Best Buy Shines Even In Weak Economy

Back in November I wrote that Best Buy would be a prime beneficiary of Circuit City’s bankruptcy and given that they were already one of the best run retailers in the country, the stock was cheap at a single digit P/E (around $25 per share). Today Best Buy reported blowout fourth quarter earnings and predicted 2009 earnings of $2.50 to $2.90 per share, which is well above current estimates of below $2.50.

Best Buy shares are up $5 (15%) today to more than $38 per share, which brings the gain since November to over 50 percent. If you have been riding this trend, the shares look close to fair value from my perspective. Taking the middle of the earnings guidance range and applying a 15 P/E (a bit higher than I would choose normally, due to the recession) I get fair value of about $40 per share, so it appears the stock’s huge move is largely behind us.

Full Disclosure: Peridot Capital was long shares of BBY at the time of writing, but positions may change at any time

Reducing Unused Credit Card Lines Is Probably A Good Thing For Everybody

Meredith Whitney, long time bear on the banking sector, is pointing to the possibility that reductions in credit card lines could result in a sharp drop in consumer spending over the next year or two. In a recent television interview she predicted that outstanding credit card lines in the United States would drop from $5 trillion to $2.3 trillion by the end of 2010, a drop of more than 50 percent. Having less available credit, Whitney argues, will result in even less consumer spending and major problems for the economy.

While I don’t disagree that credit card issuers are going to reduce credit lines (we are already seeing this trend and there is no reason to think it will cease anytime soon), I am skeptical about how much this will really impact consumer spending. The main reason is because there is only about $800 billion in outstanding credit card debt in the U.S. right now, and that figure has not been growing as fast as may have thought in recent years. While this is clearly a large number ($2,600 per person), it is dwarfed by the credit lines currently outstanding and as a result, the credit line reductions should not really have a major impact on day-to-day spending.

Essentially, Whitney is predicting that the credit utilization rate will increase from 16% currently (800 billion divided by 5 trillion) to 35% within two years. For someone with $2,600 in credit card debt, that means their credit limit will be reduced from $16,000 to $7,500. While that may make the consumer a little less confident that they have a huge cushion of credit to fall back on in the case of an emergency, I don’t really agree that it will result in a significant pullback in regular spending habits.

Additionally, this action by the nation’s leading credit card companies may in fact help them as well as our consumers, who hopefully will realize that they should have a few thousand dollars in a savings account in case of an emergency rather than assuming they will get cards should something unexpected happen. This would be a welcome event for our banking system, which benefits greatly from an increasing deposit base. As for Whitney’s assertion that a credit card bubble is the next shoe to drop on our economy; call me a skeptic. The data simply isn’t all that scary to me and if we slowly lower our dependence on credit cards, our economy will be on stronger ground as a result.

Suncor/Petro-Canada Combo Could Be First Of Many Energy Deals

Today we learned that two of Canada’s largest oil producers, Suncor (SU) and Petro-Canada (PCZ), are merging in a $15.5 billion deal due to close in the third quarter. More large commodity-related deals, especially in the energy sector, could be coming. Despite the global recession, the long-term fundamentals for the commodities sector remain intact. Lower demand is clearly going to have a large effect on demand near-term (prices have already come down a lot in most cases), but unless you think the global economy will not recover, commodities will serve as an economic barometer going forward, in both directions.

When you couple temporary price declines (in the actual commodity as well as the stock prices of the large producers) with long term bullish industry trends and supply limitations (lack of credit availability limits exploration and drilling projects used to boost supply), mergers in the current environment are going to look attractive to CEOs who are anticipating the commodity markets will rebound when the economy does.

While I don’t have specific companies in mind that have a better chance of being acquired than others (I would have preferred Suncor to be a seller rather than a buyer, given Peridot’s long-term position in the company), but I would expect this energy deal to be just the first in a series of large deals in the next couple of years.

