ANF - A Case Sudy
Investing In "Good" Companies
Selecting stocks from Market Guide's
"good" company stock screens.
By Marc H. Gerstein
August 31, 2000
Don't assume everyone really seeks "good" companies. This is a distinct investment style with benefits and drawbacks. And the benefits can show up in not-so-obvious ways. Case study: Abercrombie & Fitch (ANF).
Speak Slowly
Search for investment ideas by identifying good companies.
When I was in school, I had a professor who would respond to a statement like that by saying "It sounds good if you say it fast enough."
He'd be right on this occasion. If you browse through a bunch of books on how to invest, you'll see lots of material showing a variety of methods for identifying good companies. And if you try them out in the real world, you can do very well if you do a good job applying the principles. But you can also invest well even if you are indifferent to how "good" the companies may be. And at times, owning good companies won't assure strong investment returns.
Consider momentum investing. If a company's sales and/or EPS are growing more rapidly than those of its peers, chances are many investors will flock to the stock thereby sparking strong share price performance. The company may be a good company that has performed well over time and has the capacity to maintain strong growth far into the future. But it's also possible the company may have a lackluster track record and/or may not have the ability to maintain its torrid rate of growth too much longer. Momentum investors may consider the latter issues, but more likely than not, they'll stay with the stock as long as they believe they can get out before things slow.
There are countless ways one can approach the market and all work well on some occasions and fare poorly on others. It's not my place to tell anyone which method they should use. Different temperaments and different investment goals suggest different approaches. And many investors use more than one style.
But it will be helpful for you to understand your own preferences. This will help you understand why you chose the stocks you own. This, in turn, will allow you to make rational hold-versus-sell decisions.
Pros And Cons
The negative aspect of good company investing is that it limits one's universe and may cause you to miss some spectacular share price movements on the part of not-so-good companies that for one reason or another have caught the market's fancy. This is why many investors whose hearts are in the good company camp cross over to the other side from time to time. Again, it's perfectly fine to do that. Just make sure you understand when you've done it because your reason for buying a stock will, ultimately, influence how you decide when to sell.
The positive aspect of the good company style is that it can be less risky over time. To see this, it's important to grasp a point I've made many times in the past and will probably have to make many more times in the future: All companies, even the best managed companies in the best businesses, experience bumps in the road sooner or later. And in our contemporary market culture, any bump in the road, however inconsequential it may ultimately turn out to be, can send share prices plummeting.
Whether or not your investment was motivated by a good-company approach makes all the difference in the world when you look at your portfolio and see that your once-favorite stock is down 40%, see chat-board flame-throwers laughing it up and insulting the intelligence of anyone who would own it, look at a wave of analyst downgrades, and read articles in which writers try to create the impression they knew all along the stock was really a dog.
If you bought the stock based on something other than a good-company approach, chances are you'll want to sell it and move on to something else (with the idea you can always come back later when or if it gets hot again). If you bought the stock because you thought you were getting a good company, your thought process can change. Examine the situation with the idea of determining if the problem stems from something so fundamental, that the company may no longer be considered "good." In that case, sell. But if the problem is transitory, you'll probably do better over the longer term if you grit your teeth and hold on however much you hate seeing those paper losses every time you check your portfolio.
Case study: Abercrombie & Fitch
On 12/7/99, I presented Abercrombie & Fitch (ANF) on this site as a Stock Note feature. The day before the article, its stock closed at $30.1875. At the moment this is being written, the stock is priced at $25.5.
Obviously, this has been one of my poor choices. However much my ego might urge me to present a success story, more can be learned by examining investments that went bad.
I never wavered from the fact that I selected ANF despite known "baggage" (which was discussed in the Stock note) based on the good-company approach. And because of that I managed to avoid expanding one mistake (the original decision to feature ANF) into a second error (i.e. I did not encourage anyone to make an ill-timed sale). That's more than others, who didn't focus on the good-company concept, can claim.
To illustrate, here are excerpts from published Wall Street research reports. I'm not going to identify the analyst or the firm because I'm not looking to play "gotcha" in a field where we all make bad calls. The idea is to show what can happen with different methods.
Before looking at the reports, it's important to understand that ANF's operating problems were quite real, as is the improvement the company has been experiencing since mid-year. At all times, the analyst offered accurate factual presentations, and well-reasoned analyses of what was most likely to happen next. The analyst did good work and I'd be happy to continue to read what this firm has to say in the future. The point of contention here relates entirely to investment philosophy.
On 11/10/99, with the stock trading at $28, the analyst wrote as follows:
Abercrombie & Fitch delighted loyal investors with its Q3 earnings release, reporting EPS up 50% and a nickel ahead of consensus estimates. . . . As one of our four top "Holiday Retail Stock Picks," we could not be more pleased, and we expect a rally in the stock price on the news.
On 5/10/00, with ANF trading at 10/7/8, the analyst wrote the following:
We expect shares of ANF to languish upon management's revised guidance for future earnings. While these low share prices may be tempting, we advise investors to gain some insight into back-to-school trends before jumping on this train. . . . We think this is a "show me" stock, which we believe will remain sluggish until ANF begins to post some improved monthly sales figures.
On 8/9/00, with ANF shares priced at $19.94, the same analyst wrote:
Shares of ANF have rallied 35% since the field trip to Columbus on July 27, far exceeding the S&P Retail Index, which has been flat in the same period. We attribute the improved valuation to strong consumer response to early fall merchandise, particularly in women's apparel. . . . We believe shares of ANF represent an attractive buying opportunity for long-term investors.
This is not a game of 20-20 hindsight. I certainly don't question the 11/10/99 write-up. A few weeks later, I was bullish with the stock priced even higher, at $30.1875. This is really an issue of investment philosophy. The quoted analyst was, for all practical purposes, applying a momentum approach to ANF: buy if trends are strong, avoid if things aren't going so well. Investors can and do this sort of thing with all stocks.
But you don't have to sell just because something went wrong. You can examine the situation, decide the problem isn't structural in nature, and stick it out through the lean times. This approach would not have spared you the 64% loss between 12/6/99 and 5/10/00. But the good company approach did, at least, allow you to capture the 83% gain between 5/10/00 and 8/9/00. How many investments (big name new economy stocks included) would have done that?
It's easy to make light of the gain since 5/10/00, saying you'd have been better off not being in the stock at all. But experienced investors know there's no way to hide from buys that go bad, even in the most heavily favored technology areas. (Anyone who didn't see this point a year ago should certainly understand it by now.) Long-term investment success doesn't just depend on the decisions that go well. Much also depends on how you react when things go bad, and success comes to those who don't stretch one bad decision into two bad decisions.
What Makes A Company Good?
There are many ways to identify a company as being "good." The Market Guide Screen Center features three selections that I see as classic examples of good company screens. They are: Strong Operating Margins, Return On Investment, and Fastest Turnover.
I cite these because they are the ones most heavily dependent on company-oriented factors that transcend the question "How are things looking right now?" That's not to say these, or any other screens, are pure. When reducing the database of more than 9,000 stocks to a manageable number of choices, it's often best to use tests drawn from a contrary philosophy to help with the "final cut." For example, this weeks' Return On Investment screen uses pure good-company factors to narrow the number of choices from 9,862 to 232. Having thusly filtered out 97.65% of the available stocks, I used two performance-oriented factors to winnow the list this week to 71 selections. (So in the end, we get some "best of both worlds" flavor.) |
