Pennsylvania Investment Observer

Valuation Shrinkage

by Daniel J. Nestlerode

We all know what shrinkage is. It is, for some, the change that occurs in clothing as you get older and things fit a little tighter or not at all. For retailers, it is sometimes the mysterious disappearance of merchandise off of the shelves or storage rooms, rather than through the cash register. For investors, it is a frustrating and vexing decline in stock prices when the underlying company is posting all time record sales and earnings or profits. Here we are in the spring of 2005 and again, just like last year, corporations are fantastically profitable and yet stock prices seem to be saying that nothing good is on the horizon. The real problem is that even when you are correct about the terrific outlook for a company, the stock price wanders lower. The frustration among investors is like a page out of that song they used to sing on the television program "Hee-Haw", with the line: "If it weren't for bad luck I'd have no luck at all". Frustration turns to despair when you get a bill from your investment advisor while your portfolio shows little or no gain in your account, or a loss in your account, and yet the bloke wants to be paid for his services. This is a prescription for gritting your teeth. But don't, or you'll be spending more money at the dentist's office getting that problem fixed.

There are a couple things to remember as investors in the stock market. First, gains in your portfolio don't usually show up every calendar quarter but arrive in fits and spurts. Stocks do not provide nice, even, dependable returns. They change in price daily and plunge or soar based on the flow of money into or out of a particular stock on any given day. Second, investing is by design a long term game. Stock prices can ebb and flow for several quarters going quite a different direction than the economy. Much of day to day price changes are based on investor expectations. We all know how thwarted expectations can get us all into trouble. Usually, these expectations are not recorded anywhere and we don't realize there is a problem until after the stock price plunges. For example today, Three M (Minnesota, Mining and Manufacturing) the makers of innovative products like Post It Notes and Scotch Tape, reported record sales and earnings, higher than analysts' expectations. Yet the stock is trading down over $5 per share. Apparently, some investors had higher expectations than we knew about. On a different note, Cree reported a nice increase in sales and earnings and the stock price surged upwards. If you have been keeping tack of Cree, you would be confused because three months ago Cree reported even larger gains in sales and earnings than this quarter and the stock price plunged from 42 to 22. So now the stock price rises on more mediocre results. Go figure.

In my forty years on Wall Street, I have watched stock valuations fall to less than fives time earnings per share and rise to over twenty times earnings per share. That is an extremely wide range of valuations for a stock - $5.00 per share to $20 per shares based on the same corporate results. The average valuation is about twelve times earnings, while the current market is trading around 16 times earnings. So on a valuation basis, stock prices are expensive even though corporate earnings are at record levels. I suggest that valuations are slowly drifting back towards average levels. Statisticians would say that valuations are trending towards the mean. But these comments are general in nature and an investment in a particular stock might be very different from the overall trend of valuations. Buying companies that were once in financial trouble that have cleaned house and are now recovering is one group that often bucks the trend in valuations.

So when you are examining your portfolio and lamenting what you believe is a lack in progress, keep in mind that stock prices have been generally declining even though the underlying fundamentals are at record levels. Secondly, gains will show up suddenly and without notice, so if you pull out of the market, you will miss the possibility of significant gains when the turn comes. Third, be patient. Good results cannot be scheduled. They show up after those with weak constitution, who make investment decisions emotionally, have sold out and put their investment money in the bank or in some hot real estate deal.

Finally, I notice among investment clients, that those people with substantial money generally have the patience to wait out the markets, like we are having right now, and stick with good investments. Those with smaller portfolios generally get restive and leave the game based on their emotions, just before the market turns. Someone once said that the rich get richer and the poor get poorer. More usefully, the competent (in the domain of investment) make money and the incompetent keep giving it to them, complaining all the while about not being treated fairly or that they have been taken again by the sharpies on Wall Street or that the market is fixed and they are not in on it. Nothing could be further from the truth. You just have to decide which group you belong to. When the market finally gets going, I will be happy to remind you of the gains accrued to those who are persistent and patient and stayed the course.

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