Today, independent thinkers are also confronted with the challenge of identifying the consensus. Who isn't a contrarian or a value investor today? How can a consensus be identified when everyone claims to be different?
Even though Jim Cramer's trades are not long-term recommendations, his picks can be a very useful barometer of investor and media attitudes. Contrarians can use his picks as an indicator of current market sentiment to selectively counter.
Of Cramer's 63 buy and sell stock opinions recently issued on CNBC's Mad Money (5.29.2012 to 6.01.2012), four sell calls and two buy calls can be challenged on a valuation basis. Ulta Salon/Cosmetics & Fragrance (ULTA), and Verizon Communications (VZ) are too richly valued to be buy picks. On the other hand, Research in Motion (RIMM), Advance Auto Parts (AAP), Boeing (BA), and Eaton Corporation (ETN), are too cheaply valued to be sell picks.
These picks are summarized below:
After reviewing the price-to-earnings multiples of ULTA and VZ it is clear that these stocks are richly valued. Other static valuation metrics confirm that ULTA is pricey, whereas the price-to-sales ratio may cast doubt whether VZ's valuation is outlandish. Inspection into the past three years of Verizon's income statements reveals the stock has not recently suffered a drop in earnings, which would be part of a scenario where earnings have temporarily dropped and valuation multiples would reflect a freak loss rather than a trend of positive earnings. Thus, the high P/E ratio is a consequence of higher valuations, not temporarily disappointing earnings. In addition to static valuation metrics, the net insider selling of ULTA and VZ shares are bad omens.
Sadly, even pleasant future growth scenarios are not much consolation for such richly valued stocks. What could an investor expect from these picks?
Total returns were calculated over a three year holding period for these stocks. (I use a 3-year holding period since above-average growth estimates are not reliable further out.) Giving these buy recommendations the benefit of the doubt, each stock is assumed to be sold at a generous growth stock price-to-earnings multiple of 17 and the maximum of historical and analyst estimate values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratios, that is, price paid today divided by earnings at the end of the holding period for each stock:
3 Years Growth
Even after incorporating optimistic earnings growth, these stocks are just too expensive.
Alternatively, RIMM, AAP, BA, and ETN were discovered as contrarian buy picks with attractive valuations by sifting through the week's sell recommendations. These contrarian buy candidates were evaluated using conservative assumptions. A bargain value stock price to earnings multiple of 10 and the lesser of historical and analyst estimates values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratio, that is, price paid today divided by earnings at the end of the holding period for each stock:
3 Years Growth
The attractive valuations of these stocks protect investors from tough scenarios, providing them with better odds for positive returns.
These projected returns ignore stories and current sentiment while using valuation and math to demonstrate how buying expensive stocks can cost investors dearly. They flip the script on these six stock calls.
Bear in mind that taking on these investments is not easy. Challenging the consensus is quite difficult and requires guts of steel. Contrarians have to shut out the allure of stories, interviews in the financial media, and other distractions in order to focus on valuation.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.