mutual funds also trade stocks more often which pushes up their costs.

The tables are turned when the stock market becomes a more difficult place to make money. At such times, fully invested index funds usually take a back seat to mutual funds that keep cash on the sidelines that can be used to buy bargain stocks. Mutual funds also gain an edge by selling stocks that are doing poorly, and buying more of the stocks that are going up.

Since the stock market during the second half of this year is likely to be slower than it was previously, we think index investors should consider moving at least part of their assets to well-managed value funds.

One of the very best of the bunch is the Vanguard U.S. Value Fund (VUVLX) that purchases undervalued stocks of all sizes. The no-load fund has an 8.6% year-to-date (April 30) return, a low 0.52% expense ratio, and requires a $3,000 minimum initial investment.

Finding Current Income

Speaking of energy investments, if you are looking for current income along with good prospects for long term capital gains, it would be hard to beat Kinder Morgan Energy Partners, L.P. (KMP).

This exchange-traded limited partnership owns and operates nearly 26,000 miles of oil, natural gas, and fuel pipelines in the U.S. In addition, the company has 155 terminals that store and transport petroleum, petrochemicals, coal and other bulk items by rail and truck.

As an energy delivery and storage company, Kinder Morgan is less susceptible to changing fuel prices than the producers. Whatever happens to energy prices, the products still need to be moved from where they are processed to where they are used. In today's volatile energy market, we think Kinder Morgan looks very attractive.

The Bottom Line

The stock market correction hasn't been much fun, and it may not be over. However, with the economy performing above expectations, we think stocks will resume their upward course later this year.

Meanwhile, we think long-term investors should use the correction to buy leading blue chip stocks that have excellent prospects for future growth. This is the first time since April of last year that many high quality issues have been so attractively priced. We urge you to make full use of the opportunity.

Until Next Time

The AIA "Advocate For Absolute Returns," a publication of The Association for Investor Awareness, Inc., tracks market trends, industry news, the SEC, global trade and finance and Washington developments for you because they affect your investments. But who doesn't? Many sources report these issues as abstract facts. We feel that's not enough. The AIA Advocate's job is to warn you of what's important and how these developments translate to ground-level forces and threats that directly affect your wealth as well as your current investment opportunities. Not just information, but information you can use. Until next time...


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Posted 05-27-2010 11:30 AM by Research & Editorial Staff