The “Dogs of the Dow” strategy consists of buying a basket of the cheapest stocks out of the 30 components of the Dow Jones Industrial Average. One of the more popular strategies in recent years has been to buy Dow stocks with the highest dividend yields. But past strategies, including one highlighted by legendary value investor Benjamin Graham, focused on Dow stocks with the lowest earnings multiples.
A cornerstone of the strategy is that the cheapest stocks in the Dow will eventually see a reversal of their fortunes and will soon trade more in line with the other stocks in the Dow. Michael O'Higgins is credited with popularizing the Dogs of the Dow Theory and has written books detailing the strategy's success in the 1990s. Graham cited periods between the 1930s and 1970s when the strategy paid off. More recent studies don't exist, but in general, buying firms with solid growth outlooks that trade at low valuations can pay off in any market environment.
With that, below are three of the cheapest stocks in the Dow based off their price-to-earnings (P/E) multiples.
How does a $500 million company become a $1 billion company?
The same way a $10 billion company turns into a $20 billion company: One dollar at a time.
Investors have a lot of ways to count those dollars, or, more specifically, they have various methods to measure the growth of those dollars.
Two of the most common yardsticks in this regard come from the income statement: revenue growth and earnings growth. Other investors, Warren Buffett for instance, look past the income statement to the balance sheet, where they prefer to focus on the spread between assets and liabilities, which is known as shareholder equity.
Today, I'll show you companies with a lot of room to grow — each with a market cap between $400 million and $500 million — that are also showing serious earnings growth. Among all U.S. companies, only 20 had year-over-year earnings growth of more than 100% in the most recent quarter.
Here are three:
1. LoopNet (Nasdaq: LOOP) – The company runs a popular website with nationwide real estate listings. While thousands of sites offer prospective homeowners free ads for houses, LoopNet collects information from brokers seeking to sell commercial and industrial property. It's a relatively pricey service (about $35 a month for a subscription or $30 for a temporary login) used mostly by industry insiders. It earned $7.28 million in the most recent quarter compared with $3.31 million a year ago, a 120% increase.
Companies are doing everything in their power to make investors focus on the long-term. Monthly sales reports have been replaced by quarterly sales updates by many retailers, and quarterly forward guidance is increasingly being replaced by once-a-year outlooks that get incrementally adjusted throughout the year. That's why this coming earnings season is so important.
Earnings season begins this week and will hit a peak in early February. By the middle of February, we'll have a clear read on what kind of year many companies are expecting.
Right now, the outlook is expected to be “fair to middling.” Whereas profits for companies in the S&P 500 are expected to have grown at a 30% clip compared with a year ago, that pace is expected to cool perhaps to 10% to 20% in 2011. Right now, analysts' are targeting first-quarter profit growth of around 15%.
Here's what I'll be watching for and listening for in the slate of upcoming conference calls:
Avis Budget Group (NYSE:CAR), the New Jersey-based international car and truck rental company, announced its Q3 earnings and it appears to be headed toward weaker revenue and margins. Dan Amoss, editor of Agora Financial’s Strategic Short Report, peels apart the latest numbers to find out where the company is headed.
From his recent reader update:
“In the wake of an unimpressive third quarter earnings report, Avis Budget (NYSE:CAR) stock is rallying inexplicably. As we’ve expected for over a year now, it’s a myth that there is sustained pricing power in the car rental business.
“The industry wide rental fleet shrunk and lowered its cost structure. But will these benefits accrue to CAR shareholders? No. Not over the long term, anyway. The industry is too competitive, pricing is too transparent, and rental demand will remain too weak to allow for sustained high pricing. This environment is similar to the one that plagues the airline business.
“Avis Budget’s average daily rate declined 2% year-over-year in the third quarter. Management blames this on difficult comparisons to last year’s price increases. Management also warned that it ‘expects year-over-year pricing comparisons to remain challenging in the fourth quarter due to the substantial leisure price increases achieved last year.’
“The U.S. vacation season drives Avis Budget’s revenues to a seasonal peak in the third quarter. Pricing was weak, but revenue grew 3.2% year-over-year thanks to fleet expansion. This weakness in pricing indicates that management expanded the fleet a bit beyond its optimal size:
“The way I see it, Avis is approaching a peak in terms of its revenue and margins. If management keeps rebuilding its fleet size in order to capture additional revenue, the following two results would follow:
1. It would consume lots of cash flow; and
2. Rental pricing for the entire industry would come under further pressure.
“By pricing CAR stock at $14, the market is clearly downplaying the capital intensity of maintaining a rental fleet. History shows that all of CAR’s operating cash flows typically go right back into capital expenditures and refinancing its towering liabilities. And this window of history includes the free wheeling credit bubble years with 3-5% real GDP growth:
“Furthermore, if Avis Budget acquires Dollar Thrifty’s fleet (if it manages to get FTC approval), this acquisition would consume even more cash in the near term in exchange for a very risky, uncertain payback. On the conference call, the CFO hinted that he’s considering tapping the bond markets again in order to finance a potential DTG acquisition.
“The key question remains: will the Fed’s new inflation-promoting program boost CAR stock? I doubt it. The Fed’s inflation will do more to boost Avis Budget’s cost structure than it will to boost daily rental rates. Those cheap Korean cars it’s been adding to its fleet will become more expensive after QE2; one of the results of QE2 will likely be a shift to higher exchange rates among our Asian trading partners. A ‘mercantilist’ economic policy so popular in Asia for decades will lose its popularity as the key export market (the U.S.) behaves more like a banana republic. There are other export markets with stronger currencies, and Asian exporters will expand trade relationships with them. This trend will make both commodities and manufactured imports more expensive for the likes of Avis Budget — even as the quantity of goods demanded falls. This describes a ‘stagflationary’ environment.
“To find good ‘QE2 plays,’ portfolio managers will have to look closer at sectors closer to the raw material end of the production process. QE2 will further inflate the banking system and bond markets in emerging markets, which in turn will boost demand for commodities (even if U.S. demand for commodities remains stagnant).
“Management and sell side analysts like to point to EBITDA in arguments for valuing CAR stock. Analysts calculate ridiculous price targets for CAR by applying an arbitrary multiple to ’2011 EBITDA estimates.’ But EBITDA multiples should only apply to different types of companies — companies that generate consistent free cash flow and are private equity targets.
“I argue that CAR should be valued more like a financial stock. Book value should be the anchor of the analysis. After all, it operates with a highly leveraged balance sheet, and provides what amounts to very short-term lease financing to its customers. Well, at 3.8 times book value, CAR would be one of the most expensive financial stocks in the entire market. Such a valuation would apply to a rapidly growing company with a consistently high ROE. But Avis Budget revenue has flat lined and ROE hasn’t been positive on an annual basis since 2005.”
Dan Amoss goes on to explain how some analysts might argue that book value understates the market value of CAR’s fleet, but it’s a tough case to make in the current environment and even more so in times as recent as 2008, when Avis Budget would have found it nearly impossible to liquidate its rental car fleet under pressure.
Keep in mind, though, all the thoughts above come by way of just a quick email dispatch from Amoss. To receive his full-fledged and actionable recommendations you’ll have to sign up for his newsletter, the Strategic Short Report, which is available from the Agora Financial reports website and can be found here.
[Nothing in this post should be considered personalized investment advice. Agora Financial employees do not receive any type of compensation from companies covered. Investment decisions should be made in consultation with a financial advisor and only after reviewing relevant financial statements.]
Avis Budget Group (NYSE:CAR) â€” Peaking Revenue, Margins Likely to Collapse originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today’s markets. Its been called “the most entertaining read of the day.”
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