Buying stocks of small, high-flying companies may seem chancy, but the payoffs should make even conservative investors take notice.
When are you going to warn readers that investing in these little companies with their huge multiples is chancy business?" INC. was recently asked. Here's an answer:
Most investors think that being conservative in the stock market means taking a position with little "downside risk" (one of today's catch phrases), one that has long-term potential for price appreciation and pays a reasonable dividend -- all of which means sticking to companies of long-standing integrity.Such is the operative philosophy of many public stock funds, bank trusts, and the like.
Risk, on the other hand, is thought of as dabbling in the equities of untested corporations that haven't proved the resiliency of their stocks or the durability of their earnings. The investment objective of taking a risk is purely capital gains, not dividend return. Such companies can suffer setbacks with chilling suddenness, and on the exchanges may indeed unravel much faster than their conservative brethren. Stocks like these, both the public and many professional money managers conclude, come and go in faddish waves and do not belong in "stable" portfolios.
But which of the two stances is truly conservative? These days most people are delighted if their investments just keep up with the rate of inflation. For instance, an income fund is considered well enough handled when it reports a 20% gain for the year. Yet when you add up both inflation and the ability of money to earn more money, even a 20% gain amounts to a loss. If the inflation rate is running at 12%, as it has been, and money can be loaned at 16%, as it easily can be through money markets or Treasuries, then the least any portfolio ought to return, no matter how conservatively managed, is 28%. Anything else loses, even if it doesn't appear to.
The stock market may appear to have been lagging behind inflation year after year, but in fact a number of common stocks have far outstripped it. The problem for the investor is that to buy most of these stocks would have meant taking a risk. Or a presumed risk: Like poker, the stock market is an odds game of capital conservation, but you don't "conserve" in either game by trying to stay even.A poker player who bets only on sure hands will inevitably end up behind, because statistically there are too few pat situations. The way to conserve in poker, and in the market, is to win big when the chance -- not the certainty -- arises. Once in a while you have to push a low pair, if that's what the table dictates, and raise like hell on the come. To paraphrase an old saw, the best capital onservation is capital enhancement.
For a sense of how conservatism is risky and risk-taking is conservative, let's examine stocks in a typical recent week, that of May 18 to 22 of this year. In these five days, the Dow Jones Industrials declined 14.23 points to 971.72. Here is how owners of some traditionally "riskless," low price/earnings issues fared:
* American Telephone (P/E 6.8), down 1 7/8 to 56 1/8
* Chase Manhattan Bank (P/E 5.2), up 1/4 to 47 3/8
* DuPont (P/E 10.3), down 1 3/4 to 47
* General Electric (P/E 9.7), up 3/4 to 65 3/8
* IBM (P/E 9), down 7/8 to 55 1/2
For the same five-day period, here's the way a few INC. 100 companies behaved:
* Prime Computer (P/E 43.1), up 4 1/8 to 49 1/8
* Floating Point Systems (P/E 42), up 8 1/4 to 53 3/4
* Sykes Datatronics (P/E 78.9), up 15 1/2 to 71
* Tandem Computers (P/E 65), up 6 3/4 to 99 1/2
* Safecard Services (P/E 14.8), up 2 3/8 to 18 1/2
If your view of the market was based on these INC. 100 entries, among hundreds of other fledglings on all three exchanges, you'd never know that an air of uneasiness (fanned to some extent by Joe Granville's "sell everything" panic) hung over the stolid Dow.
And that's not the whole argument, either. The one-week jumps described above were hardly quirks, but were part of a continuing process that had begun literally hundreds of percentage points before.From its price of 12 1/4 (adjusted) only a year earlier, Prime had gained 301%, Floating Point was up 277% from 14 1/2, Sykes 545% from 11, Tandem 290% from 25 1/2, and Safecard 679% from 2 3/8. None of these companies pay cash dividends.
For the same 52 weeks, IBM was ahead around 2%, Telephone had gained some 6%, Chase Manhattan about 10%, DuPont about 18%, and General Electric a whopping 33%. Even if you add an average dividend payout of 6.7% for the group, it's a drab -- if safe -- gathering. But, in fact, is it so safe? In the six months prior to May 22, IBM lost $16.50, or 23%. So much for conservatism.
This is not to say that these diversions will continue. Right now, though, that's the way the cards are being dealt. And there's an adage on Wall Street that holds, "A trend remains in effect until that trend is reversed." Logicians will recognize the sentence as a simple tautology, but for followers of the market, it's a difficult lesson. Naturally, few people dare choose stocks that are already up by several hundred percent and whose P/Es are climbing toward 100. (One INC. 100 alumnus, Adac Laboratories, rose 3 3/4 in the same week we've described, to 20; its P/E was an impressive 2,000.) But the fact that these types of stocks are still ascending with hardly a downward hitch vividly indicates where true "conservative" action lies, at least so far.
It would be foolish counsel to claim that there is no risk in blindly buying stocks that virtually have gone straight up. Indeed, an incautious investor can get painfully signed if he or she assumes that profits are automatic at any given phase.
Even in the midst of strong moves, timing is important. The higher a stock has gone without a correction, clearly the riskier it is to rush out and buy it. That stock will come down; patience will be rewarded. But of course you have to have the guts to put out a net and catch it as it falls to the new buying level.
What was happening in many of the high fliers coming into the summer was that traders who had taken early positions and had large profits kept adding to these positions as their stock climbed, rather than selling and taking the profits as might normally have been expected. That meant that there were many nervous holders, and short-term risk became considerable. In early June, a classic shakeout occurred, and many shares were dumped as prices turned down.
But that did not mean that the trend had ended. Rather, it was an adjustment of too much of a good thing -- a cleansing process the stock market always undertakes, sooner or later. To buy after such a shakeout is a good way to cut down risk, and should be an investment discipline of any serious market player.
Until the trend reverses, the present investment challenge should not be to join in the pursuit of high-altitude fliers (let someone else make the last part of the profit until a sufficient correction occurs), but to search out a crop just starting to take off. It will require investor effort, not simply crowd-following. Among some of the areas will be factory-of-the-future, robotics, or genetics equipment makers, to name a few emerging possibilities. This need not be done only by latching on to new issues in the aftermarket -- a tactic that is perhaps becoming too widespread at the moment -- but also by discovering dormant listed companies whose product lines have undergone technological upgrading, but whose stocks have barely begun the long ascent.
You surely won't lose ground by taking 200% to 600% profits, even if some losses are scattered in. But at a steady 2% to 23%, you're slowly falling behind.