Market Buzz - With Current Valuations, Selectivity is Key

With the solid uptick in the markets we have seen over the past several years and the general rise in the level of broader valuations, we have seen investors push prices of solid companies higher. This is an encouraging trend as markets have returned to a state closer to normalcy where cash flow and earnings matter and are the driving force behind share price gains.

This was not the case in 2008-2009 and into much of 2010 where fear drove the markets and rational value was cast aside by all but the more astute investors. It was natural at the time to sit on the sidelines, but it was actually the perfect storm to buy in. Following the crisis in the fall of 2008, we issued 15 new buy reports over the next six months. Contrast this with the 7 in total we issued in 2012. We expect a similar number of “new” BUYs in the Small-Cap arena in 2014 as valuations continue to be stretched. Of course, this can change, but all things being equal, we will continue to be very selective.

The fact is there are a number of companies we are very interested in buying at present, but quite frankly they are not cheap. In other words, you are not able to currently purchase these attractive companies as cheap as we like to do. In fact, it is one of the hallmarks of our research.

At times investors can be wise to “pay up” or pay a fair to premium price to purchase great companies. Many pundits will say you get what you pay for. To a point we agree, but as we have shown over time, it is possible to buy great companies at good to great value. In an investment, there are often two components we are looking for to achieve price appreciation - 1) Above average annual earnings growth. 2) Multiple expansion.

You can achieve the above average earnings growth component if the company continues to grow net income at 25-100% (for example). Indeed, in recent times, the majority of the companies on this list have continued to do so which has been positive for their share prices. However, as we will note below, this can be a difficult level to sustain and when a stock trades at premium valuations, the market expectations are high and any misstep can lead to severe corrections.

With stocks trading at premium multiples, what is very difficult to sustain or achieve at all is the multiple expansion. For example, company A has growth of 35% and trades at 8 times earnings. Company B has growth of 35% and trades at 30 times earnings. Both could theoretically maintain the same earnings multiple and see their share prices rise by 35% (the growth in their earnings).It is far more likely that the Company B could see a doubling in the PE multiple if the market awards it from 8-16 (given its growth and the fact the average stock on the market trades at 18-19 times earnings) than Company B moving from 30-60 times earnings. Remember Company B already trades at a premium to the average stock which is tough to sustain at the best of times for great companies.

At present, there are very select buying opportunities, but “select” is the key word – we remain cautious.

2014 KeyStone Financial Publishing Corp.