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.
Today, independent thinkers are also confronted with another challenge: they have to keep identifying the consensus in a world where many people describe themselves as contrarians. 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 recently issued 99 buy and sell stock opinions on his Mad Money program (9.18.2012 to 9.21.2012). Of these calls, three sell calls and three buy calls can be challenged on a valuation basis. Walgreen (NYSE:WAG), Green Mountain Coffee Roasters (NASDAQ:GMCR), and Peabody Energy (NYSE:BTU) are too cheaply valued to be sell picks. On the other hand, Dunkin' Brands Group (NASDAQ:DNKN), Ulta Salon (NASDAQ:ULTA), and Under Armour (NYSE:UA) are too richly valued to be buy picks.
These picks are summarized below:
After reviewing the price multiples DNKN, ULTA, and UA it is clear that these stocks are richly valued according to static valuation metrics.
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, WAG, GMCR, and BTU 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 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.
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