TAG | P/E ratio
11
Buying Stocks: Don’t Succumb to The Siren Song of the Naysayers
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Buying Stocks: Don’t Succumb to The Siren Song of the Naysayers
by Alexander Green, Chief Investment Strategist
Wednesday, August 11, 2010: Issue #1321
Comedian Dennis Miller used to joke that he was at the airport when his ship came in.
A year from now, plenty of investors are likely to feel the same way. Why?
Because they’re ignoring the good news out there right now and not buying stocks. Instead they’re succumbing to the siren song of the naysayers.
And while no one can know for certain what the stock market will do in the year ahead, there are good reasons to believe that stocks may be substantially higher.
That’s because there are two traditional indicators that investors are wise to heed:
- Don’t fight the Fed
- Don’t fight the tape
Let’s take a closer look at each of these and I’ll show you why…
Don’t Battle with Bernanke
As we all know, the Federal Reserve has taken short-term interest rates to near zero. Moreover, Fed Chairman Bernanke has repeatedly said that he expects to keep them there “for an extended period.”
This is a green light for Fed-watchers. Low interest rates…
- Make it cheaper for corporations to borrow.
- Reduce the cost of owning stocks on margin.
- Make cash and time deposits unattractive relative to stocks.
A stock investor today certainly isn’t fighting the Fed.
Let’s take a closer look at the “don’t fight the tape” part…
Don’t Fight the Tape
The stock market is in a confirmed uptrend. Seventeen months ago, the Dow bottomed near 6,500. It has had its ups and down this year, but the big trend is up, not down.
- If you’re buying stocks, you’re with the tape.
- If you’re short the market or out of stocks, you’re fighting the tape. And that’s not good.
(The tape, of course, is a reference to the ticker tape of yore.)
Some investors tell me they’re not comfortable buying stocks during a recession.
Hello?
It’s true we’re not experiencing robust economic growth. But a recession is defined as two consecutive quarters of negative economic growth. We haven’t had a single negative quarter in the past year. In fact, GDP growth has averaged 2.84% a quarter over the past 12 months.
It doesn’t feel that way, of course, because housing is in a funk, unemployment is high and consumers are reluctant to spend. But for the third consecutive quarter, profits have mostly beaten expectations.
Why? Partly because companies have laid off unnecessary personnel, refinanced debt at lower levels and cut other costs. Even a modest uptick in revenue is causing a big jump in bottom-line profits.
Plus, businesses are benefiting from technological innovation, negligible inflation and booming new markets overseas, particularly in Asia and Latin America.
Feel the Fear… And Buy Stocks Anyway
Other investors tell me they can’t buy stocks because there is just so much gloom and doom out there.
Apparently, they don’t realize that negative sentiment is a powerful contrary indicator. (Or as Warren Buffett often says, you want to be fearful when other investors are greedy and greedy when others are fearful. And without a doubt, investors are fearful right now.)
Of course, there is a lot of negativity because this is an election year, too. Republicans are talking up how bad things are to increase their chances in November. Democrats are conceding that things are bad – and still blaming things on Bush – because they don’t want to seem out of touch.
Indeed, there is plenty to dislike about how the folks in Washington are running the show. But a decision to buy stocks is not an endorsement of any political party or a statement that all is right with the world. It’s merely an acknowledgement that business conditions – and profits – are likely to improve in the future.
If you disagree, that’s fine. But at least concede that you’re fighting the Fed, fighting the tape – and fighting the sentiment indicator.
Historically, that has not been a profitable strategy.
Good investing,
Alexander Green
19
Is Apple the Perfect Growth Stock?
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Is Apple the Perfect Growth Stock?
by Alexander Green, Chief Investment Strategist
Monday, July 19, 2010: Issue #1304
I’ve often said that my stock-picking approach can be boiled down to this mantra:
Share prices follow earnings.
I challenge you to look back through history and find even a single company that increased its earnings quarter after quarter, year after year, and the stock didn’t tag along.
By the same token, try to find a company whose earnings were flat or declining year after year and the shares kept rising. It doesn’t happen, even in a roaring bull market.
But is growth in earnings per share all you really need? Could it be that simple?
Of course not.
Any company can increase its earnings for a while merely by cutting expenses. But eventually, a firm reaches a point where it can’t cut costs further without damaging the underlying business. (Obviously, if you reach the point where you’re selling off key infrastructure or laying off top people to boost short-term profits, you’re hurting the company’s long-term prospects.)
There are other important factors as well and I can illustrate a few of them by pointing to a near-perfect growth stock…
Want to See If a Company is Growing? Look to These Three Crucial Factors
In order to see robust bottom-line growth, you need to see substantial top-line growth. In other words, sales have to rise, too.
And Apple, Inc. (Nasdaq: AAPL) is doing just that.
- Sales & Earnings: The company is selling boatloads of iPods, iMacs, iPhones and iPads. In many instances, it’s been unable to keep up with demand. In the most recent quarter, sales jumped 49%. That enabled earnings to soar 90%.
- Profit Margins: This is another important factor. If competitors can come in and easily underprice you, your business is vulnerable.
But Apple is well-protected with its iron-clad patents on the Mac operating system and many of the key features of its bestselling products. So it’s no surprise that operating margins top 29%. Or that Apple is up 63% over the last 52 weeks, even after the recent market dip.
