Sector ETFs overpower Individual Stocks
Why does the sector pull matter? Stocks are hostage to them, even if individual companies don’t deserve to be. That’s because of the immense popularity that sector indices and the ETFs that mimic them have gained among huge institutional money managers. To put it bluntly, they would rather play with big, liquid ETFs than mess with trying to get in and out of individual stocks. These baskets, designed by firms to, once again, give big-portfolio managers large and quick exposure to a group of stocks instead of one stock, fulfill the same role the S&P 500 futures play for the entire market. How do they impact stocks on a day-to-day basis? Let’s take the oil service group, one of the sectors most keenly dominated – I would go so far as to say it has been wrecked – by ETF trading.
The power of bonds and the Fed on stocks
How you might ask, can you figure out when a run on the stock aisle into the fixed income section of the supermarket might occur? How do you stay on top of this process so you can profit from it? I could say,”Just keep an eye on the stock market at all times.” But I have a better way. I monitor the action by following the TLT, the iShares 20+ Years Treasury Bond ETF. This security goes down when interest rates go up, and vice versa. When the TLT goes down, you can expect the stock index futures to go down soon after, as stock index futures react to every minute move of this security.
How fundamental is important to investing
When I started investing I cared only about fundamentals and focused on traditional sector analysis. The most important fundamental influence is the company’s growth rate. While a company’s past – how much revenue and earnings it has booked historically can be very important, it is not the most significant factor when we are determining how much to pay for an individual stock at any given moment. What is important is how fast a company’s sales and earnings are growing, especially in the context of what is expected of the company. The expectations are set by the analyst community which is why we have to pay so much attention to the consensus of those expectations.
At all times we are trying to figure out how fast a company can grow, compared to both all other stocks and stocks in its sector. We need to know how to assess how a company performs in times of not just domestic but worldwide economic acceleration and deceleration.
We are always on the lookout for companies that can better both their sector’s growth and the economy’s growth as a whole. If we can profit from secular growth companies, that’s terrific but we may have to pay for an expensive price. In other words, the price-to-earnings multiple, what we will pay for that stream of future earnings is higher or more expensive that what we might be willing to pay for a stock with a far more variable, economically dependent earnings stream. Many companies which are the classic growth stocks include Kimberly-Clark, Procter & Gamble, Johnson & Johnson, General Mills, Coca-Cola, PepsiCo, Kellogg and Clorox. These stocks are trading at historically high levels because they can deliver consistent, albeit slow, earnings growth in a tepid economy. If you own Caterpillar, Ford, General Motors, General Electric or Cummins, you have to be on top of world events, particularly in China, pretty much every day.
Some stocks like 3M, Honeywell and Emersons are what we call growth cyclical, hybrids that have both kinds of stocks. They hold up at times of mild acceleration and stability.
Of course, some companies are levered to individual cycles. Deere, Monsanto and Potash (acquired) are all about the farm cycle, chiefly whether or not the farmers are flush. Boeing and Precision Castparts (acquired) and to some degree United Technologies hug the aerospace building cycles and track worldwide aircraft demand.
But all stocks, whether they are cyclicals, growths or hybrids, get graded the same way by analysts: Are the underlying fundamentals of enterprise better or worse than expected, as expressed by he consensus of the analysts’ estimates? Many people are fixated on the top line, I think the bottom line is more important, what a company has left after it takes out the costs of all of those goods sold, expenses, taxes and depreciation. Bigger earnings can lead to bigger dividends. Profits matter even in this new crazy world because profits can put dividend checks in your hand and help propel stocks higher over time due to those ever-increasing dividends.
How to Grade High-Growth Stocks
1st Test: Is there potential for multi-year growth that we can put a value on, a clear growth path that provides long-term visibility with multiple revenue streams?
2nd Test: Is the total addressable market big enough for the companies to sustain their growth?
3rd Test: Does the company have the ability to stay competitive?
4th Test: Is there a possibility for the company to return capital over time, through either dividends or well-timed buybacks? Or does the company have such as well-defined growth plan that it can just continue to pile the money into the business to get consistent or accelerated revenue growth?
5th Test: Can the company expand internationally?
6th Test: Can the balance sheet support strong growth?
7th Test: Is the stock expensive on the out year?
8th Test: Does the company have the right management?
9th Test: Does the company need macro growth to meet the numbers?
10th Test: Can the company maintain or grow its margins?
Understand which hidden metrics really matter in each sector, as they won’t necessarily be the earnings per share. Know the best of breed of each sector if you want to invest in it.