As Second Quarter Ends, IPO Market Heats Up

Investors had a tough second quarter as the S&P 500 closed June up a mere 1.8% for the year. Unlike prior periods, where the IPO calendar slows dramatically in dicey markets, we have actually seen a pickup in IPO activity in recent weeks. Why the sudden interest?

With the average stock not doing much of anything, investors seem to be looking anywhere for places to make money. New offerings, whether well-known consumer brands like J Crew or Mastercard, or much hyped ethanol plays like VeraSun and Aventine, offer the potential for a quick payoff, something that has been lacking for several months in the market.

The retail investor seems to be jumping in with both feet to the IPO market, which I would use as an indication that it’s time to tread carefully. Despite lackluster financials, small investors jumped all over the J Crew deal, causing a huge spike. On a valuation basis though, the stock does not appear cheap. The ethanol plays are also expensive, with the Aventine deal actually dropping more than 10% on its first day of trading last week.

History has shown that IPOs are some of the worst investments around. Just think about why this is likely the case. Companies don’t sell shares to the public unless they think they can get a great price. Why are ethanol companies going public now, even though oil prices have been high for a fairly long time? Perhaps they are sensing that speculative interest in the industry is at elevated levels and they want to take advantage of that.

The fact that many deals, including J Crew, are being brought to market by private equity firms is another red flag. These buyout firms bought companies years ago when prices were depressed. Now the so-called “smart money” is selling their stakes to the retail investor via IPOs. Which side of that trade do you think is going to come out on top?

Of course there will be exceptions, but I would caution investors to be careful when venturing into the IPO market. There is a reason why someone has decided this is the right time to sell. With initial public offerings having been relatively poor investments over time, make sure you pay attention to the stock’s valuation, not just what company you are dealing with.

M&A Not Slowing Down

Another “Merger Monday” is shaping up nicely today, as deals continue to pour in at record levels. Wachovia (WB) buying Golden West (GDW) for $25 billion is by far the biggest deal of the day, but perhaps the most interesting is the bidding war for Aztar (AZR), casino operator and owner of the Tropicana Casino in Las Vegas.

In March, Pinnacle Entertainment (PNK) agreed to acquire Aztar for $38 per share, more than 20% above where AZR stock was trading at the time. Late Friday, the two parties agreed to a revised price of $51 per share. It’s not often that a company has to increase the price of a friendly takeover bid by 34%, but in this case, three other suitors emerged and a bidding war began.


Although Pinnacle has a signed merger agreement with Aztar at $51, it might not be done yet. Two of the bidders appear to be out of the mix, as Ameristar Casinos (ASCA) officially dropped out, and Colony Capital hasn’t been heard from since their $41 bid was trumped. Columbia Entertainment, however, saw their $50 cash bid expire Friday afternoon, and could very well come over the top sometime this week.

What is all the fuss over Aztar about? The Tropicana, although fairly old in Vegas terms, sits on prime real estate on the Vegas Strip. The buyer would like to knock it down and build another brand new casino, much like the newest hot spot, Wynn Las Vegas. Vegas is hot, and as a result, Aztar’s real estate appears to be worth far more than shareholders thought a couple of months ago when the stock was trading at $30 before the initial bid from Pinnacle.

Not only will it be interesting to see how the Aztar situation is resolved, but the overall theme of an immensely robust M&A market should be a focus for investors. The best way to play this, aside from speculating on which firms get bids next, is to go with the investment banks whose advisory fees are sky-high with the current deal flow.

Companies Shunning Quarterly Guidance?

I’ve said here on several occasions that giving earnings guidance does two things, and neither one is beneficial to shareholders. One, it puts management’s focus on short term results, not a long term strategic plan for boosting shareholder value. Two, it does Wall Street analysts’ jobs for them so they can avoid having to do any real legwork on their own.

