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Bizarro (Investment) World

June 16th, 2017

In analyzing the current state of the financial markets/investment world, my mind settled onto some major issues that should be impacting the stock markets but currently are not:  (1) Rising Interest Rates; (2) Increased Risk Assumed by Investors; and (3) Equity Valuations.

Rising Interest Rates

  • The Federal Reserve raised the fed funds rate Wednesday by 25bps to 1.25% –  the stock and bond market mostly shrugged it off since it was highly anticipated
  • The Fed also announced that there will likely be another rate hike “relatively soon” and that they were going to start reducing the size of their balance sheet by the end of this year by $50 billion per month
  • Coincidently, all of the other Central Banks around the world are also starting to tighten their monetary policy

Normally, this would spook the stock and bond markets, sending both stock and bond prices lower.  Higher interest rates impact corporate earnings in a negative way, and lower earnings lead to lower stock prices.   However, we are not in a normal market any longer.

Increase Risk Assumed by Investors

There was a study that I read earlier this week that showed only 10% of the trading volume in the stock market is currently being transacted by money managers actively managing money:

  • 90% of the trading happening in the stock market is now through hedge fund program trading, index funds, and etf’s
  • Additionally, we have record levels of margin debt outstanding

Given that so many investors are now locked into passive investment strategies, there is no one actively employing Risk Management techniques like we and other active investment managers do.  Passive strategies do not raise cash as valuations and risks rise.  Passive strategies do not sell high beta stocks when they have had significant runs higher to protect the gains.  Passive investment strategies do not re-position portfolios to emphasize defensive or undervalued sectors when economic conditions that negatively impact the earnings of companies present themselves.

Record high levels of margin debt have historically shown that investors are too enthusiastic and not paying attention to the fundamentals.  When the market goes south, the margin debt can wipe out their investments and they then have no assets to ride the recovery higher.

Equity Valuations

Given the relentless upward movement in stock prices, and in an effort to find companies that are undervalued to add to client portfolios, I recently valued all of the holdings in the S&P 1500 using my discounted cash flow model (using Free Cash Flow as the input) and compared the resulting intrinsic value to current prices. The findings were quite instructive:

  • Taken as a group, the companies are collectively 40% over-valued
  • 310 of the companies were undervalued
  • Of these, the predominant number were Financial Services, Energy and Retail
  • One company’s DCF value and price were exactly the same
  • 1,189 companies were overvalued
  • Of these, the predominant number were Technology, Aerospace/Defense, Heavy Construction, and Biotech  (one caveat about a strict DCF using FCF, many growth companies in the tech and biotech industries do not have free cash flow as they are constantly reinvesting for growth – this can negatively impact the calculation of their intrinsic value and likely has skewed the results  – meaning the 40% over-valued result is somewhat less – when I have time I plan to repeat the exercise with EBITDA instead of FCF to check the results)
  • Not surprisingly, when I calculated the Forward Rate of Return for each company, the undervalued companies’ FRR were predominantly in the double digits
  • The overvalued companies’ FRR were predominantly in the single digits or negative
  • When I made the comparison of the 1500 companies’ Price-to-Earnings, Price-to-Book-Value, and Price-to-Sales Ratios to their 10-year median values for each ratio, I was surprised by the extent of the companies that were overvalued on these metrics
  • Only about 350 companies have ratios less than their 10-year median values, and only about 100 of them were showing undervalued on all three ratios
  • Those most consistently overvalued based upon the ratio analysis were also overvalued on the DCF analysis; those most consistently undervalued based upon the ratio analysis were also undervalued on the DCF analysis
  • When I compared the companies’ PEG Ratios to our benchmarks (1.2 preferred and 2.0 tops) I was pleasantly surprised by the number of companies that passed these benchmarks.
  • Even though P/E’s were predominantly higher than their 10-year median levels, earnings growth had to have also been higher, making the higher P/E’s more palatable

With rising interest rates on a global basis, the macro economic picture is deteriorating. Combine this with investors’ assuming more risk than is warranted for the current stage of the cycle, and equity valuations on average well above fair value, now is the time for caution and prudent risk management – NOT aggressive buying of equities or of trusting your investments to a passive strategy with no one working on your behalf.

