Thursday, July 26, 2007

Festival of Falling Knives, Continued

Apparently, the "festival of falling knives" that I found so impressive two days ago was just the beginning. On July 24, a three-year record was broken on the NYSE when 351 companies listed on that exchange traded at their lowest prices in the last 52 weeks. A day later, 418 companies hit new low prices, even as the Dow Jones Industrial average recovered some of its losses from the day before.

Today, the Dow Jones Industrial Average suffered the biggest one-day loss since February 27, but much more significantly, 780 companies hit new low prices for the last 52 weeks - over twice the number that hit new 52-week lows on any day in the last 3 years. After the incredibly strong stock market performance that we have seen in the first half of this year, and with problems with subprime mortgage lending starting to snowball into what Barry Ritholtz has dubbed "The Great Credit Contraction of 2007", I have to wonder whether this market has further to fall. I also have to wonder whether it will be quite a while before the Dow Jones Industrial Average closes above the DOW 14000 mark that everyone (ok, not everyone) was so excited about just last week.

Does this mean that you should run out and sell all of your stocks and mutual funds? Certainly not. Only a few people are successful at timing the market, even when they have a well-developed system that they apply rigorously. This might be a good time to sell any stocks that have already hit the price targets that you have set for them, though, and to ease off any buying of high-risk shares - remember, high PE stocks tend to fare poorly in a serious market correction.

This is also a great time to buy high quality investments selling at low prices that are poised to benefit from the effect of a falling dollar on overseas sales. Two that come to mind, because I already own shares of them, are Johnson and Johnson and GE. Both have been market laggards over the last few years, but several trends are aligned in their favor, as I plan to detail in my next post.

Until then, I suggest that you remember the immortal words of Douglas Adams, as you keep a cool head during this sell-off:

Don't Panic!

Tuesday, July 24, 2007

Festival of Falling Knives: NYSE 52-Week Lows

When a company's shares trade at their lowest price in the last 52 weeks, it is a sign of pervasive fear among many of the holders of that company's stock. Because most listed shares trade hands several times a year, it means that most current holders of that stock are sitting on an unrealized loss. Their fear often leads them to more selling as their shares hit new 52-week low prices, which is one of the reasons that buying companies hitting new 52-week lows is often referred to by traders as "Catching a Falling Knife": because you can be badly hurt if you buy such a company and it's shares continue to fall.

Today's trading on the NYSE exchange was, therefore, a sort of "festival of falling knives": 351 companies listed on the NYSE had their share prices hit new 52-week lows - more than at any time in the last 3 years. Unlike the previous "festivals" of 200 or more new 52-week lows, which occurred on October 12, 2005 and June 13, 2006, this festival did not occur after a broad decline had already occurred.

At the top of the chart shown above, I have added a barometer which shows the percent of shares listed on the NYSE that are trading above their average share prices for the last 50 days ($NYA50R). Such 50-day moving averages are widely used by traders and money managers, and are often used as shorthand for the trend of a stock: if a stock is above the 50-day moving average, it is trending up; if it is below the 50-day moving average, it is trending down.

When this barometer shows that only 20 percent of the shares listed on the NYSE are above their 50-day moving average, the market has usually already sold off pretty well (to what is called an oversold condition), and is generally due for a rebound. The previous festivals occurred when this barometer was showing just such an oversold condition, as shown by the green circles in the drawing above. These festivals punctuated long bouts of selling that left most of the companies on the NYSE trending down, and marked the end of the down trends for many of those companies.

Today's festival, in contrast, occurred when 37.27% of the companies listed on the NYSE are above their 50-day moving average - nearly twice the number seen in the previous events. So, if recent history is any guide, the market may have further to fall, and this festival may be just the warm-up for a bigger event in the near future.

To investors with a long time horizon and a hard nose for value, such events provide buying opportunities. But for most investors and traders, a new 52-week low in a stock that they own is a very unwelcome event. And a festival of falling knives, occurring out of the blue, when the NYSE is not oversold, is a very ominous event, indeed.

Dow 14000 - The High Water Mark?

Last week, all eyes were on the next all-time record for the oldest and one of the most important barometers of stock market performance: the Dow Jones Industrial Average (or Dow Average), which was fast closing in the 14000 mark. The Dow Jones Industrial Average includes large established companies such as Boeing, 3M, and Disney; companies that are often bellweathers for their various industries. For this reason, many people watch the Dow Average to get a sense of the direction of the overall stock market.

