Do Rate Cuts Really Matter?

I find it very interesting that Wall Street has soared the last two days on hopes of more Fed rate cuts. On one hand, this makes sense, but on another, it baffles me.

First of all, stocks do better historically when rates are falling. It’s a mathematical relationship; lower interest rates increase the present value of future cash flows and vice versa. Lower rates also make stocks more attractive relative to other income-related asset classes. That’s the general concept propelling stocks higher this week, but what about the specific situation we face today?

The current dislocation in the credit markets has really hurt the market lately. We all know the state of the housing, mortgage, and mortgage-backed securities markets, but a general lack of liquidity in many other areas of credit are really having a negative impact on the ability of many companies to conduct normal business lines that require liquidity to fund operations.

Will more Fed rate cuts help this part of the problem? The market’s move in the last two days signals that it will, but I am skeptical. My thought process isn’t very complex. The liquidity crisis has gotten meaningfully worse since the Fed started cutting rates (there have been 75 basis points of cuts so far). To me, that indicates that another rate cut on December 11th (even 50 more basis points) won’t have as much of a positive impact on the credit markets as recent stock market action would have you believe.

What do you think?

Putting the Correction in Perspective

November has been the worst month for stocks in several years. The S&P 500 is now negative for the year, and sits 10% below its high and 8.5% lower this month alone. Not only do long term investors like myself take a multi-year outlook of the future when investing money, but it also helps to put things in perspective by looking back at where the markets have come from in a multi-year scenario. Much like a student who gets a C on a tough exam might be in fine shape if previous grades in a semester have been all A’s, investors need to realize that markets don’t go up all the time, just as good students can’t possibly ace every test.

Stock prices rise, on average, 75 to 80 percent of the time in any given year. After four magnificent years of gains in the market, we are overdue for some poor performance. We might finish down this year, or next year, or both, but regardless, take a look at how far we have come over the last five years:

We can’t possibly expect gains like this to continue indefinitely. Even a pullback to something like 1,300 on the S&P 500 index would simply be a normal, healthy retracement after extremely large gains. Perspective like this is important when markets are rattled, as they clearly are right now. I don’t know how long the correction will last, or how low we will ultimately go, but I will remind people that these types of moves are normal, and are required to maintain a healthy marketplace.

As for how to approach new investments in this type of environment, I don’t think meaningful changes need to be made. When fear of the unknown grips markets in the short term, as is happening right now, long term investors simply need to ignore the short term noise and focus on long term fundamental stories. Investment themes need to be able to weather your view of how the world will look five years from now, not five hours from now. If you invest in a company that has a bright long term future, and pay a very reasonable price for it, the odds are in your favor that you will make good money over time. And that fact won’t change based on anything that happens today, next week, or even in 2008.

Lampert, Sears Make Play for Restoration Hardware

Just days after I wrote about the focus at Sears (SHLD) being store redesigns, not non-core asset sales, we get a timely SEC filing from the company announcing its interest in bidding for home furnishings retailer Restoration Hardware (RSTO). The comments from Sears are very interesting. Chairman Eddie Lampert has been eyeing the company since June, and this month alone has increased his stake by 3.4 million shares, bringing SHLD’s total ownership to 5.3 million shares, or 14%.

In case you didn’t read the filing, here is what we know. Lampert indicated his interest in acquiring or partnering with RSTO in June, but he did not meet with management to discuss a deal until October. At that point he offered $4.00 per share for RSTO, which was 40% above where the stock was trading. RSTO indicated that price was too low, but Lampert insisted on conducting due diligence before raising his bid.

On November 8th, RSTO announced a management led buyout (along with private equity firm Catterton Partners) in a deal worth $6.70 per share in cash. However, RSTO stated publicly that it will consider other offers until December 13th, and that it plans to actively solicit such alternative deals during that time. Lampert appears eager to sign a confidentiality agreement in order to look under the hood and perhaps make a revised offer.

Obviously, a lot is going on here. The market’s reaction has been largely negative, but it appears that is mainly based on the short term retail environment being bad for home furnishings. Lampert is clearly not concerned with how well RSTO will do in Q4 or 2008. He is likely looking long term, trying to come up with ways to strengthen the product and profitability of Sears merchandise in a more normal retail environment.

