Saturday, May 29, 2010

Sold 100 HMA at 9.28/Spain/ Large Cap Valuation Strategy-A New Long Term Strategy

1. Fitch Downgrades Spain's Debt: On Friday, the DJIA fell almost 100 points after Fitch downgraded the sovereign debt of Spain to AA+ from AAA. NYT Did anyone actually believe Spain was a AAA credit? As of late last week, it would cost about $240,000 annually to insure 10 million of Spanish government debt. This does not sound to me as being consistent with a AA+ rating.

S & P downgraded Spain two notches already this year. S & P cut Spain's AAA rating to AA+ at the beginning of 2010 and then reduced it another notch to AA in April: MarketWatch Moody's still has Spain a AAA. WSJ Maybe Spain is an A. Italy did conclude a successful auction 11.5 billion in 3, 5 and 10 year paper last week. MarketWatch

In the interview with Ray Dalio in Barrons , he contended that 1.9 trillion of government debt has to be rolled over just in the European periphery nations over the next three years. The sovereign debt issues are not going away anytime soon. It is hard to see these nations returning to robust growth or taking any actions to meaningfully reign in spending over the long term.

2. SOLD 100 HMA at 9.28 on Friday (See Disclaimer): I recently bought HMA at $8.82. I will come back to this name when I have more confidence in the market. The proceeds will be grouped with other stock sales and cash flow to implement the new long term large cap valuation strategy. This represents a transition out of the 2010 Speculative Strategy which was a short term, trading based strategy into a new long term strategy.

3. Multiple Compression for Many Large Cap Stocks/Long Term-Large Cap Valuation Strategy: Over the weekend, I was looking at long term charts for JNJ, IBM and several other large cap stocks, along with the Value Line data on their earnings per share and dividends.

In 2001, JNJ stock was trading at a higher price than now, hitting a high of $61. The E.P.S. number for 2001 was $1.91, resulting in a P/E of 32 at the high price. Since 2001, JNJ has continued to increase its E.P.S. in every year. In 2005, the price hit a high of 70 when earnings were $3.5 but the P/E had shrunk to 20 from the 32 number five years earlier. As the earnings continued to grow, the share price continued to stagnate in a fairly narrow range bound trading band. While JNJ came close to a 73 price in 2008, that represented only a 16 P/E on the E.P.S. number of $4.57. The estimate for 2011 is currently $5.25: JNJ: Analyst Estimates for JOHNSON & JOHNSON At the closing price of $58.3 from last Friday, the multiple has now shrunk to just 11.1 on that forward 2011 estimate.

I don't think that multiple contraction is explained by a slowdown in earnings or dividend growth. The dividend has expanded from 80 cents per share in 2001 to $2.11 in 2010, an expansion of 164% and that would be close to the earnings increase too.

A chart of the S & P 500 between 1995 to 2001 reveals the ultimate cause of the sideways pattern. The market went up too fast and too far during those years, a move that resulted in clearly absurd valuations for technology and other Nasdaq stocks but also extended the valuations of large, established blue chip companies to levels that could not be justified by their rates of growth. This kind of euphoria should be expected in the final blow out phase of a long term secular bull market in stocks. Now, after almost a decade, the pendulum has swung from clearly over valued to under valued based on a sideways stock movement and a continuation of steady earnings growth over the past decade.

So, without trying to over think what has happened, I would explain this phenomenon as JNJ becoming over-priced when it was selling at a 32 P/E, relative to its prospects for earnings growth. The ensuing decade was marked by increasing earnings, and a relatively stagnant stock price, that have resulted in JNJ's P/E multiple shrinking over the past decade.

The market is not an efficient pricing mechanism. In an efficient market, JNJ's price would not have risen to a 32 multiple, nor would it shrink to the multiple in place now. Instead, a more rational multiple would be 15 to 18 times earnings. If I took 16 times earnings as a fair price, then the 2001 price would have been hovering around 30.56 rather than in a 40 to 60 range, and so on.

If I attached a 16 multiple to 2011 earnings, I arrive at a $84 price. Yet, this price would undoubtedly bring in sellers assuming it was reached in 2011, whereas institutions would have jumped at the opportunity to buy JNJ in 2001 or 2002 at 16 times earnings.

Eventually, I suspect the perception will change and many of these large caps that have continued to grow earnings during the last decade will eventually be rewarded with much higher stock prices.

JNJ is not unusual in this regard. Medtronic would be another example. MDT had an E.P.S. number of $1.21 in 2001 and a high price of almost $61. MDT may earn around $3.5 during its next fiscal year and is currently having trouble staying over $40.