Round numbers, in this case 14000, tend to function as "pivot points"; points that either provide resistance to further price increases, or, once surpassed, serve to support to prices when they pull back to that level. This behavior, in both individual stocks and in market averages, was first observed by Jesse Livermore, an innovative speculator of the 1920s. The reasons for this behavior have their basis in human psychology - people tend to anchor their attention on numbers that are easy to remember, and to make decisions based on the performance of share prices relative to those anchors. The effect of this anchoring is to cause buy and sell orders to cluster around round numbers, making these levels difficult to pass through unless the momentum of the market is particularly strong. Another effect of this "anchoring" behavior is that the media trumpets the arrival of each new round number (first 12000, then 13000, then 14000), drawing attention to the performance of the stock market, and drawing in more buyers.

So, when a market average such as the Dow passes through 12000, and then 13000, confidence and buying momentum build. And when the next much heralded number, 14000, becomes a barrier that the market can reach, but that the Dow average cannot close above, then that is a worrisome sign for the stock market.

The stock market is certain to cross 14000 sooner or later, but for at least the time being, the market is taking a breather, and a close above 14000 is most likely weeks away, in the opinion of this humble scribe.

Saturday, July 14, 2007

Avoiding the Pitfalls of Growth Investing II: There is no such thing as a buy at any price

Price is what you pay. Value is what you get.
-Warren Buffett

The preceding quote is one of my favorite quotes from Warren Buffett. These two simple sentences - and the clear implication that the price and value of an asset are not always the same - stand at the core of what value investing is all about. This line of argument also stands sharply at odds with the conventional wisdom that you "You get what you pay for", the concept that underlies the efficient market hypothesis, which essentially states that the price of an asset is always an accurate reflection of that asset's intrinsic value, given the available information.

But do you really get what you pay for?

If anyone in the reading audience bought shares in a company like Etoys, which I mentioned in the first part of this column, then your experience has showed you that price and value are not always the same thing - sometimes price can be based purely on speculative excess, and have no connection to the value of a tiny, unproven business like Etoys.

The first part of this column highlighted a few of the pitfalls of invesitng in growth stocks - specifically the traps presented by unprofitable "growth stories" and companies with high growth expectations baked into their stock prices. In this column, I will discuss why sometimes even great growth stocks are simply too expensive to consider purchasing, and the tendency of growth stocks to suffer more than other stocks during broad stock market downturns.

David Dreman Looks at Growth Stocks as a Group

David Dreman, Chairman and Chief Investment Officer at Dreman Value Management, wrote an excellent book, Contrarian Investment Strategies: The Next Generation, in which he shares the results of his analysis of the Standard and Poor's Compustat database, a comprehensive database that contains decades of informaiton about stocks traded on exchanges in the United States. As part of his research, Dreman divided up the companies listed in the database by fifths (or quintiles) according to their PE, or Price to Earnings ratios, with the aim of seeing how stocks in various PE quintiles - raning from the cheapest quintile at the bottom, to the most expensive quintile at the top - performed over different time periods and under different conditions. The most expensive quintile contains shares that are "priced to perfection" - meaning that the expectation of smooth, rapid growth is already reflected in th estock price.

Dreman draws a wide variety of conclusions from this work, but the overall conclusion is that (as a group) the stocks in the cheapest qunitiles tend to outperform the stocks in the most expensive quintiles over most time periods greater than 1 year - and also outperform the broad stock market. For example, in the 27 year period between 1970 and 1996, the growth stocks in the highest PE quintile turned $10,000 into $137,000, only 47% of the return offered by the broad market, which was $289,000. Better yet, the value stocks in the lowest PE quintile turned that same $10,000 into $708,000!*

These results support Buffet's statement, demonstrating that value is what you get, and you are likely to get more of it when you buy a shares of a business at a low price. The case for price-concious investing is reinforced by the data that Dreman presents on another issue that is dear to the hearts of many investors: how to survive a bear market.

When the Bear Growls

One of the more interesting conclusions that Dreman draws in his book regards the performance of growth stocks vs. value stocks during a bear market. For the sake of simplicity, Dreman looked at each quarter in the 27-year period of the study, and deemed any quarter where the Compustat market average of 1500 companies dropped a "bear market quarter". During these quarters, the stocks in the cheapest PE quintile dropped 5.7%, less than the overall market, which dropped 7.5%. As usual, the results from the stocks in the most expensive quintile were the worst - an average drop of 9.5%!

So, what does it all mean?

Dreman's studies make a compelling case for being concious of value when buying stocks. Ultimately, we must trust our own judgement and research more than we trust the the market when it comes to determining the appropriate price for a stock.