Full Disclosure: Peridot was long shares of Suncor at the time of writing, but positions may change at any time

How The Financials Are Greatly Masking the Market’s Earnings Potential

Some people are making the case that the stock market can rally meaningfully even without the financial sector recovering. I disagree simply because earnings are being negatively impacted so severely by loan losses and mark to market writedowns at the large financial institutions that investors won’t get a clear picture of what a reasonable expectation for S&P 500 earnings are until financial sector earnings at least stabilize, if not climb back toward breakeven.

Jeremy Siegel, well known Wharton finance professor and author of “Stocks for the Long Run” (an excellent book) had an opinion-editorial piece in the Wall Street Journal recently that was titled “The S&P 500 Gets Its Earnings Wrong” (subscription only — get 2 free weeks here if you are not a WSJ online subscriber) that made some interesting points about the currently depressed level of earnings for the S&P 500.

Dr. Siegel explains that while the S&P 500 is market value weighted (larger companies are weighted more heavily in the index than the smaller ones), Standard and Poor’s does not use the same methodology when calculated the index’s earnings. Instead, a dollar of profit from the smallest stock is treated the same as a dollar earned by the largest. As a result, the losses being accumulated by a small portion of the index are negating the profits being generated by the majority, which is making the S&P 500’s earnings look overly depressed.

Consider the data below, taken from Siegel’s column:

Siegel is suggesting that the absolutely abysmal financial performance of the market’s worst stocks last year (mostly from financial services firms, of course) is giving the appearance that corporate profits have absolutely fallen off a cliff in every area during this recession. He is quick to point out that 84% of the largest 500 public companies in the U.S. (420 out of 500) are actually doing quite well. That fact is going unnoticed because $1 of earnings from the smallest stock in the S&P is treated the same as $1 of earnings from the largest component, even though an investor in the S&P 500 owns 1,300 times more of the largest one than the smallest.

I’m not sure if Siegel is suggesting that they should actaully go ahead and change the way they calculate S&P 500 earnings (and if so, I’m not sure I would even agree with him), but I do think this data is very helpful in seeing just how much the financial sector is masking corporate profits from other sectors.

My personal estimate right now for S&P 500 fair value is around 1,050 (14 to 15 times normalized earnings of between $70 and $80). I came up with those estimates before reading Siegel’s article, but the data he provided give me comfort in the estimate. After all, if you assume the bottom 80 companies get back to breakeven and the other 420 companies maintain their 2008 profitability (both are conservative assumptions when the recession ends in my view), we see that S&P 500 earnings would range from $67 (if you use GAAP earnings) to $81 (if you use operating profits)

As you can see, any relief for the financial sector with respect to mark-to-market accounting principles could temper the writedowns going forward. Even getting the financial sector to breakeven by 2010 would reduce the negative earnings impact from the bottom 6% of the S&P 500, clearing the way for earnings to rebound pretty quickly from the $40-$50 level analysts are projecting for 2009.

Cash Flow Accounting Isn’t So Terrible, Really

Last night on Larry Kudlow’s CNBC show, the guests debated how proposed changes to fair value accounting would impact the stock market. The full clip is below, but the main argument was whether using cash flow fair value accounting (most likely what any proposed changes out of FASB will look like) is really that much worse than mark-to-market accounting. I have written about this before and I really don’t understand the argument that somehow a cash flow based valuation of asset backed securities lacks transparency and allows bankers to value their assets at whatever number they want.

Gary Schilling, the bear on Kudlow’s panel (who is predicting 600 on the S&P) argues that fair value accounting is just a forecast and you can’t accurately forecast the cash flows from an asset backed security. This view baffles me. After all, non-packaged whole loans that banks hold are valued using cash flow projections. In fact, that is standard practice. If you have a loan that is being paid on time consistently, there is little reason to think you won’t be repaid in full, and therefore that loan is reserved for much less aggressively than a loan you have where the borrower is delinquent.

The idea that one can’t accurately forecast the cash flow from a loan (or an asset backed security) ignores reality. Every loan has an amortization schedule, so you know exactly how much principal and interest you are due to receive and when. Obviously, you have to build in some loss assumptions based on the economic environment, delinquency trends, credit history, etc, but it is far easier to predict cash flows from loans you hold than it is other assets like goodwill and other intangibles, or even equities.

