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.

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.

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.

Thoughts on the Financial Media

Since it came up in discussions regarding my last post, I wanted to touch upon the issue of the financial media a bit more. I think it is important for investors to understand why media outfits like the NY Times (NYT) might not be the best resources to use when making investment decisions. Recent events involving a story the aforementioned paper published about Warren Buffett’s interest in buying a 20% stake in Bear Stearns (BSC) bring the issue to light even more.

For those that didn’t hear about it, shares of Bear Stearns rose more than 10% on Wednesday after the NY Times reported that Buffett was one of several parties discussing the purchase of a minority stake in the troubled investment bank. Within minutes other reporters were playing down the story after speaking with sources they have within the industry. The next morning, Bear even refuted the story itself on a call with investors. Lots of people have lost money due to what looks to be an erroneous report. Most likely someone leaked the story to a NY Times reporter, assuming they might publish it, causing a temporary jump in the stock price, allowing them to sell some stock at a nice profit right before the end of the quarter.

Now, yes, that explanation as to why it all happened is purely speculation on my part. However, based on what happens all the time on Wall Street, coupled with the fact that the story was immediately rebuffed by numerous sources, including Bear Stearns, leads me to be cynical and suspect that the Times did not check with many reliable sources before reporting Buffett’s supposed interest.

I bring this up because media outlets are not the most trustworthy of resources when trying to gauge the merit of a particular investment. The NY Times is often guilty of this because they are based in the financial capital of the world and have access to lots of Wall Street people, but many other media people make the same mistakes.

It shouldn’t really be all that surprising though, that is, the fact that newspapers and the media in general is often biased in their reporting. In recent months, the NY Times has published numerous stories, from numerous reporters, regarding many different financial corporations including student lending firms, credit card issuers, and mortgage companies. Some of these firms I am invested in, so although I don’t read the NY Times regularly, I have seen some of the “journalism” that has been published to the extent that it has caused stock price movements that interest me.

It is no secret that the Times has a liberal bias in many cases, and some of their attacks on large consumer lending companies makes it clear that some of their reporters are purposely trying to criticize large financial institutions for their lending practices, whether it be to college students, sub-prime home owners, or credit card dependent consumers. I guess it’s just the world we live in.

Now don’t get me wrong, I am all for throwing the book at companies that break the law or act in extremely unethical ways. By no means am I arguing that unlawful acts should not be punished to the fullest extent, and please don’t assume that I am writing strictly to make a political point. Most times I am successful in separating my political beliefs from my job as a stock picker, not only because it serves me and my clients best by doing so, but also because the views are often at opposite ends of the spectrum.

However, since consumer lending activities have become such a big issue lately, the media has started to really cross the line, in my view. It has, in part, I believe contributed to the fact that many Americans feel like they are constant victims of big business, whether it be the oil companies’ supposed price gauging (which there is no evidence of), or any type of consumer lending that has been called predatory in nature without any evidence to support the claim.

Stories in recent months from the likes of the NY Times have sharply criticized many financial institutions, and in some cases, have even gone as far as insinuated that they are breaking the law. Some examples of these horrible activities include student loan companies that factor in things like career path and which college you attend when determining your loan eligibility and interest rate, or mortgage companies that are offering wealthier white borrowers loans more often, and at more attractive terms, than minority, less wealthy borrowers. It turns out, in fact, that mortgage companies also offer their sales people higher commissions for more profitable adjustable rate mortgages than they do for fixed rate versions (much like stock brokers usually try to sell clients annuities — they have high fees and sales commissions of up to 8%!).

Now, if you read these stories without a cynical tilt you are more likely than not going to conclude that companies like Countrywide (CFC), Sallie Mae (SLM), and JP Morgan Chase (JPM) are crooks who are discriminating against anyone and everyone in the name of profitability. Those profits in the end wind up in the hands of wealthy executives and shareholders, which results in an ever-widening gap between the wealthy people making the loans and the less wealthy ones receiving them. This press coverage does result, at least in the short term, to lower stock prices and a general anger toward big business in general. In my view, these attacks are not only often unfair, but in some cases completely one-sided and oftentimes based on assumptions that are simply untrue.

