Wednesday, November 12, 2008

Looking for Relative Strength

As the markets approach their October lows and fear percolates once again, it is easy to get caught up in the hype surrounding big name stocks that are in the news. All eyes are on the big 3 automakers and people are questioning whether they will survive or be bailed out by the government. It is very difficult to imagine what the auto industry would look like without Ford and GM. But it is very easy to try and make an emotional bet on whether they survive or not.

And that is all it would be. An emotional bet. Same goes for buying any of the major financial institutions, commodity producers, or even junior explorers for that matter.

It is very emotionally satisfying to be able to say, "I picked the bottom in XYZ stock 3 years ago and am up 1400% since then." It's the type of talk that makes one look like a genius (or an arrogant jerk - depending on the tone) at dinner parties. So this is where most investors and fund managers spend their time. Trying to pick the bottom in the most beaten-up sectors.

I don't buy beaten-up companies because they're probably beaten-up for a reason. Sure, there will be the odd baby thrown out with the bathwater. But more often than not, stock prices fall because management did not properly prepare their business for unfavourable business conditions. Or perhaps their balance sheet is not transparent, their future profitability is jeopardized by a number of 'unknowns,' they are at risk of government nationalization, or a host of other potential pitfalls.

I prefer to make money.

What I am prepared to buy, are companies whose stock has not been majorly affected by the credit crisis. Companies who have no debt. Companies that have been, even for the past year, experiencing positive growth.

Additionally, I ask myself the following questions:

1) Does this company have new ideas? Or do they rely on old ideas to work again?
2) Does this company provide services or goods more efficiently than could be done before?
3) Does this company provide something that we need more of?

I am looking for something called "relative strength." Here are a few examples of stocks displaying good relative strength, and that fit my above criteria:

Emergent BioSolutions (EBS) - They make an anthrax vaccine and have a pipeline of other drugs with potential. Their biggest customer is the government. Stock is hitting 52-week highs even as the market craters. 30% revenue growth y/y.

Aecom Technology (ACM) - Company provides support for major infrastructure projects. Again, their major customer is the government. Stock price is 25% higher than October lows. 20% revenue growth y/y.

Insituform Technologies (INSU) - This company has a proprietary trenching system for replacing or upgrading underground pipe systems. Stock is nearly 50% higher than it's Oct low. Constant revenue growth.

Telecom Sao Paolo (TSP) - Operates land-line telephone, television and internet services in Brazil. Stock is 30% higher than October lows. Constant revenue growth. Pays a 12% dividend.

IShares MSCI Chile ETF (ECH) - Chile is probably the best performing emerging market over the last few weeks and is still 30% higher than it's October lows. It also fell less from it's highs earlier in the year, demonstrating a stronger economy. After living there for 3 months last year, I know that these are very smart and motivated people. If (big if) I were to make a bet on an emerging market recovery, Chile would be the first place I look.

It may seem counter-intuitive to some that I am looking at stocks that have not yet experienced big price decreases or that are way higher than they could have been had only 3 weeks ago. But during these enormous market declines, the true colours of companies are shown. We are in the process of separating the men from the boys. I want to buy companies that are strong, not weak.

So although it is my belief that stock prices in general have the potential to go much, much lower as earnings estimates get slashed, these are the types of companies I believe will be the strongest during that decline, and into the eventual recovery.

I would much rather own a basket of these stocks, coupled with a double inverse index ETF (like SDS) as a hedge than a basket of troubled companies with only a hope and a prayer that this was all just a bad dream.

But that's just me.

Disclosure: I own shares in EBS

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