Balance risk and reward on 'bargain' stocks
Even so-called value stocks have risk. But my 'sector indicator strategy' helps reduce the downside. It worked on oil-service stocks and I'm using it again on the online brokerages.
By Jim Jubak
E*Trade certainly seems less risky today at 23 5/8 a share than it did back in April at 72.25. A stock that's been beaten up certainly isn't likely to fall as far as a stock that's trading near its all-time high.
If you define risk as the potential dollar loss from an investment, then buying stocks after they've been punished by the market is a great strategy for reducing risk. For example, there's clearly no way that E*Trade (EGRP) can fall another $40 a share from its current price.
But I think that paying attention only to the potential dollar loss from an investment results in a lopsided definition of risk. E*Trade doesn't need to fall to $20 or $18 to cost you money. If the stock simply hovers near $24 for months or quarters, an investor in E*Trade is also losing money. The cash that's been locked up in E*Trade could have been invested in some other stock that actually appreciated during the period. In the stock market, time is money, too.
Anyone who wants to balance risk and reward in individual stocks -- the subject of my last column, "6 ways to worry about your winners" -- has to put time into the equation as well. To do so, I've developed what I call my sector indicator strategy. In my March 23 column, "Schlumberger leads an oil-service turnaround," I applied that to the oil-service sector. Since then Schlumberger (SLB) is up 17% and Halliburton (HAL), the stock I picked on March 23, is up 30%. Now, that same system tells me it's almost time to add another online brokerage stock -- E*Trade looks like the best candidate -- to Jubak's Picks.
Lose patience, lose money
Time, in fact, is why value investing -- a catch-all term for those strategies that try to buy stocks when they're trading below their real value -- doesn't work for most individual investors. Oh, value investing works all right in the long run -- the academic research I've seen is pretty convincing on that score.
The problem is that most individual investors aren't patient enough to hold onto a true value stock for five years or more. (Value investing also doesn't work for most individual investors because they don't buy true value stocks. Instead, they buy stocks that are simply cheaper now than they once were. But that's another column.)
I say that most investors are impatient not out of any sense of superiority, but because I know how hard it is to wait for a stock to realize its "true" value. I sold out of both Integrated Device Technology (IDTI) and LSI Logic (LSI) too soon for no reason other than that I ran out of patience. The dollar cost of this impatience is low; a value stock isn't likely to fall by 50% from the depressed original purchase price. But the value of lost time is huge. Holding a stock for two or three years and then selling before any gain has materialized plays havoc with the return on your portfolio.
I've tried just about everything I can think of to stretch my patience. I've decided that some stocks were "buy-and-forget." But have you ever tried not looking at the price of shares you own? I've set arbitrary holding periods for stocks, and missed truly logical selling points. I've even tried bribing myself; I'll buy myself a present if I hold on for another three months. But I've finally had to conclude that human nature (mine, at least) is just too hard to change.
So I decided to attack the problem from the other end. Can I do anything to decrease the time period that I have to hold a value-type stock before it starts to go up? Can I buy it closer to the turnaround?
The result was my "sector indicator strategy." In brief, it starts with buying the quality company in a sector and then using that stock's progress, or lack of it, to judge when it's time to add other, riskier stocks in the sector to your portfolio.
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Past year price movement of Charles Schwab, E*Trade and Ameritrade
The slump in online brokerage stocks
Take a look at the online brokerage sector right now, for example. If you graph three of the high-profile players in the sector, Charles Schwab (SCH), E*Trade and Ameritrade Holding (AMTD), it's very clear that they all peaked in April with secondary highs in July. And right now, all three stocks are in the dumper. Over the last three months, Schwab is down 16%, E*Trade is down 33% and Ameritrade is down 32%.
It's pretty clear why the sector has been such a disaster since spring. In April 1999, Schwab, for example, reported that the daily average trades by customers hit 160,000, up 90% from the same quarter of 1998. Revenue grew right in line with that. It was up 57% from the same quarter of 1998. Growth was just as torrid at E*Trade, Ameritrade and other companies in the sector. And the prices of these stocks reflected the expectation that these growth rates would continue.
But it became clear, almost before the ink was dry on the April quarterly reports, that growth wouldn't match these rates over the summer. And the stocks began to tumble. I added Schwab to Jubak's Picks on May 7, when the stock was already down almost $26 a share from its 52-week high.
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Price 36 15/16
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Price 22 15/16
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How low they could go
Frankly, the depth of the decline surprised me. (To be perfectly honest, I didn't set out with the idea of making Schwab my sector indicator stock. I thought I could make a profit on the shares if I bought at $52.) Of course, growth rates like these wouldn't last through the summer. Trading volumes are always light during those months. So I figured the stock would correct. But I thought a 33% decline from the 52-week high was enough. $51.91 should have been a safe entry point.