So what is the rationale for an interest in RSTO? To me, it’s not that complicated. Lampert has said repeatedly since he took over Kmart, and subsequently bought Sears, that his first priority was not growing the company, but increasing profits. Retail experts and many investors have complained about lack of store growth and negative same store sales growth, but they are missing Lampert’s point.

See, Lampert doesn’t think the problem is lack of sales or not enough customers. Sears has thousands of stores and more than $50 billion in annual revenue. The problem is, despite such a strong retail presence, the company makes very little money. In his mind, he can do one of two things. One, open more stores that hardly turn a profit, or two, maximize profits from the existing store base and then figure out how best to grow the business. Not surprisingly, he prefers the latter because he is an investor in the business. Remember, long term stock prices are dictated by profits, not sales.

How would RSTO fit into this model? First, Lampert is buying a cheap retailer during a time when home furnishing sales are weak, so he has upside with the current strore base (100 plus locations). More importantly, he can add better merchandise to thousands of his existing stores. Not only could those products potentially sell better than the ones they have now (RSTO’s product is a very high quality), but they are far more profitable because Sears would own the suppler.

Lampert seems to be focused on building store redesigns around promoting certain well known brands, many of which Sears actually owns (think Kenmore, Land’s End, etc). If the goal is to maximize profits, this model makes the most sense. Consumers have multiple avenues to purchase company-owned products. You can buy Land’s End clothing through the catalog or in Sears stores. There is tremendous potential to boost sales and have the cost structure lower at the same time. The same could be done with Restoration Hardware.

So, although the reaction to this news has hardly been positive, I think that is simply because people don’t believe in Lampert’s strategy. However, if you are investing in Sears alongside him, you have to be pleased that he has done exactly what he said he would do. Either investors want in to the plan, or they don’t. That’s what makes a market.

Whether or not the plan works remains to be seen, but Lampert’s track record to date has been pretty impressive. Although the stock is down significantly from its highs, along with all other retail stocks, investors need to keep in mind it was $15 per share when he started this whole retail endeavor. As for the most recengt news, we should know the fate of RSTO shortly, as the company has about three more weeks to field competing offers.

For those who were wondering if Lampert was up to anything on the acquisition front, it was very interesting to learn that he has been eyeing RSTO since June. Not only that, but he likely first bought shares back then at prices below $3, versus the $7 price tag today (the SEC filing noted that SHLD has owned 1.9 million shares for longer than 60 days). That kind of return is exactly the type of thing Lampert fans have been hoping for and RSTO might just be the beginning.

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

Store Redesigns, Not Asset Sales, Top Lampert’s Priority List for Sears

Investors hoping Sears Holdings (SHLD) Chairman Eddie Lampert would quickly move to transform the company into more than just a retailer have been disappointed. Lampert clearly understands the tremendous value of his company’s assets, but thus far has not moved to revamp the company as much as his supporters would have liked. Instead, Lampert seems convinced that he can boost the company’s retail operating margins closer to industry averages with better management of the store base.

In fact, a press release issued Saturday sheds light into Lampert’s game plan:

Kmart Store Becomes a New Sears

MARIETTA, Ga., Nov. 17 /PRNewswire/ — The former Kmart at 4269 Roswell Rd is now a brand new Sears. Local Atlanta residents can expect a one-of-a-kind shopping experience that offers an expanded selection of merchandise including more national brands than ever before and a 23,000 sq. ft. Lands’ End shop featuring the largest selection of Lands’ End merchandise ever at Sears.

The new Sears will come to life by offering customers a “store-of-shops,” and a fresh design layout with different flooring, fixtures, and displays. Marquee brand names now found in the new Sears include Sony, Hanes, Workwear – by Craftsman, Carhartt, Timberland and Diehard apparel, Levi’s, and Nordic Track. The store will also feature expanded Home Electronics and Home Appliance showrooms, organized around favorite manufacturers, that will also help customers choose the right look, feel and function with other brands Sears carries.

A newly remodeled hardware department will feature innovative and interactive Garage Organization, Mechanics and Carpentry shops to help customers find the right item quickly and efficiently.

Five central internet workstations located throughout the sales floor will provide free high-speed Web access to enable both the customers and associates to quickly access the internet, verify prices, shop online and contact store personnel if help is needed.

The store will also carry a wide range of convenience items previously available at the former Kmart location including full pharmacy services, health and beauty, cosmetics and greeting cards.

