When stocks are attractive, you buy them. Sure, they can go lower. i’ve bought stocks at $12 that went to $2, but then they later went to $30. You just don’t know when you can find the bottom.
—PETER LYNCH
At this point, I am in the process of putting everything together. By now, you should understand fundamentals and be able to identify certain behaviors that can affect your performance and your concepts of value. However, it can still be difficult to piece everything together in a way that creates a solid foundation for success. Therefore, in these final three chapters, I am going to lay out a guideline that I have used to become successful. The neat thing is that you don’t have to follow my exact guideline, but you can find parts that work for you and then incorporate the ideas into your own strategy. My goal is not to change everything about your investment style but rather to challenge what you believe is correct and allow you to make your own decisions once you see a few alternative methods.
A few years ago, I set out to develop a system that would allow me to find value on a consistent basis and would return gains most of the time. What I found is that such a system does not exist, and if someone tells you that such a system does exist, then you should run. In the market, there are no 100 percent guarantees. You can do all your homework and put yourself in the absolute best situation and still be wrong. However, in 2010, I created and began using what some now call the ten-ten-to-ten system. This system was created with the idea of finding the perfect balance of growth, valuation, and performance to ensure that you are not buying too high and that you are buying a fundamentally growing company. The term ten-ten-to-ten refers to 10 percent for all three of the measured metrics that in theory would suggest a perfectly valued company. Therefore, inconsistencies can indicate a stock priced too high or too low.
The system takes into account three very basic measurable items—price/earnings (P/E) ratio, earnings growth, and stock performance—by allowing you to see how a company is currently valued compared with its growth. Now I must add that no due diligence should be complete with a system this simple. However, this system can help to eliminate certain companies as potential buys and allow you to separate out companies that are presenting value. Therefore, you can research other areas of growth and spend more time looking at other important metrics. However, one fact that I have found to be true is that there is such a thing as too much research. It can cause you to contradict yourself and allow one negative to overshadow 10 positives. Just remember, a stock is kind of like a spouse—they all have flaws, but hopefully you can make the best all-around choice with the fewest number of flaws. As a result, you can use the ten-ten-to-ten system to identify which is the cheapest stock in terms of performance to valuation to growth.
In theory, a company with 10 percent growth, a P/E ratio of 10, and a one-year return of 10 percent would be fairly valued. Hence a company with 10 percent growth, a P/E ratio of 20, and a one-year return of 5 percent would be a stock that is overvalued compared with its growth (P/E ratio greater than year-over-year earnings growth) and a stock that is now posting slower returns in terms of performance. Therefore, the stock could quit returning gains until the three metrics are balanced or are at least in the same proximity. The truth is that I could write an entire book discussing this one strategy, and a whole book probably would be necessary to achieve a detailed explanation of its purpose. However, at this point, the strategy should be used only to find inconsistencies and to compare a company’s valuation with its growth. You also can add to the metrics used and incorporate revenue growth to get an even better sense of valuation. Let’s take some time to look at some examples (see the following table) to show you how this can help in identifying a potentially undervalued company.
The first area you always want to look at is the company’s earnings growth. Second, you compare it with the stock’s one year return. If the company’s earnings are growing faster than its stock (as with Apple), this tells you that the stock is even cheaper than it was last year despite a yearly return. This situation is the perfect scenario and exactly what you seek as a value investor. In fact, Apple has had so many years of posting earnings that grow faster than its stock that its P/E ratio is under 14, similar to a company that is posting flat or minimal growth.
Another point to consider is that when a company grows larger, its metrics decline in size. You don’t see too many $100 billion companies with P/E ratios of 100 (except Amazon), so as a company grows larger, the P/E ratio becomes less relevant (assuming that it’s under 16), and the company’s earnings growth compared with stock performance becomes most important. My theory is that I always want to see a large company post higher earnings growth compared with stock performance, as with Microsoft. Even though its growth was only 23 percent year over year compared with a 20 percent yearly stock return, its P/E ratio is 10.4 (which is very low even for a large company). This indicates that the company’s stock is moving according to earnings, yet over time the stock continues to get cheaper as it grows, which is a phenomenon that should occur. It indicates that the stock is moving in the right direction.
In the case of Lululemon, the company’s stock is moving faster than its earnings. This means that its P/E ratio also will continue to increase, and the stock will become more expensive. Theoretically, if the company were trading with 50 percent earnings growth, a 50 percent return, and a P/E ratio of 50, then it would be priced better for fair value. As value investors, we would not be willing to buy unless the growth exceeds the return, and the P/E ratio is less than the year-over-year growth. For example, 50 percent growth, a P/E ratio of 45, and 45 percent return would be much more attractive. Remember, when considering value, you must take into consideration the company’s growth. It’s not all about P/E ratios, although they are very important.
