But that doesn’t stop most of us having a crack. And why not? It’s good fun as long as you don’t blow yourself up.
In order to try to beat the market, most people try to find big winners — stocks that go up hundreds of per cent in a year. Take Blackmores [ASX:BKL] for example. The vitamin maker traded at $30 a share this time last year. Yesterday, it hit $200 a share, before closing the day at $175.
BKL now trades at a massive $3 billion market capitalisation. It’s on a P/E ratio of nearly 50 times this year’s expected earnings. BKL is very expensive.
This is just a wild guess, but I’d say BKL has seen its best gains. The chance of it doubling again, going from a market capitalisation of $3 billion to $6 billion, is very low indeed. After yesterday’s wild price moves, I’d sell and move on.
But these situations are very rare indeed. It’s not often you’re lucky enough to find such a winner. More to the point, it’s not something you can replicate year in, year out.
Trying to outperform the market is far more boring. It doesn’t require luck. It requires a disciplined investment process. In other words, you have to know what you’re doing.
The big benefit that you have though — over, say, a fund manager — is that you don’t need to own crap stocks. Big fund managers need to own just about every stock in the ASX 100 or ASX 200.
Even if they don’t like a stock, they still need to own it. They just say they are ‘underweight’. Which is a cop out, but it’s the way the industry works.
You don’t need to own ‘underweight’ dud stocks.
Two examples of big dud stocks that you don’t need to own are BHP Billiton [ASX:BHP] and Rio Tinto [ASX:RIO]. Both have been in a downtrend for over a year now. Their fundamentals are horrible. An over-reliance on iron ore means profits will be under pressure for years to come.
The simple idea (and reason to stay well away) is that steel demand is collapsing in China. These companies woefully overestimated the amount of long term demand for steel in China, and wasted their shareholder’s money investing in new capacity to satisfy this phantom demand.
To show you what I mean, check out this recent report from Bloomberg. It should put a chill through every Aussie iron ore miner:
‘If anyone doubted the magnitude of the crisis facing the world’s largest steel industry, listening to Zhu Jimin would put them right, fast.
‘Demand is collapsing along with prices, banks are tightening lending and losses are stacking up, the deputy head of the China Iron & Steel Association said on Wednesday.
‘“Production cuts are slower than the contraction in demand, therefore oversupply is worsening,” said Zhu at a quarterly briefing in Beijing by the main producers’ group. “Although China has cut interest rates many times recently, steel mills said their funding costs have actually gone up.”
‘China’s mills which produce about half of worldwide output are battling against oversupply and sinking prices as local consumption shrinks for the first time in a generation amid a property-led slowdown. The fallout from the steelmakers’ struggles is hurting iron ore prices and boosting trade tensions as mills seek to sell their surplus overseas. Shanghai Baosteel Group Corp. forecast last week that China’s steel production may eventually shrink 20 percent, matching the experience seen in the U.S. and elsewhere.’
A 20% decline in China’s steel production would be an absolute disaster for Australia’s iron ore industry. And it would be a disaster for Australia, given the massive reliance we have on iron ore exports.
But that is the way things are headed. China hasn’t even started to cut back on production to meet lower demand. It’s still churning the stuff out, and flooding global markets trying to get rid of it. At some point, rationalisation will come. When it does, you don’t want to own RIO or BHP, or any of the other iron ore producers.
One of the reasons why Chinese steel firms don’t want to cut production is because of their high debt loads. Producing unwanted steel at least allows them to generate enough cash to service their debts and avoid nasty defaults.
But defaults are coming…either in steel or in other State Owned Enterprises (SOEs) suffering from high debt and excess capacity.
The recently released Global Financial Stability Report, issued by the International Monetary Fund (IMF), had some scary data relating to corporate debt in China. It said:
‘…leverage has significantly increased at the tail end (the 90th percentile) of the distribution of firms.’
The report shows that there are a few dangerously indebted SOEs in China. This ‘tail end’ of companies has a leverage ratio of 350%, which is massive.
Optimists would dismiss this and say that it’s only a small amount of firms that have such high debts levels and that the risks are contained.
But keep in mind that most crises all start from a ‘tail’ event. They then cascade through to the middle of the bell curve. In this case, it would flow through to Aussie iron ore miners, the government budget, household incomes and, boom, Aussie housing.
We’re probably still a few years away from that event though. In the meantime, improve your chances of outperforming the market by avoiding the big miners.
The simple fact is that their share prices are in a downtrend. That, combined with the very dubious fundamentals of the iron ore industry gives you plenty of reasons to stay away. Do it, and it will help you outperform the market.
It’s a similar principle with Australia’s largest food retailer, Woolworths [ASX:WOW]. The stock price has been in a downtrend for over a year now. That’s the first warning sign. The second red flag is the level of competition. Aldi is a strong competitor, as is Coles. WOW will remain the dominant food retailer, it just won’t remain so with such strong profit margins.
Throw in a disastrous attempt to take on Bunnings (via the Masters home improvement business) and management and board dysfunction, and you have plenty of reasons to avoid the stock for now.
WOW will come good again. But it might take some time. Unlike a benchmark hugging fund manager, I see no reason to be there. And neither should you. There are too many other opportunities to take advantage of.
The simple (and difficult) idea of avoiding the duds and sticking with the winners will put you ahead of most other investors. Do this consistently and you’ll find yourself beating the market, year after year.
For The Daily Reckoning