Warning: Owning Stocks Is No Longer Enough

In March 2009, I wrote that investors could buy U.S. stocks with the expectation of earning acceptable returns. I would never have imagined the magnitude of the ensuing rally that is now approaching its two-year anniversary. With stocks having roughly doubled off the March 2009 intraday low, the pendulum has swung rather dramatically from fear toward greed. In that context, here's how investors should think about stocks now.

The "risk on" trade
Investors who bet on stocks in March 2009 have done very well since then. The breadth of the rally is impressive: If we look at the price return of the S&P 500's current components from March 9, 2009 through February 18, 2011, roughly four out of five rose at least 55%, almost three out of five beat the index and achieved a return in excess of 100%. The top quintile -- one in five stocks -- rose by 240% or more. As far as losing stocks, there were just 13 -- less than 3% of the total.

Tread carefully
Today, investors should be very careful regarding the specific stocks they own. The market is no longer cheap and future returns will be differentiated, enabling talented stockpickers to rise from the herd. Just owning stocks won't do the trick anymore; it's critically important to own the right stocks. In other words, you need to be a stockpicker if you want to own equities now.

In order to determine the sectors that offer the greatest opportunity for stockpickers, I looked at the distribution of stocks' price-to-earnings multiples within each sector of the S&P 500. On that basis, the four most attractive sectors for stockpickers are, in my judgment: energy, financials, health care, and information technology. Let me illustrate how the latter sector reflects this.

On the cheap end
At the cheap end of the IT sector, the reversal in investor attitudes toward tech stalwart Cisco Systems (Nasdaq: CSCO  ) over the past 11 years is dramatic. In January 2000, with Cisco's price-to-trailing earnings multiple levitating around 145, no price was too high for shares of the networking giant. Today, the equivalent multiple has fallen below 20 -- and the forward multiple is less than 11.5.

Has the demand for networking equipment collapsed over this period? Quite the opposite. Perhaps competition has intensified, or Cisco has lost its footing? The sector remains highly competitive, but it has experienced significant consolidation since 2000, and Cisco remains well-positioned. Just as investors who purchased the shares in January 2000 were virtually assured of earning disappointing returns, those who buy them today look likely to do at least reasonably well over the next five to seven years.

Two stocks that look pricey
At the other end of the spectrum, you have Red Hat (Nasdaq: RHT  ) and salesforce.com (Nasdaq: CRM  ) , which are priced at 50.9 and 107 times 12-month forward earnings. Red Hat sells services related to open-source software; unfortunately, it competes with much larger organizations including IBM (NYSE: IBM  ) and Oracle (Nasdaq: ORCL  ) . These elephants can offer companies lucrative bundled offerings that include hardware, software, and services. Yes, Red Hat's earnings are forecasted to grow 18.5% over the next five years, but that is simply in line with its industry and the sector as a whole -- which trade at just 29 and 20 times earnings.

salesforce.com has established a better franchise; in fact, it's the market leader in web-based customer relationship management (CRM) solutions. All the same, it's difficult for me to see how investors buying in at these levels will reap the sort of returns that are commensurate with the risk they are taking (the folks at our Rule Breakers service no doubt disagree with me here). The CRM market is highly competitive and the other major players in this area are, again, much larger organizations, including Oracle, Microsoft (Nasdaq: MSFT  ) , and SAP (NYSE: SAP  ) .

Don't bet on a bid
My sense is that the only way for salesforce.com shareholders to earn a good return from these levels is for an acquirer to come forward who is willing to pay a premium over the share price. That could very well happen -- I do expect the technology sector to be one of the most active sectors in the resurgent M&A market -- but it's not something I would feel comfortable betting on.

Selectivity is the watchword
Today's market is not cheap, so it's up to investors to identify attractive situations that still offer some margin of safety if they wish to achieve decent returns. The four sectors I have named above (energy, financials, health care, and information technology) are the first places I would look for these opportunities.

Looking for those right stocks? Here are "5 Stocks The Motley Fool Owns -- and You Should Too."

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. Microsoft is a Motley Fool Inside Value recommendation. Salesforce.com is a Motley Fool Rule Breakers pick. The Fool has created a bull call spread position on Cisco Systems. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of International Business Machines, Microsoft, and Oracle. Motley Fool Alpha owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (47)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 25, 2011, at 7:53 PM, Glycomix wrote:

    Cisco's ratios look wonderful: a TTM PE of 14 and a forward PE of 12.65! Due to bad press its stock price has declined 22%, from $24 to $18.65.

    I don't know why.

    Perhaps its feud with Hewlett Packerd has something to do with its decline? None of this makes much sense.

    Hewlett-Packherd (HPQ) is another wonderful buy right now HP has a current PE of 11.57 and a forward PE of 7.47. It missed its earnings guidance and suffered the wrath of the analysts. Its value hasn't slipped the notice of Nicholas Levis at Seeking Alpha: http://seekingalpha.com/article/254642-why-hewlett-packard-i...

    Hewlett-Packard (HPQ) has also declined in share price although they've done well. HP recently produced an excellent tablet computer based a cloud 'web-OS' that builds upon the success of the Ipad. Perhaps it can persuade the better app producers to port into their platform.

  • Report this Comment On February 25, 2011, at 9:20 PM, ozzfan1317 wrote:

    Coke is looking awfully cheap right now too. I bought in at 42 but its probably not too late to pick some more up.

  • Report this Comment On February 26, 2011, at 3:28 PM, dividendgrowth wrote:

    Large, cheap tech companies are usually cigar-butts: only good for flipping into those suckers who can't look beyond P/Es and other simplest metrics.

    Tech companies, beyond very few monopolies, don't have any moats because of constant changes and disruptions. They must rely on good R&D, and good R&D needs really good people. But how can you possibly track the quality of a company's employees until it's too late?

    Now let's look at Cisco, HP, and of course Intel. If you have indications that these companies have become bloated bureaucracies, don't ever think about invest in them. Trade them, flip them, just don't invest in them.

  • Report this Comment On March 07, 2011, at 12:24 PM, sept2749 wrote:

    I sat on Cisco for several years and let it go for a break even. No dividends and no real movement - so why own that stock when there are plenty of good solid companies that pay a decent dividend and provide some capital appreciation.

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