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Jubak's Journal
Recent articles:
• 7 stocks that like a falling dollar, 1/13/2004
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| | Jubak's Journal
Now, only cheap stocks will make you money
The easy money is going fast. In 2004, success will come only if youre able to separate cheap stocks from the pricey. Heres how.
By Jim Jubak
This week, Intel (INTC, news, msgs) and Yahoo (YHOO, news, msgs) announced fantastic earnings for the fourth quarter of 2003. Intels earnings per share were up 106% from the fourth quarter of 2002, and Yahoos climbed 62%.
But those results should come with a warning label: This quarter marks the peak in these companies earnings growth rate for this cycle. Earnings per share will go up next year at both Intel and Yahoo, but at a far lower rate. In 2004, Wall Street projects that Intels earnings will grow by 55% and Yahoos by 48%.
And those numbers are just a stop on the way to average annual growth rates of 15.3% for Intel and 32% for Yahoo.
This isnt happening to just a few technology stocks. In the next few weeks, most companies are likely to hit the earnings growth peak for this stock market cycle. That doesnt mean stocks are doomed to go down. But it does mean that the easy part of this rally is ending and that investors need to start paying more attention to a stocks fundamental value.
At this point in the cycle, parts of this market are still cheap, while other parts are very expensive. And, unfortunately, it can be tough to tell the difference.
Let me give you some measures that Im using to separate the cheap from the expensive.
First, let me provide some context on where we are in the cycle and why valuations are about to become more important.
A great first half; the second half is tricky
The earnings reporting season that started in earnest this week should produce some fabulous numbers. Wall Street analysts are predicting 21% earnings growth for the companies in the Standard & Poors 500 index ($INX), according to First Call. First Calls own analysis puts the likely growth rate at 25%. And even that could be low, considering the bump fourth-quarter 2003 earnings are likely to get from the falling dollar.
But the 2003 fourth quarter still is likely to mark the peak of earnings growth. Stocks and the economy have bounced off the bottom, and the easy year-to-year comparisons are ending. From here, the going gets tougher. Wall Street is calling for 13% growth in the first quarter of 2004, and First Call is predicting 12%. For the full year, Wall Street is looking for 13% earnings growth, healthy, but still a significant drop from the 17% projected for 2003.
All this creates two problems for investors:
- Earnings are growing by just a couple of pennies a share while price-to-earnings ratios are sky-high.
- Although we know earnings growth rates are about to drop, we dont know what normalized growth rates will be in the next stage of the recovery or how long that recovery will last.
Right now the stock market has upward momentum. That momentum is fueled, in part, by: surging corporate profits, vast amounts of cash inflows from year-end retirement contributions, low and steady interest rates and reduced tax rates. In short, the first half of 2004 looks pretty good for the economy and for the stock market. (Ive made the case for a decent 2004 in my article 10 real-world indicators give 04 a thumbs up.)
But the picture looks less and less rosy the closer you get to the end of 2004. As the year unfolds, the long-term problems in the economy will matter more. The U.S. Federal Reserve will be under increasing pressure to boost interest rates to shore up the weak dollar. The reluctance of foreign investors to buy Treasury paper in the face of a declining currency also will put pressure on interest rates. The twin deficits in the federal budget and the U.S. trade balance will generate their own interest-rate and inflationary pressures. Consumer debt, at historically high levels, could quickly reduce consumer spending if interest rates rise. (Ive listed some of these problems in more detail in my column 10 ways to profit from a dangerous year.)
Read more about investing on MSN Money
These problems wont necessarily derail the economy or the stock market, but they gradually make for more uncertainty. And with uncertainty on the rise, its essential that investors understand the risk-reward tradeoff for any particular equity.
Thats the picture for 2004: a relatively bullish first half of the year followed by building worries as the economys longer-term problems play out.
How am I assessing relative valuation, and relative risk and reward? Right now, through the use of sector specific measuring sticks, thats how. Ive selected a leadership stock in each sector to use as a standard for judging other stocks in that sector. Then, I value each stock based on price for projected growth, on probability of meeting those projections and on the possibility of exceeding estimates.
