RadioShack Earnings Prove Naysayers Wrong Again

Despite bearish stories out of Barron’s and the Wall Street Journal in recent weeks, electronics retailer RadioShack (RSH) shook up those betting against the stock this morning by reporting first quarter earnings that more than doubled analyst estimates. Shares are up nearly 10% this morning.

If this sounds familiar, it is exactly what has propelled shares of Sears Holdings (SHLD) from $15 to more than $190 each. Analysts, reporters, and industry experts will always sound the warning bells when they see overall sales declines, especially same store sales. Although many believe SSS to be the best indicator of a retailer’s health, stock prices reflect earnings, not sales.

We are likely to continue to see naysayers complain about poor sales at RadioShack. After all, they did the same thing with Sears and even continue to do so, despite the stock’s astronomical move. I would expect analysts to continue to underestimate the earnings power of RSH, just as they have done with SHLD. As a result, neither stock is ripe for sale yet despite the fact that negative press will continue to cause temporary worries and sell-offs along the way.

As I have written about before, RadioShack is imitating the Sears Holdings model of ridding itself of unprofitable sales. Over the last three months, RSH has shrunk its business from 6835 retail locations to only 5205. The result of closing underperforming stores has been declining sales, as one would expect, but gross margins jumped to 52% from 48% last year and earnings soared to $0.29 per share, more than doubling the consensus forecast of $0.14 per share.

Full Disclosure: Long shares of RadioShack and Sears Holdings at the time of writing

Finding the Next Starbucks – Part 3 – Compound Interest

“Compound interest is the eight wonder of the world.” – Albert Einstein

The above quote leads off chapter two of Michael Moe’s book, “Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow.” Although we learn about compound interest and the Rule of 72 in our high school math class, sometimes it takes some financial related calculations later in life to really drive the point home, enough so that it will have an effect on our saving and investment habits during adulthood.

Moe uses two compound interest examples that are worth repeating here. Although both cases are impossible to be recreated in the real world today, the dramatic numbers should at least intrigue people enough to run the numbers on their own individual financial plans. The results will still most likely be surprising for many of you.

Example #1

Purchase price for Manhattan Island in 1626 by Dutchman Peter Minuit: $24

Value today if invested at 5.0% annual rate of return: $2.7 billion

Value today if invested at 7.5% annual rate of return: $20.7 trillion

Value today if invested at 10.0% annual rate of return: $128.7 quadrillion

Example #2

You have landed a consulting job for the month of January. Your temporary employer has given you the option of earning $10,000 per week or earning $0.01 on the first day and having your daily pay double each day thereafter for the remainder of the month. Which payment plan should you choose?

Earn $10,000 per week for the month = $40,000

Earn $0.01 on first day, double every day = $21.5 million

While these examples are meant to be fantasy, not reality, compound interest is still a very important concept to consider when you are contemplating your saving and investing plans.

This post is the third in a multi-part series discussing the book Finding the Next Starbucks. You may read Parts 1 and 2 in the series below:

Finding the Next Starbucks – Part 1

Finding the Next Starbucks – Part 2

Finding the Next Starbucks – Part 2 – Definition of Risk

Before I delve into some of the specific investment concepts that Michael Moe covers in his book,“Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow,” I want to talk about one of the passages that appears in the first 10 pages that sets the stage for finding a great growth stock. Despite Moe’s focus on growth, he does an excellent job balancing that objective with a value-oriented, contrarian approach (which is a big reason why I think the book is worthwhile for a value investor as well). Consider the following excerpt from Chapter 1. I want to drill down on one sentence in particular, but these three paragraphs are very important for any investor, regardless of what types of investments they are looking for.

“Ultimately, in sports, gambling, investing, and life, there is little value in knowing what happened yesterday. The largest rewards come from anticipating what will occur in the future. As Warren Buffett once said, ‘If history books were the key to riches, the Forbes 400 would consist of librarians.

Fundamental in our pursuit of attractive investment opportunities is my philosophy of risk and reward. I view risk as measuring the potential for permanent capital loss, not short-term quotational loss, and assess the probability of that against what we think the value of the business will be in the future.

