MARKET ACTIVITY/ WEEKEND EDITION OF TRADING NOTES JULY 12, 1998 (7)
INVESTING, Con't
Take A Walk On The Dark Side
The current market's love affair with momentum stocks means value investors need to tweak their strategy.
Here's how.
By Jim Jubak - Jubak's Journal
Microsoft Investor
Value investors haven't done particularly well this year. The official numbers capture some of the damage. For example, the Russell 3000 Value Index has lagged its sibling Growth Index by slightly more than 30% in 1998.
But my guess is that most investors who try to follow a value strategy have actually done much worse than the index's 13.6% return. A strategy of buying beaten-up stocks that are trading at a discount to their peers or to their own fundamental value would have stocked a portfolio with great bargains -- Oracle Corp. (ORCL), Oxford Health Plans Inc. (OXHP), Rowan Companies Inc. (RDC), 3Com Corp. (COMS), to name just a few. But these bargains haven't produced much in the way of gains. The best, Oracle, has returned just 3.4% in 1998; the worst, Rowan Companies, shows a 37% loss this year.
I think I know where some of these value plays have gone wrong -- including my decisions not only to hold onto an oil drilling and service stock like Rowan Companies in Jubak's Picks, but to add to my industry exposure by buying Diamond Offshore Drilling (DO) because it was cheap. I think many value investors have backed the wrong stocks because they have underestimated this market's reluctance to recognize value when it comes in a tattered package. Let me try to explain why. Then I'll sketch in a value strategy modified to fit this market. And I'll end with a pick -- Schlumberger Ltd. (SLB) -- and two drops -- Rowan Companies and Diamond Offshore -- from Jubak's Picks.
What have value investors misunderstood about this market? I think we've paid too much attention to the great numbers being turned in by a relatively small number of stocks. We've been investing as if this is a healthy market that will lift all boats. Maybe because we know this market is extremely expensive -- and because we see tremendous returns going to investors in the most expensive stocks -- we've concentrated on buying stocks after big tumbles in price. Without noticing, we've redefined value investing as a strategy of buying former high fliers after they've crashed. And we've actually been most attracted to the stocks that have been crushed most in price.
That would be fine, except that this isn't a healthy, lift-all-boats market. It's actually two very different markets.
First, there's the momentum market -- the one I wrote about in my last column, "Long live momentum." That's the market where Yahoo! (YHOO) climbs $26 a share in a single day, Amazon.com (AMZN) tacks on $15, and even such stodgy big caps as Lucent Technologies (LU) and Home Depot Inc. (HD) pop almost $4 a share to hit yet another new 52-week high.
Then, there's the other market -- the one that's going nowhere or worse. On the same day (July 6) that saw Yahoo!, Amazon.com, Lucent, and Home Depot dish up those lovely gains, 2,086 of the stocks traded on the Nasdaq market went down. Only 2,062 went up. The truth is that since the beginning of the year, while the 30 stocks in the Dow Industrials were climbing almost 15% and while the 500 stocks in the Standard & Poor's 500 were gaining 19%, 4,080 of the stocks in Investor's database have shown a loss (while 4,370 show a positive return of any size). Despite the headlines, last quarter was actually even worse for the average stock; 5,633 stocks in our database showed a loss while just 2,967 pushed into positive territory.
In my last column, I laid out what this means for stocks in the first part of the market. These stocks were expensive three months ago and will most likely get more expensive as money chases the amazing recent returns from a handful of equities.
But in the second part of the market, the situation adds up to benign neglect. Bargains are intriguing in principle, but investors who are worried about future earnings growth and who can't see an end to the mess in Asia have very little reason to invest outside the narrow list of names racking up gains in the momentum market. Value stocks will have to show investors a few quarters of real earnings improvement in order to attract the attention that translates into the kind of money flows that move stocks.
To some degree, of course, that's the way value investing has always worked. The best value investors always get in before the rest of the world sees a turnaround and then wait for everyone else to see what they have seen.
But I think the general earnings slowdown and the difficulty in predicting the bottom in Asia make the traditional lag in value investing excruciatingly long right now. Buying Oracle because you believe in the company's turnaround story and waiting six months before the stock moves up is called "Getting in early." Waiting a year starts to feel painful. Waiting eighteen months without some positive feedback (commonly called profit) from the general market is more than most of us can stand.
