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Executive Summary | Portfolio | Guru Analysis | Watch List |
| Executive Summary | August 17, 2012 |
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The Economy
While growth has been slowing in many other parts of the world, the U.S. economy is showing signs that it's moving past the slowdown it hit earlier this summer. One of those positive signs was the July jobs report, in which the Labor Department said the private sector created 172,000 new jobs during the month. That's up significantly from the past couple months, when less than 100,000 jobs, on average, had been created. While encouraging, the report was far from overwhelmingly positive -- the unemployment rate actually ticked up a tenth of a percentage point, as did the so-called "U-6" rate, which, unlike the headline figure, includes discouraged workers who have given up looking for work. Still, after the past few months, the report was an improvement. The Labor Department also said that job openings increased in June to the highest level since July 2008. That's a sign that we could see a nice bounce in employment numbers in the coming months as those jobs are filled. New claims for unemployment have remained basically flat since our last newsletter, and remain down significantly from the levels we saw earlier this summer. (Unless noted, all month-over-month economic figures are seasonally adjusted; all year-over-year figures are unadjusted.) Compared to the same week last year, new claims are about 9% lower. Continuing claims, the data for which lag new claims by week, have also remained fairly steady. They now stand nearly 11% below year-ago levels. Another positive sign: Retail and food service sales jumped 0.8% in July, according to the Commerce Department, the first time since March that the figure has increased. Retail and food service sales are now 3.4% above year-ago levels. That is slightly higher than the June year-over-year increase, but still well below the year-over-year increases we saw earlier in 2012. More good news came from the industrial and manufacturing arenas. Industrial production rose 0.6% in July, according to a new report from the Federal Reserve. The May figure was revised upward to 0.1% (from -0.2%), while the June figure was revised downward to 0.1% (from 0.4%). Manufacturing output increased 0.5%, while mining output rose 1.2% and utility output rose 1.3%. At 79.3%, capacity utilization is now within one percentage point of its long-term 30-year average. The housing market, meanwhile, offered some decent news. Housing starts dipped 1.1% in July versus June, according to the Commerce Department. But the year-over-year comparison is impressive: Starts are 24.5% above where they were last July. Building permit issuance for privately owned housing rose 6.8% versus June, and now stands about 37% above year-ago levels. Since our last newsletter, the S&P 500 returned 3.7%, while the Hot List returned 8.7%. So far in 2012, the portfolio has returned 15.8% vs. 12.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 161.8% vs. the S&P's 41.5% gain. The Death of Equities? Since 2008, when the financial crisis, Great Recession, and a nasty bear market sent the investment world reeling, stocks haven't exactly been getting great press. Debt crises in the U.S. and in Europe, high unemployment rates, and several Wall Street scandals have all kept some pretty big clouds hanging over equities. There has been a lot of talk of paradigms shifts and "new normals", with many believing that the stock market's best days are behind it. Recently, Bill Gross of bond giant PIMCO sounded the latest salvo against stocks, declaring that the "cult of equity is dying". Gross said that the U.S. market will not be able to replicate the 6% to 7% real annual gains that it posted last century, largely thanks to debt woes and a slowing economy. In fact, he says that it would be impossible for stock returns to continue to outpace gross domestic product growth, which is what has happened over the past century. Gross's comments generated a lot of buzz on Wall Street and Main Street. And, to be sure, Gross has a strong track record and often provides very insightful commentary. But he made some critical mistakes in his analysis. I think it's important to examine those mistakes, and show you why I (and others) think his prognosis for the stock market is wrong. The main error involves Gross's contention that the stock market has grown faster than GDP, a trend that can't continue. "If wealth or real GDP was only being created at an annual rate of 3.5% over the [past century], then somehow stockholders must be skimming 3% off the top each and every year," Gross wrote. "If an economy's GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)? The commonsensical 'illogic' of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3% higher rate than the economy itself, then stockholders will command not only a disproportionate share of wealth but nearly all of the money in the world!" On the surface, that sounds logical -- and scary. If GDP growth does remain lower than that 3.5% or so historical rate as the economy continues to deleverage, that means very poor stock returns. But in a column on Yahoo! Finance, Henry Blodget pointed out a major flaw in Gross's logic. "Stocks have only 'appreciated' about 2% per year. That is to say, the prices of stocks, after adjusting for inflation, have only risen about 2% per year for the past couple of centuries," he says. The rest of the return (about 4 percentage points), he says, has come from dividends. "Companies have paid out cash to their shareholders, and these shareholders have either used the cash to buy more shares (from someone else -- not usually from the company) or used the cash to buy other stuff," Blodget writes. "Either way, the dividend part of the stock 'return' is then recycled back into the economy." Ben Inker of GMO (Jeremy Grantham's firm) took it a step further in defending equities in a paper on GMO's web site, saying that it's not just dividends that get recycled into the economy. He says that since 1929, growth in aggregate market capitalization and corporate profits have run fairly close to GDP growth, while stock returns have been much higher. "So