Investment Contrarians

S&P 500 Companies: Short-Term Problems, Long-Term Opportunities?

By for Investment Contrarians |

Short-Term Problems, Long-Term OpportunitiesOne of the common questions I get asked is: where are the long-term opportunities for growth? We all know that the American economy is growing extremely slowly, yet most people don’t realize how international many of the S&P 500 companies really are.

As an example, while we all think of Kentucky Fried Chicken (KFC) and Pizza Hut as American restaurants, the parent company, YUM! Brands, Inc. (NYSE/YUM), has a growth plan that is not based domestically and is instead focused on the Chinese economy.

Because S&P 500 companies are increasingly focusing on growth potential around the world, the one economy that has seen consistent increases in gross domestic product (GDP) has been the Chinese economy.

However, recent data are showing signs that the Chinese economy might be slowing down. According to the National Bureau of Statistics, industrial profits in March increased by 5.3% year-over-year, but it marks a drop from the 17.2% increase in industrial profits recorded during January and February. (Source: Orlik, T., et al., “Chinese Industrial Profit Growth Slows,” Wall Street Journal, April 28, 2013.)

Earlier this year, we received information that the Chinese economy did post a lower-than-expected GDP increase of 7.7%, down from 7.9% during the fourth quarter of 2012. The leadership in China is trying to engineer a slower Chinese economy to prevent bubbles.

So, what does this mean for S&P 500 companies?

Many S&P 500 stocks are looking toward the Chinese economy as the next great growth generator. YUM! Brands opened almost 2,000 restaurants in 2012, of which 889 were based in China. (Source: “YUM! Staying the Course: China and a Whole Lot More, 2012 YUM! Brands Annual Customer Mania Report,” YUM! Brands, Inc. web site, last accessed April 30, 2013.)

With 4,260 KFC restaurants in over 850 cities within the Chinese economy, as well as 826 Pizza Hut restaurants, YUM! Brands is extremely linked with that nation, among other emerging markets such as India.

The company plans to continue expanding in the emerging markets because the opportunities are huge. For many S&P 500 companies, the Chinese economy offers the potential for growth. However, if the Chinese economy were to continue slowing, this could mean negative ramifications for many S&P 500 stocks.

To compare the difference, there are 58 YUM! Brands restaurants per million people in America as of 2012, while there are only two YUM! Brands restaurants per million people within the top-10 emerging markets.

Take a look at the chart, which compares the S&P 500 Index as well as the Dow Jones Shanghai Index:

S&P 500 Large Cap Index Chart

Chart courtesy of www.StockCharts.com

This chart shows how closely correlated both indexes were until 2012, at which point the S&P 500 continued to move higher, while the Shanghai Index failed to move up.

If the Chinese economy continues to slow, we could see an impact for many S&P 500 companies through disappointing revenues and earnings results. While the Chinese economy offers great potential for the long term, the current price of the S&P 500 appears to be pricing in guidance much higher than what can be realized.

I believe that this divergence won’t continue for much longer. Either the Shanghai Index will begin moving upward or the S&P 500 will begin moving downward—closing this gap in performance.

It will be interesting to see if China’s leaders can manage a slight pullback in the Chinese economy without causing massive international damage to global firms. I am doubtful, especially considering the lofty levels the S&P 500 is currently at. Additionally, the Federal Reserve continues with its easy monetary policy, which is helping add wind to the sail of the S&P 500.

Even though the stocks you own within the S&P 500 might be American, don’t discount the important role the Chinese economy plays for the companies in your portfolio.

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