For instance, is it fair to imply that it is at most illegal, and at least unethical, to factor in what degree you are seeking and what school you plan on attending when deciding whether or not to offer you a student loan and at what interest rate? Believe it or not, lenders offer loans to people based on what they think the odds are of being repaid. The better your credit, the more likely you are to not only get a loan, but also a low interest rate. Lenders need to consider this issue more than any other when deciding who to lend money to. The higher the risk, the less often you will qualify for a loan, and even when you do get approved, your increased credit risk results in higher interest rates.

Now, does anyone think that which college you attend and which career path you are pursuing might be relevant factors in determining a borrower’s creditworthiness? The fact is, there is a direct correlation between education, career, and annual income. It also stands to reason that the more money you end up making, the higher probability there is that you will be able to pay back your student loan. Therefore, is it unfair to accuse Sallie Mae of illegally discriminating based on school choice or career path? Most economists would say “yes.”

The same arguments can be made on any number of fronts. Do a smaller percentage of minority borrowers get low interest rate loans because of their skin color and ethnic background, or is it because of their credit worthiness? Most likely, the latter. That does not mean we should not strive to put in place policies that seek to get minority education levels and incomes on par with everyone else, it just means that accusing the banks of racism is probably crossing the line.

The current mortgage and housing industry downturn we are seeing is partly due to the fact that lenders actually abandoned these basic lending principles. Traditionally, the better your credit history, the better loan you were offered. Not surprisingly, the housing boom led companies to get greedy. The more loans they made, the more money they made (at least in the short term, as we are finding out now).

The result was that the lenders completely turned their lending practices on their head. If you couldn’t afford a standard 30 year fixed rate mortgage with 20% down, a new type of loan was created for you allowing little or no down payment and an attractive teaser interest rate. All of the sudden, people who couldn’t get loans were able to go out and buy houses they couldn’t normally afford. And that’s how we got ourselves in this mess.

Amazingly, we lived in a world where the better your credit, the worse your loan terms! High quality borrowers put 20% down on their house and paid 6% interest while sub-prime borrowers put less down and got low single digit introductory rates. How on earth does that make any sense?

It doesn’t, but people are paying for it now. Many lenders have either gone out of business or are losing money hand over fist now since they failed to align the credit worthiness of the borrower with the loans they were offered. And yet, some people want to criticize smart lenders for doing their due diligence and aligning credit histories with interest rates.

Consumers are also to blame since those facing possible foreclosure are constantly being quoted as saying they were so intent on getting their house that they didn’t read the loan agreement before signing it. Well, if you were about to be loaned hundreds of thousands of dollars and didn’t bother to take the time to read the paperwork to find out how much that loan was going to cost, maybe it’s your fault for taking the money just as much as it was the lender’s fault for offering it to you.

I’m getting a little sidetracked here, but the basic point is this. It is imperative that lenders size up the creditworthiness of borrowers to determine loan terms that are appropriate to compensate them for the repayment risk they are taking. Doing so is not illegal or unethical, although hundreds of biased press stories will try to convince you otherwise. These issues are all coming to a head in 2007 and due to the highly divided political landscape our country is facing, people are becoming more and more inherently biased. It’s a shame that this is the case, but it is simply reality. And it’s not just the Times, of course. Conservative papers will be coming from the exact opposite end of the spectrum. It’s just the world we live in today.

This is important from an investing standpoint because you need to consider these issues if you are going to allow the media to play a role in your investment decisions. I would recommend that you not base your investing on what you read in the media. Due to inherent biases, there is going to be information left out because it doesn’t prove a certain desired point, and other information is going to be embellished to make a certain case seem even stronger.

The best thing to do is to base your decision on the facts, not on opinions. In many cases that means taking what public companies say at face value. It is true that there will always be Enrons and WorldComs in this world. However, there are far more biased press reports that ignore facts than there are crooked companies and executives. If you are trying to research a company’s mortgage portfolio, for instance, and the company is willing to break out in agonizing detail exactly what loans they have made (what the delinquency rates are, what the credit scores of the borrowers are, etc.), then you are probably better off analyzing that data than the opinions expressed in the media.

