Comments on Tuesday’s 416 Point Drop

I know, I know… I write a stock market blog and have gone more than 24 hours without mentioning the fact that we got a 400 point drop in the Dow in a single day. Since I’m a long term investor and not a trader, the events of this week really aren’t all that important to me. I really didn’t do much of anything on Tuesday other than just sit back and watch the television screen after it became apparent that something was happening that we don’t see every day.

So, why haven’t I been very active in the market this week, and what do I think about the whole thing? First, while four hundred points sounds like a lot, in the whole grand scheme of things, it isn’t. From peak to trough, intraday, we saw a 5% drop in the S&P 500 over three trading days, which is pretty substantial, I admit. However, if you use closing prices it was less than that, and if you include Wednesday’s snap back rally, it was even less than that. Currently, the S&P 500 sits 3.7% below the highs it made in February. To me, this is much to do about nothing. If we had gotten a 3.7& drop over the course of a month or two, few people would think anything of it.

Let’s take a step back and put the drop in perspective. I began to get a little cautious when the S&P 500 crossed 1,400 because I thought the market was overbought. However, it kept going up, rising another 4% within weeks. Even with this 3.7% “correction” (I’m hesitant to say that it is over) the S&P 500 is still above 1,400. So, I don’t really think this pullback has been big enough to warrant putting every cent of cash to work. We just haven’t retraced enough of the gains for me to be optimistic that the smoke has cleared, hence I am not all too enthused about the market’s short to intermediate term prospects.

If the sell-off continues, which I suspect it might, then I will likely do some buying. I’d say we would need another 3% to 5% downside from here for me to get to that point. If we instead rally right back up to the highs, then my same overbought worries will persist and I will likely take some money off of the table to save up for a rainy day, or the next 400 point fiasco.

To sum up, I really don’t think too much has changed despite this week’s events. The market is still up a lot and even with the pullback, I still don’t think we are going to see double digit returns this year. It would still take a more typical market correction for me to get aggressive on the long side, so right now I’m really just focusing on individual companies in this environment.

Dow’s 400 Point Drop Aside, RadioShack’s Turnaround is Solidly in Place

Despite Tuesday’s dramatic 416 point drop in the Dow Jones Industrial Average, you may have noticed one stock that managed to gain 12% for the day. That stock was RadioShack (RSH), the electronics retailer that I highlighted earlier this month as a major turnaround candidate in retailing, similar to Sears Holdings (SHLD).

Why all the fuss over RSH shares when the rest of the market was getting pummeled? Well, the company reported fourth quarter earnings of $0.62 per share, soaring past the $0.43 forecasted by analysts. RadioShack also gave 2007 earnings guidance of $1.00 to $1.20 per share. That second part is most important because the average estimate for RSH’s earnings is $1.12 in 2008!

That’s right, analysts aren’t exactly confident about RadioShack’s prospects. In fact, heading into the earnings report, more of them rated RSH a “sell” than a “buy” (quite a rarity on Wall Street). Prior projections of $0.91 in EPS for 2007 and $1.12 in 2008 will obviously have to be adjusted upward dramatically, as the company is on track to beat the current 2008 estimate one year early.

Since the turnaround plan at RSH was not expected to be bearing this much fruit so early, the stock price is adjusting to the success newly crowned CEO Julian Day is having. The stock has gone straight up from $16 to $25 in recent months, so investors might want to hold off buying more until the stock pulls back a bit. However, the company’s turnaround plan is firmly in place, and equity holders will likely reap the benefits over the next several years.

Full Disclosure: Long RSH and SHLD at time of writing

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

Wall Street Likely to Yawn Despite Another Blowout Quarter for Chesapeake Energy

The hardest thing for value investors oftentimes is to stand by one’s convictions, even when Wall Street doesn’t seem to take notice of what you see. Shares of natural gas producer Chesapeake Energy (CHK) have been doing nothing for more than a year. Many investors have likely grown tired from Wall Street’s yawns and have moved on to more hip names. However, CHK’s fourth quarter earnings report issued yesterday afternoon once again shows that the company is clicking on all cylinders.


