Most Financials Dragged Down with Sub-Prime Lenders

Short term market movements are often the result of what I call “guilt by association” trading. Along with the dramatic decline in sub-prime mortgage lending stocks, there has been a huge drag on most financial services companies, even if there is little, if any, evidence that the meltdown in sub-prime is set to spill over into other areas.

One of the main reasons the market has been weak lately is because of the underperformance in the financial services sector, which is the largest segment of the S&P 500 index. While mortgage lenders should be tanking ( given that they lent money to people who could only afford the temporarily low monthly payments for their new homes, and not the higher payments that would take effect when the variable rate mortgages adjusted), should every consumer finance company be getting thrown out with the bath water?

Surely there will be some spillover, as there are always lenders with bad standard practices, but we’ve seen everything from credit card companies, to auto lenders, to bad debt collectors, to student loan companies (just to name a few) all get crushed in this environment. Unless you believe that every type of consumer lender had loose credit standards on par with the sub-prime mortgage lenders, there are opportunities everywhere to snap up cheap stocks. Wall Street is acting as if sub-prime loans are the majority of the loans out there, not a small minority. Investors can take advantage of that, and should.

There is an old saying that “the market can remain irrational far longer than you can remain solvent.” This is very true, and just because many financial stocks are trading at what I would consider unwarranted levels, it doesn’t mean they can’t go down further. You may even reach a point, like I did this week on one of my holdings, where the pain is so great (not really because of the drop in the stock price, but more because of the irrationality of the drop along with its magnitude) that you just throw in the towel like others are doing.

You know that doing so could very well mark the bottom and prove to be a horrible trading decision longer term, but in the short term it will help you psychologically to just not have to see the irrationality continue. Patience is the key for value investors, but sometimes it’s just too hard to be as patient as the market requires you to be. That is why the stock market is as much a psychological exercise as it is a quantitative one.

If you have some financial stocks, either in your portfolio, or on your watch list, that are getting unfairly punished recently, do your research and make sure the worries are relevant before selling the positions. If you can hold on (and even buy more) and not have it be a psychological drag on your trading mentality, you will likely be rewarded when all the dust settles, the truth comes out, and many of the current speculation is proved wrong.

 

The Power of Multiple Expansion

Stock prices go up for one of two reasons; earnings growth or multiple expansion. If you really want to hit the jackpot with your investments, try and find stocks that can give you both. The combination of the two, as I will illustrate in a moment, is really powerful in terms of shareholder returns.

This is one of the many reasons why value investing has proven to be so successful over time. By buying stocks that have meager valuations, there is always the potential for multiple expansion. Getting earnings growth is even easier because most economies grow over time, so as long as management teams do a good job, earnings growth is inevitable over the long term.

Last year a friend of mine emailed me about a stock he was looking at, beverage giant Diageo (DEO). Diageo is one of the biggest wine, spirits, and beer suppliers in the world, known for brands such as Smirnoff, Guinness, Baileys, Captain Morgan, and Tanqueray. At the time (perhaps about a year ago or so) DEO shares were trading in the low sixties and the company was expected to earn about $4 per share in the coming year. At about fifteen times forward earnings the stock looked pretty fairly valued to me. Given DEO’s size and an organic revenue growth rate of about 6 percent, earnings growth would likely average mid to high single digits, so a fifteen multiple seemed reasonable.

I can’t remember exactly what my response to him was, but I suspect my feelings on the stock were something like “yeah, it’s a solid defensive play with a nice dividend yield, but it looks fairly priced, so I would expect the stock to pretty much track earnings growth.” Well, that assessment turned out to be quite wrong. The stock has risen by more than 30 percent since then, to the low 80’s.

So what the heck happened? Simply put, most of the gain came from multiple expansion. Beverage stocks have had a great run lately as they offer fairly predictable profits and nice dividend yields (just look at the charts for BUD, KO, and TAP). Defensive investors have placed a higher value on these stocks lately, and their stocks, which used to fetch market multiple of 14-16 times earnings are now getting 17-19 times earnings. Sales growth is still mid single digits, with earnings ranging from the high single digits to low double digits, but the stocks are seen as safe, and as markets rise, some investors look to put money in less aggressive places.

How much of DEO’s gain was due to multiple expansion? Well, they earned $4 per share in 2006 and the stock went from a 15 P/E to an 18 P/E, so that is $12 per share in appreciation due to a higher multiple. That amounts to about a 20 percent share price jump (given that the stock was around $60 per share). Add in another 10 percent or so for earnings growth and you get a stock that is up 30 percent in the last year.

I might have been wrong about Diageo, but this should help to explain why valuation is so important when investing in the stock market. Diageo’s business hasn’t really changed much at all in the last year, but investors’ willingness to pay up for the stock has, quite meaningfully in fact. And that, you see, is the power of multiple expansion.