if aggregate market capitalization has grown along with GDP and the compound return to equities has been much faster, what gives?" he says. "Do those original shareholders control 8 times as much of economic output as they did 81 years ago? Of course they don't. Investors don't invest to simply accumulate wealth that is never to be spent. Workers invest to fund their retirements. Pension funds and insurance companies are obligated to service their required payouts. Endowments and foundations pay out 5% or so of their total value every year to fund the causes and organizations they exist to support. Even the entrepreneurs who seem to be intent on maximizing their wealth splash out on the occasional mega-yacht or scoop up a small tropical island from time to time." In other words, investors don't just hoard profits and reinvest them, Inker says; they invest so they can fund future spending, and that money is recycled back into the economy. But even if stock returns can run higher than GDP over the long term, shouldn't areas with higher GDP growth see higher stock returns? And doesn't that mean the U.S. is in trouble if growth remains slow? Well, Inker explains the GDP/stock return relationship this way: "In short," he says, "there isn't one. Stock returns do not require a particular level of GDP growth, nor does a particular level of GDP growth imply anything about stock market returns." This is something I've discussed in past newsletters, via a 2009 paper published by Rajiv Jain and Daniel Kranson of Vontobel Asset Management. It examined stock market return data from 16 developed countries from 1900 to 2002, and the returns' correlation to gross domestic product growth. (The paper used data from Elroy Dimson, Paul Marsh, and Mike Staunton's book Triumph of the Optimists: 101 Years of Global Investment Returns), with updated figures for 2001-02 from University of Florida professor Jay Ritter.) Jain and Kranson concluded that "the data clearly shows that, over long periods and when adjusted for inflation, stock market returns and GDP per capital growth are negatively correlated." At best, they added, "there is no relationship between GDP per capita and stock returns over the long term." Ritter also looked at similar data for 19 developed countries from 1970 to 2002, and from 13 other countries, mostly emerging markets, from 1988 through 2002. The data for the first group showed a negative correlation between per-capita GDP and equity returns, Jain and Kranson say; the data for the second group shows a "marginally positive correlation". As I noted earlier, Inker says that aggregate market capitalization growth, corporate profit growth, and GDP growth have been pretty similar in the U.S. over the long haul. So why is there no relationship between GDP and actual stock returns? Inker, who cited Dimson, Marsh, and Staunton's data in supporting his argument, offered an explanation: "Total corporate profits and total stock market capitalization have very little to do with earnings per share or the compound return to shareholders because new companies, stock issuance by current companies, stock buybacks, and merger and acquisition activity can all place a wedge between the aggregate numbers and per share numbers." In their paper, Jain and Kranson offered a few more reasons for the GDP/stock return divergence: GDP is analogous to sales; stock returns to corporate profits: GDP takes into account the value of goods and services produced in a country -- regardless of the margins being earned on those goods. If a company cuts prices and margins to boost sales, it will be adding to GDP, but not doing much for profits, which drive share prices. Globalization: Many of the largest companies in the world sell their products and services in a number of countries, not just their home markets. So when a U.S. firm has overseas operations that are bringing in lots of sales and profits, it's good for the company -- but not included in U.S. GDP. Not the "Full" Economy: The performance of private, government-owned, or newly-formed companies often isn't reflected in the stock market, but it does count toward GDP. There are other reasons to look far beyond GDP growth, too. For instance, in emerging markets, demand may drive excellent sales growth, and, therefore, strong GDP growth. But to make money for shareholders, corporations need to turn those sales into profits. For new, up-and-coming firms, it may take time to work out the kinks and become more efficient to get the most out of their sales. All of this isn't to say that the concerns Gross and others have raised about the U.S. economy aren't legitimate. Debt and deleveraging are and will continue to be major issues for the country, and will surely have an impact on growth. But when it comes to the issue of the "death" of equities or the "cult of equity", I think the data and arguments offered by Inker and the other researchers I mentioned above are far more compelling than the proclamation made by Gross. In fact, I think claims about the "death of equities" are encouraging; stories like that show that fear and low expectations are still hovering over stocks, which indicates plenty of bargains should be there for the taking. (Remember, Newsweek famously heralded the death of equities in an August 1979 cover story, just a few years before the greatest bull market in history began.) I think that the data of researchers like Jeremy Siegel (whose U.S. market research shows 6% to 7% real returns over both the 19th and 20th centuries) and Dimson, Marsh, and Staunton (who found similar results in many international markets over the past century) shows that those 6% to 7% figures aren't a fluke. Sure, the return path won't be consistent -- it never has been. But I expect that over the long term, we'll continue to see similar returns for the broader market. And, most importantly, investors who focus on high quality, fundamentally sound stocks should do even better -- if they stay disciplined and patient. |
