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Jubak's Journal
Recent articles:
• Lost in the market fog? Follow the dividends, 9/2/2003
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3 stocks to navigate a tricky quarter
With markets on a tear but a traditionally weak period looming, look for stocks that combine momentum with value that limits downside risk.
By Jim Jubak
Value and momentum are two words seldom linked in a single investment strategy.
Value investors concentrate on finding stocks that the market has priced below the fundamental value of the business. Sooner or later, they believe, the market will come to appreciate that value and price the stock accordingly.
Momentum investors pay little, if any, attention to fundamentals. All that counts is how much upward momentum is in a stocks price now. Momentum investors want stocks that are moving higher in hopes theyll move even higher. And when the momentum fails, they sell.
Ordinarily, the two strategies have little in common.
But combining the two is the best way to navigate the tricky currents of the 2003 third quarter. A value strategy helps control risk. And momentum gives investors a chance to profit from higher prices when the economy rebounds and beaten-down stocks start to move up. By combining these strategies, investors can reap some profits now thanks to the enormous upward swing of this market as it comes out of its summer run-up.
Heres why I think a value/momentum strategy fits the current third quarter, plus three picks -- Reliance Steel & Aluminum (RS, news, msgs), Black & Decker (BDK, news, msgs) and HCA (HCA, news, msgs) -- to use to put this strategy to work in your portfolio.
- Stocks stormed through the historically soft month of August. Well, stormed for an August, anyway. The Dow Jones Industrial Average ($INDU) finished up 2% for the month, the Standard and Poors 500 ($INX) up 1%, and the Nasdaq Composite, ($COMPX) 4%. The Dow and S&P performances may not seem like much, but, for both indexes, over the past 50 years, August has been the fourth-worst month of the year.
- And they started off September with a rush, too. The Dow climbed better than 100 points, the S&P 500 finally broke through its July high, and the red-hot Nasdaq Composite tacked on another 1.7% gain.
- The economy is showing signs of life. Seemingly everywhere you look -- the Institute of Supply Management, retail sales, durable good orders consumer spending -- the signs are pointing to a recovery.
But the momentum in both the market and the economy hasnt silenced the skeptics. Each move up in the major indexes unleashes another round of criticism.
September is the cruelest month
And September, of course, is the worst month of the year for stocks. Since 1950, the Dow has fallen in 35 of 53 Septembers, according to the Stock Traders Almanac. The S&P 500 fell 32 times in the same period. The statistics favor sitting September out.
This year brings its own reasons for staying on the sidelines. After rallying since March, stock valuations look stretched. Intel (INTC, news, msgs) trades at 39 times projected 2003 earnings, and thats cheap compared with EMCs (EMC, news, msgs) multiple of 80 times projected earnings. Genentech (DNA, news, msgs) trades at 68 times projected earnings, and Cummins (CUM, news, msgs), the big engine and generator-system maker, trades at 42 times projected earnings.
Those sky-high multiples increase the potential punishment that awaits any stock that produces an earnings disappointment in the third quarter. Thats especially true for tech stocks. Technology orders in the quarter can be deceptive. Optimistic customers tend to over-order with suppliers so they dont run out of critical parts for the fourth quarter. That can lead to late-quarter cancellations as customers finally cancel double or triple bookings. Then, some customers wait until the last minute to place orders. Result: unpredictable, back-loaded quarters in which suppliers dont know what their order books look like until the last minute.
And finally, paradoxically, the angst about the markets direction hasnt made investors shy away from investing. The Chicago Board Options Exchange volatility index ($VIX.X, news, msgs) hovers at around 20, its lowest level in five years. That means there are relatively few fearful investors who can turn bullish and drive stocks higher with their buying. The number of shares sold short as a percentage of market volume has fallen, too, removing another source of fuel for continuing the rally.
Many technical indicators show this market is overbought. Investors who follow these indicators know, however, that stock markets can be overbought for some time before theres any pullback or correction.
Its this combination of fundamentals and risks that makes a value/momentum strategy well suited to the third quarter.
Value stocks are relatively low-risk because their modest price-to-earnings ratios (or other valuation multiple) will generally fall less than the market in any correction. And by buying these stocks now, an investor will be adding positions in the kind of cyclical stocks that do well in the early stages of recoveries.
With momentum stocks, the investor is buying exposure to the upward trend of the market. Plus hes getting stocks whose values at least a few investors already see. This works to his favor by reducing the time that he must wait for the market to recognize the stocks fundamental value.
Portrait of a value/momentum stock
So what does a value/momentum stock look like?
Like Reliance Steel and Aluminum. This Los Angeles-based provider of metals processing services sells more than 85,000 products to some 85,000 customers in the U.S., Europe and South Korea. Its a proxy for a recovery in the manufacturing sector of the economy.
