P/E as a Predictor of Stock Success
Cause and Effect
This Potential Leader Looks Ready to Move
I'm a growth stock guy, always have been, always will be.
Growth is the perspective I used for the very first stock I
bought (Gillette, back when it was growing at 20%-plus rates) and
has been for the hundreds of trades ever since.
That means that, when I first examine a company, the first
questions that cross my mind are: What is the firm's sales and
earnings growth, both past and future? Does the firm have a new
and revolutionary product or service? Generally speaking, does
the company look to have a multi-year runway of growth ahead?
And, of course, is the stock itself acting well, informing me
that institutional investors are enamored of the firm's
To many investors, there is one glaring item missing from this
list-the stock's valuation! Whether it's traditional P/E ratios
or something more exotic, nearly every investor puts a stock
through a rough valuation test, or at the very least, looks up
the valuation and compares it to some benchmark. While these
investors aren't necessarily value-oriented, they still believe
in getting a good deal.
But I don't! And because of that, I inevitably get emails from
subscribers asking "Are you sure about XYZ stock? The stock is up
nicely during the past year and it trades at 75 times earnings!"
You see, most investors, even if they're not strict Ben Graham
adherents, believe that a lower valuation leads to good results
... Or that a sky-high valuation leads to poor results. And that
thinking makes perfect sense in the real world-what you pay for a
house, for instance, is usually the most important factor in
whether it proves to be a good investment.
But the stock market is a contrary creature; when dealing with
growth stocks, you generally get what you pay for. If valuation
was the key to finding the next big winner, you can be sure I'd
constantly be running screens on value measures.
Yet it turns out that things like P/E ratios are not great
predictors of future growth stock performance. In fact, the vital
truth is that many investors are confusing the cart with the
horse: Valuation is often the RESULT of great performance, not
the CAUSE of it.
And the reason for that is supply and demand-in any market cycle
there are only so many true, institutional leading stocks. I am
not talking about decent growth names that run for a few months
and then peter out. I'm talking about the best of the best, the
ones that have genuinely revolutionary products that change the
way we work and live, or have some sort of new concept that's
taking huge market share (or is possibly starting a brand new
industry). Examples since 2009 include Apple, Netflix, Lululemon,
Baidu and Chipotle Mexican Grill.
When you're in a bull market, the thousands of mutual, hedge and
pension funds have to own stocks. And you can bet your backside
that they're going to build positions in the real leaders that
have the best products, the fastest sales and earnings growth and
the surest prospects to continue growing rapidly for many years.
Of course, all bull markets end, and when they do, many of these
true leaders top permanently (example: Cisco in 2000), which is
why market timing is so important. But while the bull market
lasts, the simple fact is that these and other leaders are under
big demand from big investors.
Thus, it's buying demand that creates the great performance,
which in turn causes the valuation to baloon. And what causes the
buying demand in the first place is the growth, the unique
products and the enticing prospects for the future. It's worth
remembering as you hunt for new buys.
Switching over to the current environment, I like what I see.
The market actually bottomed back in early June, but anyone who
tried buying strength for the six or seven weeks following that
low was burned. In my mind, what really transpired was a
prolonged bottoming process, where the indexes chopped around
(there were an incredible nine swings, both up and down, of at
least 4% in the Nasdaq from that June low until the end of
July!!) as money very slowly rotated from defensive stocks
(tobacco, big telecom) into more traditional growth areas (chips,
networking, software, retail, etc.).
That said, I am not super-bullish right now; while enough
leadership has emerged to carry the market higher, I wouldn't say
the advance is overly broad. And there still hasn't been the type
of power in the market that commonly characterizes strong
advances. Sure, some of that is likely due to the calendar (I'm
pretty sure most big investors will be on the beach this week),
but it would warm my heart to see some huge-volume advances.
Even so, I am not souring on the market-if anything, the advance
has picked up a little steam as the sellers have run out of
ammunition. So now the job is to identify the stocks with the
best upside potential. One name that I'm still intrigued by is
, a stock that hasn't yet joined the ranks of leadership, yet has
all the makings of a big winner.
The company is one of the few out there today that is
revolutionizing an entire industry (recruiting and hiring); this
isn't some mild improvement over Monster.com but a totally
different way for companies to find the talent they need.
LinkedIn has quickly grown into a good-sized firm ($724 million
of annual revenue during the past four quarters) thanks to
quarter after quarter of 80%-plus revenue growth.
Plus, it's not just the recruiting business that's booming for
the company-LinkedIn also makes good money in premium
subscriptions and advertising, as it aims to make its website a
professional portal of sorts. The number of unique visitors grew
to 106 million in the second quarter, up from 103 million the
prior quarter and 82 million the year before. It's a similar
story with total page views, which numbered 9.3 billion in the
second quarter, up from 7.1 billion a year ago. All of that
traffic is attracting advertisers, who wish to sell to a very
defined, targeted audience.
All together, analysts see earnings totaling 63 cents per share
this year (up 80%) and $1.31 in 2013 (up 108%) and, if you want
to look very far into the future, $2.15 in 2014.
Yet the stock hasn't gotten going yet! Why? I think a lot of it
has to do with the horrid performance of Facebook's stock, which
has been cut in half since its first day of trading. A lot of
investors imagine a link between Facebook and LinkedIn, seeing
both as poster children for the recent wave of Internet IPOs.
(It isn't helping that smaller IPOs like Zynga and Groupon
are also heading south.)
But, logically, there's no real link between Facebook and
LinkedIn; one is social media, while the other is revolutionizing
a humongous industry. And, of course, one is growing rapidly and
exceeding analyst estimates every quarter, while the other has
slowing growth and its future strategy (especially with mobile
advertising) is being questioned!
Technically, LNKD has been basing since early May, but what I
really like is how the stock has finally, after a lot of
wide-and-loose action, tightened up-shares have pulled back
calmly since gapping higher on earnings in early August, have
found some support around 100 and have begun to perk up. If you
don't own any, I think you could nibble here and look to add
shares on a powerful push above 115.
Oh, and one more thing-don't worry about the stock's huge
valuation (215 times current earnings!). Yes, it's
expensive, but it's clear the company isn't trying to maximize
its bottom line right now; instead, it's focusing on expanding
services and digging a deeper moat to keep out any potential
competition. Long-term profit margins, which currently are in the
high single digits, could easily double, and revenues are growing
like mad. As I wrote above, I think institutional investors will
be willing to pay up for a piece of a truly unique company like
All the best,
Cabot Market Letter