Jubak from msn talks about price-earnings,valuations and PFE here
Posted 7/24/98
Archived 7/31/98
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Is that a stock or a checking account?
Changes in the way people invest have turned some stocks into virtual money-market accounts. Here's how to find the names likely to surge higher on this wave of cash. By Jim Jubak
By Jim Jubak
What if, because of trends such as indexing and an increasing use of the stock market as a checking account by many investors, stocks like Pfizer (PFE) and Coca-Cola (KO) and Microsoft (MSFT) don't, in fact, trade like stocks anymore? What if structural changes in the stock market have created an entirely new way to price a group of equities that I call the money-market stocks? And what if, because of these structural changes, these stocks should trade at what, by traditional measures, are ludicrous valuations?
I had this thought in the middle of writing my last column, "Know when to hold 'em, know when to fold 'em." As I tried to set a revised target price for Cisco Systems (CSCO), I dug for new numbers, searched for confirming trends, and studied competitors' quarterly reports. But being honest with myself, I had to admit that I couldn't justify the stock's $100-a-share price and price-to-earnings ratio near 70 on the fundamentals reported by the company to date. And yet, despite that not-so-minor problem, I still felt that holding Cisco, not selling it, was the right thing to do.
This market frequently puts me in this position these days -- and I think most investors who use fundamentals to value stocks will recognize the situation. On the fundamentals, stocks such as Cisco or Lucent (LU) or Dell (DELL) were "sells" $20 or $30 ago. But it's clear in retrospect that selling then would have been the wrong decision. That leaves me feeling trapped between two equally unpalatable choices: Either I fudge the fundamental numbers to justify the stock's valuation, finding a dime here and an extra bit of P/E there, or I abandon all pretense of buying on fundamentals and simply flit from hot stock to hot stock.
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Past year price movement of Cisco, Lucent and Dell Then this last weekend, I had a conversation with a friend and fellow investor, Joe Weiner, that suggested there might be a third alternative, a different way to value at least part of the market. We began with the usual tongue-clucking over the way "ignorant" investors had been pouring money into a stock like Pfizer. Great company, we agreed, but the stock is already up almost 60% for the year. Stupid to buy more. Yet, after a moment of silence, we both admitted that we were sorely tempted to take the plunge now. As long as the money keeps pouring into the market, a stock like Pfizer won't go down, we both concluded.
Between us, Joe and I could easily recite all the standard disparaging comments about the current market. Everyone's investing -- from cab drivers to dentists. Everyone is using the stock market like a checkbook or a savings account. Everyone assumes the market can't go down. Everyone has been trained to buy on the dips. Everyone's buying the same few names. Usually, the experts who go through this litany end by lamenting that this bull market has created a new Nifty 50. Things are bound to end badly for those who invest in this over-priced group of big-name stocks, they conclude, just as they did for investors in the first Nifty 50 high-fliers in 1973.
But the more we thought about it, the more an alternate conclusion emerged. Perhaps these trends aren't so much signs of a market top, or proof that stocks are overvalued. Instead, perhaps they are evidence that the function and structure of the stock market has changed. I'm not talking about a "new paradigm" for the market as a whole, but changes in the way investors use a particular group of stocks.
Maybe a market that values Pfizer at a P/E ratio of 65 when earnings are growing at less than 20% a year is actually working pretty rationally.
If this is true, then the forces that set the prices of these stocks have changed too. Let me use just one of those observations to show you what I mean.
What are the consequences, for example, if investors use certain stocks as a checking account that pays great interest? September's tuition, the bills for the summer vacation, the initial payment on the new car lease -- those used to come out of savings put aside in a money-market fund. Now, many investors are paying bills like this from their brokerage accounts. (Don't believe me? Today in the mail I got an offer from one of my brokers to let me open a short-term line of credit secured by my portfolio.) Stocks that can deliver returns appreciably higher than a money-market fund, and that can deliver those returns dependably and with a minimal risk to capital would be extraordinarily attractive to that kind of investor.
Not every stock has the characteristics to deliver the performance that investors would expect from such a financial product. Such a stock would have to virtually guarantee double-digit earnings growth, come hell or recession. It would have to have sufficient free cash flow to buy back a sizable number of shares to support the stock's price if earnings should falter for a quarter or two. And it would have to provide sufficient liquidity so that a withdrawal by a single big investor wouldn't create a significant ripple in the daily net asset value.
What would such a stock be worth? Logically, since demand from this new kind of investor is high and since supply is limited because very few stocks actually deliver the necessary combination of return, predictability, and safety, such a financial product ought to sell at a premium price. Maybe a market that values Pfizer at a P/E ratio of 65 when earnings are growing at less than 20% a year is actually working pretty rationally.
