Watch stocks you care about
The single, easiest way to keep track of all the stocks that matter...
Your own personalized stock watchlist!
It's a 100% FREE Motley Fool service...
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.
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."