A Pattern of 18 Percent Average Gains

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Sometimes you have to look at what has worked in the past if you're going to have investing success in the future. And while one of the arguments against pattern investing is that efficient markets (we'll save a discussion of this for another day) quickly erode repetitive opportunities, some patterns still work - most of the time.

Right now I'm looking at a stock that is attractively priced, and in the last 10 years buying today (July 20^th) and selling in a little over 8 months has led to an average gain of 18 percent. And 7 of 10 years have yielded positive returns!

The stock is Callaway Golf (NYSE: ELY). After seeing Ernie Els and Phil Mickelson in the Open Championship this past weekend, two of the top players in the world who are both sponsored by Callaway, I decided to take a closer look at the stock.

Callaway is one of the top golf companies in the world and has a market-cap of $380 million. The company makes and sells high-quality irons, drivers, golf balls, golf bags, GPS range finders, and other accessories. I'm sure most, if not all, of the golfers reading this article currently own a Callaway product. Or at least they recognize the name.

Two things immediately caught my attention when checking out Callaway. First, the price-to-book ratio is around 0.5. You calculate this ratio by dividing the current stock price by the company's book value per share. A low number (such as less than 1) could mean a stock is currently undervalued. Second, the company has little or no long-term debt - a factor that should help the company return to profitability in the coming years.

And by the way, the company also pays a small dividend of $0.04.

***Although the slumping economy has adversely affected the golf industry people are likely to return to the golf course over time. Not only will people start to play more here in the U.S., but the golf market should grow in other areas around the world as well.

This international opportunity could bode well for Callaway. Fifty percent of the company's net sales come from outside the U.S, including 18 percent from Japan alone. This 50-50 division between international and domestic sales diversifies the company's revenue stream, and reduces the company's risk.

Its international sales increased 16 percent to $151.8 million during the first quarter of 2010 compared to the same quarter in 2009.

Callaway would like to focus on growing this international sales base. In its 2009 annual report it states "China and India represent our most promising emerging markets, each a potential $1 billion golf industry over the long term". The company believes its international business, especially in these two countries, will be one of its biggest growth engines for the future.

***Callaway is diversified in other aspects as well. The company generated revenue from 5 different market categories in the first quarter of 2010: woods (31 percent), irons (19 percent), golf balls (17 percent), putters (13 percent), and accessories (20 percent).

Speed to market for each new season is critical for sporting goods manufacturers, and Callaway is no exception. Golfers constantly upgrade their clubs as they look to smack the ball 250+ yards down the fairway.

Callaway increased its research and development expenses by 15 percent to $9.3 million in the first quarter of this year (compared to first quarter in 2009). To me this signals strength in the golf market, otherwise I would have expected Callaway to be more conservative with respect to new product development.

***The demographics in the US will also help the company in coming years. According to the US Census, around 77 million people in the United States are between the age of 46 and 64. As these people retire and have more time on their hands, they are likely to try and improve (or start) their golf game.

Analysts currently have a mean target price of $9.17 on the stock, and despite its tepid year to date results, down 37 percent, the stock is looking attractive. It is currently trading around $6 per share, indicating a potential 50 percent return - if the consensus price target is hit.

Analysts are also estimating strong earnings-per-share growth over the next two years. A year ago the company lost $0.27. Look for $0.09 this year and $0.42 in 2011. That growth would represent a 367 percent increase in earnings per share, and could propel the stock closer to the aggressive target price that analysts are now looking for.

***So what about this 7 out of 10 positive returns deal you ask? And how do we get that 18 percent average annual gain?

Well, Callaway's stock price is seasonally strong in the first two quarters of every year, and weak in the last two quarters (golfers usually purchase clubs and other accessories before the season starts).

Historically, as Callaway reports strong earnings in the first half of the year, analysts raise estimates and the stock price trends higher. With demand for products down and few attention-grabbing events for the rest of the year, earnings reports are weaker in the fourth quarter and the stock price tends to move lower.

Over the last 10 years, if you purchased the stock on July 20^th and sold it on April 1^st (or closest trading day if these dates fall on a weekend) of the following year, you would have had an average annual return of 18 percent. Seven out of those ten years you would have had a positive return.

Interestingly enough today is July 20^th. That means that the timing is just about perfect, if you believe this pattern will repeat again.

Take a look at Callaway and let me know what you think. I'm not going to advise you go out and buy the stock just based on these historical results, but at the same time I wouldn't be the least bit surprised to learn that the pattern still holds. Second-quarter earnings are due out on July 28^th, so expect the stock to move on those results.