'Deer in the headlights'...
'Deer in the headlights'... Investors are terrified of risk... How to get comfortable with the stock market... Everyone's fawning over Groupon... And ignoring this great company...
A few years ago, I was driving home around 10 p.m. after playing the guitar at a friend's restaurant (something I used to do for fun on weekends) when I was confronted with a gruesome sight...
It was a dark fall night as I headed south from Grant's Pass, Oregon. As I took a corner at 65 miles per hour, I had to swerve to avoid the carcasses of two large deer. The animals lay bloody, mangled, and dying in the stark headline of a pickup truck that had either just hit them or pulled up right after they'd been hit. The grim sight remains indelible in my memory.
I think of that night whenever I hear the phrase "deer in the headlights." The phrase, of course, connotes the moment before the crash, when the deer is paralyzed by the mysterious light growing larger and larger... But to me, the phrase recalls the moment after... when the bloody carnage is done.
On Tuesday, we noted the cover story of USA Today said investors were too scared of stocks to buy them. One of the people interviewed for the article said he was never getting back in. When I read that, I thought of those bloody deer.
And that's about how investors feel lately. They've been ripped to shreds by more than a decade of volatility, having (at times) huge gains torn from their hands by terrifying bear-market plunges in 2000-2002, 2008-2009, and 2011, when the market dropped 20% in five months. Now, they want no part of the stock market...
According to mutual-fund researchers at the Investment Company Institute, investors pulled $5.3 billion out of equity mutual funds in the week ending May 2. They poured just a little more than $7.5 billion into bond mutual funds.
And look at the 10-year Treasury bond. It yields less than 2%. If you're buying Treasurys right now, you're guaranteed to lose money with inflation running around 3% these days. (And that's before you account for taxes.) Sure, you won't see the kind of drawdowns you'll see in stocks, but you won't see any growth, either.
The market's valuation also reflects an aversion to risk. Right now, the S&P 500 trades at less than 14 times Standard & Poor's earnings estimate through December 31, 2012. The market's long-term average price-to-earnings ratio is over 16. Investors are scared of risk. So stocks are relatively cheap.
So with investors absolutely terrified of taking much risk, I'm focusing my subscribers on how to buy stocks safely... by telling them about the safe compounding they can achieve with World Dominating Dividend Growers (WDDGs) like Coca-Cola.
One big mistake many investors make is assuming you have to take big risks to get big rewards. Nothing could be further from the truth. You see, the best speculators I know do everything they can to eliminate as much risk as possible. I like to invest only in the highest-quality businesses and the best management teams.
For example... in the pages of Extreme Value, I've written about an incredible business that's growing sales at a triple-digit pace, up more than 200% last year. It's not like other fast-growing companies, though...
Compare it to another fast-grower, Groupon. The Internet coupon company saw sales jump more than 500% last year... But Groupon is probably worth nothing as a business. It appears to have no hope of ever making a profit.
Meanwhile, the company I recommended in the January issue of Extreme Value earned $162 million in profit last year. You can count on it earning even more this year because it has reinvested in the business and has grown its earnings capacity.
One of the big differences between Groupon and the company we hold in Extreme Value is management. Groupon is managed by a bunch of yahoos. Shortly after the company filed to go public, one of the co-founders blurted out, "Groupon is going to be wildly profitable"... which was illegal. When a company files for an initial public offering (IPO), it enters a "quiet period" when none of its employees may talk about financial results in public. Everybody knows this.
The guys running my recommendation are solid. They've been in the same business, growing it steadily, for 14 years now. (Groupon was founded in November 2008 by a guy who worked in a recording studio.) And they're conservative. After posting incredible earnings last year, they attributed the result to perfect execution and warned they were unlikely to repeat it. Legendary investor Warren Buffett routinely takes a similar strategy of muting expectations... warning everyone he's unlikely to grow his company, Berkshire Hathaway, much in the future. Then, he finds a way to keep it growing and growing.
Good managers set expectations low and deliver high. Yahoos with Internet IPOs set expectations through the roof, then deliver losses and disappointments.
You can also see the difference in the financial reporting. Instead of simply admitting that it's having trouble making money, Groupon relies on a "nonstandard" accounting term to try to make itself look profitable – consolidated segment operating income (CSOI). By normal accounting, Groupon lost $420 million last year. By CSOI, it did better, losing only $180 million. In the fourth quarter of last year, Groupon lost $15 million. By CSOI, it made $18 million. The Securities and Exchange Commission thinks something fishy is going on and started investigating even before Groupon went public.
So how is a company with little prospect of ever making a profit worth $6.4 billion in the stock market? That's more than four times sales and nine times book value. It has no earnings... so it has no price-to-earnings ratio. It's ridiculous. I'm not even confident that the company will exist five years from now.
Meanwhile, the company I recommended went public last year with little fanfare. It doesn't use phony accounting tricks. It just makes tons of money. Last quarter, it made $49 million, up 70% from the same period of the previous year.
Knowing the company's profits have grown 70% recently and came in at $162 million last year... maybe you think it trades for billions of dollars in the market... I mean, if Groupon were this profitable, it'd be selling for 100 times earnings. A new IPO with soaring earnings growth must be trading for at least $4 billion or so in market capitalization, right?
Wrong. Nobody pays attention to this company. They're too busy fawning over Groupon. Right now, my stock is worth six times earnings and 1.3 times sales. Again... ridiculous. I told my subscribers in January that the stock could double or triple in the next couple years.
I have a few stocks like this in the Extreme Value model portfolio... small companies that few people ever heard about in the financial media, which trade for dirt-cheap prices... while gushing free cash flow. I recommended one of them in May 2009 (another time when everybody was terrified of risk). At the time, it traded for around five times its free cash flow. Today, it does more than $72 million of free cash flow and is up about 120%.
So if you want to take advantage of the fear in the marketplace... you don't have to take on the risk of a junior mining stock or Internet IPO... You can buy a piece of an honest-to-goodness business that's earnings lots of money, growing really fast, and has a good, honest management team.
I'm not going to name the business here because my subscribers pay good money ($1,000 a year) for my deep research into cheap, profitable companies. To learn the name, you need to be an Extreme Value subscriber... The subscription may seem a little pricey. But there's little risk to trying it... If you decide after three months it's not for you, you can get a refund.
And one final note... Extreme Value is not for everyone. It's all about deep research and deep value. To take full advantage of this investment letter... you must be patient enough to see that value realized. If you find yourself easily scared out of stocks – like all the folks interviewed in Tuesday's USA Today – it may not be the product for you. But if you are a serious and patient investor, who really knows a good deal when he sees it, you can click here to order (without watching a long promotional video).
New 52-week highs (as of 5/9/2012): Hershey (HSY).
There wasn't much in the reader feedback mailbag this morning. We'd enjoy hearing your feelings on the stock market today. Are you scared? Are you buying more stocks or bonds? Write to us at feedback@stansberryresearch.com.
"It's easy to make it look like you pick a lot of winners when you go back as far as two or three years to pat yourself on the back for making a call. However the bottom line is this; if the market is against you, long or short, your chances for a winner decrease to slim to none." – Paid-up subscriber L.P.
Ferris comment: Where can I sign up for your letter or invest in your fund?
Dan Ferris
Medford, Oregon
May 10, 2012