Buyback's Big Trends and Best Buys

10/16/2002 12:00 am EST

Focus:

David Fried

Editor, The Buyback Letter

"Self-confidence is the first requisite to great undertakings," said Samuel Johnson. And there is often no better indicator of corporate self-confidence than buying back company shares. David Fried is the leading authority on buybacks and his Buyback Letter is the only such newsletter to base its investment decisions on share repurchases. Notes Fried, "When companies buy back their own stock, it’s an enormous vote of confidence by those who know it best." Here, we look at David Fried’s market outlook and favorite buyback stocks.

"When times are uncertain it helps to periodically review the overall economic picture," says David Fried. "The ‘Big Trends’ presented below will help you keep a clear head in what always feels like a crazy market. Underneath the market noise are, as always, solid realities that ultimately rule the day no matter what investors’ near-term hopes or fears may be.

Big Trend #1: The Inflation Trend

"Since 1920, the S&P index has gone up an average of 15.5% when inflation was in the 2%-5% range. When inflation topped 5% the S&P average rose just 1.3% per year. Currently, inflation is running well below the 5% mark. The inflation trend remains very positive.

Big Trend #2: The Long-Term Bond Yield vs. S&P Yield

"Peter Lynch, the famed fund manager of The Magellan Fund during its glory days, uses the following rule of thumb: when yields on long-term government bonds exceed the yield on the S&P 500 by 6% or more, sell stocks and buy bonds. As of September 30, the yield on the S&P 500 was 1.70% while the yield on 30-year government bonds was approximately 4.66%. The difference between the two yields is 2.99%. This indicator is positive.

Big Trend #3: Action of the Federal Reserve Bank

"The Fed lowered interest rates 11 times last year. The Fed has changed its bias to neutral. We now believe the next move by the Fed would be lower interest rates, but that is no longer a certainty. For now, our Fed indicator is positive.

Big Trend # 4: The Yield Curve

"As of September 30, the spread between a one-year Treasury bill and the ten-year bond was 1.86% and the 30-year bond currently yields 4.66%, 2.93% more than the 1.73% yield on the one-year Treasury bill. Economists generally feel that an inverted yield curve indicates that an economic slowdown is imminent. The yield curve is positive.

Big Trend # 5: Valuation

"Recent market declines continue to take the froth out of the high-flying big-cap stocks. The S&P 500 is down about 47% from its peak. However, the S&P 500 still trades at almost 32 times earnings, a historically high number, as earnings have declined faster than prices. Interest rates will have to remain low and earnings must rise to support current prices in the large-cap popular stocks. Our valuation indicator is neutral. As such, buying value in this market remains extremely important.

Big Trend #6: Investor Sentiment

"We add the total bullish percentage readings of Investors Intelligence, Consensus Index, AAII Index, and Market Vane, as reported in Barron’s every Sunday, and average this figure for the month. We consider an average reading of over 200 to be negative while readings of under 150 are positive. The average total reading for the five weeks ending June 30 was 139. We have not had a monthly reading of over 200 since December 2001. Readings over 240 have marked market highs over the past few years while readings of about 130 have marked market bottoms. Our sentiment indicator is positive.

Big Trend #7: Earnings Sentiment

"We track the quarterly positive and negative earnings surprises as reported in Barron’s every week. We feel that positive surprises and revisions are bullish for the market as they indicate that professional analysts have been too negative, while negative revisions indicate that analysts have been too optimistic. During the just-concluded quarter, positive quarterly earnings surprises beat negative surprises 78-43, a ratio of just under twp-to-one. Fiscal year earnings revisions surprises were essentially equal. This indicates that analysts’ current estimates for the balance of the year and the first quarter 2003 earnings are probably about right, meaning there will be an absence of upside surprises to drive the overall market. As such, our earnings sentiment indicator is neutral.

"In summary, five of our seven indicators are positive (inflation, yield, yield curve, the Fed and sentiment), while two indicators are neutral (valuation and earnings sentiment). Our indicators are telling us that the investment climate is positive at this time. We are still significantly off market highs. We estimate downside risk to be less than average right now. This is a change from the mid- and late-‘90s when risk was at extreme levels due to an extremely overvalued market. It is impossible to pick a bottom in the market, but our indicators are telling us that a bottom is near.

"The market continues to look and feel grim right now, as investors continue to liquidate stocks and run for the hills. I invite you to think back to the beginning of the year 2000, when the markets were just the opposite of what they are now. New highs were being hit every day and everyone was euphoric. Anyone who joined the party at its peak, when it was most popular, has done horribly. Now stocks are unpopular and no one wants to join the party. However, a few companies are busy making hay by buying back their stock for discount prices while everyone else suffers from indigestion. We have been very successful by following our investment strategy regardless of how popular it was at the time. We will continue to invest accordingly."

Fried's investment focus is long-term. According to Fried, he has closed out only 19 positions in his "Stock-Pickers Portfolio" since he began publishing The Buyback Letter four years ago. Of these 19 trades, 17 were profitable, with the average profit reaching 187%. Says David, "We don't select stocks as much as they select us. We think the management of a company knows better than anybody outside the company when its stock represents a good value, and that management will signal this when it announces a buyback plan. What would you rather invest in: a company whose management puts its money where its mouth is, or one that doesn't? The answer, we think, is obvious."

Fried also maintains a "Best Buy" list of those stocks that he believes represent the best value at the current time. The list is based upon valuation, recent news events, and buyback activity. Here are his best buys. The last two have just been added to the list and do not yet have long-term price targets.

Company Name

Ticker Symbol

Price

Buy Limit

2-4 Year Target Price

Berkshire Hathaway
Cl B

BRKB

$2,465.00

$2,500.00

$3,500.00

Rex Stores

RSC

$10.30

$12.50

$30.00

General Motors

GM

$38.90

$45.00

$100.00

OfficeMax

OMX

$4.08

$5.00

$12.00

stamps.com

STMP

$4.23

$4.25

$10.00

WebMD

HLTH

$5.05

$5.50

$12.00

Delphi

DPH

$8.55

$10.00

$20.00

Philip Morris

MO

$38.80

$48.00

$70.00

Deluxe Corp

DLX

$45.06

$70.00

 

Toys R Us Inc.

TOY

$10.18

$20.00

 

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