Mr. Market has been a very optimistic fellow so far this third quarter. Now more than ever, investors need to concentrate on separating fact from fiction.
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An Earnings Illusion
Here are the facts:
- The Russell 2000 index, a small cap benchmark, is up over 62% since early March versus the 46% lift in the S&P 500.
- The trailing P/E ratio on the Russell 200 index has soared to over 55 times as of late July compared with 24 times for the S&P 500.
...and the fiction:
- Earnings will soon resume where they left off prior to the recession.
Fool Me Once
I am very confident that the economy is healing and will work its way out of this recession. But that's where my confidence ends for now. Once this euphoria of "the world is not coming to an end" wears off, many will realize that is very unlikely that the economy will grow as it did in the past - at least not for several years.
In any case, it is likely that a premium will be afforded to investing in strong, well-run businesses. A rising tide lifts all boats and when economies are strong, poor companies can deliver. This is not a strong economy. (For more, check out Introduction To Small Caps.)
Time To Shine
This is a recovering economy where the fittest of the fit will shine at the expense of the weak. Railroad giant Burlington Northern (NYSE:BNI) will do well over time. Rails transport goods cheaper than trucks do and new advancements in railcars allow the shipment of more goods per car. This translates into an improved return on invested capital. Look north and Canadian Pacific Railway (NYSE:CP) offers a quality bet. Both of these companies trade for less than 14 times earnings, a big discount compared to the S&P.
The volume of goods transported is an excellent leading indicator of economic stability and growth. If these companies aren't doing well, very few are.
While I am not a fan of retailing for many reasons such as rapid inventory obsolescence and low barriers to entry, people do need to clothe their growing children and buy household goods. Retail giant Target (NYSE:TGT) at 15 times earnings looks pricey but the valuation looks reasonable when the likes of J Crew (NYSE: JCG) is trading at 42 times earnings, American Eagle (NYSE:AEO) is at 19 times earnings, and even Costco (Nasdaq:COST) at 20 times earnings.
Target's image continues to symbolize high quality at affordable prices. And activist Bill Ackman is a big shareholder who sees tremendous upside.
The Bottom Line
If the market goes materially higher, then yes it won't matter what you invest in. But ultimately, Mr. Market will no longer be satisfied just because a company beats expectations and loses less money. Profits matter and well-established companies with excellent track records appear to be the most value for the dollar. (For further reading, check out Determining What Market Cap Suits Your Style.)
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