Revisiting Apple’s Valuation

Apple (AAPL) and its leader Steve Jobs know as well as anyone, better perhaps, how to generate excitement around new products, as we've seen yet again with iPad 2 lines of people waiting in line for hours to be among the first to get their hands on a hot new product. But if we've learned anything from history, it should be that excitement about product launches does not necessarily translate into attractive, or even satisfactory, investment returns. (I presume it's not necessary to reiterate the decade-ago collapse of new-economy investing.)

When it comes to Apple, suggesting that investors separate themselves from the excitement is easier said than done.

For one thing, the company's Price/Earnings ratios look pretty reasonable: 19.05 when Trailing 12 months EPS is used in the computation, 14.75 when the consensus current-year EPS estimate is used, and 12.81 when the estimate of next year's result is factored in. Meanwhile, the consensus long-term EPS growth rate projection is 19.27%, which seems to already allow for quite a bit of deceleration from the blistering pace of the late 2000s (57.8% over the past five years). Accepting the consensus growth projection as is, we'd be looking at a PEG ratio of 0.99, 0.77, or 0.66 depending on which P/E computation one wishes to use.

By now, Apple fans probably know that Alex Guana, of JMP Securities, is unimpressed. While not detracting from Apple's stature as a great company, he downgraded the stock suggesting that a slowdown at a major Apple supplier might be signaling a slowdown in iPhone sales due to market share gains by Android handsets. Other analysts disagreed, but enough investors took note of Guana's caution to send Apple share down 4.5% in reaction to his report. I'm not in a position to pass judgment on Guana's theory or those of analysts who dismiss it. But with at least one respected observer doing an "emperor has no clothes" number on Apple on the one hand, I do think it would be appropriate to take another look at Apple's valuation.

The last time I did this was on June 25, 2010, when I concluded that a P/E similar to those we see now was "legitimate" given what seemed to be a reasonable or even conservative investment-community assessment of growth prospects. At that time, much iPad novelty and excitement still lay ahead of the company.

Given the spectacular success of the iPad launch and Apple's elevated earnings, we ought to again ask why the stock remains so modestly valued?

The key, I think, is now to be found in the Price/Sales ratio which based on trailing 12 month sales, is 4.12. That's very high. The medians for the industry, sector and S&P 500 are 0.70, 1.96, and 1.17 respectively. The current ratio is high even toward the upper end of Apple's own range, as we can see in Table 1.

Table 1 - Apple Price/Sales Ratios

	3/23/02	3/23/03	3/23/04	3/23/05	3/23/06	3/23/07	3/23/08	3/23/09	3/23/10	3/23/11
Sales	1.50	0.93	1.41	3.50	3.40	2.46	4.42	2.74	4.31	4.12
Based on trailing 12 month sales figures

The ratio is not now at record levels. But readings this high have been associated with some pretty spectacular sales growth rates.

It's easy to argue Apple deserves some measure of premium. It has, after all, been a stupendous growth story and one that is likely to persist for a while (assuming Guana's caution is premature). But consider its history.

Table 2 - Apple's Annual Sales Growth Rates (%)

2003	2004	2005	2006	2007	2008	2009	2010
8.1	33.4	68.3	38.6	27.2	52.5	14.4	52.0
Fiscal years end September 30th

The numbers are certainly huge. But they are choppy. We see mega-tallies as Apple launches new product followed by a move toward normalcy, at least until the next blockbuster comes along. Most importantly, we see that the highest Price/sales ratios are associated with periods when Apple was experiencing super-normal growth, or at least times when the market could easily anticipate such gains.

Right now, Apple is still riding high, a phase that's being stretched by its release of iPad 2 so quickly after the initial model debuted. But how long can this continue?

