Challenging the consensus is quite difficult and requires guts of steel. Contrarians have to resist the appeal of qualitative news stories, CEO 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.
Cramer made 69 buy and sell stock calls on his Mad Money program (9.04.2012 to 9.07.2012). Of these calls, two sell calls and three buy calls can be challenged on a valuation basis. Ulta Salon, Cosmetics & Fragrance (NASDAQ:ULTA), Whole Foods Market (NASDAQ:WFM), and Mellanox Technologies (NASDAQ:MLNX) are too richly valued to be buy picks. On the other hand, Intel (NASDAQ:INTC) and BP Prudhoe Bay Royalty Trust (NYSE:BPT) are too cheaply valued to be sell picks.
These picks are summarized below:
After reviewing the price multiples of ULTA, WFM, and MLNX it is clear that these stocks are richly valued according to static valuation metrics. As a basis for reference, the average holding of the SPDR S&P 500 (NYSEARCA:SPY) ETF has a price-to-earnings ratio of 13, a price-to-book ratio of 1.98, and a price-to-sales ratio of 1.24. Each of these stocks is much more expensive than the S&P 500 index according to every one of these ratios.
Net insider selling over the past six months for each of these stocks 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 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 Great Growth
Even after incorporating optimistic earnings growth, these stocks are just too expensive.
Alternatively, INTC and BPT 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 Poor Growth
The attractive valuations of these stocks protect investors from tough scenarios, providing them with better odds for positive returns.
These projected returns ignore popularity while using valuation and medium-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 3-year return estimates. They flip the script on these stock calls.
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