The Implications of Negative Earnings Growth

Undoubtedly, the underlying driver of the U.S. stock market in recent years could be summed up in two words; earnings growth. Equities now face a hurdle, however, as third quarter profits for the S&P 500 could very well decline year over year for the first time in five years. The implications for the market are pretty important.

At the outset of the year, market forecasters were calling for low to mid double digit returns for the market, supported by rising earnings and slight multiple expansion. It was my view that multiple expansion was unlikely (due to a lack of low P/E ratios to begin with, coupled with decelerating economic and earnings growth rates), so market returns would more likely track earnings advances, which would put us up in the mid to high single digits for the year. The S&P 500 is slightly above that pace right now, but it will likely be an uphill battle from here.

The reason is that without multiple expansion or earnings growth, there is no way for the market to advance meaningfully, by definition. The end result is likely to be a range-bound market as judged by the major indices. In fact, as the chart below shows, we have already begun to see this scenario take shape.

S&P 500 Index – Last 6 Months

From an investor perspective, this infers that stock picking will be all that more crucial to achieve investment gains. Not surprisingly, I would suggest focusing on individual situations where either multiple expansion or earnings growth are largely assured. The ideal investment candidate would be set up nicely for both, which would allow for solid gains regardless of whether or not the overall market advances meaningfully in coming months.

Countrywide Predicts Trough, Shares Soar 24%

Gauging the outlook for pure mortgage lenders like Countrywide (CFC) is a tough game and one that I am choosing not to play. The company is predicting that the third quarter was the trough and profits will return in Q4 and 2008, but nobody really knows for sure. Delinquency rates are still rising at CFC, standing at 7.1% as of September 30th, up from 5.7% three months before.

Until there are signs of stability and that stability hangs around for a while, I’m not going to bottom fish in mortgage-related companies like pure lenders or mortgage insurers. Honestly, those stocks are down so much, trading far below even recently slashed book values, that I think eventually there will be plenty of upside without even needing to time the bottom of the cycle.

Until then, I continue to like the bigger diversified banks with fat dividend yields. With these stocks yielding more than treasury bonds, I think you can justify buying low and being patient, knowing that calling a bottom is essentially impossible. I would, however, start making a list of the kinds of stocks you might want to target when things start to rebound. You won’t be able to time a purchase perfectly, but there is no way that most of the home builders, mortgage insurers, and big lenders won’t survive and be consistently profitable when the markets get back to some sort of more typical environment.

There will be money to be made, but I’m not comfortable jumping into pure plays just yet. Hopefully by sometime in 2008 things will stabilize and we’ll have a better idea of what “normal” conditions look like. At that point, making bets will be much more prudent.

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

Google Shows Restraint, Fails to Outbid Microsoft for Facebook Ad Deal

With a flurry of deals in recent months, Google (GOOG) has seemed willing to pay handsomely for attractive companies and contracts. The online ad leader has received mixed reviews for acquisitions of Doubleclick, Feedburner, and YouTube, as well as their exclusive ad deal with MySpace. With news that Facebook was negotiating with both Google and Microsoft (MSFT) on an international ad deal and a minority investment, it would not have been surprising, given their cash hoard and past deal history, to see Google outbid Gates & Company for the deal, even though Microsoft currently runs ads on Facebook’s domestic site.

In a shift for Google, reports are hitting the wires that Facebook has secured a $240 million investment from Microsoft, in exchange for an expanded ad deal that covers Facebook’s foray into the international market. MSFT is getting a 1.6% stake, which values Facebook at a whopping $15 billion. All this for a company that supposedly is on track for 2007 revenue and profits of $150 million and $30 million, respectively. That’s right, Microsoft is paying 100 times 2007 sales and 500 times 2007 earnings!

There is no doubt that adding Facebook to its arsenal of web advertising properties would have been a boon for Google, but given that Microsoft already has a relationship with them, it is not too shocking that they would expand their existing deal. While prices of less than $2 billion for YouTube and $100 million for Feedburner will likely turn out to be bargains, it was likely tougher to justify a $15 billion valuation for Facebook. Many Google shareholders are probably happy to see the company show some sort of financial restraint, even though Facebook is clearly a hot property in the social networking space.

As for Google stock, the shares have soared to $675 on the heels of another strong quarterly earnings report from the company. I still believe the stock will continue its rise, but future gains will likely be far more limited. I will likely want to sell stock when the forward P/E approaches 35 times, which right now would equate to about $718 per share.

