Cheap Stock Picks to Profit from a Scary Economy

In 25 years of investing, I’ve never seen a market remotely like this one. On the one hand, stocks are cheap based on projected earnings -- and even on past earnings. The outlook for U.S. companies, gleaned from second-quarter earnings reports, isn’t half bad, either.

But concerns about the economy haven’t gone away. Europe’s markets have perked up a bit, but a double-dip recession across the pond still looks like an even bet. The U.S. recovery is far below par -- and virtually no economists think it will gather much steam anytime some. The latest employment report, which showed that the U.S. economy lost 131,000 jobs in July, was disappointing. The jobless rate, currently 9.5%, seems doomed to stay abnormally high for years. A growing problem is the monstrous amount of debt owed by federal, state and local governments, as well as by consumers.

Consider the pluses for a minute. In their just-issued quarterly report, the canny managers of Longleaf Partners Fund (symbol LLPFX) could hardly contain themselves. Co-manager O. Mason Hawkins says that, on average, the stocks Longleaf owns trade at only 55% of what they calculate to be the underlying companies’ intrinsic value. The managers usually count themselves lucky to buy stocks selling at two-thirds of what they think they’re worth.

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Big corporations are awash in cash. Almost 10% of the market value of Standard & Poor’s 500-stock index is in cash, Hawkins says. That’s dry powder -- ready to deploy to make acquisitions, fund research and development, and, potentially, even hire new workers.

Hawkins has been through seven recessions during his 35 years as a money manager. But never before, he says, have such global leaders as FedEx (FDX), DirecTV (DTV), Walt Disney (DIS) and Yum Brands (YUM) become cheap enough for Longleaf’s strict brand of value investing. All four are currently Longleaf holdings.

At a meeting with investment advisers, including my partner, Jerry Tweddell, in San Francisco in July, and in their new quarterly letter, the managers say pessimism about stocks has rarely been so deep. “The widespread angst and concomitant volatility have helped us find new opportunities,” they write. If earnings climb 5% per year from today’s levels, the Longleaf managers add, the average annual returns from U.S. stocks over the next five years will be roughly 15%, even if the price-earnings ratio of Standard & Poor’s 500-stock index remains below its long-term average of 15.5.

Economic woes

But that’s just half the story. The economic recovery in the U.S., anemic at its best, has slowed to a crawl. Instead of spending, consumers are saving more -- good for the long haul, terrible for the short term.

The Federal Reserve is increasingly nervous about deflation. In a deflationary spiral, consumers defer buying today because they anticipate lower prices tomorrow. That cuts consumption, forcing employers to lay off workers. In a nutshell, that’s how the Great Depression unfolded. Ditto for Japan’s “lost decade.” (For more about deflation, see Deflation-Proof Your Portfolio.)

We’ve already had deflation in housing prices -- and, with a huge number of homeowners still struggling to pay their mortgage bills -- we can’t rule out another round of declines in home prices.

Then there is the debt. In saving the financial system, the Federal Reserve took on trillions of dollars of debt. Falling incomes and home prices are hitting hard at state and local budgets, raising the risk of municipal-bond defaults.

The Treasury is likewise drowning in debt. The deficit for the fiscal year that ends this September is expected to hit a record $1.5 trillion. (See What $1 Trillion Would Buy.) Federal Reserve Chairman Ben Bernanke defends the fiscal stimulus Congress has enacted to boost the economy and says additional spending could help. Over the long term, however, he warns that Medicare, Medicaid and Social Security are on unsustainable growth paths.

The U.S. is hardly alone. Most of developed Europe and Japan face similar problems. All are dealing with the demographic time bomb of an aging workforce that will produce less and place more demands on health and welfare programs.

What’s an investor to do? It’s unrealistic to expect annualized returns from stocks of nearly 10% -- the historical rate since 1926. Plan for below-par gains for the next several years (Kiplinger’s forecasts that U.S. stocks will deliver returns of about 8% annualized over the next decade).

But that doesn’t mean you can’t make money. Hawkins and other talented managers tell me they are finding screaming buys among large, growing companies. Remember, U.S. economic growth and S&P 500 earnings growth are two different things. Big companies have cut costs mercilessly to preserve profit margins. And an increasing share of their profits is coming from rapidly expanding emerging markets.

The biggest part of your stock money belongs in blue-chip companies, particularly those capitalizing on growth in emerging markets. My picks include Fidelity Contrafund (FCNTX) and Primecap Odyssey Growth (POGRX), which invest mainly in large, growing companies.

Emerging nations are not only growing; most boast stronger balance sheets than those in the developed world. Put 10% to 15% of your stock money in T. Rowe Price Emerging Markets Stock (PRMSX) to profit from these opportunities.

The U.S. economy won’t be out of the woods for years. But there are still superb investment opportunities.

Steven T. Goldberg (bio) is an investment adviser.