If we could identify these money-market stocks, we'd have a list likely to show better-than-average gains as that baby boomer cash continues to flow into the market over the next decade.
Some of the smartest corporate management teams have understood this demand for stocks that behave like high-yield money market funds, and have done their best to deliver financial results that meet the expectations of this new kind of investor.
This isn't the first time something like this has happened in U.S. financial history. When an earlier generation of investors demanded high and growing dividends, companies did their best to deliver them. And it's not altruistic, of course. CEOs and CFOs know that if they can deliver earnings that entice investors to pay 50 times earnings for a stock, they have created a powerful competitive weapon called "low cost of capital." Whether a company harnesses that high-multiple advantage by going to the market with a secondary stock offering to raise capital, or by using shares to make an acquisition, it has a decided strategic advantage over a competitor with a stock trading at just 20 times earnings.
All this is of more than just theoretical interest. If we could identify these money-market stocks, we'd have a list likely to show better-than-average gains as that baby boomer cash continues to flow into the market over the next decade. We'd know that we shouldn't be scared away by the high P/E multiples these stocks command. And we might even be able to catch a stock or two as it's about to gain membership in this group, enjoying the big jump in multiple that goes with the new status.
I've taken a stab at putting together such a list. It's a first stab, so I hope you'll take a hard look at the data on your own. I built my list by running two screens in Investor's Finder and then pasting the two sets of results together in a single Excel file.
Investment
Finder
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Investor subscribers can see Jim's list of stocks in theInvestment Finder.
The screens themselves are pretty simple. I set only two requirements: A stock had to belong to the Standard & Poor's 500 and it had to show a return greater than or equal to the 22.02% returned by the index for the year to date. (Since 151 stocks returned 22.02% or more, you have to run two screens to get around Finder's cap of 100 companies on the size of a result set.) I ran a first screen with that requirement to get the top 100 names and then ran it again after adding a requirement that a stock have a return less than or equal to the lowest return in my original 100. That will complete the list.
I also asked Finder for a big dump of "Display Only" data. (To see a list of the almost 20 data items I asked for, click on the link in the sidebar.) I then exported each screen separately to an Excel file and finally combined them.
After that, I began narrowing the list and studying the survivors. First, I eliminated stocks that didn't show reliable double-digit earnings growth. So out went all stocks without a P/E, or without double-digit earnings growth quarter-to-quarter or year-to-year, or in projected earnings growth over the next five years. [Note: Any data cleaning you can do at this point will help. If you know that legitimate one-time charges have reduced the growth rate, by all means put the stock back in. I kept Cisco and Merrill Lynch (MER) for that reason.] I also eliminated stocks without a five-year record of earnings growth -- not enough track record to qualify as a money-market stock. And then I eliminated stocks with less than $10 billion in market cap, or that trade less than 600,000 shares a day on average -- not enough liquidity. That reduced my list to 32 stocks.
Glossary
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To see a full description of PEG ratios and how they are used, see Investor's Glossary.
I then calculated a current P/E to projected five-year growth ratio -- a projected PEG ratio -- and sorted the list on that basis, putting the stocks with the highest PEGs at the top. (I used a recalculated current price-to-earnings ratio of 65 for Cisco.)
What does this list look like? As expected, the stocks are pretty expensive. The projected PEG ratios start at 3.26 for Schering-Plough (SGP), and nothing earns a PEG ratio below 1.35. That's pretty steep, considering that I'm using projected earnings growth rates.
Most stocks on the list have rather modest projected growth rates -- below 20%. Microsoft, Rite Aid (RAD), Tellabs (TLAB) and EMC (EMC) are notable exceptions. (Editor's Note: Microsoft publishes Investor.) These stocks aren't expensive because they're the fastest-growing companies, but because their earnings are solid and reliable. Most of these stocks have far lower institutional ownership than I expected. Coca-Cola (KO) and General Electric (GE), for example, are only 50% owned by institutions. Wal-Mart Stores (WMT) is just 38% institutionally owned.
The top 18 -- from Schering-Plough to Costco -- I'd call the bona fide money-market stocks.
