Now, you probably wouldn't charter a deep sea fishing trip and then insist to the captain that he take you to that one place in the ocean where no one ever catches any fish. If you did, the captain would tell you that all you'll get for your money is a boat ride, and if he's crusty and grizzled enough he might tell you to your face that you were nuts. At least he would suggest that there are reasons why fish aren't caught in certain places. But you would then remind him that you're paying and you want to avoid the hot fishing spots and discover something that every other fisherman has overlooked. You might even call this your contrarian approach to hooking a big one. As crazy as this sounds, it is how some investors go about choosing stocks. When investors look at those stocks that have been moving up strongly on continued good news from the companies, they may tend to assume that it is too late to invest in those stocks. They then turn their attention to some stocks that have not made such impressive moves. Especially in a strong market, which we have certainly been experiencing lately, investors may conclude that they have missed out on some opportunities and then go trolling for the laggards.
Investing is not fishing, of course, and we definitely want to "buy low and sell high." The challenge is that what has moved up is not always as high as we might conclude, and what has lagged is not always as cheap as it might appear to be. I always emphasize that diversification is crucial, and here we want to understand that diversifying means more than just buying a lot of stocks in different industries. We should also think about diversifying across different investment styles. The value approach can be quite rewarding, but we have to distinguish between those stocks that are under-priced for some temporary reason and those stocks that are down for very good reasons. When we looked at the potential for "bear traps," I cited Radio Shack (RSH, $7.00) as a stock that looked cheap because it had declined significantly--but one that seemed to lack any catalyst to move in the other direction. If we can steer clear of such traps we can realize very good returns by focusing on value. However, we might also think about devoting a portion of our portfolios to more aggressive growth situations. These stocks, sometimes known as "momentum" stocks or high relative strength stocks (meaning they have been strong relative to the market and thus outperforming), look anything but cheap, at least at first glance. Priceline (PCLN, $640), the online travel booking company, has a price-to-earnings (P/E) ratio above 30 and shows a total return of over 1,000% over the past five years. The company reported stellar earnings after-hours on February 27th of $5.37 per share versus a consensus estimate of $5.05, and the next day the stock was up 41 points, about 7%. A move like that is enough to scare some investors away from buying (and give them some bruises from kicking themselves for not having bought earlier). However, we need to look a little deeper. PCLN has shown earnings growth well above the P/E ratio, and they are projected to continue growing earnings at about a 30% annual rate over the next three years. When we compare the P/E multiple to the growth rate (to get the PEG, or price/earnings to growth number), the valuation seems less daunting. A good rule of thumb is that the PEG ratio should be less than 2. A higher P/E is consistent with higher earnings growth, and that's what investors are paying for. After the earnings report several research analysts raised their price targets on the stock, now ranging from about $725 to $850 per share.Remember, also, that the absolute price of a stock means nothing unless we compare it with earnings and earnings growth. With stocks trading in the triple digits, I find it helpful to divide the stock price by 10 in my thinking, so that the move in PCLN is like a $59 stock going to $64.
We'll take a brief look at some other names in a moment, but first let me emphasize (again) a couple of key points. First, always do your homework on a stock's fundamentals. A stock can rise dramatically based more on speculation than on sound fundamentals, so we always want to make sure that we've studied sales, margins, and earnings. Also, we need to read the reports from the analysts. I want to see earnings estimates and price targets moving up, not staying put. Second, diversify, diversify, diversify. Don't put all of your eggs (especially your nest eggs) in one basket. Momentum-type stocks can fall dramatically at the first whiff that the growth story may be faltering. Just look at NetFlix (NFLX, $108), once a tremendous growth story that traded at around $300 last July, but has plunged over concerns about the future viability of the company's business model. Knowing the fundamentals and being diversified are the two best ways to protect ourselves, and it's a good idea to take some profits when stocks have had major moves. We can hang on to our winners, but trim them back so that no one stock represents too great a percentage of our portfolio.
With those caveats, I still say that venturing into these waters can be extremely rewarding. Please note that the focus here is on companies that already have a successful track record of strong growth and profitability, not on smaller and newer enterprises that, for all the potential they may offer, have not yet "shown us the money." As an example, Zipcar (ZIP, $13) is a car-sharing service that has had success in urban areas where many people don't own cars but may need one for just a few hours every so often. ZIP hasn't gotten any real traction yet, and the shares are down more than 50% over the past year. It's an interesting concept, but the big guys like Avis and Hertz already have rental fleets and likely pose a competitive threat. Nobody really knows yet whether ZIP can make a real success out of this. Here we are looking at companies that are already quite successful, and their success is reflected in their stock prices. I recall quite clearly how hard it was to buy shares of Microsoft (MSFT, $31) back in the early 1990s--hard because the stock had already increased substantially in value and the P/E multiple was high. Investors who bought anyway were handsomely rewarded, as the stock continued to outperform the market.With this type of growth investing we are putting our money in strength--strength in the stock price that is backed up by strength in the company's fundamentals. Some people cynically refer to this type of investing as "buy high, sell higher." That may be true, but we have to accept the fact that a truly successful company is not going to go unnoticed by the stock market. When we devote, as we should, some portion of our portfolios to value stocks, the ones that the market is not rewarding with buying pressure, we are essentially taking the position that the market is wrong, and that we are smarter than the market. That approach also carries risk--the risk that the market is right and the stocks are cheap for a reason and may get cheaper. With the growth portion of a portfolio, I am willing to take the risk that the market is right, but that the company's prospects are even more favorable, for a long period of time, than the market has priced into the stock.
In addition to PCLN, here are some names that are showing momentum in terms of earnings and stock price. Potential investors should pursue additional research and consult their financial advisers before committing funds to these stocks.
Apple (AAPL, $534)--In the unique position of being both a growth stock and, arguably, a value stock. If AAPL were to trade at a P/E multiple closer to that of PCLN, the shares would be priced close to $1,000. As it stands, AAPL trades at close to a market multiple.
Autozone (AZO, $383)--The "Do-It-Yourself" retailer of auto parts also has growth opportunities in the "Do-It-For-Me" (commercial) market. A play on the increasing age of the average car in America, there is some concern that a sustained rise in gas prices could prompt consumers to accelerate their purchases of newer, more fuel efficient vehicles.
Cerner (CERN, $75)--A leader in health care technology that should benefit with the continued adoption of electronic health records.
Dollar Tree (DLTR, $91)--Several of the discount stores fit this profile, including Ross Stores and TJ Maxx. Somewhat of a defensive play, the thesis here is that the companies would still do well as the economy improves, because they save consumers money.
Intuitive Surgical (ISRG, $508)--Makes robotic surgical systems.
Lululemon Athletica (LULU, $68)--The growing source for high-end yoga and fitness apparel.
Verifone (PAY, $51)--Electronic payment terminals and other payment technologies.
Whole Foods Market (WFM, $80)--A major trend toward healthier eating.
Yum! Brands (YUM, $66)--Not healthy, but growth opportunities for Kentucky Friend Chicken, Pizza Hut, and Taco Bell in other countries.
Following this strategy will no doubt produce a few losers. That's why there is something known as "catch and release"--we can sell them. If we are skilled at picking our stocks, however, we may end up with a few stocks that are multi-year winners, long-term successful companies that can make up for the ones that didn't work. When you do end up reeling in the big one, you might want to consider having it mounted as a trophy you can hang on the wall. That would be called your child's college diploma.
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of AAPL, AZO, CERN, DLTR, ISRG, LULU, PAY, PCLN, WFM, and YUM. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as a recommendation to buy or sell any security. Prospective investors should consult their financial advisers before investing in any stock.
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