Full Disclosure: No position in DEO at the time of writing

Microsoft’s Stock Drop After Vista Release Was Very Predictable

Investors may have heard at one point or another that by the time news hits the papers, it’s too late to make money in the stock based on those events. Too often someone reads about a positive development for a certain company and rushes out to buy the stock, only to get stuck with a losing investment. This happens time and time again because Wall Street is a discounting mechanism. If something is going to happen in the future, but we know exactly what it is and when it will occur, stock prices have already taken the news into account before it actually happens.

Microsoft (MSFT) stock is the perfect example of this. Some investors may have bought MSFT shares recently because their new operating system, Windows Vista, hit store shelves on January 30th. With a new revenue stream finally in the market, investors might postulate that Microsoft sales will accelerate dramatically, and with that will come appreciation in the stock price.

However, Microsoft stock actually peaked less than a week before the Vista release, and subsequently dropped about 10 percent in less than a month. In fact, this is not the first time Microsoft has dropped shortly after a major product release. Since I knew from past experience that Microsoft shares tended to sell off shortly after new product offerings hit stores, I decided to look back and see just how similar the stock’s patterns have been around the time of each of their last four Windows upgrades (Windows 95, 98, XP, and Vista). While I figured the data would be fairly similar, it was really striking.

As you can see from the chart below, Microsoft stock always peaks very close to the official Windows release date. In fact, for 3 of the last 4 upgrades MSFT peaked within 1 week of release. Amazingly, the shares have dropped by around 10 percent within 1 month of peaking in each of the company’s Windows upgrades.

These results are really fascinating, not only for the trend that they confirm, but the specific magnitude especially. So, remember this the next time Microsoft releases a major new product.

Full Disclosure: No position in MSFT at time of writing

Why I Don’t Think the Fortress IPO Signals a Top in Hedge Funds

Many people will likely point to today’s IPO of Fortress Investment Group (FIG) as evidence that we are nearing a top in the hedge fund and private equity bull market. While I have no opinion on the investment merits of the stock (it is up 73% on its first trading day, and I have not looked at their financials), I do not think that this IPO alone is worrisome for the markets.

While the growth in new hedge funds and private equity funds will likely slow in coming years, both are here to stay given that they are truly viable investment vehicles. Just because these types of funds are newer than investment banks, mutual fund companies, and other buy-side asset managers, it doesn’t mean they should not be publicly traded. They are able to do things such as sell short, profit from arbitrage opportunities, and take a long term view with a turnaround situation without the constant badgering from short-term oriented analysts. There is a real market for these strategies, and it is not just a fad.

However, just because they are here to stay, it doesn’t mean that hedge fund and private equity growth won’t slow. Whenever you have a huge spike in interest for something, you will ultimately have people getting involved who are in over their heads. With more hedge funds being created, there will be more failures in the future. It doesn’t mean hedge funds are bad, or just a fad, it simply means that like many other businesses, the strong survive and the weak get weeded out.

While I do think public hedge/private equity funds are here to stay, that is not to say that investors should go out and buy up as many shares as they can. Much like investment banks like Goldman Sachs (GS) and asset managers like Blackrock (BLK), these companies will fall on hard times when markets turn south. Investors will need to compare and contrast a company like Fortress to a Goldman, or a Blackrock, to determine how their financial results will fare in various market environments. Using that information will help them decide how much they are willing to pay for each of their respective stocks relative to each other.

Full Disclosure: No positions in BLK, FIG, or GS at time of writing

Bill Miller Writes About the End of “The Streak”

If you have read about my investment philosophy on peridotcapital.com you will see that I refer to Bill Miller (manager of Legg Mason Value Trust) in comparing my value strategy to others that are more well known than myself. Miller looks at the market differently than most, and I use many of the same techniques when I manage money, so he is an excellent person to read about if you want to get a better idea of what Peridot Capital is all about.

A logical question would be “If Bill Miller is so good, why should I invest with you instead of him?” If you look at Miller’s performance in recent years, it pales in comparison with his longer term track record. The reason is quite simple; as Miller as gotten more and more publicity, money has poured into his fund.

He now manages billions of dollars, and as a result, is very limited in the stocks he can buy for his fund. Since Miller prefers very concentrated portfolios, he is now limited to investing in very big companies. With a smaller universe from which to choose his investments, Miller’s margin of outperformance is narrowing with each passing year (see chart).

As you may have heard, 2006 was the first year since Miller took over the fund in 1990 that Legg Mason Value Trust failed to beat the S&P 500 index. Although “The Streak” is now over (it is the longest streak by a mutual fund on record), Miller’s overall investment philosophies remain very relevant. For managers who don’t have the task of investing tens of billions of dollars, continuing to invest according to a contrarian investment strategy will prove very profitable.