This is important. When I was unperturbed a the 4-plus Price/sales last year, iPad had just gotten started and had not yet had an opportunity to make its presence felt in the reported financials. Considering the situation today, where iPad is an established fact, what's ahead? Can iPad 2 serve as a blockbuster new product of the magnitude of the original tablet and generate a dramatically higher sales growth rate than Apple would have achieved had it continued to sell the original? Will there be an iPad 3 for Christmas followed by an iPad 4 by some time in 2012? Will there be an iPhone 5, or perhaps the better questions are when it will arrive, and whether the world will treat it as a completely new product category? Is there some other pioneering blockbuster on the horizon? Bear in mind that for several years now, Apple's growth has really come from what are essentially line extensions on just one product, the initial iPhone. Will all due respect to Steve jobs as an innovator, how many more times can he mount the big stage, tap icons and resize pictures by flicking his finger while preaching world domination, before it becomes white noise? Ultimately, how many more 50%-plus sales growth rates are in Apple's future?

Unless Apple can keep these super-sized growth rates coming, if not every year than at least with reasonable frequency, it may be time to start wondering about 4-plus Price/sales ratios.

What, you may ask, about the still-reasonable P/E ratios. After all, when all is said and done, what we really care about is earnings.

In my opinion, the disparity between the very high Price/Sales ratio and the seemingly modest P/E ratios is a red flag. Last year, with iPad first taking off, I was willing to let it slide, a call that was unspectacular but OK (Apple stock is up 28%, versus 20% for the S&P 500). That was then. Time marches on, so we always have to reassess the numbers in light of the new state of affairs. Looking at the situation today, even if Apple can grow sales enough to justify the Price/sales ratio (a very big "if"), I think the Street's unwillingness to pay up for it is more of an issue. Opinions that were reasonable when a growth surge was ahead of us aren't necessarily so reasonable when we've reached or are near the top of the cliff. Now, it's time to consider a different angle. Even if the Street is willing to accept the notion of powerful sales growth, can we assume it will continue to be at least matched by EPS growth. In other words, should we now be looking for margins to narrow.

Commentators were quick to honor iPad 2 as having permanently insurmountable dominance of the tablet market even before it and some rivals actually saw the light of day. Maybe that'll be the case, maybe not. Either way, the key question is: At what price? Can Apple be the first technology-product producer in history to avoid the precedent of narrowing margins over time? Maybe. But do you really want to bet your nest egg on it?

Consider Apple's gross margins.

Table 3 - Apple's Gross Margins (%)

2003	2004	2005	2006	2007	2008	2009	2010
27.5	27.3	29.0	29.0	33.2	35.2	40.1	39.4
Fiscal years end September 30th

We see the late-decade margin expansion that resulted from Apple's market leadership. But we also see what stock traders would call resistance at the 40% level, a time when Apple has been riding as high as any company in memory.

There is, of course, the iTunes agle. Bulls could argue that Apple isn't just a hardware producer and that we need to take into account its powerful distribution business. That's true. But distributors don't have 40% gross margins. At Amazon.com (AMZN), as powerful a cyber-distributor as we have nowadays, gross margins have been stable for a while in the 22% vicinity. It's too early to assess Amazon's new Android App Store and its potential impact on the rival protocol. Apple fans undoubtedly can cheer the company's trademark suit against Amazon's use of the phrase App Store. Actually, though, for investors, we can file that under "W" for "Who cares." Everyone knows who Amazon is and its app store will do what it will do regardless of what it's called and regardless of the outcome of lawsuit that is of interest to nobody except the Law and Public Relations firms that get to log billable hours. Ultimately, iTunes is no longer new. We have to assume the investment community knows it's there and is taking its potential into account as it determines how much it's willing to pay for each dollar of Apple's EPS.

so the valuation ratios are, in essence, telling us that investors are looking askance at the sustainability to the sales-growth story and are nervous about the extent to while Apple will be able to translate all the additional sales dollars it gets into profits. Put another way, Mr. Market, while enthusiastic (arguably giddy) about sales prospects seem skeptical about EPS estimates and the long-term growth projection. Indeed,if the numbers are to be trimmed, then it would turn out that the effective P/E ratios aren't as low as we now think. I was willing to disagree with the market last June. Now, with tablets out there and competitors coming, I think it's time to get on board with the consensus.