An interview on CNBC last Friday afternoon was centered around how some companies have begun to stop issuing quarterly guidance in favor of annual projections. Evidently the number of company giving guidance for three-month periods has dropped from over 60% to slightly more than 50%. I don’t expect most firms to take the Sears Holdings/Google approach of not issuing guidance at all, but this is certainly a good start. A company should never be put in a position to feel compelled to ship product on the last day of a quarter just to hit their numbers, appease shareholders, and prevent a one-day stock price blowup.

One ramification of this shift is that quarterly earnings results will be more volatile. Rather than coming in right on target or a penny ahead of consensus every quarter, there will be a lot more instances of big upside surprises and large shortfalls. This will undoubtedly make share prices more volatile during earnings season, but it will also make my job as a money manager much more fun and important as more surprises require more analysis and decision making.

Fortunately, there seem to have been relatively few earnings warnings this quarter (this is a trend I began to see last quarter as compared with prior periods), so I would guess results will be pretty good when companies begin announcing their first quarter results later this month.

First Quarter Comes to a Close

For me it’s very tough to be disappointed in any way with the market’s performance in the first quarter. I have been pleasantly surprised at how well stocks have acted throughout 2006 thus far. The S&P 500 index rose by 3.7% for the period, even as 10-year bond yields jumped substantially, from 4.40% to 4.85%.

It was an excellent backdrop for stock pickers, and the performance of my 2006 Select List echoes those sentiments. The 10 stock list has posted a gain of 12.2% since the beginning of the year. The group was led by 4 stocks that jumped more than 30% each, including Lionsgate (LGF), the movie studio behind Crash, the Oscar winner for Best Picture.

Heading into the second quarter, my outlook remains as it was on January 1st, cautiously optimistic. I still think we are set for mid-to-high single digit returns on the S&P 500 in 2006. Earnings should continue to be strong, but without multiple expansion, huge gains in the indexes are unlikely. Low double digit gains are not out of the question, but we would need many things to fall into place, including a Fed that stops raising rates soon and oil prices that are subdued. Possible, but not probable in my view.

Given that we got nearly a 4% gain in Q1, I can’t help but think we are overdue for a market correction. We haven’t seen a 10 percent drop in more than 3 years, which is very unusual. Market momentum is very strong here and first quarter earnings reports this month will likely be solid, but as we enter a seasonally weaker period for stocks, I am still expecting a pullback even if it doesn’t seem like the market wants to go down right now.

That said, there are still many individual stocks that are attractive. As share prices have rallied the list of undervalued names has undoubtedly gotten smaller, but values can still be found by those who look hard enough. And I would suggest holding some cash because when a correction comes, the list of bargains will once again expand.

Best of luck to all of you in the second quarter.

Shareholders Sue No Matter What

From the Chicago Sun-Times:

Judge OKs lawsuit by those who lost money during Kmart takeover

A federal judge in Chicago has given the green light to plaintiffs who charge that Sears Chairman Edward S. Lampert and former Sears CEO Alan Lacy failed to tell shareholders they were plotting Kmart’s takeover of Sears Roebuck and Co.

The plaintiffs making the complaint sold their Sears stock between Sept. 19 and Nov. 16, 2004, and lost out on a spike in Sears’ share price that occurred when Kmart and Sears announced Nov. 17, 2004, that Kmart would acquire Sears.

U.S. District Judge Robert W. Gettleman ruled that the aggrieved shareholders cited sufficient facts so they can try to prove that Lampert and Lacy violated securities laws by failing to fully disclose their negotiations.

The shareholders allege that Sears, with Lacy’s knowledge, was repurchasing shares at what they contend was an artificially low price, effectively increasing the interest of Lampert’s hedge fund and making Kmart’s takeover of Sears easier.

Now not only do we have shareholders who sue when stocks they own take a tumble, we also have those who sue when stocks go up after they sell? Lawsuits in this country are really getting out of hand. Let’s go through a few reasons why this story is ridiculous.

