Don’t Peek
Be skeptical. Keep cool. Hang in there.


When you buy a stock, you should think of yourself as a steadfast partner in a business. The value of that business changes from day to day, thanks to what Gustave Flaubert, the French novelist and all-around wit, called “the thermometer of public opinion.” Those short-term price changes are almost always irrelevant, and looking at them can make you overwrought — susceptible to the classic errors (like selling too soon) of emotion. Thus, my rule: Don’t peek, which, I’ll admit, is an admonition that few of us can adhere to. Over the past month, however, I have had very few opportunities to peek. I was traveling, mainly in remote and exotic places, like the wetlands of northern Australia and the pavements of downtown Damascus, where Internet connections and newspapers with stock pages are scarce.

What happened while I was away?

You know. Stocks went up. Between Aug. 1 and Sept. 3, the Standard & Poor’s 500-stock index and the Dow Jones industrial average each rose 5 percent. The technology-heavy Nasdaq composite rose 8 percent. General Motors (GM) went from $37.27 to $42.61; AMR (AMR), the parent of American Airlines, from $8.95 to $12.73; Intel (INTC), from $25.02 to $28.22.

Since mid-March, the Dow has risen 2,000 points, or about 30 percent, including dividends. The Nasdaq is up nearly 50 percent. The bear market is over — and it all happened on my summer vacation, while I was paying no attention at all.

Now what? First, make sure you understand the lessons of the bear market, the main one being that no one knows when stocks will suddenly turn around. Also, when they do, it’s often with such unexpected force that it leaves investors in the dust, wondering just what happened. Amazon (AMZN) has doubled since spring. Two years ago, it was left practically for dead, trading below $6 a share; it’s now more than $46. Yahoo (YHOO) has tripled in a year.

If you’re not in the stock market when the surges occur, your portfolio won’t recover the losses it suffers during the downdrafts. Robert Torray, manager of the Torray Fund (TORYX), which I have often praised in these pages, pointed out in his latest letter to shareholders that during the 236 trading days ending on June 30, 2003, the S&P 500 rose 24 percent, but if you had missed the five biggest up days, you would have lost 2 percent over the period.

Naturally, Torray is a buy-and-hold kind of guy. His fund, which Morningstar calls “one of the best stock-picking vehicles out there,” declined in 2000, 2001, and 2002, but it has recovered nearly the entire loss this year, and it has returned an annual average of 8.5 percent since September 1998, compared with 2.3 percent for the S&P.

Torray’s top holdings include Amgen (AMGN), the largest biotech drug company; Illinois Tool Works (ITW), manufacturing and finance; J.P. Morgan Chase & Co. (JPM), financial; Kimberly-Clark Corp. (KMB), paper products; and Automatic Data Processing (ADP), computer services.

There’s no guarantee that the bear won’t come back soon — though the economy appears to be recovering nicely. My guess is that it’s behind us for a long while, and in this post-ursine environment, here are some suggestions:

Be skeptical of claims that stocks are overvalued. According to Barron’s, the price-to-earnings (P/E) ratio for the Dow stocks is 21; for the S&P, 33. Those valuations may seem high, but P/Es have actually fallen this year as stock prices have risen. Why? Because earnings are rising even faster than prices.

By year-end, the Dow’s P/E is likely to be about 18 and the S&P’s will be in the mid-twenties. But if prices continue to surge, P/Es could level off or even climb. That wouldn’t bother me. In fact, in this time of low interest rates, I believe P/Es are exceptionally low, not dangerously high. As a recent report by Sanford Bernstein, the New York research firm, puts it, “Equities are unusually attractive relative to bonds. … The equity risk premium (defined as the expected return on stocks minus the yield of 10-year Treasuries) is about one standard deviation above normal.” In other words, investors have priced stocks at historically low levels compared with bonds.

Think of it this way: A company with a P/E of 20 has an earnings yield (E/P) of 1/20, or 5 percent. That means, the stock is producing $5 in profits for every $100 you invest. At a time when 10-year Treasury bonds were yielding 7 percent or 8 percent (that is, $7 or $8 for a $100 investment), a P/E of 20 may have been high. But today, a 10-year Treasury bond, by contrast, is producing just $4.50 in “profits” — or interest.

Ten years from now, the T-bond will still be paying $4.50 in interest, but, if earnings rise at a rate of 6 percent annually, the stock will be generating $8.95 in profits; if earnings rise at 10 percent annually, $12.97. Yes, the bond is less risky, but the likely payoff in the stock far outweighs the risk.