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Guru Spotlight: Kenneth Fisher For decades, the price-to-earnings ratio has been the most widely used valuation measure for stock investors, and a key tool in the arsenals of many of the gurus I follow. While legendary investors like Benjamin Graham, Peter Lynch, and John Neff all used the ratio differently, they and many others agreed that the ratio itself was a key to finding bargain-priced stocks. The investing public and media seems to share their view, with the P/E ratio having long been the only valuation metric that most newspapers include in their daily stock listings. But in 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher -- the son of Phillip Fisher, who is known as the "Father of Growth Stock Investing" -- thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings -- even earnings of good companies -- can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term -- how well or poorly the company's underlying business was performing. While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price 3 to 10 times in value in a period of 3 to 5 years -- rarely decline significantly. Because of that, he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR), which compared the total price of a company's stock to the sales the company generated. Fisher's findings -- and his results -- helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. (He is a perennial member of Forbes' list of "The 400 Richest Americans", his money management firm oversees tens of billions of dollars, and he is one of Forbes' longest running magazine columnists.) The common sense, mostly quantitative approach he laid out in Super Stocks also caught my attention, and led me to create my Fisher-based Guru Strategy. It's important to note that today, Fisher says his approach to investing has evolved quite a bit since Super Stocks. The key to winning big on Wall Street is knowing something that other people don't, he believes, and when too many people became familiar with PSR investing, he says he needed to find other ways to exploit the market. So why have I continued to use my Super Stocks-based model? Two reasons: First, Fisher's publisher reissued the book in 2007, with the same PSR focus. Second, the strategy flat out works. Since its July 2003 inception, my 10-stock Fisher-based portfolio has gained 166.9%, or 11.4% annualized, while the S&P 500 gained just 40.3%, or 3.8% annualized (figures through Aug. 14). That makes it one of my most successful long-term strategies. Price-to-Sales and "The Glitch" Fisher is a student of investor psychology, and his observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth and become the darlings of Wall Street, raising expectations to unrealistic levels. Then, they then have a setback. Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray. But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's price begins to rise again. If you can buy a stock when it hits a glitch and its price is down, you can make a bundle by sticking with it until it rights the ship and other investors jump on board. The key in all of this was finding a way to evaluate a firm when its earnings were down, or when it was losing money (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer: by looking at sales, and the PSR. According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a Super Stock. To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales. One note: Because companies in what Fisher called "smokestack" industries -- that is, industrial or manufacturing type firms that make the everyday products we use -- grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products, Fisher said. He adjusted his PSR target for these firms, and the model I base on his writings looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4. Beyond the PSR While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin. Other quantitative measures Fisher used include profit margins (he wanted three-year average net margins to be at least 5 percent; the debt/equity ratio (this should be no greater than 40 percent, and is not applied to financial firms); and earnings growth (the inflation-adjusted long-term EPS growth rate should be at least 15 percent per year). Fisher also made an interesting observation about companies in the technology and medical industries. He saw research as a commodity, and to measure how much Wall Street valued the research that a company did, he compared the value of the company's stock (its market cap) to the money it spends on research. Price/research ratios less than 5 percent were the best case, and those between 5 and 10 percent were still indicative of bargains. Those between 10 and 15 percent were borderline, while those over 15 percent should be avoided. One of the Best The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool. While it uses the PSR as its focal point, it also makes sure firms have strong profit margins, earnings growth, and cash flows, and low debt/equity ratios. That well-rounded approach helped it get through one of the worst periods for the broader market in history and stay far, far ahead of the market over the long haul -- all while the PSR has been a well-known investing tool. I expect this solid approach will continue to pay dividends over the long haul. Now, here's a look at the stocks that currently make up my 10-stock Fisher-based portfolio. Northrop Grumman Corporation (NOC) Autoliv Inc. (ALV) Coca Cola FEMSA SAB de CV (KOF) The Warnaco Group (WRC) General Dynamics Corporation (GD) The TJX Companies, Inc. (TJX) Apollo Group Inc. (APOL) HollyFrontier Corporation (HFC) Capella Education Company (CPLA) Stepan Company (SCL) News about Validea Hot List Stocks The TJX Companies (TJX): TJX reported that net income jumped 21% in the second quarter as same-store sales rose 7%. For the quarter ended July 28, net income was $421.1 million, or 56 cents per share, up from $348.3 million, or 45 cents per share, in the same quarter last year, the Associated Press reported. Analysts, on average, expected a profit of 55 cents per share, according to FactSet. Revenues were $5.95 billion, up sharply from $5.47 billion a year earlier but slightly below average analysts' predictions of $6 billion. TJX also upped its full-year profit outlook. The Next Issue In two weeks, we will publish another issue of the Hot List, at which time we will rebalance the portfolio. If you have any questions, please feel free to contact us at hotlist@validea.com. |
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