It is with this perspective that I fly right in the face of conventional wisdom, which suggests the bigger the return, the more risk one has to assume. From my point of view, large returns will occur when we find an opportunity where the upside potential is substantial, yet the price we pay for it is not. My goal is to find a stock whose price is below what I think the appraised value should be, not what the quotational value is as indicated by the current market price.”

Much of that may seem logical and obvious to a value investor. However, to a growth investor it may be a bit off-topic. After all, they focus on growth first, with valuation often trailing in importance. By combining the two, as Moe suggests, you can significantly boost your chances of finding the next great growth stock.

I want to expand on one part of that passage:

“Conventional wisdom, which suggests the bigger the return, the more risk one has to assume.”

It amazes me that “risk” is almost always defined as how volatile a stock is. If you open a college level finance textbook , risk is almost always defined as how much a stock moves up and down relative to some other benchmark. In most cases, a stock’s beta is used to compare an individual stock’s “risk” with that of the overall market, the S&P 500 index. So, a tech stock with a beta of 1.50 is much more “risky” than a utility stock with a beta of 0.50.

I strongly disagree with this assertion, and it appears Michael Moe also objects to this conventional wisdom. Should the words “risk” and “volatility” by synonymous? I don’t believe so and let me explain why. Consider two stocks you are evaluating for a one year investment horizon. Both stocks currently trade at $50 per share. After doing a careful analysis you determine that:

*Company A has a 70% chance of rising to $60 in one year, and a 30% chance of falling to $40 in the same time frame. The stock’s beta is 1.50.

*Company B has a 50% chance of rising to $55 in one year, and a 50% chance of falling to $45 in the same time frame. The stock’s beta is 0.75.

Which stock is more risky?

If you consider risk to be volatility, you are going to say Company B is less risky. If you calculate the expected value of Company B stock in a year, you get $50.00 per share, a zero percent gain.

If you consider risk , as I do, to be the odds of permanent capital loss, you will conclude that Company A is less risky. Not only is your expected value in a year higher ($54.00, a gain of 8 percent), but the odds of losing money are only 30 percent, versus 50 percent for Company B.

I would argue that Company A is less risky despite the fact that the betas of each stock imply that Company A will move twice as much, in percentage terms, during the typical trading day. In my view, risk and volatility are different animals. For me, risk is defined as the probability that I lose money during my desired time horizon for a particular investment.

If I’m investing for one year, I want to minimize the odds that after the year is up, I am underwater on the investment. How volatile the share price is during that year is pretty much irrelevant to me because if my analysis is correct, the stock will be worth more than I paid for it after a year’s time.

This post is the second in a multi-part series discussing the book “Finding the Next Starbucks.” You may read Part 1 in the series here: Part 1 and be sure to stay tuned for more posts in the series.

 

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Finding the Next Starbucks – Part 1

I just crossed another book off of my Amazon Wish List and got the idea to feature monthly book reviews on The Peridot Capitalist. It might be a stretch to pin myself down to reading a new book each and every month, so I won’t make any promises. But let’s just say that I will plan on sharing positive reading experiences with you all in the future. I won’t commit to a specific review frequency in order to ensure that I make suggestions because they are worth your time, not just because the calendar flipped to a new month.

Anyway, I just finished “Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow” by Michael Moe, founder and CEO of ThinkEquity Partners. At first I was leery of the book simply because of the title. In my opinion, many investors obsess over finding the next Microsoft or Google, when in reality, the odds of doing so are close to zero. The end result is people getting caught up in “story stocks” without any regard for the stock’s valuation relative to what a reasonable growth assumption would be.

The most recent example of this was Sirius Satellite Radio (SIRI). For months it was the stock I got more questions about than any other. I wrote about it several times back in 2004 and 2005, explaining how the shares were trading at levels that couldn’t be justified with any degree of confidence as far as future financial projections were concerned.

Still, you could tell many people really thought Sirius could be the best performing stock of the next decade and they just had to own it. The single digit price tag fueled the urge even more, as they thought the stock was so cheap. Well, today Sirius stock fetches a mere $2.77 a share (down about 70% in less than three years) and is fighting to merge with their only competitor in order to stay afloat. Sirius and XM Satellite (XMSR) were worth more than $20 billion combined back then. Today that figure stands at just a little over $7 billion.

