The Dow Is Floating Toward 14k--Here's Your Next Move
Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Why won’t this rally die?
As we pass through government turbulence and a mediocre earnings season, it seems investors are more willing than ever to float listlessly into the sun.
Defying recent history
This market is definitely defying recent history--and expectations.
Since 2008 the stock market had been wildly volatile and earnings were largely undervalued. That’s changed, today the P/E ratio of the S&P 500 is very rich at 18 and volatility has plunged as the VIX toils near 13. Last year it touched 45.
You know what they say about “the calm;” what follows it can get pretty messy.
What’s really driving this market higher?
Theory: the Fed is "QE-crazed" and bond rates are so low that large investors have to buy stocks.
You should expect this trend to continue and you should actually find some comfort in it. There’s a tangible reason why stocks are overbought after all, and its reason enough to believe that they'll continue to soar.
Stocks rising baselessly=scary.
Stocks rising because they’re the “best of two evils”=better.
There's simply no alternative to stocks right now. The bond market is "unhealthy" and under constant assaults by the Fed; the government wants investors buy stocks.
With record low interest rates you can’t win in bonds, and just imagine if those interest rates creep up! Then you’ll be getting hammered in the short-term (low returns) and long-term (plummeting values)—stay away!
Dow 14k—a stock pickers playground
When the market is overvalued but still forcing you into stocks; smart stock picking matters.
Here’s your Dow 14k game plan:
1). Sell "extended rally" stocks--now
You don't want to be the last one holding the hot potato. Overvalued markets push stocks like Salesforce.com (NYSE: CRM) higher and higher--until they don't.
As the chart below illustrates, Salesforce.com's meteoric rise in share price--including a near 60% rise this year--has little causal relationship to the company’s actual performance (diluted EPS).
Salesforce is really a wonderful company, but it's dangerous in this market. Even if the company meets all of analysts’ expectations over the next year it would only be growing at rate of 25%--not 60%.
And if it starts to miss its lofty expectations (even slightly), it'll get ugly--just ask Apple shareholders.
The fact is the stock is trading at such a ridiculous premium based on speculation that its "tomorrow" will be much better than today.
At some point, cautionary voices will surround CRM and it's reasonable to expect that it will (eventually) trade closer to its earnings.
And even if we project a ridiculous forward multiple, say 30x, we would still come to a price of just $58--even if CRM hits all expectations for 2013.
2). Adopt a “yield appreciation” strategy
Overvalued markets demand that you start playing defense. Bonds aren’t paying but you may also be feeling “nervous” in stocks, so buy high dividend payers—a hybrid between the two. You’ll get regular income while staying in the healthy market. And if the market sells-off high yields will grow and offer a “yield appreciation” safety net as a “bottom” in these stocks is quickly established by new investors chasing the accelerating yield.
3). Buy Quality
The only way that this “yield appreciation” strategy works is if the dividend is safe. The best way to determine if a business is high caliber is by tracking return metrics (ROE or ROA) and profit margins. Many companies’ juice earnings by cutting costs or expanding recklessly, only top businesses can earn a high return and charge more for their products or services.
It’s simple; businesses that earn high returns on investment are highly unlikely to cut their dividend.
These stocks meet these criteria (high yield + high ROE + high PM)
|Microsoft (NASDAQ: MSFT)||3.30%||22.62%||21.20%|
|Altria Group (NYSE: MO)||5.26%||94.15%||15.98%|
|Coca Cola (NYSE: KO)||2.75%||26.52%||18.63%|
4). Feel free to send me a "thank you" letter
2 Final Hurdles--We're Not Done Yet!
To avoid "dividend traps," only purchase stocks with a pay-out ratio below 50%. If a company is paying more than 50% of its earnings back to shareholders it has to be desperate to keep shareholders on board (huge red flag).
The second tie breaker is subjective: ask yourself, which company can survive an Armageddon scenario? Yep, when playing “defense” you want to imagine the worst (recession, etc.) and pick a stock that would still thrive.
So who wins?
To work in reverse order, I feel that Altria, Coca-Cola and Microsoft can best survive an "Armageddon" scenario. Altria sells a product that would survive a nuclear holocaust (cigarettes). Coca-Cola and Microsoft are both growing solidly in emerging markets (especially KO) and do not have "juggernaut" competitors (especially MSFT). Yes, if Apple has taught us anything it is that tech is a free for all--except for Google.
Which brings us to the puzzling case of Altria's pay-out ratio; it's a whopping 90% while Coca-Cola and Microsoft both come in at safer sub-50% percentages. While Altria may offer a higher yield, its pay-out ratio has risen faster than dividend increases.
Conventional wisdom says Altria's yield is higher (than KO and MSFT) because it doesn't offer much growth. But, if it's not growing EPS, where is it getting the money to pay-out 90 cents on every dollar it earns?
Unfortunately, the pay-out ratio spike coincides with an unfavorable fiscal strategy to take on more debt while depleting available cash.
Why is Altria so bent on paying-out an unsustainable dividend?
Reckless or (clueless) management? Or perhaps something even more pernicious, perhaps it's a red flag that the long term sustainability of the business model is at risk. Don't stick around to find out; no matter the reason, the pay-out is fiscally irresponsible.
On the other hand, Microsoft and Coca-Cola are quality companies that both offer high income, while still keeping enough cash to re-invest in their businesses. I recommend that you sell your bonds and “extended” plays immediately, and instead start a 1/3 position in each of these companies; distribute the remaining 2/3’s on market dips.
Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends 3D Systems, Coca-Cola, and Salesforce.com. The Motley Fool owns shares of 3D Systems and Microsoft and has the following options: Short Jan 2014 $55 Calls on 3D Systems and Short Jan 2014 $30 Puts on 3D Systems. 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!