Unger: Avoid playing the stock market 'tic-tac-toe' game

Ray Unger  —  8/03/2007 11:40 am

Like gamblers that play roulette, many investors try to beat the market by playing "tic-tac-toe" -- betting on where the "ball" will land on a particular square. When it works, fine. When it doesn't, ouch.

What is this tic-tac-toe game?

As the graphic shows, there are nine squares that resemble tic-tac-toe. Instead of Xs and Os, investors bet on which square will perform the best during short periods of time. Each column represents riskiness -- value, blend, and growth. Each row represents market capitalization -- large, medium, and small.

Value stocks sell at the lowest price-to-earnings ratios or P/Es, while growth stocks sell at the highest. The center column -- blend -- means that both types of stocks are represented. Value stocks are generally industrials, mature companies, or companies where investors have modest expectations. Companies like Exxon-Mobil, AT&T, and Citigroup fall into this category. Exxon-Mobil, for example, is expected to earn $7 a share in 2007, and not much more in 2008. Its stock is trading at $86 or 12.3 times earnings. That's lower than the average P/E of the S&P 500 Index.

Growth stocks have much higher P/Es. Investors in stocks like Apple expect earnings to grow much faster than the value stocks. For example, Apple's selling at $130 per share, and analysts expect the company to earn $3.50 per share. Thus, the stock is selling at 37.1 times earnings. But investors pay more for Apple because they expect next year's earnings to be much higher -- 2008 earnings are expected to reach $4.20 per share.

The up and down rows represent the market capitalizations of these stock groups. Large capitalization stocks like Exxon-Mobil are represented on the top row. It has 5.6 billion shares outstanding, and with its stock selling at $86 per share that translates into a market capitalization of $482 billion. Likewise, Apple has 665 million shares which puts its market capitalization is $87 billion. These stocks are in the large cap row. The medium stocks have market caps of between $10 billion and $1 billion; and small caps are under $1 billion.

Investors who research mutual funds use this type of graphic to determine the size and riskiness of the stocks in the funds. For example, the blacked out box in the graphic indicates large cap/blend stocks. This is the style box for the S&P 500. It's a blend because half the stocks in this index are considered growth and the other half value -- hence the blend. And since the S&P 500 is comprised of the largest companies in the market, its market cap is large.

With that brief explanation, let's now get down to the game.

During each three-month period one of these squares will outperform the others -- that's the ball I referred to. During the 1990s, the large cap growth square, which included high-tech stocks, performed the best. After years of such performance, investors jumped on the large cap growth square at the expense of the other squares. The peak of ownership in this sector was early 2000. Guess what happened? The performance ball shifted to small cap value, i.e., the square with the least ownership.

Now with the ball having rested on that small cap value square for several years, investors are again loading up based on recent performance. Not a good idea. We don't like making such bets. Quite the contrary. We suggest a balance in all squares.

To cover the top row (value, blend, growth) we prefer an S&P 500 index fund. With so few mega-cap stocks being scrutinized by so many Wall Street analysts, it's difficult for active managers to beat this index. With an S&P 500 index fund you get the large cap exposure at minimal cost.

The lower two rows (medium, and small cap) are better represented by actively managed mutual funds. That's because these market areas are less efficient and there's more opportunity for performance. The following three funds cover these areas well: medium cap, Oppenheimer Main Street (OPMSX $22.73); small cap value, James Small Cap (JASCX $22.90), and small cap growth, Managers Essex Small/Micro Cap Growth (MBRSX $21). Playing the tic-tac-toe game can be painful if you're wrong. Better to place smaller bets on each for more consistent returns.

Ray Unger is president of Unger Capital Management in Madison. He can be reached at 833-9400; e-mail: rayu@ungercap.com

Ray Unger  —  8/03/2007 11:40 am