Chesapeake reported earnings of $0.90, 13 cents above estimates of $0.77 per share. Revenue came in at $1.87 billion, versus the consensus view of $1.52 billion. Spectacular quarters are nothing new for CHK, as they have reported stellar results for many quarters in a row now. However, the stock has merely been tracking the commodity price of natural gas, ignoring the fact that shares trade at 8 times trailing earnings and 5 times trailing EBITDA.

The weakness in Chesapeake shares, relative to its operating results, is likely due to two things. First, CHK has issued a lot of convertible debt to fund increased natural gas production, and continues to do so. In order to hedge their positions, buyers of the convertible debt simultaneously short the common stock in order to lock in the income generated from the convertible securities. The good news is that the land grab that CHK has embarked on is largely over so they are doing fewer acquisitions. In fact, CHK’s long term debt actually fell in Q4 for the first time in a long, long time.

Investors also worry about falling natural gas prices when analyzing Chesapeake shares. This explains why CHK has been following spot gas prices for months now. This logic, though, ignores CHK’s massive hedging activities (they sport the most aggressive hedging program in the industry). The company has hedged 50% of their gas production above the current market price for both 2007 and 2008. As a result, commodity price risk should not be a large concern for CHK investors.

As value investors know, it often takes a long time for Wall Street to realize that they have mispriced equities. Over the long term, CHK stock has reflected the value of its underlying business, even when short term movements do not. This time should be no different. And if the company’s management team grows tired of waiting for their value to be realized, they surely would have numerous options if they were to sell their company outright to get out of the fickle public marketplace.

Full Disclosure: Long CHK common stock, as well as the preferred “D” shares

Busted Dot-com Ideas Breathe New Life

If you remember the dot-com bust pretty well you may recall a company called AllAdvantage. Back in the 1990’s this Internet start-up was one of the first to recognize that online advertising really was the wave of the future. AllAdvantage paid you to surf the web. The idea behind it was simply to install a toolbar on the screen, fill it with advertisements, and the company could pay you to surf the Internet with money it got from the advertisers, and still have some leftover for itself.

AllAdvantage caught on with web users quite easily, as one could imagine. Just install this bar on your screen, ignore it when browsing online, and get paid. Since AllAdvantage didn’t require you to click on anything, it was quite easy to take advantage of the system. College students would leave their Internet Explorer browsers open on their computers when they left for the day, allowing them to collect money for “surfing” when they were really all the way across campus attending class.

Not surprisingly, AllAdvantage went under along with thousands of other web start-ups, mainly because it paid out more than it collected from advertisers. There was no safeguard to assure that would not happen. However, it appears the business model is making a comeback.

A new company called Agloco has improved upon the model. Again, you install a toolbar and get paid for surfing the web just as you do now. However, web surfers get paid a cut of any ad revenue that is generated, thereby ensuring that Agloco doesn’t paid out more than it collects. So, users will need to use the toolbar’s search engine or click on ads in order for the model to generate revenue to distribute to users.

Whether or not the idea will work remains to be seen. However, the service is set to go live shortly, and those who made a killing off of AllAdvantage before it went belly-up, or anyone else who is interested, can sign up at Agloco’s web site and they will email you when the service goes live.

Is Halliburton’s Discount Warranted?

As energy investors are aware, shares of Halliburton (HAL) have been trading near historically low valuations for much of the recent past. I have largely dismissed the discount as being merely a consequence of having a huge amount of U.S. government business due to the Iraq war. Once that is over, or as soon as the Bush Administration was out of office, my thinking went that huge no-bid contracts allowing the company to charge the government anything they wanted would vanish, and Halliburton’s financial performance would lag. Hence, the stock is discounting this reality in the marketplace.

