The Great Independent Research Debate

There is a very simple reason why Peridot Capital does its own research; there are very few people I trust more than myself to implement my investment philosophy. As much as so-called “independent” research claims to be such, experienced investment professionals know that research is often far from independent. All you have to do is ask yourself, is there reason to believe that this research is independent?

In the case of a buy-side firm like Peridot, there is every reason to believe that our research is independent because it is solely used internally to make investments on the behalf of clients. If clients do well, the company will prosper, and if they do poorly, clients will leave.

But what if a company doesn’t manage money? What if they are solely in the business of selling research? Do they have to be independent? What is keeping them from doing whatever it takes to sell the product? After all, selling research is their only line of business. It’s the same reasoning that some journalists print things that might not be completely accurate. They are in the business of selling papers, or magazines, or whatever their product is. How do tabloids stay in business? Is it because their stories are always accurate? No, it’s because people buy them.

I decided to write this piece after reading a transcript of testimony given by Kim Blickenstaff, CEO of Biosite (BSTE), a small medical diagnostics company based in San Diego. Her testimony was part of a Senate Hearing this week entitled “Hedge Funds and Analysts: How Independent is their Relationship?” Below is an excerpt:

“In the ten months from February to December 2002, the number of shares [of Biosite] controlled by short sellers increased from 690,000 to 7.1 million shares, which represented nearly 50% of our outstanding stock.

During this same period, Sterling Financial Investment Group, a Florida-based research firm, issued at least seven negative research reports on Biosite, each carrying a Sell/Sell Short recommendation, and an $11 target price. We believe that these reports contained numerous inaccuracies or false and misleading statements, which ultimately lent volatility to the stock’s performance, thereby harming many of our long-term, fundamentally-based investors.”

There are many issues I have with this testimony from Biosite’s CEO.

First, short sellers do not “control” shares of stock. They borrow shares from other investors and immediately sell them in order to raise cash proceeds. The investors who have sold the stock short no longer control the stock, they simply owe it to someone, and will have to buy it back at some point in the future to repay the loan.

Second, Blickenstaff claims that negative research reports issued by Sterling between February 2002 and December 2002 were successful in “harming many of our long-term, fundamentally-based investors.” This is interesting given that Biosite stock was $18.37 on February 1, 2002 and closed December 31, 2002 at $34.02 per share. So, even as the number of shares sold short increased more than 10-fold, the stock price soared by 85 percent. How exactly long-term investors in Biosite were hurt by this I’m not exactly sure. Sounds like these types of investors should beg short sellers to target their stocks!

What can we take away from all of this?

One, short sellers do not cause stock prices to go down. If a stock can rise 85% as half the outstanding shares are being borrowed and immediately sold, such as argument is easily discounted as silly.

Two, independent research is not always independent. Merely listening to Sterling’s negative view on Biosite stock (which did prove to be inaccurate) would have lost you a lot of money if you were in fact a long term investor who wanted to “invest” (versus “trade”) in BSTE shares.

Three, if you are an “investor” then you should, by definition, have a long-term view. Traders focusing on the short term probably were hurt by these negative research reports because they likely caused a quick drop in the stock price upon being published. In the short term, any kind of report can influence stock prices, accurate or not.

Over the long term, however, company fundamentals will matter above all else. Since the research Sterling published turned out to be incorrect, the stock price went up, not down. That is why someone who bought the stock in February before all the short sellers and negative reports came out of the woodwork, and held it throughout all of this sketchy behavior, would have made 85% on their investment in less than a year.

Hopefully you can see why people should do their own research and invest for the long term. If your analysis proves accurate, you will make money, no matter whatever anyone else out there is doing. That is the philosophy I use when managing my clients’ money, but it is valuable for anyone who doesn’t want to be adversely affected by the inherent conflicts of interest on Wall Street, whether you are a Peridot client or not.

Will Bernanke Throw Investors a Bone?

We know that interest rates hikes work with a lag, so it takes 6-12 months for the effects to ripple through the economy. We know that we’ve had 16 straight rate hikes that has taken the Fed Funds rate from 1% to 5%. Shouldn’t Chairman Bernanke and the FOMC take a break, and see how the two-year long rate-raising campaign affects everything?

That’s the case for the Fed to quit. I’m in that camp, personally. It’s not like the Fed can’t raise rates whenever they want to anyway. If they pause for a month or two and regret it, you can always go back and raise some more. Would such a plan have any drastic repercussions? I doubt it. And let’s not forget, even though the market gets on a regular timeline with the FOMC meetings, Bernanke and Co. can move between meetings if they need to.

The way I see it, the stock market has stabilized after getting down to S&P 1,225, 8% below the highs. It has a little room to rebound, given the chance. If we get more of the same later this week from the Fed, and by that I mean a 25 bp hike and a similar statement to recent ones, equities will have a tough time to hold current levels. Uncertainty is always bad for stocks. If we get a signal that this hike is the last one for a while, I think can get a brief rally that might get us to back close to 1,300 on the S&P 500. At that point, I’d probably do some selling.

Another less likely option, but a good one nonetheless, would be to move 50 bp this week and signal a pause. This would satisfy both those looking for a hawkish stance on inflation, as well as a pause to observe the ultimate effects of all of these hikes. I think the market would rise in this scenario as well. I hope Bernanke decides to take a wait and see approach, but we’ll just have to, well, wait and see.

Anadarko Announces Two Large Buyouts

I can’t recall a time when a company has announced two large acquisitions at the same time. Today we hear that Anadarko Petroleum (APC) will buy both Kerr McGee (KMG) and Western Gas Resources (WGR) for more than $21 billion in cash. With Anadarko’s market cap around $22 billion before the deals were announced, they are essentially doubling the size of the company overnight, creating the country’s largest independent exploration and production company.