The idea that someone else selling a loan makes every loan like it worth that exact amount ignores the fact that credit trends differ between banks, regions, etc. If you hold loans that are current on both principal and interest, there is no reason you should be forced to write down the value of that loan simply because a distressed seller, completely unrelated to you, is forced to sell their loans at a discount to get rid of them quickly.

Fortunately, the updated FASB guidelines should go a long way to solving this issue in the coming weeks. Banks lose money on loans all the time, and that will continue with or without mark-to-market accounting. There is no reason a financial services company should be forced to take an accounting loss on an asset if they are still being repaid on time and as expected.

Later this week I will illustrate why adjusting these accounting rules on financial services companies will do a lot to alleviate investor fears and bring some stability back into the stock market, which we have already begun to see in the last week or so.

Time Warner Completes Cable Spin-Off, Sets Stage For AOL Split Next

Time Warner (TWX) has long been a media conglomerate difficult for investors to dissect. However, that may be about to change and the moves could finally extract some value for Time Warner shareholders. The company will complete its spin-off of Time Warner Cable at the end of the month, which offloads billions of debt to the cable company and frees up cash flow at TWX.

Time Warner is also making some moves at its AOL division. AOL has hired Tim Armstrong, formerly the head of U.S. sales at Google, as its new CEO. The conventional wisdom is that Time Warner will spin off AOL as well, in order to allow Armstrong to maximize profit and growth potential at the online unit.

All of this should be good news for Time Warner shareholders, whose stock has been cut in half over the last year and sits near its lows. Time Warner retains some very strong brands, including HBO. With less debt from the cable division, coupled with a $9 billion cash infusion from the spin-off and a new strong management team at AOL, investors might finally begin to look at the stock again in the intermediate term.

As a result, bargain hunters who prefer strong large cap companies might be interested in checking out TWX shares at $8 each. Not only do they sit near their lows, but they yield 3% and trade for less than 5 times trailing cash flow.

Full Disclosure: No position in TWX at the time of writing, but positions may change at any time

Merrill Lynch’s David Rosenberg Gets Less Negative

For those of you who don’t know Merrill Lynch chief economist David Rosenberg, he has been very bearish on the U.S. economy for a long time, long before the recession hit. Some give him credit for predicting how things would play out, while others criticize the fact that he was years early and therefore missed a lot of the upside before being right about the drop. Both points are reasonable, but I bring his name up because he was on CNBC this afternoon sounding much less bearish than any other time I can remember. Not bullish (heaven forbid), but not all that negative either.

Rosenberg pointed out that the stock market typically bottoms out about 60% to 65% of the way through a recession, which by his projections means we are about 90% of the way through this bear market. His downside target for the S&P 500 is 600, but he oddly adjusted that downward after his original level of 666 was reached “too early.” He gets to 600 by taking $50 of earnings and applying a 12 multiple. As you can guess for my recent writings, a 12 P/E on trough earnings is much more reasonable in my view than some of the single digit predictions of other strategists.

I typically don’t put too much weight in the absolute predictions of either the most bullish or most bearish people on Wall Street because both groups tend to stay in their respective camps far too long (Meredith Whitney comes to mind). That said, when long term bears begin to get more positive, it says a lot for where the market and economy are. If you can get people who hated stocks and panned the future prospects for the U.S. economy, to become even mildly bullish, I think that says something about how much negativity is priced into equities.

Historical Data Disproves “Trough P/E Multiple on Trough Earnings” Myth

Doug Kass, a hedge fund manager dedicated to short selling and frequent guest on CNBC, made a call on the air Monday that the S&P 500 could make its lows for the year this week. A bold call indeed, given that Doug is a short seller and has been correctly bearish on the economy’s prospects for a long time. His reasoning is mostly based on extreme pessimism (not unlike in November when we made a short-term low) and low valuations.