  • Statistically, the portfolio that is cautious when the markets are overvalued and aggressive when they are undervalued significantly outperforms other styles of management including passive index styles and buy-high-sell-low
  • It can be difficult for an investor, professional or otherwise, to maintain prudent risk management standards in the face of the hype over index funds and etf’s and the hype of the high flying stocks in hot but overvalued market
  • Investing is a marathon and not a sprint – what really matters is that our clients have the largest pot of money possible when they need it (retirement is a big one) and not following the latest fad that wins in the short-term but causes the client to lose in the long-term
  • Stock market returns do not come in a straight line.  Stock market returns are not like receiving interest on a CD or a bond.  Active investment managers can book profits and raise cash when valuations get too high then use that cash to buy back shares when corrections happen.  Passive investment strategies ensure that you lose money in the correction and wait for the recovery only to get back to where you started.

I do not know when this market will roll over and correct.  There is no way to know what the catalyst for the pullback will be.  However, when it happens, I and other active investment managers who have cash on hand to purchase stock in great companies at a significantly reduced valuation will be almost as happy as our/their clients when the correction subsides and stock prices resume their march higher.

When that happens and we turn the page on this investment cycle, this Bizarro (Investment) World where prices continue higher in spite of materially negative issues will revert to an Investment World where earnings, cash flow, and valuations matter.  And I will be happy to see that happen.

Investment management is risky business and it is always best to trust a professional to deal with the complexities of generating and protecting wealth.

Here is something from this century for those of you reading this who weren’t alive in the early 80’s and may have never seen Risky Business:

And for those of you that wanted a full Bob Seger video, here is my favorite:

 

–Mark

“Never A Borrower Nor A Lender Be”

May 3rd, 2017

Screen Shot 2017-05-03 at 7.56.43 PM

Double click on any image for a full sized view

I ran across this graph of the total debt in our country and I was astounded.  The graph from Yardeni and Assoc shows that our nation has total debt of nearly $70 Trillion.

I had to stop and think about how much a trillion dollars actually is since my checking account is a few zeros shy of that number.

Look at it this way, if you were to spend $115 Billion every hour of every day of one year, you will have roughly spent $1 Trillion.  In 2016, the US government added $1.4 Trillion to the national debt, which now stands just shy of $20 Trillion.  If you look at it from a per person standpoint in our country, each person owes $60,000 to cover the outstanding debt – or a family of four owes nearly a quarter of a million dollars.

How can that ever be repaid???

When you add in the other debt, from states and municipalities, from corporations, from consumers, etc, you total $70 Billion.  Its too depressing to think about because there is absolutely no way it will ever get paid off.  We as a nation are collectively bankrupt – and the deferred liabilities like unfunded Pension and Healthcare Obligations of the US Gov’t of $20 Trillion (per the Business Insider) plus state municipal pension obligations of $1.75 Trillion (per CNBC) and corporate unfunded pension liability of $3.79 Trillion (per the California Policy Center) and we have a nearly $100 Trillion problem.

The only way out of this is to continue to print money so that the debt is paid back in severely deflated dollars.  Demographics will not allow for adequate population growth to ensure GDP grows at a +4% level, so inflation is the only answer – or such a severe depression that all the debt is wiped out but I am not ready for a Road Warrior type of lifestyle.

Screen Shot 2017-05-03 at 8.15.39 PM

Maybe not tomorrow, maybe not this year, but at some point, the chickens will come home to roost and we will have some ugly decisions to make.  At a minimum, our government cannot add $1.4 Trillion to the debt each year – don’t believe those news items saying that the deficit is shrinking like we have heard for a couple of decades.  If our spending only $400 billion deficit per year as we heard in 2016, there is no way we could have put on $1.4 Trillion in new debt.  The government has lots of ways to obscure what they do at both the state and national level, always follow the money and you will see what is really happening.

With the stock market surprisingly holding onto its gains in spite of the fact that:  (1) economic indicators have turned down, and (2) the Federal Reserve stated today that they were on pace to raise interest rates again in June, we will continue to hold onto above average levels of cash so that we have funds to invest when we finally get the over due correction.

The stock market months ago separated from the economic reality of our country – that cannot continue and the smart money is holding on the sidelines to buy when values are more compelling.  I know it is hard to sit back and see the market at current levels, but its better to give up a couple of points of upside in favors of double digit upside in the not too distant future.