You can do this with any sector youre interested in, and at the end of this column Ill suggest a couple of yardstick stocks for other sectors. Ill start, however, with technology stocks.
The technology yardstick: Cisco
Price for projected growth. Its Cisco Systems (CSCO, news, msgs) consistent growth rate that makes it so useful as a valuation measure. For the last five years, Cisco has grown 14.4% annually; Wall Street projects its earnings will grow 14.8% annually over the next five years. An investor who bought Cisco stock on Jan. 13 paid a multiple of 45 times projected earnings for projected 14.8% growth over the next five years. That produces a PEG ratio (Price/earnings ratio to Growth) of 3.
(To calculate my PEG ratios, I divided 2003 earnings (projected or reported) per share by the price per share, and divided that number by the projected growth rate for the next five years. To obtain projected earnings growth data, go to key ratios and type in the ticker for your stock.)
By historical standards, thats a high PEG for Cisco or any stock for that matter. Before the technology bubble of the late 1990s, investors looked to buy growth at a reasonable price when stocks were priced at a PEG ratio of 1 or less.
But, for the moment, lets not judge Ciscos price but simply use it as a measuring stick for other technology stocks in this market. No investor should be willing to pay more for this unless he or she is getting a superior stock: that is likely to grow earnings at a higher rate than Cisco in the future.
It turns out that, even by the Cisco standard, most of the technology sector is overvalued. Broadcom (BRCM, news, msgs), for example, a stock that climbed 125% in 2003, trades at a price-to-earnings ratio of 88.5 on projected 2003 earnings. Wall Street estimates Broadcoms growth for the next five years at 27%. Even so, that gives Broadcom a PEG ratio of 3.3, making it a more expensive way to buy projected earnings growth than Cisco.
Yahoo? Even worse. The stock sports a price-to-earnings ratio of 135.6 on reported 2003 earnings and that, even with Wall Street projecting earnings per share growth of 32.2% annually over the next five years, gives Yahoo a PEG ratio of 4.2.
If you were grading these stocks on a curve, with Cisco as C, you might give Broadcom a C- and Yahoo a D.
Probability of meeting growth projections. Historically, its certainly possible to make a case for Cisco growing earnings at 14.8% annually for the next five years: After all, Cisco did grow earnings by 14.4% annually over the last five years. (To see the earnings estimates, click here.) As the dominant company in its market, Cisco is poised to take more market share in new opportunities such as Internet telephony.
On the other hand, Cisco is a maturing technology company, and its reasonable to suspect that growth rates will drop as a company matures. Some analysts project Ciscos annual earnings growth at no better than 7% annually over the next five years.
Broadcom doesnt give investors a historical earnings record to use as comparison. The company showed earnings in 1998 and 1999 but losses in 1997, 2000, 2001 and 2002. Hard to build a pattern out of that. On the other hand, Wall Streets projected five-year annual earnings growth rate of 27.10 isnt all that much higher than the consensus for Broadcoms industry of 22.3% growth.
The projections for Yahoo seem doable but a stretch. Wall Street is projecting that the company will grow earnings per share at an annual rate of 32% annually over the next five years. Thats down substantially from the 52.6% earnings growth rate over the last five years. But sustaining an average of better than 30% growth for five years in a business that still relies largely on the cyclical advertising market and that faces tough competition is a major challenge.
On this yardstick, Id give Cisco a C, Broadcom a C-, and Yahoo a C-.
Possibility of exceeding projections. It seems only fair to look at the potential for unexpected upside as well as for unexpected shortfalls. Something could go right that Wall Street hasnt considered, and that might give the stock more upside than weve given it credit for so far.
As usual Cisco, our yardstick, gets a C. If Internet telephony catches fire more quickly than expected and if big service providers like Verizon (VZ, news, msgs) not only adopt the technology but make Cisco their vendor, then Ciscos growth rate could be a couple of points above current projections. Because of the companys huge sales base, the effect isnt likely to be much larger than that.
Broadcom earns another C- here. It dominates the market for chipsets for cable modems. That market, however, is relatively mature, so theres not much unexpected growth likely there. In server chipsets, the company faces new competition from Intel. The most promising new market, chipsets for wireless networking, is extremely competitive, and I dont see unexpected gains for Broadcom there.