With the Halliburton spin-off of its KBR (KBR) subsidiary, all of the sudden we have the division with much of the Iraq war criticism tied to it trading on its own. After Halliburton disperses its majority stake to shareholders, Halliburton will look a lot more like a leading oil services company, and much less like a company being propped up by the Bush Administration, and more specifically, former CEO Dick Cheney. Interestingly, in 2006 KBR represented 43% of sales for HAL, but only 7% of operating income.

The KBR-free Halliburton would once again be a good comparable for Schlumberger (SLB), the other large services company that, before the war in Iraq, traded very similarly on Wall Street. With such a scenario unfolding, there might not be a good reason to have a such a wide valuation disparity between the two largest energy services firms.

Both stocks have similar dividend yields of around 1% per year. HAL trades at 12.3 times 2007 profit forecasts, versus 16.8 times for Schlumberger. As much as I wanted to come to another conclusion, based on political views of the Iraq war, I must admit that the stock is cheap. A purely long play on HAL, or a paired trade with a short Schlumberger position to play a possible narrowing of the valuation gap, could be attractive.

Full Disclosure: No positions in the companies mentioned

Don’t Expect Express Scripts to Bow Out of Caremark Bidding

Pharmacy chain CVS (CVS) has increased its bid for Caremark (CMX) by $4 per share in an attempt to secure the pharmacy benefits manager. Rather than simply raise the per-share amount of its merger offer, CVS has chosen the unconventional route of sweetening its offer by promising a special dividend to Caremark holders should the deal go through. With CVS increasing the proposed special dividend to $6 from $2, their offer is now fairly comparable to the opposing cash and stock offer from rival Express Scripts (ESRX).

You may recall I already weighed in on this rare type of deal sweetener in January. I still believe offering a one-time special dividend to CMX holders is more like changing the deal terms from all-stock to cash and stock, since CMX shares will go down after a one-time large dividend is paid.

With the bids more similar now, I would expect Express Scripts to raise its offer shortly, perhaps as early as after the close today. They will not go the special dividend route. They want Caremark badly and realize that in order to convince Caremark holders to merge with a main competitor, and not a retail pharmacy, they will have to pay handsomely.

With consultants having already recommended investors reject the prior CVS offer, Express Scripts may very well land support for an increased bid, as they know that CVS is being very conservative with their special dividend strategy. All in all, I think Caremark prefers to do a horizontal merger with CVS, rather than a vertical integration with Express Scripts, but the offers must be at least comparable for such a move to survive a shareholder vote.

Full Disclosure: No positions in the companies mentioned

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

Altria to Spin Off Kraft… Shocking!

It’s amazing how many people have been quoted saying the Altria (MO) spin-off of its 89% ownership of Kraft Foods (KFT) will send the shares of MO to between $100 and $110 each. If we’ve known about the spin-off forever (we have, even though the exact date was just announced) why has the stock been trading in the mid 80’s? I guess I’m just not convinced that something like a spin-off, that surprised absolutely no one, will result in a 20% move in the shares of a company that, let’s face it, makes cigarettes.

Altria shares, ex-Kraft, trade at about 15 times 2007 earnings. Is this a bargain for the leading maker of so-called “cancer sticks?” Doesn’t seem to be. How much will investors be willing to pay for a company that sells a product that kills people and is hardly a rapidly growing market opportunity? Although the decline won’t be as rapid as many of us would like, I have to think that over the long term the number of people who smoke will go down, not up.

For this reason, shares of cigarette firms, including MO, traditionally have traded at a discount to the market. With shares of Altria trading at about a market multiple, it’s hard for me to understand why the actual spin-off of Kraft will cause a huge stock price spike. Such a move would require either 1) investors paying an above-average multiple for a business with a below-average growth rate, or 2) a dramatic increase in future earnings due to the financials flexibility that the spin-off provides.

The latter seems more likely than the former, but I still think Altria shares are fairly valued at current prices. In fact, it’s interesting to note that MO stock has actually dropped from above $87 to $85 since the company announced the details of the Kraft spin-off. The stock remains an excellent dividend play, but investors expecting an immediate move up to $100 or more might have to wait a little longer than some are predicting.

Full Disclosure: No position in MO