The 'Secret Sauce' of Investing

It's amazing how many stocks just wander within trading ranges over multiyear periods. They make money every year. Dividends rise over time, yet the shares seem to move somewhat randomly. Long-term holders get frustrated with a lack of sustained progress. Yearly highs and lows, though, are often quite far apart. That means buy-and-hold types missed great trading opportunities. Could those cyclical fluctuations really have been predictable? You'd better believe it! What's the secret sauce for investors with reasonable time horizons of perhaps six to 24 months? Stock prices frequently move much further, in both directions, than would be justified by changes in EPS. When things are going well, traders tend to extrapolate and they ratchet up valuations. When times are tough for a specific company, or the market in general, shares fall and P/Es contract. Barring dividend cuts, lower prices automatically translate into higher yields. Here are two examples that illustrate the principle. Both MSC Industrial Supply and Crane are good-quality stocks that exhibited relatively small changes in profitability from 2011 through 2016. The charts were generated using data as of April 10, 2017. MSC Industrial Supply earned $3.43 per share in 2011. In 2016, EPS were only 9.6% higher. From its early 2012 peak of $84.80 to its April 10, 2017, quote of $95.94, MSM gained about 13% plus dividends. Fair enough. MSM's average P/E over that entire six-year period was 19.2x. Shareholders typically received yields of around 1.73%. Traders' three best entry points (green-starred below) each started at discounted multiples accompanied by better-than-average dividends. Conversely, all three should have sold moments (red-starred) each represented higher-than-normal P/Es along with less-than-average yields. Pretty simple, right? How valuable was that knowledge? MSM ramped 70% from 2011's low to 2012's peak. It jumped 57% from 2012's subsequent bottom to 2014's top. Investors who saw the value analogy in late 2015 had a shot at 94% gains early in 2017. People who realized MSM was pricey near those pinnacles would have known it was time to sell. Crane showed a similar valuation cycle. EPS grew from $3.70 in 2012 to $4.23 in 2016. That was only 14.3% cumulatively over four full years. Its average P/E from 2011 through 2016 was 13.8x. A typical yield was 2.18%. Armed with that knowledge, it was easy to trade CR effectively. The three best buying opportunities (green-starred) occurred with single-digit multiples along with much larger-than-normal yields. Each of the red-starred, wish you'd sold periods flashed higher than average P/Es. They were also paying lower than average yields. Investors near Crane's 2011-12 bottoms could have more than doubled their money by the middle of 2014. Buyers during the early 2016 selloff saw up to 89% paper gains in less than one year. Holding onto CR when its valuation went clearly above normal (red-starred) didn't work out well. What could be simpler? Based on this system, neither MSM nor CR appeared attractively valued as of April 10, 2017. I reaped big gains on both these stocks by buying when they were, by definition, out of favor and cheap. I'll be ready to own them again when the values again become compelling.

The 'Secret Sauce' of Investing

2 companies show how cyclical fluctuations are more predictable than you might think.

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