In spite of the above statement, as companies in my favorite investment themes have a pull back in price, we are buying or adding to positions.  Those themes are:  cloud computing, selfies, experiences, home life, and pets to name a few.  These are all things that are in secular upswings (businesses moving operations into the cloud; people wanting to look their best knowing that there will photos of themselves on facebook or instagram; the current trend of people not spending money on stuff but spending it on events or vacations that they can experience with families and friends; the trend toward staying home and ordering pizza, watching movies, and playing video games; and the fact that people will spend money on their pets through good times and bad, particularly since the pets are part of the family and add to the home life trend).

For those of you who grew up in the 60’s and 70’s, this is for you…

For those of you who want something a bit more recent (ok, its still from the 90’s) this is for you…

Mark

Our Schizophrenic Economy

March 22nd, 2017

00Thanks to Zero Hedge for the above graphic

Double click on any image for a full sized view

 As I do most mornings, I read through various news papers and financial websites to see what is happening in the world, the markets, and our economy.  This morning, I was listening to the business news on CNBC and a guest was talking about our booming economy at the same time as I was examining the chart above that appeared under this caption:  “Industrial Production has never declined on a 24-month basis without the US economy being in recession.

How can two sources reach such diametrically opposed conclusions?

If you look at the stock market, you would think that CNBC is reaching the correct conclusion.  Check out the 5-year graph below of the S&P 500 Index:

00Looking solely at the price graph in the middle, you see a fairly consistent upward trend with only a couple of corrections and the index near an all-time high.  That sort of price action can be intoxicating and draw in investors who have been on the sideline waiting for another of those corrections in order to invest.

However, if you look at a couple of the indicators on the graph, I read those as troublesome for the market.

First, you see the two pink dashed lines that bracket the price graph in the middle.  Those two dashed lines represent a level of 10% above and below the 200-day moving average.  In previous posts here on the blog, I’ve written that these two levels are strategically important as the index historically has oscillated between levels that are either 10% above the index’s 200-day moving average or 10% below the 200-day moving average.

What this means is that from a historical perspective (and obviously there is no guarantee that the market will act in the same fashion as it has in the past), a safe time to buy stocks is when the market hits the line that is 10% below the 200-day moving average and important time to sell is when the market hits the line that is 10% above the 200-day moving average.

If you look closely, the market touched the 10% above line a few days ago and has been weak ever sense.  If you look back to the two corrections in August 2015 and January 2016, both of those drove the price down to that lower line, but the market soon recovered to higher prices.

Below is a 20-year view of the index with a weekly instead of daily price graph:00This 20-year view gives you some longer-term perspective.  Even when the market falls apart like it did in 2001-03 with the NASDAQ crash and 2008-09 with the Subprime Debt crash, with the price graph dropping below the lower line, it is still a good indicator that you should consider putting some money into the market and NOT selling at the bottom.

The other indicator that is bothering me is the PMO (price momentum oscillator) at the bottom of the 5-year graph above.  On the far right, you can see that the black indicator line has has fallen below its red signal line.   This is telling us that even though the index has not yet materially fallen, the momentum behind the move that has pushed prices higher has weakened significantly.

Check out the longer term graph below and you can see from a historical perspective the relationship between the two:

00This chart is a monthly view of the index instead of a daily.  You can see that I’ve circled that spots where the PMO changes direction and the market follows suit.  This has been a fairly reliable indicator of when the market is going to change direction.

So which is right?  Are the economic indicators that are flashing warning signs of recession correct or is the stock market that has continued to power higher based upon the hope for tax cuts and simplified regulation correct?

For what its worth, I don’t have the answer – only time will tell which right.  However, what I do know is that the stock market is over-valued by 10% or so and that we are due for it to correct back to the 200-day moving average or maybe more (see the prior blog post for a discussion of my fair value model for the S&P 500 Index to understand the 10% or so over-valued statement).

Prudent investment management dictates that we maintain a conservative posture with regard to our investment activities.  Because of this, we will maintain above average cash and fixed income reserves in order to have liquidity to buy our favored companies when the inevitable pullback occurs.

To The Moon, Alice, To The Moon

March 1st, 2017

MarketClick on any image for a full sized view

Well, we had a huge day in the market today and I thought that it deserved a bit of discussion.  As everyone who reads the blog knows, I am very cautious on the markets right now given their level of extreme excitement, extreme greed, extreme overvaluation, and negligible expected forward returns.

