5 stocks for riding the rebound

By Jim Jubak

I can't think of much good to say about this economy: 84,000 jobs lost in August and an unemployment rate of 6.1%. Or the stock market: down hard for four days running last week before an anemic end-of-the-day rally broke the string on Friday. I can't say Monday's rally on news that taxpayers would bail out the mortgage market makes me want to put on my rally hat either.

And I certainly can't tell you when the carnage will end, when the economy or stocks will bottom, or when we'll all be able to see signs of a recovery. I suspect we'll have to wait until the second half of 2009 for that good news. Over the past year, the only thing predictable about this downturn has been that it has lasted longer than most of us expected.

But slowdowns in the economy and downturns in the financial markets do have one good result: The bad times test companies, their managements and their strategies, and they separate the good companies from the bad. In good times, every CEO looks like a genius, and every strategy seems like a winner. In bad times, we learn who truly earns that huge paycheck and bonus, and which strategies will deliver the goods.

Most of all, though, the bad times tell investors which companies have identified such juicy opportunities for growth that they feel they just have to invest even in dicey times like these. Identifying such companies and buying their stocks is the best, simplest and lowest-risk way to make money in the stock market -- hands down.

Cashing in -- or out

Why is it so important? Because companies that generate generous amounts of profits and reinvest those profits at superior rates of return put compounding to work for themselves and for their investors.

A company that generates billions in profit but doesn't have an attractive opportunity to reinvest that cash will return that cash to shareholders as a dividend or by buying back shares, which increases the price of existing shares. That's what many of the major oil companies are doing. ExxonMobil (XOM, news, msgs), for example, didn't have enough profitable places to reinvest the $52 billion in cash generated by operations in 2007, so it paid out $8 billion in dividends and bought back $31 billion in stock that year. That's exactly what a company in ExxonMobil's position is supposed to do.

Contrast the long-term return to shareholders from that cash strategy with the strategy of a smaller oil company, such as Devon Energy (DVN, news, msgs), with lots of investment opportunities. Devon's cash flow in 2007 of $6.6 billion is just 13% of ExxonMobil's cash flow, but because Devon has a full plate of investment opportunities in the Barnett gas shales and in the deep water Gulf of Mexico, almost all of that cash -- $6 billion -- was reinvested. Only about $500 million went directly back to shareholders in the form of dividends and buybacks.

Why should investors prefer the stock of a company that reinvests almost all of its cash flow to one that returns most of it to shareholders? Simple. Devon can reinvest that $6 billion in cash at a rate of return that an individual investor would be challenged to match. Devon's current return on capital is 8.4%. So investors can expect that in 2008 the company will earn $500 million on its reinvestment of $6 billion.

In 2009, Devon will earn another 8.4% on that $6 billion, plus 8.4% on that $500 million in profit from the year before, assuming that the company reinvested it. And in 2010, Devon will earn another 8.4% on that original $6 billion, 8.4% on that reinvested $500 million and 8.4% on the gains from that reinvestment. And so on.

(Return on capital is a backward-looking number. It reflects how much a company is earning on past investments. A company that has been making heavy investments that haven't yet turned profitable will show a lower return on capital now, with a rising return on capital in the future. I think the case for owning Devon Energy is even stronger than this, because I project the company's rate of return on its capital investment will increase over time as its current investments go into production.)

My parents drilled lessons on the power of compounding into my head. Maybe yours did, too. At the time, I thought it was a plot by parents who wanted me to save part of my allowance for tomorrow instead of blowing it all on comic books today. But you know what? Compounding really does work, and it works the same magic with the stock of a company that is generating lots of cash and that has lots of opportunity to reinvest it at a high rate of return as it does with a savings account.

Stocks to watch

In today's column I'm going to tell you about five companies that are passing the test of today's bad times. All are putting a substantial part of their profits back into their businesses, compounding the returns for shareholders, and all are sticking to their growth strategies even though times are tough. (None is in the energy sector, not because I scorn the currently modest valuations and big future opportunities in the sector but because Jubak's Picks owns enough in the energy sector. It's time to start planning to broaden the portfolio for the 2009 market recovery.)

I don't think you want to buy these five stocks quite yet. If the recovery in the economy and the stock market will be in place by mid-2009, the market should start anticipating that uptick at the end of 2008 or in early 2009. If you want to get in early but not too early, I'd suggest starting to build positions in these stocks in late October or early November. Right now, I'm simply going to add them to a watch list.

And because I've been doing a lot of that lately -- flagging stocks that you might want to buy in a few months or quarters -- I'm going to start an "official" Jubak's Journal watch list to keep track of all these ideas. You'll find it at the bottom of this column.

Continued: Deere

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