Why It's a Stock Picker's Market (ALLT, PKT, SPY)
It's a stock picker's market. What does that mean? It means that you
shouldn't just buy an index or a broad based mutual fund right now and
hope for the best.
Rather, right now you need to selectively pick stocks if you want to make
any money at all.
Everyone is more focused on Italy, Greece and the rest of Europe than
they are with the actual earnings of companies in the S&P 500 (large
cap index) and the S&P 600 (small cap index).
People forget about individual stocks when they focus only on the macro
picture of Europe - and that's a mistake.
This distraction means stock pickers have an information edge that they
can exploit, as long as they do a bit of research and exercise some
patience.
Implied correlation - a measure of how closely S&P 500 stocks trade
together - is hovering around 80 percent. So, most large-cap stocks are
moving together. The culprit remains European debt concerns; no surprise
there.
With the vast majority of stocks trading in tandem, how can a stock
picker outperform?
Here's how: This intense correlation will break at some
point. When it does, individual sectors and stocks will once again
establish leadership positions. Naturally these leaders are the stocks
that you'll want to be in, and it would be beneficial to get into them
before the correlation breaks, at least with an initial position. You can
always buy more when your suspected leaders confirm themselves as
such.
We know that expected growth is the single greatest contributor to stock
price performance. So while news out of Europe continues to fascinate,
I'd argue that investors should sift through the third quarter earnings,
figure out which individual companies are most likely to post strong
growth in the final quarter of 2011 and into 2012, and start buying
shares.
I tend to prefer a top down approach to single out individual stocks
since this satisfies my brain's linear tendencies. So let's start at the
top: with reported results for the third fiscal quarter of 2011.
Before you roll your eyes; I'm acutely aware that many readers don't want
to spend the time reading about earnings or projected growth. I know it
can be boring. But honestly, if you're not willing to do the bare minimum
amount of research - not just listening to other's opinions, but actually
reading an earnings release or listening to an earnings call - than
you're really just relying on luck.
That's not a solid strategy, and this market will be very unforgiving for
the unlucky. So, getting back to earnings...
As of Monday, 87 percent of S&P 500 companies, 80 percent of S&P
400 Mid Caps and 76 percent of S&P 600 Small Caps had reported
earnings
This sample size means we have a pretty good idea of how companies
performed in the third quarter. As you should expect based on my 'stock
pickers market' statement, not all companies that reported have stunned
analysts.
Across the market cap range roughly 60 percent of companies have beaten
on top line revenues, with mid-caps outperforming - 63 percent of mid
caps have beaten revenue expectations.
Moving down to earnings, the results are a bit better with at least 60
percent of all companies that have reported beating expectations. Large
caps led the out-performance with 69 percent beating versus 64 percent
and 61 percent, respectively, for mid and small cap stocks.
This is all backward looking - by Monday we'll be able to tally up the
numbers for many of the remaining companies that reported this
week.
The takeaway is that on average, revenue and earnings have been solid.
That means there is still growth to be found - this is a very positive
sign.
The bad news is that roughly 40 percent of companies have missed revenue
and earnings projections. Buy an index and you'll wind up owning both the
under and overachievers.
You might agree that it would be better to just buy the overachievers -
hence my tendency to favor individual stocks right now.
Let's look forward to 2012. Like I said, expected earnings tend to be the
biggest predictor of stock market performance. I crunched the most recent
data compiled by Credit Suisse's quantitative research group to build the
following chart.
We're looking at 2012 expected earnings per share for small caps versus
large caps. First thing you should notice is how dramatically small caps
are expected to outpace growth in large caps in every sector.
Second thing you should zero in on are the sectors that are expected to
outperform, namely small cap telecommunication, energy, consumer staples,
financials and material stocks. I'll cut financials simply because I
don't follow that sector, and I'll add info tech; I'll explain why in a
minute. These are the sectors I follow, and they all appear positioned
for significant growth.
In energy, I'm inclined to favor oil explorers and producers since these
stocks have leverage with oil above $90.00. Oil services companies are
worth a look too.
In consumers staples I'd lean toward food and beverage companies. These
are typically defensive which is good in this environment. But get into a
rapidly growing small cap food stock and you could own a takeover target
or a future dividend payer.
Many small gold and silver miners, especially the explorers, won't have
positive earnings and won't show up in the S&P 600 Small Cap Index.
But with general strength expected in the materials sector, and in
precious metals prices, I'm a fan of mining stocks. Best bet here are the
emerging producers - those that will have a new mine coming into
production within 6 months.
And finally, information technology - even though earnings growth is
lower than other sectors at 21 percent, it's important to remember that
this sector lumps software, hardware and semiconductor stocks all in one
basket.
While I didn't include figures for each of the three industries within
info tech, analyst consensus is that software and services companies
should be growing faster than the others. Recent results from companies
like Allot Communications (Nasdaq: ALLT) and
Procera Networks (AMEX: PKT), two companies that provide
network analytics software, are worth digging into.
Remember, at some point stock correlation is going to start dropping from
80 percent and trend toward a normal range around 15 percent - the
average since 1930.
When it drops, you'll be better positioned to make money if you've
concentrated your investments in specific stocks and in high growth
sectors.
With earnings season winding down we already know that around 40 percent
of the market has not met expectations. And we have a pretty good idea of
which companies have beaten. Most importantly, we know which sectors are
expected to outperform in 2012.
Right now, with the world fixated on Europe, you can gain an information
edge if you ignore the noise and focus in on individual stocks in these
sectors. As always, average into a position to decrease risk, and make
sure you define your investing horizon.
Best Regards,
Tyler Laundon
Analyst, Small Cap Investor
PRO
Richmond, Vermont
Disclosure: None
