A "Rational" Defense

05/27/2005 12:00 am EST


Jamie Dlugosch

Editor, The Rational Investor

"Investors need a reality check," warns Jamie Dlugosch, whose "rational investing" strategy now puts him in the cautious camp. Here, he outlines his market concerns, as well as some ideas to help investors position themselves more defensively.

"I am not nearly as optimistic as many of my peers about the market. I am optimistic about the economy and I don’t think we are near a disaster. However, I’m concerned about value and earnings growth. If you look in general at the major indexes, they are all trading a very healthy multiples of forward earnings, which I think is a mistake. On a forward basis, we are trading at 22 times earnings on the Russell 2000 and the S&P. As a ‘rational investor,’ one of the things I try to do is take a reasoned approach. And if earnings are growing on a single digit basis, and multiples are in the high teens or low 20s, that just doesn’t make sense to me.

"The good news is that there are still some phenomenal ways to make money, particular in defensive stocks. That's my main theme now. We’ve been buying defensive stocks for the past year, and over the last three or four months, we’ve been eliminating our smaller caps and more aggressive holdings. I would look for low risk holdings. This is not the time to take risks, at least for the next 12 to 18 months. You can sit on the sidelines and build cash positions, or you can make some nice money in large cap, defensive names that are paying dividends. Some of the dividends are rather rich, which is a bonus if you are waiting.

"DuPont (DD NYSE) is my favorite large-cap name. I like it for two reasons. One is that we’ve seen profit margins suffer in the last year due to high raw material costs. However, I think that the commodity inflation that we’ve seen over the last year is an inefficiency in the market, and you will eventually see some deflation in commodity prices. So you will get a double-whammy with DuPont, first from an expansion in its multiple as more investors start buying stocks like this, and second, as profit margins increase along with a drop in commodity prices. Another way to play what I expect will be a sideways market is to do some arbitrage. One suggestion for those who understand this strategy is to take a long position in Merck (MRK NYSE) and a short position in  Pfizer (PFE NYSE). I think Merck has done a wonderful job at identifying its problems. On the other hand, I don’t think Pfizer is handling these issues nearly as well. I think that’s an arbitrage opportunity in the drug sector, based on my expectations that Merck will outperform Pfizer."

"Meanwhile, I think one of the largest inefficiencies in the market now relates to small-cap stocks. The last five to seven years, the multiple expansion in small caps has been unprecedented, to the point where small-cap stocks are now priced like mid- and large-cap stocks. And if there is anything from academia that I believe in, it is the liquidity premium in the market. It doesn’t make sense for someone to pay the same multiple on a large-cap stock as a less liquid small-cap stock. One of two things has to happen. Either large-cap stocks have to expand their multiples, or small-cap stocks have to decline. I am of the opinion that small-cap stocks will correct over the next 12 to 24 months. So we are short a mutual fund that specializes in performing inversely to the Russell 2000 index. I am using Rydex Inverse Small Cap (RYSHX ), although I'd note that other fund families have similar inverse funds. In any event, I’d stay away from small caps. If you own them, sell them. If you’re willing to take some risk, you may make some profits by ‘shorting’ them through a bear fund. Otherwise, stick to defensive, large-cap stocks for the next 18 to 24 months."

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