If a company is unwilling to disclose the data you feel you need to make an appropriate investment decision, then find another company that will. In the world we live in today there are too many people with an agenda or a bias that colors what they feel, think, and publish. Heck, I’m guilty of it too. If I’m going to write about a stock that I am invested in, won’t I tend to be bullish? Of course.

However, the merit of my opinion can be greatly increased if I use facts to back up my assumptions. If someone offers up facts and you agree with their underlying assumptions, it is far more likely they will be right. If you read or hear something with a lot of opinion and speculation, but little in the way of facts (say, for instance, in the case of Warren Buffett’s supposed interest in buying Bear Stearns), perhaps it is prudent to be more skeptical.

Take the case of Bear Stearns, for example. On Wednesday the NY Times reported that Warren Buffett was discussing taking a 20% stake in the company. There was no evidence in the story that suggested the rumor had any merit. Within 24 hours numerous reporters were doubting the story after talking with their sources and Bear dismissed the rumors directly. We cannot know for sure if Buffett will wind up buying a 20% stake in Bear Stearns, but based on the factual information we have, I wouldn’t be willing to bet any money on it.

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

Insider Selling Could Mean Anything, Whereas Buying Can Only Mean One Thing

At Peridot Capital, I tend to ignore insider selling completely. Sure, a lot of sales inside a company can indicate management feels their stock is overpriced, but there are dozens of other reasons top brass sell stock, and they are never required to give the reason for their actions. Investors should be able to tell if a stock is grossly expensive or not on their own, if they indeed manage their own money, so insider selling data really can’t be relied upon.

Insider buying, however, I believe is crucially important. While I can make a laundry list of reasons why someone chooses to sell a stock, the reasons to buy are much fewer in number. In fact, there’s only one (to make money). It’s not surprising that studies have shown much more meaningful correlation to stock performance and insider buying, as opposed to insider selling. And with that, I’ll leave you with the following Associated Press story that ran on Friday evening. To those who think there are bargains among the wreckage of the latest correction, you’re not the only ones…

AP: Insider Buying Set Records in August

Friday September 7, 6:17 pm ET

NEW YORK (AP) — Insiders purchased shares of their companies’ stock at a record pace in August, analysts said, as credit market deterioration threw stocks into a tailspin during the month. The trend of buying among insiders, who are typically long-term investors, was one of the few bullish signals last month, said, a Web site that tracks insider transactions.Company Insiders Bought Stock at Record Pace in August As Credit Market Woes Stunned Market

According to Thomson Financial, insiders drove buying volumes to their highest monthly levels since 1990, with $465.5 million in purchases.

Insiders in the energy, retail and insurance industries led the buying spree, said analysts in a research report released Wednesday.

In the energy sector, insider buying was at its strongest since the spring of 2005, boosted by large purchases by RPC Inc. Chairman Randall Rollins, Cheniere Energy Partners LP Chief Executive Charif Souki and insiders at other companies. Schlumberger Ltd. Director Michael Marks and Nustar GP Holdings LLC Director William E. Greehey also bought shares as their companies’ stock came down from 52-week highs.

In the retail sector, which was hurt as economic uncertainty slowed shopping this summer, top executives at several companies bought stock as shares fell to 52-week lows in August. American Eagle Outfitters Inc. Chairman Jay Schottenstein and other insiders bought 184,575 shares. Barnes & Noble Inc. Chairman Leonard Riggio bought 100,000 shares, his first purchase in two years. The CEO of Best Buy Co.’s international operations bought 11,300 shares, the largest insider purchase of the electronics retailer’s stock in more than two years.

In the insurance sector, more than 10 insiders bought shares at Conseco Inc. after the company’s stock plunged in August. Also, Prudential Financial Inc. Chief Financial Officer Richard J. Carbone bought 10,000 shares last month. Unitrin Inc. and American Financial Group Inc. were among other insurance providers that reported large insider purchases in August.

