Dow at Five Year Highs: What to Buy and Sell

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With the Dow recently hitting five-year highs it is getting harder to find value in this market.  In fact, for the first time in over a year, I'm seeing some sell signals in favorite stocks of mine.  But don't despair.  While I recently added some key names to my sell list I still found some very attractive long term investments.

Part of being a successful investor is not only knowing when to buy, but also when to sell.  I love oversold conditions and pride myself on spotting them.  However, in the same way I spot oversold conditions I also observe the inverse, and that's when you sell.

HOME DEPOT

For the record I absolutely love Home Depot (NYSE: HD).  But recently it has broken through its previous 5 year P/E record high of 22.90.  Currently Home Depot sports a P/E of 23.73.  Fundamentally, that gets me wondering how much longer this recent climb can continue.  Value investors are backing off since the recent price spike has shrank the dividend to 1.70%, however, this yield still comes at the expense of a 41% payout ratio.

Looking at a three-year chart (Figure 1) Home Depot has had quite a run over the last 16 months moving from $30 to well over $66 for a 120% gain in that short time.

Figure 1:

<img src="/media/images/user_14634/hd-3-year_large.png" />

 

While the stock may be soaring, the fundamentals don't really support such a move.

Revenue:  Looking at past vs current revenue there appears to be little significant change.

Earnings:  While margins have been improving earnings growth has not been impressive enough to warrant a 120% stock price increase.

Sales:  With a housing rebound taking shape there is speculation that sales might increase.  But how quickly the recovery will manifest is largely in debate.  I am personally in the camp predicting a slow and steady recovery that will play out over the next decade.  Therefore, I believe the huge gains seen recently are premature.

Margins:  As noted earlier margins are improving.  Year over year profits, ROI, and ROA are all higher than their five year averages.  While these efficiencies are impressive given the large scale nature of Home Depot's operations, the 2-3% improvements are not enough to justify a 120% move higher.

Conclusion:  This stock is getting expensive at the $67 level in my opinion.  Selling to lock in gains after such a great run never hurts.  If you simply must continue to ride this stock please consider a trailing stop in the 3-6% range, taking into consideration your current profit and risk tolerance.  I often use trailing stops in conditions exactly like this to ensure that I walk away with gains.

VALE

It's always a bit of a bummer to have to sell a great stock like Home Depot.  Fortunately if you can replace it with another quality stock the pain isn't so bad.  I think Vale (NYSE: VALE) could be that stock.  High yield, attractive value fundamentals, and a great future are just a few of the things I'd want to point out to my fellow value investors.

Allow me to sum up my case with a table (Figure 2) containing some key fundamentals.

Figure 2:

<table> <tbody> <tr> <td>Valuation</td> <td>Vale</td> </tr> <tr> <td>P/E</td> <td>8.92</td> </tr> <tr> <td>Forward P/E</td> <td>8.74</td> </tr> <tr> <td>Price/Book</td> <td>1.32</td> </tr> <tr> <td>Price/Sales</td> <td>2.83</td> </tr> <tr> <td>Yield</td> <td>3.00%</td> </tr> <tr> <td>Avg. Five Year Profit Margin</td> <td>35.70%</td> </tr> </tbody> </table>

Along with attractive value there has been a shift in the macro-economic outlook.  The multi-year downtrend was created by the slowdown in China and amplified by speculation of a hard landing.  Now that China has made a soft landing and might even be gearing up for some rapid growth the fundamental view of Vale's future may have changed.

Once again, let's review the order of operations:

Value first:  Without value you are buying a bubble.  Air isn't worth much and neither is the bubble holding all that air inside. 

Facts Change: A fundamental macro-economic shift put this stock on my watch list.

Conclusion:  We have value, and a macro-economic shift all pointing to a bullish run for Vale.  However, due to the major price fluctuations seen recently this stock is not for the squeamish.  Speculative Buy and Hold. 

BONUS DISCUSSION: JOY GLOBAL

Recently Joy Global (NYSE: JOY) has caught my attention.  First with its attractive valuations (Figure 3) following the recent stock price drop.  This was brought about by negative sentiment surrounding China and the potential decreasing demand for raw materials extraction equipment.  Then, as mentioned before, it looks as if China is making a bit of a soft landing and setting up for quite a comeback.

Figure 3:

<table> <tbody> <tr> <td>Valuation</td> <td>Joy Global</td> <td>Industry</td> </tr> <tr> <td>P/E</td> <td>8.6</td> <td>12.4</td> </tr> <tr> <td>Price/Book</td> <td>2.53</td> <td>2.75</td> </tr> <tr> <td>Yield</td> <td>1.1%</td> <td>0.90%</td> </tr> <tr> <td>Avg. 5 Year Dividend Growth Rate</td> <td>3.22%</td> <td>-4.03%</td> </tr> <tr> <td>Avg. 5 Year Sales Growth Rate</td> <td>14.47%</td> <td>-14.55%</td> </tr> <tr> <td>Long Term Debt/Equity</td> <td>0.51</td> <td>1.47</td> </tr> <tr> <td>Avg. 5 year Net Profit Margin</td> <td>12.90%</td> <td>5.30%</td> </tr> </tbody> </table>

On top of these attractive numbers Joy is also beating the industry average in RoI, RoA, and is a leader in capital re-investment.

Here we can again see the above thesis in action.  Value first and then the observation that the macro economic outlook of China is changing.

Conclusion:  Joy Global has been placed on my personal watch list.  Valuations look attractive but I would like to see the demand for raw materials significantly rise for two consecutive quarters to confirm that new extraction equipment will be needed in greater supply.  That would produce a more favorable earnings environment.  Currently the P/E is 8.6 and the Forward P/E is 9.73.  As a general rule I hardly ever buy companies with a greater Forward P/E.  But as analysts raise earnings estimates for the future look for that Forward P/E to shrink.

Overall Conclusion:  I always get a good feeling about a stock when value and macro-economics all line up pointing to good things in the future.  But I also make sure to watch for the other side of that equation.  High P/E's, unsustainable stock price returns, and poor (or overly optimistic) macro-economic outlooks, can also help you call a top in your favorite stocks.  Even a long term value investor needs to actively manage their portfolio to take advantage of both buying and selling opportunities for maximum returns over the long run.  Never be afraid to take profits or at the very least play with the house's money.


Lulupoopsalot has no position in any stocks mentioned. The Motley Fool recommends Home Depot. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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