This new format will help customers create the look they want and find the gifts they need all in one convenient location. Shoppers will find the quality brands they have come to know and love like Diehard, Craftsman, Ty Pennington, and Kenmore plus extended assortments of national brands from Nordic Track, Schwinn, Reebok and more. Customers can also shop for great fashions with the first 23,000 sq. foot mega Lands’ End shop that brings the legendary brand to life with items for women, men, kids, baby and home. Now families can touch and feel the quality and see the details of Lands’ End products. A special monogramming service is also available to easily personalize just about any Lands’ End item that will take a stitch. There’s even free shipping on any catalog or order placed from the store.

It remains to be seen if Lampert can boost profit margins further at Kmart and Sears. Initial attempts were successful, but 2007 has brought little improvement, due in part to the weak retail environment in both the low end consumer and home improvement/furnishing markets. That has resulted in Sears stock being down 28% year to date.

This press release is further evidence that Lampert is focused on improving store margins, not diversifying business lines. As a result, it indicates that the Sears investment thesis remains a long term story. By the way, if anyone lives near this redesigned store in Atlanta, I’d be curious to hear your thoughts on the new store.

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

SandRidge Is An IPO To Watch

In general, IPO investing is not a very rewarding experience. If you can get in on a hot deal at the offering price, then obviously you can make good money, but studies have shown that recent IPOs lag the market in general after they are available to the public. The reason is pretty simple. More often than not, corporations will choose to sell stakes in their companies when they think they can get a very good price. If the firm gets a good price by selling, investors certainly can’t expect to get a good deal when buying simultaneously.

Now, this is all generally speaking. Of course, there are plenty of IPOs that are selling stock because they have reached a certain size and are seeking a way to fund growth. If they succeed in growing as they plan, investors could make very good money investing early on. A recent IPO that I think is worth watching is SandRidge Energy (SD), a natural gas producer run by Chesapeake Energy (CHK) co-founder Tom Ward.

As I have written here before, I am a big fan of Chesapeake as a long term play on the domestic natural gas market. As far as I can tell, they are the best company in the business, and are currently the leading independent natural gas company in the country. CHK was co-founded by Tom Ward and Aubrey McClendon in 1989 and until last year they ran the company together, Ward as COO, McClendon as CEO.

Initially there was worry when Ward left Chesapeake, but as time went on it became clear that he wanted a new challenge. Now he is running SandRidge Energy, a smaller but rapidly growing firm focused on Texas exploration. Is the fact that a very smart and successful guy like Ward is at SandRidge enough of a reason to buy the stock? In my view, it very well could be. When you have someone who has been as successful as anybody at finding natural gas reserves, it bodes very well for a new company he left a great job to focus on.

If you are bullish on the natural gas market long term, as I am, SandRidge is certainly a company to watch. The stock is up nicely from its recent IPO. The stock was initially indicated to price between $22 and $24 per share. Higher than expected demand pushed the offering price to $26 and the stock opened at $32 on the first day of trading. Today it’s trading above $33 per share. I would suggest waiting for a pullback before buying in, but SD is definitely a company to watch as it continues to grow.

Full Disclosure: Long shares of Chesapeake Energy at the time of writing

Forget Writedowns, Bank of America Gets $16B Writeup!

From the Financial Times:

BofA set to gain $30bn on CCB stake

Tuesday Nov 13 2007

Bank of America (BAC) on Tuesday said it was sitting on a potential gain of more than $30bn on its investment in China Construction Bank, highlighting the paper profits some western banks have made on holdings in their Chinese counterparts.

BofA paid $3bn two years ago for an 8.5 per cent stake in CCB and an option to increase to 19.9 per cent at a very low price. The bank plans to record a gain of about $16bn on its existing stake in the fourth quarter.

“On paper we have a potential gain in excess of $30bn,” said Joe Price, BofA’s chief financial officer, adding that it would be able to cash in some of its holding over the next 2 to 3 years.

Not only does BofA have less subprime mortgage and MBS CDO exposure than other big banks, but they also have done some smart things which will certainly help them weather the storm.

