Over the past few weeks, I wrote about risk and research, explaining some of the ins and outs of these sometimes esoteric and difficult to understand concepts. In this week’s column, I want to apply this information to the selection of stocks for a portfolio, to explain some of the key things investors should look for, and avoid, when choosing stocks for their specific portfolio.
So what is a “good” stock? To me, a good stock is one that has the potential to increase in value, period. There are many good companies out there that are not good investments, because they are priced so high that the amount of risk involved in buying them is too high relative to the potential for profit. There are also many decent companies on the market that are good investments, because they are priced right. So the first thing we need to understand is that there is a distinct difference between a good company—one that operates efficiently, has good management, good products, good market-share, etc, etc, and a good investment—a stock that we can buy at a good price and make a profit.
In my recent article about research, I discussed the differences between fundamental and technical analysis. Fundamentals include things like I mentioned above—management, products, market-share, etc. All of these pieces of information are important, but they only represent what has already occurred. The problem is that stocks don’t trade on what already happened; they trade on expectations of what will happen in the future. This is where science must become art—investors must take historical facts about the fundamentals of a company and try to determine what will have with the company in the future.
One of the simplest and widely used forms of making projections about a company’s future is to estimate future earnings for the company. There are several methods for making earnings projections, including using historical earnings to identify any trend; reviewing the industry within which the company operates and what its growth rate is and then applying that growth rate to the most recent earnings of the company, making any adjustments to the growth rate that are appropriate given the company’s products, position in the industry, etc; asking management for a prediction on where they believe earnings will be over the next year or two; or taking a bottom-up approach and reviewing each product or service the company sells and estimating how much of each the company will sell over the next year, five years, etc, and then adding up the individual sales amounts for each to get the total.
By identifying what future earnings are expected to be, the investor can perform valuation calculations to determine an expected future price for the stock. Then, using the current price of the stock and an expectation for the amount of risk that the stock will contain, the investor can decide if the risk/reward ratio is attractive enough to warrant an investment.
Fundamental analysts are basically going through these kinds of operations and calculations for stocks on a regular basis, and are publishing their expectations for future earnings and stock prices. They look at all kinds of factors, and each has their own methodology, but in the end they are all just making predictions about future prices. To the extent that the investing public believes the combined analyst estimates on a give stock will in large part set expectations for the future price of the stock, and will therefore influence trading in that stock.
Here is the problem with this whole scenario – analysts are human beings, and they work for companies that have various interests, not all of which are aligned with the interests of the individual investor. Analysts are very reluctant to go against the crowd, even if they have doubts about their assumptions or conclusions.
We saw this in the case of Enron, where all of the analysts following the company continued to release glowing reports about the company, even when they freely admitted that they could not understand how Enron was generating such large, consistent profits. We all know how that ended.
Another example occurred during the tech bubble, when analysts could no longer justify the valuations of Internet stocks, so instead of saying that they were overvalued, they invented new methods of valuing stocks that had no earnings, like expected future advertising revenues when the company had not sold a dollar in advertising yet. Again, we all know how that ended. Do I have to mention the mortgage and housing markets? I think you get the point.
The broader problem we all face as investors right now is that analysts are once again very optimistic about the economy recovering, therefore have based their earnings projections for stocks on a robust economic recovery. Investors, keying off of these optimistic earnings expectations, believe that anytime the stock market sells off, that stocks are cheap, and therefore they should buy. This is why we continue to see bad news knock the market down, and then an immediate positive reaction where the market will bounce several hundred points. The bounces are a direct result of the misperception (In my opinion) that stocks are cheap when they dip, which in turn is based on analyst predictions (that are wrong in my opinion).
One key earnings estimate that many market participants watch closely, and on which they depend for valuations and investment decisions, is the S&P 500 earnings estimate and the resulting P/E ratio, for the current year and for next year. For 2010, the current earnings estimate for the S&P 500 Index is about $80, resulting in a P/E (price to earnings) ratio of about 13.5X. For 2011, earnings are estimated to be about $94, which results in a P/E ratio of about 11.5X. Both of these numbers make the current level of the S&P 500 (about 1,083 as of June 10th) look pretty reasonable (cheap). This is why we see investors jumping into stocks anytime we get a dip in the stock market.
If you believe Standard & Poor’s estimates for earnings, you would have to agree that these P/E ratios are attractive—an average P/E ratio for the S&P 500 Index is about 15X, so anything below 15X makes the index (the overall stock market) seem pretty cheap. We have had plenty of instances where P/E ratios for the S&P 500 have moved up into the high 20’s and beyond, so an 11.5X multiple is certainly cheap in comparison. The problem again is that these are just estimates… they are a somewhat educated guess, influenced by many outside forces, not all of which are correct or even reasonable in any way.
If you agree with analysts that the economy is going to rebound sharply, and you believe that their earnings estimates are accurate, then the market is attractive and stocks should be purchased. If, like me however, you believe that we are facing some very serious economic challenges, and that the economy will take a long time to recover, and that the pace of that recovery will be slow and painful, then these earnings estimates cannot be justified. If this is the case, then earnings estimates will have to be adjusted down significantly, and therefore the perception of valuations will also come down, which means stocks will come down, which in turn means that they are not a good buy at current levels.
From a technical perspective, the S&P 500 recently broke down through its 200-day moving average, which is a strongly negative technical indicator. The last time this happened was in March of 2008 at about 1,300, several months before Lehman Brothers collapsed and sent the market into a tailspin. The S&P 500 briefly rallied and regained the 200-day, but failed again in the summer (still before Lehman blew up), and fell all the way to a low of 666. I am not suggesting we are going down that hard, but the violation of the 200-day is certainly negative, and flies in the face of all of the positive fundamental analyst opinions.
For investors trying to make some sense out of the current stock market volatility, and who are trying to find practical, actionable methods to choose investments for their portfolios, my advice is to question everything. Do not simply take earnings estimates from some analyst as fact—they are guesses! Do not simply assume because everyone else seems to be making money in stocks and buying, that you should also be a buyer at current prices.
Finally, evaluate each stock and each investment in your portfolio, not only on its own merits, which is important, but also against your personal comfort level with the risk inherent in that investment, and evaluate how that investment will impact the overall risk profile and potential performance of your overall portfolio. An individual investment may appear to have a risk level above your comfort zone, but as a component part of your portfolio, it could be a good fit. It is the combination of all of the risks and returns of the securities in your portfolio that collectively determine your overall risk and your overall return. At the end of the day, there are lots of people out there, including me, ready to give you an opinion about the stock market or individual stocks. But, it is your money and your peace of mind that is at stake, so ask questions, do your own homework, understand when something is fact and when it is not, and make good, informed decisions; or just say no.