Despite my initial skepticism, Michael Moe really never started to lead readers down the path that usually results in buying Sirius at 9 bucks. As a result, I was pleasantly surprised with the book because it was able to focus on growth investing, but also did not ignore the valuation component. Too often people assume that if a company grows fast enough, they will make a killing regardless of the price they pay. The book outlines some very good lessons to follow when investing in growth companies, and although I didn’t agree with everything contained in the 300 plus pages, Finding the Next Starbucks is definitely worth a read.

Since it will take quite a bit of space for me to discuss the major points I think are important in the book, I will spread out my comments over several posts in coming days. Stay tuned for more to come and perhaps we can get a solid discussion going as well.

Capital One Reduces Guidance on Mortgage Weakness

Frankly, I prefer my headline above to the one I saw atop an Associated Press piece on Friday that was quite a bit more frightening:

“Capital One’s Mortgage Woes Lead To Profit Plunge”

It’s a shame that whoever wrote that article didn’t really do much research before writing about the company’s first quarter earnings report last week.

First, the facts:

1) Capital One’s first quarter earnings fell 43% to $1.62 per share from $2.86 in the year ago period.

2) Capital One reduced 2007 earnings guidance from $7.60 to $7.20 per share.

What about mortgage woes leading to a profit plunge? Why isn’t that fact number three? Well, that’s not really what happened. The year ago comparison was affected by one-time gains in 2006, so profits really didn’t fall by 43 percent on an apples-to-apples basis, despite what many articles have stated.

The weakness in the mortgage market was the main reason Capital One reduced guidance for the year by 40 cents, but it was not a large contributor to the widely reported (but misleading) 43% profit decline. Capital One’s mortgage business lost $12.6 million in the first quarter, reversing a year ago profit of $35.4 million.

Since Capital One has 415.5 million outstanding shares, we can calculate how much the mortgage business contributed to the profit decline. A delta of $48 million equates to a negative impact of $0.12 per share. Twelve cents! The sky is hardly falling. Capital One’s mortgage division is a very small part of their business. Last year they bought North Fork, a New York regional bank with a mortgage division called Greenpoint. Even after the acquisition, most of COF’s profit stills comes from credit cards, not mortgages.

As for Capital One stock, it’s no surprise that the shares fell more than $4 after releasing a weak earnings report and lower guidance. As I mentioned recently when talking about M&T Bank, the regional banks will have short term earnings pressure due to the flat yield curve and a weak mortgage environment. First quarter reports from these banks will be disappointing, as was the case with both MTB and COF.

However, investors in Capital One stock (myself included) should view the shares as a long term investment. The current banking environment (flat yield curve and unprofitable mortgage lending) will not persist forever. Now, I do not know when mortgages will return to the black (Capital One is assuming no incremental mortgage earnings in 2007) and I can not tell you when the yield curve will steepen. It might be six months, one year, two years, I just don’t know. Frankly, nobody predicted the yield curve would stay flat this long. In fact, this is the longest period it ever has stayed flat without a recession. However, that time will come. It always does.

Why should investors continue to hold consumer lending stocks like Capital One if 2007 earnings are likely to be weak and positive catalysts could be months or even years away? Because the stock is a bargain. If you wait until the mortgage market improves and the yield curve steepens, COF shares will be $90, not $70, and you will have missed 20 points very, very quickly.

How much downside is there in Capital One stock in the low 70’s? Not much in my view, it probably continues in its recent trading range (the stock has been dead money for a while). Even in the negative business environment we currently see for consumer lenders, COF is still most likely going to earn more than $7 per share this year, giving the stock a P/E of 10 on a depressed earnings level. Once things improve, earnings will soar and the multiple should expand. When that happens, COF could easily be in the triple digits, but unless you buy the stock beforehand, the train might leave the station without you.

Full Disclosure: Long shares of Capital One at time of writing

Could We Get a 7-Year Double Top on the S&P 500?

