Contrary to conventional wisdom, the consumer-discretionary sector currently offers attractive investment opportunities.
Yes, consumers are in a wary, cash hoarding mode, and are likely to stay that way for a while. The sector as a whole isn't poised for a breakout. But smart, careful, research-based stock selection can reveal absolute gems that can be had at bargain prices. We believe these are investments that have a strong potential to pay off handsomely over a three- to five-year span.
Make no mistake: the outlook is very sobering for the overall economy this year, especially in the first six months. Consumers have switched from spending to saving; the savings rate has gone from essentially zero to almost 3 percent. It very well could continue to build and move into the 5 percent to 6 percent range, which is where we were during the 1999 through 2001 recession. Consumers are pulling back, and are likely to do so for a while.
Also, alternative investments performance hasn't panned out as expected. As a result of poor performance and difficult liquidations, equity mutual funds could benefit as a result of rebalancing. And cash is piling up on the sidelines. For the first time since 1991 there's more money in money market funds than equity mutual funds. Money has been fleeing stocks, corporate bonds, asset-backed securities, hedge funds, commodities and international securities in a massive flight to safety. We're also seeing large balances in government-guaranteed CDs and savings accounts. There is plenty of cash out there waiting for opportunities, and keep in mind that cash is earning virtually nothing.
We'll be in a choppy market until people begin to feel a little more comfortable about the economy and the employment situation, but once they start sensing that, the cash hoards will to start moving and looking for places to grow.
At that point, the sector could begin to perform well, and those companies that have survived the downturn will prosper.
And that, of course, is the key. Not every company is going to make it through to the other side. And that is where the "smart, careful, research-based" stock selection becomes essential. Some companies will pick up market share during the shakeout as competitors fall and will be well-positioned for the recovery.
We're focused on companies with good balance sheets and free cash flow generation. In a market when capital is not as available, having a strong balance sheet and the ability to generate free cash flow becomes a particularly important characteristic. These are the type of companies we believe are positioned to survive an extended period of reduced demand.
Beyond the financials, take a close look at the demand side. In this economy, people aren't buying recreational vehicles or taking cruises; big-ticket items are not attractive. Small indulgences are expenditures people will still make to relieve the gloom of the recession.
Panera is a strong company for these reasons. The balance sheet is sound, they occupy the right niche and so far have executed well in a difficult environment. Plus, they've locked in attractive wheat prices for the year that will serve them well if agricultural commodities surge once again.
Chipotle is another company in a similar niche. It now presents an excellent buying opportunity. And this, ultimately, is why it's a good time to move into consumer discretionary. These are examples of the first stocks that will come back strong, and if you wait for the recovery it will be too late to derive the benefit from the run-up.
Just be sure you pick the right stocks. Look for strong balance sheets, good cash flow and low debt, and low dollar-item purchases. You'll want companies that don't have to access the credit market in order to survive.
Robert Male is a CFA charterholder and joined Kornitzer Capital Management in 1997. He is a portfolio manager for Buffalo Funds, www.buffalofunds.com, working with equity portfolios. He can be reached at (913) 677-7778 or robertm@buffalofunds.com.
