Book Review: Grande Expectations – A Year in the Life of Starbucks’ Stock

Recently I was asked if I would consider reviewing a new book about coffee giant Starbucks (SBUX) entitled Grande Expectations – A Year in the Life of Starbucks’ Stock. I am not a shareholder in the company, but I am very familiar with the loyal customer base they have been able to amass over the last fifteen years or so since the company’s 1992 IPO. Although I am not a coffee drinker, my mother is among the millions who rarely go a day without visiting the neighborhood Starbucks store.

One of the reasons I agreed to read and review the book is because the performance of Starbucks over the last three years has been a valuable lesson for growth stock investors and I was curious to see what conclusions the author, Karen Blumenthal, would draw based on her research. As you may know, Starbucks shares have been dead money since late 2004 despite the company’s continued growth. Even in the face of the chain’s 20% annual growth rate, investors have been disappointed in recent years mainly because although growth has been strong, the stock’s P/E has been compressing, which more than offset any earnings growth.

Blumenthal essentially devoted a year to following Starbucks. She visited investors (both retail and professional), attended the annual meeting, met with analysts, and spoke directly with the company’s management team, all in an effort to find out what kept the Starbucks story ticking and what issues the company and its investors faced every day.

After reading Grande Expectations, it seems to me that there would be three main groups of people who might be intrigued by the work. The first group is the most obvious, Starbucks enthusiasts. The book does a great job of giving readers an inside look at the company’s history, how it operates, and what exactly management spends most of their time thinking about. If you want an insider’s perspective, Grande Expectations will likely be an enjoyable read.

The book is also being marketed as a investor tool to provide “unique lessons in understanding how the market really works.” On this end, I think it is important to distinguish between which type of investor would benefit from the book. I would recommend Grande Expectations for beginner investors who want to learn more about the basics of how the stock market works, how the industry players are related, and how various segments of the investment advisory business (research analysts, retail shareholders, mutual fund managers, etc) play a role in the investment process.

Blumenthal spends a good deal of time talking not about Starbucks specifically, but how, for instance, a research analyst following the company does his/her job, or how a mutual fund manager decides to buy or sell the shares. If you are interested in learning more about these players, in addition to learning about Starbucks specifically, then the book could be valuable.

Aside from Starbucks watchers and novice investors, I don’t think experienced investors, professional or individual, would learn a lot from the behind-the-scenes look the book offers. These people, myself included, already know how the industry operates and I found myself skimming through some of the book, including parts like one that explained Reg FD or the supposed wall between investment banking and sell-side research analysts. If you are looking for new insights as to how the pros do their jobs, in hopes that it will enable you to boost your investment returns, I would say that would only be case if you are not already an experienced investor.

Surprisingly (or not surprisingly given the author is a journalist, not an investor) the book really does not focus much on the reason why Starbucks stock has underperformed in recent years (P/E compression). Most of the investors cited in the book admit the P/E is high, but continue to hold or buy the stock because of the company’s consistent growth. This logic can be acceptable to an extent, and is the reason why Starbucks deserves an above-market multiple, but paying 40 or 50 times earnings eventually will come back to haunt you. Investors have seen this firsthand during the last three years as shares have moved sideways due to P/E compression completely offsetting earnings growth.

All in all, this book provides excellent insights for novice investors and loyal followers of Starbucks, but falls short in providing extremely valuable investment insights that could not be found in most other investing books already on the market. As a result, I would expect other reviews to be mixed depending on which perspective the reader has on Starbucks stock.

Don’t Blindly Follow Carl Icahn (or anyone else for that matter)

From the Associated Press:

BONITA SPRINGS, Fla. (AP) — Shareholders of WCI Communities Inc. elected billionaire Carl Icahn to the board of the struggling homebuilder on Thursday, more than four months after management rejected his $22-per-share takeover bid. Icahn and WCI clashed for weeks over Icahn’s proposed takeover and control of the board, each urging shareholders to support their candidates, before settling recently on the compromise approved Thursday. WCI nominated three of its candidates, plus Icahn and two of his candidates. Three additional directors were nominated jointly by WCI and Icahn. Icahn companies control more than 14.5 percent of WCI.