It is impossible to say when the market will afford these steady growers a higher multiple, and they deserve a higher multiple than companies whose earnings are more cyclical and less reliable. I believe that this will happen, the timing is the only open issue. When it does start to happen, those who bought these kind of stocks now will experience decent appreciation on the stock price based mostly on a multiple expansion from undervalued to fairly valued. In the 1990s, it was not unusual for MDT stock to sport a 30 P/E. Now a good return could be achieved with just a 15 multiple.

IBM would be another example. In 1999, IBM reached $139 per share with an E.P.S. that year of $3.72. Even after the recession, the stock hit $126 in 2002 when earnings fell to $3.95 from $4.35 in the previous year. Since that down year, IBM has reported year-over-year earnings increases reaching an E.P.S. of $10 in 2009 and the consensus estimation is for $11.27 this year. Yet, the price of the shares closed last Friday at $125.26. When IBM was selling at $125 in 2002, the P/E was over 31 and now it is at 11.11 times 2010 earnings and slightly less than 10 times estimated 2011 earnings. A 15 multiple on 2011 estimates would give me a $184 price target. IBM: Analyst Estimates for INTL BUSINESS MACHINES IBM recently forecasted $20 per share in earnings by its fiscal 2015: At 15 times, that would translate into $250 per share, a double from its current price.

There are many others that fit into this category: large, financially stable companies that have grown earnings over the past decade, selling at a low multiple of current earnings, and near a 1 PEG.

The strategy has to be long term. I do not know when the perception will start to change, and investors consequently start to recognize that these companies are steals at the current prices. I asked myself a question. If I had the dough to buy JNJ  for 10 or 11 times earnings, would I do it? Needless to say, I am more than a few bucks short of being able to do that, but that is how an investor needs to think. I doubt that investors' perceptions will change anytime soon, so there may be plenty of time to gradually implement the strategy as cash flow is received from interest and dividends. Otherwise I will need to pick up the pace of some stock or mutual fund sells.

While the strategy is long term, it is not forever. These companies are subject to the law of large numbers. One of more of them could make serious mistakes that impacts their long term growth potential. Barring unusual circumstances, most of these large stocks will need to be sold when and if the multiple approaches 25 or even starts to exceed 20 on forward earnings estimates. An unusual circumstance would for example include one or more new products that would justify a temporary multiple expansion into the 20s, or a recession that might temporarily cause a decline in earnings and an expansion of the multiple.

Another component of the strategy will be to add an ETF that contains only the largest companies where these values are now congregated. One such ETF, which is not currently owned, is iShares S&P 100 Index Fund (OEF). There are some others that I would consider buying including iShares Morningstar Large Value Index Fund (JKF) and the iShares S&P Global 100 Index Fund (IOO).

Headknocker has allowed a fifty grand initial funding for this strategy.


  1. My CEF portfolio has outperformed PCEF by 2.1% total return since April 1. I am going to keep comparing them over the next several months to see if PCEF is worth adding or not. Prior to this week PCEF was trailing my port by 3.2%. I didn't have a very good week!

    I have 17 CEF's with a fairly equal ownership.

    *Total Return includes all trading fees and dividends.

  2. Rick: PCEF was one of those ETFs that had some wild trading on May 6th, the day of the flash crash. It hit an intraday low of 18.22 and closed at 24.03. A number of closed end funds also had particularly unusual activity also.

    I also try to look at my total portfolio's beta and how it reacts in both up and down markets. If the S & P 500 falls 8% in a month, I am pleased with a 4% decline in my total portfolio which is close to what I had in May. The CEF component went down more than that but performed better than the market averages. The individual bonds held up very well and probably advanced in May as a group. I know that I am going to have bad months, along with the good so I accept that. I am more interested in how the portfolio reacts during the bad month, bad quarter or even a bad year. I also want a portfolio that has less volatility than the stock market but capable of beating the market on a yearly basis in both up and down markets. In a year like 1999, I will underperform, but otherwise I outperform in up and down years with an eclectic portfolio that is less volatile and in a constant flux.

    When we move out of this long term secular bear market, anyone who has achieved a 5% annualized return after inflation since 1997 will have done extremely well and will deserve kudos. You will not see many professional mutual fund managers doing that well.

    The key is always to preserve capital during these long term bear markets, and to advance it some, and then clean up when the next long term bull arrives. If the past is prologue, a 14% annualized return after inflation is doable in the long term bull market cycle.

  3. It looks like I was down about 3% for the month and up about 2% YTD for my total portfolio. CEF's only make up about 20% of my total portfolio. The comparison with PCEF is to see if I would be better off selling my individual CEF's and buying PCEF. My plan is to track it for 9-12 months before making a decision.

    I have been about 40% cash since the end of Jan. as I search for some investments outside of the stock markets.