Stock Quotes in this Article: CSC, CSCO, MDT, PFE

DENVER (Contrarian Edge) -- The world today is riddled with unique economic, political and demographic risks. Finding attractively priced assets that will perform well in spite of these challenges is excruciatingly difficult. For investors, though, one segment of the market -- the highest-quality stocks -- still offers attractive risk-adjusted returns.

First, it’s important to understand the risks that make most other asset classes perilous in the current environment.

Where to begin? China, the world’s second-largest economy, is facing an enormous overcapacity bubble in commercial, industrial and residential real estate. Japan, the world’s third-largest economy and second-most-indebted nation (Zimbabwe holds the title there) is in a debt bubble, addicted to unsustainably low interest rates and able to borrow at rates normally reserved for near-riskless borrowers. However, its significant indebtedness and demographic profile (every fourth Japanese is over 65 years old) should barely qualify it as a subprime borrower.

Although the U.S. economy is steadily recovering (unless you are unemployed), the rate of growth in this recovery is unsustainable, as it is propelled by government intervention (such as QE2) and stimulus -- neither of which can be relied upon as a long-term driver.

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    These are the top three global economies, and all face huge challenges going forward, which is why I’ve been skeptical about the health of the global economy for a while now (and I haven’t even mentioned Europe being rampaged by PIIGS).

    It is hard to tell if we’ll have inflation, deflation or both, but problems in China and Japan will likely lead to higher global interest rates, since they are the largest foreign holders of the U.S. debt, and as their respective bubbles burst, they’ll be forced to become net sellers. Over the next few years, global GDP growth will be lower than in previous decades, as consumer deleveraging will be followed by government deleveraging, which will also force higher taxation.

    There is no safe place to hide; every shelter carries a different risk. Bonds will do great if we have deflation, but they will be decimated in case of inflation. Gold is not a cash-generating asset, and nobody really knows what it is worth. (“Higher price” is not a valuation metric.) China is the incremental buyer of industrial commodities (here is a factoid: it is responsible for two-thirds of global demand for iron ore), so even if we have inflation, commodity prices will still decline with plummeting demand when China cuts back. Exposure through bonds or equities to the countries that have fared the best so far -- the likes of Canada, Australia and Brazil -- will not protect you in the future, since those countries have been the primary beneficiaries of the Chinese bubble.

    Before I depress you further, don’t despair and reserve a space in a cave, stocked with canned food and ammo. Instead, this is the time to own high-quality stocks -- no, the highest-quality stocks -- with strong balance sheets, so higher interest rates will not dent their profitability. Their businesses need to have a competitive advantage and the power to raise prices for their goods or services in case inflation hits, or maintain their prices in case of deflation.

    And they need to be noncyclical businesses. Let’s pause for a moment, because this point is paramount.

    For a long, long time, the Street yawned at cyclical stocks. They never received high valuations; in fact, the only time they would trade at above-market P/E is when declines in earnings (usually during recession) outpaced declines in price. The Street’s indifference was understandable: If the company in question was a commodity producer, its fortunes were at the mercy of a very volatile commodity; if it was a capital equipment maker, it went through feast-and-famine cycles of the economy.

    However, in the late 2000s the market perception toward cyclical stocks changed. They had grown earnings at double-digit rates for six years, and even in 2008 -- the year the U.S. economy entered the Great Recession -- their earnings still went higher. They were not marching to the drum of the U.S. economy, but to the beat of the Chinese drum. They were no longer priced as cyclical stocks but as secular “growth” stocks. They sported high valuations on top of very high earnings, with profit margins at multi-decade highs. The global financial crisis changed the street’s perception of them briefly; but today, only a few years and a few trillion in stimuli later, these companies are reclaiming their “growth” status and the high valuation that comes with it.

    I cannot recall a single instance in history when the same bubble was reinflated twice in a row, but this is exactly what has happened to cyclical stocks: the pre-Great Recession bubble is being reinflated today. Coordinated global stimuli will do that.

    For a company to be truly high-quality, its business has to be insensitive to the health of the global economy. Interestingly, historically there was usually a premium built into high-quality company valuations, as investors are willing to pay more for their high returns on capital, strong balance sheets, lower risk, and the certainty of their cash flows. Deeply cyclical stocks have traditionally traded at a discount to the market. Not today: Low quality is expensive, and high quality is cheap. Dirt cheap!

    By way of example, what follows are a few companies that I consider to be highest-quality, and I own these stocks in our accounts. The first two are in health care. Though the uncertainty that Obamacare brought is behind us and its impact on the industry will be relatively small, health care stocks did not get the message.

    Pfizer (PFE), the largest pharmaceutical company in the world, is trading at less than eight times earnings. It is generating enormous cash flows, pays a 4.5% dividend (which it just raised) and will be debt-free in the not too distant future. Yet the market puts zero value on its enormous pipeline of drugs in development and the $10 billion PFE spends annually on R&D.

    Medtronic (MDT) -- the maker of pacemakers -- is trading at 10 times 2011 earnings. If you look at its stock chart for the last decade, you’d think MDT’s business had stagnated; it has not. MDT has grown sales and earnings 14% a year over the last 10 years. Both PFE and MDT have an enormous tailwind behind them: Baby boomers around the world will be consuming more drugs and more medical devices over the next three to five years, no matter what happens in China or Japan.

    We recently bought Cisco Systems (CSCO) and Computer Sciences (CSC). Cisco -- the maker of internet plumbing -- disappointed Wall Street and gave lower guidance, and its stock suffered huge losses as a result. Today it is trading at about 11 times next year’s earnings, or less than nine times if we adjust the price for the $25 billion of net cash it has on its balance sheet. Though there is some cyclicality to Cisco’s business, as we consume more data and video over the Internet, the demand for Cisco’s products will increase more than enough to overcome the business cycle.

    Finally, the most boring of this bunch is Computer Sciences, an outsourcing company for large corporations and the federal government. It is trading at nine times next year’s earnings, and the company has announced a stock buyback of close to 12% of its shares. It is a very stable and growing business, as the trend toward outsourcing non-core functions continues. CSC has about $1 billion of net debt that it can pay off in about a year if it chooses. CSC is the only public business in its field: Due to the attraction of high recurrence of revenues, every public competitor has been bought by someone else -- Affiliated Computers by Xerox (XRX), Perot by Dell (DELL), EDS by Hewlett-Packard (HPQ). Though our CSC purchase will work out without it, in the world of QE2 and (artificially) very low interest rates, CSC becomes an easy acquisition target.

    I am asking you to see things that have not happened yet, because success in investing comes not from drawing straight lines, but from the ability to see around the corner.

    Vitaliy N. Katsenelson, CFA, is chief investment officer at Investment Management Associates. He is the author of The Little Book of Sideways Markets. To receive future articles by email, click here.