History often written by the biggest winners
It is the magnitude of your successes — not the frequency — that determines whether you’re successful in the stock market. Most investors understand this truth, or at least they’re aware that one big winner can make up for several losers.
Unfortunately, many draw the wrong conclusion from the data, betting on speculative stocks in hopes of hitting a big winner. That is exactly the wrong approach, for big losers can impact returns nearly as much as big winners. As shown below for random 10-stock portfolios, missing a big winner is often more costly than holding a big loser, partly because stocks can go up without limit but can go down at most 100%.
Still, that is no reason to roll the dice. Because you don’t need to pick your stocks randomly, you should make the outlier effect work for you. In other words, cut your losers quickly and be open to letting your winners ride. Some related lessons:
Don’t worry about the winning percentage of your stock picks. A long line of researchers has shown that investors tend to sell winners too early (to lock up gains) and sell losers too late (to avoid taking losses). So, don’t fixate on your purchase price. Whether you can get back to break-even on a stock is irrelevant; what matters is whether a stock represents one of your favorite picks going forward. If it doesn’t, you should sell.
Be wary of experts with price targets. When we added Freeport-McMoRan ($116; NYSE: FCX) to our Focus List in December 2005 at $53.45, very few analysts expected the stock to double over the next 30 months. Neither did we. To our credit, however, we didn’t sell simply because the stock had reached a preconceived price target. We evaluated Freeport and all our stocks at least twice a week, selling any that no longer qualified as top buys.
Spread your bets. With a 30- or 40-stock portfolio, you can achieve most of the benefits of diversification. Even a 15- or 20-stock portfolio will dramatically reduce the volatility you experience compared to a five-stock portfolio, while giving you a much better chance of owning at least one positive outlier.
Position yourself for positive surprises. Betting on the most aggressive stocks is a recipe for disaster, but you can help yourself by looking for high-quality stocks with the potential to be big winners. Five such stocks are reviewed in the following paragraphs.
Shares of Adobe Systems ($40; NASDAQ: ADBE) seem cheap relative to both their historical valuation and their growth potential. Over the last three years, Adobe averaged a forward price/earnings ratio of 27, roughly in line with that of many peers. At current prices, the shares trade at less than 20 times projected year-ahead earnings of $2.05 per share. A return to the three-year average valuation over the next 18 months could drive a 48% increase in the share price.
Adobe — the dominant software maker for the development of multimedia content — stands to benefit as usage of the Internet expands beyond text to graphics, audio, and video. With more than 95% of online video using Adobe’s Flash software, the company is well-positioned to capitalize on Internet trends. Consensus estimates project per-share-profit growth of 26% in fiscal 2008 ending November and 14% in fiscal 2009. New product releases later this year should provide the company with a significant earnings boost, and the fiscal 2009 estimate looks conservative. Adobe is a Buy and a Long-Term Buy.
Packaged gases, such as helium for party balloons and combustible products for welding, are not the sort of goods investors typically associate with growth companies. But Airgas ($60; NYSE: ARG) has carved out a business model that gives it impressive and steady growth numbers in a cyclical field. Over the last five years, Airgas has delivered annualized growth of 18% in sales and 23% in per-share profits. Consensus estimates project per-share-profit growth of 26% in fiscal 2009 ending March and 15% annually over the next five years.
Acquisitions account for much of Airgas’ growth. In 2007, the company bought 18 businesses. Business models built around acquisitions tend to be risky, but Airgas has managed quite well, growing profit margins steadily over the last three years. Fees for renting tanks generate strong and rising cash flows, contributing to 87% growth over the last three years. Controlling about 25% of the market for packaged gas, Airgas has plenty of opportunity to expand. The retail gas industry is highly fragmented, with about 50% of the market in the hands of small, independent distributors. Airgas, which plans to boost prices by 15% to 20% on Aug. 1, is a Buy.
Specialty-insurance providers such as Assurant ($67; NYSE: AIZ) are often misunderstood. The company targets niche markets, avoiding larger and better-understood markets that also tend to be more competitive. While many insurers face serious losses from subprime mortgages and other problems in the housing market, Assurant actually benefits from the chaos. The specialty-property division, representing half of 2007 profits, provides insurance that creditors take out when borrowers have trouble repaying their mortgages. As delinquencies rise, so should Assurant’s profits from the specialty-property business. The company already controls 70% of this market and is considering acquisitions that could further boost share.
Assurant has leading positions in several other businesses, such as insurance for funeral expenses, manufactured-home coverage, and employer-funded dental plans. Trading at 11 times trailing per-share earnings, Assurant has room to grow. The stock’s trailing price/earnings ratio has averaged 13 over the last 10 years, and a return to that valuation could vault the stock above $90 by the end of next year. A price of $90 may be aggressive, but Focus List Buy Assurant seems capable of a jump to $80 to $85 over the next 18 months.
Shares of Manitowoc ($32; NYSE: MTW) have been under pressure since the company first offered to buy Enodis, a British maker of foodservice equipment. The acquisition, expected to close in the December quarter, will lower Manitowoc’s exposure to cranes, the chief driver of growth over the last few years. To beat out rival Illinois Tool Works ($47; NYSE: ITW), Manitowoc raised its bid to $2.7 billion, which has some investors concerned about the debt needed to fund the deal.
Merger-related worries, coupled with expectations of a slowdown in the crane market, have the stock trading at just 11 times trailing earnings. However, the crane market has so far remained strong. Although demand for cranes could slow, several company-specific factors (an emphasis on energy and infrastructure end markets and expansion in emerging markets) should support earnings growth at Manitowoc.
The company believes acquiring Enodis will significantly enhance its foodservice business, opening up new markets and broadening the product line, which should create cross-selling opportunities. If the stock returned to its 10-year average trailing price/earnings ratio of 19 by the end of this year, it would trade above $60 per share, up more than 100%. While such a huge gain seems unlikely, a rebound to $40 or $50 over the next year would not be a surprise for Manitowoc, a Focus List Buy and a Long-Term Buy.
Qualcomm ($46; NASDAQ: QCOM) stands to benefit as such third-generation (3G) cell phones as Apple’s ($175; NASDAQ: AAPL) iPhone and Research in Motion’s ($123; NASDAQ: RIMM) BlackBerry Bold hit the market this summer. An increasing number of consumers should adopt the new technology over the next year. Neither phone maker currently pays royalties to Qualcomm for licensing its patents. But Qualcomm’s stranglehold on 3G technology is likely to generate substantial licensing payments from Apple and Research in Motion. Also, when the new BlackBerry and iPhone models launch, they should spur consumer demand for 3G capabilities. New opportunities in China, as the country restructures its telephone industry, also provide significant growth potential.
Though Qualcomm has increased earnings at an annualized rate of 18% over the last three years, the stock has not kept pace, currently trading well below 2005 highs. At 20 times projected year-ahead earnings, Qualcomm trades at a substantial discount to its five-year average forward P/E ratio of more than 24. A return to the historical norm over the next year could lift the shares near $60. Qualcomm is a Focus List Buy and a Long-Term Buy.