The following commentary was originally sent to Action Alerts PLUS subscribers on Jan. 4, 2016, at 12:04 p.m. ET.
Global markets have given investors a cold shoulder rather than a warm welcome on the first trading day of the New Year, with a 7%-plus drop in the Shanghai Composite -- driven by weaker-than-expected manufacturing data and a falling yuan -- spreading like a virus throughout the balance of the international markets, with Europe's benchmark index (STOXX Europe 600) down 2.6% and the two U.S. benchmark indices -- Dow Jones Industrial Average and the S&P 500 -- down 400-plus points and 2.2%, respectively, at this writing.
The steep selloff came after overnight data showed that Chinese manufacturing activity fell to 48.2 in December from 48.6 in November, marking the 10th straight month of a sub-50 reading (which indicates a contraction in manufacturing activity). This latest disappointing data point out of the region casts a cloud of doubt over whether the central bank's easing monetary policy, commitment to currency control and increased fiscal spending can stabilize the economy. The subsequent 7% drop in the CSI 300, a benchmark of the 300 largest publicly traded companies in mainland China, triggered a new circuit-breaker system that effectively halted trading.
If economic instability within the world's second-largest economy wasn't enough to send shockwaves across global markets, geopolitical risk emerged overnight as well following reports that Saudi Arabia has severed its diplomatic ties with Iran, injecting even more animosity into a region already doomed by escalating political tension and outright war.
Since our Nov. 10 note laying out our increasingly bearish global market outlook, the Dow and S&P 500 are down by roughly 750 points (5%) and 4.7%, respectively. The piece -- which discussed both our domestic and international concerns -- is the reason we have subsequently raised and held onto historically high levels of cash ($160,000) in our Action Alerts PLUS portfolio. While we continue to view the United States as the most stable economy on a relative basis, we remain concerned about rising rates in the face of both internal and external structural economic deficiencies. The Fed's 25-basis-point December rate hike -- while seemingly insignificant on the surface -- ups the ante for future rate hikes and sets us on a path toward an upward sloping trajectory in rates through the balance of this year. The Fed's reliance on a strengthening job market as the primary basis for its monetary policy decisions fails to take into account the severe, persistently low levels of inflation. Global instability -- both on an economic and geopolitical level -- serves to compound the negative impact of higher rates.
In respect to our own portfolio, we first want to address the six stocks most exposed to China on a percentage of total sales basis: Apple (AAPL) at 15%; Cisco (CSCO) at roughly 10%; Dow Chemical (DOW) at 30%; Starbucks (SBUX) at roughly 5%; Starwood (HOT) at roughly 5% (pre-merger); and Thermo Fisher (TMO) at roughly 5%.
We view Apple as oversold and would remind investors that the company delivered exceptional third-quarter 2015 results in China when the region's markets experienced an even more severe data-driven selloff in early August. We believe the long-term growth story is being overpowered by short-term supply-chain disruptions. There are several other growth levers in the near to mid-term for the stock, including continued iPhone upgrades, innovation across consumer electronics, Apple's increasing enterprise opportunity, market share momentum and budding emerging markets (which have low LTE penetration but are growing). In addition, with Apple sitting on over $200 billion of cash while generating $70 billion in expected free cash flow this year alone, we believe investors are also overlooking the company's unprecedented financial strength.
Next, Cisco's pragmatic, balanced strategy of driving growth through a blend of organic investments, tuck-in acquisitions and partnerships should resonate well with long-term investors. Unlike most other large-cap tech firms that likely need to gain exposure to cloud computing via acquisitions, we believe Cisco's current (strong) cloud platform offers sufficient organic growth opportunities in and of themselves. Moreover, management's decision to prioritize revenue visibility (by shifting toward a subscription model) appears to be building momentum, with product deferred revenue growing over 15% last quarter. All in, we view the stock as a good play on large-cap diversified tech, whereby the model is sturdy and the capital allocation program has upside potential.
As previously mentioned in our DOW trade alert, we think the combined Dow/DuPont (DD) entity will offer a leading position in the three distinct markets it will look to conquer -- agricultural chemicals, material sciences and specialty products.
For SBUX, we stand behind the name as the company's continued focus on digital and mobile technology is differentiating the coffee chain from its competitors (we have often called it a technology company disguised as a coffee retailer). As the consumer continues to adopt a mobile way of life, SBUX will benefit being a leader in the trend. In addition, the company is also beginning to allocate more attention toward food sales, which will help drive better comps in North America and higher check prices -- both good for the company's and stock's performance. Valuation (given its 50%-plus year-over-year move) is the only aspect that tempers our otherwise outright enthusiasm.
On HOT, although we remain cautious on the name given the headline risk associated with a deal of the magnitude it has agreed to with Marriott (MAR), we like the combined entity in the longer term as we see both cost and revenue upside given the combined market share, strong loyalty programs, and stable fee-based model. In addition, we see share upside once the deal closes given the potential for MAR to implement a massive buyback program.
Finally, in respect to TMO, contrary to what the markets seem to be implying, China represents merely 5% of the company's revenues. While we would never say the exposure is negligent, we would say it is more than manageable. In fact, we believe the company's geographic reach and business diversity will allow it to grow through this. One of the main reasons we bought the stock in the first place was for the company's high level of diversification across both geography and products. While Thermo Fisher is far from a flashy company, it has an impeccable history of consistency. We can sleep well at night knowing the business is stable, dependable and void of knee-jerk surprises. It's easier to understand, therefore, why Larry Robbins' famed hedge fund, Glenview Capital, has held the stock without selling for nearly a decade.
We will be actively monitoring the market for opportunities to selectively deploy our cash into the continued selloff, focusing on companies with strong balance sheets, robust free cash flow generation and diversified portfolios. We will be updating subscribers with incremental commentary on any fresh information.