Do not think that any of this suggests Apple is a short candidate. For that angle, we'd need a market-wide calamity or negative sentiment (i.e. such as would occur if Apple were to break precedent and fail to beat guidance). Aside from that, it looks to me like Mr. Market has made a thoughtful assessment of Apple's worth as a company and is not likely to budge absent a truly significant new development, something beyond anything now being contemplated.

In other words, what we seem to have here is a case of fair valuation. Don't count on an attitude adjustment on Wall Street to make Apple run ahead of the market from here. Instead, we'll need something truly novel (probably beyond iSomethng X) from Cupertino.

A Tale Of Two Warehouse Clubs

It’s easy to love Costco (COST). The shopping experience, while admittedly not for everyone, appeals to many based on low pricing and something of the flavor of a treasure-hunt. For investors, the appeal is a loyal customer base (fostered by the membership program), a broad-based product mix featuring a hefty dose of everyday necessities (which, together with the low prices, undoubtedly helped the company get through the recession with less pain than many other big-box retailers), and a cost-efficient operation. Don’t you just wish you could make that work for you as a shareholder? Too bad COST is unlikely to do that for you.

I’m not saying COST stock is a dog. Actually, it’s reasonably well-rated by many of the twenty-plus analysts that cover it (the weighted average recommendation score is 1.92 on a scale of 1.00 being best and 5.00 being worst). The problem, so to speak, is the nature of the investment case you have to make here. The most important issue, for COST and most other big-name stocks, is whether you think they’ll meet, miss, or beat the consensus estimates for the next quarter and whether the next round of sales and earnings guidance to be issued by management will be more or less favorable than analysts now expect.

Some investors are good at this sort of thing, at least some of the time. Others aren’t. But even the more successful players are not really cashing in on the positive merits of a business like this. They’re primarily gaming the guidance. They could be doing this with COST. It could be Wal Mart (WMT). It could be McDonalds (MCD). It could be Coca Cola (KO). It could be Microsoft (MSFT). It could be Cisco (CSCO). It could be any one of countless big-name stocks, the common themes being analyst coverage, and an exciting business/growth story that, when you sit down and really think about it, you realize is yesterday’s news.

Figure 1, a long-term comparisons between COST and the S&P 500, shows pretty clearly that the rewards for investors who recognized the merits of Costco’s business model were pretty much fully distributed more than a decade ago. Ever since its late-1990s market splash, COST has been just another big-name stock; sometimes outperforming the market, sometimes underperforming, but on the whole, just another name.

Figure 1

Interestingly, though, the small-cap segment of the market is serving up another opportunity for investors to participate in a Costco-type story: PriceSmart (PSMT), which runs warehouse clubs in the Caribbean and Central America. The business models are similar (membership-based, big-box stores, low prices, efficient operations) albeit tailored to PSMT’s locales (products with local appeal and square footage that may be small by COST standards but huge in local contexts).

PSMT is not by any means a start-up. Trailing 12 month revenues are already up to $1.3 billion and the company also looks established and “legit” by other metrics: Returns on Investment of 13.13% and 6.53% for the trailing 12 months and last five years respectively, versus industry medians of 8.84% and 4.49%; Sales growth rates of 7.81% and 18.13% for the trailing 12 months and last five years respectively, versus industry medians of 5.15% and 2.74%; operating margins of 4.99% and 3.18% for the trailing 12 months and last five years, just about equal to industry medians, and a 0.19 Total Debt to Equity ratio, versus an industry median of 0.37.

At first glance, stock valuation metrics seem to put PSMT at a disadvantage: the forward PE (calculated based on estimated EPS) is 20.00 for PSMT versus an industry median of 15.62. The PEG ratio, here, is 1.67 versus 1.00 for the industry. Moreover, the consensus analyst long-term EPS growth rate projection is 12% for PSMT, versus a 14.5% industry median.

So on a purely numerical basis, PSMT does not seem like such a big deal. But if investing were just a matter of reading numbers, we’d all be gazillionaires. The challenge is to decide which numbers are most significant, and in some case, which are most credible.