In other sectors, Yahoo Inc. President Susan Decker and Director Arthur Kern bought more than 65,000 shares of the Internet search company, which has slipped against rival Google Inc.

Also, three directors of American Express Co. bought 63,000 shares of the credit card company in August.

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

Just Don’t Panic

On days like this the best advice I can give is, don’t panic. Panic selling just because the market gets a little scary will, more often than not, prove to be a big mistake. Every once in a while the psychology of the market takes over. Regardless of fundamentals, stock prices simply move in irrational ways. The best thing to do is simply sit tight and wait it out.

This is not to say that every stock’s move lately is irrational, but a company can post strong earnings, have a good conference call, get a nice stock price bump, and then a few days later the market tanks and the shares are much lower than they were before. In the short term, psychology always trumps fundamentals.

However, if you’ve done your homework and are confident in your investment thesis for particular names, just wait it out. You can add to positions if you want, but that can be hard in a tape like this. Selling into the panic most likely will cause you to have called the bottom and not profited from it.

Are there any real contrarian buys out there? I would not try to bottom fish in the mortgage area. There will be a point in time where Countrywide (CFC) is a buy, but I think we have a long way to go. It looks like the housing market won’t improve much, if at all, in 2008. I think it’s too early to jump in.

That said, the reason why CFC will be a buy at some point in the future is because of the valuation. Unlike the brokerage stocks, which could be facing peak earnings, Countrywide is staring at trough earnings and the stock still trades at a 10 P/E. It could certainly get worse before it gets better, so CFC’s recently reduced 2007 guidance of $3.00 per share might be too high. Who knows, maybe they’ll earn $2.00 when it’s all said and done, which means there is plenty of downside left. Until housing stabilizes for a long period of time and inventories diminish, I would stay away.

All in all though, just don’t panic. We’ve gone through periods like this before (earlier this year in fact), and things always wind up being okay longer term. Unless we see serious and sustainable ripple effects in the economy from the housing market, I am not overly concerned. However, patience is required during times like these more than others.

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

Should We Invest in Unethical Companies?

I had a telephone conversation last week with a new client and one of the questions he had for me was, “Do you invest in unethical companies?” He was speaking about Wal-Mart (WMT) specifically, it turns out, but there are a lot of investors who avoid buying shares in companies with which they disapprove of their products, their way of doing business, or both. Common examples include stocks with ties to alcohol, tobacco, firearms, casinos, Mideast oil, etc. It was a good question and one that I don’t think I’ve addressed on this blog before, so I figured I would give my perspective.

Before I get into an explanation, the answer to this question is yes, I will buy shares in the likes of Anheuser Busch (BUD), Altria (MO), Halliburton (HAL), Wal-Mart, and MGM Grand (MGM) if I think the stocks are good investments. This assumes of course that the client is okay with this. If a client does not want to own certain stocks, I have no problem following their request.

The issue here, in most cases, is whether or not you want to support companies like this if you disagree (insert a stronger word here if you prefer) with what they stand for. Many people equate buying stock to supporting a company. The reality though, is that Wal-Mart does not benefit in any way if I were to buy 100 shares of their stock. That action simply results in one of their current investors transferring their shares to me, in return for cash. Wal-Mart does not benefit monetarily from that transaction. After an initial sale of common shares, the money changing hands is between individuals, so the company is out of the picture.

I have no problem ceasing support for companies I don’t like. However, if I wanted to stop supporting Wal-Mart, for example, I would simply choose to never again set foot in one of their stores. No longer shopping there is adversely affecting their business. Not investing in their stock is not having the same effect. Since my job is to make money for clients, I will generally invest in the stocks that I feel can accomplish that goal, regardless of whether or not I like the underlying firms or not.

This reasoning of course assumes that you are not buying shares in an IPO or a new offering of stock through which the firm is directly receiving the proceeds from the sale. In those cases, not buying the stock does have an impact on them, even though there will always be someone else willing to invest even if you’re not. Still, it’s the principle that is important.

Full Disclosure: No positions in the companies mentioned at the time of writing, but not for the reasons discussed above 🙂

Sam Zell Called a Top, Will Steve Schwarzman Do the Same with Blackstone?

