The Wal-Mart Bear Market – Part 2

How is it possible that a large cap industry leader can grow its earnings more than 90% over half a decade and yet return a negative 15% to shareholders? Did Wal-Mart do anything wrong, and if so, what?

No, Wal-Mart management did nothing wrong from 2000 to 2005. In fact, they did exactly what their job was, to grow the business into the world’s most dominant retailer. The fault lies with the shareholders who bought the stock at $55 five years ago.

Now you might think that accusation is absolutely preposterous. After all, aren’t investors who saw the growth potential in Wal-Mart back then very perceptive? Didn’t they do exactly what a good growth investor should do?

I would argue against that notion. In fact, Wal-Mart investors made a very common mistake, a mistake that hundreds of people fall victim to every single day on Wall Street. They wanted to own shares of WMT but didn’t pay any attention to how much they were paying for them.

I’m not talking about share price. Many people conclude a $5 stock is “cheap” and a $100 stock is “expensive.” In fact, share price alone does not make a stock good or bad, cheap or expensive. Investors who bought WMT shares at $55 in May of 2000 forked over a whopping 40 times earnings for the stock ($55 per share divided by $1.39 in earnings).

Contrary to the common belief that stock prices follow earnings growth, there are many exceptions. When stock have enormous P/E ratios (a P/E of 40 is about 3 times the average stock’s P/E since 1900) it is often a signal that investors are getting a bad deal, regardless of the company’s future growth potential. If the P/E multiple that investors are willing to pay decreases dramatically over time, not even a 91% gain in profits can make up for the damage shareholders will incur.

Today Wal-Mart stock trades at $47, or 18 times this year’s expected earnings. If you have a company’s P/E ratio fall from 40 to 18, and earnings grow 91%, you are left with a 15% loss on your investment. This can explain why the high-flying tech stocks on the late 1990’s are down so much from their peaks. Cisco Systems (CSCO) is making more money now than they ever did during the Nasdaq bubble, but instead of trading at $82, which was its all-time high in early 2000, the stock is under $20 a share today.

This example should help investors realize that oftentimes the key to growth stock investing is the price you pay, and not the future growth of the company you are investing in. Even though the hype for many promising growth companies can be hard to ignore, try not to lose sight of that.

The Wal-Mart Bear Market – Part 1

Let me give you a couple of statistics and then I’ll ask a question. Wal-Mart (WMT) has grown its annual sales from $180 billion in 2000 to an estimated $317 billion this year, a total increase of 75%. Earnings per share since 2000 have soared from $1.39 to an estimated $2.66 for 2005, an increase of 91%.

Investors are constantly searching for growth when they try and pick winning stocks. People who foresaw the growth that Wal-Mart could sustain so far this decade clearly have done well, right? There is little doubt that having achieved revenue growth of 75% and profit growth of 91% over a 5 year period would be reflected in a very strong gain for Wal-Mart stock. This leads me to my question. How have shares of Wal-Mart performed during that 5 year span?

If you ask former Fidelity star mutual fund manager Peter Lynch this question, he would most likely tell you that over time stock prices follow corporate earnings. As a result, estimating WMT shares have risen 91% in the last 5 years would be a good answer, because for the most part, Lynch’s statement proves correct.

The only problem is, there are exceptions to that rule. Just because a company grows at a very rapid pace, this does not ensure significant price appreciation of that company’s stock. In fact, despite sales growth of 75% and earnings growth of 91% since 2000, Wal-Mart shares have lost 15 percent of their value during that time, falling from $55 to $47 per share.

Part 2 of “The Wal-Mart Bear Market” will be published shortly, and will examine why WMT investors have suffered and what we can learn from this example.

Most Ridiculous Item of the Day

Mark Klee, a technology fund manager, on why he doesn’t own shares of Google:

“We don’t own Google. The valuation is just too high for us. We do own Yahoo, though, Google’s main competitor.”

So Google stock is too expensive, but he owns Yahoo. As a mutual fund manager, you would think Klee would understand how silly this view sounds to anyone who follows these two companies. Google trades at 50x 2005 earnings and 39x 2006 profit expectations. Yahoo’s ’05 and ’06 multiples are 65x and 51x, respectively.

I’d love to know why Yahoo is cheap enough for him to own, but Google’s valuation is too high, especially when Google is growing faster. As far as GOOG’s $14 jump today, to an all-time high of $255 a share, I still think the stock has more room to run. I would not be surprised to see $300 by year-end, at which point I will most likely take some money off the table.

Fortunately, Sentiment Indicators Remain Low


The UBS Investor Optimism Survey was released today and continues to point to extremely bearish investor sentiment. This contrarian indicator, coupled with record high short interest on the New York Stock Exchange, show the upward potential this market continues to have. According to the UBS Survey, investor optimism hit its lowest level since May 2003. The above chart shows how the S&P 500 has performed since then. The index has risen nearly 33% in just two years.

CEOs: Just Run Your Companies

Did anyone catch the Cyberonics (CYBX) conference call yesterday? I would never have noticed it as I don’t follow the stock, but continuous coverage on CNBC got me wanting to mention it. The company’s CEO went ballistic after the stock got crushed on news that the Senate is investigating the FDA’s decision to recommend approval of the company’s product after initially suggesting it be rejected.

