From Vitaliy Katsenelson comes a reminder that good fundamentals do not necessarily equate to good stock market performance (at least not in an easily predictable time frame):
Imagine an analyst bringing a “fresh” stock idea to a portfolio manager at a large mutual fund. He’d say something among these lines: Cisco is a buy, it has a bulletproof balance sheet with $25 billion of net cash (cash less debt), the stock is cheap – trading at 9 times earnings (excluding net cash), it’s providing double-digit returns on capital, and it is a dominant player in the industry, which is poised to grow at a faster rate than the economy, since, thanks to iPads, Androids, Kindles, Hulus, and Netflixes, we’ll all continue to consume digital content.
I can just see the portfolio manager’s smile, his laugh and comment that “This stock is a value trap, it has gone nowhere in more than a decade.” I’m glad I’m not that analyst, as I’d have a huge burden to overcome. After all, Cisco has shattered the dotcom dreams of many investors in the years following 1999, when it hit $80 a share and, for a brief moment, was one of the most valuable companies in the world, sporting a modest P/E of 100+. Since then, gravity has caught up with Cisco’s stock (it always does), and it has declined almost 80% from its highs, to $17. Most investors who bought the stock since ’99 either lost or made no money. Draw a straight line through its chart (you have more than a decade’s worth of data points), and you see it’s either going to zero or at least will continue to go nowhere. Now, you add to this performance a few quarters of disappointing Wall Street guidance, and you have an untouchable, un-recommendable stock.
However, fundamentals – take any metric: revenues, earnings, cash flows – will tell a very different story: they either tripled or quadrupled since 1999. Through no fault of its own, Cisco’s stock was too expensive in 1999, and it took time for the stock to catch up to its fundamentals. Of course, as usually happens, investors get overexcited on both sides of valuation. The same investors who could not get enough of Cisco at over 100 times a little more than decade ago, don’t want touch it at 9 times earnings with a ten-foot pole.
Since 2000, CSCO is -69.66% while the S&P 500 is -9.77% (12/31/1999-05/26/2011). CSCO has underperformed the S&P 500 by nearly 60% over a period of time when its fundamentals have “either tripled or quadrupled.” Value managers may be loading up on CSCO with the expectation that the market will eventually come around to recognizing its apparently strong fundamentals. They have been waiting for over a decade now. How much longer will they need to wait?
If the fundamental story on CSCO is right — and it may well be — relative strength will not be the first to pick up on it. It will take a period of time for CSCO to show positive relative strength versus the market before it would become the type of security that we would add to our portfolios. The flip side, however, is that relative strength keeps us from sitting in poor performers for years on end while we wait for the market to come around to our way of thinking.
By the way, CSCO is underperforming the S&P 500 by over 25% again in 2011 (through 5/26/2011).