For the bears who continue to point to the fact that Google’s market cap has irrationally matched or exceeded that of blue chip companies like Citigroup (C) and Wal-Mart (WMT), I would caution people against such comparisons. Lining up a software company side by side with a retailer or a bank really is comparing apples to oranges. Instead, I would suggest you compare Google’s valuation with other software companies.

With a low 30’s forward P/E ratio, given Google earnings growth projections over the next 3 to 5 years, I think investors will conclude that Google’s share price is not only quite reasonable, but will continue to rise if the company can deliver earnings growth rates in the 20 to 30 percent range annually for the next several years. Even if you factor in decelerating profit growth as well as continued P/E contraction, you can still project a stock price meaningfully higher than current levels over the longer term.

Full Disclosure: Long shares of Google at the time of writing

A Trade Idea As Another Bank of America Entry Point Presents Itself

On July 30th I mentioned how I thought Bank of America (BAC) stock at $47 was attractive with a 5.4% dividend yield. The shares moved above $52 since that post, but today are falling back sharply, to $48 each, after the company posted poor third quarter results, just like every other bank has thus far. The dividend now stands at 5.3%, and I think it is very safe.

If you want to generate even more income on this trade, you could buy the stock to collect the dividend and any capital appreciation, while simultaneously selling out of the money call options on the shares to collect more cash. For example, the May 2008 52.5 calls are selling for about $1.75 each right now. Buying the stock and selling those calls would result in a breakeven point of ~$45 per share over the next 7 months or so. Conversely, your upside would be up to $52.50 on BAC stock, plus dividends and option premiums of around $3 per share (up to 15% in total gains).

If you think the stock will trade within the recent range of the high 40’s to low 50’s, this trade would be a great way to make a double digit percentage profit if BAC can make up the few points of recent losses in coming months.

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

Thoughts on Crude Oil’s Record High Above $88 Per Barrel

I have recently suggested investors consider taking some profits in the crude oil market, but prices in the low 80’s price range has not stopped the commodity from continuing its ascent. Crude oil is hitting new historic highs today above $88 per barrel. The contrarian in me prefers to buy weakness and sell strength, so even though the current rise could continue, I am not going to jump on the momentum train and suggest people pile into crude in the short term. Longer term, though, I think it is worth taking a look at what will ultimately dictate where oil prices go.

To understand oil market dynamics, one can simply boil it down to supply and demand. There is a debate right now among energy watchers as to whether or not we are actually reaching a peak in world oil production. Obviously, if that is indeed the case, and demand continues to rise on the heels of a global economic expansion, higher oil prices are the likely result. However, official projections from various agencies still project that production will increase to meet higher demand, despite evidence in recent years that production gains are easier said than done.

Consider information from the U.S. Energy Information Administration. The EIA’s own data shows that despite a trend of ever-increasing oil demand around the world, production has actually been leveling off. In 2005 and 2006, world oil production was 84.63 and 84.58 million barrels per day, respectively. Estimates for 2007 stand at 84.72 million barrel per day.

As you can see, world oil supplies have been essentially flat for the last 3 years. Interestingly, energy experts have predicted production increases in the past for this period, but such gains have not been realized. This data gives the “peak oil” theorists some ground to stand on.

Once again, the EIA is projecting 2008 oil production worldwide to increase meaningfully, to 87.06 million barrels per day. If this forecast proves true, those suggesting that international oil production has already peaked will be dismissed. However, if production fails to meaningfully rise during 2008 in the face of higher demand (for the fourth consecutive year), chances are the oil markets will reflect this dim supply/demand outlook in the form of higher prices.

The chart below shows the data I have referenced above in graphical form. In my view, this is the trend we should be watching to see where oil prices are headed in the intermediate to longer term. The short term, however, is anyone’s guess.

Source: U.S. Energy Information Administration web site

Why Bears Focus on GAAP Earnings, & Why I Don’t

A very popular argument you hear from the bears these days is the fact that many market strategists are basing their stock forecasts on what are called “operating earnings.” Since third quarter earnings season is in full swing this week, I thought I’d take a moment to give you my views on “operating” earnings and the comparison with the bears’ preference, “GAAP” earnings.

First of all, let’s clarify the difference between the two measures. GAAP stands for Generally Accepted Accounting Principles. These are the rules that accountants use when creating financial statements for corporations. However, just because accountants prefer GAAP, that does not mean that stock investors should necessarily care as much as they do about GAAP earnings.