That kind of delay is certainly conceivable right now. Morgan Stanley's economists are now saying that the Japanese economy will bottom no earlier than the March quarter of 1999. Some semiconductor equipment companies are starting to wonder if the turnaround in their industry will come in 2000 and not in 1999.
In this kind of market, with this kind of uncertainty, I think you should revise your definition of a bargain. I think value investors still should look for stocks that have gone down, but I think they should look for stocks that have gone down less than their peers in an industry. That smaller-than-average decline could be a signal that this company will bounce back more quickly than its peers -- that it may actually lead its industry upward -- and that the company might be taking steps that will improve its competitive position in its industry.
As I laid out in my column, "Ten tech stocks to buy . later," I think the likely extreme length of the down cycle in the semiconductor equipment industry makes it too early to invest in Applied Materials (AMAT). I'd wait at least six months -- even though the company is the prototype of the kind of value I'm talking about. At every downturn in the very cyclical semiconductor equipment industry, Applied Materials makes key acquisitions of smaller, cash-strapped equipment makers in order to expand its product line. The company continues to invest heavily in research and development during these tough times, so that competitors who entered the down cycle with a sizable technology lead find themselves suddenly behind Applied Materials when good times return.
So how do you go about finding companies like this? First of all, forget about screening on biggest price declines or lowest price-to-sales ratios. All these exercises will do is turn up the cheapest -- but most troubled -- stocks in an industry. Instead, you want to start by casting a very loose net, then compare the stocks this captures with the performance of their industry peers.
My screen actually has only one real requirement: I look for stocks that fell in price in the last quarter. (You can vary the time period -- and, in fact, I encourage you to run this same exercise for both six months and a year as well. Doing all three will catch stocks that would otherwise escape because they're poor performance doesn't precisely fit a single time period.) I also require that a stock has a market capitalization of $12 billion or more, but that's simply to get the sample down to a size that Investor can handle. You can run the same screen with a low market capitalization -- say, below $2 billion to pick up just small-cap stocks. (Investor subscribers can click the link to the left to see the full list of stocks in the Investment Finder.)
Every other factor in the screen is requested as "display only." That means I get to see the data, but it doesn't effect the selection of the sample. "Display only" factors include industry name, price to book value (a standard value measure that compares a stock's price per share to the value per share of a company's assets), industry average price-to-book value, price-to-sales ratio (which compares the price of a share of stock to the company's sales per share), and industry average price-to-sales ratio.
Once I've built this screen I save it and then create a modified version to use in comparing each company with its industry peers. (To do that, I change the requirement for a decline in stock price in the quarter into a "display only" for the quarter's stock price and substitute the appropriate industry for the market-cap criterion.)
I suggest you start your study of a list like this either with a cluster of companies in the same industry or with an industry that you know from experience might offer good hunting for value stocks. For example, I've spent so much time in the trenches with the oil and gas equipment and services industry -- most of it knee-deep in red ink -- that I started my work with Schlumberger. (Investor subscribers can click the link to the left to see the full list of stocks in the Investment Finder.)
Schlumberger is clearly a relative-value stock. Its 8.8% price decline in the last quarter is well below the 85% decline of the worst performer in the group, Concord Energy (CODE). Schlumberger's price to sales and price to book ratios are also well above the average.
But all that really means is that this stock has held up in price during a period that has crushed its peers. Now I want to find out if that relative out-performance is justified and whether the stock might actually be cheap given its quality.
Looking at Schlumberger's business, the relative outperformance seems reasonable. This is a highly diversified company -- much more so than most of its peers -- so revenue should hold up better in the down market for the oil industry. Part of the company's product line -- its electronic systems for extending the life of oil and gas fields -- is high-margin, high-tech gear. And like an oil and gas equipment clone of Applied Materials, Schlumberger has been building an impressive record of deals in the tough times that began last year. This year's deal to acquire Camco International gives the company even more market share and advances it toward its goal of being a one-stop shop for oil equipment and services.
Is the stock a value at its current price? It is well down from its high, and the price-to-book and price-to-sales ratios are certainly below the 10-year highs of last December. It is certainly not priced at the kind of rock-bottom levels you'll see at the darkest point in an oil industry cycle.