First of all, the headline doesn’t even make sense. You can’t “lose money” on a stock you no longer own. Missing out on profits and losing money are not the same thing. If you thought about buying a Powerball ticket when the jackpot hit $200 million but decided not to, you didn’t lose out on a chance to win the lottery. You simply chose not to play.

The basis of the lawsuit is that Kmart management failed to disclose they were in merger negotiations. What company in their right mind would disclose this? As soon as news of such talks hit, Sears stock would have rallied, raising the price Kmart would need to pay. This would hurt Kmart shareholders, not help them, making the deal less attractive financially. Arguing somebody broke securities law by not disclosing buyout negotiations, which could easily have broken down, is preposterous.

They go on to say that Sears was repurchasing stock at low levels to make Kmart’s takeover easier. There would be no reason for Sears to do this, it would not have a meaningful effect. Sears stock was cheap. That explains why Sears was buying back shares and why Kmart was interested in a business combination. That is just a good use of capital by both sides. Shareholders of both Sears and Kmart should be happy about that. In fact, the reason the stocks soared once news of the merger broke was because it was perceived as such a good move. Both retailers were struggling and this was seen as a way to get smaller, leaner, and more profitable.

Current Sears Holdings shareholders need not be worried. This Chicago Sun-Times article is the second I’ve read in recent days that sharply criticizes and questions the current retailing strategy of Edward Lampert and company. As long as people are still negative and focused on retail strategy and not economic value, I’m happy to be a shareholder of Sears Holdings.

WSJ Exposure and a Stock Pick

Thanks to Kevin Delaney and the rest of the team at The Wall Street Journal for featuring me yesterday in a front page story about my trading in and views on Google (GOOG). It certainly made for a fun and eventful day, most notably a full inbox and a phone ringing off the hook. If you would like to read the story, it can be accessed through wsj.com in addition to March 2nd’s hard copy. I also have an electronic copy if you aren’t a WSJ online subcriber, so email me if you’d like a copy.

On to the market. I have been pleasantly surprised how well the market is acting so far this year. I am tempted to take some money off the table, but the momentum is clearly strong right now. Hopefully nothing will get in the way of that. What do readers think? Feel free to comment.

As for specific stocks, I would suggest investors take a look at Abercrombie and Fitch (ANF). The stock was down $6 yesterday after weaker-than-expected same store sales for February. A lot of hot money was in the stock, so the decline may have been more than normal. Keep in mind that SSS were still up more than 5% for the month, and February is the second least important month of the year for retailers. The stock looks very cheap down here under $60 per share.

Ford Axes Quarterly and Annual Guidance

Investors will likely view Ford’s decision today to refrain from offering future financial guidance as a negative. After all, it could very well indicate that the company either has no idea how their financials will look, or that they have little confidence in meeting the objectives they will set.

Even if true, companies should join Ford and realize that it’s too difficult and unproductive to accurately predict future profits, especially if you are managing a business for long-term success, not to simply meet investors’ short-term goals.

Wall Street might not like it, but now Ford could be better able to make the right decisions to get back on track. This is not an endorsement of the stock, as I have not looked closely at it, just a pat on the back for getting rid of guidance that benefits nobody except the research analysts who rely on it to do the bulk of their jobs.

Closing the Books on 2005

PERIDOT’S PERFORMANCE

I would like to take a moment and thank all of Peridot Capital’s clients for their business in 2005. This past year was a very successful one despite the fact that the S&P 500 index only returned 3.0% for the year. Peridot was able to book average gains of 10.7% for our equity+fixed income accounts and we look forward to another profitable year in 2006. Shortly I will be mailing out our Annual Letter and will be posting a copy here online as well.

THE BLOG’S FIRST 15 MONTHS

This blog has now been in operation for 15 months and I would like to thank all of our readers for your support in this endeavor. I recently completed an analysis of my investment opinions that have been posted here since late 2004. I was curious to see how they have performed compared with the market as a whole.

