Debunking the Risk/Reward Principle
By Arne Alsin
Special to TheStreet.com
7/16/01 12:58 PM ET
URL: thestreet.com
Most investors believe that to earn high returns you have to take high risk. And if you take low risk, you'll generate low returns -- the risk/reward principle. But like a lot of the gibberish spouted on Wall Street, that's nonsense.
If I can buy a stock at 75 cents on the dollar, relative to the underlying business value, my risk is low and my reward is ample to the extent the stock returns to fair value. And if I can buy the same company at 50 cents on the dollar, my risk is even lower, and happily, my potential reward is higher -- in direct contravention to this supposed truism, the risk/reward principle.
My theory on risk and reward is backed up with real-world evidence, below, as I update all 21 recommendations posted in prior columns.
Every equity below represents, in my opinion at least, a low-risk position. There are no tech companies, big-caps, or high price-to-earnings stocks (based on normalized earnings). All of the market favorites from the last cycle -- Intel, Microsoft, GE and Sun Microsystems, to name a few -- are excluded.
Even if some positions are arguable in terms of risk, in the aggregate I don't believe there is a question that the positions are lower in risk than the average growth stock. And, of course, the reward speaks for itself.
Tracking the Picks From Year's End
Stock Date of Column Symbol Cost Current GAIN
Whirlpool 12/19/00 WHR $40 $68.66 71.65%
Circuit City 12/28/00 CC 10.80 18.19 68.43
United Airlines 12/28/00 UAL 35.88 35.58 -0.84
E Trade 12/28/00 ET 7.34 6.11 -16.76
J.C. Penney 12/28/00 JCP 10.25 27.39 167.22
Raytheon 12/28/00 RTN 27.50 26.11 -5.05
TRW 12/28/00 TRW 36.38 42.45 16.68
Georgia Gulf 12/28/00 GGC 15 16.24 8.27
Hasbro 12/28/00 HAS 10.06 14.52 44.33
Office Depot 12/28/00 ODP 6.94 10.20 46.97
HB Fuller 12/28/00 FULL 40.31 50.84 26.12
Return 38.82%
This Year's Recommendations
Stock Date of Column Symbol Cost Current GAIN
Safeco 1/26/2001 SAFC $24.00 $28.83 20.13%
Delta Airlines 3/30/01 DAL 39.50 45.70 15.70
Centennial Bank 3/30/01 CEBC 7.75 9.35 20.65
Northwest Airlines 4/17/01 NWAC 23.50 24.66 4.94
Liz Claiborne 4/24/01 LIZ 44.50 49.90 12.13
Kmart 5/2/01 KM 10.40 11.36 9.23
Ameritrade 5/9/01 AMTD 7.55 6.47 -14.30
York International 5/10/01 YRK 30.44 31.39 3.12
Textron 6/5/01 TXT 58.97 54.79 -7.09
Continental Airlines 7/12/01 CAL 50.00 51.00 2.00
Return 6.65%
With nary a sell recommendation, turnover of the portfolio is zero, though I have made it clear that I believe United Airlines, a unit of UAL (UAL:NYSE), is the worst-managed airline in the sector and that Northwest (NWAC:Nasdaq) and Continental (CAL:NYSE) are better alternatives.
Investors should not run out and buy all 21 recommendations because the run-up in a number of names has altered the risk profile. Because I am not close to recommending a sale of any of these issues, I'll highlight the best buying opportunities as of today.
Year-End Recommendations -- Favorites
Because we are just entering earnings season, the prospect of new information makes some positions a bit more difficult to assess. I continue to like E*Trade(ET:NYSE) a lot at current levels, but investors have to be willing to wait for a better stock market to see sustainable action to the upside.
As the yield curve steepens, I am more sanguine on the economy, which makes valuations at TRW (TRW:NYSE), Georgia Gulf (GGC:NYSE), Office Depot (ODP:NYSE) and Whirlpool (WHR:NYSE) very compelling.
Current-Year Recommendations -- Favorites
It is difficult to choose among recent picks, but I continue to believe Northwest Airlines and Continental will gain at least 50% over the next year or so as business gains momentum off of a multiyear cyclical low. And Kmart (KM:NYSE)? See my face-off later Monday with Chris Edmonds where we go toe-to-toe on the topic. |