That’s right, Icahn wanted to buy WCI for $22 per share. The stock currently trades at $9. That boneheaded bid lands him a board seat because of his 15% stake in the company. But hey, if I was a shareholder and he bid $22, I’d vote him on the board too.

Seriously though, I bring this up because many investors blindly buy stocks that billionaires like Icahn and Buffett get involved with. Although they make a lot of money, they are human too, so they make mistakes just like the rest of us. As a result, do your homework even if you want to follow a great investor into an investment. If your research yields a strong reason to buy (which would likely not have been the case with WCI) then at least you have less of a chance of making a mistake.

Full Disclosure: No position in WCI

Forget Betting on NFL Games, Wager on Fantasy Performances!

I probably wouldn’t have seen this story if I didn’t have a merger arbitrage position in Station Casinos (STN), but I’m glad I did. It turns out that Station sports books in Vegas are now going to let you bet on your fantasy football players. Here is the first couple paragraphs of the AP story:

Vegas Sports Book to Take Fantasy Bets

Thursday August 30, 12:33 pm ET

By John Mcfarland, Associated Press Writer

Las Vegas Sports Book to Start Taking Bets on Players’ Projected Fantasy Statistics

The billion-dollar business of fantasy football is getting another new player: Las Vegas oddsmakers. Station Casinos Inc., the fifth-largest sports book in the country, was to become the first to release a betting line — at 7 p.m. EDT — and start taking wagers based on players’ projected fantasy statistics.

So instead of plunking down a bet on whether the Saints will beat the Colts next week, or how many points will be scored, a better in Vegas can wager that Reggie Bush will finish with more than 16 fantasy points. Or that Peyton Manning might be under 21.

I can just see it now. People betting against their own fantasy roster to ensure they win some cash, either from their bets or from winning their fantasy league. It really is a good idea for Station though, as I have no doubt there will be enough people doing this to make it worthwhile for their books.

Full Disclosure: Long shares of Station Casinos until the merger closes

Inventory Levels Suggest Housing Market is Far from a Bottom

There are undoubtedly a bunch of contrarians tying to find a bottom in the housing market, but I don’t see any evidence that a rebound is anywhere in sight. The key metric here is home inventories. Without a drawdown in the inventory of unsold homes, prices will not stabilize, let alone begin rising again.

The July report from the National Association of Realtors shows single family home inventories jumping more than 2% year-over-year to nearly 4 million units. Not surprisingly, sales for the month dipped to a five-year low and prices fell 0.6% from last year.

Including condos, inventories soared 5.1% to a record 4.59 million units, putting total inventory at a 9.6 month supply. It’s going to take a long, long time to work through that much supply, so don’t expect the housing market to stabilize anytime soon.

Bank of America Tries the Value Game with Countrywide Investment

In recent years Bank of America (BAC) CEO Ken Lewis has taken a decent amount of heat from shareholders who have seen his acquisition spending spree as a bit reckless, at least in terms of the prices he has been willing to pay. Deals for the likes of FleetBoston and MBNA have made sense strategically, but the huge premiums offered did little to convince BAC investors that they were getting a good deal. That, in part, has contributed to the fact that BAC has been afforded a low multiple in the marketplace, relative to other large banking institutions, in recent years.

I found it interesting, given the deals that Bank of America has done already this decade, when news crossed the wires that BAC was investing $2 billion in Countrywide Financial (CFC) in the form of convertible preferred stock. The terms of the special stock issuance (a 7.25% annual coupon, convertible into almost 20% of the company’s common shares) were attractive, but that would be expected given the turbulence in the mortgage market right now. Countrywide is the largest independent mortgage lender in the nation, but still is facing short term funding concerns as the commercial paper market, a key tool for the company, has been drying up quickly in recent weeks.