Investors often create their own measures of value based on what they truly care about when investing in publicly traded businesses, namely cash flow. For example, capital intensive businesses are typically valued on EBITDA, or earnings before interest, taxes, depreciation, and amortization. EBITDA is usually simply called cash flow.

Moving back to the market in general, 2007 estimates call for the S&P 500 companies to earn $93.50 in operating earnings but only $86.00 under GAAP. If you find a 16 P/E appropriate, for instance, you can surmise a fair value on the S&P 500 of either 1,496 or 1,376, depending on which earnings number you use. If you are a bear and are trying to convince people that stock prices are overvalued, which number are you going to use? Obviously, the latter since it is 8% lower.

One of the larger components that accounts for the difference in GAAP and operating earnings is the expensing of stock options. As many of you know, the accounting industry has mandated that companies treat stock option grants as expenses, and reflect that on their GAAP income statements. Since operating earnings focus on actual cash flows from operating activities, they exclude options-related expenses because it doesn’t actually cost a company any money to issue stock options to their employees, even though those options may have monetary value to the holder in the future. GAAP rules account for the expenses to differentiate between firms that issue options and those that do not.

Personally, I have to disagree with the accountants on this one. If booking imaginary expenses for option grants was supposed to show investors that two firms with different compensation structures are indeed different, then they have ignored the fact that the effects of issuing options do show up on the income statement already for all publicly traded companies; under “earnings per share.”

Issuing options does not in any way change the amount of profit a company is earning. As a result, I think it is silly to pretend that it does by expensing them. What is does do, however, is dilute existing shareholders by increasing the total shares outstanding of a corporation. Two companies that are identical in every way except their use of options (or lack thereof) will report different earnings per share (EPS) numbers. The company that issues no options (and thus has no so-called expense) will report higher EPS than a company that issues options, assuming all other factors are equal and held constant.

In my view, that is where investors can differentiate between options issuing firms and those who shun the practice. The dilutive effect of issuing options does in fact show up on the income statement, you just have to move further down the page to see it.

As long as companies that issue options have lower share prices than those that do not (again, assuming all other factors are equal and held constant) there is no reason to pretend that it is actually costing a company real money to issue options. If you do, then the dilutive effect is counted twice (lowering net income once by calling options an expense, and a second time by reducing earnings per share on that lower net income figure via higher share count).

That hardly seems fair to me and as a result, for companies that issue a lot of options (tech companies, for example), in my view it is perfectly fine to use non-GAAP earnings when valuing stocks.

Analysts Got It Right As Google Passes Wal-Mart in Market Value

Regular readers of this blog know that sell-side analyst research reports are not something I reference very often for trading recommendations. The numbers show that analyst picks fail to beat the market consistently, and do so with more volatility, just as most mutual funds do. That said, given that most Wall Street research is positive in nature (they want you to buy stocks, after all, so they make money) there will be a lot of times that I agree with the analysts, merely due to probability.

In May I wrote positively about search giant Google (GOOG) when it was trading in the low 460’s (Google Looks Cheap, Believe It Or Not). At the time I wrote that upside to $600 per share looked like a conservative price objective, with downside limited most likely to only $450 per share. This view was also the consensus view on Wall Street, with most analyst price targets right around $600 per share.

Well, the analysts got it right this time, so let’s give them credit. Google crossed $600 per share this week, jumping $5 yesterday to reach an all-time high of $615 per share. In doing so, Google now has a larger market value ($192 billion) than Wal-Mart (WMT) ($184 billion), a fact that many seem to find pretty staggering. I want to make two points about this in justifying why investors should not be alarmed by recent trading action in Google stock.

First, the reason why we see analysts now raising their price targets on Google closer to $700 per share is due to the fact that 2008 earnings estimates are approaching $20.00 per share (As I predicted in May) and the company’s growth rate should be in the 30 percent range for the next several years. Most any investor will tell you that a P/E equal to or slightly above a company’s growth rate is fairly common.

A conservative valuation on Google of 30 times earnings gets you to $600 per share, and a P/E of 35 or 40 for one of the world’s fastest growing companies is a price tag that many investors will be willing to pay, hence the rising price objectives. Personally, I would not be loading up the boat on Google at current prices, but a trading range of $500 to $700 per share over the next six months or so seems reasonable. Given we are right in the middle of that range right now, Google shares are a solid hold, with a bias toward profit taking over purchasing if a trade needs to be made.