Fortunately, for those who aren’t familiar with Bill Miller, he writes quarterly letters that are made available to the public, regardless of whether you own shares of his fund or not. In his latest, Miller discusses the end of “The Streak” and other important value investing concepts.

While I would no longer recommend investors buy shares in his fund for the reasons mentioned, I definitely suggest that those interested in contrarian value investing in general, or Peridot Capital more specifically, should read his quarterly letters. You may access his latest letter here.

Targeting Market Winners for 2007

I’ve been spending time on the Peridot Capital 2007 Select List lately, hence my blogging frequency has slowed a bit. At any rate, my strategy for 2007 is going to be a bit different than last year. With the market having done extraordinarily well since August or so, my tendency to take a very contrarian approach will be even more apparent than usual as we head into early next year.

I forget the exact number of days, but it has been a very long time since we have had a 10% correction. I’d be surprised if one didn’t come next year. After we get a sell-off, and therefore digest these out-sized gains we’ve seen, I’ll likely become more aggressive. Until then, my investment selections (as readers will see when the 2007 Select List is issued during the first week of January) will focus on large caps that have lagged the market in 2006, as well as smaller cap growth stocks that should continue to do well regardless of the domestic economic environment in 2007 (I’m not going to try and predict when, if at all, a recession will hit, as it’s anyone’s guess).

Despite the double digit gain in the S&P 500 so far this year, my research recently has uncovered many large cap growth companies that are trading at market multiples. Earnings growth for these firms should be above-average, but for some reason their P/E multiples are not. The common debate among Wall Street strategists right now, as they try to gauge the market’s overall direction in 2007, seems to revolve around whether or not the S&P 500 multiple should remain around 15 or 16, or perhaps rise to the 17-18 area. I’m not really comfortable forecasting P/E expansion in 2007, but for companies that are set to grow earnings per share at 12 to 15 percent annually for the rest of the decade, there is no doubt in my mind that a 15 or 16 P/E is too conservative. So, while I believe market gains overall in 2007 will be below 2006 levels, there are still values to be had.

Stay tuned for more details, both in the upcoming second annual Select List, as well as future blog postings.

Overvalued Stock Screen

Every once in a while I will run a screen to find stocks that might be overvalued. This can serve to identify candidates for short sales. After a nice upward move in the market, coupled with increased bullishness among market pundits, searching for some shorts to hedge seems reasonable.

I screened for U.S. companies with market caps of at least $2 billion that sport price-to-sales and price-to-book ratios of at least 10. The screen yielded 10 stocks, which are listed below in alphabetical order.

Akamai Tech (AKAM)
Amylin Pharma (AMLN)
CBOT Holdings (BOT)
Celgene (CELG)
Chicago Mercantile Exchange (CME)
Genentech (DNA)
Intercontinental Exchange (ICE)
Las Vegas Sands (LVS)
Ultra Petroleum (UPL)
Vertex Pharma (VRTX)

Full Disclosure: I am short shares of Celgene (CELG) at the time of publication.

My Take on Mark Cuban’s Latest Venture

In case you haven’t heard, billionaire entrepreneur and owner of the Dallas Mavericks, Mark Cuban, has caused quite the commotion by announcing his latest venture, ShareSleuth.com. The site, which will debut next month, will be a blog-style investigative reporting site that will focus on exposing corporate fraud. The site will be edited by Christopher Carey, a long time business reporter who recently quit his job at my hometown paper, the St. Louis Post-Dispatch.

Sounds pretty cool, right? Well, all was well and good until Cuban disclosed that not only does he plan on investing in the site, but he also will be taking investment positions based on what the investigations uncover. He plans on disclosing all of his investments, but will make the trades after the research has been done and before the site publishes its findings.

Given the controversial nature of most of what Cuban says and does, it’s not that surprising that many are outraged at this idea. However, let’s calm down and analyze exactly what is going on here. Then we can decide if what Cuban plans to do is illegal (it’s not) or perhaps unethical.

This company is going to investigate individual companies and the people behind them. If something fishy is uncovered, Cuban might make trades based on this information (presumably by shorting common stocks). Then the research will be published on ShareSleuth.com and any positions Cuban has will be fully and properly disclosed.

Now some might be up in arms that Cuban will be in a position to short a company’s shares prior to his editor publishing the negative research to the public. Let’s think about this for a second. How is what Cuban plans to do any different than a hedge fund, pension fund, or mutual fund manager coming on CNBC and talking about what stocks he or she likes. The manager has previously conducted in-depth research, come to a conclusion, traded the stock, and come on the air to explain and disclose the position.

I really don’t see how ShareSleuth.com will be any different than someone from Goldman Sachs recommending a stock on CNBC. In fact, investors should be happy that there will be a new place to find negative research on public companies. Most of the time everybody is telling you what investments to buy because they are in the business of selling investments.