A Discussion of Falling Share Prices
When share prices fall, it’s important to determine whether the situation will last for a couple of months, which can be quite normal, or for several years, which can be insufferable. I suppose if you’re a trader, you might literally be looking at a timeframe that encompasses a few days or weeks! But an undervalued stock strategy will, by nature, include stocks that are cheap because they’re out of favor, meaning that investors might continue to ignore them for some time period after your purchase. But as long as the company’s earnings growth outlook remains as strong as it did when I bought it, I’m going to hold that stock with an expectation of future capital gains.
Sometimes the earnings outlook for a company changes enough that I will sell a stock; and other times the outlook changes, but the stock remains attractive, as with Mattel (MAT). We can even see share prices fall, even though a company has a fantastic earnings outlook, as with Chipotle (CMG).
When I buy stocks, I require them to offer 15% earnings growth plus dividend yield in both the current and next years. (e.g., 12% EPS growth + 3% dividend yield = 15% total growth)
If next year’s earnings growth expectation declines to a point where the EPS growth plus dividend yield fall into the 5% to 10% area, I will contemplate exiting the stock, no matter what the share price is doing. Such was the case when I sold Applied Materials (AMAT) and E*Trade (ETFC).
If the current year’s earnings growth expectation declines, but next year’s growth expectation remains strong, I will hold onto the stock (presuming that the P/E continues to reflect a low valuation). Eventually, undervalued stocks rise, and I’m willing to wait for that scenario to play out. Such was the case with The Priceline Group (PCLN), and currently with Universal Electronics (UEIC).
Chipotle is expected to see EPS rise from $0.77 in 2016 to $7.73 in 2017 and $11.03 in 2017 (December year-end). Those numbers represent tremendous earnings growth, and the P/Es are still low in comparison. I therefore expect a complete turnaround in the share price, and I will hold the stock.
Mattel definitely saw its 2017 earnings outlook deteriorate since I added the stock to the portfolio. Fortunately, the 2018 outlook reflects significant earnings growth, and the company hired a new, experienced CEO a few months ago who is implementing a strong vision for the company’s expansion. EPS are expected to be $0.80 and $1.02 in 2017 and 2018, representing 27.5% EPS growth next year with a corresponding P/E of 16.6. As long as the P/E remains substantially below the earnings growth rate, I consider the stock to be a bargain that will eventually rise to a fair valuation.
Does This Buy-and-Hold Strategy Work?
From October 2015 through August 2017, the 35 stocks that I’ve sold from Cabot Undervalued Stocks Advisor averaged an annual total return of 14.1%, with an average holding period of 9.7 months. (Total return = capital gains plus dividends.)
Twelve of those stocks (one-third) delivered total returns between 18% and 59%. Nine of those stocks (one-fourth) lost money, with five of the nine losing less than 7%. Four of those companies were bought out by larger companies.
An undervalued growth stock strategy is going to require more patience and longer holding periods than an aggressive growth stock strategy. It’s going to be just right for some investors, and inappropriate for other investors.