Over time, Apple has brought down the price of most of its products, but not because competitors were forcing them down. Management did it because they wanted to broaden the potential market for Apple’s products. That’s key.
- Return on Equity: This key metric is calculated by dividing earnings per share by book value (or net assets) per share.
Why is this important? Because it tells you how efficiently management is deploying the firm’s capital. Warren Buffett – who puts a great deal of emphasis on ROE – says anything above 17% is good. Apple’s return on equity is twice that.
Happy Customers… Happy Shareholders
Apple has done plenty of other things right, too. It’s a consistent innovator and is a world-class marketer. (Its products are so cool, customers find themselves lusting over things they don’t even need.) And it’s done a good job of keeping a lid on costs.
The end result? Earnings per share have boomed over the last decade. And while the broad market has gone nowhere, shares of Apple are up several-fold.
It’s a classic story of a company that keeps its customers coming back because it makes them happy. And the resulting increase in earnings keeps shareholders delighted, too.
Good investing,
Alexander Green
18
Why Value Investing and Trading Don’t Mix
0 Comments | Posted by Alexander Green in Alexander Green
Why Value Investing and Trading Don’t Mix
by Alexander Green, Chief Investment Strategist
Tuesday, May 18, 2010: Issue #1262
Last week, I spoke at a special conference on value investing at the beautiful Driskill Hotel in Austin, TX.
Virtually every stock market investor talks about “recognizing value.” I’ve found that interest in value investing ebbs and flows depending on the market. No one wants to overpay for a stock, or keep holding one if the price gets nutty.
And that leads to a basic question: How do you find value in the stock market?
It depends whom you ask…
The Fathers of Value Investing
The fathers of value investing, of course, were Ben Graham and David Dodd, two teachers at Columbia Business School who wrote the investment classic, Security Analysis.
They argued that value investing is about buying companies that are selling below their intrinsic value.
How do you determine that? According to Graham & Dodd, that means buying companies that…
- Trade at significant discounts to book value.
- Have high dividend yields.
- Have low price-to-earnings (P/E) ratios.
Buying this way is not only supposed to lead to higher returns. It’s also designed to provide a significant “margin of safety.” The idea is that if you buy a security right, your downside is limited.
A number of academic studies have shown that if you follow the principles of Graham and Dodd, you should do very well over the long term.
But there are potential problems with this approach…
Don’t Let a Cheap Stock Suck You In
First of all, stocks are rarely as cheap as they were back in the 1930s when Security Analysis was written. Or even as cheap as they were back in 1982 when the typical stock sold for less than book value and eight times earnings and yielded more than 6%.
And if you sat out the last 28 years out because stocks were too expensive, you missed an awful lot of opportunities.
When you do find a stock that does meets Graham and Dodd’s stringent requirements, you also need to be patient. Why? Because companies that are very cheap are out of favor for a reason. Sales are often flat or down. Earnings are weak. Profit margins are low.
You can’t succeed just by buying a company that’s cheap. (It can always become cheaper.) You have to buy a company that will someday – and perhaps not too far off – be dear to others. Otherwise, when will you take profits?
So maybe Graham and Dodd’s message needs modifying. (Warren Buffett, Graham’s most famous student, has certainly found ways to modify it.)
The Problem With Defining “Value”
I’ve found that the definition of value and the tools to achieve a margin of safety are flexible. And The Oxford Club has found successful ways to bend them.
To my mind, any stock that goes from $10 to $50 was a “value” at $10. I don’t care what the P/E or price-to-book was at the time. With the luxury of hindsight, it was clearly a bargain. Why quibble?
But die-hard value investors will argue that if the stock was “overvalued” at $10, it’s only more grossly so at $50 – and therefore, you’re at great risk holding it.
I disagree. If you use our customary trailing stops, your upside is unlimited and your profits fully protected. As long as a stock keeps trending up, we’re content to hold on – no matter what the valuation. When the stock eventually turns, as all do eventually, our stops will keep the profits from slipping through our fingers.
As for value analysis, quite frankly, we don’t spend a lot of time poring over P/Es and book values. We’re just interested in identifying companies that are likely to show dramatic, better-than-expected growth in the quarters ahead. These stocks tend to be more expensive than average, just as companies that will show little or no growth tend to be cheaper than average.
This method works, too…
Do You Have the Key Traits to Profit From This Approach?
The independent Hulbert Financial Digest has ranked our Communiqué among the top five newsletters in the United States for 10-year performance.
And our approach has one significant advantage over value investing. It works quickly.
- Growth stocks tend to sprint.
- Profits often come sooner rather than later.
As someone who spent 16 years as a money manager, I know that most investors don’t have the patience to be good value investors. (John Templeton, for instance, held companies in his flagship Templeton Growth Fund an average of 7.5 years.)
Yet clients will start to grouse if a stock doesn’t move for six months. They call it “dead money” and start itching to move it elsewhere.
I understand this instinct. But deep value investing and rapid trading don’t mix.
If you’re a patient, truly long-term oriented investor, value investing can work wonders. If you’re not, you’ll be better off searching for companies that are set to smash estimates.
When a stock doubles or triples – or rises 50-fold or more like Apple (Nasdaq: AAPL) and Amazon (Nasdaq: AMZN) – don’t worry, other investors will concede it was a “value” before.
Good investing,
Alexander Green
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