Take a look at the graph above – in the RSI indicator at the top of this S&P 500 Index graph, you can see the huge turquoise area above the top line.  This indicator is telling us that there is extreme excitement and buying interest in the markets and that they are due for either a pullback or a rest with some weeks of sideways movement.

greedCheck out the Fear and Greed Index above – this is one of the highest readings I can remember seeing on this indicator.  Contrary to what you are hearing on tv, market do not go in a straight line like a rocket to the moon.

Fair ValueAbove is a spreadsheet I’ve posted on this blog in the past – it is one I use to gauge where the market is valued compared to its historical valuation levels.  It uses four  different valuation measures and comes up with a weighted average valuation.  Right now, it shows that the market is 13%+ overvalued.

Expected ReturnsThis is another spreadsheet that you have seen in the past here.  It is one that I use to calculate the expected forward returns for the S&P 500 Index over the next decade.  Based upon today’s valuation for the market, we should expect a forward average annual return of 3.86%.

I know it is fun to watch your portfolio value go up when the market is on fire like it is now.  However, it is equally as gut wrenching to watch the value of your portfolio go down when the market takes a major tumble.  That is why it is imperative that investors employ risk management techniques to make sure they keep the gains in their portfolio when the market goes down.

We are employing those risk management techniques, booking gains on certain holdings, keeping cash and short term bonds on hand to protect the portfolio from the inevitable downdraft that will take the valuation down toward or below its fair value.

Our strategy will be one we have used over the decades I’ve been managing money – use that cash and those short term bonds to buy shares of companies we want to own that have superior investment characteristics at liquidation prices from investors that did not manage their risk and are panicking during the inevitable correction.

Warren Buffet has said that “You pay a very high price in the stock market for a cheery consensus.”  And that “the time to buy is when there’s blood in the streets” (I believe he was paraphrasing one of the Rothchilds in the last half).

This is in essence what we are doing – employing the greater fool theory of investing:  we sell appreciated shares of stock to someone and book our gains, then buy it back from them later at a significant discount.

The market does not go in a straight line like a rocket heading to the moon – there will be a day of reckoning  when fear “trumps” greed.  But until then our strategy will be to continue to make money off the investments we have in the market, book profits when the fundamentals so dictate, and manage our risk so that we can take advantage of any corrections and the people who did not manage their risk.

–Mark

Bonds Are Boring? Hardly

February 3rd, 2017

10 yr

Double click any graph for a larger view

With bond yields on the rise, the investment landscape has change quite a bit.  Last July marked a low spot in bond yields with the 10-year Treasury Note hitting a 1.34% yield.  You can see that low on the chart above and the subsequent steady move higher until the November election.  The move higher in yields after the election was the fastest move in yields that I have ever seen.

At that time, bond investors believed that the new administration would institute pro growth policies that would move the sluggish sub 2% GDP growth we currently have to between and 3% and 4% GDP growth.  That sort of growth is typically inflationary so investors were moving yields higher in anticipation of higher inflation.  However, you can see that since early December, investors have begun to waiver in that belief and yields have come down a bit.  However, now that the Congress is behind tax reform and regulatory reform, growth could very well pick up and yields could embark on another move higher.

If we are in fact moving into a period of sustained moves higher in rates, this could be the end of the 30+ year bond bull market that has taken yields on the 10-year from just shy of 16% to today’s 2.5%.  You can see this move in the graph below.

Screen Shot 2017-02-03 at 2.02.14 PM

The graph above gives you a long-term historic perspective.  But lets focus on the graph below that I have annotated with a red trend line that follows yields as they have fallen over the years:

10 yr bull 30 yr

The thing that bothers me is that yields have broken above the down trend line – IF this means the bull market is over, then from a purely technical perspective we could see a move to 5%.  You can see the blue line I have drawn at the double top in yields on the left side of the blue line.  The double top is a strong technical level that will act as resistance if yields approach 5%.

The real question is, from a fundamental perspective, would the economy support that level of yields?  It really wasn’t that long ago that we had 5% yields – in fact it was just prior to the Great Recession that started in 2009, commensurate with the subprime crisis.  If you were to look at GDP growth at that time, it was in that 3% to 4% range.

This is not a prediction that we are headed to 5% yields, but rather a recognition that it is possible if the new administration’s policies do in fact spur GDP growth (that is no sure thing – lots of variables enter into it).

So, for prudence sake, I want to give you some perspective on what we are doing in the face of rising yields relative to our clients’ portfolios that have an allocation to bonds.

