Thursday, December 22, 2011

Investment Discipline Needed Now More Than Ever (Cont.)

I remain wary of the possibility of a "melt up" or a "melt down" in major stock markets.  Given the simple arithmetic of the difficulty of recovering from large losses, I am biased toward capital protection.

I have favored the shares of some of the world's leading companies, which have attractive dividend yields and moderate growth prospects for earnings and dividends.  There also are a number of depressed stocks that are quite cheap based on earnings and cash flows.  I am concerned, however, about the solidity of those earnings and earnings estimates for 2012.  Expectations are crucial to investment success.  High expectations for profit growth--for a single company or the market as a whole--are likely to produce disappointment and losses.  The converse is true for low expectations.

When aggregate expectations for earnings growth are low, the return on stocks has generally been in the high teens on an annual basis.  Conversely, when forecasts are for high growth, the return on stocks is about zero.  I am pleased that the 2012 consensus earnings growth for the S & P 500 has been easing, but it is fairly high, at 12%.  With Europe, Japan, and the U.K. likely to be in recession and the possibility of China suffering a hard landing in 2012, 12% growth seems too high.

When profits don't meet expectations for individual companies, investors in those stocks pay a high price.  Oracle, for example, yesterday had a significant profit shortfall and its stock fell 12%.  Concerns about the company's exposure to a sluggish Europe might signal broader concerns for the earnings prospects for other multinational companies, as well as for European companies.  

Deciphering whether a company will miss its earnings target is not easy.  In general, I try to avoid stocks that have a preponderance of "buy" ratings by Wall Street analysts, as there is much greater room for disappointment than when there are comparatively few buy ratings versus "hold" or even "sell."

There are few individual stocks that I would aggressively buy at current levels.  While there are a significant number that are quite depressed and seemingly undervalued, I am eagerly waiting for fourth-quarter results to be reported so I can do further analysis before committing substantial cash reserves.

Steve Lehman

S & P 500:  1252

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