If you believe, as I do, that the boom in oil drilling will resume once Asia starts to soak up some of the world's extra supply of oil, then the stock seems very reasonably priced. With Schlumberger, I'll be waiting for that turnaround in the best company in the industry, one that should come out of this pause even stronger than it went in. That makes the stock a good value to me.
I'm adding Schlumberger to Jubak's Picks -- and at the same time dropping Rowan Companies and Diamond Offshore. I think those two companies are very good pure plays on the upside of the oil-industry cycle. I think once investors are convinced that the cycle has turned, they should move up even faster than Schlumberger. But if Schlumberger works as I hope it will, it should move up before these smaller stocks, giving me both an earlier profit and early warning to jump back into the sector.
And, if worse comes to worst and this down cycle for oil lasts longer than I think, I've moved into the financially strongest company in the sector, the one best positioned to take advantage of its peers' problems. Call it value investing with a long-term safety net.
New Developments on Past Columns
Ten tech stocks to buy . later
Wall Street can't make up its mind about Applied Materials (AMAT). On July 6, Salomon Smith Barney put the stock on its list of exceptional stocks for the rest of 1998. Two days later, BT Alex. Brown offered a very different opinion. The firm trimmed FY 1998 earnings estimates to $1.16 a share from $1.36 a share, and hacked its FY 1999 earnings estimate to 97 cents a share from $1.54 a share. That puts BT Alex. Brown about 20 cents below the consensus earnings estimate of $1.35 for Applied Materials' fiscal 1998 year that ends in October, and a whopping 64 cents a share below the consensus estimate for 1999. I'll put my money on the BT Alex. Brown view -- especially since it confirms the June cut to $1 for FY 1999 by Morgan Stanley. I think the consensus earnings estimates still have a long way to fall for Applied Materials, and so it's way too early to look for a bottom in the stock.
Other stocks on the Salomon Smith Barney "exceptional stocks" list, by the way, were Alcatel (ALA), Allstate Corp. (ALL), Amgen Inc. (AMGN), Black & Decker Corp. (BDK), Chase Manhattan Corp. (CMB), Honeywell Inc. (HON), IBM Corp. (IBM), Motorola Inc. (MOT), Navistar Corp. (NAV), Schlumberger Ltd. (SLB), Schering-Plough Corp. (SGP), Williams Companies (WMB), Wal-Mart Stores (WMT) and Xerox Corp. (XRX).
Changes to Jubak's Picks
Add Schlumberger
I'm adding Schlumberger (SLB) to Jubak's Picks with a July 1999 price target of $85. I like the stock's combination of modest risk and solid upside. Shares of the international oil and gas equipment and service company are trading about $25 a share off the 52-week high of $94. And the company's diversification into telecommunications, metering and test equipment, and electronic smart cards makes the shares less sensitive to oil prices than most companies in its industry. On the upside, I like Schlumberger's positioning at the high-tech end of the oil service business. Its cutting-edge electronic systems for detecting and monitoring oil flows allow an oil producer to get up to 50% more oil from an existing field. The company's international exposure -- about 75% of business is outside the U.S. -- and its ability to offer everything from seismic detection to enhanced oil-recovery technology should make the shares among the first to move upwards when oil prices begin to recover.
Drop Diamond Offshore Drilling
Cheap hasn't been enough. I bought Diamond Offshore (DO) at $46 and change on February 27, 1998, when the stock was already $20 a share off its 52-week high. Since then (through July 8) shares of this owner of the world's largest fleet of semi-submersible drilling rigs have fallen another $8, or about 16%. That's not a bad performance relative to the rest of the drilling industry -- which has been pounded as the price of oil plummeted. Stocks of companies that specialize in deepwater drilling did hold up better than stocks of less specialized service companies. But relative performance doesn't put dollars in my pocket. I don't see a sustained turnaround in oil equipment and service stocks until a recovery in Asia starts the price of oil moving upward again. Even when that happens, I think more liquid stocks such as Schlumberger will move up first. So I'm selling Diamond Offshore from Jubak's Picks.