Someone told me long ago that individual bonds are preferable in a rising yield environment.  However, bond mutual funds and closed-end bond funds (bought at a discount to NAV) are preferable in falling yield environments.  Below is some of the logic that we employ when making decisions in managing a bond portfolio.

  • Investors do not understand that they can lose money in bonds – they view them much like CD’s where a dollar in is a dollar out, plus the earned interest.
  • With a bond fund in a rising rate environment, the loss that they see on the principal of their investment can equate to multiple years interest earned, depending upon the credit rating and duration of the bonds in the fund.
  • Providing clients a portfolio of individual bonds, A rated or higher (whether taxable or tax exempt, subject to the needs of said client), allows us to structure a portfolio that has frequent cash flow for reinvestment as yields move higher and as the bonds mature at face value.
  • Even if there is some market value fluctuation, everyone knows that it is temporary, as they see those market values move to par at maturity.  You do not have this with a bond mutual fund where there is no maturity date for the bonds to reach.
  • When building a portfolio for clients, it is imperative to be sure that your positions are fully diversified with no concentrations in companies, industries or sectors.   I’ve seen several investment managers not take the same diversification precautions with individual bond portfolios that they do with equity investments.  In 2008, several managers had a significant overweight in financial industry bonds.  They were lured into them as the banks, brokerages and insurance companies were paying much higher interest rates on their bonds than similar maturity and rated non-financial industry bonds.  Their clients suffered significant and irreparable losses when Bear Stearns and Lehman Brothers collapsed.
  • Mortgage backed amortizing bonds, like GNMA’s, which are great for larger institutional clients because of their constant cash flow, are absolutely not right for individual clients.  The accounting for the principal and the interest is too complex and many individual clients view the entire P & I payment as income that they can spend – not a desirable outcome if they need to reinvest the principal for future income purposes.
  • In a falling rate environment, closed-end bond funds bought at a discount can be extremely profitable.  In the past, we have purchased both taxable and tax exempt closed end bond funds at 8% – 10% discount to NAV, collected the income, and held them until they reached a roughly 5% premium to NAV.  We easily made over double digit returns on this strategy without undue risk (we stick to investment grade corporates, governments, or muni’s).
  • Bond mutual funds also work very well in a falling rate environment.  You can purchase a fund with a long duration that will maximize your capital appreciation as yields fall and you collect the income stream as you wait.
  • If you were to have a portfolio individual bonds of similar duration as the bond funds, investors can be confused by the lengthy maturity date far into the future.  You therefore end up constructing the portfolio with shorter-dated bonds and therefore abdicating the larger capital gains that comprise a large part of long-term strategy in bond portfolio management.

One last thing I wanted to point out is bonds can have a place in an all equity portfolio as well.  There is a strategy that we utilize when a stock market correction runs its course –  we invest in high yield bond mutual funds.   The capital gains you realize from the high yield bonds as the stock market recovers are even larger than those from the stock market itself.  The high yield bonds are a higher beta way to capitalize upon the recovery with a portion of your equity portfolio – but we never allocate more than 5% of an equity portfolio to high yield – it just would not be prudent.  Check out the graph below:

HYG

This is a graph  of the S&P 500 Index showing the 2008-2009 stock market crash and recover in red and high yield bonds in blue.  You can see that the high yield strategy provides higher returns during the recovery part of the stock market cycle and then they revert to an equity level return as the recovery runs its course.

 

 

 

Why High P/E’s Matter

August 10th, 2016

Historic PEDouble click any image for a full sized view

I’ve written on the blog about the high Price to Earnings Ratio in the market right now – as you can see on the image above, from a historic viewpoint, we are at one of the highest levels in history other than during the dot.com crash and the subprime crash.  Its a funny thing, the peak reading during those crashes are after corporate earnings have fallen to minimal levels but prices hadn’t yet fallen to compensate for it.

We have had 18 months of earnings contractions while the prices for stocks have continued higher.  In other words, if you look at the P/E Ratio, you can easily see why it is climbing:  we have increasing prices (P) and falling earnings (E) so mathematically in a fraction, when the numerator is increasing and the denominator is decreasing your result is a larger number.

It dawned on my, though, that I haven’t really explained the math behind WHY high P/E ratios are a bad thing, and it all boils down to future expected returns.

As one of our clients like to say when he stops by the bank:  buy low, sell high.  The reason is that you make more profit when you for a price that is higher than where you bought, and the greater the spread between the buy price and the sell price is what yields you more profit.

