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Looking for strong stocks in all the right places

In a tough market, this U.S. advisory finds stocks to buy in two industries with good fundamentals. Two Canadian entries lead the way.

The usual terms are “bottom up” or “top down” investing. The bottom half of the equation means concentrating on strong individual stocks. The top half involves taking a good hard look at the economy, identifying industries that are bound to do well and picking your stocks accordingly.

Whatever name we use, it only makes sense to look for solid ground in a market that’s apparently built on shifting sands. What we’re actually going to do is look at a system that manages to come at the problem from both directions.

This system rates stocks on a complex series of criteria, and in the process it has turned up two industries that are doing well. And while the advisory comes to us from the U.S. — straight from Wall Street, in fact — two of the leading stocks it turns up are Canadian.

The advisory is Dow Theory Forecasts, and its system has grown out of the ideas of the original Dow theorist, Mr. Charles Dow.

The system is called Quadrix® and it considers more than 100 variables in six categories — Momentum, Quality, Value, Financial Strength, Earnings Estimates, and Performance. Don’t worry, we’re not going to list all the variables.

We’ll get straight to the results. We’ll also tell you how a perusal of the Dow Jones Transportation Average can help you judge the markets in the days ahead.

Top and bottom of the list

Why, this advisory asks rhetorically, do we have so many energy and insurance companies on our Buy and Long Term Buy Lists, and so few biotech or homebuilding firms?

The homebuilding one seems pretty easy to answer, given the housing slump in the U.S., but that’s only part of the answer.

The advisory displays a chart with the average Quadrix scores of 24 industries. Oil and gas drilling firms are out in front, with insurance and re-insurance companies not far behind. Integrated oil and gas companies are third, and oil and gas equipment and service firms are fifth, so that only leaves room in the top five for one other entry. That happens to be employment services, which is probably not a good sign for the U.S. economy in the months ahead.

The advisory bluntly advises that investors avoid any stocks in the bottom nine industries, and that’s not particularly promising from a Canadian point of view. Just above the two cellar-dwellers, homebuilding and biotech, come forest products and precious metals. Gold is also in this category, as are financial multisector firms, i.e., banks.

Lunkers lurking in the pond

The advisory points out that its system is set up to isolate quality stocks regardless of their industry group. “But when an industry group as a whole has poor fundamentals and unappealing prospects, even the best stocks in that group face an extra handicap in the quest to earn above-average returns.

“Even the murkiest ponds have a few lunkers lurking in the weeds, but good anglers prefer to drop their hooks in a lake well stocked with fat fish.” If you’re not up on your fishing vernacular, a lunker is a big one, often a big one that nobody has been able to catch, sort of a legend in its own pond.

The advisory’s system has netted the 15 highest-scoring stocks in the strongest scoring industry groups, and presents five of them for individual profiles. “Think of these stocks as the biggest fish taken fresh from the best fishing holes.”

We start in a fishing paradise, Canada.

Asia is the cornerstone

Two Canadian insurance firms have figured prominently on this advisory’s Buy List for some time. But it bears repeating that the regular recommendation of a Canadian stock in a well-circulated U.S. advisory is bound to be a benefit to all shareholders.

Manulife Financial (TSX;NYSE-MFC) gets top billing from this advisory. Among its greatest strengths is the fact that it sells much more than insurance. Pension products, annuities and mutual funds are all part of its repertoire. “That business and geographic diversity has helped Manulife deliver consistent profit growth in recent quarters.”

One of its temporary advantages is the fact that it has stayed away from the credit pollution that has seeped into the financial markets. While other financial firms were struggling with writedowns, Manulife was building its funds under management up to $399 billion in 2007, with the sale of variable annuities in the U.S. and Japan particularly strong.

“Asia represents a cornerstone of Manulife’s growth strategy,” adds the advisory. “The company continues to expand in high-growth markets.” It has launched new annuity products in Japan and Singapore and started an asset-management company in Thailand. A joint venture that is already up and running in 23 Chinese cities is seeking regulatory approval to open more sales offices.

Consensus estimates project that per-share profit growth will come in at 19 per cent for 2007 and grow to 21 per cent in 2008. Manulife gets this advisory’s highest rating as a Focus List Buy and Long-Term Buy, which means it’s good for the short and the long haul.

Asia is the cornerstone (II)

Sun Life Financial (TSX;NYSE-SLF) gets high marks for several of the same reasons as Manulife. It sells many different financial products to many different individuals and groups. And it expects to see its growth multiply beyond the borders of Canada.

Aggressive investments in the U.S. should pay off in 2008, says the advisory, but once again the cornerstone of growth is Asia. SunLife is well established in India, is “growing its footprint” in China, and is also active in the Philippines, Hong Kong and Asia.

