What happens to “buy and hold” stock investors?

…I have always argued that you must cut your losing positions because they may take years to come back if they ever break even. Back in the 1930’s, RCA was the top touted stock but it took 30 years to break even from the 1932 price level. Ever hear of Enron, Worldcom, Lucent, etc… Two of these will never return a break-even investment for their holders and one may take another 5, 10, 15 or 20 years to break even (if ever). Lucent traded above $60 in late 1999 but has since traded in the $2 range. I know of a family member that went crazy buying up shares in 2002 and 2003 while it traded between $1.50 and $2.50. I know she still owns these shares to date and I told her not to do it and even sent her a free trial subscription to IBD in 2002. The stock closed at $2.77 yesterday. I know she is showing a profit but I also know she has locked up large sums of money in a dead stock that she is “hoping” will come back. She lectures me that I am a risky investor but I laugh to myself because LU may never make a watch list of mine ever again. I know she won’t read this so this is why I write about the topic.

Last night, two familiar stocks crossed my daily screens that were flying high in the late 1990’s and early 2000’s. The first stock, NVDA, was one that I owned many years ago as I was learning about video cards, photoshop and other large software programs that required cards from this company.

I was working with an architectural firm in Connecticut when I had a discussion with the principal owner about a company named Nvidia. This architect traded in the market seriously but on a casual basis in my opinion. While reading a magazine, he saw a story on Nvidia and how they were stealing market share from ATI and the other leaders at the time. Their technology was by far the best on the market and they were extremely innovative compared to the industry leaders. Based on that article and the fact that his firm just purchased computers with these chips, he immediately bought several hundred shares.

As I remember back, he loved high tech companies as did everyone and bought shares of Intel (INTC) and Cisco (CSCO) for each of his nieces and nephews on their birthdays. He would always say that they would thank him when they turned 18 and needed money for college. His quote was something like this: “If I give them $100 now, they will blow it in one shot at the mall; if I buy them shares, they may hate the gift now but will understand when college tuition is knocking on the door” and then he would say: “Intel & CSCO will never go down”. – Big mistake! This was the “buy and hold” mentality, even during the crazy 1990’s. Looking at a 5-year chart for Intel, the stock has not recovered the highs of 2001 and sits at a loss for shares purchased five years ago. Cisco is no where near its former highs of $70, $80 and $90 (it closed at $18.35 yesterday). I hate to say this but those nieces and nephews are showing losses (from the original installments of $100) that become ever bigger when you consider depreciation of the dollar and some inflation. The buying power of the $100 from 5 years ago is not the same today. If he bought them a mutual fund or invested into their education IRA’s, they may have made some nice profits.

Looking at his other stock, NVDA, he made a lot of money buying and selling because he felt NVDA was a fad, different from Intel. I don’t know if he ever sold his entire stake but if he didn’t, he would only be breaking even this week from shares purchased in May of 2002. Shares bought in early 2002 would still be showing a loss, four years later. I can’t imagine locking up my money for four whole years while a stock is sitting there doing absolutely NOTHING. On top of the stock doing nothing, he would have missed the education stocks of 2002, the builders stocks of 2002, 2003, 2004 and the final leg in 2005. He would have missed CECO, COCO, HOV, TOL, NVR, CTX, LEN, APOL, TZOO, TASR, FORD, URBN, APPL, RIMM etc. as the list goes on. No one person owned every one of these superstar stocks but the chance that he may have bought one or two of these market leaders exists.

The other stock making the screen last night (also a former MSW Index stock in late 2005) was NDS Group (NNDS). The stock closed at its highest level since June of 2001. To make an all-time high and allow some investors to break even if they are still holding from 2000, it would require the stock to gain $30 from the current $44 level.

I only provided a few short examples but you get the idea of the article. Don’t ever think for one minute that today’s leaders will be tomorrow’s leaders and that buying and holding is the ultimate answer. Turn to mutual funds if you prefer the buy and hold strategy. At least these fund managers will sell their poor performing issues and give you a “chance” by adding current day leaders.

The moral of the story: have sell rules and never hold a losing position!


Checking the Financials

Last night, I allowed a very small stock with very low volume make the “Interesting Stocks” section of the daily screen. I also said that I would look into the numbers deeper (fundamental analysis). WIRELESS XCESS (XWG) is engaged in the nationwide sale and distribution of a wide range of products, accessories and components for cellular phones, including batteries, chargers and antennae. The Company’s products are generally sold through third party retail stores or Web sites and directly to customers on the Company’s Web site.

