Smith Brain Trust / June 23, 2022

Midyear Stocks to Watch

Midyear Stocks to Watch

Amid the highest inflation in 40 years, the “outlook for U.S. stocks in the second half of 2022 is very uncertain with at least a 50% probability of a recession in 2022 or 2023,” says Clinical Professor of Finance David Kass at the University of Maryland’s Robert H. Smith School of Business.

Kass notes key factors:

  • The consumer price index registered an 8.6% increase over the past 12 months, along with the economic impact of Russia’s invasion of Ukraine which has led to a substantial increase in the price of oil.
  • The Federal Open Market Committee (FOMC) raised interest rates “by an aggressive 75 basis points” to 1.50-1.75% – and projects an increase to 3.4% by year-end 2022, and to 3.8% in 2023.

“Since equity prices are primarily determined by interest rates,” Kass adds, “the S&P 500 index has declined by 23% year-to-date as interest rates have been moving higher.”

With the economy projected to slow down because of the FOMC raising interest rates to reduce demand (and therefore, inflation), corporate profits, another major determinant of equity prices, are also expected to weaken in the second half of 2022. These factors, Kass says, point to that probability of recession.

How should investors respond? Kass advises having at least a 5-10-year horizon. “The S&P 500 (with dividends included) has had a positive return in 80% of the years from 1942-2021 and has had a compounded annual return of 10% since 1928,” he says.

Although past performance is no guarantee of future outcomes, Kass adds, “it is likely that the overall market as measured by the S&P 500 would continue to increase at its historic 10% rate (dividends included) in the years ahead as both GDP and corporate profits continue to grow.”

Kass, at the beginning 2022, recommended 12 stocks. Of those, he says “11 have declined and only one showed a positive return (Teck Resources + 26.5%). The overall portfolio declined 26.6% year-to-date, which puts it approximately in the middle between the S&P 500 (-22.9%) and Nasdaq (-31.0%).”

So, against this “bear market background,” Kass recommends an “equally weighted portfolio of 14 stocks for midyear 2022,” which include six new picks and eight stocks previously recommended at the beginning of 2022.

Kass’s six new recommendations are:

Activision Blizzard (ATVI): This is a merger arbitrage recommendation. Microsoft has agreed to acquire ATVI at $95 per share, which represents a 27% premium over ATVI’s current price of $75. This transaction is expected to close within one year but is subject to regulatory (antitrust) approval in the U.S. and EU. Berkshire Hathaway (Warren Buffett) has taken a $5 billion stake in ATVI during the first quarter of 2022.

Chevron (CVX): A beneficiary of high oil prices and an excellent hedge against inflation, Berkshire Hathaway (Warren Buffett) has taken a $26 billion stake. It is now the fourth-largest equity holding in Berkshire’s portfolio.

Citigroup (C): Currently trading at a price/earnings ratio of five and near a 12-month low, Berkshire Hathaway (Warren Buffett) has taken a $3 billion stake during the first quarter of 2022.

Occidental Petroleum (OXY): Another beneficiary of high oil prices and an excellent hedge against inflation, Berkshire Hathaway (Warren Buffett) has taken a 15% stake in the company ($8 billion). OXY has a price/earnings ratio of 8.

Paramount Global (PARA): Formerly ViacomCBS, Berkshire Hathaway has taken a $2.6 billion stake. It is currently trading at a price/earnings ratio of 5.

Twitter (TWTR): This is a merger arbitrage recommendation. Elon Musk has agreed to acquire TWTR at $54.20 per share. This represents a 31% premium over TWTR’s current price of $37.

Kass’s 8 “repeat recommendations” from January 2022 are:

Alphabet (GOOG, GOOGL): The growth prospects for this search and ad giant remain very bright. Its valuation is now more attractive after its 26% decline year-to-date.

Amazon (AMZN): After declining 36% year-to-date, its valuation is now more appealing. Berkshire Hathaway has a $1.7 billion stake.

Apple (AAPL): Warren Buffett (Berkshire Hathaway) has recently been adding to its $150 billion stake, representing its largest holding and equaling over 40% of Berkshire’s equity portfolio. AAPL has a large ongoing stock buyback program and is earning a very high rate of return on its invested capital.

Bank of America (BAC): This very well-managed bank is the second-largest holding in Berkshire Hathaway’s equity portfolio. With a price/earnings ratio of 9 after a decline of 28% year-to-date, its valuation is appealing.

Berkshire Hathaway (BRK.B, BRK.A): This extremely well-managed conglomerate by Warren Buffett has substantially outperformed the market over its 56-year history, with a compounded annual return of 20% per year as compared to 10% for the S&P 500 (with dividends included). Warren Buffett has recently been buying back its shares, indicating that he views these shares as being undervalued.

Meta Platforms (META): After a 51% decline in 2022 year-to-date, META’s current valuation is very attractive. It is a cash flow machine which dominates the social network space.

Microsoft (MSFT): After a 26% decline year-to-date, Microsoft is now more attractively priced as it continues to grow rapidly in its cloud applications.

Teck Resources (TECK): Even after rising 26.5% year-to-date, shares of the Vancouver-based miner of coal, copper, and zinc are reasonably valued and flying a bit under the radar. As the economy shifts from combustion engines to EVs, copper will be the new oil in the years ahead.

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