Fight the Good Fight -- Against This Tape!

"Don't fight the tape" is a common investment aphorism. It is especially pronounced in the current market rally. Bulls use the phrase to justify their belief that expensive stocks will continue to march higher despite poor fundamentals.

Me? I fight the tape. That's how value investors make money. I purchase decent companies at very low valuations after large stock-price declines. "Fighting the tape" is part of my formal buy discipline. I am the antithesis of the "mo-mo" investors and the chart monkeys. Call me a "no-mentum" investor.

I do not enter a battle without reason or information. Purchasing shares of companies at compelling valuations is my strongest line of defense. Fundamental research plays a significant role in my preparation. Diversification of my holdings into different market sectors prevents overconcentation disasters.

Do I win all of my battles with technically challenged stocks? Not a chance. There are many more fundamentally challenged, chart-infatuated players out there than value portfolio managers. Because they control the short and intermediate term, my first purchase or short sale is frequently early. Price momentum is a powerful foe. Occasionally, low valuations provide little support for unforeseen fundamental problems. I have experienced a few "value traps." But, more often then not, a valuation-driven investment philosophy provides limited risk and ample reward opportunities.

On the long side, I still think small- and mid-caps represent the best value. HealthSouth (HRC), a leading provider of rehabilitation and outpatient surgery services, looks compellingly cheap. At $12.20, the shares trade for 10 times 2002 cash EPS and 6.5 times EBITDA . (Editor's note: All stock prices are from Friday's close.) Sensient(SXT), a leading flavors and color company, closed at $16.22 Friday and trades for the same valuations as HealthSouth. The savings and loans, including large-cap Washington Mutual (WM) (at $30.91), trade for attractive valuations, yield generous dividends and have meaningful share repurchase programs. Black & Decker (BDK) (at $34.30) trades for 12 times depressed 2002 cash earnings and should benefit from lower interest rates and a stronger economy next year.

The apparel stocks, despite significant rallies since late September, appear cheap and will benefit when investors want more economic sensitivity. One of my favorites is Liz Claiborne(LIZ), an exceptionally well-managed and cash flow-positive company trading at $49.15. The shares trade for 12 times next year's cash earnings.

On the short side, I think that technology shares can be sold into rallies. Investors still cling to the belief that happy days are right around the corner for tech bellwethers such as Cisco (CSCO), Applied Materials (AMAT), Intel (INTC), Sun (SUNW), Oracle (ORCL) and JDS Uniphase (JDSU). Technology bulls promote the 2002 turnaround story and dismiss valuations as irrelevant in a cyclical upturn. Don't believe it. Buying tremendously expensive stocks on the hope of a recovery is not a prudent investment strategy. Instead, fight the tape and sell or short into further strength.

My favorite tech sector to short is the semis. One of my best short ideas is Texas Instruments(TXN). Let me explain. Texas Instruments is a fine company; it's fundamentally better-positioned than it has been in decades. Furthermore, the company's sales and profits will rebound strongly when the economy recovers. These two facts, however, do not make the stock a great investment. Currently priced at $31, Texas Instrument's $58 billion market cap trades for between six and seven times normalized revenue (much higher if you annualize next quarter's revenue). If its profit margins average 10% to 12% after tax, in line with the past five years, the company is valued at 50 to 70 times normalized profits. The company is currently unprofitable and expects to make marginal profits in 2002.

The semiconductor business is undergoing a significant slowdown in secular growth and profitability due to increased competition and overcapacity. And, other companies like Intel and Analog Devices (ADI) are invading their DSP (digital-signal processing) market. So, what are 50 cents of normal profits and $1 of peak profits in 2005 worth? In my opinion, Texas Instruments is worth much less than $32 a share. This company is not alone. If one calculates normalized revenue and profits for most mega-cap tech shares, the results are similar: exceptionally high price-to-sales and price-to-earnings valuations on recovery fundamentals. Shorting typical semiconductor stocks is a battle with the tape that I am happy to fight.

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