One advantage of being a geezer on Wall Street is that you’ve seen a lot of markets and the different ways people can think about stocks. In the mid-1980s everyone was looking for “restructuring plays” that a junk-bond financed corporate raider might attack. After the 1987 crash there was a takeover boom and every broker became an overnight expert in merger arbitrage. In the late 1990s it was all about one-decision growth stocks; Cisco looked cheap in 1999, provided you calculated the PE using estimated 2010 EPS. Coming out of the financial crisis it was all about macro; correlations were high so you could trade ETF’s and forget about individual stocks.
In recent years another distinctive characteristic of Street thinking, and Wall Street research, is the search for a catalyst. It’s not enough to find a stock with a reasonable valuation that really will grow 15% per year over the next five years. To give it a compelling “Buy” rating that will excite the sales force, the analyst needs to find a reason why it will perform well soon. That is what many hedge funds, a key client base of brokerage firms, are looking for, because they can use financial leverage and stock options to make a good return quickly. For hedgies, 10% in two months is better than 25% in 12 months, or so I was told by the research director of a giant fund.
I have no problem with this approach to investing, but it only works for certain smart professionals who are staring at their screens 14 hours a day and are constantly getting new ideas from dozens of analysts and salesmen. It doesn’t work for individual investors. They are better off owning solid growth stocks for long periods of time, much as Buffett does. That means holding them during periods when there is indeed no “catalyst,” as the stock goes sideways or even down for a few months even as earnings grow.
Consider Starbucks, which I own. The stock climbed above 80 last November but has since declined to the low-70s. The chart looks pretty bad. The company reported earnings last Thursday, and the news was mostly good – on target EPS, 6% comp sales despite bad weather, interesting new initiatives. Yet one well-respected analyst maintained his “Hold” rating and $80 price target (implying 14% total return in a year) because consensus EPS estimates were not likely to be raised. In other words, the company will keep growing and you will make good money in a year, but the stock is fairly priced and it is hard to think of a reason why there will be upside surprises in EPS and stock price. Me, I’ll take a 14% annual return every day of the week.
Perverse Side Effects
The “what’s the catalyst?” mentality has certain perverse effects. It draws Wall Street’s attention to controversial and volatile but fundamentally terrible stocks. A great example is J.C. Penney. What a mess. Take a mediocre company in a bad business—selling to middle class Americans under assault from Obamanomics—and bring in a Silicon Valley retail guru who revolutionizes the business (out with weekly coupon circulars, in with coffee bars and branded boutiques) and pretty much destroys it. (You have to try really, really hard to get minus 25% same store sales when the U.S. economy is not in a depression.) Investors should have simply stayed away, or stayed short, for two years as the stock dropped 78% and underperformed the SPX by 110%. But Street traders, attracted by JCP’s volatility, kept playing the short and the long side of the name.
Another perverse effect is that analysts will oversimplify a business as they search for a catalyst. Most large companies have many divisions serving diverse markets. They are not highly “leveraged” to a single market. But, in search of a catalyst analysts and investors will oversimplify a business and argue that the shares will be driven by one macro variable. For example, John Deere (which I also own) has been a consensus short of hedgies on the theory that corn prices will drop, U.S. farmers’ incomes will fall, and their purchases of tractors and combines will plummet. But, there is more to the DE story than farmers in Iowa. Fully 36% of revenues are outside the U.S. Looking at 2013 operating income, 6% is construction and forestry (which are improving) and 15% is financial services. As for the 79% of operating income generated by the “Ag and turf” division, U.S. farmers’ income is driven by the price of soybeans and other crops, in addition to corn. The bear story on DE may ultimately be proven right, but so far it has not worked. Over the last six months DE has outperformed the market by 590 bps.
Another case, similar to DE, is Caterpillar, which supposedly was a “play” on weakness in China. Although China’s economy has indeed been weaker than expected, which has hit CAT’s mining equipment business, CAT shares have performed well because other end markets that it serves, such as construction and energy, have been strong.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
