The above is never something I would venture to take a stab at, but GMO’s Jeremy Grantham has made a name for himself by making bold predictions about the future. His latest quarterly letter, entitled “On the Road to Zero Growth” is one of his best, in my opinion. A highly recommended read if you are interested in a 16-page article characterized by a lot of economic jargon. Granted, it makes a lot of sense and was written by someone who has been right an awful lot over his multi-decade investment career. Just thought I would share the link. Enjoy!
Another piece of data supporting the idea of contrarian investing, this time from Bloomberg.
The money quote:
“Companies in the Standard & Poor’s 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest “buy” recommendations gained 165 percent, according to data compiled by Bloomberg. Now, bank favorites include retailers and restaurant chains, the industry that did best in last year’s rally and that are more expensive than the S&P 500 compared with their estimated 2011 profits.”
According to data compiled by Bloomberg from twelve of Wall Street’s largest investment banks, strategists expect the S&P 500 index to rise by about 10% next year, which would mark the third straight year of double-digit gains for U.S. stocks. Their figures, based on operating earnings in the low 90’s for the broad index, equate to a year-end P/E of about 15 times, in-line with the market’s historical average.
Investors well-versed in market history may not feel like these predictions are all that interesting. After all, the market averages a 14-15 P/E ratio over the long term, and the mean return for the S&P 500 since it was created is about 10% per year. These Wall Streeters are clearly not going out on a limb with these estimates, which is hardly surprising given their nature to hedge their bets in an effort to protect their jobs (by rarely differing very much from the consensus view).
Since consensus viewpoints typically will not make us money, it is helpful to think about whether the odds are that the market does better or worse than these predictions. Personally, I would guess the odds are better that we see single digit returns in 2011, as opposed to a better-than-expected gain. I say that because P/E ratios are unlikely to rise given that interest rates are headed higher. Couple that with the fact that analysts consistently overestimate forward earnings growth (by a factor of nearly 2 times). A long term study by the consulting firm McKinsey has found that long-term earnings at public companies grow by about 6% per year on average, versus projections by industry analysts of 10-12% heading into any given year.
All in all, U.S. stocks are far from overvalued, but with strong earnings growth in 2011 already expected and a ceiling on multiples seemingly close by, returns in the year ahead should be decent but not fantastic, especially given that we are coming off two above-average years in a row for the U.S. stock market.
According to financial data collected by Thomson Reuters, 70% of S&P 500 index companies have reported third quarter profits so far and earnings are up 30% year-over-year. This compares to estimates of just 24% growth and explains why the U.S. equity market is knocking on the door of the 2010 highs made back in April. For all of the pundits complaining that Washington DC politicians have been bashing Corporate America too much, aggregate corporate profits are actually making new record highs (second quarter earnings were an all-time record) so we have to wonder exactly how tough companies really have it these days.
As we head into 2011 analysts are expecting corporate profits to keep surging, by about 13% next year. With P/E multiples about average historically, the strength of earnings will likely dictate much of market’s movement in 2011. Analysts notoriously overestimate profit growth (by a factor of nearly 2x over the long term according to studies done by McKinsey), so once again they are very optimistic about the coming year (corporate profits grow about 6% per year over long periods of time). As is usually the case, the numbers are telling a better story of reality than political and private sector commentators, which is why the market is doing pretty well despite 9.6% unemployment.
To gauge market prospects for next year, investors should continue to look at the numbers and ignore the posturing in the media and on the campaign trail. As things stand now, I would expect another gain for the U.S. equity market in 2011, but the magnitude will depend on whether the analysts are right or once again overly optimistic. That could be the difference between single digit and double digit returns over the next 12-15 months for stocks.
And on a somewhat related note, don’t forget to get out and vote tomorrow.