Intuitive Surgical trades with a P/E ratio far above earnings growth, and its stock is growing nearly 70 percent faster than its earnings. This indicates that the stock is not only overvalued but also could experience a period of years where it either sees no return or even trades significantly lower. Even then it still may be overpriced. Under Armour is an example of what I expect from Intuitive Surgical in the next couple years, possibly sooner. Under Armour experienced several years where the stock grew much faster than earnings. As a result, the company is still growing by 41 percent year over year, but its stock rose only 10 percent last year, allowing the P/E ratio and the growth of earnings to match more closely. You can see with 41 percent earnings growth that the company still has quite a wait before its value will reflect its earnings. So basically UA could be a meaningless hold unless your goal is no return.
Foot Locker, on the other hand, is a perfect example of an undervalued stock with growth that far exceeds value. Foot Locker’s earnings are growing more than double the speed of its stock price, and its P/E ratio is less than 25 percent of its earnings growth. This indicates that the stock could experience a very long uptrend and return very large gains. I am not suggesting that it could carry a P/E ratio of 60 because all industries are valued differently, but at its current valuation, it is very possible that it could now grow with earnings, maintain its current P/E ratio, and still be considered undervalued.
Panera Bread, in my opinion, is fairly valued, perhaps a little undervalued, and if it continues on this route, it could become a great value investment in 2013. In this case, the company’s 30 percent earnings growth and its P/E ratio of 30 are near the benchmark for the ten-ten-to-ten strategy. Its one-year return of 17 percent shows the correction that took place in its shares, which is what will most likely occur in shares of Intuitive Surgical, Lululemon, and Under Armour. Now that the company’s valuation matches its growth, the stock can trade with more consistency and be more rewarding to its shareholders. I would not call it a value investment but rather a fairly valued investment.
Let’s say that you are considering three potential investments. You like each company equally and believe that they would all make good investments. You think each is priced well, but then you use this very simple formula, and it eliminates one. You can then perform additional due diligence to determine whether or not both companies are expanding and operating efficiently, and you can perform a comparison of their balance sheets or cash positions in order to determine which is the best. Sometimes investing can become overwhelming with so much information that it is nearly impossible to cover each aspect of a company, especially because changes in the market happen so speedily. This formula is to serve as a starting point and is something I have used for the last few years to find companies with earnings growth that far exceeds stock performance.
Before I conclude the discussion of this strategy, I want to show you an example of how this strategy works. The examples I just explained are stocks at their current positions that I used to determine whether any could be presenting a good buying opportunity. But the following table shows McDonald’s (ticker symbol MCD) metrics; this is a great company, but a company whose stock performance exceeded its growth, which has since led to a correction.
The first thing to do is to look at the first row of data. This information is from the full year 2010-2011 and takes into account the stock’s growth year over year and then its stock performance from December 2010 until December 2011. Notice that the stock had gains of 31 percent despite earnings growth of only 11 percent. Sometimes this is okay, but only if the stock has a P/E ratio that is below its earnings growth. For example, if the stock’s P/E ratio is 5, then it would be acceptable. However, its P/E ratio is nearly double its earnings growth, which means that the stock is growing much faster than its earnings. When this occurs and you see metrics such as this, you can be certain that the stock most likely will correct, unless the company all of a sudden begins growing by 30 percent year over year. And since McDonald’s is a $90 billion restaurant, its chances of such aggressive growth are slim to none.
Now that you can see how overvalued shares of McDonald’s were trading at the end of 2011, let’s take a look at what happened next. In the first quarter of 2012, the adjustment period began to occur. The company’s earnings grew by only 5 percent, and its stock lost 14 percent of its value during the first six months of 2012. However, its P/E ratio is still 16 despite earnings growth of just 5 percent, which is probably consistent with its full-year earnings growth throughout the remainder of 2012. But since McDonald’s is a massive multi-billion-dollar company that is well established and will continue to thrive, we have to consider a slight premium for its valuation because, after all, this is McDonald’s that we’re talking about. However, even with its 2012 loss, I still wouldn’t buy nor would I consider the stock to be a value play. Most likely the stock will maintain a level of flat trading for the next 16 months until its metrics are more aligned. Some investors even may be tempted to buy because of its loss. Yet this is a perfect example that just because a stock falls doesn’t mean that it is presenting value. Its growth is still nowhere near its valuation, and the distinction is simply too large for McDonald’s to be considered a value investment.
If you determine that this formula is something you believe could be beneficial to your own strategy, then you need to identify extreme differentiations between value and growth (which is value investing). This strategy is yet another that can be incorporated using limits to find a cheap purchase price while eliminating emotion. I can tell just by looking at the earnings growth compared with performance and the P/E ratio that both Foot Locker and Apple are undervalued. There is a major misconception among investors that value is cheap, which means a stock only presents value when it is trading lower. However, this is simply not the case. A stock can easily trade flat for six months, yet it may grow by large margins and become a value if the company had a fair valuation at the start of the six-month period of flat trading. Similarly, a company can grow by 20 percent with a P/E ratio of 10 and stock gains of 5 percent and still be presenting upside and could be a good investment with further research. Whether you return gains or loss, it all depends on when you buy. This very simple formula can help you to determine whether a stock is presenting value. However, you must remember that this simple strategy is one step, not the only step in determining a buy. It just gives you a good start.