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

As Usual, Bill Miller’s Letter is a Good Read

I’ve been a follower of Legg Mason’s Bill Miller for a long time. Having grown up in Baltimore, where Legg Mason is based, I was able to learn a lot about him and his investment strategy before most others did so via the publicity surrounding his stunning 15 straight years of beating the S&P 500 index. Miller is a contrarian, value investor, just as I am. And although I don’t always agree with his stock picks, his insights into the market and long term investing are particularly well written. I even quote him on Peridot Capital’s web site, because he is far more articulate that I am when addressing many important investment concepts. You can usually learn something by reading an article about him, or his actual letters to investors, which are published every 3 months.

Last week, Miller’s third quarter commentary was especially insightful, as it addressed many of the turbulent events of the recent past and explained how he views the current marketplace. I’ve provided a link to Miller’s third quarter letter to investors for those of you who are interested. I suggest that long term contrarian investors add the letters to their personal reading list on a quarterly basis.

Crocs Stopped Dead In Its Tracks

If you’ve ever owned a momentum stock, you know that things are a lot of fun, until the company misses a quarter. Investors’ love affair with trendy footwear maker Crocs (CROX) ended last week, as the company’s third quarter earnings release left much to be desired for the momentum traders hoping for yet another blowout quarter. The stock has been crushed to the tune of 45% in just 3 trading days and now fetches $41 per share, down from its high of $75.

After such a move, it appears that there might be an investment opportunity here if you have a good understanding and expertise of trendy fashions. For such opinions, I am not your guy, as I have no idea what the future for Crocs will look like and won’t even fathom an uneducated guess. Lots of people surely think the company’s shoes are merely a fad. However, if you disagree with that, you might want to take a look at the shares as an investment.

Here’s why. Last week Crocs issued 2008 guidance of 35-40% sales and earnings growth but that was not enough to keep the stock from tanking. If you believe in the Crocs story (that the company can continue to grow from here), the stock is only trading at 15 times the $2.70 earnings guidance the company has issued for next year. If 2008 will indeed bring investors 35-40% earnings growth as predicted, and the company can grow (at all) in the years after that, buying Crocs today around 40 bucks will actually prove to be a wise decision. I don’t know enough about shoes to feel confident in that view, but I bet some people do. If so, the stock might finally be reasonably priced.

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

Mobile Phone Initiatives Help Google Become 5th Most Valuable U.S. Company

Google’s plans for a strong push into the mobile phone market has excited investors enough to not only push the stock over $700 per share, but perhaps even more startling, the Internet search and advertising giant is now the fifth most valuable U.S. company. For a firm founded in 1998, this is an astounding ascent in less than a decade. My initial thought when seeing this list was to simply conclude that it is really ridiculous, and hence time to unload every single Google share I own. If you just look at the numbers and the other names on the list, it is hard to justify Google coming in at number five, no matter how dominant, profitable, and fast growing they are. But then I started thinking about other ways to put this list into context, and began to able to justify their position.

Let me give a brief explanation and then please feel free to give both sides of the argument from how all you see it. I have said before (and maintain) that investors need to compare similar companies when making valuation calls. They are called “comps” for those of you who have worked, or do work in the investment banking industry. If you are taking a firm public, you look at comparable publicly traded competitors to get an idea of how much investors are willing to pay for your client’s shares, which aids you in determining an IPO price. It is the same process when you are selling your home. The comps your real estate agent uses to come up with an initial asking price is based on houses in your neighborhood, similar to yours in size and amenities.

This is important because we need to compare Google to other technology companies. In this case, the comps would be the likes of Microsoft, AT&T, and Cisco. Does Google belong on a list with those other leading tech firms? Well, Microsoft owns the operating system and business software space, AT&T leads in telephony, as well as Cisco in networking equipment. All of these areas have become crucial to everyday life and represent huge market opportunities. Is Google really any different? Sure, the Internet has really only been mainstream for ten years or so, but think about how crucial it has become in most people’s everyday lives. Compare how much time you spend on the Internet to the time you spend on the phone on any given day, or using Microsoft Office at work. I bet it is comparable for many of you. For me, it trounces those two.

Some mistake Google for “just a search engine,” but we do many more things on the Internet than use it to look something up. Email is a core communication tool, moreso than the telephone, for many of us. Just thinking about what I do online now, the list is quite long. I pay my bills, maintain my address book, get weather forecasts, go shopping, manage my fantasy football team, trade my stock portfolio, check movie times, read blogs, get news reports, get driving directions, book airline tickets, archive my photo collections, balance my checkbook, manage a to-do list, etc. I could go on, but you get the point. Before the Internet I did all of those things via the television, the newspaper, the telephone, through the mail, or at my desk. Now I do them all digitally over the Internet, in many cases with the help of Google software.

