Stealth Performance

We started the week with a report that housing starts in December increased 5% to a 1.835 million-unit annual rate, the highest since June 1986.  December building permits rose 8.2% to a 1.880 million unit annual rate.  The increases were larger than expected and provide strong evidence that the housing boom remains healthy and will likely remain so for months to come.  The boom continues to be fueled by historically low interest rates.  The average rate on a 30-year mortgage was 5.97% last week.  That was close to the 5.85% at the start of the month, which Freddie Mac, the No. 2 buyer of mortgages, said was the lowest since the 1960s.

Thursday, the Conference Board reported that its index of leading economic indicators in December rose 0.1% after rising a revised 0.5% in November. The index has increased for three straight months.  A surge in building permits and a rise in hours worked at manufacturers helped boost the index, which comes amid an uneven economic expansion.  Economists expect that growth probably slowed to 1% or less in the fourth quarter of last year and may increase to 2% at an annual rate this quarter.

Eight of the 10 indicators the Conference Board uses to calculate the index pushed up the measure and two had a negative influence.  The group bases its measurement on seven previously reported economic statistics and estimates for three others.  Besides a rise in building permits and a longer factory workweek, the index was bolstered by a more confident consumer and increases in orders for both business equipment and consumer goods.

Many market watchers worry that the overall market cannot make significant gains because current valuations are too high.  Capital Group’s Michael Johnson, who spoke as part of a panel at the World Economic Forum inSwitzerland, said’s recovery will be limited because stocks haven’t become inexpensive. “It’s very unlikely any broad-based increase in equity markets will occur in the next year,” he said.  The aggregate prices of the 500 companies comprising the S&P 500 are almost 18 times this year’s expected profit.  During the 1990 recession, stocks sold for less than 14 times earnings.

But, while many investors remain on the sidelines an increasing number of individual companies are quietly taking off.  A recent Bloomberg stock screen using our strictest investment criteria showed close to 75 companies that are up in price at least 10% so far this year.  The average price increase for the group was 16%.  Companies on the list include communications, health care, technology, consumer cyclical and non-cyclical, home builders, and industrials.  We own a significant number of them and plan to own more within limits of reasonable diversification.

Stocks are beginning to trade once again on their fundamentals.  The hype that drove them up during the bubble years is a distant memory.  The pessimism that drove them down in the years that followed is dissipating.  Good old fashioned investment criteria such as profitability, valuation, unique strengths, barriers to entry, and innovation are beginning to drive companies’ stock prices again.  We are likely returning to an environment where investing in undervalued growth companies can bring returns exceeding broad market averages.

International risks such as Iraq,Venezuela,North Korea, and terrorists’ threats continue to impact markets as does the sluggish recovery of our domestic economy.  But we are experiencing evidence that superior companies can sustain their gains sufficiently to outperform the broad market over time.  Of the 75 companies mentioned above, 70 of them have outperformed 50% of all stocks in the market for the past 30, 60, and 90 days.

The volatility in these companies’ share prices remains high, but it is falling to levels approaching historical norms.  As volatility falls and more companies beat analysts’ estimates, investors will gradually return to the market.  But it is our view that the process will take longer than usual.  While the more timid wait many of the bargains of today will disappear.

Market averages will eventually return to their historical norms of 10-12%.  But, in the meantime, the possibility of these returns is increasing.  Many companies today demonstrate earnings growth of 15%, 20%, and 30%.  Most of them are offered at sale prices today.  Returning to our list of 75 undervalued excellent companies; the average P/E to growth ratio (PEG) of the group is 87.  The PEG ratio is the price to earnings ratio for each company divided by its expected growth rate.  That the average is substantially below 1 suggests a very reasonable market valuation for the group.

Time-honored valuation methods reveal there are indeed bargains in the stock market.  And investors are taking advantage of those bargains as recent price movements indicate.  We strive to be among those smart investors who are willing to look beyond current uncertainty and invest in and hold excellent growth companies identified by sound fundamental investment criteria.  By seeking out these ‘stealth’ market performers and owning them we expect to provide superior long-term results for our clients.