by Michael Tarsala
Feeling down about the markets?
Join the club. The zeitgeist is that U.S. stocks will be beholden to European governments and that we could see a repeat of last summer's decline. Maybe something worse.
Then you talk to Bob Gay, manager of the Earnings Surprise model. He‘s the guy Barron's highlighted last month based on his fundamental investment process.
Gay just put more money to work in new stocks including Nuance Communications (NUAN), VMWare (VMW) and F5 Networks ((FFIV). He added 7 new positions this week; he usually adds about 7 a month. As a result, the amount of cash in his model dipped to 16%, down from 30% previously.
Why now?
He thinks there are long-term bargains to be had, and a third bear market in 15 years is unlikely because of the all the cash in corporate coffers, and the rate at which companies are redeploying it.
I'll let Bob explain:
My interest is purely in what's going on with corporate profitability.
There has been a slowdown on the top line in the last quarter. Frequency of improvements have come down to about 20% of capital value, a pretty low proportion historically.
So the question is whether we dropping off again into another two-year decline, which we've seen two of in 15 years, or if this is just a temporary slowdown?
The variable I watch to gauge the duration of top-line weakness is capital expenditures in proportion to sales. And that's been rising for three quarters.
Historically, that shows that the top-line weakness of U.S. companies is unlikely to be sustained. It's more likely to be a transition to a more capital goods-oriented economic recovery.
The Earnings Surprise model does not make hedging decisions. So my strategy there for dealing with the ongoing market volatility has little to do with stock selection. It's really about moving to cash when stocks become extended, and leveraging the portfolio when stocks become depressed.
So that's why I took my cash position down significantly this week, in response to the market's weakness and added a number of names to the portfolio.
We'll be monitoring these, of course, but what we'd be looking for in the second and third-quarter numbers is evidence that companies can sustain their sales growth rates.
Question him all you want, but he does have a track record: He's the former quant research head at DLJ, and the Earnings Surprise model has beaten the market by 3x since July 2010.
And there seems to be a method to every market move he makes.
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