Noodles & Company Falls Back To Earth, Still Not A Bargain

About 14 months ago fast casual restaurant chain Noodles and Company (NDLS) had one of the most successful initial public offerings of the year, more than doubling on its first day of trading from an offer price of $18 per share. That very day I warned how overvalued the stock was at its then-$36 price. Investors trampled over each other to buy the shares for a few more days (the stock peaked at $51.97 on its third day of trading) and then reality slowly began to set in. Paying more than 40 times cash flow for NDLS, or any stock for that matter, is a very dangerous proposition.

After several quarters in the public spotlight, many recent high-flying IPOs have crashed and burned. Most are in the retail space, such as The Container Store (TCS) or Zulily (ZU). Amazingly, even after huge drops, most of these stocks are not yet bargains. Circling back to Noodles & Company, which is trading below $20 per share today after reporting lackluster earnings last night, the stock still trades at about 15 times cash flow (enterprise value of more than $600 million for a company that booked EBITDA of about $20 million during the first half of 2014). That price is still on the high side of fair, even if you believe in the growth story and think NDLS will succeed in continuing to grow its unit base by double digits annually for many years to come. I’m not a huge fan of the company to begin with, so a 15 multiple is not even in the ballpark for me to consider it as an investment, despite the fact that I have favored growth stories in the restaurant area for a very long time.

For bargain hunters, it certainly makes sense to watch these recent IPOs as they crater back to earth. However, be careful not to jump at something just because it is down 50% or more from its peak. NDLS is a perfect example of a stock that is down a ton (62% in the past year) but is still not cheap. You really need the valuation to be favorable to justify bottom fishing in recent IPOs. Some of them went so far above a reasonable price right out of the gate that a price drop alone puts them in the “less expensive” category, as opposed to “undervalued.”

Full Disclosure: No positions in NDLSTCS, or ZU at the time of writing, but positions may change at any time

The Average Investor Can (And Should) Ignore the 60 Minutes Story About “Rigged” Markets

The piece on 60 Minutes this past Sunday has ignited a discussion about high-frequency electronic trading systems and undoubtedly has spiked sales of the new Michael Lewis book entitled “Flash Boys: A Wall Street Revolt” which digs deep into the topic. Since I have yet to read the book, I am not going to get into many details here, but the big issue is that technology has become so advanced these days that certain people are now able to get insights into what orders are coming in for a particular security, and jump in front of those orders to make a few pennies per share on the backs of smaller investors. It’s gotten so bad (read: unfair) that a company called Virtu Financial Inc, which recently filed documents to go public, disclosed that it has only lost money on one day out of the first 1,238 trading days it has been operating.

Since I work with regular retail investors, the most salient question my readers might want to ask is “Does this affect me?” I would say “No, it doesn’t.” There are definitely counter-arguments to be made, but for the typical investor (who is investing in the stock market and planning on holding a stock for months or years) the existence of high-frequency trading firms should not even be a blip on their radar. The market is not “rigged” against the types of investments they are making. If you want to invest in Company A, you have done your research, and you feel as though paying $20 per share for that stock is an attractive price, then all you have to do is enter a limit order to buy Company A at $20 per share. In that scenario, you know what you are getting, you know what price you are paying, and you feel good about your odds of success. Over time if your investment thesis proves accurate then you will make money, and vice versa. Nothing else really should matter to you.

Now, it is hard to argue that we should embrace or even accept a system where certain groups of people with more money and better technology should be in a position to game the system and earn a profit 1,237 out of every 1,238 days the market is open. Hopefully regulators will do everything they can to close these loopholes in the system. That said, the discussion around whether regular investors should change how they save and invest based on this new book or the 60 Minutes segment are focusing their coverage and attention on the wrong headlines, in my view. Carry on.