With this deal, Lewis seems to be taking a contrarian approach. Obviously, I will not fault him for that given my investment strategy preference, but I just found it interesting that he had the patience to not bid for CFC when mortgage times were good (evidently the two firms have been talking about possible partnerships for years) and was able to pull the trigger when most others would be too afraid to do so.

Only time will tell if the Countrywide investment was a good one, but I like what Lewis did here. He gets CFC shares at $18 each if the company comes out of this mess a strong survivor, gets paid 7.25% per year while he waits for things to play out, and slides ahead in line of common stockholders to claim any assets should the worst case scenario unfold for the country’s leading mortgage player. Evidently he thinks the possible bankruptcy rumors are unfounded, and if he’s right, shareholders will have a tough time arguing with this latest deal.

Full Disclosure: Long shares of Bank of America at the time of writing

Barron’s Points Out Cramer’s CNBC Performance Fails to Impress

A very interesting cover story in Barron’s this week about CNBC market guru Jim Cramer and the track record of his investment recommendations on his nightly television show, Mad Money. Essentially, Cramer’s picks were found to have lagged the market over the last two years. While certainly not surprising to professionals, many retail do-it-yourself investors need to be aware of this story.

I wanted to write about it because I get a lot of emails asking about certain stocks, and very often the inquiries I get coincide exactly with new Cramer picks. Given Cramer’s successful stint as a hedge fund manager, many may be surprised to learn that his picks don’t perform well at all relative to the overall market. However, there are reasons this should not be very surprising.

The most glaring that I can think of is that Cramer needs to fill an entire hour of television time five days per week. That means he needs to come up with a handful of “great, new investment ideas” each and every day. Logic should tell you that there simply aren’t that many great investment opportunities. How much confidence do you think he truly has in every pick he highlights on his show? He might not concede anything himself, but watchers of his show should keep in mind that making so many picks almost ensures that you get a good mix of bad ones to go along with the good ones. You really can’t expect anyone, Cramer included, to post market-beating results while giving out so many recommendations.

You should also keep in mind that Cramer is no longer in the hedge fund business, he’s in the entertainment business. He wants to bring in viewers and in trying to do so, he needs to make it interesting so people keep coming back. In doing so, it would not be surprising to think he might try and get viewers a little more excited about his picks than is warranted. In trying to boost his ratings, it is understandable that he might cheer lead a little bit more than the typical market professional. Not surprisingly, this might set his picks up for disappointments on the performance front.

I’ll leave this topic with one more point about Cramer. To his credit his record at Cramer Berkowitz, his hedge fund, was very good. I believe his investors’ returns net of fees were around 24% annually, or something in the mid twenties (I read his autobiography, but it was awhile ago). This number, on the surface, appears to be excellent. However, keep in mind a couple things about that figure.

First, Cramer ran his fund from the early 1980’s through the 1990’s. Essentially, his time running money professionally overlapped exactly with the greatest bull market our country’s stock market has ever seen. I believe the S&P 500 compounded at around 15% per year during his hedge fund days. So, it’s not like he was making 20-something percent during a time when making money was difficult.

Second, if you read his autobiography, Confessions of a Street Addict, you’ll learn that he made a lot of that money in some pretty interesting ways. Since he was a big player, he made tons with IPO share allotments that he was allowed to flip on the first day of trading, which amounted to free money with little risk. In his book he also talks about how he would get word of analyst upgrades and downgrades before the information was made public to everyone, because his firm was a big client of the investment banks who issued sell-side reports.

If you factor in the market averaging 15% and throw in the other ways in which Cramer was able to make money for his clients with very little effort or insight, you might understand a bit more why his picks on Mad Money have left much to be desired. If you want to learn about the market and be entertained, Cramer can have a lot to offer. For stock picks though, I would not suggest you tune in for that reason alone.