Frankly, I would not bet the farm on the industry as a whole achieving anything near 14.5% EPS growth rate over the next three to five years. The companies are too mature and U.S. consumers will likely take a long time to reduce their leverage, especially with income prospects sluggish at best. Conversely, I wouldn’t be at all surprised if 12% turns out to be too low as a projection of PSMT’s growth rate considering the opportunities that lie ahead of this much-less-mature company: operational improvement at existing, and still-young, stores; addition of new stores in countries in which the company already operates; expansion into other countries in the region; possible expansion beyond Central American and the Caribbean; and perhaps most important, presence in developing markets that offer much more upside from the potential evolution of a consumer-middle class.

I’m not being a rebel when I speak dismissively of the Wall Street growth projections. Try asking a sell side analyst how he or she comes up with the long-term expectations if you ever get a chance. Don’t worry about struggling to keep a straight and polite face. Chances are they’ll chuckle, or roll their eyes, or maybe even laugh out loud as they respond.

Obviously, I can’t swear a PSMT investment will succeed, or even outperform COST on a three- to five-year basis. But at least I know I’d be thinking about and evaluating the potential for the warehouse club concept to catch on with a lot of consumers who are unfamiliar with it, which makes me feel a heck of a lot more like an investor than I do when I sit around trying to game the guidance.

Who’s Afraid Of The Big Bad Downgrade? Not Me!

We have a bunch of analyst downgrades this morning. UBS dropped Hewlett-Packard (HPQ) and Intel (INTC) from Buy to Neutral. Oppenheimer lowered H&R Block (HRB) from Outperform to Perform. Bank Of America/Merrill dropped ranks on a host of stocks including Weyerhauser (WY), Visa (V), Raytheon (RTN), and Lockheed Martin (LMT).

I like to think we're long past the stage where we get overly upset over this sort of thing. A well-written analyst report can do quite a bit to help you understand the dynamics of a company, but well-written reports are harder to come by due to employment cutbacks on the sell side over the years and the fact that such reports, when they are created, are usually distributed only to institutional clients.

But even in the best of reports, should we, or anybody else, really care much about whether the stock is rated Buy, Outperform, Neutral, or whatever? A decade ago, many who were new to Wall Street machinations were fascinated by this. Then came the stories of conflict of interest and so forth and analysts came to be viewed with scorn. Now, we may have gone to the other extreme. I'm seeing some strategists who are acting contrary to what analysts suggest; buying on downgrades.

The question for today is whether the contrarian view is any better than a follow-the-ratings strategy.

I tested such a strategy on StockScreen123 by creating a very simple screen that identifies all stocks for which the average analyst rating is more bearish than it was four weeks ago. Then, I backtested the strategy over the past five years, assuming the screen would be re-run and the list refreshed every four weeks. Figure 1 shows the result.

Figure 1

Are you awake yet?

Actually, the strategy did outperform the S&P 500 index - a bit. The question is whether that level of excess performance is meaningful. Statisticians have fancy ways to test for this sort of thing, but we needn't bother. Figure 2 provides a nice, clear answer. It shows the performance we'd have achieved had we simply bought and held the Rydex Equal Weighted S&P 500 ETF (RSP).

Figure 2

The results are almost identical. This suggests the limited amount of excess performance we thought we had achieved by trading against the analysts could just as easily have been achieved by selecting stocks included in the S&P 500 index and investing equal amounts in each, as opposed to the market-capitalization weighting protocol that is standard for the index.

The bottom lone here is that as far as I can see, analyst downgrades mean nothing. Yes, this sort of thing generates headlines. Yes, this sort of thing can even generate some short-term selling (we see anecdotal evidence of that). But no, this sort of thing does not generate enough selling pressure to make for a viable contrarian investing strategy.

Apple: What You Can't Know, What You Can Know

I had an interesting debate recently with a Portfolio123 user who was big on combining stock screening with a subjective company-by-company analysis focusing on things like whether the company's business is understandable, whether it has a durable competitive advantage, whether it has a talented management team, and so forth. (If this strikes you as a Warren Buffett-esque approach, you're right; Buffett's name often came up in the discussion.)

