Investors turned traders give up their edge

NEW YORK (MarketWatch) � The trading mentality prevalent in today�s stock markets has converted Wall Street fundamental analysts to reaching conclusions and giving advice based on short-term technical factors.

Click to Play Olstein: Quality of earnings is key

Stock investors should focus on the quality of a company's earnings, says Bob Olstein, manager of Olstein All Cap Value Fund. He talks with Jonathan Burton about two favorite buys.

It wasn�t always so. A fundamental analyst�s job used to involve valuing a company based on a study of business operations, balance sheets and the effect that predicted future economic trends would have on a company�s ability to generate earnings and cash flow.

Technical analysts would attempt to predict future price swings or target prices for a stock by assessing crowd behavior and studying charts of short-term price movements and trading volume, with no concern for a company�s business fundamentals.

Most investors today, including the analysts, are in the here and now and are not paying attention to the bigger picture. It is estimated that almost 80% of all stocks are traded electronically based on computer models and algorithms whereby traders are in and out of markets within milliseconds. Hundreds of orders are capable of being entered within a second, creating abnormal market volatility and wild swings in the stock prices that have little to do with a company�s long-term ability to generate excess cash flow (which eventually determines intrinsic value).

Volatility and lack of confidence in markets, in turn, has reduced time horizons over which investors and analysts are willing to put their neck on the line. Rather than relying on and discussing a company�s ability to produce free cash flow over two or three years, analysts focus on quarterly �misses� and �beats� � buying and selling before and after quarterly earnings releases with three-day to three-month price targets.

But the shorter the time horizon, the lower the probability of being right. Waiting can be frustrating at times, as most investors tend to obsess over whatever happened in the markets most recently, assuming things will be that way �forever.� Most market fads and/or trends last longer than anticipated, but �forever� usually ends unannounced. Read more: 5 stocks market detectives have locked up.

Patience and profits

Accordingly, it is extremely difficult to be a traditional fundamental analyst or money manager when most investors and analysts focus on the short-term stock gyrations of a stock, created by traders who have little concern for long-term fundamentals.

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Yet investors and analysts with the patience to stick to the fundamentals, despite the negative events emanating from Europe and the volatility created by high-frequency-trading, are being presented with many outstanding profit opportunities.

Some examples of stocks held in the Olstein portfolios are situations where the upside appreciation far outweighs the potential downside risk. We believe these opportunities were created by investors and analysts who embraced technical analysis and thus are in the moment and myopic.

For example, consider Sealed Air Corp. SEE , which�manufactures specialty packaging such as bubble wrap as well as packaging equipment.

The company acquired Diversey Holdings, a global provider of solutions to the cleaning and sanitation market. Although the acquisition should be cash-flow-accretive during the first years, the market reacted negatively to the debt needed to acquire Diversey and forecast that first-year earnings would be dilutive and down because of non-cash amortization charges. Diversey sells its products into the same markets as Sealed Air which represents material cross-selling opportunities. At Sealed Air shares� current price of around $19 we believe the benefit to future earnings is not being recognized.

In one December research report on Sealed Air, the analyst seemed to be caught up in the short-term negativity surrounding the Diversey acquisition. The analyst seemed indifferent toward Sealed Air because earnings would not take off for a few years. His target price was $18 a share based on earnings that would stagnate at $1.75 a share for the next few years. However, at the same time, the analyst projected earnings of $2.60 a share for 2013.

Yes, Sealed Air has to prove that the acquisition will benefit shareholders, but if the analyst is correct about 2013 earnings of $2.60 a share, the stock is ridiculously cheap at $19. Buying when negativity is already built into a stock tends to limit downside if you are wrong.

Another example of obsessing on short-term problems rather than long term values is Intel Corp. INTC � currently selling at just under $28, with a dividend yield of 3% and a cap-ex and research budget of $15 billion � a major portion of which is aimed at rectifying its lack of product in the growing smart phone and tablet market.

/quotes/zigman/20392/quotes/nls/intc INTC 26.05, -0.89, -3.29% /quotes/zigman/67211/quotes/nls/armh ARMH 23.14, -0.61, -2.57%

At the same time that analysts are dissing Intel, they are recommending ARM Holdings PLC ARMH �, a rapidly growing chip development company selling at 70 times estimated earnings because of its dominance of its chips in the smart phone market. To us, ARM represents a stock priced to perfection. There is even talk that ARM will take market share from Intel in personal computers and servers. A December research report on the ARM/Intel rivalry ignored the fact that Intel has already committed billions of dollars to become a meaningful participant in the markets in which ARM is enjoying success.

Analysts are giving little credit to the fact that Intel�s more expensive chips which go into servers are the backbone of the smart phone and tablet market, and their sales are correlated to the number of smart phones in use. Read more: Intel arming for battle with Arm Holdings.

It is possible that ARM (an outstanding company) may continue to grow at above-average rates for a long period of time but watch out below if there are disappointments along the way. So we�re putting our money on Intel. If we�re wrong, the negativity surrounding the company, in combination with a low price/earnings ratio and protected high dividend yield should limit the downside.

Robert Olstein is chairman and chief investment officer of Olstein Capital Management and manager of the Olstein All Cap Value Fund