Although actively managed accounts should exceed the investment advice given here (mainly because most of my picks on this blog are never updated when an outlook has shifted, whereas active portfolio managers take immediate action as news develops) I was still hoping to find that the analysis provides some value to our readers. Sure enough, it did.

From November 2004 through December 2005, investment recommendations from this site have averaged an 11% gain. The S&P 500, meanwhile, has risen only 7% during that time. The spreadsheet I created for the analysis can be found here. Since many stocks have been mentioned multiple times on this site, I only used the initial mention to calculate performance figures. While it would have boosted the numbers to count every positive mention of Google shares throughout the time period, I don’t feel like that is an accurate measure of how well our “average” pick (or pan) performed.

PERIDOT’S 2006 SELECT LIST

As mentioned late last year, I will be publishing a 2006 Select list shortly (hopefully it will be ready on Tuesday). The list will comprise 10 stocks Peridot feels will outperform in 2006. To maintain a fully diversified group, one company will be chosen from each of the 10 major sectors of the S&P 500; technology, telecommunications, financial services, consumer discretionary, consumer staples, healthcare products, energy, materials, industrials, and utilities.

The list, to be made available for purchase online via PayPal, will cost $20.06 and will be emailed to you directly in Adobe Acrobat format after payment has been received. I will make a blog entry with a link for those of you who are interested when the list is completed.
___________________________________________________________

Thanks again to both clients and readers of this blog for your support of Peridot Capital Management and have a very prosperous 2006.

Regards,

Chad

Peridot Book Club

For those looking for a good stock market read, I suggest Wharton professor Jeremy Siegel’s “The Future For Investors.” Siegel’s follow-up to “Stocks for the Long Run” (published the 1994) offers a very interesting and compelling outlook for stock markets throughout the world.

Not only are potential challenges addressed (selling pressures due to retiring baby boomers and the rise of China and India as global economic powerhouses), but Siegel also presents characteristics of past market winners and losers, and how they will be affected in coming decades.

While he offers portfolio asset allocation advice toward the end of the book, with which some will agree and others will prefer to deviate from, I think the real value of the text is in the quantitative evidence Siegel offers from his extensive research and his outlook on the rest of the 21st century. This definitely will help investors think about their investment portfolios in a valuable and comprehensive way.
All in all, a must read for those interested in hearing opinions of a brilliant professor who called the top of the Nasdaq market bubble months before the collapse began.

Despite Cash Hoards, Companies Aren’t Paying Out

With cash reserves of U.S. public companies sitting at all-time record highs, investors might think dividend payments would be booming as well. Combined with the relatively new 15% dividend income tax rate, investors should be reaping the rewards of record cash payouts. However, the average S&P 500 company is paying less than 2% annually out to its shareholders.

Why does the average large cap stock pay out less than 2% in dividends? Well as we’ve seen this year, M&A activity has been red hot. Corporate profit margins are at cycle highs, so further cost savings have to be squeezed out via merger synergies. So far in 2005, deals have been running rampant on Wall Street. One need just look at the recent earnings report from Goldman Sachs (GS) to see evidence of that.

In addition to mergers and acquisitions, the rise of stock option compensation over the last two decades certainly accounts for the reduction in dividend yields. In order to minimize the equity dilution from option issuances, companies need to instate massive share repurchase programs. The money to do so comes straight from free cash flow that would otherwise be widely available for cash payouts to shareholders.

Throughout history, stock market returns have come from the combination of equity price appreciation and dividend payments. Yields that have averaged about 4 percent historically, along with 6 percent annual growth in earnings, explains the 10 percent average annual return from equities since the 1800’s.

With 2% dividends and peak margins upon us, it’s no wonder that some suspect future stock market returns, say during the next decade or so, will fail to hit the magic 10 percent mark. Even if somehow peak margins can be sustained, which is unlikely, investors are only looking at 8 percent annual returns from stock indices in the near to intermediate term. While that kind of performance pales in comparison to the great bull market of 1982-1999, it will still mark the highest return of any asset class, so abandoning the stock market because of it makes little sense.