None of the information presented in this column is intended to suggest that it is impossible to find a winning investment among the growth stocks that have the highest PE ratios, or that appear to be expensive by other measures. However, there is convincing evidence that it is very difficult to find outstanding investment returns by buying growth stocks, and that you will do better if you find stocks with great fundamentals and stromg prospects for growth before those prospects are already reflected in the PE ratios. The screen that I provided in part one of this column will help you to find such investments, and hopefully this two part column has provided some very good reasons to look for investments using this screeen.

* Contrarian Investment Strategies: The Next Generation, pgs. 155-157.

Avoiding the Pitfalls of Growth Investing

Investing in stocks with high expected growth rates - also known as growth stocks - can be exciting; it can also be difficult and dangerous. Everyone loves to buy a company that is firing on all cylinders, growing sales and earnings at a rapid clip, and watch as the combination of improving business fundamentals (and recognition of those improving fundamentals) brings in the profits. Investors who bought into Apple (AAPL) or Google (GOOG) in 2004 and held on did very well. Examples such as these make growth investing look like a cinch – a sure ticket to easy street. And yet, that is not necessarily the case.

It pays to be aware of some of the risks that tend to afflict investors who favor fast growing companies, and to be aware of the steps that you can take to protect yourself.

There are four basic risks that growth investors face to a greater extent than other investors:

  1. The “Growth Story”: purely speculative growth or unprofitable growth
  2. If a company is growing quickly, it will be expected to keep growing quickly
  3. Growth stocks tend to suffer more in market downturns
  4. Growth stocks can become overpriced

In this column, I will discuss the first two of these risks – growth stories and elevated expectations. I will address the other risks that face growth investors in the second part of this column, to be published next week.

The “Growth Story”: purely speculative growth or unprofitable growth

The first problem with growth investing is that some stocks touted as growth stocks have no track record of strong financial growth, or have a track record of growth which is rapid, but not financially sustainable. I call this kind of company a “growth story”, by which I mean that the growth of the business is more of a story than a reality. The story may be compelling and make intuitive sense, but it is still a story, not yet a company which can be counted upon to deliver growth. There are two types of “growth stories”: purely speculative growth stories, and unprofitable growth stories.

Examples of purely speculative growth stories are seen each day by anyone with an e-mail account. Most of us are barraged daily by unsolicited “spam” messages in our inbox, touting stocks with a minimal history of creating revenues and no history of earnings, and which trade on the OTC exchanges as “pink sheet” stocks. Most of these stocks are available for a few dollars a share, and are nearly surefire ways to lose money.

Some purely speculative growth stories are listed on more reputable stock exchanges, and may have merit as speculative investments for those investors who are able to pick out the next big biotech stock while it is still a start-up. Still, even the best purely speculative growth story is a destination for money that you can afford to lose, or risk capital; not the place to find the companies that will serve as the foundation for your retirement portfolio. Investors who bought shares in eToys during the dot-com bubble and held on, hoping for the growth story to become a reality, experienced first-hand the difference between a growth story and a profitable and growing company. Despite a great story (and lots of hype about how eToys was sure to outflank its brick-and-mortar competitor, ToysRUs) eToys never turned a profit or reported great revenue growth, and shareholders were left with nothing but a sob story when eToys entered chapter 11 bankruptcy on March 7, 2001.

The second type of growth story – fast but unprofitable growth - is more dangerous, and more difficult for the average investor to recognize because it is usually accompanied not only by extensive hype in the media, but also by revenue growth. An example of a company that has grown rapidly, but not profitably, is Sirius Satellite Radio (SIRI). Like many unprofitable growth stories, Sirius financed its expansion by taking on debt and offering additional shares. Between fiscal year 2002 and 2006, sales at Sirius Satellite Radio moved from $810,000 to $637 million as it expanded its customer base, but the number of shares outstanding soared from 77 million to 1.4 billion, and total liabilities increased from $670 million to $1 billion. Yet the value of a share of SIRI moved from a closing price of $3.67 on June 7, 2002 to $3.03 as of this writing (July 2, 2007).

Shares of Sirius did experience a price spike to in the interim, closing as high as $9.01 on December 7, 2004, driven largely by the hype generated by the deal inked with Howard Stern; but unless you sold into that price spike, that didn’t do you and good. And the shares given to Howard Stern to recruit him to Sirius contributed to the dilution of existing shareholders. The point is that while SIRI was building their business, growing revenues 768 fold between 2002 and 2006, they were not building shareholder value. People who stuck with this stock underperformed the holders index funds..