After researching the Annual Income Statement, I have come to these early conclusions:
Revenue rose from fiscal year 2003 to 2004 from $11,469 to $15,307 (all numbers in thousands in this analysis) but the total revenue in 2002 was at $14,068. Looking at these numbers, you can see how revenue fell in 2003, only to rebound in 2004.

Next, I looked at the Net Income applicable to common shares and I saw an increase from 2002 to 2004:
2002: ($541)
2003: ($164)
2004: $1,008

Remember that numbers in parenthesis are represented as negative, so the ($541) and ($164) represent losses.

The increase would be great except that sales are not increasing with the same consistency. Companies have two ways to increase their bottom line:
1. Slash costs and operating expenses
2. Increase Sales

I prefer companies that are increasing sales rather than slashing operating expenses. To defend my opinion, a company can only cut costs by so much for so long, meaning the rise in the stock price will eventually stop. Companies that increase sales generally have products that are in demand and can continue to increase earnings though greater revenue streams. The best companies do both, cut costs and increase revenues, allowing the EPS to rise quarter over quarter.

Looking at the bottom line for Operating Income or Loss for Wireless Xcessories, we can see a decrease in operating expenses, therefore giving the bottom line room to grow:
2002: ($524)
2003: ($171)
2004: $909

When I look to Assets, I see an increase in cash from 2002 to 2004 but I see a decrease in Net Receivables from $1,213 to $1,144. The inventory has also increased which isn’t the best thing if sales aren’t also increasing. The total current assets have increased year over year but I am a bit skeptical because liabilities have also increased slightly.

After checking out the cash flow statements, I can see that borrowing has declined but total cash flow from operating activities are down from 2002 to 2004 from $1,487 to $1,066.

The CEO has been selling shares in June in the $8 range but I don’t have any concrete data other than basic yahoo finance to finalize my opinion. As far as earnings are concerned, I haven’t been able to come across reliable information as the company is young and was a penny stock as recently as last year.

Bottom line, the company may continue to increase its stock price based on speculation and cost cutting but I won’t be very interested in buying shares in the company until revenues increase by at least 25% per quarter.

I hope this helps with your own analysis,


PEG Ratio

I have been using PEG ratio for the past several years with great success. It cannot be used alone but is a very powerful tool when integrated with the basics (price, volume and chart reading). I am going to use the definition form investopedia.com as it makes complete sense and doesn’t get too confusing:

What the PEG Ratio is:
“The PEG ratio compares a stock’s price/earnings (“P/E”) ratio to its expected EPS growth rate. If the PEG ratio is equal to one, it means that the market is pricing the stock to fully reflect the stock’s EPS growth. This is “normal” in theory because, in a rational and efficient market, the P/E is supposed to reflect a stock’s future earnings growth.

If the PEG ratio is greater than one, it indicates that the stock is possibly overvalued or that the market expects future EPS growth to be greater than what is currently in the Street consensus number. Growth stocks typically have a PEG ratio greater than one because investors are willing to pay more for a stock that is expected to grow rapidly (otherwise known as “growth at any price”). It could also be that the earnings forecasts have been lowered while the stock price remains relatively stable for other reasons.

If the PEG ratio is less than one, it is a sign of a possibly undervalued stock or that the market does not expect the company to achieve the earnings growth that is reflected in the Street estimates. Value stocks usually have a PEG ratio less than one because the stock’s earnings expectations have risen and the market has not yet recognized the growth potential. On the other hand, it could also indicate that earnings expectations have fallen faster than the Street could issue new forecasts.

It is important to note that the PEG ratio cannot be used in isolation. Like all financial ratios, to properly use PEG ratios, investors must use additional information to get a clear perspective of the investment potential of a company. Investors must understand the company’s operating trends, fundamentals, and what the expected EPS growth rate reflects. Additionally, to determine if the stock is overvalued or undervalued, investors must analyze the company’s P/E and PEG ratios in relation to its peer group and the overall market.” – provided by www.Investopedia.com

This is the first time that I will try to teach PEG ratio to an extended audience without face to face interaction or a very detailed personal e-mail. I have noticed that people can get confused with my explanation when I try to generalize the procedure that I use.