Other commentators debate the valuation point. CNBC’s own Bob Pisani made the case that assigning a 7 or 8 P/E ratio (a typical number at bear market bottoms) to this year’s depressed earnings level forecast (currently around $50 for the S&P 500) is reasonable. Pisani concluded that unless you think that earnings in 2009 will be substantially above $50 (which is very unlikely), the market is not cheap because 7 or 8 times $50 is 350-400 on the S&P 500 index, versus today’s sub-700 level.

When Kass was on the air on Monday he rightly suggested that putting a trough P/E on trough earnings is not appropriate, but market commentators continue to insist that is where the market needs to go before a cyclical bottom can be put in.

I have argued against this logic on this blog before (sorry to keep harping on it), but I decided to dig up some evidence on this topic so perhaps we hear less of it in the future. Below you will find the earnings of the S&P 500 relative to the level of the index from 1970 through 1985, a time period that encompasses both the early 1970’s recession and the early 1980’s recession, both if which are similar in depth to what most believe will be our fate this time around.

From this data you can clearly see why everyone is using a trough P/E ratio of between 7 and 8 times earnings (the bear markets bottomed at a 7 P/E in 1974 and at 8 in 1981). The year of both market bottoms is in boldface to show these levels.

The key here is to look at the level of S&P 500 earnings during both 1974 and 1981. Although the stock market traded at the trough P/E ratios during those years, earnings were at record highs both times! The 1974 level of earnings ($9.35) had never been reached before. The same goes for 1981 earnings ($15.18). Therefore, the idea that we take trough earnings and apply trough P/E multiples is simply unfounded if we look at the very data people have supposedly been using.

Not surprisingly, I am far from the first person to point this out. John Hussman, former professor of economics and international finance at the University of Michigan, actually has created a more relevant P/E ratio called “price to peak earnings” which suggests that trough P/E ratios on previous peak levels of earnings are far more reliable bear market valuation tools.

Where would this type of P/E ratio peg the bottom of the current bear market? Well, S&P 500 earnings peaked at $87.72 back in 2006. Multiply that figure by 7.3 and 8.1 and you get a range for the bear market trough of between 640 and 710 on the S&P 500 index. Interestingly, especially given comments from Doug Kass predicting a possible yearly low this week, the index is in the 680’s currently, which is right in the middle of that projected range.

Hopefully actual data is enough to debunk seemingly popular myths about bear market low valuations for the stock market. While this evidence does not make it impossible for the S&P 500 to dip to 400-500, it would make such a move unprecedented in terms of the last four decades of market history, during which we have seen two recessions that are proving to be very similar to this one.

How Bank Solvency Can Be So Hotly Debated

I wanted to pass along some excellent work by Gary Townsend of Hill-Townsend Capital on how there can be such a hot debate on Wall Street about the solvency of our nation’s large banks. Essentially, it comes down to this: if you take loans on bank balance sheets and mark them to market, you can show that the bank is insolvent. Of course, bank loans held for investment are not marked to market according to GAAP (instead loan loss reserves are set aside over time to cover future losses), but why let some silly accounting rules get in the way of bank solvency analysis!

Here is a graphic put together by Townsend to illustrate how a bank (in this example, Capital One, a Peridot holding coincidentally) can be very solvent under GAAP but insolvent if you mark every loan on its book to market.

Gary comments on the data above by adding the following:

“So with full-bore MTM treatment of Capital One’s balance sheet, after net MTM adjustments of just over $12 billion, the company’s tangible book value of $28.24 per share falls to minus -$1.21. There are innumerable other examples.

The point is that the market takes Capital One’s MTM disclosure, does the math, and values Cap One as if the loans were marked to market anyway. That’s how Capital One and many other banks are well-capitalized according to GAAP and regulatory standards, but insolvent in the view of many market participants. GAAP results become irrelevant. And it’s how Roubini and others come up with their huge loss numbers, on their way to declaring the U.S. banking system insolvent.