If the Internet has transformed our daily lives this much in ten years, isn’t it safe to assume that it is not going away? If Google is going to be a leader in providing many of these services, and can make money on them through advertising (much like your local newspaper or television station), then I can completely understand why they would be joining the likes of Microsoft, AT&T, and Cisco in terms of market value. Obviously, things can go wrong and new companies can take over an industry. After all, for every AT&T, Cisco, and Microsoft that has continued to lead despite intense competition, there is a Digital Equipment, Silicon Graphics, or Polaroid that has practically vanished because of it. Google’s fate is unknown, but people are betting that they maintain their lead, and I do not think that is such a ridiculous belief to have.

In my mind, if the Internet continues to change the way we live and help us accomplish tasks more quickly and efficiently than prior tools such as TV, phone, mail, or print media, and Google continues to be a leading software company focused on enabling all of these things, who is to say they should not have a seat at the head table with everybody else?

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

Alright Bernanke, Enough with the Rate Cuts

Do you get the feeling that FOMC Chairman Ben Bernanke is lowering interest rates more because that is what the markets want, and less because it is actually helping the problems we have in the housing and credit markets? The debate has long been whether or not the mortgage crisis will be contained or spread into the rest of the economy and cause a recession. With third quarter GDP growth coming in at 3.9%, the highest rate since early 2006, it is clear that the economy is a lot more than just the housing market.

While GDP growth should slow meaningfully in Q4, it does appear the mortgage problems are contained. Unless rate cuts will help stabilize the housing market, which is not a likely result, I don’t see the need to go ahead with them just for the market’s sake. After all, commodities like gold, oil, wheat, corn, etc are soaring. The result will be higher prices for consumers, which we have already begun to see as companies like FedEx, Colgate, and Procter & Gamble are all raising prices to maintain their profit margins and stock prices.

In the face of apparent inflation pressures, interest rates could ultimately be headed higher, which would make the recent cuts even more baffling. It’s true that the government’s inflation data doesn’t seem to jive with reality, and maybe that will reduce the likelihood that rate increases are in our future, but when press release after press release announce price increases from major manufacturers due to record commodity prices, it’s hard to deny inflation is real.

So what will cure the housing market’s woes if rates cuts won’t do the trick? Honestly, just the laws of supply and demand. The housing market is still falling with no signs of stability in sight. As long as delinquency and foreclosure rates continue to rise, and home prices continue to fall, the credit market issues (loan losses and asset backed securities writedowns) will continue. The value of loans won’t stop falling until the performance of such loans improves, or at least stop deteriorating.

Rate cuts won’t help because they have no direct impact on home prices or mortgage delinquency rates. This will be apparent when we see fourth quarter loan performance continue to get worse, not better. As home inventories are worked off and more home owners refinance into fixed rate loans, the markets will eventually stabilize. It will take time though. I don’t know when, nobody does, but hopefully we can get there by the end of 2008.

As for whether the housing market weakness has spread to other areas, this debate obviously will continue. From third quarter earnings season we see that the weakness has really been contained to home builders, mortgage lenders, banks and investment firms that own securities backed by mortgage loans, and companies that provide insurance for mortgages and mortgage backed securities. It is my belief, and many will certainly disagree, that consumer spending is not as bad as some would have you think, and the fact that growth in spending is lackluster has much more to do with the face that real wages have been stagnant for years, and not because of the housing market. In addition, the fact that consumers are staying current on all their other monthly bills, even when they are delinquent on their mortgages, shows that the housing market’s issues really are fairly well contained.

As for policy moves, I think actions should be focused exclusively on stabilizing the housing market. While pleasing to the markets, I don’t see any direct impact on housing from rate cuts. Just imagine how great it would be if we could get back to a “normal” housing market. People would have to get used to not making much money on their homes (real estate returns historically don’t outpace inflation), but the credit markets would stabilize and corporate earnings could resume their growth trend. Even a flat housing market would be welcomed by investors, to say the least.

Full Disclosure: No positions in the companies mentioned