Worries about higher interest rates and two rate increases from the Federal Reserve certainly didn't help these stocks. But the sector had another problem that was bigger than I'd figured. The competition among existing online firms, as well as from the online services being launched by increasingly aggressive full-service firms, was driving up the cost of acquiring a new customer. A late-August announcement from Ameritrade neatly summarized the problem. It said acquisition costs per each net new account likely would be above $500 for the quarter ending Sept. 30, up from $157 in the prior quarter. Even factoring in a big seasonal jump in advertising spending in September because of the launch of the new TV and football seasons, it's still likely that Ameritrade's spending per net new account will double during the quarter.
What's the likely story at the other firms? Lehman Brothers estimates that acquisition costs this quarter at E*Trade should be about the same as last quarter. I don't expect to see a big pickup in costs at Schwab, either; the company's strong brand name brings in new business by itself and Schwab already advertises so extensively that a big jump in spending isn't necessary.
But volume continued to slow, even at Schwab. On Sept. 15, the company reported that daily average trades were 126,000 in August, down 14% from July (even if up 27% from August 1998.)
Is that the end of the bad news? Almost, but not quite. If the Fed decides to raise rates Oct. 5, brokerage industry stocks are likely to take another hit. And the quarterly earnings reports coming out in October are likely to look pretty shabby in comparison to the April and June reports. There's a good likelihood that at least one of these companies will issue disappointing numbers on account growth or costs. Schwab, for example, has upped its investment in new infrastructure so that it can stay ahead of the competition. Other firms may have to match that spending.
By the time those reports come out, everyone should really hate these stocks. And that's the time a value-oriented investor would like to buy. (A true value investor would, of course, never put a dime into any of these stocks. All are trading too far above their intrinsic value, even now.)
Jubak's Archives
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Recent Jubak articles:
? 6 ways to worry about your winners, 9/14/99
? How I'll catch the next big wave, 9/10/99
? Top dog doesn't always lead the stock pack, 9/7/99
More?
Waits for signs of recovery
My sector indicator stock strategy, however, says that if you want to reduce the time you spend waiting for a turnaround, you should wait for some signs of a recovery in the price of Schwab, the quality stock in this sector. If you don't already own Schwab, any signs of strength in that stock would be a buy signal. The price is right now; all you're doing is waiting to time the buy. If you already own Schwab, a move in those shares would be welcome in itself, but also a sign to move a step down the quality ladder and buy E*Trade.
I'll be watching that stock carefully as a possible add to Jubak's Picks when the time is right.
While I've got my sector indicator strategy tools out, however, I am going to make another buy in the oil-service sector. The sector has been pulled back lately on worries that OPEC will back off from its production targets when it meets Sept. 22. I think that's extremely unlikely, so I'm going to use the current weakness to move another step down the quality scale and add a position to Jubak's Picks in Global Marine (GLM). Even though the stock is way up from its 52-week low of $7.50, it is still one of the cheapest in the sector.
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1-yr Chart
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Changes to Jubak's Picks
Add Global Marine (GLM)
When the oil-service sector was headed to hell in a handbasket last year, the two drill ships under construction at Global Marine were a huge liability that helped drive the stock down to a 52-week low of $7.50. The company was spending scarce cash to build new drilling capacity at a time when the rates that oil companies were willing to pay for existing rigs was falling. But now that oil has held above $20 a barrel for a while and the number of rigs in use has climbed off historical lows in North America (and shows signs of doing the same internationally), those two ships are prime assets. The company already has 31 rigs in operation. Analysts estimate that Global Marine will earn 62 cents a share in 2000, making the stock one of the least expensive in the sector, despite its recent run-up. I'm adding it to Jubak's Picks with a September 2000 target price of $24 a share.
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Updates
New Developments on Past Columns
Picking up on telecom mergers
Speaking of stocks that have crawled off a bottom, Advanced Fibre Communications (AFCI) hit my December target price of $20 on Sept. 15 on the strength of a "buy" recommendation from BancBoston Robertson Stephens and a "strong buy" from SG Cowen. (The Robertson Stephens recommendation was a reiteration of a previous "buy"; the SG Cowen call was an upgrade from a previous "buy" rating.) Analysts at both firms noted that the company was likely to meet or modestly beat estimates of 7 cents a share for the September quarter and, just as importantly, show continuing improvement in the company's cash balances and a decline in the days sales outstanding. I think it's too early to sell this one; the company is just regaining its balance and isn't yet showing any pickup in international sales. I'm keeping it in Jubak's Picks and raising my target price to $27 by June 2000.
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