You must enjoy crunching numbers and have a calculator handy to estimate your own PEG ratio. You also must have access to quality statistical information from the web (past earnings and future earning estimates). A variety of websites produce a PEG ratio but I have not found one site that has a reliable PEG ratio that I can use for my own research, so I calculate it myself, ensuring accuracy with the final number. You will start to realize why I spend so much money making sure that I always have accurate numbers rather than using the free internet sites for my statistics. The free sites work but always cross reference your numbers; this is your hard earned cash that you are dealing with, we wouldn’t want to throw it away because of careless mistakes.

Using Paincare Holdings (PRZ – see the recent case study), I will demonstrate why this stock looks so attractive during this sideways market.

First, you will need to gather the past earnings numbers; going back at least 2 years and going forward two years.

2003: 0.05
2004: 0.14
2005: 0.25 (E)
2006: 0.34 (E)

Now we need to calculate the growth from year to year.
Subtract the earnings of 2004 by 2003 and then divide by 2003.
Repeat the process to determine the growth rate for the following years:

2004: (0.14-0.05)/0.05 x 100 = 180% growth rate

2005: (0.25-0.14)/0.14 x 100 = 78% growth rate

2006: (0.34-0.25)/0.25 x 100 = 36% growth rate

Now, take the current price (we will use the close from Monday night – $5.10) and divide it by 2004 earnings and then by the 2004 growth rate:
2004: 5.10 / 0.14 / 180 = .20 PEG Ratio
2005: 5.10 / 0.25 / 78 = .26 PEG Ratio
2006: 5.10 / 0.34 / 36 = .41 PEG Ratio

Now, I take all three and add them up and divide by the total number:
.20 + .26 + .41 = 0.87

0.87 / 3 = 0.29 PEG Ratio (Very Positive).

Using the definition from above, Investopedia states that a stock is evenly valued at a PEG ratio of 1 in a rational and efficient market. Please note that the stock market is not very rational or efficient so we only use this number as a secondary indicator and tool, after our fundamental and technical analysis is complete. PRZ’s PEG Ratio of 0.29 leads me to believe that the stock is undervalued, compared to its peers and overall market.

To determine a price target going forward, using today’s numbers, we can conclude that $12.50 and $19.50 could be achievable in a rational and efficient market. Remember, we don’t work with rational and efficient markets!

How do I get those numbers?

Use this calculation for 2005
$19.50 / 0.25 / 78 = 1 PEG Ratio

Use this calculation for 2006
$12.50 / 0.34 / 36 = 1 PEG Ratio

I now have an exercise for everyone:
Calculate and determine the PEG ratio and some price targets for LaBarge (LB) going forward. I will upload my results tomorrow during the day to allow everyone to complete the exercise. This is where the education will get fun! This is a nice tool to determine possible price targets and stock valuations. As time moves on, I will introduce another tool to help determine price targets, using charts.

Finally, once you determine the PEG ratio of the stock you are looking to buy, take the time to calculate the PEG ratio for the “sister stocks” in the industry group to see if they have higher or lower PEG ratios. Keep in mind, PEG ratios don’t work for companies with negative or non-existent earnings numbers.


Don’t Buy Stocks based on P/E Ratio alone

…I use the P/E ratio as a secondary indicator for buying and selling stocks but I don’t use the ratio in the same a manner as many value investors teach. I will explain the difference in my methodology for using the P/E ratio to your advantage.

Many value investors will pass on a growth stock that has a P/E ratio higher than a predetermined level. For example, they may discard all stocks that have a ratio of 15 or higher, no matter what industry group they come from. Some investors will discard any stocks that have P/E ratios above the industry group averages, concluding that they are grossly overvalued. I am not saying that this method doesn’t work, because it does but it will not work when you focus on buying young innovative small cap stocks that are growing at tremendous rates, rates that “big caps” can no longer sustain.

I have never passed on buying a stock due to its P/E ratio being too high. What is too high? Too high to one investor may be low to another investor. This is the same logic that I use when speaking of stock’s prices. One problem that have with some value investors is their lack of understanding of the movement of the P/E ratio line on a chart. As a stock begins to move 100% or 200% from its pivot point, the P/E ratio will also move higher over the course of time. Plotting the P/E ratio on a chart will show you how much of a gain the ratio has made as the stock continues its up-trend.

Value investors that pass on buying stocks with P/E ratio’s above a certain threshold have missed some of the biggest winners of all time (the 10-baggers as Peter Lynch would say). Analysts frequently downgrade stocks when their P/E ratios cross what they believe to be fully valued thresholds.

