Rational Investing: Undervalued issues ride out market frnzy well

Let's lay the groundwork for a successful investing year in 2001.

This time last year we were advising investors to lower their expectations; to not expect the markets to provide in 2000 the performance they had provided during the 1997-1999 period. We were particularly concerned about the amount of buying of mutual funds or managed accounts designed to track the S&P 500.

Here's why: Twenty issues represent more than one-third of the market value of that index. Those 20 issues accounted for more than 50 percent of the S&P 500 Index returns and valuation levels for those 20 issues were well above historic norms.

We also expressed concerned about the euphoria in the area of the tech stocks, especially those that were Internet-related. The strangest of years was ending a year in which momentum investing carried some stock prices to insane levels. In my December 1999 column I quoted one of my favorite financial analysts, Keith Mullins of Salomon Smith Barney, who put it this way:

"First, while it sounds like a tale from Lewis Carroll, the best investment strategy for 1999 has been to invest in companies that lose money. No kidding."

While a number of stocks were trading at very overvalued levels, a large number of issues were trading at price/earnings and PEG (price/earnings/growth rate) ratios that were irrationally low. Good companies with solid earnings growth were not simply being ignored, they were frequently a source of funds for traders determined to "go with what's moving."

It was a period in which reasoned investing was replaced with greed and the belief that the "new technology era" called for a "new metric." That new metric replaced such supposedly outdated measures as PEG, since it could not be applied.

After all, there is no price-to-earnings ratio or price-to-earnings-to-earnings growth rate ratio if there are no earnings. So analysts were having to justify owning the new technology stocks, the touted "waves of the future," with measurements such as price to sales, number of eyeballs(!), number of Internet users, etc.

Ultimately, earnings do matter (that should be every investor's mantra) and reality returned. When it did the overvalued issues suffered and the undervalued issues performed. But the performance of the forgotten companies was stealthy, with many of the big brokerage firms not recognizing the changing valuations until very late in the year.

Instead, the gurus of Wall Street were recommending the Yahoos, Amazons and e-bays as they continued declining in value. (Many of the same analysts have finally started downgrading these issues at levels as much as 80 percent below their old buy recommendations.)

We do not make specific stock recommendations without knowing the individual investor's risk tolerance and objectives, however, in last December's column, we did provide suggestions in terms of attractive industries: "acquire companies that do have earnings and are selling at unbelievably low valuations relative to historic measures. Look especially at the financials (banks, insurance, and investment firms), home builders ... and drug and grocery companies."

Of course, not all companies in these industries did equally well. Screening for those with a P/E less than their earnings growth rate and comparing them on the same basis with the tech issues would have dramatically pointed out the valuation disparities.

With that information, investors could have restructured portfolios, providing substantial appreciation potential while removing overvalued, vulnerable, issues.

(Clark Davis is a 30-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money management company. Questions or comments can be directed to him by mail via The Springfield Business Journal, 313 Park Central West, 65806 or by e-mail at sbj@sbj.net.)