How to Play a Selloff

 | Nov 09, 2012 | 7:23 AM EST  | Comments
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How do you use a selloff? I've got a ton of methodologies.

You can go back to stocks of companies that have done well that got hammered anyway. You can decide to start picking at stocks you have been waiting for to come down, the preferred way of Action Alerts PLUS. But the one I want to focus on this morning is to look at stocks of companies that are doing terrifically, but they simply got too expensive.

Consider the case of Whole Foods (WFM). Here's a company that reported 8.3% comparable sales numbers, one of the highest of all the companies I follow. It has a huge growth path as it only has 342 stores with the ability to have as many as 1,000 before it starts cannibalizing itself. It remains a revered institution with a good housekeeping seal of approval aspect that amazes while at the same time it has been able to close the price gap between "regular" supermarkets and itself to the lowest level since it came public.

Best of all it is spewing cash and has the least-stretched balance sheet in the business, one that allowed the board to raise its dividend to 20 cents from 14 and to continue to buy back shares.

There's only one problem: it sells at 31x earnings. In this environment, where people are selling anything that's not nailed down, where Whole Foods represents a huge capital gain and therefore a giant tax hit next year if nothing is done about the fiscal cliff, Whole Foods becomes Public Enemy No. 1 for the taxable investor. There's just too much gain NOT to take.

So what do you do? You figure out, OK, where would Whole Foods be a gift? At what price would a 15% grower that can grow for years and years be regarded as cheap? What would you pay for the roughly $3.00 that the company can earn next  calendar year?

To me, an ideal price might be 25x earnings. You are not going to get a quality company like this on the cheap, not one with this reputation, this management and this balance sheet.

I think anything more than 25x earnings, or $75, you take a pass. Remember, this is how you use a sale not how you let it use you. Plus, when it gets to $75, I wouldn't even put on a full position. Much better to buy half and then wait, say, until it sells at 22x earnings to buy more and then 20x earnings to buy the rest.

Sure, if the growth rate suddenly slows you are going to lose a lot of money. But you will be buying it at a cheap rate historically and that's the correct prism for higher-growth investing.

You can do this exercise with a whole bunch of companies. I am only picking on Whole Foods because the quarter was everything you could ever want out of a company except for one that is so expensive that nothing could ever be enough.

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