Are You Prepared?
Jul 20th, 2006 | By Penny Sleuth Contributor | Category: Investing Strategies, MacroeconomicsStocks rise and stocks fall. That’s the way the market works, always has and always will. Yet it’s shocking to me how often people are surprised when their stocks fall. It’s even more shocking that people are surprised by bad returns when the major economic, financial and political warning signals are going off for all to see and hear — as they are today.
Consider the following warning signals right now:
1) Rising interest rates
2) Geopolitical turmoil
3) High valuations in nearly all sectors — especially in the small caps
John Hussman, president of Hussman Investment Trust, noted this week that “Tornadoes are more likely to strike when a tornado warning is in effect…And not surprisingly, financial tornadoes are more likely to strike when such tornado warnings are in effect.”
He goes on to explain…
“When you’ve got a tornado warning, you don’t necessarily conclude you’ll actually get hit by a tornado, but you also aren’t surprised if it starts raining. And even if the rain gets heavier, or the wind blows, you aren’t surprised again and again. Once you get the tornado warning, you basically allow for the possibility of a tornado. You pack up the garden party and head inside for a while. Bad news doesn’t surprise you. You don’t count on it, but you have a subtle expectation that it might arrive.”
These are words of wisdom all good investors will take to heart — and will not ignore. And right now, there is a tornado warning in effect for the entire small-cap sector. Consider the signs for yourself:
Higher interest rates: Access to cheap capital (a.k.a. loans) is the lifeline of any company. As interest rates fall, capital becomes cheap and banks are willing to take more risks by lending to smaller, riskier companies. This is exactly what happened from 2001-2005. But with interest rates on the rise, capital is becoming more and more expensive. In other words, that lifeline that was once available to nearly every small-cap company is no longer. That spells doom for many to come.
Geopolitical turmoil: As you have seen in recent weeks, investors (both retail and institutional) prefer safer, larger stocks in times of political unrest. Since the beginning of May, the S&P 500 is down 3% while the Russell 2000 is down 8%. And with no end to the war in Iraq and the possibility of new skirmishes in Korea and Iran, I doubt the political scene will be smooth for some time.
High valuations: At the peak of the 2000 rally, smaller companies were dirt-cheap. The smallest 50 companies on the S&P 500 traded for just 10.1 times earnings. Meanwhile, the 50 largest companies traded for 35.6 times earnings. Since that time, small caps have rallied and blue chip stocks are down 15%. And today, the smallest 50 companies trade for 22.9 times earnings, while the 50 largest have a much lower P/E of 17.9. In other words, small-cap stocks (as a whole) are expensive.
Generally, when the market is up against rising rates, geopolitical unrest and high valuations, stock returns have not been satisfactory. And when you couple these three signals with clear signs of mania binge buying (as I’ll show you next), it should not be hard to understand why a tornado warning is in effect for the small-cap sector.
All week, my intrepid intern, Jimmy Nelson (aka “Intern Jimmy”), has been crunching numbers, building charts and working in Excel. I asked him to build a list of both fundamentally sound and unsound small-cap stocks on the NYSE and compare their returns over the last six months. I wanted to see what kinds of stocks investor have been buying of late. Are they buying solid companies with lots of cash? Or are they buying crap companies worth less than the paper their stock is printed on?
What we found gives credence to my fears about the chance for a small-cap tornado.
Intern Jimmy and I used the following criteria to screen for both groups of stocks:
Fundamentally Sound:
1) Market cap <= $1.5 billion
2) Trades on the NYSE
3) P/E <= 15
4) Free cash flow >= $1 million
5) Revenue growth >= 1%
6) Net income growth >= 1%
7) P/B <= 1.5
8) P/S <= 1.5
Fundamentally Unsound:
1) Market cap <= $1.5 billion
2) Trades on the NYSE
3) Earnings per share <= $0
4) Revenue growth <=15%
5) Free cash flow <= $0
6) P/B >= 2
After running the screens using a Morningstar database, we ended up with a group of 20 fundamentally sound stocks and 16 “garbage” stocks. From there, Jimmy tracked each stock’s performance and created an index to represent both the fundamentally sound and unsound groups. He then backtracked each index and showed their real returns since the beginning of January. Take a look at the chart below to see how each group fared:
As you can see, the garbage stocks have risen 6.21% this year, while the fundamentally sound group of stocks is down nearly 17%. These returns are indicative of a late-stage rally. Let me explain…
Small-cap stocks have outperformed their large-cap peers handily since 2000. In the beginning of that rally, investors bought because small-cap stocks were cheap (recall they traded for 10 times earnings in 2000). In other words, they bought for fundamentally sound reasons. But recently, fundamentals have all but been forgotten. Speculators (not investors) have been buying small-cap companies with great stories but nothing in the way of cash, earnings and revenue.
This kind of irrational buying behavior typically happens in the late stages of a rally. For a recent example, just think back to the dot-com orgy.
At the end of the day, this kind of binge buying cannot go unpunished. Terrible stocks that have been bid way up will come crashing down. And the people holding them will be surprised to see their fortunes wiped out.
Please do not be one of those “surprised” investors.
You need to know that the conditions are right for a financial tornado (a major drop in the small-cap sector). That does not mean a tornado will strike. But it does mean you might want to start bringing in the patio furniture. You may want to make sure you have enough food and water to last a day or two should the power go out. And you should come up with a plan so you are prepared if a twister does hit.
Now is not the time you want to be holding garbage stocks. Make sure you are prepared.
Regards,
James
July 20, 2006
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