The current market environment makes it tough to decide which stocks to adequately allocate your capital. In this regard, it is always best to find stocks that have strong relative strength. Relative strength is not an index to follow nor any ranking system (popularized by Investors Business Daily), rather it is an analytical method based on comparing the underlying stock in question with the performance of the overall market; more qualitative than quantitative.
A general example here is if the markets are down 5-10% year to date and the stock in question has barely moved within the same exact time frame, or even moved higher by a certain percentage, you have a strong stock that has been excluded by the market. The probability of superior returns here is obvious. Despite what seems to be so general and mundane may prove to become your biggest asset as your identity as the speculator.
In such a market, these stocks are difficult to find (which is why you come to this blog). While one can go to the 52 week high list, it is often populated by every investor and commonly screened. There is no edge there. We have to often dig deeper.
In order to do this, one of my best methods, which I have taught and explained, is the focus on defining the economic backdrop on a cyclical scale and a secular scale. Then, focus on stocks that have the best core business model to benefit from secular trends and have not been hurt by the cyclical downturn of the markets.
What does this all mean?
- Focus on what the current environment is on an economic level. Every market is cyclical in nature (boom & bust), and many sectors get taken down when markets get depressed. In today's case, the economic backdrop has proven unfavorable to commodity and mining sectors dealing with the industrial development of emerging markets.
- Focus on the secular themes of the economic environment. What this implies is the focus on the business trends that have not gained much favor, have not participated in the depression of the general market, and have done well from a business operational standpoint despite of the troubles that may have been published by popular media.
- Single out these companies and look at their stocks. Remember, stock performance and corporate performance are two distinct and independent phenomenons for the large part. They only become a focus when the entire industry comes into focus and fund managers require the "hard numbers" in order to push their point and data mine what is in front of them to justify their decision. Many fund managers allocates data found to their initial hypothesis (thus doing everything they can to reinforce their initial view point. There is a large psychological position here in regards to trader performance, but that is for a later date). The main point to be decided here is singling out the stocks of these companies and then focusing on their relative strength.
If you have done the 3 points staged above, the populated list of stocks to trade from ought to be a powerful list. Even if these equities in question have not made the "52- week" high list, they may very well be and stand to provide you with the luxury of their returns.
A stand-up example of the three points above:
Neogen Corporation (NASDAQ:NEOG)
What does NEOG do?
Neogen Corporation, through its subsidiaries, engages in the development, manufacture, and sale of various products for food safety testing and animal health applications. It operates in two segments, Food Safety and Animal Safety.
Does the company have reach?
The Company's food safety segment consists primarily of diagnostic test kits and complementary products marketed by sales personnel in the United States, Canada, the United Kingdom and other parts of Europe and by distributors elsewhere to food producers and processors to detect dangerous and/or unintended substances in human food and animal feed, such as foodborne pathogens, spoilage organisms, natural toxins, food allergens, genetic modifications, ruminant by-products, drug residues, pesticide residues and general sanitation concerns.
The animal safety segment is engaged in the development, manufacture and marketing of pharmaceuticals, rodenticides, disinfectants, vaccines, veterinary instruments, topicals and diagnostic products for the worldwide animal safety market. The majority of these consumable products are marketed through a network of national and international distributors, as well as a number of large farm supply retail chains in the United States and Canada.
Macroeconomic Effects: The Secular Theme
As of September 2008, the world population stands at 6.725 billion. On its current growth rate, the world population should swell to 9 billion by 2042 barring any global health epidemic. With this in mind, the US contributes to about 26% of global economic wealth, but to emerging markets, they consist to about 50% of the imported agriculture product.
With rising income levels and global expansion of food retailing and foodservice outlets, food consumption patterns, as measured by spending on different types of food products, appear to be converging across countries. Food products and multinational retail and foodservice chains from the U.S. and other high-income countries have become increasingly common in middle-income nations such as China and Thailand. For example, fast food sales in China more than doubled between 1999 and 2005, while sales from Western-style supermarkets increased almost sixfold, from $16 to $91 billion during the same period. Changes in food preferences and food delivery mechanisms appear to be mutually enforcing, with worldwide tastes and diets evolving along with increasingly modern food retailing and foodservice outlets. This cyclical relationship between food demand and delivery mechanisms is increasing the similarity of food delivery and consumption around the world—a phenomenon referred to as "convergence."