The decline in stock prices during the bear market was strictly the result of lower earnings — not lower valuations. Despite the doomsayers like Bill Gross, the Pimco bond guru, who predicted earlier this year that the Dow would fall to 5,000 because of contracting P/Es, those ratios have remained strong throughout the bad times. Now, as earnings start increasing with the economy, stock prices are increasing, too.

I’m not saying that you should ignore P/Es and other valuation indicators entirely. Just don’t be scared off by people who say they’re too high. Even cautious analysts are catching on. Edward Jones, the conservative St. Louis-based firm, is recommending such stocks as Emerson Electric (EMR), which makes a wide range of electronic products, at a P/E of 22; Harley-Davidson (HDI), motorcycles, at a P/E of 21; and Wal-Mart Stores (WMT), the world’s largest retailer, at a P/E of 31.

Keep cool, and look at the numbers. While most investors remain gun-shy, the risk is that, as the recovery builds steam, more and more of them will get carried away with enthusiasm. “Be cognizant,” writes H. Bradlee Perry of David L. Babson & Co., that “succumbing to emotion — especially the tendencies toward greed and fear under different stock market conditions — will always overcome rationality.” You can’t help it. When it comes to stocks, emotion trumps reason. The best you can do is to recognize this ugly truth and avoid acting on it.

Perry advises: “Be sure you are investing in companies, not stocks. A company is a real-life entity that can be analyzed with a considerable degree of logic. … In contrast to a company, a stock is a piece of paper whose price moves erratically in response to both the business fundamentals of the company and unpredictable investor emotions. So stocks, per se, are unanalyzable.”

One useful way to analyze companies is to examine how efficiently they use their resources. A recent article in Dow Theory Forecasts focused on three key indicators: return on equity (ROE), which is the ratio of a firm’s earnings to the book value of its outstanding shares (that is, its “common equity”), a figure that’s found at the bottom of the balance sheet; return on investment (ROI), earnings divided by the sum of common equity, preferred stock, and long-term debt (that is, all of the capital that a company deploys); and, finally, return on assets (ROA), where the denominator is the total of all the things a company owns (cash, inventory, buildings, machines, etc.).

Among the companies that Dow Theory identifies as leaders in their industries in ROE, ROI and ROA are Anheuser-Busch (BUD), the brewer, with a spectacular ROE of 54 percent, meaning that it makes more than 50 cents on every dollar of stock investment by its shareholders; Eli Lilly (LLY), pharmaceuticals, with an ROE of 35 percent and an ROI of 24 percent; Guidant (GDT), medical devices, with a comparatively lofty ROA of 18 percent; Family Dollar (FDO), discount chain, with good returns across the board; and Oracle (ORCL), software, with an ROE of 37 percent and an ROA of 18 percent.

You are sure to suffer losses, but hang in there. The bear market may be over, but that doesn’t mean every stock you own will go straight up. For an example, look at our financial guinea pig, Shaw Group (SGR), the company that provides pipes and engineering services for utility-plant construction. Shaw was the focus of a piece I wrote earlier this year on how to analyze a stock. When I wrote about it, Shaw traded at about $9 a share. Since then, its price has bounced all over.

In June, Shaw went as high as $12.62, but it skidded below $7 in August on lackluster earnings. Then, suddenly, it became the beneficiary of the blackout that hit the Northeast and Midwest. On Wednesday and Thursday of last week, the stock shot up from $8.75 to $11.87 — a gain of 36 percent — on news of a contract to build a New York power plant and on an upgrade from “avoid” to “hold.”

Shaw is a risky stock that’s trading at a big discount, but it is essentially the same company today as it was last month. Sure, the environment for building new plants has improved, but not all that much. Shaw was simply a company that had fallen out of favor briefly and is now back in the good graces of Mister Market, the manic-depressive who’s a metaphor for the mass of investors worldwide who set prices each day.

The Dow may be up 2,000 points since March, but it has another 2,000 points to climb to get back to its all-time high of 11,723, reached on Jan. 14, 2000. It won’t get there tomorrow, and there will be sickening declines along the way. But persevere. Become a partner in good businesses, build diversified portfolios or just own index or broad equity mutual funds. And keep them. Sitting still is hard to do, in investing and in life, but there are delightful rewards for the faithful.

Of the stocks mentioned in this article, James K. Glassman owns and Automatic Data Processing.

James K. Glassman is a fellow at the American Enterprise Institute and host of Of the stocks mentioned in this article, he owns and Automatic Data Processing. This article originally appeared in the Washington Post..


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