Both of these purchases show just how undervalued energy companies are in the public markets these days. Anadarko is paying a 40% premium for Kerr McGee ($16.4B) and a 49% premium for Western Gas ($4.7B). Despite these huge cash premiums, the deals will be accretive to earnings. Few seem to disagree that our natural gas needs will continue to rise, but for some reason the stocks trade at exceptionally low valuations. This has resulted in a lot of M&A activity, and likely will continue to do so.

Best Buy Test Marketing Macs Should Boost Apple

Electronics retailer Best Buy (BBY) announced yesterday that they have begun test marketing Macintosh computers in some of its stores. A potential distribution deal with one of the largest retailers of computers, combined with new software that can run Windows, sure bodes well for Apple’s Mac division. You have to like the odds that people buy Macs over Gateways at retail.

Investors seem to be focusing on iPod sales right now, as the stock is down significantly to $57 and change. While not inexpensive, shares of AAPL seem to have more room to run than most tech stocks.

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, 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 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 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.

An iPod from Microsoft?

Evidently Microsoft (MSFT) is developing a digital music device and download service to compete with the iPod and iTunes from Apple (AAPL). Headlines like these show that Microsoft is feeling the heat and believes it must reinvent itself. I would agree completely with that assessment, but I also disagree with their apparent strategy.

Merely copying successful products that have already attracted scores of competition is not going to reinvigorate growth at Microsoft. They need to play offense, and by that I mean, develop new technologies and products. They should aim to be first to market, and force others to play defense by copying them.

Adding another video game system to the market is not very innovative. Adding another mp3 player to the market is not innovative. Ditto for a music download service. The companies that are taking aim at them today aren’t doing so by copying. They are doing so by innovating. Google changed the online advertising market, has the best product out there, and now dominates.

Google’s beta of a new, free, online spreadsheet program isn’t merely an imitation of Excel. You can see where Google is going with this. Low end computers nowadays can cost as little as $300 with a monitor included. However, if you want to put a copy of Microsoft Office on your new home machine in order to do work on weekends, the software package could easily double your system’s cost to $600.

Large corporations have big pockets, so they will likely continue to equip all new systems with the full version of Office. Consumers though, hate paying hundreds of dollars for software that is oftentimes essential to do anything productive on their computer. Microsoft may have a monopoly on desktop software, but their dominance has nowhere to go but down the drain as other companies innovate. An online spreadsheet program complete with free storage space on Google’s own servers could ultimately dent Microsoft’s Office business, though it will take time.

Selling video game consoles and imitation iPods might make up for some of the business Microsoft will undoubtedly lose to companies such as Google, but the margins will be so much lower that it will never completely make up for it. Right now Microsoft gets nearly all of their operating income from Windows and Office. Those businesses are under attack, but do you really think the way to reinvent the largest software company on the planet is to go after the iPod?

Caterpillar Sets Growth Goals

Yesterday at their annual meeting Caterpillar executives laid out a growth outlook for the next five years. The headline peaked my interest because it seemed aggressive. Cat CEO James Owens announced that sales will grow to $50 billion in 2010 and earnings per share will grow at a compund annual rate of 15%-20% between 2005 and 2010.

For a fairly large, mature business like Caterpillar, as much as 20% annual EPS growth over a five year period sounded very optimistic to me, but upon doing a little further number crunching I realized that the plan really wasn’t all that aggressive after all. Current estimates for 2006 and 2007 imply earnings growth of 31% this year and 13% next year. This comes on the heals of a 40% surge in 2005, the first year of the period in question.

So, from 2005 through 2007, earnings are expected to grow 28% per year on average. In order to hit the midpoint of the 15-20% annual goal for the entire six year period, profits in 2008-2010 will only have to average about 7% annually.

Given this outlook, are Cat shares a buy at the current $68 per share price tag? Let’s assume the midpoint of the growth plan is achieved (17.5%). That puts 2010 earnings at about $7.30 per share. Let’s assume a modest 12 P/E on those profits, given that we are talking about a cyclical heavy machinery company. We get an implied share price of $87 four years from now, about a 30% gain from current levels.

Not a horrible return, but not as good as you might expect based on the headlines we saw yesterday. This also assume that the global economy remains strong for many more years. A global recession will likely hurt very cyclical businesses like the one Caterpillar dominates.

Getting the Froth Out

Over the last year or so the markets have done well despite the rally being very narrowly focused. Consider what was working up until May. International, energy, gold, copper, industrials. The investment banks did great too as M&A activity hit record levels. What about other areas? Healthcare, technology, telecom, media, banks, retail. Not a lot of performance in those areas, even though they make up a huge portion of the U.S. market.

The result of such a narrow market was that everybody began chasing what was working and shunning everything else. The copper move from $3 to $4 a pound was probably solely due to hedge funds piling in. The moves were parabolic, especially in commodities and international stocks. Finally we have reached a point where people are getting nervous, nervous enough to reduce risk. This is leading to extreme selling in the areas that have done best. Basically, we are getting the froth out of the market.

It is this explanation, and not anything fundamentally wrong with the companies, that is causing the massive sell-off. Goldman Sachs (GS) reported a great quarter this morning. The stock is down 6 points. GS is still doing well. In fact, they advised on the Maverick Tube (MVK) buyout announced this morning. The market action has been violent, but prices are getting a little out of whack with reality at these levels, unless the world really is headed for horrible times. Not impossible, but it’s tough to make that case at this point.