Some things in life are worth more than other things although they offer the same use, such as a car. I tend to use this example often but I would rather own a Mercedes for $50k over a Pinto for $10k. They will both take me where I want to go but I value the amenities that the Mercedes gives me and the added comfort, quality and style that comes with the luxury vehicle. The same holds true for stocks, certain companies offer greater appeal and are valued at higher ratios than their competitors. The best materialistic things in life, including growth stocks, are usually bought at a premium.

The P-E ratio uses a stock’s current price and divides it by total earnings per share over the past four quarters. For example, currently GDP has a P/E ratio 51.06 with a share price of $24.00. Its last four quarters of EPS add up to $0.47. Its P-E ratio is $24.00 divided by $0.47, or 51.06. MSN Money Central has the P/E ratio listed at 51.30.

Growth stocks usually sport higher P/E ratios than the rest of the general market, even at the start of up-trends. A high P/E ratio typically means that the stock is enjoying strong demand. If a stock climbs in price from 40 to 60, its P/E ratio also gains 50%. Even though the P/E ratio may be high according to some analysts and value investors, the stock may be about to breakout from a cup-with-handle and go on to double from this point. Would you want to miss out on a possible 100% gain because the P/E ratio is too high?

Investor’s Business Daily conducted an excellent case study in 1996-97: “The 95 best small- and mid-cap stocks of 1996-97 had an average P-E of 39 at their pivot and 87 at the peak of their run-ups. The 25 best large caps of those years began with an average P-E of 20 and rose to 37. To get a piece of these big winners, you had to pay a premium.”

When I purchase a stock, I note the current P/E ratio and chart it along with the price. Historically, P/E’s that move up 100%-200% or more while the stock is advancing, usually become vulnerable stocks and can start to become extended and flash sell signals. It holds true for a stock with a P/E starting at 15 and going to 40 or a stock with a P/E of 50 and going to 115. Don’t skip over EXCELLENT companies that are growing at amazing clips because of a high P/E ratio. What may seem high now, may be low later on! Earnings and Sales are much more important. Price and volume are the most important. The P/E ratio is just a secondary indicator that can be used to further analyze the stocks in your portfolio.

Always use price and volume as your first line of offense and defense. From this point, turn to some dependable secondary indicators to confirm your original analysis and then make a decision. I would never throw out a stock because its P/E ratio is too high. Take GOOG for example, every value investor missed the 100% gain that this stock boasted after the release of its IPO. Growth stocks are expensive for a reason, don’t forget the analogy to a Mercedes.

Enjoy the Weekend,

Where do I get Institutional Numbers?

I have received almost two dozen e-mails asking where institutional numbers can be found such as the ones I placed on the most recent case study. These numbers can be obtained by any investor on numerous websites on the internet for a fee to that specific research house. I personally use the numbers from Vickers Research as I have told many of you individually through e-mail. Several types of accounts can be purchased through Vickers Research depending on the amount of information that the individual investor is looking for. The fees vary greatly and can become quiet expensive for the novice investor. A standard research plan for their services can range between $100-$200 per month and higher. I do not have any affiliation with Vickers and have never endorsed their products. I am just spreading the knowledge and allowing everyone in the community to research one of the many research houses in the country that collects institutional data each year.

Daily Graphs, a sister company of Investor’s Business Daily, also offers basic institutional sponsorship numbers on their charts but they lack in expanded detail. The complete package for Daily Graphs does cost over $1000 per year. Each tool can be purchased a la carte for a smaller fee but I don’t have the details in front of me at the moment. You all can venture to their website for the price structure.

Research tools can become very expensive for the novice investor that is not making a significant amount of money in the market. I would suggest to hold off and not purchase these tools until you are making a consistent profit using the tools on the web that are currently free such as earnings and sales on numerous websites. This additional information will be overwhelming if you have not mastered the basics of investing taught through our philosophy. I made consistent profits early on in my investing career without ever looking at institutional numbers but I now study these numbers and use them to help me make buy and sell decisions. I suggest one step at a time. I added that case study to let you know that the learning process never ends and you will always find new tools to add to your arsenal.

As I say on the FAQ page of our website, MSW is not affiliated with any company within the financial industry or any company in any industry for that matter. We use several tools from many companies around the country to produce our screens and case studies but we do not interact or corroborate with anyone at these companies. I do not accept links on this website and I do not want banner ads plastered on any of my pages as I would like to keep the site clean of any outside influence. The only links that I do provide are for books that I strongly recommend or free websites that allow you to use financial data or charts.