Our 2023 stock picks

Good morning. The US government hit the debt ceiling yesterday, meaning it is now spending down whatever it has in the bank. Janet Yellen thinks the last coins may have been dug out from behind the national couch cushions by summer, if Congress can’t cut a deal to raise the ceiling. Email us with the odds of a default: robert.armstrong@ft.com and ethan.wu@ft.com.

Still pessimistic, but more cautious

Unhedged thinks chances of a recession in 2023 remain reasonably high. US Federal Reserve tightening is fast approaching its apex but, contra market expectations, we think rate cuts will only come at the tail-end of the year, at the earliest. The Fed has too much on the line, economically and reputationally, to do anything but hold rates high for months. Inflation has rolled over, but softening on the margin belies how hot it still is. Returning to target will be painful. Core services inflation probably can’t normalise without workers getting cut.

Professional prognosticators have caught on; Bloomberg’s aggregate of forecasts puts recession odds at two in three. So has the yield curve. The three-month/10-year yield spread, with its perfect recession-calling record, has been inverted since November. Meanwhile, the US economy is slowing. Retail sales and industrial production have fallen for two consecutive months, and forward-looking manufacturing surveys are gloomy.

It might seem a bountiful time to go short on most everything, but 2023 is not so straightforward. Higher interest rates already chopped 20 per cent off US equities in 2022, and as the economic slowdown has materialised, stocks have only bounced. How should a stockpicker proceed?

This is the backdrop against which we enter the FT’s 2023 stockpicking contest. Last year our approach to the contest was to win or die trying. Back then we wrote:

The point of stock picking contests is not to maximise expected returns. It is to maximise expected glory, while minimising expected humiliation. That is to say, all that matters is coming in first, not coming in last, and looking clever doing it.

This led to good results last year — our all-short portfolio of high-beta stocks beat the market like a drum. But it left us feeling a bit like we cheated. We took a directional bet on the market and got it right. The picks, in retrospect, were not as challenging or interesting as we might have liked. So this year we’re taking a more nuanced approach: rather than just making a wild grab at glory, we have given some thought to protecting capital, too.

Given that our central forecast is that the US will be in recession at year end, that means we still have a short-biased portfolio. But we put a hedge in: two long positions that we think will do fine in the case of recession, while giving us exposure to a rising market, if a soft or nearly soft economic landing unfolds.

We have also concentrated on US consumer stocks, mostly because they are just fun to talk about: most people live in a house, watch TV, eat pizza and so on.

The contest rules, as a reminder: five stock picks, long or short, equal weighted; currency and dividends don’t count. Clock starts ticking on Monday. Entries are due by midnight GMT on Sunday. You can enter your own picks here.

We are not stockpickers. We don’t spend much time thinking about individual companies, and these picks were worked up under time pressure. We don’t have real skin in this game (under FT rules, we are not allowed to own individual stocks). So this ain’t investing advice! We go through this exercise to put our broad beliefs about markets to the test, in the hopes we might learn something, about markets or ourselves.

With that disclaimer, here goes. Our long picks are Domino’s Pizza and Nestlé; our short picks are PulteGroup, Netflix and Coinbase.

Our long picks are two variations on one theme: global branded food companies whose sales and margins should prove relatively resilient in a slowing economy. But the two companies are very different.

Domino’s Pizza is a low-cost option for a night at home. It operates on a franchise model, which will limit the company’s exposure to the worst of the pain in a downturn. It should be helped by a loosening labour market, too, as it becomes easier to find cooks and drivers. Lower food inflation will also help. The stock is not cheap, at 26 times forward earnings, but the company’s fat, stable margins and high return on equity justify the price. The long-term chart is a thing of beauty. The shares are down a third from the dizzying heights of lockdown, when delivery food was the only game in town.

In a recession or a slowdown, you want to own high-quality stocks, and Nestlé is probably the highest-quality food company in the world, with great margins and returns to go with steady growth. At 23 times forward earnings, it is cheaper than many other defensive stocks. Boring? Sure. We think it could be a good year for that.

PulteGroup is a homebuilder. Its stock fell along with its peers as Fed tightening drove mortgage rates up. But since September, the group has come roaring back. Pulte is back near its all-time peaks, and with demand still high and input costs normalising, its margins are as wide as they have ever been. We asked Rick Palacios of John Burns Real Estate Consulting what has driven the homebuilder rally. He puts it down to low valuations (Pulte is at a mouth-watering six times forward earnings), lower costs, expectations of cooling inflation, hopes for lower mortgage rates and good balance sheets. We think that rates are going to fall slower than the market expects, even as demand declines, that margins must normalise, and that home prices have more room to fall. That low p/e ratio may prove deceptive as the “e” declines.

Netflix shares rose 7 per cent in late trading last night after it announced much better than expected subscriber growth (and the departure of Reed Hastings as chief executive). The growth is encouraging, and Netflix is a great service, but we think the economics of the streaming industry are terrible and probably getting worse. Year-over-year revenue growth, last five quarters, per cent: 16, 10, 9, 6, 2. Operating margins, which peaked in 2021, are falling. The stock, having bounced by 90 per cent off its mid-year lows, is not cheap enough at 30 times earnings.

Coinbase is still the biggest public company in crypto, and therein lies the problem. It is a $11bn company whose value rests on a fundamentals-free asset changing hands as often as possible. This seems a dim prospect. Coinbase’s revenues have shrivelled as coin prices have fallen and retail investors lose interest in crypto:

Coinbase is trying hard to cut costs, which remain high, but revenue is what scares us. The company is not getting better at monetising what trading activity remains. The value of volume on Coinbase’s trading platform was cut in half between the third quarters of 2022 and 2021, but in that same period transaction revenue fell by two-thirds.

A bounce in crypto prices could revive interest in Coinbase’s stock, which has already fallen 85 per cent since its 2021 IPO. Our bet is the opposite: crypto prices stay depressed and Coinbase keeps bleeding value as stock investors sour further on it. Bond investors seem to have already gotten the memo; the five-year market-implied probability of default is 50/50. (Armstrong & Wu)

One good read

How protectionist are the US’s new industrial subsidies? In the grand scheme of things, not very, writes Michael Pettis.