Rational Decisions Result in Superior Returns

Knowing what stocks are really worth gives you the power to make logical buy/sell decisions. The best way to estimate value is comparing a stock's current P/E and yield (if applicable) to its own historically normal levels. Overpriced stocks and underpriced stocks almost always revert back towards normal over time. That's the key to making smart investment decisions for those with reasonable (6 to 18-month) time horizons. On Jun. 22, 2017, I published an article here on Real Money Pro comparing 3M to Tractor Supply . MMM was quite popular while trading near what was then an all-time high price, and at its highest P/E in more than a decade. MMM's yield was subpar compared with its own typical level as well. Tractor Supply had the opposite look. Nobody liked it. The stock was near a multi-year low price and was offered at its lowest P/E in more than 10-years. Its current yield was more than double its long-term average. Somewhat surprisingly, considering what was going on with the stocks, MMM's previous and expected future growth rates were inferior to those for TSCO in every major category. Traders were flocking to 3M due to its better share price momentum while ignoring TSCO's superior metrics and cheaper valuation. Those shunning Tractor Supply apparently were adhering to the never catch a falling knife school of investing. 3M was clearly too expensive. From that Jun. 21, 2017 quote, it offered poor, perhaps even negative, future returns if it regressed to the mean. That would be true even if MMM managed to hit new earnings records in both 2017 and 2018. MMM had experienced three periods of similarly poor performance (see black double-headed arrows below) since 2007, as the stock got ahead of the share's fundamental value. Conversely, Tractor Supply offered outstanding upside simply by moving back to a more normalized valuation. Like 3M, TSCO was expected to post record EPS in both 2017 and 2018. On that basis TSCO figured to reach more than $83 by the end of 2018, about 56.5% above its Jun. 21, 2017, quote. As it turned out, both 3M and TSCO ended up exceeding profit expectations for 2018. MMM is now looking for EPS of $9.97 this year while TSCO expects to earn $4.28 per share. Both raised their payouts during each of the past two years. Now for the good stuff. Did the stocks perform in line with my theory? You bet they did. In the sixteen plus months from Jun. 22, 2017 through Oct. 31, 2018 MMM lost about 13% per share. TSCO gained more than 75%. That huge disparity in stock price movements is easily explained. MMM predictably suffered through P/E compression while TSCO predictably benefited from P/E expansion. That 88% difference over around a 16-month holding period makes a huge impact on how your portfolio would look. Follow these three rules if you seek to achieve better than average long-term results. Fill your accounts with undervalued shares. Avoid the siren song of high momentum, overpriced stocks. Have the patience to let regression-to-the-mean work its magic. All goal prices are moving targets subject to tweaking as quarterly numbers are released. The principle of buying out-of-favor cheap stocks versus popular but expensive stocks, though is far more important that all but the most significant estimate changes. I have been making money using this technique for more than four decades. I bought lots of TSCO in the summer of 2017 as it sank towards the $50 range. I drastically increased the size of my position last spring when market craziness gave me a second chance to buy Tractor Supply at under $60. I'm now hoping to be called away on those shares in 2019, via covered calls sold at $90, $95 and $100 strike prices.

Rational Decisions Result in Superior Returns

Knowing what stocks are really worth gives you the power to make logical buy and sell decisions.

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