Tip: When Engaging in Insider Trading, Be Discreet!

Evidently a Hong Kong couple thought the rest of the world was asleep. Listen to what they did before their brokerage accounts were frozen, preventing them from pocketing an estimated $8.2 million. Tell me if you think their broker, Merrill Lynch (MER), might catch on that something was a bit suspicious.

In early April the couple’s account was worth $1.2 million, consisting of mostly fixed income and commodity investments, along with a small position in Intel (INTC) stock. All of the sudden, they wire $10 million into their account and borrow $5 million on margin to buy 415,000 shares of Dow Jones (DJ) for an average price of $35.14 per share.

Just days later Dow Jones gets a $60 cash offer from News Corp (NWS) and the couple tries to sell all $23 million worth, netting a profit of $8 million. How on earth do people really think Merrill Lynch isn’t going to notice this? Regulators often do investigations after M&A deals are announced to try and uncover illegal activity, but this case was handed to them on a silver platter.

It will be interesting to see what happens to these people. I hope they get the book thrown at them. Perhaps a copy of the insider trading laws would be a good start.

Full Disclosure: Long Intel $10 2009 LEAPs at the time of writing

Dow Winning Streak Longest in 80 Years

It has truly been a breathtaking run, with the Dow Jones Industrial Average rising in 24 of 27 sessions, the longest streak since eight decades ago in 1927. Unfortunately, Tuesday’s four point drop snapped the streak. How should investors play this? Many are stuck between two prevailing ideas, either ride the momentum to ensure not missing it, or wait for a pullback and buy on the dip. The problem is, there aren’t any dips. We got a 7 percent correction a couple months ago but it was so short-lived that many didn’t have time to get back on the train before it left the station again.

I am sitting on an above-average amount of cash right now, due to an overbought market that I am uninterested in chasing, coupled with a seasonal inflow of deposits. Since I’m a value investor, not a momentum trader, I am content with sitting on cash and waiting for an excellent opportunity. With the broad market rallying so strongly, such a dip might only occur in select names, as opposed to a widespread sell-off that makes many stocks compelling.

Why not just get my money in when short term momentum is strong? There are far fewer bargains now than there were six months or a year ago. Although I might miss some upside in the short term, due to above-average cash positions during a long winning streak, I still believe that buying dips and not rallies will prove to be more profitable when we look back a year from now.

The result could be lagging returns in coming days and weeks, but when we get another pullback and I have the ammunition to jump at true bargains, those purchases will more than likely make up the lost ground and plenty more over the intermediate to longer term.

Market Correction Comes and Goes Much Like Last Year

Did you notice the S&P 500 hit a new high today? It seems this market corrects much more fast and furious than in prior periods, but the corresponding snap back is just as quick. If you blink, you might miss it. Just last month we were spooked by a 400-point one-day drop in the Dow after a huge sell-off in the China market. Chinese stocks rebounded to make new highs and now the U.S. market has done the same. The 2006 correction was very similar, short and swift. In fact, compare the two charts:


Bears will undoubtedly be looking for a failed breakout and another leg down. Despite the fact that the market has been pricing in an interest rate cut, and yet no rate cut seems imminent, stock prices keep chugging along. I am in the camp that believes the Fed is on hold and won’t cut rates due to a perceived credit crunch. Things would have to get meaningfully worse on that front for Bernanke to move, in my opinion.

Where does that leave stocks? I am still standing by my mid-to-high single digit return prediction for the U.S. market in 2007. Currently the S&P 500 is up 3.5% year-to-date. I just can’t get overly bullish with decelerating profits and a Fed that is still concerned with inflation. What would be the catalyst for a big move up? Earnings would have to really be strong. I’m not expecting a huge downward revision to current estimates, but this economy doesn’t seem to me to have much upside right now.

With what we know now, the market seems pretty fairly valued overall. I think we’ll trade between 14 and 16 times earnings in this environment. The strategists calling for P/E expansion I think are dreaming. Sure employment is high and interest rates and inflation are relatively low, but we still have single digit earnings growth and a slightly above-average valuation on the market. Hardly reason to be overly bullish.

In times like these, I’d suggest investing in cheap companies rather than a fairly valued market.

Use Sites Like Yahoo! Finance With Caution

Investors need to be careful when they do stock research on portal sites like Yahoo! Finance. If you enter a symbol in these sites you will quickly get a summary of where the stock trades. Not only do current prices show up, but also other metrics like market cap, earnings per share, P/E ratio, dividend yield, etc.

Keep in mind that oftentimes these numbers are wrong. They can include one-time items like EPS charges and gains, as well as special dividends. Also, the numbers aren’t always adjusted in a timely fashion to account for stock splits. The reason I wanted to point this out is because of an email I received summarizing the contents of this week’s Barron’s Magazine. It said the following:

ST Microelectronics, one of the top five global semiconductor companies, has been beset by troubles including flat sales, a struggle to cut costs, removing itself from the low-margin memory chip business, and competition from strong rivals like Texas Instruments and Qualcomm. Yet its 23x P/E multiple is double that of TI — and Technology Trader Bill Alpert “doesn’t get it.”

