The Dash to Trash
John Mauldin's Outside the Box

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Introduction

Today we deal with trash. This week's piece is not only regarding the problems with "trash investments" itself but investors' dash towards it! My good friend and fellow writer, James Montier, takes a long look at the market and probes it in search of value. In his article, James walks us through the valuation of different equity classes and the investor sentiment currently surrounding them.

For those who are unacquainted with Mr. Montier, he serves as the Director of Global Strategy at Dresdner Kleinwort Watterstein, a London and Frankfurt based investment bank. He is also a prolific writer and author of the book "Behavioral Finance - Insights into Irrational Minds and Markets."

In his article "The Dash to Trash," James explains how investors have embraced junk and shunned value, causing mispriced valuations with respect to small and large cap equities. Furthermore, he goes on to explore why people not only flock to trash, but why they are willing to pay up for it. Such stocks often lead to little more than volatility and, eventually, poor performance. I hope that you will enjoy this article and maybe, just maybe find some new meaning in the old quote, "One man's trash is another man's treasure."

John Mauldin, editor

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The Dash to Trash

By: James Montier

Investors seem to be displaying signs of pure fearlessness. Perhaps they see themselves as high-wire walkers, bravely showing their skill to the breath-holding crowd. To us they look more like Wile E. Coyote, running in thin air before looking down and realizing they have nothing to support them, and succumbing to the inevitable gravity check.

Our fear and greed index continues to remain at extreme risk-loving levels. This suggests that it is an obsession with return without any regard for risk, that best characterizes investors' behavior at the current juncture.


Further evidence of this enthusiasm for all things equity can be found by looking at the short interest ratio on the QQQQ (Nasdaq ETF). The short interest ratio shows the outstanding short interest divided by the average 30-day volume. Currently, short interest stands at just 1.5 days' volume! With the Nasdaq still trading on nearly 40x trailing earnings there doesn't appear to be a lot of interest on the downside. Just in case you think 40x is perfectly reasonable for the Nasdaq, hazard a guess on the average PE multiple for 1995/6 before the internet bubble... if you came up with a number of 13x, you were absolutely right.


This desire for 'junk' is supported by the analysis contained in Andrew Lapthorne's latest missive on style performance (see Global Style Counseling, 3 April 2006). The market is sending a clear signal that greed is good and junk is the best way to go. Andy's work shows that those firms with low dividends, high volatility of earnings, high beta and high uncertainty have been the best performers in all markets so far this year.


Standard and Poor's construct a quality ranking for equities (also known as the earnings and dividends ranking). The rankings are based on per-share earnings and dividends track records over 10 years – echoing some of our prior work on use of criteria set out by Ben Graham. Basic scores are adjusted for rate of growth, the stability within the long-term trend and cyclicality. The final scores are translated into a ranking classification (shown below).


Andy's findings are confirmed when one casts a cursory eye over the best performing stocks in the S&P500 so far this year. Of the top ten stocks so far this year, none are rated as anything higher than average: 9 of the 10 are rated below average, 6 have the lowest quality rating (C). This out performance of junk is not limited to the top few stocks. The chart below shows an equally weighted year-to-date performance by quality ranking. The worst stocks have had the best performance (C ranked stocks up an average 17% YTD) whilst the best quality stocks had the worst performance (A+ stocks up a mere 1.2% YTD).


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Security Type Closed-End Fund
Annual Dividend $1.80/share
Dividend Yield 9.6%
Portfolio Value $2.0 Billion
Discount to NAV +4.4%
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A recent study by Standard and Poor's shows this is an unusual situation. In general, the highest rated quality stocks outperform the junk, and do so with lower risk.


Given my value bent, I really don't mind buying junk, so long as it is appropriately priced. Which, of course, begs the question: what price junk? The table below shows the current valuation and the 20-year average for each of the quality baskets across three different measures.


The chart below summarizes the data. Averaging across three measures1 shows that high quality is currently trading at a sizeable discount to historical norms, whilst low quality is trading at substantial premiums to its normal valuation. So, far from buying junk because it is cheap, investors seem to be happy to buy junk despite its expense. From a value perspective, quality is relatively cheap.


1 Trailing PE was omitted due to the extreme overpricing of junk on this measure, but including it doesn't alter the results shown in any qualitative way.

Size and quality are not unrelated. In general, higher quality companies will tend to have larger market capitalizations than lower quality companies. For instance, firms in the A+ basket have a median market cap that is nearly 3x larger than those on the B- basket at the current juncture. Thus the relative pricing between large and small caps can serve as a noisy proxy for quality. The chart below shows the Graham and Dodd PE (based on 5 year moving average earnings) for US large and small caps. The picture ties in well with the analysis above, as small caps are trading at a quite incredible 31x – a record high.


The final worrying sign of a surge of interest in junk equity is provided by the volumes data on the OTC Bulletin Board (OTC BB). The OTC BB is a quotation service for OTC securities (i.e. those not listed on the Nasdaq or any of the national exchanges). It is to all intents and purposes, a market place for low quality stocks. Volumes have exploded in true mania style. At the time, 2000 looked like a huge surge in volumes; now it's barely a blip!


One final observation: this dash for trash is not limited to equities. As a recent Bloomberg report points out, "U.S. companies one step away from default are selling a record amount of bonds... Even CCC rated companies, considered in so-called technical default, meaning they asked investors to revise the terms of their (existing) debt, were able to sell bonds in the first quarter." Doesn't sound much like prudent investment to me. Quality is being shunned in all forms. Whilst the herd is busy pumping but not dumping the latest junk stock, a dedicated contrarian with a value tilt might just look to pick up some quality at a reasonable relative discount.

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Conclusion

Your always throwing out the trash analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.

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Posted 04-24-2006 9:49 PM by John Mauldin

Comments

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