In playing devil's advocate, I asked how confident he could plausibly be in his ability to accurately assess such issues. I'm concerned that well-meaning investors armed with books that present an overly idealized view of what you can learn by studying a business overestimate how much they know and, hence, wind up making bad decisions.

A Case Study: Apple

Let's focus on Apple (AAPL), which ought, one would think, be easy to decipher given how widely talked and written about it is.

Consider iPad, which is likely to pay a big role, for better or worse, in Apple's ongoing profit trends and stock price. Many of us have seen it; some of us own it; most of us believe it's either a game-changing milestone or an over-priced toy, and, it seems, everyone has an opinion on how well or poorly it will do.

The Art, Science And/Or Voodoo Of Forecasting

Unfortunately for forecasters, nobody can really predict what's going to happen. The forecasts you see depend, by necessity, on a chain of assumptions many of which are themselves highly uncertain.

Prognosticators can start with plausible assumptions about population and the percent of people who own laptops, iPods and/or iPhones. From there, however, we shift to guesswork. What percent may add iPad to their existing repertoire of gadgets? How many may take this as a first such gadget? How many more might buy it if or when prices get cut? How far will prices have to fall to boost demand? Might Apple introduce super higher-priced adaptations? What new apps might come out that persuade detractors to switch gears and jump on the iPad bandwagon? What will the pattern of growth look like, meaning how fast will market penetration ramp up from zero to a "normal" level beyond which general economic factors will play a bigger role (as may now be the case with iPod)?

If you haven't got a headache by now, consider that iPhone 4. We need to engage in similar exercise for that. We also have to make assumptions about how competitive efforts from Research In Motion (RIMM) and the Android consortium developing between Google (GOOG), Verizon (VZ) and Motorola (MOT) and potentially others. Speaking of competition, we have to assume a slew of iPad killers will be launched and wonder if any will rise above the crowd.

Bad News, Worse News, Good News

This looks bad. We don't really know as much about Apple as we might have thought we did.

Now, for some good news. Investors can live with the uncertainties described here because there are, actually, a lot of other highly relevant things you can know about Apple that will help you make a thoughtful yes-or-no decision about the stock.

The solution is to be found in the numbers, things we can know. If we can learn to move beyond the "past performance is no guarantee . . . " mantra foisted upon investors by lawyers and regulators, we'll find a wealth of information that can help us develop very reasonable assumptions about the future.

Growth Rates


Let's consider Sales and EPS growth rates for Apple, which are shown in Table 1. As you review the numbers, bear in mind that the original iPod debuted in late-2001 and the original iPhone came out in mid-2007.

Table 1 - Annual % Growth Rates

	2002	2003	2004	2005	2006	2007	2008	2009
Sales	7.1	8.1	33.4	68.3	38.6	27.2	52.5	14.4
EPS	267.8	4.1	267.0	351.4	46.3	73.4	72.6	33.9

When iPod was born, consumers didn't quite know what to make of it or iTunes and we see a slow build in sales. As to the mega-percent gains we see in early-decade EPS, brush them aside. I haven't dug deeply yet but pending further review, I'll assume those reflect unusual gains or charges, not recurring business trends. Starting in 2004, though, it looks like iPod began to pick up serious traction, helped probably by consumer familiarity, increasing comfort with and credibility for iTunes, and new iPod variations. This isn't an idle history recitation: notice how those developments translated into numbers.

By 2007, though, we saw some deceleration since by then, many owned iPods and felt no need to buy new versions. We also see the upward jolt resulting from iPhone's debut. Notice, too, the quick deceleration in 2009. Note the pattern: an initial ramp-up, as market penetration went from zero to something, followed by a leveling off.

Hold these thoughts. Let's now move on to something else.

Valuation

Table 2 shows some basic valuation metrics.

Table 2 - Annual % Growth Rates

	AAPL	Industry Median
PE (using estimated EPS)	20.17	17.57
Projected LT EPS Growth Rate	17.5%	15.0%
PEG Ratio	1.15	1.17

That should give pause to those who say Apple is overpriced. The valuation might actually be OK. It all depends on the reasonableness of the earnings projections.

Analysts are looking, on average, for a 49% EPS gain in 2010.

