We answer your market questions

4/7/2008


Q I always thought that owning dividend-paying stocks would protect me during down markets. However, during this particular bear market, many of my dividend-paying stocks have not performed well. What’s the difference this time around?
A Historically, dividend-paying stocks have provided a bit of a cushion during bear markets. However, the recent bear market has been driven largely by a sell-off in financial stocks. Many of these financials paid big dividends and were widely held in income-oriented portfolios. Remarkable developments in the banking, mortgage, and credit markets led to crushing declines in many banks, insurers, and other high-yielding stocks. Investors should consider the following two lessons:

Not all bear markets are the same. Thus, traditional strategies for weathering a bear market (such as owning dividend-paying stocks) may not always work. For that reason, investors need to maintain portfolios diversified not only across asset classes, but also across strategies. Owning only high-yield stocks, for example, is not a pru-dent investment strategy. High-yield stocks tend to be concentrated in only a few industries, leaving you vulnerable to industry-specific risk.

Investors should focus on total return, not dividend return. A stock’s total return consists of its dividend return plus capital gains. Since long-term capital gains and dividends are taxed at the same maximum 15% rate, investors should have no preference for generating cash flow via dividend income versus selling stocks and booking long-term gains. The Forecasts tends to favor stocks with lower yields but better dividend-growth prospects and capital-gains potential. Over time, these stocks give you the best chance to build a winning portfolio.

Among dividend payers in the financial sector, Wells Fargo ($31; NYSE: WFC), yielding 4.0%, is rated Long-Term Buy.

Q Why are my utility stocks down sharply this year? I thought they would be doing better given the volatile market.
A The Dow Jones Utility Average is down more than 7% this year, versus a decline of 5% in the Dow Industrials and a 9% gain in the Dow Transports. Weakness in utilities during a time of market volatility and falling short-term interest rates doesn’t jibe with past performance. One factor affecting the group is the increasing dependence of utilities on nonregulated operations, usually power-generation and oil or natural-gas businesses. While these nonregulated units have juiced profit growth, they have also boosted utility stocks’ risk.

Declining energy prices will hurt many utility stocks. And the shift to nonregulated operations reduces the recession resistance of utilities, as these nontraditional businesses are often more susceptible to economic cycles. Thus, a slumping economy may have a greater impact on utility profits today than it would have in the past. To be sure, quality utility stocks remain an excellent way to diversify a portfolio. But investors who expect today’s and tomorrow’s utility stocks to behave like yesterday’s will likely be disappointed. Forecasts favorites in the utility sector remain energy/utility hybrids Energen ($63; NYSE: EGN) and Questar ($58; NYSE: STR), both rated Long-Term Buy.

Q The decline in Humana ($47; NYSE: HUM) stock was incredibly fast and violent. Why the big price drop, and why didn’t you see it coming?
A Humana truly blindsided Wall Street. The company beat the consensus earnings estimate by $0.11 per share for the December quarter, raised earnings guidance in February, and a month later slashed its March-quarter earnings expectations nearly in half.

When a company so badly misses the mark, and does so shortly after giving such positive guidance to Wall Street, investors lose confidence. And when investors lose confidence, they sell en masse. Given the reduced earnings outlook and Humana’s loss of credibility, the Forecasts felt that the shares no longer ranked among our best investment ideas for the next 12 months. Thus, we sold.

Q I love General Electric ($38; NYSE: GE). It is a great company with market-leading positions. But you recommended I sell the shares. Why should I sell?
A At the Forecasts, our mission is to recommended what we see as the best stocks. Since recommending 300 names will not help you, we focus on our favorites. Yes, GE is a leader in its markets. And yes, it is a quality company. But GE is not among our 40 to 50 favorite stocks, which is why we downgraded the stock to Neutral.

As an aside, we at the Forecasts are a bit perplexed when investors talk about how great a stock GE has been. Actually, GE stock has lagged the market by a wide margin since peaking at more than $60 per share in 2000. In fact, the stock still sells for 36% below the 2000 high, while the S&P 500 Index is down less than 11%. If anything, the Forecasts was too patient with GE, as these shares have not provided lasting gains for investors in the last six years.

Q Should I be worried about how the presidential election affects the stock market next year?
A Not really. While Republicans have long been perceived as pro-business, the market does not play favorites at election time. Since 1864, Republicans have won 21 presidential elections. In the year after those elections, the market rose 10 times and fell 11 times. In the years after Democratic wins, the market rose seven times and fell six.


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