Mythbusters

4/6/2009


 

The market’s sharp decline over the last 18 months has spawned a number of market myths, including the three debunked below.

Stocks are offering good values right now since they have fallen so much from previous levels.

Investors often make the mistake of using the amount of a stock’s decline as a proxy for value. “Cheap” and “value” are two different characteristics. As we have seen over the last 18 months, especially in the financials, cheap stocks can get cheaper and cheaper if the underlying business is deteriorating.

A better approach is to look forward, not backward. Is the stock a value, not because it has fallen 50%, but because of its price/earnings ratio relative to revenue and earnings prospects?

While lots of stocks trade at big discounts to previous highs, only a small number of these stocks represent good values with attractive upside potential. Fortunately, our Quadrix® stock-rating system can help separate attractive values from merely “cheap” stocks. Investors who seek stocks down from their highs should use Quadrix to separate genuine values from the simply cheap. Consider such Focus List stocks as Biogen Idec ($52; BIIB) and Dolby Laboratories ($34; DLB); both down approximately 30% from their 52-week highs; and Transocean ($59; RIG), which has rallied nicely this year but is still down more than 60% from its 52-week high. All three earn Overall scores of 96 or better. See charts of these stocks below.

Individuals are the “dumb” money.

Hardly any investor has been immune to making “dumb” investment decisions over the last 18 months. Obviously, individuals made mistakes in terms of portfolio allocation and stock selection. That’s to be expected during a once-in-a-lifetime market decline. However, individual investors don’t have a monopoly on dumb investment moves.

The list of “smart” money investors who had disastrous performances in 2008 is quite long and includes Warren Buffett, whose investment vehicle, Berkshire Hathaway ($2,820; BRKb), is down 40% from its 52-week high; sovereign investment funds, which bought way too early in a host of financial stocks and suffered heavy losses; and highly-touted hedge funds, many of which posted losses of 40% or more in 2008.

In fact, in some respects, individuals have an important advantage over professionals in the market. Individual investors don’t have to deal with forced selling as a result of client redemptions and margin calls. Consequently, individual investors have greater flexibility to take advantage of buying opportunities as a result of wholesale selling by professionals.

Many stocks look like steals because of their high yields.

Dividend investing has been a minefield, especially this year. According to Standard & Poor’s, more than 40 companies in the S&P 500 have cut dividend payouts this year. The cuts translate to a total reduction of roughly $41 billion a year in cash lost to shareholders. That amount is greater than all the cuts in 2008.

Investors should expect more dividend cuts as the year progresses, as the stigma of a dividend cut has been lessened significantly because of cuts by former blue chips like General Electric ($10; GE). An important lesson to be learned is the stock market does an excellent job of telegraphing dividend cuts. Indeed, if a stock’s yield is several percentage points above the yield of the typical stock in its sector, the dividend is likely at risk.

Don’t make the assumption that you are right and the market is wrong regarding a stock with an oversized yield. The market’s track record is better than most investors’ when it comes to forecasting dividend cuts.

Investors also need to be aware that, in some cases, high yields are a mirage. Take the real estate investment trust (REIT) industry, where yields are typically high. Because of an Internal Revenue Service ruling, many REITs are permitted to pay up to 90% of their dividends in the form of stock in 2009. Thus, an investor who buys a REIT thinking the 10% yield will provide lots of cash flow may be greatly disappointed when 90% of the dividend is paid in stock.

For investors who want a stock with a decent, safe yield and excellent dividend-growth prospects, consider Johnson & Johnson ($53; JNJ), which has raised dividends every year for 45 years. Johnson & Johnson, yielding 3.5%, is a Focus List Buy and Long-Term Buy.


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