Concepts like this seem simple but there is a real mathematical relationship between low and high, and you can predict what your returns will be using a formula developed several years ago by John Hussman.   I turned the formula into an excel spreadsheet so that I could project what future returns for the stock market will look like based upon today’s P/E ratio and one assumed to be in place at some point in the future.

Check out this image of my spreadsheet:
Hussman

If you look at the full sized view, you will see that this formula includes  the historic stock market growth rate using the S&P 500 Index to represent the market, the dividend yield for that index, an assumed 10 forward investment horizon, the current P/E ratio for the index and the forward P/E ratio for the index from today’s Wall Street Journal Online.

You can see that using the formula shown on the spreadsheet, with the P/E ratio at today’s elevated levels, we can expect an average annual total return on the S&P 500 of 4.02% including dividends, significantly less than the historic average of 8.69% (you can see the calculation of that return in the pale yellow box on the right side of the image.  You can see that buying at these elevated levels depresses future returns.

But what happens if we have a market correction and the forward P/E normalizes to its historic reading of 15?  Here is that calculation:

Hussman 2

All else being equal, a correction in the stock market that dropped prices so that they caught up with earnings (decreasing prices and decreasing earnings in this scenario), your forward expected average return for the next decade is 2.23% including dividends (which are estimated to be 2.01%).  Buying near historic high valuations has a big impact on your future returns.

However, just as you might expect, if you are brave and buy into a correction when the P/E has fallen to near-bear market lows of 7, and wait for it to grow back to the historic average of 15, your results are completely different:

Hussman 3In this scenario where you did in fact buy low and sell high, your average annual total return is 14.59%.

In this blog, when I talk about the risk/reward ratio (I know I have and I likely didn’t explain what I meant to an adequate degree) this calculation is a good example of it.  Buying now when the valuations are high mean you are assuming the risk that the P/E falls toward its historic average but your expected return is barely above inflation.

But by buying when the market has corrected at a low valuation (albeit when its very scary to put your money into the stock market) and waiting for the market to just normalize to historic average valuations, your risk is low but your expected return is exceptionally high.

For this reason, we are maintaining our cautious stance on the market, being opportunistic when we get short-term pull backs and putting cash into the market, but being prudent and taking cash back out of the market when it moves back higher.  When will we get the big correction?  No one knows but you have to be prepared and invest your money wisely, buying low and selling high, not the opposite.  Its better to be wise and smiling than greedy and crying.

For all you classic rock fans out there, I’ve been listening to Willies Roadhouse on XM Radio – so bear with me as I play some of my favorites from there before we return to Styx, GNR, and other popular choices here on the blog:)

Mark

 

 

When Growth Becomes Value

July 26th, 2016

When a growth stock with a high P/E Ratio drops in price yet their EPS growth is up significantly from just six years ago, you get a Growth Stock at a Value price!

GILDDouble click on any image for a full sized view

Gilead Sciences is a top notch Biotech company that has seen its stock price tumble more than 30% over the last year along with most of its competitors.  The biotech industry had the unfortunate luck to be painted with the same brush as the drug company that overnight raised the price on one of its drugs 5000% when a new owner took over.  The political establishment jumped on this and made statements about punishing the industry when it was really just one bad owner who needed to be corrected.

At the current price, Gilead trades at a 6.75 P/E ratio when the stock market is trading at a 25 P/E ratio.  It projects that it will earn $30 Billion this year.

It has two bread and butter franchises:  one is an HIV franchise that has been revitalized with a new drug that is out performing expectations (according to analyst David Katz) and the other is a Hepatitis C cure (not just a treatment but an actual cure) that has been so successful for so long that the market for this drug is shrinking, albeit slowly.

This last issue, the shrinking market for its Hep C cure has the market up in arms and when earnings were released today investors sold off Gilead for a > 6% loss on the day because it lowered its revenue guidance from $30.5 Billion to $30 Billion.

I was one of the buyers today and made a bit under 1% for our clients in our growth strategy, doubling down on our current position – unfortunately, I was also a buyer when the stock was down a bit more than 25% but the fundamentals justify the purchase decision.

So I thought I’d give you some insight into the sort of analysis we do on a company like this that leads me to buy it.

1.  GILD has 61 products in Phase III trials per CMLviz (the last step before the FDA can approve a drug).  Investors should not be overly concerned about the Hep C market shrinking when somewhere in these 61 new drugs there could be one or more that will be block busters like the two principal franchise it currently has.  Having this number of drugs in Phase III trials is a catalyst for future earnings growth many company’s could only wish to have.