Does that make sense? Go back to Table 1 and look at how the catching on of iPod and the ramp-up of iPhone impacted results. We can't expect the current new products to match because they will not be as large a proportion of Apple's total business as the old pioneers were. But the gain analysts expect in 2010 is well below what we see associated with prior new launches. So analysts are leaving room, quite a bit of room, for the new products being smaller portions of the total business and for potentially slow initial consumer adoption. Bear in mind, also, that estimated 2010 results reflect two major product launches, iPad and iPhone 4, in contrast to the past, when major launches occurred one at a time. There's a lot that can go wrong that can cause Apple to miss the target, but that's always the case in Corporate America. Based on what we're seeing here and now, I'm inclined to accept the projected 49% 2010 EPS gain. That means the 20.17 forward PE presented in Table 2 is legitimate.

Now, look at the projected long-term (assume three to five years) 17.5% EPS growth rate and notice how modest it is compared to what Apple has achieved in recent years. While nobody knows if iPad or iPhone 4 will take over the world, it seems clear that such a level of success is not necessary for the company to hit the 17.5% growth projection. All that's needed is for the iPod to not fall off a cliff (or if it does, to at least have the fall cushioned by increased iTunes sales based on a larger customer base) and for the new products to have at least moderate success. Anyone comfortable with these unspectacular assumptions should be willing to accept the 17.5% growth-rate target, which would make the 1.15 PEG ratio legitimate.

What We Now Know

This is just a sample of the analytic process, so there's a lot more that can be done with Apple's financials. That said, even this gives investors a lot to go on than they get by watching or participating in the endless and often virulent debates between Apple fans and Apple haters.

We still don't know the future, but we have learned some important and relevant things: (1) while numbers that depict past performance guarantee nothing, they can teach us a lot about the dynamics of a business, and (2) it won't take nearly as much success as many assume in order to justify Apple's current stock price.

Subjective issues like durable competitive advantage, etc. are fun to contemplate, but if you really want to make thoughtful decisions about stocks, you really need to work with the numbers.

It's Different This Time - Yes, Really

The stock market has not been a fun place to be since 4/23/10, and with 2008 still looming so large in our memories, we have to wonder whether we're again heading for something really ugly. At present, I don't think that's in the cards.

Differences

For normal people, the ultimate obscenity is known as a " four-letter word." For investors, the ultimate obscenity may be a four-word sentence: "It's different this time."

That underscores the trepidation I feel as I point out some important differences between now and late 2008.

For starters, the current downturn did not begin at anything even remotely resembling a peak price level, as we can see from Figure 1, a Yahoo! Finance S&P 500 price chart.

Figure 1

Actually, considering the vigor and persistence of the bounce of the early-2009 bottom, it's easy to argue that the market was due for a rest and would have found a reason, any reason, had Greece, Spain, et. al. not served one up so readily in the spring to start the ball rolling.

Stateside, there's a huge difference in expectations. Before the 2008 meltdown, many still though sub-prime lending and the accompanying approach to derivatives was a good thing. Now, we know better, much better. Going into 2007-2008, the financial system still had a lot of junk that needed to be cleaned up. It may not be pristine now, but it seems plausible to argue that we're a heck of lot cleaner than we were back then.

Finally, there's the nature of the stock selling itself. What happened in 2008 was not an ordinary bear market, or even a severe bear market. It was a completely different animal.

Figure 2 shows the number of S&P 500 stocks which fell 5% or more in one week at various points in time.

Figure 2

It's pretty bad so see how often a large number of blue-chip stocks fell so much so quickly, and it's interesting to note that we've been seeing some of that in the very recent past. Let's use that to get a general feel for how market weakness plays out in the real world.

Next, look at Figure 3, which raises the ante by charting the number of S&P 500 stocks that fell more than 10% in a week.

Figure 3

Now, we're starting to see some distinctions. The 2008 melt-down was different from most other bad periods in recent memory. The only other thing that came close was the post 9/11 selloff.

Finally consider Figure 4, which shows the number of S&P stocks falling more than 15% in a week.

