'Expensive' Is No Longer A Bad Word to Investors
Reprinted courtesy of Monday's Wall Street Journal
What goes up, nowadays, will likely go up more.
It doesn't sound sensible to investors trained to buy low, sell high. But buy high, sell higher, seems the most rewarding way to invest these days.
Analysts trying to explain how blue-chip stocks are setting records amidst so much profit and interest-rate uncertainty have a one-word answer: momentum.
Momentum investing, at its simplest, means buying companies whose earnings, sales or stock prices are rising. It means worrying little about price/earnings ratios and other valuation measures. Don't sell a stock because it's "expensive," sell it when the momentum breaks. Okay.. I agree except take out rising.. we need to watch the 2 former, the latter criteria will follow.
"The return to price momentum has been as high as it has been in measurable history," says Michael Weiner, portfolio manager at Banc One Investment Advisors in Columbus, Ohio, who studied what factors drive stock performance. "That is, the only thing you know is that if you hold the stocks that have done well for a quarter or half a year or a year, those stocks ... will do well for the next year."
Kevin Johnson, research director at Aronson & Partners, a fund manager that invests according to quantitative models, has found similar trends. "It's almost like appreciation begets more appreciation. As the rich get richer, the cheap get cheaper."
In the 1980s, momentum was the specialty of a handful of managers focused on small, high-growth companies. Since then, however, more managers have adopted elements of momentum while eschewing the label: buying companies with positive earnings surprises and upward earnings estimate revisions, and selling those with negative surprises and downward revisions.
Richard Bernstein, chief quantitative strategist at Merrill Lynch, has been surveying fund managers on their investment styles for a decade, and over the period, momentum -- of several types -- has solidified its spot as the most popular style. Last year, more than half of managers used estimate revision and earnings surprise, [sic!] and more than 40% used earnings momentum. [sic!] Only one quarter used price-to-book value and just 13% used dividend yield, compared with 50% in 1989. [dividends! nope not our stocks]
In one example of momentum investing, on Friday drugstore chain Rite Aid Corp. warned that fiscal fourth-quarter earnings per share could be as much as 42% less than analysts expected. Rite Aid had been a momentum darling, its stock rising from $15 in mid-1996 to more than $50 earlier this year, closing at $37 Thursday, still a rich 48 times trailing earnings. But after the warning Friday, the crush of sellers forced the New York Stock Exchange to delay opening trading in Rite Aid for more than an hour. It opened at $25, down 32%, and fell to $22.5625 at the close.
"If something isn't working out short term, people who are investing in momentum plays just want out right away," says Howard Kornblue, a value-style manager at Pilgrim America Group. "If enough people are acting this way, you have movements that are very, very large. When I heard the news about Rite Aid, my inclination is, this is probably one heck of a buying opportunity." [ed. comment I agree ]
Last December, when toy maker Mattel Inc. warned of earnings weakness, Mr. Kornblue, a shareholder, figured such a business setback should have taken several weeks to work its way into the stock price. He was disheartened to see it drop 22% on its opening trade on the Big Board. He has since sold most of his stake.
For those stocks that don't disappoint, the ride up has been tremendous. But because fewer and fewer companies in the past few years have gone without some earnings trouble, the market has been carried higher by a shrinking group of very large, increasingly pricey companies. [ed. note.. yes but since we can have the option of entering companies that do 'surprise' we can enjoy these 'shrinking companies' and there are enough of them around. This is why I say even if a company is overbought after earnings, give it a chance to retreat and it could become a really profitable 2-3 month hold]
"The problem with momentum in recent years is that there hasn't been any change in it," says James Paulsen, chief investment officer of Wells Capital Management. "There's been one-directional leadership and momentum."
Mr. Paulsen's growth managers sold Microsoft Corp. about a year ago because it had gotten too expensive. It has since become even more expensive, and Mr. Paulsen's team is interested in buying it again "on the right pullback."
Large-capitalization stocks have outperformed across the board. They were the reason the Standard & Poor's 500 Index rose 26.7% and the 30-stock Dow Jones Industrial Average rose 16.1% last year. But the Value Line index, which measures the average performance of about 1,700 major stocks, fell 3.8%. So far this year, the Dow industrials are ahead 7.6%, and the S&P 500 5.3%, but the Value Line is down 3.2%.
Last year, momentum carried the companies in the S&P 500 with the highest price-to-book-value ratios -- the "growth stocks" -- up 41% while the value stocks -- those with the lowest price-to-book ratios -- rose just 12%. So far this year, growth stocks are up 6.4% and value is up 4.1%.
There are some fundamental reasons other than momentum for these results. Edward Kerschner, PaineWebber investment strategist, argues that in a low-inflation environment, fast-growing companies are worth more. "In a low-interest-rate environment ... you really are paying a lot for what is far out in the future. With America Online, it is what you get five years out. It's not that the market isn't looking at value, it is that value is farther in the future. And if most of your value is in the future, the price of disappointment can be huge."
The rising valuations for Microsoft and General Electric Co. are justifiable as long as they maintain their earnings growth. Software company Oracle Corp. had tripled from its September low to its February high. But its weaker-than-expected revenue growth of 19%, reported last week, prompted investors to pound it down 23% Friday on the Nasdaq Stock Market.
[ed. comment exactly.. the weaker than expected results are the death throes of the former hi-flyers and companies like ORCL and RAD that have been darlings of Wall Street... as long as they didn't, heaven forbid, disappoint big momma and <gasp> dare not to meet expectations!]
Is momentum's spell about to be broken? There are some signs it could be. The Nasdaq Composite Index, which is heavily weighted towards half a dozen giant technology names, has eased 5% since its record close Feb. 1, though it's still up 8.6% for the year. But the money appears to have simply rotated to other blue chips: The Dow industrials are up 5.7% since Feb. 1 while the Russell 2000 index of small-cap companies is down 6.5%.
Peter Henderson, a specialist at the New York Stock Exchange, thinks the sight of individuals paying outlandish prices for Internet companies with no earnings has made professional managers more comfortable paying 40 to 65 times earnings for Coca-Cola Co. or Gillette Co. "People are getting maybe a little lax in their discipline, and that's okay because momentum is here. But eventually that could come back to haunt them," he says.
--E.S. Browning contributed to this article
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