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 49 buy and sell stock calls on his Mad Money program (10.15.2012 to 10.18.2012). Of these calls, four buy calls can be challenged on a valuation basis. Amazon.com (NASDAQ:AMZN), Kinder Morgan Energy Partners (NYSE:KMP), Panera Bread (NASDAQ:PNRA), and Domino's Pizza (NYSE:DPZ) are too richly valued to be buy picks.
These picks are summarized below:
After reviewing the price multiples of AMZN, KMP, PNRA, and DPZ 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 14.0, a price-to-book ratio of 2.07, and a price-to-sales ratio of 1.32. Each of these stocks is much more expensive than the S&P 500 index according to every one of these ratios.
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 Great Growth
Even after incorporating optimistic earnings growth, these stocks are just too expensive.
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 four stock calls.
Read the article disclaimer.