What does this Blackstone Group (BX) IPO mean? That seems to be a question that everyone is trying to answer. There is no doubt that monumental events, such as Blackstone Group becoming the first private equity firm to go against its own culture and issue stock to the public, deserve to be analyzed on Wall Street. That does not mean this IPO has to mark the end of something, whether it be the boom in private equity led leveraged buyouts, mergers and acquisitions, or even the overall equity market. Still, there is evidence that sometimes these game-changing events can signal something.

Consider an example. Earlier this year Sam Zell, a brilliant contrarian investor and businessman, sold his crown jewel, commercial real estate giant Equity Office Properties (EOP). The sale of EOP signaled to many that Zell thought the price he could get was so large that he had to cash out given the huge bull market for commercial real estate. There would be no other reason for Zell to sell after all these years. It appeared that the market forced his hand and he quickly moved on to Tribune (TRB), a company at the opposite end of the exuberance spectrum.

What is amazing is how well Zell timed his exit from EOP. As you can see from the chart below, the iShares U.S. Real Estate Fund (IYR), an exchange traded fund serving as a benchmark for publicly traded REITs, peaked on February 2, 2007. The index has fallen sharply (17 percent) in the five months since. Now get this, shareholders of EOP voted to approve the sale of the company on that very same day, February 2nd. And who bought EOP in a deal valued at more than $39 billion including assumed debt? Steve Schwarzman’s Blackstone Group.

Things like that (it’s not the first time this has happened) are exactly why people are trying to figure out what to gleam, if anything, from the Blackstone IPO. From my perspective, I think it says something about the global boom in M&A activity, but not necessarily the broad equity market. I think the market on the whole is tied to the economy more than anything else, of which private equity is tiny sliver. More likely, Blackstone decided to go public because they thought their firm would receive a peak valuation right now, both because PE firms are in high demand and because profit levels are through the roof due to immense deal volumes.

As we have seen in recent weeks, even a small increase in interest rates can startle investors. As soon as borrowing costs go up, it becomes much harder to issue debt to buy equity, which is exactly the mechanism that is fueling most of this private equity boom. It doesn’t matter if a 5.5% or 6.0% ten year bond rate is still pretty low in historical terms. It’s not 4.5% and therefore deals will be harder to complete. Fewer deals mean less money for the likes of Blackstone.

It will be interesting to monitor how the M&A market unfolds in the near to intermediate term. Worldwide M&A deal volume in 2006 rose 38 percent to $3.8 trillion, shattering the previous record of $3.4 trillion set in 2000. The first quarter showed year-over-year growth, so 2007 is on pace for another record. It would not be surprising, especially given the eerie coincidence of the aforementioned sale of Equity Office Properties, if we are near the peak in M&A. If that is the case, it will be yet another reason why people are so quick to postulate what something like a Blackstone IPO really means for investors.

Full Disclosure: No positions in the companies mentioned

Playing the Changes to the S&P 500

We just learned that three former highflyers are being removed from the S&P 500 index to accommodate the addition of three spin-offs from Morgan Stanley (MS) and Tyco (TYC). These changes reminded me of an article I wrote back in 2005 about the contrarian way to play these types of index modifications.

What essentially happens is that poor performing stocks are the ones that get removed from the index, in favor of better performing ones, or as is the case now, spin-offs from member companies. Contrarian investors, not surprisingly, would take the view that the very fact that a stock is being removed from an index due to poor performance would be an excellent contrarian indicator.

The piece I wrote two years ago, Examining Changes to the Dow 30 Components, focused on the Dow because that index often is changed arbitrarily even when no stock get bought out and needs to be replaced. In the case of the recently announced changes, it is simply bigger firms replacing smaller ones. Still, the three beaten down tech stocks could very well represent contrarian long ideas. If you would like to take a closer look, the trio includes ADC Telecom (ADCT) at $19.14, PMC Sierra (PMCS) at $8.14, and Sanmina (SANM) trading at $3.41 per share.

Full Disclosure: No positions in the companies mentioned