If you follow semiconductor stocks you might know that Texas Instruments does not trade at 11.5 times earnings. If it did it would be a screaming buy. I’m surprised that a writer for Barron’s would make a mistake like this, but as soon as I saw it, I knew exactly where Mr. Alpert got that number; Yahoo! Finance.

Sure enough, when you enter STM and TXN into the site, it shows trailing P/E’s for the two stocks as 23 and 11, respectively. However, if you dig deeper you will learn that the TXN number is way too low, likely due to one-time items that Yahoo! (or more accurately the supplier of its data) did not remove. The actual trailing P/E ratio for TXN is 18.5. No wonder Barron’s “doesn’t get” why TXN trades at half the multiple of STM, it really doesn’t.

Don’t make the same mistake Barron’s did. Always double check numbers on finance portal sites if they look a bit strange. Chances are they were miscalculated.

Full Disclosure: No positions in the companies mentioned

Comments on Tuesday’s 416 Point Drop

I know, I know… I write a stock market blog and have gone more than 24 hours without mentioning the fact that we got a 400 point drop in the Dow in a single day. Since I’m a long term investor and not a trader, the events of this week really aren’t all that important to me. I really didn’t do much of anything on Tuesday other than just sit back and watch the television screen after it became apparent that something was happening that we don’t see every day.

So, why haven’t I been very active in the market this week, and what do I think about the whole thing? First, while four hundred points sounds like a lot, in the whole grand scheme of things, it isn’t. From peak to trough, intraday, we saw a 5% drop in the S&P 500 over three trading days, which is pretty substantial, I admit. However, if you use closing prices it was less than that, and if you include Wednesday’s snap back rally, it was even less than that. Currently, the S&P 500 sits 3.7% below the highs it made in February. To me, this is much to do about nothing. If we had gotten a 3.7& drop over the course of a month or two, few people would think anything of it.

Let’s take a step back and put the drop in perspective. I began to get a little cautious when the S&P 500 crossed 1,400 because I thought the market was overbought. However, it kept going up, rising another 4% within weeks. Even with this 3.7% “correction” (I’m hesitant to say that it is over) the S&P 500 is still above 1,400. So, I don’t really think this pullback has been big enough to warrant putting every cent of cash to work. We just haven’t retraced enough of the gains for me to be optimistic that the smoke has cleared, hence I am not all too enthused about the market’s short to intermediate term prospects.

If the sell-off continues, which I suspect it might, then I will likely do some buying. I’d say we would need another 3% to 5% downside from here for me to get to that point. If we instead rally right back up to the highs, then my same overbought worries will persist and I will likely take some money off of the table to save up for a rainy day, or the next 400 point fiasco.

To sum up, I really don’t think too much has changed despite this week’s events. The market is still up a lot and even with the pullback, I still don’t think we are going to see double digit returns this year. It would still take a more typical market correction for me to get aggressive on the long side, so right now I’m really just focusing on individual companies in this environment.

Market Winning Streak Reaches 8 Months

Readers of this blog know I have cautious on the market since the S&P 500 broke through the 1,400 level, but stock prices have continued to rise (about 3 percent more, in fact). January marked the eighth straight month of gains, the longest monthly winning streak in a decade.

Traders will likely try and play the momentum until it fades, but keep in mind that rallies like this are rare, and will end. The first quarter is typically a seasonally strong one, leading up to tax day in April when 2006 IRA contributions are due. The old saying “sell in May and go away” usually spells trouble for the market in the summer, before the historically strong fourth quarter begins.

I can’t tell you how many more months we will see gains for the U.S. market, but the streak will end, so just make sure you are not blind-sided when it does. It is very easy to get lulled into a false sense of security when things are going well, but they often will turn on a dime. We will see a pullback this year, and it will feel painful. Just be prepared for it, so you make rational decisions when the time for action is upon us.

CNBC: Stop Hyping Your New Web Site!

A few years back CNBC, in partnership with MSN and some investment companies, began promoting the “StockScouter” ranking system. The quantitative formula ranked stocks using a 1-10 scale on numerous criteria and investors could sort companies by their StockScouter ranking on the CNBC/MSN web site.

This was fine, except they took it a bit too far by mentioning the StockScouter ratings constantly on the air during CNBC broadcasts. After each executive interview they would tell you what StockScouter said about the company being profiled. Not only that, but when portfolio managers came on air recommending stocks, their opinions were followed by a comparison to StockScouter’s opinion, which often led to the awkward on-air moment when a top-rated fund manager was told by Sue Herrera that StockScouter rated their top holdings “a 2 out of 10.”

Fortunately the StockScouter was removed from CNBC airwaves eventually, probably due, in part, to the fact that it would give very high “safety” ratings to stocks like eBay (EBAY) and Yahoo! (YHOO) on a consistent basis, shares that clearly were not “safe” investments.

