Monday, March 7, 2011

Front-Page News

There are various approaches to successful investing in the stock market.  Some market participants identify stocks whose prices are rising at an unusually rapid rate (price momentum), or they combine that with identifying companies whose revenues and/or earnings are also rising at exceptionally rapid rates (fundamental momentum).  They then ride that success and try to be alert enough to tell when the trends are changing.  

Others may use the approach that famed Fidelity fund manager Peter Lynch espoused by urging investors to look in their backyards and invest in companies whose products they use and are familiar with.  Some institutional investors who have substantial computing and quantitative staff resources use elaborate modeling techniques that may entail rapid trading and portfolio turnover.  Whatever approach you use, my view is that if it works for you, stick with it.  Above all, know yourself as an investor.

For me, that means combining contrarian psychology with identifying undervalued stocks.  I supplement those considerations with a company’s financial strength, earnings momentum and surprise, and management quality.  The essence, though, is a contrarian approach to markets.

While I utilize a screening approach that includes a number of factors, I believe that a skeptical and contrarian mind that pays attention to developments around the world is critically important.  It isn’t necessary for one to have access to the highly complex asset-allocation models that many institutional investors have in order to succeed. 

An individual investor who pays attention, particularly to what is reported in the news, can do well.  Cover stories have been outstanding contrarian examples over the years.  By the time a topic reaches the front page of a weekly magazine or daily newspaper, the subject’s market price already likely reflects the theme.  Developments, if not yet the market price, may already be moving in another direction.  Numerous examples over the last few years exist, with bullish stories on the Indian and Chinese stock markets, the housing bubble, and bearish talk about the U.S. dollar.  The front-page topics appeared in publications ranging in investment sophistication from The Economist and Barron's to Newsweek and Time.  

Today may provide another contrary example.  The New York Times has a page one story, “Patent Woes Threatening Drug Firms.”  It cites in particular the patent expiration later this year of Lipitor, Pfizer’s blockbuster drug.  It explains that the Pfizer example is just the most extreme case of problems that the entire industry faces from patent expirations, pressures from governments in Europe and the U.S. to reduce drug prices, and the inability to discover new compounds that are meaningful advances over existing products.  

Industry analysts, portfolio managers, and even casual investors have known about these issues for years, which is why Pfizer, Lilly and Merck, for example, sell for only eight times 2011 earnings estimates on average (versus 13 for the overall stock market).  While I don’t endorse massive buying of drug stocks now, they do seem to represent one of the few areas of undervaluation in today’s stock market.  

Abbott, a diversified health-care company with significant drug revenues, sells for 10 times 2011 earnings estimates, has a dividend yield of 4%, generates excess cash flow from operations, and has raised its dividend for 39 straight years.  And unlike some of the pure drug companies who might have flat or declining earnings over the next two or three years, Abbott is expected to produce earnings growth of nearly 10% annually.  (Disclosure:  I own shares of Abbott.)  As for the others, closer analysis is needed, but when a stock such as Lilly or Astra Zeneca has no net buy recommendations among several dozen analysts who cover the stock, it may be time for contrarians to look more closely.

Steve Lehman

S & P 500:  1308
Russell 2000:  810

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