When it comes to the litany of life's frustrations, or at least the frustrations of investing, few experiences rank higher than losing money. Seeing one's treasure evaporate, as almost all investors witnessed during the market and financial meltdown of 2007-2009, makes for an ulcer-inducing angst all its own, where the only palliative is a bottle of scotch emptied in the company of misery. But what about the frustration of failing to make money in a market that is soaring? The most intense frustration, after all, is the one you're dealing with today, even if past frustrations were of greater consequence. So, if the market is jumping like Richard Simmons (pictured above) at a caffeine-fueled aerobics class but your stocks can't seem to get out of bed, that's going to be a problem--and you're probably not going to feel comforted by the reminder that it's not 2008 all over again.
Very often the conventional investment wisdom tells us that the antidote for such under-performance is patience, and this is valid to an extent. We can't expect our stocks to go up immediately after we buy them. In fact, our case for owning any particular stock likely is based on our assessment of the company's future potential--a potential that is not currently reflected in the stock price. We may have to wait some time before the market recognizes such potential. That is all well and good, but we also need to remember that where patience is supposedly a virtue, the conditions that try our patience are assumed to be temporary. If your spouse comes home from work every night to knock back a fifth of Jack Daniels and kick the dog, then the dog, at least, is not going to appreciate your patience. Or, as Albert Einstein once observed, one definition of insanity is doing the same thing over and over again and expecting different results. So, in the interests of preserving our sanity, let's take a look at some situations where patience might not be a virtue.
First on the list of usual suspects is the possibility that we have been lured into a value trap with some of our stocks. As we've reviewed here previously, it's called a trap because the stock looks cheap on some traditional measures of valuation, but is actually cheap for good reasons. My "poster child" value trap stock has been Radio Shack (RSH, $3.00), which a number of research sources were calling a "buy" at $15, then at $12, $8, and all the way down to its current price. One didn't need to be a Chartered Financial Analyst (CFA) to know that selling consumer electronics in a bricks-and-mortar retail store was not exactly a growth business with strong competitive advantages. Furthermore, a stock trading at a price-to-earnings (P/E ratio) multiple of 10x may look cheap, but it's not so cheap if earnings are growing at only 5%. Likewise, a stock with a P/E ratio of 30x is not necessarily expensive if earnings are growing at 25%. A commentator on CNBC recently remarked that "Valuation in itself is not a catalyst." That quote should be taped to every investor's computer screen as a reminder that without some positive catalyst down the road, a stock can languish--and appear cheap--for a very long time. These stocks are likely to be a drag on your overall performance, because even a consistently rising market is not likely to bring them out of the dumps. Investors may be more tempted by such stocks in a soaring market, because the natural tendency is to eschew the strongest stocks and seek out something that hasn't participated in the rally. This is sometimes a mistake. The idea of finding a discarded diamond while rummaging through trash bins sounds intriguing, but the reality is that the vast majority of what you'll find is indeed there for a reason.
Patience is appropriate in more legitimate value cases, where a company with a solid business and strong competitive position has hit a rough spot, or has at least been out of favor. As an example, shares of Coca Cola (KO, $41) are up only about 5% over the past year. The company has a nice dividend yield of 2.75%--if you have to wait for performance, it's good to be paid for your patience. Ebay (EBAY, $53 ) took a hit this week after reporting earnings that slightly missed expectations. A big part of the investment case here is PayPal, which is making inroads with its payment processing services. I also find Scripps Networks Interactive (SNI, $72) interesting. The company owns HGTV, Food Network, Travel Channel, and has the Internet presence to go with them. The stock is up 33% over the past year, but still, in my opinion, offers value.