The company is coming off the bottom of a deep cyclical earnings trough, Earnings per share fell from $1.37 in 2001 to 95 cents in 2002 to 75 cents for the 12 months that ended in June.
But earnings are now forecast to climb to 90 cents a share for all of 2003 and another 60% to $1.45 in 2004. That growth will take the stocks price-to-earnings multiple down from 31 now on trailing 12-month earnings to 26 projected for 2003 to 16 projected for 2004. I think theres good value in a stock trading at 16 times projected 2004 earnings -- and has the potential to grow earnings 60% in the same year. And it doesnt hurt that the company has exceeded Wall Street earnings estimates by 20% and 11% in the last two quarters.
What happens if the market turns down? Because its a value stock, Reliance is less volatile than the market as a whole. Its beta is 0.8; the general market has a beta of 1 by definition.
Now, consider the stock as a momentum play. The stock bounced off its 50-day moving average on July 16, just about a week after the 50-day average crossed above the 200-day moving average. The stock earns an A technical rating from our StockScouter, and its relative strength has moved up to 65 over the last three months from 23 for the last 12 months. The shares recently hit a 52-week high, but momentum indicators say that this one is headed higher.
Two more names that fit the bill
Black & Decker moved above its 50-day moving average on Aug. 24, and the stock is still about $4 a share below its 52-week high. It trades at 14 times trailing 12-month earnings per share, at 12 times projected 2003 earnings, and at 11 times projected 2004 earnings. Wall Street projects that earnings will grow by 10% in 2004.
HCA has moved up steadily since June, when value investor Warren Buffett began accumulating shares. (Berkshire Hathaway (BRK.A, news, msgs) didnt disclose that its Geico subsidiary bought 10 million shares until an August filing with insurance regulators.) The stock moved above its 50-day moving average on July 24 and above its 200-day average on Aug. 26. Relative strength has climbed to 76 in the last three months from just 6 over the last six months.
Earnings per share should rebound in 2003 to $2.81 from $1.56 a year ago. The bulk of the companys legal troubles are behind it. (The company reached a $631 million settlement with the U.S. Justice Department over allegations that it had overcharged Medicare.) Its 2004 earnings may reach $3.07 a share. That puts the P/E ratio at 14 on 2003 earnings and 12 on 2004 earnings, down from 24 on trailing 12-month earnings per share.
Im going to add two of these stocks, Reliance Steel and HCA, to Jubaks Picks with this column.
Im also selling Performance Food Group (PFGC, news, msgs) out of the portfolio because it has hit my target price.
Dont get the idea that this is a raging endorsement of the current market and its current momentum. It remains risky out there. My recent picks, including Exxon Mobil (XOM, news, msgs) in my Sept. 2 column, are attempts to give Jubaks Picks exposure to the very real existing technical and macroeconomic momentum without adding too much risk to the list.
You might even say these picks are an attempt to balance value and momentum.
Sell Performance Food Group
Performance Food Group has hit my target price of $40 a share. After upping my target price once, I think its time to sell. The stock is up 22% since I added it to Jubaks Picks on Sept. 24, 2002, at $33.06. The stock now sells at 26 times trailing 12-month earnings -- pricey for a food distributor. (Full disclosure: I will be selling my own position in Performance Food Group three days after this column is posted.)
Buy Reliance Steel and Aluminum
Consider this stock a proxy for the recovery that seems to be gathering strength in the manufacturing sector. Despite the stocks recent momentum, it remains a good value on projected 60% earnings growth for 2004. And the stocks relatively small market capitalization of just $740 million gives Jubaks Picks some much needed exposure to the small cap sector. As of Sept. 5, 2003, Im setting a target price of $32.20 for Reliance Steel with a deadline of July 2004.
Buy HCA
The countrys largest hospital chain, HCA did nothing but disappoint investors for the year that began in June 2002 when the stock traded at $51.90. Disappointing earnings and a federal investigation into alleged Medicare overcharges dropped the stock to a low of $27.85 by April. But, with the Medicare settlement behind it, HCA looks as if it will start churning out earnings again. Wall Street sees earnings per share of $3.07 in 2004. As of Sept. 5, Im adding this one to Jubaks Picks with a target price of $54 by September 2004.
New developments on past columns
Lost in the market fog? Follow the dividends
Wall Street analysts keep predicting falling energy prices but the real world so far has been moving in the opposite direction. From Memorial Day to Labor Day, crude oil futures climbed by 8.3%, about twice as fast as they usually do during the summer months. And with tight inventories and refineries already running at capacity, some analysts are starting to talk about the possibility of $30-a-barrel oil for the rest of 2003. Crude oil inventories finished last week at 283 million barrels, an increase of 3.7 million barrels from the previous week but still 7% below inventory levels at this point in 2002. Prices at $30 would be good for energy stocks such as Exxon Mobil (XOM, news, msgs), if not for the economy as a whole.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Performance Food Group. He does not own short positions in any stock mentioned in this column.
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