The problem, of course, is that the MTM results have little to do with the intrinsic value to a bank of a loan or a security that it plans to hold to maturity. In a bank, the decline in a loan’s value is offset with a forward-looking provision for loan losses. The decline in the loan prices net of loan loss allowances is not due to credit deterioration; it’s the result of the distortions and speculation in the world’s financial markets. Mark-to-market accounting isn’t improving the transparency of bank accounting. It has reduced it, with enormous and growing damage to our economy and prospects.”

Full Disclosure: Peridot Capital was long shares of Capital One at the time of writing, but positions may change at any time

Why Not Just Sell And Wait For Rosier Days?

I was emailing with a client yesterday and during the course of the conversation he asked the following:

“Are you overloaded these days? It seems to me that right now all we can do and should do is wait….there’s still more downhill. I understand your investment philosophy does not concern itself with short term events, but still…shouldn’t there be an exception if you have reasonable expectations that the market will sink more before it bounces?”

Since it is a good question, and one others may be wondering about, I thought I would elaborate here rather than just respond privately.

This client is right, I am not a market timer and do not base investment decisions on what the stock market may, or may not, do over the short term. If the market’s short-term direction merely correlated with economic activity this would not be a wise philosophy. We would all simply sell our stocks when the recession began and wait until it ended before getting back into the market.

The reason why market timing is so difficult (and why I choose not to partake in it) is because the stock market is not a proxy for the economy over the short-term. The Dow didn’t drop 300 points on Monday because the economy got worse, and the next time it goes up 300 points it will not be because the economy got better. There are so many crosscurrents that affect day-to-day stock market movements that it makes it very hard to guess which way things will go, even during a severe recession.

As an example, consider the last three months. If you asked economists and market watchers how the economy did over the last three months, there would be a consensus view that it has been bad and is getting worse. As a result, one might conclude that stocks would simply drift lower day after day, week after week, month after month, because there is no evidence that the economy is improving.

If we look at market data, however, we see that the S&P 500 rose by 27% between the lows made on November 21st (741) to the highs made on January 6th (943). Did the economy improve during that time? No, it got worse.

Since January 6th the S&P 500 has dropped from 943 to 700, a loss of 26%. What explains this move down? A bad economy? Probably not entirely, given that it has been bad the entire time despite two dramatic (and equally substantial) market moves in opposite directions.

We could make a list of at least a dozen reasons why the market rose 27% over a six week period, only to fall 26% over the next eight. All of those factors combined determine the short-term movements in the market and personally, I find them oftentimes irrational and highly difficult to predict.

To further illustrate the point that markets and economies don’t always move in tandem, consider the last recessionary period of this magnitude that our country faced, 1980-1982. Look at how the stock market fared during this three-year period compared with key economic figures such as GDP growth and unemployment:

Does the above data make any sense on its own? Not really. After all, the market rose significantly in the years the economy declined and fell during the year it rebounded temporarily. Joblessness rose consistently over the entire period. Simply assuming that the market will stay bad if the economy stays bad is too simpleminded for such a complex marketplace. There are so many variables that play into it, it could give you a headache trying to make sense of it all.

As a result, I choose to simply focus my time on researching individual companies, their long term prospects, and their share price valuations. There are plenty of people who prefer to focus on other things, and that’s fine, that is what makes the market. We are all looking at the exact same data and still come to many different conclusions or choose to focus on different data points entirely.

As a long term investor, I am investing in a world where the stock market rises in any given year about 75% of the time. Not only that, but sometimes it goes up dramatically even when the economy sucks (as the data above shows). Over the long term, historical data has shown that there is a direct, inverse correlation between current share price valuation and future share price returns. Over the short term, stock prices are dictated by any number of factors and the near-term movements are anyone’s guess quite frankly.

I prefer to stick to one aspect of stock market analysis. That is just my preference, it doesn’t make it right or wrong, it’s just what I am good at and have confidence in. Other market participants prefer to ignore the things I look at and focus on those that I ignore. Thank goodness for that, because without that discord, there would be no market for us to participate in, and it certainly would not be inefficient enough to present compelling investment opportunities for all of us to try and profit from.