As far as the Wal-Mart market value comparison goes, the discrepancy that might seem overdone to the casual observer really isn’t out of whack with reality. In 2008, Google is expected to earn a profit of $6.1 billion, which is less than half of Wal-Mart’s expected net of $13.8 billion. This implies a P/E on Google of more than double Wal-Mart, which is the case (31x vs 13x forward earnings). However, given that Google’s margins and growth rates are far higher than the world’s leading retailer, investors can easily justify the market values of both companies. That said, Wal-Mart appears to be the better value, trading at a below-market multiples, versus 2x the market for Google.

Full Disclosure: Long shares of Google at the time of writing

What Does a 3.5% Stake by Ackman’s Activist Firm Pershing Square Mean For Sears?

I’m not going to try and sugar coat the last few quarters for Sears Holdings (SHLD) investors. Let’s face it, it’s been a tough time lately for shareholders of the retail chain. After an unbelievably strong performance in recent years on the heels of Chairman Eddie Lampert’s turnaround efforts, the current economic environment is something that the highly admired hedge fund investor can’t control. The main business at Sears Holdings has been negatively impacted by both sagging spending at the low-end consumer level (Kmart’s target market), as well as declining expenditures on new home projects (a big part of the picture at Sears — think Kenmore and Craftsman). As a result, the stock has been in a real funk since July or so.

Not surprisingly, the weak share price has attracted another very smart value investor. We have learned that Bill Ackman, who runs Pershing Square Capital, has taken a 5 million share (3.5%) stake in Sears Holdings. Given that recent weeks have seen SHLD drop down to the $125 area, from a high of $195 earlier this year, seeing a very successful investor like Ackman coming in isn’t surprising, but it has helped boost the stock a bit in the short term. Shares are trading up to the mid 140’s right now.

So what does this Ackman investment mean for investors? Well, Ackman has been very successful in retail-oriented investments that often result in him taking an activist approach with management. Investments lately in McDonalds (MCD), Target (TGT), and Wendy’s (WEN) have done very well, though the Target stake is new enough that big changes at the company have yet to be fully felt other than in the stock price.

There are two possible reasons we could be excited about the news that Pershing Square has amassed a $700 million stake in Sears; it represents a new investment by a very smart value investor, and it signals that Ackman plans to take a large activist role with the company and management, leading to changes that will unlock shareholder value. I agree with the first reason but am less optimistic about the second.

Obviously, interest in Sears from someone like Bill Ackman strengthens one’s conviction that the stock is indeed vastly undervalued. I have believed this for years (and the stock has risen sharply during that time) and my views have not changed despite the stock’s poor performance this year. But still, contrarian investors should still always be looking for things that either reaffirm or contradict their views on a particular stock. This announcement certainly succeeds in reaffirming my confidence in Sears as an attractive long-term investment.

That said, I think the assumption that Ackman will be able to successfully pressure Sears management into making drastic changes is more unlikely than not. Typically, activists investors can put heat on senior management because they own more stock than them. In essence, management is working for those investors and therefore a CEO would not want to anger enough large shareholders that it could cost him/her their job. In the case of Sears though, Eddie Lampert is the chairman of the board and the company’s largest shareholder!

Lampert and his hedge fund (ESL Investments) own 46% of SHLD, compared with Ackman’s 3.5% stake. How much pressure can realistically be applied given these ownership percentages is unclear. I suspect Lampert has a plan and is going to stick to it, despite a growing investor base (myself included) that wishes he would accelerate some of his plans due to the fact that his core business is facing several headwinds in the current economic climate that are beyond his control. All in all, this news is positive for investors and I agree that Sears Holdings stock represents great value, especially at recently depressed prices.

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

Should We Cheer or Jeer Bernanke and the Fed?

A reader asked if I would share my thoughts on the views expressed in a Yahoo! Finance article written by Wharton Professor Jeremy Siegel on Thursday regarding the Fed and whether or not it should be flooding us with rate cuts.

The piece, entitled Don’t Blame the Central Banks — Thank Them, was well written and sought to comfort readers that coming to the aid of the banking industry is a good thing and could potentially help avoid a recession. Opponents of the Fed’s recent rate cut point to the fact that it is a bail out, and contributes to a moral hazard problem.