Figure 4

Imagine a 15%-or-more stock price decline in one week. It's by no means unprecedented. We've seen situations like that when bad news comes out, often something very disappointing on the earnings front. But such events are usually scattered occurrences.

Imagine more than 300 simultaneous such situations within the S&P 500, the blue chips, the supposedly safest and most respectable part of the market!

That's powerful. That's also rare, enough so to even exceed the post-9/11 market drop. Making matters worse was the backdrop. Aside from the 2008 peak, unusually high levels continued to occur for several months.

Now, it's clear that late-2008 was a very special situation and that what we've been experiencing so far this spring has no resemblance at all to it (despite, even, the now-infamous flash crash).

It's definitely been rough out there. Figure 2 makes that clear, and so, to a lesser extent, does Figure 3. But we're not experiencing anything like the widespread and largely indiscriminate equity-dumping that occurred in late 2008.

Even so, we can't be complacent. Look again at Figure 3. We had nearly a year of persistently bad readings before the bottom fell eventually out of the market. We can even see a bit of that in Figure 4. Similarly high readings, albeit not as spectacularly high as late-'08, marked much of the early-decade bear market as well.

The most recent (spring of 2010) many-big-declines readings we see in Figures 3 and 4 are not cause for panic. But the trend bears watching. If it doesn't recede soon, we will want to fasten our seatbelts.

Why Investors Defy Critics And Use Leveraged ETFs

Leveraged ETFs are hated by many gurus and commentators but are loved by investors.

Critics fear misuse by investors who hold these newfangled securities too long. They are designed to double or triple the performance (or the inverse of the performance) of the target index when held for a day. But if held longer, all bets are off, as the zigs and zags of daily price action can cause leveraged ETFs to chart unexpected courses. (Depending on how long one holds such an ETF, and how erratic the index's path, it's actually possible to lose money on a leveraged short ETF even if one correctly assumed the index would fall.)

But judging by the volume of trading, these securities are loved by investors. Among the 100 ETFs that rank highest for 60-day average volume, 32 are leveraged, split evenly between leveraged long and leveraged short.

What gives? Are there really so many daytraders out there who are holding leveraged ETFs for a single day, and guessing right about market direction onften enough to stay solvent and continue coming back for more?

That's possible. There is, however, another possible expnalation. Maybe these ETFs can actually contribute in a ocnstructive way even to someone whose market timing is less than 100% perfcet and who, hevan forbid, actually does hold them for more than a day. Actually, I'm in this caegory.

I used StockScreen123.com to create a model for low-price stocks, those which trade below $3.00 and can be bought or sold with reasonable spreads through the window-trading platform of on-line broker FolioInvestong.com. I love this segment of the market. It usually offer much better returns than I can get even from other kinds of small-cap investing, and this segment offers opportunities to hit big-time investment home runs. However, risk, here, is real and substantial. Being exposed to stocks like these when the market is gyrating wildly can be a painful experience.

Obviously, I could go into and out of these stocks based on my assessment of market conditions, but even if my timing is reasonably accurate, the drain form dealing with even reasonable low-price-stock spreads can add up. So I decided to hold my stocks through thick and thin and when I'm worried about the market, add a leveraged ETF, specicifally, the Direxion Daily Small Cap Bear 3X ETF (TZA). On May 21st, I bought enough TZA to result in my having a 15% stake in it, and 85% in my regular low-price stock portfolio.

Figure 1 is the performance record of this account as presented on the FolioInvesting web site from 5/21/10 through 6/5/10. The dark blue line represents my portfolio, which was up 0.43% over this volatile period. The light blue line represents the Russell 2000, which was down 2.36%. As to TZA I bought it at 6.986 and on 6/5,it closed at 7.54 for a gain of 7.92%.

Figure 1


There's noting fancy happening here. My timing hasn't been perfect and my stake in TZA in the past couple of weeks hasn't always been beneficial, although it was so at the end of last week and still is as of this writing.

