Less Stress, More Returns

The market might have improved recently, but that hasn’t calmed the nerves of many investors — or even some pros. Talk of a double-dip recession, a stock market pullback and the ongoing problems in the financial industry is keeping at least some people on edge. But a number of investors think they have an answer: the equivalent of Xanax for their portfolios, stocks of companies that in almost any economy generate a consistent stream of cash and boast solid balance sheets. These stocks might not double in a couple of months, but they likely won’t crash and burn, either. With the economy still uncertain, some experts say these stable, or stress-free, stocks are the best buy at this point. And among the smaller firms, there are bargains to be had, analysts say.

To be sure, this approach wasn’t hugely successful during the run-up last spring, and it won’t be if the market goes on another tear. In the six months since the market’s bottom, debt-free networking giant Cisco Systems rose 60 percent; its struggling, debt-laden rival, Alcatel-Lucent, more than tripled. But now some investors question whether the lesser lights can keep their momentum going in the absence of a robust economy. A so-called high-quality company, in contrast, has predictable sales and profits and not a lot of debt. Plus, these stocks have history on their side. In the past three business cycles, high-quality stocks, on average, beat lower-quality stocks, rising 23 percent nine months after the worst point of a recession, compared with an average 17 percent for the latter, according to Ned Davis Research.

Investors looking for such stalwart companies often gravitate to a handful of well-known giants, such as Johnson & Johnson or IBM. But some savvy managers are moving into smaller and midsize companies. Smaller firms don’t need to increase their profit much in dollar terms for it to have a big benefit on the bottom line. Eric Cinnamond, who manages the $256 million Intrepid Small-Cap fund, recently sold off some of his volatile oil companies and replaced them with regional supermarket Weis Markets, a steady company he calls “too boring to fail.” Below, a look at five overlooked companies that could lead to a less stressful stock portfolio.

The American consumer is not dead. Shoppers might think twice these days about maxing out their credit cards, but they are still spending — especially at places such as discount retailer Ross Stores. While other retailers have been clobbered, the Pleasanton, Calif.–based firm has been reporting monthly sales increases and even raised its profit expectations for 2009. The recent embrace of thriftiness has helped, but Ross also is improving itself, says Aram Green, portfolio manager for Legg Mason Partners Small Cap Growth fund, which owns the shares. With recent technology upgrades, Ross is pushing its merchandise out the door faster, boosting operating profits and generating plenty of cash. This also means shoppers are seeing fresher merchandise.

Ross tries to act like one of its own bargain shoppers as well. The company searches for goods that manufacturers have been stuck with after other retailers canceled their orders. Ross then buys the goods at a steep discount. Since Ross doesn’t need to plan orders far in advance like traditional stores, it can chase hot fashion trends — a big plus when consumers are increasingly skittish. “We have a lot of flexibility,” Chief Financial Officer John Call tells SmartMoney. “That’s why our business has been steady.”

Started by two brothers nearly a century ago, Weis Markets differentiated itself back then by not accepting credit, requiring customers to pay cash for their groceries. These days credit cards are welcome in their stores, but the small regional grocer still eschews debt on its own balance sheet, and that has given it the flexibility to invest in its business.

The company has spent nearly $1 billion on its stores since the mid-’90s, focusing on technology to keep shelves stocked and increase the frequency of deliveries to offer the freshest food. Analysts say these moves let Weis compete in a market against giant grocery chains and Wal-Mart. Weis owns a dairy and ice cream plant at its corporate offices in Sunbury, Pa., as well as distribution and meat plants, all of which help keep a lid on costs.

Last year profits took a hit, as food-related commodity inflation ate into earnings. But those commodity prices have since fallen, and analysts expect that to help Weis’s bottom line. Small changes, such as customers’ increasing preference for more profitable private-label brands, can quickly translate into a big increase in profits, analysts say.

After paying for all its expenses and investments, Weis has a free cash flow yield — the amount of free cash divided by its market value — of about 10 percent, much higher than other grocers’. Cinnamond says owning Weis these days is “like going to the bank and getting a 10 percent yield on a CD.”