What this implies is that food delivery systems and consumption patterns in middle-income countries like China and Thailand are converging, or "catching up" to countries with higher income levels. Income growth has been a primary force behind converging global consumption patterns, but globalization of the food industry is also contributing.
As we can see here, globalization of food structures implies an over reliance on security and on the few distribution channels for major products.
Secular Implications for NEOG
Key Operating Metrics for Q1 ending Aug 31:
Current earnings have proven very favorable and has shown NEOG's independence from the cyclically depressed markets we are now in. NEOG revenues for the first quarter of FY 2009, which ended Aug. 31, increased 26% from the previous year's first quarter to $28,805,000. First quarter net income increased 24% from the prior year's $3,011,000 to $3,733,000, or to $0.25 per share in the current year compared to the previous year's $0.21. This compared to a 2% GDP growth and negative growth rates on corporate profits implies the clear cut "relative strength" concept I outlined above.
Bolstered by the acquisitions of Kane veterinary products (August 2007), Rivard detectable veterinary needles (December 2007), and immediately accretive DuPont disinfectants (June 30, 2008), Neogen's Animal Safety Division led the company's first quarter revenue growth, with a sales increase of 45% from $9,150,000 in FY 2008 to $13,256,000 in FY 2009. The division's sales increase included growth in products sold to veterinarians through ethical market channels, growth in products sold to large food-animal producers and processors, and a continued increase in sales of diagnostic products.
Neogen's first quarter revenues, net income, and earnings per share all represent quarterly records for the 26-year-old company. The quarter also marked the 62nd consecutive profitable quarter from operations for the company, and was the 66th of the past 71 quarters when Neogen reported revenue increases as compared with the previous year.
Key Operating Metrics for Fiscal Year Ending in July:
- Operating income grew 46%in the quarter due to higher gross margins and leveraging other costs, resulting in an increase of more than 300 basis points in the operating margin.
- The largest beef recall in U.S. history occurred in February, and followed recalls of contaminated spinach, peanut butter, and pet food. With the recent salmonella outbreak once thought to be from tomatoes but now possibly linked to peppers from Mexico, oversight of expanding food imports into the U.S all leads to what we see as the risk of a globalization of food distribution channels and thus the higher demand for superior testing; and in this case NEOG is the lead company to provide this global service.
- The gross margin was above a year ago at 52.0% versus 51.1%. Neogen benefited from
higher volumes. Recent manufacturing consolidation and greater automation contributed to lower direct labor costs and reduced overhead.
- Raw material costs, such as grains used in rodenticides and materials for culture media, have been a drag on margins, but the company has initiated price increases this year in response.
- Strong sales of culture media tend to depress the gross margin but favorably impact operating margins due to lower selling and research expenses. Neogen was able to leverage the increase in other operating expenses, which rose 12% and lagged the rate of sales growth. General and administrative expenses rose 8% as legal expenses have moderated though option expense was above a year ago. Sales and marketing costs were up 13%.
- Neogen added to its sales organization for new products and invested in foreign operations. This was well below the rate of revenue growth as the company leveraged its existing sales resources and benefited from mix effects in certain product lines. Research spending was up 28% consistently year over year.
Now that we have isolated the stock and examined the recent performance, the stock has appreciated in a market where the broader index and stocks have been depressed year to date. Moreover, in keeping with the themes portrayed in the previous posts, the stock has ~ $14.53 million share outstanding and less than 56% owned by institutions with 13% or so owned by insiders. This allows more opportunity for institutionals to own the fund.
Moreover, this implies the lack of awareness of NEOG to many fund managers and institutions out there (other wise the institutional ownership would be near 75% + ). In addition, there are no top wall street firms covering NEOG, with only marginal analysts initiating coverage.
The stock is a great play on the consequence of a globalized world, and is set to be one of the outperforming stocks in the market.
Disclosure: Author holds a long position in NEOG