Will the Bull Market in Exchanges Ever End?

Over the last few years we have witnessed an undeniably sensational run in the stocks of various stock, bond, and derivative exchanges. Private and owned by seat holders for generations, the latest bull market in the equity market, which has lasted four years, has allowed the New York Stock Exchange (NYX), the NASDAQ (NDAQ), the Chicago Merc (CME), the Chicago Board of Trade (BOT), and the New York Mercantile Exchange (NMX), to all go public and see their stocks soar.I must say that I have avoided playing this sector. The stocks IPO’d to extreme fanfare, and with such jubilation came steep valuations that fell outside of my investment discipline. I have warned investors to be cautious with these stocks, many of which sport P/E ratios of 40, 50, even 60 times forward earnings. The Chicago Mercantile Exchange, which recently agreed to merge with the CBOT in an $8 billion deal, has risen more than 1,000% since it’s opening trade and now trades at nearly 20 times revenues.

Some readers might chalk up my negative comments as merely trying to rain on the parades of people who have actually made good money in these names. However, in all honestly, I merely want to let people know that these stocks, while they are all the rage right now, trade at levels that will be hard to justify if things start to go bad.

Is it reasonable to think the tide will shift in the other direction at some point? I think so, but the timing in impossible to know. Let’s focus on what factors have driven the bull market in these stocks. The last four years have brought the exchanges increased demand, and subsequently, increased volume. In response, they have been able to introduce new products and raise their fees on existing ones. More business, along with pricing power, leads to surging profits. Hence, the stocks have outperformed dramatically.

But, will the music stop? Eventually I think it has to. Why? Because bull markets end. Exchanges are very cyclical, though many investors don’t relaize this because they were private entities during the last bear market. What happens when the bear rears his ugly head? Prices drop, volume evaporates, demand is reduced, price increases aren’t possible, and all of the sudden, revenue and profits will decline. For companies already trading at 40 to 60 times earnings, with 20 percent plus growth rates projected, such a scenario would likely hurt investors in the exchanges immensely.

Do I know when the bull market will end? Of course not, nobody does. All I can tell you is that we have had a great run over the last four years, with the S&P 500 averaging mid double digit returns annually. If you feel comfortable owning these stocks and riding the momentum, that’s completely your call. I just want people to understand what the risks are. That way, when the next bear market hits, they understand it will be time to take whatever profits are left off of the table and move on to something else. Until that happens, I will continue to sit on the sidelines, in awe.

Nymex Insanity

November 7, 2006: 

An ownership seat on the Nymex division of Nymex Holdings Inc. sells for a record $5.8 million, just 10 days before the exchange plans to go public. The sale, which includes 90,000 shares, topped the previous record of $5.5 million on April 28.

November 17, 2006:

Nymex Holdings (NMX) goes public at $59 per share and trades at $140 in afternoon trading. The 90,000 shares that Nymex seat holders now own are worth $12.6 million. 
I’ll have more on the Nymex IPO in another post sometime next week, but I just wanted to mention this today since many retail investors are buying this IPO. Keep in mind that the value of a Nymex seat has more than doubled in the last 10 days. Does that make sense? Proceed with caution, please.


Sears Holdings Drops 5% After Earnings

It’s the same old story with Sears Holdings (SHLD). In fact, I feel like I’m just repeating myself a lot. However, I have long been positive on the stock, and it is one of Peridot’s top five holdings, so rather than ignoring it just for the sake of not sounding repetitive, I will likely continue to share my views on the company and the stock’s investment merit.

In case you missed it, Sears reported Q3 earnings of $1.27 per share and sales of $11.94 billion. The revenue number was at the high end of estimates, and the earnings number included investment income of 42 cents per share. Excluding one-time charges and investment income, earnings did miss consensus estimates, which caused the sell-off in the stock.

Comments on the quarter across Wall Street were very predictable. Same store sales were down, which is bad and must be turned around at some point. Earnings were up on cost cutting, but such moves can’t be maintained forever. Most analysts are ignoring the investment income when looking at the quarterly results, because they are unrelated to operating activities of the main retailing business.

It is my view, however, that ignoring the investment income is a mistake for investors. If an investment in Sears stock was merely a bet on the retail operations, then I can understand not caring about profits derived from investing excess cash. However, a large piece of the investment thesis behind SHLD has been, and will continue to be, Eddie Lampert’s ability to allocate excess capital in order to earn returns that far exceed those of the retail business. There is a reason he changed the name of the firm to Sears Holdings. It’s a holding company. There is more than just retail here.

Investors who are in Sears merely for the retail operations should probably move on to something else. SHLD will continue to report declines in same store sales and grow profits via cost cutting, share repurchases, and investment income. This will ultimately lead to a tremendous increase in shareholder value.