File this away as the most amusing item of the day. I always get a kick out of some of the investment articles I see on various finance-related web sites. Now, I am sure I have made a few mistakes over the years on this blog, but never anything like what the Forbes Investor Team posted on their site today. In a piece written by John Reese of Validea Capital Management, there are four stock recommendations, including Genentech. Here is what John says about the company:
The South San Francisco-based biotech firm ($100 billion market cap) has averaged a 22.1% ROE over the past three years, has increased EPS in six straight years, and has almost three times as much net current assets as long-term debt. It isn’t cheap, selling for almost 30 times trailing 12-month earnings, but my Lynch-based model thinks it’s worth it, given its 41.6% long-term growth rate. (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate.) Another reason the strategy is high on Genentech: the firm’s conservative financing. It has a debt/equity ratio of less than 20%.
Of course, this is amusing because Genentech was acquired by Roche more than a year ago, in March 2009, and the stock has not traded since. I have to question this manager’s “Peter Lynch-based model” given that it flashes buy signals on stocks that do not even exist anymore. Hilarious.
In recent days I have been paying special attention to shares of Blackberry maker Research in Motion (RIMM). The stock is one that had decent earnings this quarter but some investors wanted more, which prompted a pretty significant sell off in the stock. Despite the market having recently made new yearly highs, RIMM shares have dropped from the high 80’s to the mid 50’s. The stock is down several points today after the analyst who covers them for Citigroup downgraded it from “buy” to “sell.”
Skipping the “hold” rating completely is pretty rare on Wall Street, but what caught my eye even more was that the analyst lowered his price target on RIMM from $100 to $50. What happened to make the company worth 50% less overnight in his view? The upcoming release of Motorola’s Droid smart phone.
Call me skeptical of this bold call from Citigroup’s research department. The new Droid is going to be such a huge success that it will translate into a 50% haircut in the value of Research in Motion, which has a stronghold on the corporate smart phone market? Have we not seen dramatic hype surrounding new cell phones recently that only served to disappoint investors? The Palm Pre comes to mind immediately. While it may help Palm get back on the map, the Pre is certainly not looking like a genuine iPhone challenger like many were expecting. Should we believe that the Droid will similarly make a huge dent in RIMM’s Blackberry franchise?
I haven’t made the plunge into RIMM stock yet, but the odds are getting higher each day the stock continues to slide. At a current $55 quote RIMM trades at 11 times 2010 estimates ($4.85 per share), which seems reasonable even if that figure proves too high due to increased competition. Right now I might just be willing to make the bet that the Blackberry retains its lead in the corporate market for years to come. If so, the stock looks pretty cheap here.
How have this analyst’s past calls on the mobile sector turned out? Pretty lousy, which is par for the course on the sell side. Today the analyst upgraded Motorola to a buy and downgraded Palm and RIMM to sell.He initiated coverage for all three back in September 2007. Here is how the calls since then have turned out:
His track record on Palm has been decent; initiated at sell at $8, upgraded to hold at $6, and now back to sell at $11.
How about RIMM? Dismal. Recommended as a buy twice at $99 and $69, and now says you should sell in the mid 50’s.
Lastly, the Motorola record isn’t all that impressive either; hold at $18, buy at $12, hold at $6, buy today at $9.
All in all, the current negativity on Research in Motion looks overdone to me and as a result I am considering a contrarian investment. As always, please share your own thoughts if you care to join the discussion.
Full Disclosure: Peridot Capital had no position in RIMM at the time of writing, but is certainly taking a very close look at current prices.
There are several reasons I typically ignore Wall Street analyst calls. The most compelling is the fact that sell side recommendations over the long term have been shown to underperform the market with above average volatility. Those are lose-lose metrics for investors.
Such poor performance is largely attributable to analysts being backward looking when they make research calls, despite the fact that they are supposed to be analyzing the equity market, which is a forward looking mechanism. Too many times analysts will upgrade stocks after the firms report strong numbers and vice versa, which does nothing to add to investor returns relative to the benchmark index they are trying to beat. Successful investing requires insight into the future, not reaction to the past.
To illustrate this point, consider an upgrade from UBS analyst Wenlin Li on Monday. Li covers Baidu.com (BIDU), the internet search giant in China. Baidu reported second quarter earnings of $1.61 per share, above consensus estimates of $1.44.