From my perspective, I think it is important to differentiate between a bail out and a Fed that provides additional liquidity and reduces the discount and federal funds rate. I am firmly against a bail out of any kind because it rewards (or at the very least seeks to reduce the negative repercussions from) poor decision making by the private sector. I agree that moral hazard is a real concern.

We live in a nation that is fueled by incentives. In most cases, people make decisions based on the incentive structure that is present at the time. If we bail out lenders who made stupid loans as well as the borrowers who were so eager to borrow money than they couldn’t afford to pay back, then nobody will learn from their mistakes and they will be made again and again, at the expense of taxpayers.

An important point to make, however, is whether or not the Fed’s actions thus far should be considered a bail out. Surely the Congress and President Bush could sign into law some sort of plan that essentially bails out troubled lenders and borrowers, but let’s focus on what our central bank has done so far. As Siegel points out in his article, the Fed has taken the lead in increasing the level of available liquidity. It allows those who want access to capital but can’t get it due to short-term market inefficiencies to have ways to get it. Our market-based economy will be better suited when we can eliminate, or at least sharply reduce, a liquidity crisis.

In my view, this is not a bail out. No borrowers are having their loans forgiven and no lenders are getting reimbursed for unrecoverable loans. When you have market participants providing capital into a market based system, and the system temporary stops working (i.e. capital becomes scarce), I applaud the Fed for stepping up in their role as a lender of last resort. We can argue how much of an impact it has had thus far, and will have in the future, but I have no doubt it is helping in some measurable way.

What I find interesting with this mortgage crisis so far is that the companies that have filed for bankruptcy (there have been more than 50 mortgage lenders go under so far) and the companies that have stopped making new loans, have fallen upon hard times due more from a lack of liquidity than loan defaults and property foreclosures. Interestingly, most home loans are being paid on time. As of August 31st, the nation’s largest mortgage lender had 95% of its loans being paid on time. Other lenders have seen their loan portfolios perform even better than that (delinquency rates at another banking institution company discussed last week on this blog are 50% below those of Countrywide).

Now, that is not to say that there isn’t a problem. The sub-prime sector of the market has seen delinquent rates reach more than 20% at some of the more careless lenders, and many of them are no longer in business as a result. I just hope that the actual performance of these loans is what ultimately causes the lenders to sink or swim. If you made bad loans, you deserve to go face the consequences, with no help from anybody.

However, companies whose loans are performing okay also found themselves teetering on the brink due to a lack of capital in the marketplace. If the Fed can provide liquidity to maintain an orderly market, I think they are doing the right thing. That won’t have any impact on how many loans are defaulted on, and I think that is what should determine how much money these firms lose and whether or not they can continue to stay in business. The might lose a lot of money in the short term, but very few can argue that isn’t justified based on the lax nature of their lending standards in recent years. What I’d prefer not to see is a lender be forced into bankruptcy due to lack of liquidity, only to see their loans bought up by third parties who actually recoup most of the outstanding money.

I am all for the Fed’s aiding in the liquidity crisis, but let’s make sure the people who lent money to people who couldn’t pay it back don’t get bailed out, even if that means a family has to give up their house in the process. If they can’t afford the house, I see no reason to fight hard for them to stay in it when they can move into another one (or rent) they can afford.

Banks Announce Major Writedowns? Duh!

That’s not even really my headline. It’s what the market is saying this morning after both Citigroup (C) and UBS (UBS) announced huge losses during the third quarter. Citi plans to take $3.3 billion in write-downs for the quarter, consisting of $1.4 billion from LBO loan commitments, $1.3 billion from losses on sub-prime securities, and $600 million from fixed income trading losses. Also hitting the wires today was news that UBS is projecting a quarterly loss of up to $690 million.

So the market’s getting crushed, right? Well, not exactly. Citi stock is up 1 percent, with UBS up 4 percent. The Dow is higher by more than 100 points, and once again sits above the 14,000 level. Now, I am not telling you this as a proclamation that the worst is over and we are off to the races. I don’t know when the credit losses will peak, and there will be more write-downs in the future, even additional adjustments from Citi and UBS.

The takeaway from this morning’s action is that everyone and their grandmother knew these write-downs were coming. The stocks have been hammered because of that. The rallies today should not be that surprising as a result. It represents a relief rally because, at least for now, the losses aren’t as bad as they could have been. That doesn’t mean things won’t get worse, it just means that, for now, the world is not ending.

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