In the past, I have shared my investment philosophies and what I look for in stocks. I want companies that are growing earnings and revenue, they have good management efficiency measurements (ROE, Profit Margin, Etc.), and they are trending higher. I also want stocks that have some skepticism toward them because I believe for a trend to be maintained, there have to be some investors that can flip over to a bullish stance on the company.
Conversely, I stay away from stocks where the company is seeing earnings and revenue decline, seem to be trending lower, and have optimistic views from analysts and investors. You have probably heard the expression, “A rising tide lifts all boats”. This is generally true, but some boats aren’t seaworthy and I don’t want to be on one of those boats when the sea gets rough.
I feel with the big rally since the beginning of October, and really since the beginning of 2019, there are a number of stocks that have been lifted with the overall market, but don’t really deserve to be at the price that they are at.
As I said there are probably a hundred stocks that I feel are trading way higher than they should be, but I wanted to show you one example. Navistar (NYSE: NAV) makes and sells commercial trucks, diesel engines, school and commercial buses, and service parts for trucks and diesel engines. If we look at the chart, the stock has been trending lower since peaking in January ’18. There have been cycles where the stock rallied rather sharply, but the overall trend has been to the downside. A trend channel has formed that helps define the various cycles.
If we look at the period from last December’s low to the high in March, the stock rallied over 66%. From the low this past August through the high in November, the stock gained over 60%.
The chart paints part of the picture on Navistar, but the fundamentals paint another part of the picture. The company saw earnings fall 46% in its most recent earnings report while revenue fell 16%. The company has seen net income fall in each of the last four quarters while revenue has fallen in the three of the last four quarters.
Navistar’s management efficiency measurements are below average as well. I looked at three different sources for a return on equity, but none of them had one listed. The return on assets is low at 3.12%, the profit margin is only 1.96%, and the operating margin is 5.93%. All of these measurements are below average when compared to other companies. It is especially concerning that these indicators are so low on a company that has been around since 1902.
I don’t have anything personal against Navistar. So many times when I write a cautious or bearish article about a company, readers seem to think I have something against the company. Most times it isn’t the company itself I have a problem with—it’s the stock that I have a problem with. When I see a stock rally sharply like Navistar did last fall, I have to ask if the rally is warranted. The other thing I usually have an issue with is the sentiment toward the stock in question. Navistar isn’t a great example here because the overall sentiment shows pessimism as a whole.
Schlumberger (NYSE: SLB), the oil services firm, is a better example of excessive optimism on a stock and company that hasn’t been performing well. Like Navistar, Schlumberger saw its earnings decline in the most recent report and in this case the revenue was flat compared to the previous year. The ROE is low at 6.2% and the profit margin is only 6.5%. The return on assets is at 3.0% and the operating margin is at 9.6%. All of these figures are below average.
The chart shows that the stock has been trending lower over the past few years, but the decline hasn’t been as organized as the one we saw on Navistar.
Even though the overall trend is down, the stock did jump from over 36% from its October low to its December high.
Where Schlumberger is really different from Navistar is in the sentiment. There are 33 analysts covering the stock at this time and 26 of them have the stock rated as a “buy”. There are six “hold” ratings and one “sell” rating. For comparison purposes, I look at the number of buys as a percentage of the total number of ratings. In this case, the buy percentage is at 78.8% and that is higher than the average stock.
We also see that the short interest ratio is lower than the average stock. The short interest ratio simply measures the number of shares sold short divided by the average daily trading volume. In Schlumberger’s case, the short interest ratio is currently at 1.7 and that is below the average reading which is around 3.0.
Here you have a stock that has been trending lower, the company’s management efficiency measurements are below average, and the earnings have been declining rather than growing. Yet investors and analysts are still more bullish toward the stock than they are the average stock. That is a scenario that suggests to me that the trend lower may not be over yet.
You can use this information in a couple of ways. If you only buy stocks and don’t make bearish bets on companies, this process can help you avoid companies that may not hold up very well when we hit a rough patch in the economy or the market. If you want to make money on the downside, you can sell stocks like these short or you can buy put options on them. Either way, make sure the boat you are on is seaworthy before the seas get rough.