This really isn’t a prediction as much as it is just mere speculation about what could happen to the market in the coming weeks and months. Short term movements don’t really concern me as I mostly just focus on undervalued companies regardless of market level, but sometimes it’s still interesting to point things out.

A lot is being made about the Dow making new all-time highs lately, but as many of you know, the S&P 500 is still about 3 percent below its peak from the year 2000 at the 1,527 level. Here’s a 10-year chart of the S&P 500 index:

One possible scenario would be for a long term double top around that level. A lot of strategists are dissatisfied with the 7 percent correction we got in March and want some kind of retest of that level, or even better, a full 10 percent correction in the S&P 500 so we can get that monkey off our back.

Is a double top around 1,527 the most likely scenario? Of course not, but it’s still interesting to think about. I definitely would not rule it out and it would make for some good headlines. The market is clearly overbought, so if we truly need another pullback, as many seem to think we do, what better way for it to play out? It would make for a very intriguing chart pattern, one that technical analysts could cite for years.

Don’t Get Caught Up in Optimism from Company Management

Aside from company-specific issues at Yahoo! (YHOO), the main takeaway from the search giant’s poorly received first quarter earnings report should be to take what management says with a grain of salt. Yahoo! stock soared from the high 20’s to the low 30’s after CEO Terry Semel went on the record saying how great its new online advertising system, Panama, was going to be. Obviously, when investors saw poor results and a lackluster outlook from the company, they felt blindsided.

Why would Terry Semel be so optimistic when the numbers didn’t reflect that optimism? Because he’s the CEO. Management always sees the glass half-full. Many of them believe it is their job to be company cheerleaders. Very few executives refrain from trying to spin anything to be as positive as they can. Investors need to keep that in mind. Don’t go out and buy a stock just because you saw the CEO on television and he or she was bullish.

It can be hard to ignore that sometimes. After all, if you watch shows like Jim Cramer’s Mad Money, these guys are always brought on camera to defend their company against negative press or to hype their next big thing. A lot of these people are pretty darn good at telling their stories.

Since management will often spin the truth, does that mean that investors should dismiss everything a CEO or CFO ever says? Absolutely not. This is how I would judge these comments. Don’t just take what they say as gospel. Managers should earn your trust. Carefully monitor what they say over an extended period of time and compare that to what actually happens.

If you follow this logic, only managers that tell the truth and consistently understand their businesses should earn your trust. Armed with this knowledge, namely a management’s track record talking to investors, you know who to listen to and who to dismiss as merely a cheerleader.

Successful investing is not easy. If you could just watch TV and make money like Jim Cramer says, everybody would be rich. However, we know that doesn’t work. After all, most professionals can’t consistently beat the market. If you want to be in the small group that does, be skeptical when company management teams start telling you how great things are unless you have reason to believe they know what they are talking about.

Full Disclosure: Short shares of YHOO at time of writing

Five Reasons to Sell Your Yahoo Stock

Shares of Yahoo! (YHOO) are falling 5 percent in after-hours trading tonight after the company reported first quarter earnings of 10 cents per share, a penny below analyst estimates. If you are an investor in the company, here are five reasons to sell your stock:

1) They are overhyping Panama

CEO Terry Semel and company have been hyping their new ad platform, Panama, ever since it launched. Yahoo! stock has risen 25% so far in 2007 mostly due to the fact that it appeared the new system would really boost results. With first quarter profits below expectations and second quarter guidance in-line with projections, it appears they are overhyping Panama’s potential and any benefits from it are clearly priced into the shares already.

2) Growth in the U.S. is over

I was amazed when I saw this figure in their press release. Revenue in the United States for the first quarter was $1.1 billion, growth of zero percent over 2006. This should be a red flag. It’s true that international market opportunities trounce those domestically, but Yahoo! stock is selling for prices that reflect a high growth Internet leader. With no growth in the U.S. it will hard for the company to deliver superior results going forward.

3) Their time has passed

There was a time when Yahoo! was hot. Those days are over. Their email is still popular and I pay them 20 bucks a year for their fantasy sports program, StatTracker, but Google is eating their lunch in search and other properties Yahoo! bought a long time ago to diversify out of search (HotJobs, etc) just are not going to be growth engines. They just can’t stand out from the crowd anymore.