Now I don’t know the details of the story, nor do I really care, but I couldn’t help notice how irrate the CEO was on the call from clips I heard on CNBC. He blasted short sellers for supposedly starting rumors and was infuriated that people were contacting the FDA to learn more about possible pressures applied to get the CYBX device approved.

After screaming at people on the conference call, the CEO spent more valuable time writing emails to CNBC criticizing their reporting of the story throughout the day. With a very important product under review by the FDA, doesn’t he have more important things to do with his time than yell and scream at analysts, short sellers, and business reporters?

If you are a CEO, your job is to run your company. How well you do will determine where your stock trades. News reporters and short sellers do not determine stock prices over time. How much money Cyberonics earns does. Sure, a false rumor might send your share price down a dollar or two in a day. However, why be infuriated by this? As a CEO, it shouldn’t matter if your stock is $30 on Monday, $28 on Wednesday, and $31 on Friday. Leave that for traders to worry about.

It’s amazing how many CEOs hate short sellers and spend so much of their time trying to discredit them (Overstock.com’s Patrick Byrne comes to mind as a perfect example). If you want them to feel pain, fine, just hit your numbers and those betting against you will lose their shirt. That seems like the best gameplan for those who are doubting you and your company.

Just do your job well, run your company correctly, and the stock price will take care of itself.

A Tale of Two Buybacks

There have been a lot of big name investors in the news recently, including the trio of Warren Buffett, Kirk Kerkorian, and Carl Icahn. The media tends to lump all three men into the same group of people investors should pay great attention to. After all, when Buffett disclosed he bought Anheuser Busch (BUD) stock weeks ago, the stock jumped from $45 to $48 in a single day. Kerkorian issued a tender offer for General Motors (GM) shares that resulted in the largest one day gain in the stock in more than a decade.

Icahn perhaps deserves less attention. His track record is not as solid as Buffett or Kerkorian, and Wall Street evidently realizes that his shareholder activism efforts with the likes of Blockbuster (BBI) don’t always add any value for stock owners. In fact, when Icahn recently released a list of stocks in which he purchased stakes in recent weeks, most of the stocks barely budged.

Today I will focus on two stock buybacks, one of which was precipitated by Icahn’s discontent with the management of Kerr-McGee (KMG), and the other non-Icahn related buyback that resulted from a huge cash stash at Motorola (MOT). As you can see from the chart of today’s trading below, the stocks have reacted differently to the news of their respective buybacks.

First, the good news. Motorola has $6 billion of cash on its balance sheet currently, net of debt. CEO Ed Zander today announced that the company will buy back up to $4 billion in stock, about 10% of the total outstanding shares. Both Motorola and Nokia (NOK) have huge cash balances that have contributed to Peridot’s extreme interest in the stocks over the last year. Investors should always pay attention to balance sheets, in addition to earnings per share. When companies are flush with cash, they will usually do something good with it eventually, just be patient. MOT shares have been up between 3 and 4 percent today.

As you can see, Kerr-McGee shares are faring much worse today, falling by as much as 8 percent. Here’s a quick synopsis of the story there.

Icahn, unhappy with the management of KMG (despite the stock’s rise from $50 to $80 with the last 12 months), threatened last month to attempt to get elected to the company’s Board of Directors. Icahn agreed to abandon the effort after Kerr-McGee launched a “Dutch Auction” tender offer for 46.7 million shares. The move would cost $3.97 billion based on a purchase price of $85 for each KMG share, in order to avoid a proxy battle with Icahn.

With KMG shares trading at $74, Icahn basically has forced Kerr-McGee to buyback 29% of its total shares outstanding for $85 apiece. Today, the stock opened at $69. How exactly is buying back stock at $85, when your share price is $69, good for shareholders? That’s a $16 per share premium to the price on the open market. Icahn evidently thinks that is a good investment of nearly $4 billion for the company.

You know what makes it even worse? KMG doesn’t even have the $4 billion to buy the stock with, so they are borrowing the money. The company secured a $5.5 billion credit facility to fund the purchases. So, in addition to the $16 per share premium it is paying (an extra $747 million above market value) Kerr-McGee also has to pay interest on the entire amount.

Something tells me Warren Buffett would never force a company he owned a significant stake in to throw away money like that, let alone money they needed to borrow to do so.

J.P. Morgan Recommends Buying Delta

Delta Airlines (DAL) shares are jumping 10% this morning to $3.30 per share on a J.P. Morgan upgrade.

From the newswires:

Delta Air Lines was upgraded to overweight from neutral at J.P. Morgan due primarily to valuation. Analyst Jamie Baker believes Delta may have to declare bankruptcy in 2006, but the shares are pricing in a high probability, about 75%, of the air carrier going bankrupt in 2005. “While the market’s bankruptcy conclusion may ultimately prove accurate, we believe it is one winter season premature,” Baker said. “With equity purgatory not far below current levels, the option value reflected in Delta shares is expected to improve as capital-raising efforts gain momentum.” Baker estimates “equity purgatory” to be at about $1.50.