If, however, you are like me and are investing in this stock for the entirety of the operation, then you should stay with it despite today’s decline. Sears is a holding company and will continue to boost shareholder value via multiple ways. In fact, as the company finds new avenues for allocating capital, they will become less and less reliant on Sears and Kmart than they already are. While this will draw criticism from many, especially retailing analysts, the end result will be a rising share price, which is really all that matters to me.

Full Disclosure: I own shares of Sears Holdings personally, and my clients do as well.


Which Group of Analysts Will Be Right About Earnings?

Glancing over earnings estimates for the duration of this year and 2007, I noticed a very interesting dichotomy. Bottom-up analysts are still quite bullish on corporate profits, forecasting year-over-year growth in each of the four calendar quarters during 2007. Top-down analysts, conversely, are predicting annual declines in earnings beginning in Q3.

Which group will be correct? It’s simply too early to know. I would tend to side more with bottom-up analysts in general, merely because they are basing their forecasts on what actual company management teams are saying, as opposed to merely taking a broad macroeconomic view of the world.

That said, I am worried that earnings growth will be difficult to maintain. Over the last couple of years a majority of the gain in S&P 500 earnings have come from the energy and materials sectors. As we head into next year, contributions from these groups could be minimal, if not negative. Commodity prices seemed to have peaked for the short term, and although I do think we are in the middle of a secular bull market in the group, there is no reason to think we could not see a breather in the run during 2007.

If energy and other commodity stocks find it difficult to grow earnings, other groups would have to see accelerating profit growth to make up the difference and continue to boom in corporate earnings. I can’t really see what areas would be up to the task.

What is the implication for stock prices going forward? Depending on what earnings number one uses for the S&P 500, we are currently trading between 15 times (operating) and 16.5 times (GAAP) 2007 earnings estimates. Market bulls suggest that P/E multiples should expand given the outlook for economic and earnings growth. However, if corporate profits begin to see year-over-year declines in the back half of 2007, such multiple expansion is unlikely.

With multiples staying flat or declining, and profits peaking, it would be hard to make the case that stock prices have a lot of room to run next year. Perhaps that is why the S&P 500 seems to be having trouble breaking past recent highs in the 1,390 area. As it stands right now, I don’t see the S&P breaking meaningfully above 1,400 in the short term until we have increaased confidence that a more bullish scenario could play out.

As Predicted, More Biotech Buyouts

When I wrote about the Merck (MRK) deal to acquire Sirna Therapeutics (RNAI) on 10/31 and predicted more biotech deals were coming, I didn’t realize it would only take a week and a half. Last night, Genentech (DNA) announced plans to acquire Tanox (TNOX) for $20 per share in a deal worth more than $900 million. The all-cash tranasaction is expected to close by the end of the first quarter.

Tanox is not a company that has gotten much attention on Wall Street, in terms of product potential or as a possible buyout candidate. Like I said in my last piece, it is very tough to know which of these small and mid cap biotechs will get bids. It appears there are some royalty synergies with this deal, which explains in part why DNA targeted them.

On another note, shares of Genentech have been flatlined for a while now (see the chart below) and are beginning to not look as overvalued as they have in the past. While a 30 forward P/E would rarely be considered extremely cheap, further weakness in DNA shares might allow for an attractive entry point for a firm that can grow earnings north of 20 percent per year.

Dow Hits Record on Democratic Sweep

Doug Kass, managing partner of Seabreeze Partners, predicted a Democratic sweep on CNBC’s Kudlow and Company program yestertday afternoon. The result, he thought, would be a severe sell-off in the market. Much like Kass’s calls for doom and gloom on Wall Street have been wrong in recent months, they were wrong this time as well. Now you can say that the Rumsfeld resignation helped boost stocks, which I cannot dispute, but the Dow was only down 25 points or so before that news hit the wires.

So why the positive reaction on Wall Street? There are weak spots. Healthcare stocks are down. Pfizer (PFE) down 2 percent is attractive. Sallie Mae (SLM) got hit too, as the Dems want more affordable college loans. But other areas, such as oil, are actually up and in some cases up strongly. Fears of a windfall profits tax are overblown. The idea is silly in a market-based economy. I’m glad that the Dems really aren’t pushing hard for it. As much as I don’t like the fact that big oil is getting tax breaks (I think that is one place the Dems can try and raise taxes and not take heat for it), passing on some of their profits to the government during good times is not a viable idea.

Anything truly outlandish would likely get vetoed by President Bush. The Dems will want to get things done, and if Bush shows any willingness to compromise on anything, we might get a handful of things done in Congress over the next two years. That is more than we can say about recent memory, so that is a positive development for the American people, and the stock market.

