Zaegs (98.83)

What To Do With the Markets Down

August 09, 2011 – Comments (3) | RELATED TICKERS: UAM , NLY , KMP

With the market down big from its recent highs, most everyone is understandably afraid of what's to come in the future.  Almost all stocks are being sold down huge.  Interest rates are moving closer to zero each day.  Governments are going bankrupt.  Nothing is going to work.  We're all doomed!

On the contrary, things might not be all that bad.  I'm not going to say that everything is great.  That would be absurd.  But perhaps the world isn't ending.  Let's put this 10% drop in perspective with recent history. 

Remember that only one year ago, the S&P dropped 20% from March to July, and later climbed higher...all the way up to 1,350 before we started are most recent drop.  When the drop started in March last year, the S&P was around 1,200.  Where is the S&P now?  1,140.  So after a huge 20% drop we managed to get back up to these levels.  That doesn't seem like the end of the world that was being portrayed last year.  I don't think we're in for another great depression this time either.

Even if everything doesn't go that well, there are still stocks that can and should be bought...not out of desperation, but because they can make you money even in bad times.

Large dividend payments are the most obvious way to protect you against falling stock prices.  Why?  As the price of the stock goes down, the dividend percent goes up.  So the stocks will only fall so far before investors buy to take advantage of the great dividend rate.

My personal favorite is Annaly Capital Management (NLY).  This stock has a 16% dividend.  That's right.  A 16% dividend!!  Now, realize that they can frequently raise and lower their dividend depending upon how well the business is going.  But even if they cut the dividend in half, it would still be amazing.  NLY is a Real Estate Investment Trust (REIT) that is required to pay out most of its earnings as a dividend. 

NLY doesn't do anything particularly proprietary.  They're just really good at it.  Put simply, Annaly Capital borrows money at low rates and invests that money at higher rates (real estate loans).  They profit on the spread between the two rates.  Conceptually it's simple stuff.  So, why do I believe that these folks are so smart and that the stock will continue to do well?  Recent history helps.  Since the S&P topped out in October 2007, it has lost almost 27% to date.  Annaly Capital?  Up 11.8%...and paying dividends all along the way.  Not too shabby huh?

Another one that's pretty well known because it gets a fair amount of press these days is Kinder Morgan Energy Partners (KPM).  Now, I won't go into the debate about whether you should own KPM or its parent company Kinder Morgan (KMI) or Kinder Morgan Management (KMR).  If you want a quick overview on that topic, see Wikipedia.  KMP will do just fine for this discussion. 

KMP is a pipeline operator, essentially charging a toll whenever a customer wants to transport its products through the pipeline (think natural gas).  KMP is a limited partnership, meaning that it pays out a large portion of its earnings as a tax-free dividend.  KPM currently has a 7% dividend.  Let's do the same exercise for KPM that we did for NLY: Since October 2007, it's up 32.2%...and paying dividends all along the way.  How does your portfolio look during that period?

I'd recommend grabbing a high dividend stock such as these that will pay you even as the market declines.

I'll readily admit that I'm not much of a "value investor" in the sense of looking for companies that have struggled and been beaten-up for it.  In this case, there are some stocks out there that very cheap compared to their book value and actually make attractive acquisition targets.  We're not talking about companies that just sort of went down a little or that have historically attractive P/E ratios.  We're talking about the stocks that have truly stunk-up the joint and likely have all the bad news baked into their price.  One such company is Universal American (UAM).

Universal American is an insurance company (now primarily Medicare) going through some rough times.   UAM was hit with CMS (Centers for Medicare & Medicaid Services) sanctions back in 2010, thereby not allowing UAM to market its products to new members.  All indications are that these sanctions will be lifted prior to the 2012 selling season this fall.

Furthermore, as witnessed by WellPoint's recent acquisition of CareMore, the merger & acquisition market in the Medicare industry is heating up.  Universal is a prime takeover target given its valuable membership.  Another insurance company (such as HealthSpring who recently raised cash specifically intended for making an acquisition) could buy UAM for its membership and streamline overhead expenses, something that UAM also struggles with.

I estimate that UAM could get $14-$15 in a takeover bid.  The stock today is at $9.6.  A $14 purchase would be a 46% increase!  Even if they only got $12-$13, that's a 25-35% increase.  By the way, UAM barely got hit yesterday in the huge sell-off.  That says a lot about the stock.

Okay.  Here's where I put on the brakes.  If you follow this blog regularly, you're aware that I am a big growth stock investor.  I like finding high-growth stocks with great long-term outlooks and waiting to buy them on a discount.  So what gives?  Is this not exactly the discounting we're looking for?  It is...but we don't need to rush back in. 

When large, broad correction such as this take place, the high-growth, high-valuation stocks tend to get hit the hardest.  In these situations, it's best to stay out of the way of high growth stocks until things settle back down.  My philosophy is to buy some small amounts on the way down, but to buy the bulk of the investment when the stocks start shifting back up.  Why? Even if you miss a few percent of the increase after it has bottomed, you'll likely do better than if you're buying to stock while trying to guess the bottom.  Investing is not about picking perfect tops and bottoms.  You should sell as stocks start to go down and buy as they start to come up.  Be patient on this one.  Let the correction take its course.  If the company is good, there will be plenty of gains to be had later.

As I mentioned previously, I don't intend to convince people that everything is grand.  However, there are good investment opportunities out there. I was fortunate to have half of my portfolio in cash waiting for discounts. That has allowed me to buy some on the way down, including the aforementioned UAM.  Take advantage of this time to buy solid, high-dividend companies and those companies that are so beaten-down that their valuation doesn't allow them to go much lower.