Recommending a stock that you think will be worthless a year from now is a very interesting call.

As I always do, let’s take a look at this analyst’s track record on Delta shares. Here are prior opinions with closing prices on the day of the recommendation:

03/12/03 Buy $7.48 close
07/20/04 Neutral $5.40 close
10/15/04 Sell $3.42 close
10/26/04 Neutral $4.63 close
05/18/05 Buy $3.35 open

If you’re wondering if you should buy Delta at $3.30 a share today, it’s tough to feel confident with this analyst’s call. After all, Baker wanted you to buy at $7, do nothing at $5, sell at $3, do nothing at $4, and buy at $3.

InfoSpace Authorizes $100 Million Buyback

Evidently the board of InfoSpace (INSP) sees the same type of value in its stock that I do. The company has announced it will buyback up to $100 million of its shares in the open market. With a $1 billion market value, this represents 10% of the company’s outstanding shares. Quite meaningful if you ask me.

Although I have noticed the magnificent balance sheet InfoSpace possesses, the stock’s pre-buyback announcement price of $29 a share shows that many investors clearly have not. By buying back stock and increasing the company’s earnings, Wall Street hopefully will see how undervalued the shares really are.

With $384 million in cash and no debt on InfoSpace’s balance sheet as of March 31st, shareholders need not worry that the $100 million investment will hurt the company’s ability to grow. At $30 per share, the stock remains dirt cheap and a very attractive acquisition candidate. A buyout at 20x earnings, net of cash, would amount to $48 for each INSP share.

Bush’s Support of Free Trade Questionable

President Bush is a huge fan of markets. Rather than take meaningful action toward surging oil prices, he’ll simply let the market correct itself. With the Chinese currency pegged to the U.S. dollar, the Administration is pressuring China to let it float. Let the markets determine currency values, not governments.

I think that’s a great position actually. Markets do work, so we may as well let them. When it comes to free trade then, it’s no surprise that Bush says he supports global free trade. After all, the global economy is a perfect example of a enormous market for goods and services at work. And it does work, very well in fact.

So it’s no wonder that when the Bush Administration imposed steel tariffs in 2002, many of his supporters were irrate. The tariffs were imposed to stop cheap steel imports from flooding the U.S. market, hurting U.S. steel producers by increasing competition and lowering prices.

Dozens of U.S. steel companies had filed for Chapter 11 bankruptcy protection since the last 1990’s due to an inability to compete effectively in the global market for steel. The tariffs were lifted in 2003 after the World Trade Organization pressured the U.S. and threatened to strike them down. Bush attempted to claim that the tariffs had served their purpose for a year, and now it was time to eliminate them, but everybody knew that it was simply a huge mistake, and fortunately there was enough pressure overseas that they were overturned.

However, the Bush Administration once again is attempting to close down the U.S. to free trade. The U.S. has reimposed quotas on Chinese textile imports such as cotton patnts, shirts, and underwear. How does reinstating quotas support the notion of free trade?

U.S. retailers have been urging Bush to not to reimpose the quotas. The reason is simple, prices for the U.S. consumer will go up as a result. Inflationary pressures are the sole reason the Fed has been raising interest rates. Quotas and tarriffs will only serve to increase prices, which will result in higher interest rates and lower economic growth, here and abroad.

Economic policies like these will only hurt the U.S. economy, and as a result, prevent a new bull market from getting underway anytime soon.

Market Struggles As Fed Unlikely To Stop

After a mini rally in the market last week, investors were hopeful it would continue for a little while longer. However as this week has shown, such hope was overly optimistic. The S&P 500 is once again headed back down to its support levels. As much as Wall Street wants Alan Greenspan to stop raising rates, few people really think that will happy anytime soon.

The old adage “Don’t Fight the Fed” continues to hold true. The S&P 500 closed at 1,141 on June 30, 2004. That was day of the first rate increase in 4 years, when the FOMC took the Fed Funds rate from 1.00% to 1.25%. Ironically, the major support level for the S&P 500, which has held throughout 2005, is right around 1,140. Investors trying to fight the Fed have found themselves treading water in a market that has not budged since the first of the eight 25 bp rate hikes.

With earnings still growing nicely, valuations are not stretched by any means at this point. We just need a catalyst. Some economists believe Greenspan could stop right here at 3.00% Fed Funds. Others say he will go to 3.50%. While I am hoping for a stopping point at 3.50%, I truly think we are headed to 4.00%. The FOMC needs to leave itself some room to cut rates if something really bad should happen, and they have a history of going too far.

This time will most likely play out in a similar fashion. If the 10-year bond stays where it is, we might have an inverted yield curve before too long. The Fed might kill the economy trying to preempt inflation and the cool the housing market, even though inflation isn’t really a huge concern at the moment. And besides, mortgage rates are based on the 10-year, not Fed Funds.

All in all, the market will continue to be tough for most, if not all, of 2005, unless Greenspan remembers what happened last time he took rates too high (think March 2000) and decides to be more cautious this time around. Cross your fingers.