Trim Your Winners
With rising interest rates and oil prices sapping the market's strength, this is a great time to get rid of risky stocks and funds that invest in them. The overall market still looks reasonably priced, but stocks in several market sectors have gotten way ahead of themselves.
A great place to start your hunt for places to trim: by looking at price-earnings ratios. They are one of the simplest measures of value, and also one of the best.
So cast a suspicious eye at sectors and stocks with high P/Es -- unless, of course, they have lofty earnings-growth prospects that justify their prices. Standard & Poor's 600-stock index, a widely followed small-cap index, currently trades at 20 times analysts' estimated operating earnings for 2007. By contrast, the S&P 500, which is dominated by stocks of large companies, trades at a P/E of 16.
It's not just that small-company stocks are more richly priced than their large-cap brethren. Small companies are expected to deliver better earnings growth than large ones in '07, but not by much. S&P estimates that earnings will rise 8% among small-cap companies this year, compared with 7% among large caps. This is clearly the time to trim some of your small-cap stocks and funds.
Where to trim? The priciest sectors among small caps are telecommunications (average P/E of 34), health care (P/E of 28) and technology (P/E of 24).
Even among large caps, as represented by the S&P 500, you can find over-priced sectors. The average large-cap tech stock trades at a P/E of 23. Consumer discretionary stocks aren't far behind, trading at a P/E of 20.
With pressures on the consumer from falling home prices, rising interest rates and oil prices, and high debt loads, consumer-discretionary companies -- those that sell products that aren't day-to-day necessities -- are a particularly good place to look for sell candidates.
That's what Brent Wilsey, a San Diego investment adviser, thinks. A list of sell candidates that he recently put together includes two consumer-discretionary stocks: Blue Nile (symbol NILE) and RadioShack (RSH).
Blue Nile stands out. The online retailer of diamonds and other jewelry has itself been a blue streak, rising from the mid $20s last August to $56.70 as of the close on June 25. But analysts, on average, estimate that the company will earn just 90 cents a share this year, putting the P/E at 63. Analysts predict that Blue Nile's earnings will rise only 8% this year and 11% next year.
Wilsey is concerned about Radio Shack's 10% drop in sales and 49% slide in earnings over the past 12 months.
Currently, Wilsey has only 35% of his client assets in stocks. I'm not as confident as he is of my ability to time the stock market. Long term, the money tends to be earned by those who keep their long-term money in stocks.
But moving some of your investments from high-priced areas to lower-priced areas is common sense. I think putting no more than 10% of your stock money in small caps and no more than 20% in mid caps is prudent today. Invest the bulk of your stock money in large companies.
Growth versus value
Then there's the dichotomy between growth and value stocks. Growth companies are those whose earnings are expected to rise relatively rapidly. Consequently, they tend to sport high P/Es. Value stocks are those that investors expect little of, so the shares often sell for a song.
Investors had their fill of growth stocks in the late 1990s, when they drove shares of tech, telecom and other fast-growing companies to unsustainable heights. Investors subsequently suffered a terrible case of indigestion in the form of the 2000-02 bear market. Since that bear market began, value stocks -- which are usually underappreciated and which typically represent boring, slow-growing or troubled companies -- have been the market's darlings.
How long can that go on? Based on the S&P indexes, not much longer. The P/E on the S&P 500 Citigroup Growth index is just 17, compared with 15 on the S&P 500 Citigroup Value index. That's an unusually narrow spread. Investors, in other words, aren't paying much extra for growth.
Growth versus value in the S&P 600, the small-cap index, is a true head scratcher. Here, the average P/Es for value stocks are actually higher, at 21, than the average P/Es on growth stocks, at 20. How can that be? Fast-growing companies cost less than slow-growing companies?
Don't expect that anomaly to last. I suggest tilting your portfolio toward the stocks of large, faster-growing, higher-quality companies. The behemoths look best for the months and years to come. Trim what's been doing best: Small caps and "value" stocks.
Funds that look good now
What funds to buy? My favorite funds include Marsico Growth (MGRIX) and Vanguard Primecap Core (VPCCX). Both specialize in large, growing companies. Selected American Shares (SLADX), which pays more attention to value, will help round out your large-cap portfolio. And don't ignore foreign stocks. Value-oriented Dodge & Cox International (DODFX) is still the most appealing large-company foreign fund.
Just remember that no matter how expensive one sector may look relative to another, it's hard to know when market sentiment will change. As Sam Stovall, S&P's chief market strategist, puts it: "The fundamentals tell you what's going to happen. They just don't tell you when."
Steven T. Goldberg (bio) is an investment adviser and freelance writer.