And give Yahoo a B-. The company has dumped Google as its search engine and is going after that market full speed. Search is the fastest-growing segment of the Internet business, and the opportunities are a significant plus for Yahoo -- that is if the company can manage the difficult transition to its own technology from Google.
Taking into consideration all three areas of valuation, Id give Cisco a C and both Broadcom and Yahoo C-. Neither stock at this point in the market cycle represents a better combination of risk and reward than Cisco.
And thats important, since I think that its quite possible to beat the yardstick itself in this sector. Intel, for example, is trading at a PEG ratio of 2.5, certainly an improvement on Ciscos 3. The company managed to grow earnings at 18% annually in the five years before the bubble broke in 2000. That makes Wall Streets projections of 15.3% growth over the next five years reasonably plausible, as does Intels ability to translate its manufacturing prowess into higher profit margins. Right now Intel is getting almost no credit for its non-PC businesses -- you know, those excursions into communications, for example, that havent yet produced anything but losses. Those businesses could well start to contribute, giving Intel an upside not yet in the stock.
A B is certainly better than a C, but Im still looking for that elusive A in the sector. Readers who think they have found one, please let me know. Ill give you full credit if it pans out and keep you anonymous if it doesnt.
I think this method works to relatively value other sectors as well if you pick the right yardstick stocks. In the drug arena, Id suggest Johnson & Johnson (JNJ, news, msgs) as my yardstick. In retail, use Walgreen (WAG, news, msgs). In consumer goods Pepsico (PEP, news, msgs) is a good benchmark. In financial services, American International Group (AIG, news, msgs) gets my nod.
Changes to Jubak's Picks
Buy Carbo Ceramics
The recent bad news from Royal Dutch Shell (RD, news, msgs) that the company had over-estimated reserves by 25% is good news for companies in the business of helping oil companies recover more oil and gas from existing wells. With drilling for new supply increasingly expensive, what is called enhanced recovery becomes an even more attractive proposition. Carbo Ceramics (CRR, news, msgs) dominates the market for ceramic proppants used to extract oil and gas from wells with a 57% market share, and ceramic proppants are gradually picking up market share in the over all proppant market. I listed Carbo Ceramics as one of my picks for 2004 in my Jan. 2 column 10 ways to profit from a dangerous year. Im adding it to Jubaks Picks with a target price of $63 a share by September 2004.
Buy Schlumberger
Same theme -- oil production companies need to increase production from existing wells -- different stock. Schlumberger (SLB, news, msgs) was a member of my 10 dogs ready to bark in 2004 list of Dec. 16. While Carbo Ceramics is more of a momentum pick (the stock is trading close to the top of its recent price channel), Schlumberger is more of a value pick. Schlumberger recently traded at 27 times projected 2004 earnings; with Wall Street expecting earnings to grow by 31% in 2004, that gives the stock a PEG ratio (PE to growth rate) of just .88. Cautious investors should note that the company is due to report earnings on Jan. 23, and buying the stock now is predicated on my belief that the company will report decent continuing progress in its effort to refocus its business on oil services. As of January 16, Im setting a target price for Schlumberger of $64 a share by August 2004.(Full disclosure: I will be buying shares of Schlumberger for my personal account three days after this column is posted.)
New developments on past columns
Bull market in metals is just beginning
I think were getting the temporary correction in the shares of metals stocks that many market analysts have been expecting. In the first two weeks of the year, Noranda (NRD, news, msgs) has dropped 5.8%, Southern Peru Copper (PCU, news, msgs) 3.4%, Freeport-McMoRan Copper and Gold (FCX, news, msgs) 15.02%, Inco (N, news, msgs) 5.75%, Newmont Mining (NEM, news, msgs), 12.52% and Rio Tinto (RTP, news, msgs) 3.9%. Given the runups these stocks experienced in 2003, the current pullback isnt unusual. I think it will soon present a buying opportunity for investors who believe that industrial metals and gold are likely to out perform the stock market in 2004 as demand continues to soar in China and the dollar continues to weaken.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American International Group, Freeport McMoran Copper and Gold, Noranda, and Pepsico. He does not own short positions in any stock mentioned in this column.
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