Prior to the earnings report Li had a sell rating and $150 price target on Baidu, which was trading over $300 per share. That in itself appears to be a contrarian call, which would be commendable (wrong, but commendable nonetheless). After the strong report was released, despite only a small upside surprise, Li upgraded the stock to neutral and raised the price target to $380 per share, a stunning increase of 153 percent.
How does a single quarter’s earnings beat of 12 percent explain a 153 percent increase in one’s fair value estimate for a stock? It doesn’t, not by a long shot. This is the epitome of a completely useless Wall Street research call.
To see how this analyst messed up so badly, we only need to look at the changes made to their BIDU assumptions. Li now estimates 2009 revenue at $658 million, up from $542 million, while 2010 and 2011 sales are revised upward by 33% and 38%, respectively. Gross profit as a percentage of sales estimates were also revised upward, by 60% this year, next year and 2011, and net profit was revised up by about 40% per year.
Remember, an analyst’s sole job is to follow companies and estimate how much revenue they will bring in and what proportion of that will flow through to the bottom line. Without solid insight into these metrics ahead of time, analyst calls are of little use to investors, which unfortunately is the case more often than not on Wall Street.
Full Disclosure: No position in BIDU at the time of writing, but positions may change at any time
For those of you who don’t know Merrill Lynch chief economist David Rosenberg, he has been very bearish on the U.S. economy for a long time, long before the recession hit. Some give him credit for predicting how things would play out, while others criticize the fact that he was years early and therefore missed a lot of the upside before being right about the drop. Both points are reasonable, but I bring his name up because he was on CNBC this afternoon sounding much less bearish than any other time I can remember. Not bullish (heaven forbid), but not all that negative either.
Rosenberg pointed out that the stock market typically bottoms out about 60% to 65% of the way through a recession, which by his projections means we are about 90% of the way through this bear market. His downside target for the S&P 500 is 600, but he oddly adjusted that downward after his original level of 666 was reached “too early.” He gets to 600 by taking $50 of earnings and applying a 12 multiple. As you can guess for my recent writings, a 12 P/E on trough earnings is much more reasonable in my view than someÂ of the single digit predictions of other strategists.
I typically don’t put too much weight in the absolute predictions of either the most bullish or most bearish people on Wall Street because both groups tend to stay in their respective camps far too long (Meredith Whitney comes to mind). That said, when long term bears begin to get more positive, it says a lot for where the market and economy are. If you can get people who hated stocks and panned the future prospects for the U.S. economy, to become even mildly bullish, I think that says something about how much negativity is priced into equities.
In recent months it would have been difficult to find a stock that Wall Street analysts were more pessimistic about than struggling smart-phone maker Palm (PALM). According to Thomson/First Call, 23 analysts follow the stock, 10 have sell ratings, and only 2 have buy ratings (the rest were neutral). In a world where brokerage firms make money by getting people to buy stocks, such negative sentiment is rare.
As a contrarian, I had actually been accumulating shares of Palm throughout 2008 in some client accounts, as hints of a possible recovery in the company’s business began to appear. Most notably, the combination of a sizable equity investment from private equity firm Elevation Partners (run by Roger McNamee, a man I have great respect for) and the hiring a former research and development star from Apple (Jon Rubenstein).
In recent months Palm had explained to investors that they were revamping their software platform and with the help of Rubenstein and McNamee were set to launch a new set of innovative products in 2009. Given how short-sighted Wall Street is, Palm shares struggled as the iPhone and new Blackberry products came to market. Wall Street analysts were negative on Palm because they claimed Apple and Research in Motion were way ahead of them in terms of products and market share. The stock actually reached a low of $1.14 per share in December, down from $4.00 just a month earlier.
The reason I was interested in the stock was not because I disagreed with the analysts’ assumptions (I too expect Apple and RIM to have higher market share than Palm), but rather because they were ignoring the fact that the global cell phone market is over 1.2 billion units. Palm could lag Apple and RIM and still collect 5% or 10% of the worldwide market, which would translate into tens of millions of units and perhaps several billion dollars of revenue. The idea that Palm had to beat out Apple and RIM to stay in business (some analysts are projecting Palm will file bankruptcy) seemed off the mark to me.