Capital One Shuts Down Mortgage Unit, Shifting Attention To More Profitable Areas

Those who have said the mortgage market’s survivors will thrive due to fewer competitors are certainly right, but as the Capital One (COF) announcement last night shows, even those that could survive might not even try to do so. The company has decided to shut down its GreenPoint wholesale mortgage unit and cut 1,900 jobs as a result. The secondary mortgage market is to blame, as Capital One is one of many banks that can no longer sell mortgages at profitable prices to investors in order to fund new originations.

Despite the headlines that will undoubtedly result from this news, let’s go through what it actually means for Capital One in dollar terms. GreenPoint was hardly in shambles before this announcement. After losing $12.6 million in Q1, the division actually earned a profit of $2.6 million in Q2, and management was assuming a breakeven year in 2007. During the second quarter, wholesale mortgages represented an immaterial 0.3% of Capital One’s net income. For the first half of 2007, the unit’s $10 million loss negatively impacted the company’s earnings by only 0.7%.

Why the rush to shut down Greenpoint then? I was actually surprised they didn’t halt new originations for a while to see how the secondary market shaped up in coming months, but given that there were 1,900 jobs within GreenPoint, and the odds of it generating any significant earnings in the short or intermediate term was essentially zero, it does make sense that Capital One management decided it was not a good use of resources to continue to fund the division. Why not just save a ton of money and cut the thing loose now?

Interestingly, even in 2006 when the mortgage market was great, GreenPoint only earned$138.5 million. That’s a lot compared with this year, but even then it contributed only about $0.33 to Capital One’s earnings of more than $7 per share. As you can see, even in good times GreenPoint might not be missed all that much, especially if the company can reallocate that money into higher return projects, which I suspect it can.

And keep in mind that this decision does not mean that Capital One is no longer in the mortgage market. They will still be loaning money to home buyers in the form of new mortgages and home equity loans through their local banking operations. They simply decided to halt the wholesale business in order to have more control over their loan operations.

All in all, this decision sets Capital One up nicely heading into 2008. The mortgage pressures on earnings will be lifted meaningfully, much of the merger related charges and other restructuring charges will be behind them (2007 was an integration and transition year), and the yield curve has steepened somewhat in recent weeks, so the company’s margins should improve.

Given that Capital One is still slated to earn more than $7 per share this year before one-time special charges related to the GreenPoint closing and merger-related charges will decline in 2008 as cost savings are further realized, I would not be surprised to see an earnings per share number meaningfully above $8 next year, (perhaps even approaching $9). In addition, after the company’s current $3 billion buyback is completed (it is more than half done), I would expect a new “bank-like” stock dividend put into place as well. In such a case, Capital One stock should no longer be anywhere near the current $66 quote.

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

Post-Vacation Thoughts

Wow. What a week and a half to take a vacation. Either it was a great time to miss, or it was the opposite. Obviously I’m biased, but I’d have to go with the former. Sometimes the daily volatility of the market sends investors on more of an emotional roller coaster than anything else, and that isn’t usually helpful. After all, roller coasters end up right where they started for the most part.

It looks like the S&P 500 traded in a 8.9% intraday range during the 8 trading days I missed, from 1370 all the way up to 1503. Despite that, when all the dust settled, stock prices dropped only 2 percent during my time away, so really my trip (I was in Boston and Cape Cod) saved me some emotional highs and lows.

I haven’t had a lot of time to catch up yet, but one thing did get my attention, so I thought I would share. I don’t know if it got a lot of airtime or not (likely not given it was pretty eventful with the Fed moves, etc), but the market finally got the long awaited 10 percent correction (at least on an intraday basis — 11.9% — it was only 9.6% on a closing basis).

