Valuation Is Key to Future Returns

 | Nov 28, 2012 | 2:30 PM EST
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As the 2012 comes to a close, I always like to go back and see what investments worked best during the year. An 11-month performance record is hardly a satisfactory holding period; nonetheless, the data are worth examining.

For example, most investors would be surprised to know that the best performing S&P 500 constituent so far in 2012 has been PulteGroup PHM. The shares are up more than 160%. The second-best performing S&P name is Sprint Nextel (S), which is up more than 130%. In fact, the chart below gives you the top 10 S&P 500 performers so far this year.

Looking at the chart (and note that this is only an 11-month holding period -- one can make an interesting observation. Nearly all these stocks began the year being hated or ignored by Mr. Market. Analysts weren't recommending homebuilders, not many people were enamored with oil refiners, and more people were talking about Facebook (FB) instead of washers and dryers. Another useful observation is one that sits firmly in the value investing thought process: Popularity often comes with an expensive price tag. Or as Warren Buffett likes to quip, "You often pay a high price for a cheery consensus." Unpopular investments, however, often can offer tremendous value for the patient, forward thinking investors. Even better, value works as a catalyst regardless of micro or macro.

So, as end of the year approaches and we look ahead to 2013 and beyond, I will be looking closer at that elite club of out-of-favor businesses for potential ideas. Obviously, investing in this manner should be done carefully. It's the exception, not the rule, that an out-of-favor stock becomes a winner. For example, I'm not so sure about RadioShack (RSH) or Supervalu (SVU), which are both off by 70%, year-to-date. RadioShack is small retailer of electronics that is probably destined for extinction. If Best Buy (BBY) is struggling for its place in the market even after the demise of its No. 1 competitor Circuit City, I don't see how RSH has a chance. And Supervalu is a highly leveraged grocer that is not only competing with Kroger (KR) and Publix, but now Wal-Mart (WMT) and Target (TGT) as well.

The unloved areas that intrigue me today include areas such as natural gas where I see tremendous future long-term potential. Natural gas is a win-win in the U.S.: We have tons of it, it's cheap, and it's clean. We are seeing many domestic and international companies develop plants here in the U.S. that will run off natural gas. Two years ago, ExxonMobil (XOM) paid a pretty penny to buy up XTO in order to make a strong push into the natural gas market. Today you can own Chesapeake Energy (CHK) for a fraction of the valuation Exxon paid for XTO.

Sterling Construction (STRL) is another name I picked at the beginning of the year and, so far, that pick does not look intelligent. But I haven't given up on the name and I keep watching it. I've heard rumblings that about part of grand bargain may include a bump in fuel taxes, which would help fund a highway spending bill. Like housing, the infrastructure industry will pick up and when it does, a debt-free business such as Sterling, which is trading at 67% of book value, will look incredibly cheap.

Valuation is the key determinant to future investment results. It's an unyielding truism that valuation, i.e., what you pay, determines what you get in terms of results.

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