Regardless of what the Republicans say, Democrats are not bad for the economy and stocks. The numbers simply don’t support that view, in fact, they show the opposite. My very first post on this blog two years ago looked at the market and the economy under Democratic and Republican administrations. Economic growth, employment, fiscal responsibility, inflation, and stock market returns are all better under Dems. Now I know that Bush is still President, but the point is made merely to refute the idea that Dems having more power with respect to policy means lower stock prices. It’s simply untrue.


Another Golden Opportunity in Citrix Systems

Software maker Citrix Systems (CTXS) was one of the ten stocks I highlighted on the 2006 Peridot Capital Select List (which, by the way, has returned 18% year to date – look for an announcement about the 2007 Select List in early January). After posting a gain of 40% through the first six months of the year, in my Select List Mid-Year Update I recommended investors take their profits as the stock traded above $40 per share. It appears that we are getting another chance to make money in the name.

After an earnings disappointment, Citrix is trading back down to $28 and change, which is where I recommended purchase at the beginning of the year. Given that the company has the ability to grow sales and earnings at a low to mid double digit rate, the current valuation looks very attractive.

Estimates for calendar year 2007 stand at about $1.50 per share. The company’s balance sheet is pristine, with no debt and $736 million in cash, which equates to $4 per share in net cash. So, investors buying CTXS at $28 are getting a stock with an enterprise value of only $24 and $1.50 in earnings power. This equates to a 16 forward P/E multiple, which in my view is too pessimistic given Citrix’s growth outlook.

I would expect Citrix shares to head well into the thirties again during 2007, and as a result, suggest investors reenter the stock. Evidently, CTXS management agrees the shares are undervalued, as they just announced a new $300 million share repurchase authorization.

Full Disclosure: I own shares of Citrix Systems (CTXS), as do Peridot clients.

GE to Banc of America: Thanks for Trustreet

GE Capital must be very happy that most Wall Street analysts don’t have a clue how to value the companies they follow. On 10/30 they announced a deal to buy Trustreet Properties (TSY) for $17.05 per share in cash. Investors were rewarded nicely, as TSY investors are being paid a 36 percent premium to TSY’s closing price of $12.51 on 10/27.

Clients of Banc of America Securities, however, are far from thrilled. The investment bank initiated coverage of TSY in February with a “neutral” rating with the stock trading at $13.85 per share. By August the stock had dropped 17 percent and the analyst covering Trustreet, Ross Nussbaum, downgraded the stock to “sell” with the shares at $11.44 each. Oops.

Less than three months later, GE Capital swoops in and offers 49% more than where TSY was trading at the time of the “sell” recommendation. How these people keep their jobs baffles me. How can an analyst, whose sole job is to value public companies, be off by a whopping 50% when doing so? Clients who sold their shares at $11 and change must be fuming, as are those who shorted it after a rare “sell” call.

Meanwhile, smart value investors are smiling. The sell side analyst community continuously gives them gifts, like TSY at eleven bucks. GE Capital, too, must be thrilled that Mr. Nussbaum keeps his job despite being incredibly bad at it. After all, without so much analyst negativity, TSY shares might have been trading much higher, and GE Capital would have had to offer more than $17 to persuade Trustreet management to sell the company.

As usual, investors who listen to analysts get the worst of it. I know many of my readers are familiar with my advice to avoid paying attention to sell side analysts, and many of you do just that. Still, when things like this happen, I can’t help but mention them just in case some of you are suspect of my opinion.


How the Election Might Affect the Market

Stock markets will always react to elections in some way and this year should be no different. Fortunately, the volatility that is created, either in specific sectors or the broad market, is often overdone. This could create opportunities this coming week.

First, let’s tackle the broad market. This is fairly simple to gauge. Markets hate uncertainty, so any result at the polls on Tuesday that brings into question the political climate over the next two years should make some people nervous. However, any short-term weakness we see from this uncertainty should be expected to be fairly short term in nature. Traders always shoot first and ask questions later. Cooler heads usually prevail, and investors will jump in to correct any inefficiencies that were created by quick, emotional, and merely reactionary decision making.

As for individual sectors, the stock price movements will likely be very evident this year. Dems are talking about windfall profits taxes for big oil, as well as healthcare costs spiraling out of control. These two sectors will likely get sold if the Dems turn in a solid performance at the polls. So would contractors who have been making billions over in Iraq. Think Halliburton (HAL).

The question we need to ask ourselves, though, is how will this affect the next two years, really? Even if the Dems take both the House and Senate (I think this is quite unlikely) Bush will show us a new side of his; the veto side. Markets tend to like gridlock because it can result in compromise, which ultimately means things actually get done on Capitol Hill. However, Bush is hardly one to be receptive to compromise, so I wouldn’t hold my breath.

Overall, I think we can get some buying opportunities if certain sectors see sharp sell-offs on the heals of the election. Let’s keep an eye out for this and if anything peaks my interest, I’ll let you all know (and feel free to do the same).

And don’t forget to vote on Tuesday!