Every long-term portfolio should have some sector diversification, but diversity doesn’t mean squat if you don’t have the right holdings.
Continuing my weekly series of examining each major market sector, I’ll look at a stock from a sector that every long-term diversified portfolio should have, and another you should avoid.
Services has a very specific definition. It is that portion of the economy that produces intangible goods. Thus, employees in this sector produce services rather than products. So think of a financial planner or a doctor. As for actual businesses, you should think of transportation, scientific and technical services, administrative companies, health care and even entertainment.
This is a pretty broad set of companies to look at — so much so that in later weeks I’ll pluck some picks to buy and sell from some of services’ subsectors. For now, here’s the best and the worst from the whole sector:
The Stock You Must Buy
While railroad stocks are not as cheap as they once were, they are still benefiting from the recovery. The reason is that, while jobs may be lacking in this recovery, companies that deal in finished and raw goods are actually doing quite well. Many of these companies have tons and tons of material to ship, and airplanes are too darn small. Nor can they transport tons of goods in a Prius. Trucks have limited utility. The only real method for super-large transportation needs are the railroads.
The Purchasing Manager’s Index isn’t quite screaming that the economy is on fire, but it is growing, and that’s enough to like the railroads.
My “must-buy” in this category is Canadian Pacific Railway Limited (NYSE:CP). It’s a big player in transporting commodities, merchandise, vehicles and parts, forest products and mining materials. CP has 14,700 miles of serving the principal business centers of Canada, from Montreal to Vancouver, British Columbia; and the Midwest and Northeast regions of the United States.
Analysts see 40% earnings growth this year, 25% next year and 10% thereafter, yet Canadian Pacific Railway stock trades at only 18 times estimates. CP holds a lot of debt — $4.6 billion — but it’s only paying about 5% on it.
I also just noticed that hedge fund manager Bill Ackman has a 23% position in the company. Ackman is known for taking positions in companies he believes are significantly undervalued. I think that’s a vote of confidence that can’t be ignored.
The Stock You Must Sell
My “must-sell” choice also is in the transportation business, but it moves people. That would be the airline industry, which I’ve never liked (with one exception).
Airlines are struggling, and just about every one has filed for bankruptcy at one point. Presently, American Airlines parent AMR Corp. (PINK:AAMRQ) holds that title. Yet I see American as emerging in good shape. That said, I see no reason to hold any airline except the consistent winner, Southwest Airlines (NYSE:LUV).
Of the others that are public, I would sell Delta Air Lines (NYSE:DAL). The simple truth is that airline travel is a commodity; only Southwest distinguishes itself, and just barely.
Delta has $7.2 billion in net debt, and only put out $1 billion in free cash flow in the trailing 12 months. That’s just enough to be sustainable, especially given the constant air fare competition, high fuel prices and inability to carve out a special niche for itself.
Don’t be fooled by DAL’s low stock price. It’s not a value — it’s a value trap.
Other Sector Picks
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.