Knowing What You Know

1/26/2015


Investors seeking returns that exceed the market require a superior process, superior knowledge, or both.


"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." . . . Mark Twain


We believe our process of using Quadrix to identify reasonably valued growers gives us an edge. As for knowledge, we also study individual companies. But even our best efforts require some degree of estimation due to the limits of available information.

Borrowing from an exercise described by noted investor Howard Marks, we try to classify the degree of certainty for what we know about two recommended stocks.
What we know for sure

Aetna ($95; AET) — Acquisitions and organic expansion helped Aetna's recent growth outpace its peers. It delivered 18% higher per-share profits on 28% revenue growth in the 12 months ended September, besting all other S&P 500 managed-care firms.

Schlumberger ($82; SLB) — Weakness in the energy sector leaves the shares at their cheapest in a long time. Before the December-quarter earnings report, Schlumberger's trailing P/E ratio was 14.5, hovering at its lowest point since August 2009.

What we think we know

Aetna — Despite repeated legal challenges, the Affordable Care Act (ACA) appears here to stay. Public exchanges should help drive growth, with Aetna expecting to add about 100,000 members from exchanges this year. While enrollment numbers have been soft in recent weeks, they will likely surge ahead of the Feb. 15 deadline, as happened last year. Aetna announced plans this month to raise its minimum wage and improve health benefits, which could be interpreted as management's confidence in its long-term growth prospects.

Schlumberger — Demand for Schlumberger's oilfield services faces near-term pressure. The count of U.S. land rigs has fallen 14% from the October peak, and Schlumberger expects that decline to continue in the March quarter. Industry surveys say drillers will cut 2015 spending by 25% to 30% in North America, compared to a decline of 10% to 15% internationally.

What we know we don't know

Aetna — Medical utilization is beginning to increase, though structural changes, specifically higher deductibles, may keep utilization rates lower than in the past. Aetna has aggressively raised prices for 2015, but costs could climb even faster

Schlumberger — The biggest questions concerning Schlumberger center on oil prices. In January, the International Energy Agency predicted that oil inventories will keep rising in the first half of 2015, meaning that a rebound in prices "may not be imminent." How long must investors wait for oil to recover? If the new normal for oil prices settles below $60 a barrel or even $50 a barrel, how many drilling projects will remain viable?

For more on Aetna and Schlumberger, read the Quadrix Spotlight.

Conclusion

Then there is what we don't know we don't know — rare, black-swan events that defy investors' best preparations and are one reason our buy list contains more than 25 stocks.


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