Now, normally this would be unimportant enough that I might not even mention it, but there are a couple reasons why I think it is notable this time around. First, there were tons of people who were refusing to jump in with excess cash until we got that “official” drop. It sounds silly, but when investment strategists think the market is overbought, as many had for several months as the S&P crossed 1400 and then 1500, they need a significant sell-off to be convinced some excesses are removed. I have no doubt that market players who were waiting for a 10% down move are beginning to put some cash to work slowly.

Normally, a 10 percent correction is no big deal. We expect them to happen. I don’t have any statistics handy, but I’d guess we see one every year or so on average. They are normal and very healthy. Amazingly though, we had gone four and a half years without a full 10 percent drop in the S&P 500 index. This worried a lot of people because it was the longest streak ever without a sizable market drop. I don’t think it signaled the end of the world or anything to anybody, but when you go that long, you are due for a fall, and while nobody knows exactly when it will happen, it still prevents investors from getting overly bullish and firmly committing investment funds. The streak, in the eyes of many, was simply a symbol of the times, an overbought market that was being powered by many things, including the private equity M&A boom, which appears to be normalizing.

As I comb through the individual company news times of interest from the last week and a half, I’ll be sure to share anything that catches my eye that would have otherwise been posted had I been in the office. Feel free to let me know if there is anything you would like me to write about in coming days. It’s good to be back, and thanks for your patience during my vacation time.

What A Difference A Week Makes

I can hear the class action lawsuits being lined up already. On July 30th, mortgage REIT Luminent Mortgage Capital (LUM) issued a press release confirming that their 32 cent per share quarterly dividend would be paid as scheduled and not canceled, as many on Wall Street were predicting. The stock closed above $7 per share on the news. A week later on August 6th, they canceled the dividend and may be on the verge of bankruptcy, as evidenced by the stock’s more than 85 percent drop to less than a buck.

Either Luminent’s management team has no clue about their business, or there was some wishful thinking inside the company that will likely have to be defended in court. You often hear investors getting upset when companies fail to come out and deny Wall Street rumors that appear are untrue. However, in the case of Luminent it appears that even if a company does issue a statement it might not be accurate.

Now, it’s true that the mortgage-backed security (MBS) market has dried up quickly, but given the market environment, if there was any chance at all that things at Luminent could have worsened that much in a week’s time, the company really blew it by confirming the dividend. Just think how many people held on to the stock (or even bought) because of that press release.

If you own stock in any mortgage REIT, make sure you understand how quickly things can turn for them. Since they are forced pay out their income in dividends each quarter, they can’t stockpile cash for tough times. As a result, when the margin calls come there is no money there to pay, causing the stocks to be worthless nearly overnight. New Century Financial might have been the first mortgage REIT to go under, but it wasn’t the last, and Luminent won’t be either. Many think NovaStar (NFI) might be next.

Full Disclosure: No positions in the companies mentioned at the time of writing

Hedge Funds Can Just Freeze Redemptions… Must Be Nice

Maybe it’s just me, but is anyone else amazed that when hedge funds run into trouble (as many have recently by investing in mortgage-backed securities) and investors ask for their money back, the fund can simply say no? This is astonishing to me.

Now, don’t get me wrong. Managers can run their funds any way they want. Typically, fund rules stipulate that investors can withdraw money only during certain windows (quarterly and annually are most common). That makes sense, as it can be tough to put on positions if people can just come and go as they please. But how about when you ask for your money back during a pre-approved window and the hedge fund comes back and says “Sorry, but we have frozen redemptions.”

Bear Stearns (BSC) did this with their recent funds that ultimately went bust and are being sued right now because of what they allegedly told investors regarding the riskiness of the portfolios when they tried to get their money out.

Why on earth would anyone invest in a hedge fund that gave you no guarantee that you could take your money out if you wanted to? How can hedge funds get away with simply denying one’s request? Do any readers out there invest in hedge funds? Are you worried about wanting to get your money out at some point and being told you can’t? Seems risky to me…

Full Disclosure: No position in BSC at the time of writing