Drop Rowan Companies
What can I say? I bought Rowan Companies (RDC) on Oct. 21, 1997 at $41 a share on momentum in the oil equipment and service sector. Since then, I've had momentum all right -- all downward. The Asian economic crisis and the world oversupply of oil cut the legs out from underneath world oil prices and that eventually sent the stocks of the companies that supply the oil producers down, down, down. I should have sold sooner instead of fighting the logic of falling oil prices. My loss in this position was about 52% as of July 8. I've had enoug
Day Traders Emerge As Market Forces
Globe & Mail
Investing for the long term is the mantra of the value investor. Hang in for five or 10 years, as Warren Buffett does, and you will retire in style. But defining "long term" is a highly subjective exercise. For a peculiar species of investor known as the day trader, long term is an hour and owning shares for a few minutes is routine.
Day traders are investors only in the broadest sense of the term. Using ultrafast electronic trading systems, they dart in and out of stocks and rarely hold a position overnight. None of the traditional measures of analysis and value is used and, in some cases, the people in front of the screen do not even know the business of the company they are buying or selling. All they care about is momentum. If a stock is moving up, they pile in, earn a few cents a share and bail out in droves the instant the tide turns. Do that enough times a day and you can make (or lose) a small fortune.
The advent of the day trader helps to explain the increasing volatility of the stock market in general and certain stocks in particular. If a stock that shows every sign of being kind to you suddenly plunges for no apparent reason, there is a good chance the day traders can be blamed. Their lightning-quick arrival and departure tends to exaggerate a stock's "normal" trajectory. This is why they are considered evil by traditional investors; to them, day traders are nothing more than quick-buck artists bent on whipping the market into a froth and turning everyone into nervous wrecks.
Day traders are quick to defend themselves. They argue they do everyone a favour by adding liquidity to the market and narrowing the spread, the difference between a stock's bid and ask price. In the past year, the typical spread on a Nasdaq stock has narrowed by about 30 per cent, meaning both buyers and sellers are getting better deals.
Day traders have been around for years but two factors -- technology and the raging bull market -- have turned them into market forces. Experts think this new army of traders can account for as much as 20 per cent of the trading volume on Nasdaq, their favourite hunting ground.
Advances in trading technology have given them the ability to trade more quickly than the top houses on Wall Street. A day trader at a small firm in New York says the relatively cheap software he uses allows him to flip a stock faster than mighty Fidelity Investments, his former employer, which spends hundreds of millions a year on technology.
Day trading is not limited to the professional day-trading shops, such as New York's Schonfeld Securities. Anyone with the stomach to put their own money on the line can play the game. Small U.S. brokerages, such as Broadway Trading, offer an easy route in. Broadway supplies wannabe traders with a trading room and the hardware and software required to use the electronic communications networks that post prices on Nasdaq's market-maker system. Broadway charges customers 2 cents (U.S.) a share in commissions on trades and, for another $1,200, will train neophytes on the art of day trading.
The technology allows you to trade from home. A number of Internet services, such as the Pristine Day Trader, provide a "virtual" trading room where clients can obtain a steady flow of stock market data, commentary and trading tips. "Breakouts and stocks that are on the verge of exploding to the upside are issued in a matter of seconds," its promotional literature says.
The bull market, particularly among technology stocks, has been a day trader's dream in recent months. Traders who can take phone calls -- conversations, not surprisingly, are usually limited to five-second bursts -- claim they have made killings on Yahoo, Amazon.com, Lycos and other gravity-defying Internet names. Yahoo gained $26.37 one day last week.
Stocks, though, do not have to soar into the stratosphere to make money for day traders. They are happy to sell shares for 1/8 or even 1/16 of a point (known as a "teenie") higher than their purchase price. If you buy enough shares, say 1,000 at a time, and do it often enough in a day, you can go home with a tidy profit. The bravest players will buy on margin, giving them greater exposure to a particular stock, or go short, allowing them to make money when shares go into reverse.
A day trader in New Jersey says the one golden rule is to go for big, liquid stocks. "The key is to be able to get out in a hurry," he says. "When a stock goes into reverse, you don't want to face a vacuum of buyers and sellers. That's when you can get murdered." Stocks with volatile trading patterns are also favourites because they have more potential for short-term gains.
Whether you like it or not, day traders are here to stay and they are coming to Canada. Although no professional day-trading firm such as Schonfeld exists, some Bay Street firms are devoting an employee or two to the business and home-day traders, equipped with their fancy Internet software, are popping up everywhere.
They should be encouraged. Their advent has helped to break the near monopoly of the big, expensive market makers, adding a healthy dollop of democracy to the stock markets. "We help to level the playing field," one trader says.
|