2.  We are buying this classic growth stock at a significant discount to the market (6.75 P/E ratio).  Normally, you only get to buy deep cyclicals at this sort of valuation, not a company earning $30 Billion this year with 61 potentially significant catalysts to earnings on the horizon.

3.  Investors get a > 2% dividend yield on a biotech stock.  In all the years I’ve been a growth stock investors, it has been tough to find companies that are growing their earnings faster than the market and the economy while paying a dividend yield  greater than the yield on the S&P 500 or the yield on fixed income investments.

4.  Check out this graph of productivity (Revenue per Employee):

GILD rev empGilead is off the charts compared to its competitors (graph courtesy of CMLviz)

5.  Check out this graph of efficiency (Revenue per $1 of Expense):

GILD rev expAgain, Gilead is off the charts compared to its competitors (graph courtesy of CMLviz)

6. Check out this graph of Revenue Growth (you can see why its a growth company):

GILD rev growthNormally, the earnings multiple valuation for a company like this is higher than the market multiple – because of the political impact, you are getting a growth stock for a value stock multiple.

7.  When I calculate the target price for GILD using our multi-factor valuation methodology, I come up with $148 or 80% potential upside.  Gilead is currently trading at the bottom of its 52 week price range.  The risk to reward ratio is clearly favorable.

8.  The Morningstar Fair Value price for GILD is $124 (making it 34% undervalued today) and their Sale Target is $168 (or 100%+ potential upside).  The risk to reward ratio is clearly favorable.

9.  When I perform our standard calculation for under-valued Vs over-valued, I come up with a fair value today of $126, making it currently 35% undervalued.  This is based upon an extrapolation of next year’s earnings estimates, book value, estimated sales, and estimated cash flow using a ten-year weighted-average of the Price to Earnings ratio, Price to Book Value Ratio, Price to Sales Ratio and Price to Cash Flow Ratio.

Given the superior operating performance of Gilead Sciences, Inc., its potential earnings growth catalysts, its above average dividend yield, its current undervaluation and the potential upside leading to a superior risk to reward scenario, Gilead is a buy in my estimation.

One thing to remember – even though a stock is cheap, it can always get cheaper.  If Gilead drops in price some more, I will be a buyer – investing is a long-term activity that cannot be constrained by a calendar.  Yes, I might not be a winner on this one stock by 12/31 when clients get their annual statements.  However, buying good companies with strong earnings power at cheap prices is the hallmark of how you make money investing in stocks.  You don’t always see the results tomorrow, but you will see the results with patience and conviction.

Mark

Brexit Bounce Back

June 29th, 2016

The common stocks that make up the S&P 500 Index have experienced their second day of recovery as investors now realize that the actual exit in Brexit will not occur for a long time into the future.

SPX 2016-06-29

Double Click on any Image for a Full Sized View

If you look at the graph above, you will see that I’ve drawn some Fibonacci Retracement lines that mark the high before Brexit was announced and the low two days ago.  As of close of market today, we have retraced 62% of the Brexit Breakdown.

Below is the action for today only:

spx today

You can see that the market topped out today about 45 minutes before close and the computers kicked in, sending it lower while the Stochastic was in overbought territory.  This indicates that we could open lower tomorrow as people take profits they’ve made on this short term swing.  It will not impact us because we intend to hold our beta plays until the market gets back to or above 2050 as fits with my stair step lower scenario for the market for the balance of the year.

As far as the purchases go that we have made during the recent drop, the strategy was two pronged:  continue to move money into companies that are primarily domestic in keeping with the turmoil in the rest of the world or to move money into defensive or recession resistant companies that will have less volatility on the downside in keeping with my market scenario for the balance of the year.

The defensive or recession resistant investments did not move up as much as some of the higher beta domestic investments, but that is expected.  Here is a sample of the performance of some of the purchases the past few days:

AT&T up 1.50%

Nvidia up 2.50%

Southwest Airlines up 5.45%

Waste Management up 0.97%

Dominion Resources up 3.21%

United Kingdom ETF up 0.79%

This is on top of the 3.5% we made on the Long Term Treasury ETF we used to hedge against the correction and give us the freedom to capitalize upon the market moves.

I’ll be back with more as the market makes it moves – and I hope you enjoy this Pitbul remake of the classic Rolling Stones song.

Mark

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