Well, it looks like CNBC is wasting viewers’ time again with the relaunch of “the new CNBC.com” web site. The site went live in recent weeks and at every moment they get, CNBC anchors try and convince viewers that the information on the site is somehow new and better than any other site out there. Among the earth-shattering innovations on the new CNBC.com; advanced charting, up-to-the-minute news items, and even… hold your breathe… a portfolio tracker!

They even have a special desk where anchors sit and guide viewers step by the step through the process of charting a stock, etc. I know CNBC has plenty of time to fill during the day, and obviously they want people to go to their web site. However, hyping their product offerings so much during the actual broadcasts, especially when it has little to do with the rest of their content, is extremely annoying. They really should just run a few commercial spots every hour to advertise the web site so people like me aren’t tempted to change channels when they do a segment of CNBC.com 101.

Does a Roller Shoe IPO Signal that this Market is Too Hot?

As you may have noticed, 2006 has been the year of the consumer IPO. Familiar and popular consumer brands have debuted on the public market to much fanfare. Names like Chipotle Mexican Grill (CMG), Crocs (CROX), Mastercard (MA), and UnderArmour (UARM) have all made investors a lot of money. Of that group, Crocs is really the only one that I looked at and said to myself, “Boy, that will be a great short when the fad dies and the stock’s momentum dies down.”

Well, that is until we learned that a roller shoe company called Heely’s (HLYS) was going public at $21 per share on Friday, putting the firm’s value at more than half a billion dollars. Shoes with wheels on them? Wall Street can’t be serious.

I am not saying the company isn’t selling a lot of shoes right now, and retail investors are going to bid the stock up a lot just like they did with Crocs as soon as it starts trading. That said, I can’t believe this company is going public. It must say something about the overly bullish stock market environment we find ourselves in right now.

While I won’t be buying any Heely’s shares, I hope they go through the roof. Maybe the company’s market value even hits a billion dollars or two when it’s all said and done. What an excellent short candidate that would make it.

Is Annual Guidance a Reasonable Expectation for Investors?

Regular readers of this blog are aware that I think public companies giving out quarterly earnings guidance is something that should be eliminated in order to ensure that management teams run their businesses for the long term, not with a goal of “hitting the quarter” any way possible.

It is also fairly unreasonable to expect a CFO to be able to predict whether certain expected revenue will be booked in June or July several months in advance. It can make all the difference in the world in trying to meet or exceed previously issued guidance on a three-month basis, but should investors really care if a big order is shipped on June 25th or July 5th? I tend to think not.

Fortunately, many companies have ceased issuing quarterly guidance. Some, however, are taking this practice a step further by halting annual guidance as well. I was listening in on the Affiliated Computer Services (ACS) quarterly conference call yesterday afternoon, and they announced that they will no longer provide revenue or earnings guidance on an annual basis. ACS’s 2007 fiscal year began in July, so investors looking to get some sort of idea of how the next year will shape up are at a loss.

So, this brings us to an important point. Should investors be upset if they aren’t provided annual guidance? I tend to say “yes.” Forecasting an entire year (without breaking it down by month, quarter, or even half) shouldn’t be as difficult and unproductive as issuing quarterly guidance. I don’t care if some business gets pushed into Q2 from Q1 at the last second, but I still want to have some idea of how 2007 is going to look compared with 2006.

If I don’t have any idea how fast a company will grow its earnings, how can I assign the stock a multiple that I think represents fair value? It makes life awfully difficult. Just give us a range of, say 5%, for forward annual growth. If ACS says 2007 growth in earnings will be 5%-10%, I have an idea of how much to pay for the stock. If I don’t know if growth is expected to be 0% or 15%, the fair value ranges I could come up with become so wide they are fairly useless.

 

So Far, So Good on the Earnings Front

We still have a lot of reports to come, but so far second quarter profit reports have once again come in very strong. Aside from the obvious, a fairly strong economy, I think there are two key reasons why we are seeing strong corporate results.

The first is clean corporate balance sheets. Public companies are flush with cash which gives them a lot of flexibility in managing their business. Excess cash has been used for acquisitions as well as share repurchases quite heavily in recent quarters. M&A can be very accretive if done right, and buyback programs can add a penny or two to the bottom line in any given quarter.

The second reason earnings have been so strong, in my opinion, is because managements have finally figured out that the key is to under-promise and over-deliver. This is true in any business, public or private. However, in the go-go days of the late 1990’s, stocks would only rise if the firms beat numbers and raised guidance every three months. CEOs had to be overly optimistic in everything they said in order to prop up their already richly valued stocks. As a result, expectations got way out of line and eventually the bar had to be ratcheted downward.

I think today is different. The trend has been to beat numbers and issue cautious guidance. This serves to hurt share prices right after results are released, but it brings expectations down for future quarters. Then, the company beats the reduced expectations the next quarter and again issues cautious guidance. The cycle simply repeats itself over and over again. Executives have finally figured out that hyping their company’s future prospects can end badly if they fail to deliver on the lofty promises.

Readers of this blog know that I’d prefer companies shun quarterly guidance completely. However, if they insist on giving out financial projections every three months, at least most are setting the bar low enough that they can at least hit, and often even surpass, their projections.