Economic Outlook and Stock Picks

The US economy can often be characterized by the various forces at work, pulling in either direction.  At the present time, and much of the time, the strongest forces at work are the state of the consumer and the state of US companies.  One reason for current optimism is that US companies have enjoyed a strong earnings season with most companies beating estimates both on the top line (revenues) and the bottom line (net income).  Additionally, the consensus view is that corporate profits will increase by 35% next year.  One of the main reasons behind these strong results can be linked to a good amount of cost cutting by firms.  Unfortunately, firms have been sitting on these increasing amounts of cash instead of paying out higher dividends to shareholders or reinvesting the funds. 

Since these strong profits are not flowing through to the labor market or the broader economy, there are reasons to be concerned for the state of the US consumer.  Evidence continues to mount that the consumer, or roughly 70% of GDP, is in rough shape.  The biggest factor is most likely the 9.5% unemployment rate because this limits the availability of disposable income.  Consumer confidence readings continue to come in around 50.  (A reading around 100 is indicative of an expansionary economy).  Retail sales continue to decline as consumer savings rates increase.  Each of these factors, in addition to the looming withdrawal of fiscal stimulus, leads me to believe that the S&P 500 will likely be trading 10-15% lower, or under 1000, in the next six to twelve months.

Another concern stemming from the increasing inability of US policy makers to stimulate growth is disinflation, or eventually deflation.  Deflation, or falling prices, is painful because it makes businesses and consumers reluctant to spend and invest, further hurting profits and the economy.  Inflation has steadily fallen since the beginning of the year and is now at 1%.  Therefore the possibility of deflation is very real. 

Given cash-heavy corporate balance sheets and risks of deflation looming, I would suggest investing in companies with stable, or relatively certain, cash flows and the ability to increase dividends.  The rationale behind investing in these types of stocks is that the income is effectively worth more and more over time as prices fall because their cash flows and dividend payouts are relatively stable.  Three stocks that I would recommend holding during the current economic period are Eli Lilly & Company (LLY), PPL Corporation (PPL), and Paychex, Inc. (PAYX).  Each of these companies has a high dividend yield with the potential to grow dividends due to large amounts of cash on the balance sheet and should perform well regardless of whether the economy experiences deflation.

Eli Lilly and Co. is a leading maker of prescription drugs, offering a wide range of treatments for neurological disorders, diabetes, cancer, and other conditions.  Recently, the company has had a great deal of success in reducing operating costs by lowering marketing and administrative expenses.  This has led to strong near-term earnings growth.  The dividend is paid quarterly and is currently around 5.4%.  Cash and short-term investments currently comprise about 18% of total assets, which provides a large cash cushion and room for dividend growth or further investment in product development.

PPL Corporation (Pennsylvania Power & Light) is an energy and utility holding company with three operating segments:  the supply segment, the Pennsylvania delivery segment, and the international delivery segment.  The supply segment is involved in electricity generation and marketing of electricity and other power purchases to deregulated wholesale and retail markets.  The Pennsylvania delivery segment provides electric utility services in the regulated Pennsylvania market while the international delivery segment provides electric utility services overseas, mainly in the UK.  PPL’s dividend currently sits at 5.1%, and has increased at an 8% annual rate since 2005.  Cash flow from operations has doubled since 2002 while assets have grown only 42% so there is a significant amount of support for the dividend.  Additionally, PPL’s earnings mix is fairly diversified due to the geographic heterogeneity in operations. 
                       

Paychex, Inc. is a leading provider of payroll processing, human resources, and benefits services.  PAYX’s business success can be attributed to the low amount of capital required for operations and the company’s ability to capitalize on its competitive advantages.  One of the primary advantages of PAYX concerns high switching costs for customers since the cost of changing payroll processing vendors is a cumbersome task.  The company currently has no debt on its balance sheet and is able to generate strong cash flows that support the 4.8% dividend.