That's OK. I'm not trying to win a spot on TV as the next great daily forecaster or change the world or win a Nobel Prize. I only want to inject enough stability into a normally high-risk-high-reward stock portfolio to give me the fortitude to stay put and avoid allowing myself to get scared into selling a potentially great stock portfolio at the wrong time. Inb that respect, TZA is serving me well right now, as it has done in simiular contexts in the past.

This is one example of how one fundamentally-oritned non-daytrader uses leveraged ETFs. I can't speak for all the others who use these products, and judging by the volume, there are a lot of them. I suspect, however, that amopng that crowd, there are many other stories that while not identical to this one, are likely to be at least soemwhat similar.

"Double, double toil and trouble; Fire burn, and caldron bubble."

Those familiar with Shakespeare should recognize that as coming from a scene in Macbeth in which three witches meet in a dark cave to do the kinds of things that witches are usually assumed to do when they meet in dark caves. Those who aren't up on Shakespeare might, however, mistake this as something from a treatise on market timing; perhaps a ritual that precedes the shuffling of a deck of tarot cards. It would be an easy mistake to make. Market timing is often assumed to have more in common with sorcery than serious analysis.

But before we chuckle and move on, let's pause and try to take a more dispassionate look at the topic. We know it's hard (if it were easy, nobody would have lost money in 2008 and nobody would have gotten caught up in the market's current downturn), but is it really impossible?

We're going to explore this by assuming we'll invest in the S&P 500 SPDR (SPY) and testing a couple of timing strategies to see how effective they are in telling us when we should move to the sidelines. Figure 1 helps us establish a benchmark. It shows a 3/30/01 - 5/25/10 StockScreen123.com backtest of a buy-and-hold strategy for SPY.

Figure 1

(Notice that the red line, which represents our SPY strategy, is above the blue line, which depicts the S&P 500. That reflects slippage — the gap between the ETF's goal of matching the S&P 500 and what it actually achieved. That's an interesting topic, but one for another day.)

Now, we'll add about as simple a market timing strategy as one can devise. We'll be in SPY only when the 50-day moving average of the S&P 500 is above its 200-day moving average. At other times, we'll be on the sidelines earning what we assume will be a zero return. Figure 2 shows the results of the backtest, assuming we review our timing model and act, if necessary, once per week.

Figure 2

Translated to numbers, $1,000 invested in the strategy grew to $1,824 versus $937 for the S&P 500, and $1,099 for being in SPY at all times. The pre-2008 high for the timing strategy was $1,606 (reached on 9/29/07), versus $1,352 for the index and $1,501 for the permanent position in SPY.

That's interesting. One of the easiest timing strategies imaginable, one that can be implemented in less then a minute by anybody with access to price charts on free web portals, could have kept us on the sidelines for most of two big bear markets of the 2000s. It wasn't perfect. Using 50- and 200-day moving averages makes for slow signals. But even with that, we still could have been spared a lot of financial pain.

Notice, though, that it has not yet signaled the May 2010 drop. If the weakness lasts long enough, the timing strategy will catch up, but the swiftness of the early slump has been noteworthy enough to make us wonder if there is a way to generate a quicker sell signal. Obviously, use of shorter moving averages would help. The problem, there, would be too many false signals at other times.

Figure 3 shows the results of a conditional moving average timing signal I created on StockScreen123. It normally compares the 50- and 200-day moving averages, but switches to a protocol that takes us out of the market if the 5-day S&P 500 moving average drops below its 20-day moving average at times when the CBOE volatility index, the VIX, is 30 or higher.

Figure 3

It's hard to see, but if you look closely, you'll notice a little horizontal red line sticking out on the right, indicating that this strategy did recently signal a down market (specifically, on 5/1/10). The long-term performance of this strategy is not significantly different from the basic 50-200 day moving average comparisons — $1,000 in the conditional strategy grew to $1,803 as of 9/29/07 and $2,062 as of 5/25/10, but it will be interesting to continue watching in the weeks and months ahead, to see if it's worthwhile to continue to use VIX to help us decide if we should work with longer- or shorter-term moving averages.

Obviously, I do not now have all the answers. More study is needed. But it does, at least, seem apparent that I should be working with screening and backtesting, as opposed to books on tarot or cave-based cauldron cookery.