Netflix and Tesla: Early Signs of Froth in a Bull Market

It is quite common for a bull market to last far longer than many would have thought, and even more so after the brutal economic downturn we had in 2008-2009. Only just recently did U.S. stocks surpass the previous market top reached in 2007. Although it does not mean that a correction is definitely imminent, the current stock market rally is the longest the U.S. has ever seen without a 5% correction. Ever. Dig deeper and we can begin to see some froth in many high-flying market darlings. Fortunately, we are not anywhere near the bubble conditions of the late 1990’s, when companies would see their share prices double within days just by announcing that they were launching an e-commerce web site. However, some of these charts have really taken off in recent weeks and I think it is worth mentioning, as U.S. stocks are getting quite overbought. Here are some examples:

TESLA MOTORS – TSLA – $30 to $90 in 4 months:

tsla

NETFLIX – NFLX – $50 to $250 in 8 months:

nflx

GOOGLE – GOOG – $550 to $920 in 10 months:

goog

 

You can even find some overly bullish trading activity in slow-growing, boring companies that do not have “new economy” secular trends at their backs, or those that were left for dead not too long ago:

BEST BUY – BBY – $12 to $27 in 4 months:

clx

CLOROX – CLX – $67 to $90 in 1 year:

clx
WALGREEN – WAG – $32 to $50 in 6 months:

wag

 

Ladies and gentlemen, we have bull market lift-off. My advice would be to pay extra-close attention to valuation in stocks you are buying and/or holding at this point in the cycle. While the P/E ratio for the broad market (16x) is not excessive (it peaked at 18x at the top of the housing/credit bubble in 2007), we are only 15-20% away from those kinds of levels. Food for thought. I remain unalarmed, but definitely cautious to some degree nonetheless, and a few more months of continued market action like this may change my mind.

Full Disclosure: No positions in any of the stocks shown in the charts above, but positions may change at any time

As The Dow Jones Industrial Average Hits A Record High, Is The Stock Market Overvalued?

How can we tell if the U.S. stock market is getting too pricey? Well, if you watch CNBC long enough or read enough stories in the financial media, you are likely to learn dozens of ways people will try and answer that question. There is not one right answer. If there was, successful investing would be easy and it is far from it.

I decided to dig into the numbers and present one way we can evaluate the stock market at today’s levels relative to prior market peaks, in order to see if we are nearing a point where we should start to get worried. I chose five of the most noteworthy market peaks over the last 25 years or so. After each of these peaks, the S&P 500 index fell at least 20% peak-to-trough. Some of the corrections were relatively normal, mild bear markets (the 1990 recession; -20% and the 1998 Asian financial crisis; -22%). Others were more pronounced (the 1987 crash; -33% and the dot-com and housing bubble bursts of 2000 and 2007; -50% and -58%, respectively).

I have graphed the P/E ratio of the S&P 500 index at each of these five market peaks. At one extreme we have the 1990’s bull market led by internet stocks, which saw equity valuations easily reach record-high levels, but at other peaks the results are more uniform, with markets typically topping out with P/E ratios in the high teens or low 20’s.

market-tops-peratios

As you can see, today the S&P 500 sits at 16x earnings. While we are approaching levels that should be considered elevated, one can argue that another 10-15% upside in P/E ratios would not be out of line with historical data. That said, making a large bet that valuations will reach the high end of the historical range is not something I would take to the bank. To me, this data says that the market is starting to get pricey, and although we could very well squeeze more upside out of this bull market (largely because with interest rates so low, equity investors are willing to pay more for stocks), I would still be cautious. As a contrarian, ever-higher stock prices only increase my preference to raise more cash and wait for the next correction, even if we don’t know exactly when it will come.

S&P 500 Index Reaches 1,500 Again: A Multi-Decade Triple Top

spx-16year

If you are thinking we have seen this level on the S&P 500 index before, you are absolutely correct. As you can see, the last 16 years or so has been a roller coaster ride, with three separate bull runs to around these levels, and the prior two have ended badly thanks to bubbles bursting (dot-coms in 2000-2001, housing in 2008-2009). So do you want the good news first or the bad news?

The bad news is pretty evident from the chart. We have reached a triple top and U.S. stocks have now risen 125% from their lows made in March 2009. That is a huge move in just the last four years. It warrants being cautious in the short term, as the market does feel overbought here.

The good news is actually pretty good though. At the March 2000 peak of the dot-com bubble, the S&P 500 reached 1,553 and the index components earned $56 in profits. P/E ratio: 28 (the highest ever recorded). Students of market history should have realized that stocks were dramatically overvalued. (Author’s note: As a college sophomore at the time, I was less than well-versed in market history, so it was the beginning of my history lesson, and a very good one at that).