One of the more frustrating investments is the one that involves a great company but a horrible stock. In Chapter 7, I discussed short interest and short-interest ratios, and I indicated that when companies have high ratios using these metrics, they are often kept trading below their worth, regardless of fundamentals.
One of the most frustrating stocks I’ve ever owned is Spectrum Pharmaceuticals. I’ve owned it for several years and have returned very large gains, but the company constantly remains below its worth. It is one of the fastest-growing biotechnology companies in the market, and it has a diversified product line, a large pipeline, a lot of cash, and every positive indicator that you’d look for in a company. Yet it remains around $13 per share.
Perhaps the most significant reason that Spectrum trades with such an undervalued stock price is that it has high short interest and a high short-interest ratio. The stock is trendy, and once it reaches certain price levels, it trades lower aggressively. Over the last few years, it has had several periods where it would rally and reach new highs, but then it falls and trades to a lower level, although higher than previous lows. As a result, it is always trading in an uptrend, but the trend itself is very frustrating because this is a stock that should be trading at two to three times its current valuation.
Now here is where you test your patience as an opportunistic value investor, with companies such as Spectrum Pharmaceuticals. What is the correct way to play a company with sales growth of 50 percent, earnings growth of 90 percent, and a P/E ratio of under 8? Also, keep in mind that the company has a great balance sheet and strong cash flow to complement its fundamental growth. Your gut tells you to buy the stock, but because of its performance, you hesitate and may even start to believe that it’s a deadbeat investment, which means that you believe it won’t trade higher.
There are many stocks such as Spectrum in the market. Spectrum is a biotechnology company, and this particular industry is driven by speculation, rumors, and perception, unlike any other in the space. Therefore, in biotechnology, you have a large distinction in value, with some companies overvalued and others undervalued. But the good news is that even in an industry such as biotechnology, eventually a company’s fundamentals and its valuation will align—but it may take some time.
In Chapter 9, I talked about Sprint and used it to explain how performance changes perception. When a stock falls, there are more investors who are pessimistic, but when it trades higher, all are optimistic. As an investor, if you expect to succeed, you need to change this thought process and be greedy when others are scared and scared when others are greedy. Companies such as Spectrum at $13 with a $780 million market capitalization or Sprint with a price under $2.50 and a market cap of $7.5 billion will eventually rise. These companies, and many more, have seen too great fundamental improvements to be kept down long term, and almost always when a stock falls in the category of “great company, horrible stock,” once it starts to rise, the rise is very quick and very aggressive. Therefore, those who endure the volatility and frustrating returns are almost always rewarded with large gains.
Perhaps the best indicator of which stocks to buy and when to buy should be the economy. Now keep in mind that I didn’t say the market—I said the economy. Sometimes the market will trade higher despite slowed growth and a horrible economic outlook, and at other times it will trade lower despite improvements in the economy. A good example may be the auto stocks in 2011 and in the first quarter of 2012. Both Ford and General Motors have continued to create new lows despite being two of the true bright spots in the economy (a major sign that both stocks will rise).
Throughout this book I’ve told you to simplify the market and to try not to learn everything about all the companies that trade in the market but rather focus on certain industries or certain stocks and then broaden your knowledge over the course of years. However, one other way to break down the market and make it smaller is to monitor cyclic and secular companies by the strength of the economy. Allow me to explain.
A cyclic company will grow with a strong economy. It needs good growth and strong demand, and when these two catalysts are present, these stocks will flourish. These are companies that produce products that grow in demand when the economy is strong, such as steel and chemicals and, in some ways, the automotive and banking industries.
A secular company, on the other hand, does not need a strong economy to grow. It will perform well regardless of the economy. In fact, such companies tend to thrive in flat or even down economies. The reason is that secular companies create products that we must use, and when threatened in a down economy, investors will transition their money into these stocks as a form of protection against the down economy. Examples of industries in the secular space include food, dishwashing detergent and household necessities, biotechnology, medicine, and the less healthy tobacco and alcohol companies.
So how do you play secular and cyclic? A good way to play these trends and invest on the strength of the economy is to break the market into two sections, secular and cyclic. If the economy is thriving, then invest heavily in undervalued cyclic industries and/or companies. But when the market is flat or struggling, then buy stocks in companies that produce medicines that must be used, such as for cancer or diabetes, or Phillip Morris and Anheuser-Busch because people have to take medicine and will smoke, drink, or both regardless of the economy. Once you learn how to identify the direction of the economy, combine it with knowledge of the undervalued stocks in the space, and your returns will increase by an incredible margin and you’ll be one step ahead of everyone else.