Another possible culprit in under-performance is really not so much a culprit as a circumstance of timing. Different sectors in the market are strong at different times, and being in the wrong place at the wrong time can be a drag on shorter term returns. Consider, as an example, the oil refiners, which are not really growth stocks in the traditional sense. Marathon Petroleum (MPC, $68) rose from about $43 last summer to a high of $93 early this past spring, and if you owned the right companies in this sector during that time frame, they would have contributed significantly to your outperformance. The market's love for these stocks has largely been due to what is known as the "crack spread"--the difference between what refiners pay for crude oil and the price they can get for the refined product (gasoline, for instance). New supplies of oil here in the United States have kept the price of what is known as West Texas Intermediate Crude relatively low compared with the price of Brent North Sea Crude. The refiners have been in the sweet spot of paying the former price while the price at the pump is supported by the latter, higher price. Lately this crack spread has been narrowing, and with it the benefit to the refiners. So, what helped your performance for a time is now detracting from it. The home builders have followed a similar track. They are not typical growth stocks, either, but they have seen tremendous increases in earnings coming out of the housing bust. Ryland Group (RYL, $41) rose from $23 last summer to a high of $50 this spring, but then Mr. Bernanke started talking about tapering the Fed's bond buying. Higher interest rates may not kill the housing recovery, but they won't help it, either.
Now, let's step back for a minute and recognize one important thing. We need to evaluate our investment performance over longer periods of time, and no one is likely to beat the market averages every single quarter. The shorter term numbers are a regular test, not the final exam. But, if we don't have infinite patience to own Coca Cola and aren't nimble enough to catch Marathon Petroleum at just the right time, then what is the answer? Most investors understand the importance of diversification, but many of them may miss diversifying across varying investment styles. Certainly it is important to own good value stocks and to have the patience to stick with them, but it also helps to devote a portion of one's portfolio to true growth stocks--and the best of the best growth stocks are going to exhibit strong relative strength. This means that they are not going to look cheap, and, in a perverse bit of reasoning, they are probably not worth owning if they do look cheap. Intuitive Surgical (ISRG, $373), the maker of robotic surgical systems, was a darling of growth stock investors for a time, but has more recently been plagued by slowing growth and some supposed safety concerns. You would have done quite well owning the stock from 2010 until the first quarter of 2012, when the shares went from around $300 to almost $600, but the relative strength has been suffering since then. Now this week the stock is down again on the heels of more disappointing results, even setting a new 52-week low at levels not seen since 2011. If you want to take a round trip, take it to Tahiti and not in your stocks. The point, though, is that the declining relative strength gave you some time to abandon ship--you are more likely to sell these types of stocks on the way down, not on the way up. Does this make ISRG a value stock now? Nobody knows, because the market has always valued the company as an aggressive growth stock. Investors who buy it here may well be adding more risk to the burden of patience.
Experience shows that such growth stocks can be very powerful and profitable, but only the rarest ones will continue their outperformance over more than a few years (think Microsoft in the 1990s). Experience also shows that such strength is important to own, in measured doses, in a strong bull market. If we're hunting for strength today, here are some stocks that may fit the bill: Cree (CREE, $68), a maker of those new LED light bulbs; Celgene (CELG, $135), the biotechnology company that is on a roll with new treatments and plans for earnings to reach the $13-$14 range by 2017; Netflix (NFLX, $265), which has transformed itself from a mail-order dvd rental company to a video streaming service and now to a content provider with a boatload of recent Emmy nominations; Lions Gate Entertainment (LGF, $32), with the Hunger Games and Twilight franchises; and LinkedIn (LNKD, $201), the Facebook for grownups. What all of these stocks have in common is that they have had tremendous runs already and thus will likely fall the hardest in a general market decline or with any disappointing company-specific news. No risk, no reward--no guts, no glory.
The final point I'll make today is to emphasize that the companies mentioned above are not for all investors, and no investor should buy only the strongest stocks in terms of relative strength. So, consider how much risk you need to be taking. Someone with 20 years until retirement might want to own some Celgene shares, for example. But if your daughter is a high school senior and you're thinking about putting her college fund in LinkedIn or Netflix to gain some quick extra bucks, then while you're at it you'd better pick up a job application for her at Hooters. Because that's how she might end up paying her college tuition. The market may occasionally do what we expect it to do, but you can bet that it will never do what we need it to do. So tread carefully and be careful out there. And be strong--but don't dress like Richard Simmons.
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of KO, EBAY, SNI, CELG, NFLX, LGF, MPC, RYL, SNI, and LNKD. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security. Stock prices are as of noon, Central Daylight Time, July 19th, 2013.
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