Challenging the consensus is quite difficult and requires guts of steel. Contrarians have to ignore the allure of popular glamor stocks, interviews in the financial media, and other distractions in order to focus on valuation.
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 101 buy and sell stock opinions recently issued on CNBC's Mad Money (7.23.2012 to 7.27.2012), two sell calls and four buy calls can be challenged on a valuation basis. Amazon.com (AMZN), The Sherwin-Williams Company (SHW), Whole Foods Market (WFM), and AT&T (T) are too richly valued to be buy picks. On the other hand, Pitney Bowes (PBI) and Hasbro (HAS) are too cheaply valued to be sell picks.
These picks are summarized below:
After reviewing the price multiples of AMZN, SHW, WFM and T, it is clear that these stocks are richly valued according to static valuation metrics. Net insider selling of these picks over the past six months is also discouraging.
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 each of these stocks. (I use a three-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, PBI and HAS 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. PBI shares earn a handsome return even after declining earnings. HAS shares see a worst-case scenario of a slight -0.5% loss after applying the lower of historical and projected earnings growth. This is a very limited downside.
These projected returns ignore popularity while using valuation and near-term growth to calculate the consequences of buying expensive and cheap stocks. Instead of picking stocks based on current popularity, the calculation of expected returns converts growth projections and a reversion from current extreme valuations into three-year return estimates. They flip the script on these six stock calls.
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