Sell side analysts generally recommend stocks based on what is known, not what could happen in the future. Even though the public knew a successful R&D guy from Apple was now heading up Palm and was slated to introduce a brand new operating system and product lineup in 2009, since the facts at the time were that Apple and RIM were crushing Palm, practically nobody on the Street liked the stock. At a buck or two though, Wall Street was pricing Palm shares based on the worst case scenario, so the risk-reward trade-off highly favored going long the stock, not betting against it.
Last month Elevation Partners increased their equity investment in Palm from $325 million to $425 million, obviously approving of the company’s plan. Yesterday at the Consumer Electronics Show (CES) in Las Vegas Palm unveiled its new operating system and a model of the Palm Pre, the first of its next generation smart-phone products schedule to be released by Sprint in the U.S. sometime during the first half of this year. Palm stock soared 35% on Thursday and is up another 30% today to about $6, bringing its total gain since the December low of $1.14 to more than 400%.
Today analysts are more optimistic (I even saw at least one upgrade) based on the promise of the new operating system and Palm Pre product. Once again, the sell side has waited until the news is out and already priced into the stock (it’s already gone from $1 to $6 in the last month) to become more optimistic on Palm’s prospects. Therein lies the inherent flaw in most brokerage firm research; they base their recommendations on announcements that the market adjusts for immediately, thereby ensuring what they have to say has little or no added value by the time clients read it.
Now, you may insist that an analyst should not blindly assume that a new product being worked on will turn out to be good, so recommending Palm before knowing what the Pre phone looks like would not have been wise. I cannot argue with that, so maintaining a hold rating until seeing the new products is completely understandable if you did not want to put your neck out.
What I cannot understand is a sell rating on a company whose stock price is implying bankruptcy even though the company is getting private equity investments and you know that a highly respected former Apple exec has been leading a new R&D team for over a year. Are we supposed to act surprised that the Palm Pre looks promising? You may not have wanted to bet on it sight unseen, which is fine, but you can’t say that what Palm introduced yesterday was surprising given what we already knew was happening over there.
As usual, Wall Street hated the stock at $1, $2, or $3 but likes it a lot more at $6. Now you know why I like to be a contrarian.
Full Disclosure: Peridot was long Palm shares at the time of writing but positions may change at any time
I really thought we would finally see a less negative view on Citigroup (C) from Meredith Whitney a couple weeks back when the stock hit three bucks. Whitney, you may recall, is the Oppenheimer & Co banking analyst who downgraded Citigroup to “underperform” last year when the shares traded for around $40 each. Last month, Citigroup hit a fresh intra-day low of $3.05, capping a stunning 13 month 92% drop in the shares of what once was one of the most valuable U.S. companies.
What a perfect time that was to remove a “sell” rating. At $3.05, Citigroup stock likely had two possible long term outcomes; go bust or go a lot higher. Whitney could have closed the book on what would have been one of the best analyst calls of all time. It would be easy to justify upgrading Citi to “neutral” at $3 per share. After all, after a 92% drop, the risk-reward trade off is far less compelling unless you really think the company won’t survive. Whitney has never indicated she thinks Citigroup will go under, so I have to think recommending investors sell the stock at $3 makes little sense, unless she wants to remain the most bearish analyst on Wall Street and an upgrade of a large bank stock wouldn’t fit that mold.
In the past two weeks, Citigroup stock has surged by more than 150% from the ridiculously low $3 quote to $7.70 per share as I write this. If that $3 print turns out to be the low (I am not predicting that necessarily, as I have no idea where bank stocks could trade in the short term), Whitney might have to remove her “underperform” rating at much higher prices, which tarnishes the call because she would have that rating on the stock as it doubled, tripled, or even quadrupled in value.
If the stock goes back down in the coming weeks or months, I think Whitney would be well-served to put a neutral rating on the stock, claim victory, and cement her Citigroup call as perhaps the best sell side recommendation of all time.
It would not be an easy decision given the banking sector still has not overcome its problems, but moving on would signal to investors and her clients that she has not resorted to simply being the most bearish banking analyst on Wall Street. Just because that is what put her on the map, it does not mean staying bearish for too long could not take her off of it just as quickly.
Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time