Learning to Dump the Losers


After taking a good hard look at their diminished portfolios, most investors would probably have to admit that their main problem wasn't that they picked the wrong stocks but rather that they held them too long. Even after a two-and-a-half-year bear market, many investors remain emotionally attached to underperformers, says Greg Forsythe, a senior vice-president at Charles Schwab (SCH) and the person behind Schwab's new equity ratings.

Introduced last May, Schwab's A-to-F rating system is intended to give investors objective help in making buy and sell decisions. Indeed, some widely held and much-loved stocks get D and F ratings -- names like Apple Computer (AAPL), Krispy Kreme (KKD), Hewlett-Packard (HPQ), Target (TGT), and Southwest Airlines (LUV).

What investors sorely need is a sell discipline, Forsythe says. That would help them shed losers and free cash to invest, now that the seeds of a market turnaround may have been sown. BusinessWeek Online Associate Editor Amey Stone spoke with Forsythe about how investors can use the new ratings to figure out which stocks to sell and why companies that seem attractive don't always make good investments. Following are edited excerpts of their discussion:

Q: Let's start with some background on the equity ratings. How do they work?

A: Basically what this system does is rate 3,500 companies an A, B, C, D, or F, according to the outlook over the next 12 months. We look at them from four different investment perspectives: valuation, fundamentals, momentum, and risk. The Schwab Equity Rating represents the weight of the evidence when we combine those four different perspectives.

Q: So it's a quantitative approach?

A: It's a data-driven, very objective, systematic approach. What makes it interesting is that our computer model is able to factor in things that aren't strictly from companies' financial statements -- for example, analyst opinions and earnings-estimate revisions. We update the ratings each weekend, but only about 5% of the stocks change ratings each week.

Q: So, in a nutshell, the idea is that investors should buy the A stocks and sell the Fs?

A: The basic way we suggest clients use the rankings is to buy A-rated stocks and then hold them until they become rated D or F. That would typically have people holding stocks for three, four, or five years.

What these ratings really help with is giving investors a strategy for deciding when to buy something and under what conditions they will sell it. I think the most serious and shared problem among all investors -- including professional investors -- is the lack of a sell discipline.

Q: Can you elaborate on what you mean by sell discipline?

A: It's having some kind of rule or criteria for deciding when you want to sell an existing holding. Most people don't have such a rule. That leaves them vulnerable to letting emotion drive their investment decisions.

This is especially true for people who bought a stock that fell in price but remain fixated on holding it until it returns to the price they paid. This is what we call "Get-even-itis." Investors hate to take losses. It makes them feel bad. Today, many people suffer from this, even the pros.

Q: You would think investors would be eager to sell losers to take the tax loss.

A: It's certainly true that if you're holding a poor performer, why not go ahead and "harvest" the loss and upgrade your portfolio into new equity with better prospects? It doesn't make a whole lot of sense to hold losing positions when the government is willing to give you a tax benefit for selling.

Q: Let's talk about some of the companies that show up on the sell list.

A: As you'll see, there may be some very good companies that are rated D or F. What these ratings are really saying is that the stock is unattractive at this point.

Q: Point well taken. One of the stock's you rate a D is Hewlett-Packard (HPQ), a battered tech name that's struggling to regain the faith of investors since its merger with Compaq.

A: A lot of investors might think this stock is undervalued [trading around $14 as of Oct. 24, down from a high of $75 in early 2000]. But it's a D even at today's price. HP still sells at above-average multiples of its earnings, operating income, and free cash flow.

The other thing we find unattractive right now is its large increase in shares outstanding. The company issued shares to buy Compaq, and our research has found that large increases in shares are really a management signal that they think that a stock is expensive currency. Issuing more shares is also dilutive to current shareholders.

Q: Target (TGT) also gets a D, yet this is a fast-growing discount retailer that many investors love.

A: Target is a company that you might think has been doing well, but we find some real red and yellow flags, especially when we look at its fundamentals. Basically, we don't think it has the financial strength to grow at above-average rates in the future.

It is growing, but it's generating below-average growth in free cash flow and free cash flow return on investment. Free cash flow is where companies get the ability to fund future growth. Without that, they have to go out and borrow money or issue more shares. At Target, we also see that asset utilization is very poor and inventories are growing faster than sales.

Q: Now, this one is sure to really make some shareholders angry: Apple (AAPL) is a company that people love, and you dare rate it an F!

A: People certainly are emotionally linked to Apple. However, emotions are the enemy of the objective investor. Per our analysis, Apple is pretty unattractive across the board. It's still selling at an above-average multiple of earnings and cash flow. Management is issuing shares (as opposed to buying them back), which we mentioned before that we don't like to see. And short-sellers are selling more and more of Apple short.

Its fundamentals aren't great either, when you look at free cash flow growth and free cash flow return on investment. Its earnings quality is very poor. We come to this conclusion by looking at the difference between operating cash flow and reported net income. There is some management discretion as to how you report your net income, but in the long run, operating cash flow and net income must converge. If net income is much higher than operating cash flow, the tendency is for net income to fall back in line. Apple looks particularly poor on that measure.

Q: Southwest Airlines (LUV) is another company that many investors revere. Why the negative showing there?

A: Southwest has been immune from problems in the airline industry in a lot of investors' minds. But that's breaking down now. Analysts are cutting earnings forecasts and their recommendations on the stock. Investors are bailing out, as you can see from the poor price performance. Short-sellers are increasing the degree to which they're selling the stock short. The stock can't go up in the face of all this negative sentiment. When you couple that with its high valuation, that's two huge strikes in terms of its prospects -- as a stock, not as a company.

Q: Finally, let's discuss your F rating on Krispy Kreme Doughnuts (KKD).

A: Krispy Kreme has an interesting story, but when you look at it as a stock, there are a lot of negatives. Its rating in terms of valuation is very negative. It has very high multiples. Also, management is issuing shares, and short-sellers are selling.

As for its fundamentals, there are many ominous signs for the future. Return on investment is low, earnings quality is poor. As we talked about earlier with Apple, net income is far higher than operating cash flow. Asset utilization is also poor. All of these things are masked right now by its growth rate.

This is a classic example of a fad-type stock. It's a rapidly growing company that will need further capital investment to sustain that growth. If it's growing faster than its ability to earn a strong return on investment, that's a classic example of a company that will disappoint people.


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