Consensus estimates for per-share growth follow pretty closely in Manulife’s footsteps, too, at 19 per cent for 2007 and 22 per cent for 2008. Trading at 11 times 2008 estimates, the stock seems exceptionally well valued to the advisory, which makes it a Buy and Long-Term Buy.

That’s the Canadian content. Now it’s time to go drilling.

Deeper and deeper water

Wherever the price of oil goes, the search for oil is not going to slow down anytime soon. And companies in the drilling trade get top marks on this advisory’s list of industries.

Oceaneering International (NYSE-OII), as its name suggests, serves a highly specialized area, deepwater drilling, “which requires complex engineering in harsh environments.”

Oil companies are moving into deeper and deeper water to develop new reserves, yet the engineering expertise for these ventures is in short supply. That puts Oceaneering in the driver’s seat, and the company’s pre-share profits have risen at an annualized rate of 61 per cent over the past three years. Much of that income has been put right back into the company to expand its remotely operated vehicle (ROV) and other subsea products.

The price of ROVs is rising and Oceaneering expects to add 30 more of them to its fleet of 204 by September. The firm’s backlog for subsea products is large — $380 million — and should get much larger in 2008. The company is a Focus List Buy, i.e., one of the advisory’s best buys for capital gains over the next 12 months.

Strong rig demand

We also head out to sea to find the next pick, Transocean (NYSE-RIG), which is the world’s largest offshore drilling contractor. Like Oceaneering, it’s a deepwater specialist. It “continues to benefit from strong rig demand and tight supply.”

Transocean’s backlog grew enormously with the purchase last year of GlobalSantaFe: it stands at $34 billion with a fleet of 140 vessels, which makes the company twice the size of its closest competitor. The firm’s record for safety and high-quality rigs gives it an extra edge.

There’s a bit of a double take involved in the estimates for per-share profit growth — it’s expected to come at 181 per cent for 2007 and a lesser but still eye-popping 61 per cent for 2008. And the stock is only trading at 11 times year-ahead earnings. Thus it gets the same high rating as Manulife — a Focus List Buy and a Long Term Buy.

Last on the list of five comes another insurance firm, this one a specialized American one, UnitedHealth Group (NYSE-UNH). It’s the second-largest health insurer in the U.S., with a great many private clients as well as a strong presence in Medicare-sponsored programs. The company has grown internally and by acquisition and does a good job of bringing new companies into the mix smoothly.

UnitedHealth reported strong fourth-quarter results a week ago, and gets a Long-Term Buy recommendation from the advisory.

The other 10 strong stocks in high-scoring industries contain some household names and some not-so-household names. One is in asset management — Affiliated Managers Group (NYSE-AMG), which directs a group of “boutique” investment management firms. Besides UnitedHealth, there are two more managed health care firms, Coventry Health Care (NYSE-CVH) and Humana (NYSE-HUM).

In life and health insurance, the two Canadian firms are joined by a pair of famous American entries, Met Life (NYSE-MET) and Aflac (NYSE-AFL). Multiline insurance is represented by Hartford Financial (NYSE-HIG), and Assurant (NYSE-AIZ). Another drilling firm, National Oilwell Varco (NYSE-NOV), makes the list, as do two integrated firms needing no introduction, Chevron (NYSE-CVX) and Exxon Mobil (TSX-XOM).

Transports leading the way down

If we can identify the industry groups that should yield the best results, we can also discover which industry will give us the biggest clue as to where the economy is going. Look at the Dow Jones Transportation Average in the weeks ahead, says this advisory.

Keeping an eye on economically sensitive stocks “is always good policy, and the Transports are particularly relevant in today’s environment of elevated recession fears.”

For the past four years, the Transports were out ahead of the Industrials and other sectors as the market went higher. Now they’re leading the way down. Here’s what to look for.

The Transports have already suffered a bear market decline, falling well over 20 per cent below their July high. “Another leg down would suggest investors may be worried about something worse than a mild U.S. recession, such as a global downturn.”

Next, since the Transports are a good barometer for the cyclical aspects of the economy, they could supply the answer to this question: “How much impact will the credit crunch have on the broader economy?”

Finally, exports have been touted as one of the few bright spots in the U.S. economy. “A slowdown in export volumes would be very bad news for the Transports — and for the U.S. economy.”

This month, the Transportation Average has gone low enough to brush the 4,000 level. It currently stands at a slightly more encouraging 4,470.75. But another fluster of downward activity could signal trouble ahead.

In a story full of ups and downs, the bottom line is that investors should go fishing only in a spot where there are sure to be lots of keepers. At the moment, that would be a spot full of insurance salesmen and deepwater drilling rigs. Hope you catch your limit.