At the 2007 peak of the housing bubble, the S&P 500 once again pierced the 1,500 level, topping out at 1,576. Earnings for the index hit $88, giving the market a P/E ratio of 18. That is still a high valuation, but rather than being unprecedented, the market was simply at the top end of its historical valuation range. Dangerous, yes, but not unheard of.

You can see where I am going with this. Today the S&P 500 sits at 1,502 and 2012 earnings are likely to come in around $100. That P/E ratio (15) is only slightly above the long-term median of 14. So the U.S. stock market is not materially overvalued as it was in both 2000 (by a large margin) and in 2007 (by a smaller margin). Now, that does not mean we cannot see stock prices fall meaningfully from these levels. After all, P/E ratios aren’t everything (despite the dot-com bubble being far more dramatic in terms of overvaluation, the market actually fell more after the 2007 peak because the economic shock was larger), but U.S. corporations are now earning enough in profits to justify the S&P 500 trading at 1,500, especially compared with the two prior peaks on this long-term chart.

My takeaway: it makes sense to be cautious, but not alarmed.

The Most Entertaining CNBC Segment Ever: Ackman vs Icahn

Yeah, I don’t think they like each other. It’s rare that two hedge fund titans are on the opposite side of such a controversial trade (Herbalife HLF) and in this case the result is an on-air feud. If you have any interest or follow Ackman, Icahn, Herbalife, and/or activist hedge funds, you might find this as entertaining as I, and many others in the industry, did on Friday when this altercation unfolded live on CNBC.

ackmanphoto

CNBC: Ackman vs Icahn 01/25/13 (27 min 39 sec)

What Can Happen When Markets Are Run By Computers? Stock Trading Might Go Nuts Like Today!

This afternoon the U.S. stock market went bananas and I decided to sit down in front of the television, watch, and enjoy myself. When the entire market is run mostly by computers, not only can traders control the minute by minute action but they can even set the computer up so that once certain price levels are reached, their trades get executed automatically, so actual human action is not even necessary. What happens when the computers are overloaded or someone makes a mistake? Well, watch this short segment from CNBC and see how the Dow Jones can drop 500 points and then make it all back in less than five minutes.

This is why many people think short-term trading in the market is nothing more than gambling. Literally anything can happen on any single day, in a single hour or minute, or in this case, a few seconds. Market watchers will tell you to use limit orders as a way to specify your exact desired buy and sell prices to avoid getting taken to the cleaners when markets react violently like this.

The problem with that, of course, is that your order may hit in a moment of panic, and had you known that was happening, you never would have made the trade. Imagine if you came home today to learn that you sold 100 shares of Proctor and Gamble at $50 (a limit order you had set) because it traded there for a brief second based on computer malfunction, but rebounded to $61 within seconds. You would be furious. Limit orders are not always the answer. Investors, especially those who are novices, need to be very careful. As we saw today, the market can be a landmine.

Trading in Dendreon Stock Shows Why Short Term Trading Is Such A Gamble

You may have heard about Dendreon (DNDN), a small money losing biotechnology company that is in the process of getting its cancer vaccine, Provenge, approved by the FDA. Full results from a crucial phase three study were released yesterday afternoon in Chicago, but about half an hour prior to their release, shares of Dendreon fell off a cliff for a couple of minutes and trading was halted for “news pending.” Between 1:25pm and 1:27pm ET Dendreon stock fell from above $24 to as low as $7.50, and were halted at $11.81 per share.

Immediately investors were baffled. The most plausible explanation was that the full study results somehow were leaked early, someone learned they were bad and sold their stock, which in turn caused others to panic and sell too. That would have been an odd turn of events, however, because the company had indicated recently that the study results were clearly favorable.

When the news was finally released to the public there were no surprises, which makes those trades just before 1:30pm very strange. The NASDAQ exchange quickly investigated the trades to see if any were made erroneously, but they found nothing wrong and the trades will stand. Today the stock reopened and is currently fetching about $24 per share.

