Thursday, January 27, 2005

FROM SMALL TO VALUE

MAKE THE MARKET MOVE OR LIVE WITH THE CONSEQUENCES!

One reader says he missed my call to move from small caps to value. Actually, for several months I have written that the sectors I like are defensive in nature such as health care, consumer staples and energy. I have written more than once that it is time to buy "the big, the dumb and the ugly". I have said several times to reduce small caps and stocks that have a high correlation coefficiency to small caps such as emerging market stocks and high tech manufacturing stocks. Finally I have offered to monitor accounts because it is much easier to talk about what to do if I can see what has been done.

In one of my moderated retirement accounts, the owner noted my call to sell small cap funds and has moved 100% of funds to a value equity fund. This is a young person who aggressively puts 100% of a still relatively small retirement fund into one fund. A quick assessment shows the total returns for 2004 to be better than 16% and the account hit a home run in 2003 doing 84% in an international growth fund.

This year, the account is off 2.87%. This return is excellent when compared to the 4.31% loss suffered by the small gap growth fund. Of course a perfect market timer (no such thing) would have moved to the money market on the last day of 2004 and would have moved back to stocks a few days ago.

SMALL STOCKS UP 1400 PERCENT--BUT SMALL STOCK RETURNS REGRESS TO THE MEAN!

In the 9 years following the real estate recession of 1974, the average small stock increased 15 times in value! Yes, the average small stock was a 15 bagger! Any poor slob who had money and the courage to invest at the market bottom in 1974 made a return of 1,500% in 9 years if he bought the average small stock! $10,000 would have become $150,000. Many stocks did 3 to 10 times as well. A smart and lucky investor could have turned $10,000 into 1.5 Million. (The figures are posted from my memory of Ibbotson and Associates studies).

Of course, sooner or later the worm must turn and in 1983 it did. From 1983 to 1990 100% of the over-performance was lost! The really bad thing is that many investors waited until the market was roaring in 1983 to buy small stocks (I naively bought a few myself including my all time best performer which has returned 120 times its original value). Please remember the way news works--the super performance of small stocks was not reported widely until the spring of 1983--nine years after the start of the run!

Folks it has happened again. I just ran a chart on the Value Line Arithmetic Index. The S&P 500 and most other indices are market weighted. This means the really big stocks account for most of the moves. The Value Line Arithmetic Index out-performs the S&P when small stocks do well. This index has gone up 14 times in value since the 1990 real estate recession!

There is a possibility that small stocks will go through a blow off phase for the next few months. They could jump 20% or more in value pulling in some greater fools. I personally will not be playing the game. Partly because, after the bubble, investors may be too skitish to pile on. Also because the rotation appears to have already begun. High tech stocks stopped over-performing many months ago and small stocks turned a few weeks ago. Again, I plan to buy mostly out of favor stocks for the next several years while continuing to hold my high flying internet stocks.

Out of favor stocks are those that are dull but cheap. The nominal price is not the important factor. Stocks that trade low relative to the underlying value are what I will seek. Measures such as price to book value per share, price to earnings per share or price to sales per share will be important considerations. I am now much more likely to look at the PEG ratio before buying a stock. (The PEG ratio is the ratio of the PE to the Growth rate.) Next week, I plan to post at least one value stock. I will post as often as I can. As always I must inform you that I am only an amateur. I cannot recommend that you buy anything. I have 42 years experience buying stocks including a career as a professional but as a retired amateur, I write for education and entertainment purposes.

FOR EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY!
I have mentioned that I keep buying airline stocks in MY aggressive account. Some of these stocks do not have PE's because they do not have earnings. In some cases they do not have price to book ratios because their book values are negative numbers. Buying these stocks requires bravery or stupidity and it is only in hindsight that we will know which. The fact is that I have purchased stocks with negative book values before and made really good money on many. The most recent example was the purchase of Nextel (NXTL) at $3.90 per share. I later added more shares but on the original shares I have an unrealized gain of about 750%.

