These 13 beaten-down stocks offer a 'margin of safety' from a possible credit shock, according to a top-1% fund manager

  • Higher-than-anticipated interest rates could lead to economic pain and even a credit shock.
  • Top-1% fund manager James Abate explained why he hasn’t given up on stocks yet.
  • Here are 13 value stocks to buy in this shaky environment, according to Abate.

Leading fund manager James Abate isn’t predicting a repeat of the financial crisis, but he is worried that banks could get their biggest test in years if interest rates keep rising.

While investors have zeroed in on how the Federal Reserve’s rate hikes are impacting inflation, consumer spending, and corporate earnings, Abate is keeping his eyes on delinquency rates and the potential for collateral damage to financial institutions and the US economy.

“The thing that people should really be paying a lot of attention to more than anything is the credit cycle,” Abate told Insider in a recent interview. “And that’s what could lead to further problems within the banking sector as well as, actually, the overall economy.”

Beware a credit shock

Abate, who’s the founder and chief investment officer at Centre Asset Management, guided his Centre American Select Equity Fund (DHAMX) to a top-1% finish in 2022 by relying on his own research instead of simply following the crowd.

To position his portfolio for what’s next, Abate said he’s closely watching the gap between yields of medium-grade BAA-rated bonds and ultra-safe US Treasuries. Lower-quality bonds like BAAs have higher yields since investors need better compensation in exchange for taking on more risk. 

When there’s a narrow spread between high- and low-quality debt, it suggests that investors are comfortable buying riskier bonds, which causes their higher yields to fall since bond yields and prices move inversely. But if there’s a wide gap, it may mean that investors are fearful, which explains why they’d turn away from riskier debt and instead flock to the safety of US bonds.

All types of bonds have been crushed in the past year as the Fed has hiked rates. Yields for the 10-year Treasury Note and corporate BAAs have skyrocketed in the past year while prices fell, though data from the St. Louis Fed shows that the gap between the two has actually narrowed in recent months as markets price in fewer future interest rate hikes from the Fed.

Gap between 10-yr and BAA

Federal Reserve Bank of St. Louis

However, Abate said that if rates rise more than expected, the credit market could be in for a type of shock that the Fed itself has warned could lead to a large, persistent economic decline.

“Looking at spreads — either corporate BAAs vs 10-year bonds — right now, they’re relatively benign near 2%,” Abate said. “If those moved up near 2.5% or 3%, that would really be a very important signal that what the Fed is doing — both in terms of raising rates and the yield curve — is starting to put a lot of credit stress into the system.”

13 stocks to buy for safety during uncertainty

While higher interest rates could seriously damage the bond market, Abate noted that the Fed’s hikes are already hurting earnings, liquidity, and industries like construction and housing.

Barring an unexpected pivot in Fed policy, Abate is bracing for an economic downturn.

“All the traditional top-down indicators are simply glaring with recession for the upcoming year, if not sooner,” Abate said.

However, Abate isn’t throwing in the towel on stocks. The fund manager said he expects profits to be roughly flat in 2023, adding that earnings expectations “are not falling off a cliff.” And while profit margins and asset efficiency are declining, he said they’re still historically high.

With that said, the winners of previous bull markets won’t necessarily work in this new backdrop. One sector that Abate said he’s especially wary of is technology, which he sees as reliant on economic strength in addition to low interest rates, even though it outperformed during 2020.

“The top-down playbook that a lot of people look to, to be guideposts for sector rotation or other types of asset allocation rotation, I think is something that needs to be taken with a grain of salt,” Abate said.

Instead, Abate said he’s increasingly moving toward low-risk, low-volatility companies in sectors like consumer staples and healthcare. And while the fund manager said he’s cut his exposure to some stocks in the energy and materials sectors, some of those firms still stand out.

“When you’re looking at companies across the board, what we’re trying to find is companies that have what we call a margin of safety,” Abate said. “The key for us is always trying to find those companies that have depressed but accelerated profit margins. And in some cases, it’s companies that were suppressed due to covid or supply-chain issues.”

Consumer goods companies Campbell Soup (CPB), Clorox (CLX), and Kimberly-Clark (KMB) appear to offer the best of both worlds right now since they can hold up well in a recession or benefit if stock valuations expand while earnings stay flat, Abate said.

A pair of medical device makers — Medtronic (MDT) and Zimmer Biomet (ZBH) — are poised for a post-pandemic bounceback as elective surgeries that were postponed or canceled are rescheduled, Abate said. Both are enjoying accelerating revenue and better asset efficiency.

Other top ideas within the healthcare sector are biotech firms Biogen (BIIB) and Gilead Sciences (GILD), Abate said. Both are up about 30% in the past six months thanks to sudden surges. Biogen’s boost came from an encouraging data release about its Alzheimer’s treatment in late September while Gilead’s surge came from a strong earnings report exactly 30 days later. 

Outside of those two sectors, Abate said he likes a quartet of mid-cap industrials companies that dealt with supply issues from the pandemic — Flowserve (FLS), Hexcel (HXL), Kirby (KEX), and Spirit AeroSystems (SPR) — even though he’s not crazy about industrials broadly.

Lastly, Abate remains optimistic about Exxon (XOM) and also likes Schlumberger (SLB). These oil giants should continue to succeed, assuming that oil prices stay high with supply tight.

While nothing is guaranteed in markets, Abate said that 2023 will provide many opportunities for fund managers like him to outperform.

“Most of the easy money has been made,” Abate said. “So this is a year where stockpicking and concentration of idiosyncratic ideas is how a fund can distinguish itself from its peers and the index.”