This story only serves to further my personal belief that short term trading in the stock market is so speculative that it is really nothing more than gambling. Evidently somebody somewhere thought they saw or heard something that was negative for Dendreon, others followed suit and sold their shares like lemmings jumping off a cliff, but in reality there was no news at all.

Undoubtedly some investors quickly hit the sell button during those few short minutes yesterday afternoon, fearing that if they didn’t their stock would fall even further (Dendreon stock sold for $2 in March, so many people had huge gains). They lost between 50% and 75% of their money for no reason. Other investors surely had large paper gains in Dendreon and had stop loss orders in place to limit any future losses. Many of those stops were triggered as the stock collapsed from $24 to $7 and rebounded to $12 and those investors also lost big time.

As you can see the market is very complex and sometimes things happen that are not rational and should never have happened. Speculating on near term movements of stocks (especially small biotech companies) is a very risky endeavor. All the market needs is a willing buyer and a willing seller to agree on a price in one split second. Reality need not apply in such a case, but millions of dollars can be lost in a matter of minutes, as was the case with Dendreon yesterday.

Traders beware. In some cases Wall Street can look very much like a casino.

Full Disclosure: No position in Dendreon at the time of writing, but positions may change at any time

After a Brief Break, Here’s A Merger Arb Trade For You

Regrettably I was out of town for several days and as a result it has been awhile since I’ve posted anything. So, I decided to give you all a conservative trade idea now that the market has had a huge run over the last four weeks. We are definitely getting overbought here, so tread carefully.

Anyway, I am a big fan of arbitrage opportunities and I think there is a merger arb play right now with the pending merger between Merck (MRK) and Schering Plough (SGP). The deal should close by year-end and the agreed upon cash and stock ratio (SGP shareholders get $10.50 cash and 0.5767 shares of Merck for each SGP share they own) implies a total deal value of $25.76 for each SGP share. That represents a premium of 9.4% based on Friday’s closing prices for both stocks.

Normally, someone wanting to make this trade would simply short ~58 shares of MRK for each 100 shares of SGP they were long, wait for the deal to close, use the new Merck stock they receive to cover the short position, and pocket the 9.4% financial spread as profit. In this case, the actual return would be slightly less because Merck’s dividend yield is above that of Schering.

However, there is another way to play this (and a more profitable one) because Schering Plough has a convertible preferred issue (SGP-PB). This security pays a higher dividend than the common (7.1% versus just 1.1%) and converts into SGP common in August of 2010. By that time, it will actually convert into Merck stock, since Schering will no longer be an independent company.

The attractive thing about the convertible preferred is that it too trades at a discount to implied value upon conversion. The convertible currently trades at $210 but would convert into $214 of SGP stock if converted today. Add in the $15 annual dividend and the spread is even higher.

How would an investor play this? Simply by buying the SGP preferred instead of the common when simultaneously shorting MRK common. Rather than using common stock from the merger to cover the short, you can simply wait until the preferred converts into common in August 2010 to cover the short. In the meantime you can collect the 9.4% deal spread, a 7.1% annual dividend as well as the 4% spread on the convertible security.

Full Disclosure: Peridot Capital has positions in both SGP and MRK at the time of writing. Positions may change at any time.

So Far, Technical Support Levels Holding Up Well

During crazy market times like this I can talk my head off about fundamental issues that show the market is undervalued, but fundamentals don’t matter right now. Stock prices are claims on future corporate profits forever? Who cares, earnings are going to be terrible in 2008, 2009, and maybe even 2010. Rather than trying to convince people (correctly) that earnings this year or next really don’t have a material impact on a company’s long term equity value, let’s focus on what does seem to be working right now… technical analysis!

Long time readers of this blog know I don’t use technical analysis because for a long term investor, charts don’t tell us what stocks will do, earnings and valuations will. Still, technicals do work quite often in the short term because thousands of people are looking at the same thing and acting in the same way. Today was no exception, as the 10-yer S&P 500 chart below shows.

The 2002 closing low for the index was 776. Today we sank at the open, hit 776 and bounced significantly (818 as I write this). The long-term 2002 support level has held, which is crucial for the short term market environment. I might not care where the market trades today, next week, or next month, but a lot of people do.