Company % Price
Change YTD P/E Ratio Projected EPS Growth
(Next 5 Yrs.) Forward PEG
Schering-Plough (SGP) 65.7 50.2 15.4 3.26
Pfizer (PFE) 58.2 62.4 19.4 3.22
Coca-Cola (KO) 26.8 54.6 17.2 3.17
Walgreen (WAG) 52.2 48.7 15.4 3.16
Wal-Mart (WMT) 74.5 42.0 13.6 3.09
Microsoft (MSFT) 81.0 70.1 23.7 2.96
Colgate-Palmolive (CL) 29.9 39.8 13.6 2.93
U. S. Bancorp (USB) 26.1 40.2 13.9 2.89
Bristol-Myers Squibb (BMY) 32.9 38.6 13.4 2.88
Warner-Lambert (WLA) 101.0 66.5 23.4 2.84
General Electric (GE) 30.1 36.3 13.4 2.71
Merck (MRK) 30.5 35.8 14.1 2.54
Abbott Labs. (ABT) 36.5 31.3 12.4 2.52
Home Depot (HD) 60.1 56.8 23.3 2.44
The Gap (GPS) 77.4 43.7 18.8 2.32
AIG (AIG) 39.9 31.1 13.6 2.29
Cisco Systems (CSCO) 85.1 65.0 29.1 2.23
Costco (COST) 45.4 33.8 16.1 2.10
Rite Aid (RAD) 40.2 31.9 15.6 2.04
Dayton Hudson (DH) 55.9 29.6 14.7 2.01
Tyco Int. (TYC) 45.7 35.3 19.3 1.83
Lowe's (LOW) 74.6 37.8 20.7 1.83
First Union (FTU) 25.0 20.7 11.8 1.75
Merrill Lynch (MER) 40.5 20.3 11.8 1.72
BankAmerica (BAC) 30.9 21.4 12.8 1.67
Tellabs (TLAB) 68.3 50.6 31.3 1.62
EMC (EMC) 90.9 43.3 26.8 1.62
Travelers Group (TRV) 34.8 24.2 15.2 1.59
Oracle (ORCL) 23.5 35.3 24.5 1.44
Federated Dep. Stores (FD) 27.7 20.1 14.3 1.41
MBNA (KRB) 33.4 30.1 21.8 1.38
United HealthCare (UNH) 23.4 26.1 19.4 1.35
(Figures as of 7/21/98)
I think the stocks on this list fall roughly, and rather naturally, into two groups after they're ranked by projected PEG ratios.
These stocks aren't expensive because they're the fastest-growing companies, but because their earnings are solid and reliable.
The top 18 -- from Schering-Plough to Costco (COST) -- I'd call the bona fide money-market stocks. This group is dominated by the obvious names, with a few surprises in the retail sector such as The Gap (GPS). Most of these stocks would have been in this group five years ago. And they're all expensive. Investors are paying a big premium here for a history of reliable earnings growth.
The bottom 14 is a combination of stocks working their way out of this elite group because they haven't been able to deliver sufficiently reliable earnings in recent quarters -- Oracle (ORCL), for example -- and stocks earning their way in. EMC is the most interesting newcomer -- its earnings growth rate looks solid for the future and it's higher than the norm for a money-market stock. Investors are still catching up with this company and despite its 90% rise already this year, it remains cheap for a stock with these characteristics. If the current pullback in some technology stocks spreads to a modest correction across the whole group in August -- a definite possibility, I believe -- I'll add this stock to Jubak's Picks. Right now, though, the price is right for long-term investors but a little steep for a portfolio with a 12- to 18-month time horizon.
In the market, there are dozens of reasons for a stock to be astronomically expensive. Providing an alternative to a money-market fund is just one of them. But I think it does explain why some stocks trade where they do.
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Don't kill the cockroach strategy
Great news hurts! On July 20, Citrix Systems (CTXS) announced record revenue of $59 million -- up 129% from the same quarter in 1997. Earnings per share rose to 38 cents -- excluding one-time charges for the acquisition of APM Ltd. That's a penny ahead of analyst estimates and 100% above earnings per share for the second quarter of 1997. So why did the stock fall $5.63 the next day?
I don't think you need to look any further than the effect of that one-time charge. Without it, the company beat Wall Street estimates. With it, the company missed expectations big -- a loss of 11 cents a share vs. projections of 37 cents. I don't think focusing on the 11-cents-a-share loss is the right way to measure the company's results. The charge for writing off in-process research and development costs at APM is perfectly legitimate. But many earnings-reports calendars -- including the one on Investor -- are reporting the 11 cents-a-share loss as the quarter's results. Think how it looks: Expected 37 cents, reported a loss of 11 cents. I'd use the selloff as a buying opportunity if you'd like to add to your position in a stock that, even after the plunge, is still up 16.4% since I recommended it in Jubak's Picks on April 24.
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