Unprofitable growth stories can be avoided simply by refusing to take a major position in any company which does not report current profit in the form of earnings per share (EPS). To screen out companies without current earnings, enter the following parameter into the MoneyCentral Deluxe Stock Screener, located at

Latest Fiscal EPS >= 0

These types of “growth story” stocks are not what we are looking for – we want stocks that are growing and have been growing consistently and profitably for the last several years. We can do this by requiring reasonably high current and 5-year average ROE, ROA, and ROI, all of which measure profitability by measuring profits as returns against equity, assets, or invested capital respectively. I will go into more detail about how these rates are calculated and how to use them in a future column, but for now it is enough to know you can enter the following parameters into the Moneycentral Deluxe Stock Screener to avoid investing in an unprofitable company.

Return on Equity >= 7
ROE: 5-Year Avg. >= 8
Return on Invested Capital >= 8
ROI: 5-Year Avg. >= 8
ROA: 5-Year Avg. >= 5

We will also add another parameter to ensure that the company has grown revenue over the last 5 years at a compounded rate greater than inflation –we will use 4%:

5-Year Revenue Growth >= 4

Additionally, we will let the stock exchanges do some of the work of separating the growth stock wheat from the growth story chaff by requiring that our candidates are listed on the New York Stock Exchange, or NYSE. The NYSE has some of the most stringent listing requirements in the world, but lists enough companies to provide a wide array of opportunities. If you would prefer to focus on companies that are a part of the S&P 500, which is another very exclusive group of stocks, you can substitute the NYSE-listing parameter for the following parameter, which will narrow your field to the 500 companies that are currently components of the S&P 500 index:

Exchange = NYSE


S&P Index Membership = S&P 500

If it is growing fast, it will be expected to keep growing fast

Another problem with investing based on high expected growth rates is that companies with high, sustainable, EPS growth rates are the exception, rather than the rule. Many companies can achieve high rates of growth for a few quarters, but few can do so over longer periods of time. Picking the wrong stock, the one with the unsustainable growth rate that will revert back to more normal levels in a few quarters, can cost you dearly. If you purchase a stock with high current and recent growth rates, the expectation of future growth is usually already discounted, or incorporated into elevated analyst consensus expectations for the stock, higher than average PE ratios, or both. If other investors get the unwelcome surprise that EPS growth was below analyst expectations, they will react by dumping your stock.

The only way to address this issue is to buy stocks with low, achievable expected growth rates and PE ratios that are not much higher than average. To screen for reasonable growth expectations, we’ll require that the analyst consensus expected EPS growth for the next 5 years is less than 40%. To screen for reasonable PE ratios, we will require that our companies have a PE ratio that is less than twice the PE ratio of the average company included in the S&P 500 index:

EPS Growth Next 5 Yr <= 40
P/E Ratio: Current <= 2*S&P 500 P/E Ratio: Current

If you are using the version of this screen which searches within components of the S&P 500, you have narrowed your field from 500 companies to only 154 companies which pass this screen as of this writing. The stocks on this list include consistent, profitable growers such as computer and iPod maker Apple (AAPL), software giant Microsoft (MSFT), apparel maker Coach (COH), beverage and snack conglomerate Pepsico (PEP), latte king Starbucks (SBUX), healthcare behemoth Johnson and Johnson (JNJ), and mutual fund manager T. Rowe Price (TROW).

The NYSE version of this screen still presents more than 200 candidates, the maximum number of results that can be displayed on the deluxe screener, but many of the more speculative stocks listed on the NYSE have been removed from consideration by this screen. The refinements that I will add to this screen in the second part of this column will reduce the number of candidates from the NYSE exchange

Please check the next posting of this column, when I will go into detail about the risks of holding growth stocks during market downturns, as well as the risks of buying growth stocks at any price.

Friday, July 6, 2007

Fog Light Finance: Cutting through the fog of the financial world

Welcome to Fog Light Finance!

The purpose of this web log (or blog) is to share my interest in finance, while sharing some insights to help cut through some of the "fog" that each of us face when making financial decisions. I also plan to share some thoughts on a few other topics, including interesting themes in fiction, chess, media and economics.

This blog was inspired by the work of Charles Kirk on The Kirk Report, Barry Ritholtz's work on The Big Picure, the books and Web site of Victor Neiderhoffer, and the many brilliant books written by Robert Hagstrom - most especially his book Latticework.

This site is for educational purposes only. Please do your own homework before buying or selling any asset, and take any free advice (including mine), with many grains of salt.