4) Google is eating their lunch

When Google reports first quarter numbers on Thursday, you won’t see U.S. growth anywhere near zero. Google has taken over Yahoo!’s leadership position in search and internet advertising and has the cash stockpile to continue to innovate and grow faster than Yahoo! can. There is certainly room for more than one player in this market, but without major changes at Yahoo! it is hard to see how they will reinvent themselves.

5) Google shares are cheaper

This is best reason of all to sell the stock. Google has the momentum, more growth, more resources, and amazingly, a cheaper stock! Google shares trade at a 2007 p/E of 33, versus 59 for Yahoo. Why not just sell your Yahoo! shares and buy Google? There is more growth potential and even if you believe the potential to be a little overhyped, you are paying a lower multiple of earnings to get a faster growing business anyway.

Full disclosure: Long Google and short Yahoo! at time of writing

Market Correction Comes and Goes Much Like Last Year

Did you notice the S&P 500 hit a new high today? It seems this market corrects much more fast and furious than in prior periods, but the corresponding snap back is just as quick. If you blink, you might miss it. Just last month we were spooked by a 400-point one-day drop in the Dow after a huge sell-off in the China market. Chinese stocks rebounded to make new highs and now the U.S. market has done the same. The 2006 correction was very similar, short and swift. In fact, compare the two charts:


Bears will undoubtedly be looking for a failed breakout and another leg down. Despite the fact that the market has been pricing in an interest rate cut, and yet no rate cut seems imminent, stock prices keep chugging along. I am in the camp that believes the Fed is on hold and won’t cut rates due to a perceived credit crunch. Things would have to get meaningfully worse on that front for Bernanke to move, in my opinion.

Where does that leave stocks? I am still standing by my mid-to-high single digit return prediction for the U.S. market in 2007. Currently the S&P 500 is up 3.5% year-to-date. I just can’t get overly bullish with decelerating profits and a Fed that is still concerned with inflation. What would be the catalyst for a big move up? Earnings would have to really be strong. I’m not expecting a huge downward revision to current estimates, but this economy doesn’t seem to me to have much upside right now.

With what we know now, the market seems pretty fairly valued overall. I think we’ll trade between 14 and 16 times earnings in this environment. The strategists calling for P/E expansion I think are dreaming. Sure employment is high and interest rates and inflation are relatively low, but we still have single digit earnings growth and a slightly above-average valuation on the market. Hardly reason to be overly bullish.

In times like these, I’d suggest investing in cheap companies rather than a fairly valued market.

Merck Does Investors a Favor

Shareholders in Merck (MRK) must be breathing a sigh of relief. An FDA panel voted 20-1 against approving Arcoxia, the company’s experimental arthritis pain killer, but the stock rallied $1.50 in after-hours trading Thursday night. Why such enthusiasm? Merck just happened to announce an increase in earnings guidance for 2007 right after news of the FDA committee’s decision hit the wires.

While many companies fail when it comes to looking out for investors, Merck deserves kudos for the timing of this announcement. An increase in 2007 guidance to $2.80 per share, versus current consensus estimates of $2.65 is more than enough to reverse the stock’s direction short term. Had the company waited until later in the month to announce the profit projections, the stock likely would have just recouped the losses suffered due to the FDA decision. Now, investors get a higher stock price despite the overwhelming angst over Arcoxia.

Now, one could argue that Arcoxia was not expected to be approved, so perhaps the stock would not have fallen very much. After all, the drug is a Cox-2 inhibitor, same class as Vioxx. However, by timing this announcement the way they did, at the very least it tells shareholders that the company does have its share price on the radar screen. That is a lot more than many public companies these days can say.

Should you go out and buy the stock hand over fist? That might be a bit extreme. Merck trades at 17 times the updated 2007 profit estimate. That seems about right to me. Throw in the 3.3% dividend yield and you have large cap stock that I would characterize as a solid hold, especially if the market’s jitters from last month come back later in the year, but not something you need to be throwing fresh money at all of the sudden.

Full Disclosure: No position