Sell Risk, Buy Pharma

There is a sketch by comedian Tom Green where he stands outside on the deck of a boat in the middle of a storm and proclaims: “It’s crazy!” However, as the intensity of the storm continues to increase, Green has to repeatedly correct his earlier assessment: “When I said it was crazy [earlier], it wasn’t crazy. Now it’s crazy!” This is how many value investors must have felt about the market this year. I know I did.

Back in May, I wrote an article for Seeking Alpha where I essentially alleged that the market might have reached a low point in March, and recommended to buy stock. As examples for buys, I suggested E*Trade (ETFC) and Alvarion (ALVR). Alvarion I liked also because the Israel-based company was suffering from a high shekel and low U.S. dollar at the time, and I found that the dollar was underpriced and bound to recover eventually (I used a comparison to the buying power of the Euro to show the disparity). I also felt pretty good about my stock picks at the time—both E*Trade and Alvarion were already up about 30% since I had bought them in March. Indeed, one could have made over 70% profit on ALVR by buying at its lowest point in March and selling at its highest point in May. Today, both stocks trade closer to around 30% of their March share price levels rather than 30% above them.

At least, I was right about the mispriced dollar, and both the Euro as well as the shekel currency rates have come down since, but this clearly hasn’t rescued the price of ALVR shares. I also managed not to suffer the entire drop by selling falling stock and then buying it back cheaper after a market drop. But similar to Tom Green in the storm, I believed many times along the way that prices were “crazy” (low), only to find even crazier prices down the road.

An alternative to the often contrarian position taken by value investors is to instead try to identify and follow trends. Indeed, one of the comments posted in response to my May article appears to advocate this strategy. However, the commenter used energy prices as an example, probably in reference to crude oil futures trading at $140 per barrel at the time after analysts had already called $70 overpriced. Of course, oil has since come back down to the 40s and 50s, and I can only hope that the commenter did not bet on the perceived “trend.”

In fact, when oil futures hit $140, I created a virtual fund with Marketocracy for the sole purpose of shorting energy-related stocks, and boy did that thing take off. But I did this for my entertainment only. I don’t like shorting stock in real life, because, theoretically, the sky is the limit on losses, and getting out can be difficult if there is a short squeeze. Short traders who had bet on Volkswagen stock going down in Germany (Frankfurt/Xetra symbol: VOW) had to learn this lesson the hard way recently, when Porsche’s (Frankfurt/Xetra: PAH3) secret accumulation of 70% interest in Volkswagen was made public and Volkswagen’s stock skyrocketed over 300% in two days in late October as a result.

So, with all these trading strategies seeming to fail, the question investors ask is: What now? Well, almost everyone agrees that the market will recover eventually. Neither the U.S. nor the world economy will stay in recession (or even depression, should there be one) indefinitely. Experts only argue over how long and what form the recovery will take. A common position is that the recovery will be L-shaped and will take many years. Others, like Brian Wesbury (the prominent economist who is currently with First Trust Advisors), foresee a quicker V-shaped recovery, betting on all the cash sitting on the sidelines only waiting for the right time to jump back in. Of course, history tells us that the market may also seesaw for many years before recovering, as it did after 1929.

However, undeterred by how many times “wolf” was cried this year about supposed market bottoms, the right (long-term) strategy is still to buy while shares are cheap and reap the profits once the market has recovered or, even better, during the next bubble. The problem is getting there, so aside from the obvious advice that one should not invest any money now that one may need soon, one should probably stay away from risky stocks as well (the market is volatile enough as it is), including many of the financials or smaller companies that may face bankruptcy. Indeed, now is a good time to get rid of those risky investments and realize the losses before the end of the year to allow for a pertinent tax deduction in April and thereby stick part of your loss with Uncle Sam (your own, personal TARP program, if you will).

In terms of which stocks to buy instead, some, like Lisa Hess of Forbes magazine, suggest to play it safe by buying index funds, such as the Diamond Trust Series 1 (DIA), which tracks the Dow Jones Industrial Average index (DJIA). Personally, I believe that one can still try to beat the market by picking individual stocks from those indices, while hedging against losses by writing call options, or buying puts, where or when one finds it necessary.

For example, back in May/June, hedge fund manager and former Raymond Jones analyst Michael Krensavage recommended pharmaceutical stocks because they were cheap, and I think his argument still holds today. Back then, he recommended Forest Laboratories (FRX), Johnson & Johnson (JNJ), Noven Pharmaceuticals (NOVN), Pfizer (PFE), Schering-Plough (SGP), and Wyeth (WYE). JNJ was trading at $65 at the time, and it still trades close to $60. NOVN was at $12 at the time, and still trades at $10.5 now. Compared to the rest of the market, this isn’t bad. Krensavage also liked Merck (MRK), but did not recommend it then because its share price had gone up significantly since he had originally put Merck on his buy list in December 2004, when it cost $29.62 per share. Merck is now back down at $25, so it should probably also go back on that list.

Johnson & Johnson, Merck, and Pfizer all form part of the Dow Industrial Average, so one should consider them established enough not to be a total gamble. Schering-Plough, Wyeth, and Forest Laboratories are not on the Dow index list, but they are still S&P 500 stocks.

Disclosure: The author owns ETFC, PFE and SGP, and owns PFE and SGP December 2008 call options.

References:

“The Dispreputable Market in Volkswagen,” FT Alphaville, Oct. 27, 2008.

Rich Karlgaard, “Recovery—Then Big Inflation,” Forbes, Nov. 17, 2008, p. 25.

Lisa W. Hess, “Annus Horribilis,” Forbes, Nov. 17, 2008, p. 138.

Matthew Herper, “Valuing Pharma Like Metal Benders,” Forbes, June 16, 2008, at 72-73.

For a historical chart of the Dow Jones Industrial Average since 1900 on a logarithmic scale, go to http://stockcharts.com/charts/historical/djia1900.html.

For an excerpt from the storm sketch by Tom Green on MTV’s S.S. Spring Break, go to YouTube at http://www.youtube.com/watch?v=K0l2X-QkbXM.

For Marketocracy virtual fund management, go to http://www.marketocracy.com.

Comments

[Dan Jacome:]

6x PE, 8% yield has PFE on my radar

2008 Nov 25 11:41 AM

[mkreisel:]

Obama talks about spending cuts and budget priorities.

What is the porkiest portion of the federal budget, huh?

2008 Nov 25 09:00 PM