The market environment seems to have turned for the worse. Investor sentiment is deteriorating. U.S. GDP numbers are coming in lower than expected. And to top if off, the reality that unemployment may actually be worse than 9.1% is now hitting home.
Even though we are likely to avoid a double-dip recession, that makes no difference to investors today. In the short run, stocks only seem to be going up if news of additional artificial stimulus is coming.
Given the Fed's accommodative language, a QE3 of some sort is likely in the playbook later this year. The arrival of QE3 will surely excite Mr. Market and likely provide the desired effect of temporarily elevating stock prices. Depending on how low markets go between now and that highly-anticipated announcement will determine how much of a high Mr. Market will have. But anyone interested in a little more capital gain than that bestowed by the Fed should participate in this market with two simple, yet invaluable guideposts. Like any sensible investment tool these are no guarantees to higher returns, but their application will likely keep you ahead of the pack.
Have Realistic Expectations
One of the most expensive mistakes investors make is believing they can realize outsized returns no matter the market environment. When markets are in decline, virtually all equities seem perfectly correlated. As of last week, less than a dozen stocks out of thousands traded at a 52-week high. Anyone who thinks they have the intellect to pick out these needle-in-a-haystack names should forgo investing in stocks and instead head for the racetrack.
Als, future returns are directly correlated to valuation. An investment in Deere (DE), widely considered a business of high quality, made at the beginning of 2008 when the S&P was trading 1,378, or a cyclically adjusted P/E of 24, is down about 13% today. Buying Deere at the beginning of 2009 when the S&P was trading at 865, or an adjusted P/E of 15, has generated a return of over 95%. Staring point matters.
Looking at the equity landscape today, investors will be severely disappointed if they think anything beyond a high-single-digit return (after taxes and inflation) is likely for the broad S&P 500 index at current levels. That means the 15% or so of pros who will outperform the market may do no better than to expect 11% to 14% returns. There is nothing fake about realistic expectations. Knowing and understanding them leaves your capital well preserved for the rare opportunities like 1947, 1981, and March 2009. Sometimes not losing is the same as winning.
Think Like a Business Owner
As much as it sounds like a cliché, if you treat a stock like a piece of paper that has a daily quotation, then expect little from your investment in that little piece of paper. If you choose what to invest in as if you were owning the whole company and attach your analysis to factors like management quality, cash flows, and price, your rate of error will likely go down significantly. In up markets, it seems like any investment criteria leads to capital gain. If only markets would always go up. Thinking like a business owner ensures that when the proverbial tide goes out you won't be caught swimming naked.
Such a mindset is why I would prefer to own fertilizer giant Potash (POT) at a P/E of 21 vs. Procter and Gamble (PG) at a P/E of 16 and a yield of 3.4%. Both are high-quality profitable businesses. Yet Potash exists in an environment where there is little competition and a degree of pricing power. When prices are unattractive, Potash simply turns off the capacity. P&G on the other hand is dealing in a new environment where its customers, namely Wal-Mart (WMT), will continue to squeeze out every penny of savings. And P&G will have to cooperate. Of course, price is the ultimate detriment of value and at the right price, P&G could be more attractive. But in terms of growing intrinsic value over time, Potash is the clear winner.
The promise of fabulous future growth matters not one iota to me in considering a name like Netflix (NFLX), which is trading at 54x earnings, or inverted, a 1.85% earnings yield. In today's world, folks are quick to turn down purchasing commercial real estate at annual cap rates, or the ratio between net operating income and price paid, of 12%, a tangible rate of return that you receive with every payment. Yet those same folks are eager and content with earning 1.85%. Those same folks should then be indifferent to paying $1 million for office space producing $18,500 in annual operating income.
Investing is rarely about hitting home runs but a lot of singles and doubles. And when the pitches are outside the strike zone, as many of them are in today's environment, the best strategy is to simply wait. Swing aimlessly in today's market is a recipe for a poor batting average at best and a significantly more expensive lesson at worst.