The measure that shows airline stocks to be really cheap is the price to sales ratio. You have all heard the old saw about the guy that was losing 5 cents per dozen selling eggs and decided to make up the difference by selling more eggs. The airlines keep competing for market share in the hopes that a competitor will be the first to go out of business. If one or more of these companies go out of business, then the remaining firms may start to have a profit margin to multiply times all those sales. The earnings could be big for the next 10 years.

Winston-Salem received good news today. USAir will consolidate its reservation center in the partially empty center here in town. Piedmont Air was founded in Winston and has always had a work force presences here. With most travelers booking over the internet, the need for large numbers of reservation assistants is a thing of the past. Winston has had other good news recently. Dell computer will add a factory here, Reynolds Tobacco purchased Brown and Williamson and brought the work here and Low's has added a computer center here.

All this good news for Winston-Salem ties back to where we are in the economic cycle. The economic recovery is over and the expansion has begun. During the typical expansion pressure will be on the cost of resources. The price of raw materials, labor and money will all trend up ward. Companies will have to watch their cost to make profits.

In many ways, the current economy is similar to what happened in late 1984. Long interest rates went down in 1984, large cap stocks began to perform well and the small caps ended their very long run (small caps typically continued to go up a little in price, just not nearly as much as the large caps). Three years later, October 19 of 1987, interest rates had spiked and the market dropped something like 15% in one day. The good news is that we are not close to 1987 yet. We should have at least a couple of better than average market years ahead of us. I remain 100% invested in stocks with no bond allocation. I am a relatively aggressive investor who is becoming more selective about which stocks to buy.

GOOGLE EARNINGS

Google will announce fourth quarter earnings on February 1st. The good news is that as is indicated by the very high advertising revenues reported by YHOO, the report should be good. The bad news is that earnings reports for high flyers is often at best good and at worst horrible. Even if the company has very good numbers, the stock is priced for very good numbers already. If the numbers are weak in anyway shape or form or if the numbers are strong but there is even a hint that the earnings will slow in the future, the stock could get hammered.

I say all the above about GOOG just to let you know the situation. I will probably not respond to the numbers unless they are extremely disappointing. This is a large position for me but it is a long-term position. If the stock were to do extremely well for an extended period, I might lighten up a little. My hope is for the long-term growth to be as strong as I believe it will be.

It is interesting to see how quickly other firms mirror the services offered by GOOG. Desk top search is already a common offering and I am told that YHOO has the best software. Putting together internet phone service or an internet browser will be tough feats. So far, I do not know of another firm scanning whole libraries. The video and TV services announced by YHOO and GOOG are very different.

Jim Brinkley, President of Leg Mason Wood Walker, is fond of saying that economics wins. The GOOG TV service is a great example. There has been a service for searching TV available for several years. The cost has been $500 per user per month and it relies on day old video tape. The service announced by GOOG uses up to the minute data and is free of charge. Of course, GOOG will charge advertisers for key word and content based search placement.

As you can tell, I like GOOG a lot. I bought more shares last week. It is impossible to know if the company is really worth 20 times book or 20 times sales. It must grow a lot to be worth so much.

The company reminds me of Xerox in 1963. At the time, clerks and secretaries typed everything with a carbon copy. (How many young folks today even understand what the initials cc: mean?) Xerox had the patents, had built the factories and the stock had soared quickly from $30 to $70 per share. In those days one needed to trade in 100 share lots and 100 shares at $70 was much more than the average persons annual salary. There was great skepticism. People openly joked about why would anyone pay 10 cents to make a copy when carbon paper sold for 79 cents for a box of 500 sheets. It was an easy decision for most companies as 8 sheets for a penny or 10 cents a copy was not a serious question.

Never-the-less, investors who bought and held on made a fortune. I clearly remember the two weeks when the stock broke out above 70 and went all the way to 360. It didn't hardly slow down for about 10 years.

The Xerox (XRX) company produced life changing technology. Ironically, GOOG is using Xerox technology (and probably Xerox equipment) to scan in every page of every book in the library. The results will be life changing. There are many uses for the GOOG technology and the competition is fierce but I am a believer.




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