Other warning signs Alexander cites are when there is a disconnect between what management says and what's happening in the marketplace, or when a company starts to stray from its formula for success. "Pressure from Wall Street and investor expectations can make managements do foolish things," he says. "You don't want to have your business driven by Wall Street. Big companies are better off because they don't need Wall Street for cash."
Finally, some observers like Golub and PanAgora's Bruce believe there are opportunities to exploit gaps between perception and reality in various industries. For example, in the consumer discretionary retail arena, PanAgora favors Radio Shack, which was down 13.5% for the year as of August 9 compared to the sector average of -3.7%. Radio Shack's P/E ratio is 12.8, while the sector average is 18.4. Twenty of 24 analysts have revised their estimates upward on Radio Shack. "This change of sentiment will cause multiples to expand," Bruce says.
He contrasts Radio Shack to Circuit City, Wall Street's current darling in this business. Circuit City stock has climbed 24.4% for the year through August 9, and its P/E multiple has ballooned to 34.1, while analysts' revised earnings estimates have been largely negative. Bruce believes multiples will back toward the industry norm.
Every industry has its list of favorites and losers. The drugstore business has Walgreens and Rite Aid, the pharmaceutical business has Pfizer and Bristol-Myers Squibb and the discount store business has Wal-Mart and Kmart.
Typically, the price differentials between the winners and losers are huge, sometimes too huge. Is that gap justified? "Often the businesses are similar but the P/E multiples vary around the averages," Bruce says. "For each firm, there is a perception of what the business can do. If people get very optimistic or too excited they can make it too expensive."
Wal-Mart probably is a greater company today than when it was Wall Street's darling in the 1980s, but it has captured such a huge chunk of the nation's retail sales its growth rate has been moderating for years. "A key problem investors face is that the returns of the future may become a far cry from returns of the past," Bruce says.