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Some Portfolio Updates

SHLD- Is there something Going On Here?
SHLD has been bouncing around rather undramatically between $170 and $180 for the better part of a couple months now. Investors have been waiting for Eddie Lampert to make his next long awaited acquisition and for the FY 2007 results on about March 1st. Barring any significant news, I had not expected the stock to do much of anything exciting either way. Something very interesting happened Monday while you were at lunch. At about 12:30 buyers (or one big one) came into the market big time and SHLD shares jumped from $178 to almost $183 in only 16 minutes. Clearly somebody thought they new something. Had this just been a mutual fund buying shares to accumulate a position they would have done so gradually and not caused the spike in the price. This was somebody big rushing in as fast as they could to be there before an event. It is clear that they though news was imminent that was going to drive the stock up and wanted to be there first. It is called “unusual volume”. No news was released and the stock settled just shy of $180 up 1.55 % for the day. Nobody can keep a secret on Wall St. no matter how hard the regulators try to keep them quiet. Keep an eye out…

OC:
Owens Corning (NYSE: OC) announced that it is currently scheduled to announce its fourth quarter and full-year financial results on Wednesday, Feb. 21, 2007, prior to the opening of the New York Stock Exchange.

Dave Brown, president and chief executive officer, and Mike Thaman, chairman and chief financial officer, will host an earnings conference call on Wednesday, Feb. 21 to discuss the company’s results for the fourth quarter and full year of 2006.

Owens Corning also established the following dates to announce financial results in 2007. These dates are a forecast of Owens Corning’s earnings announcement calendar and are subject to change.

   -- May 2, 2007 - First quarter 2007 financial results
  -- Aug. 1, 2007 - Second quarter 2007 financial results
  -- Nov. 1, 2007 - Third quarter 2007 financial results

ADM:
Archer Daniel’s Midland announced CEO Patricia Woetrz has been named Chairman of The Board. ADM, the world’s largest producer of both ethanol and bio diesel, is the largest American company headed by a female CEO. ADM also raised it quarterly dividend by 15% to 11.5 cents a share. This is payable on March 9th and will be reflected in the portfolio in the April update.

DOW Chemical CEO Andrew Liveras
In re-reading the recent interview he did after last quarters earnings something struck me. Mr. Liveras in a value investor! Look at what he said when asked if DOW would use its growing cash hoard to make acquisitions. He said “asset prices in many areas are inflated due to private equity” he went on, “in this environment we would be more likely to be a seller of assets than a buyer”. In the same vein he said “any acquisition we were to consider would have to be immediately accredive to earnings”. Translation: If it is not cheap enough to add to earnings this year we will not do it. So, he is willing to sell overpriced assets and will only buy underpriced ones…. sound like a value guy to me.

The Wall Street Journal & Value Plays:
On Thursday Feb. 1 I posted here that Altria shareholders should dump their Kraft shares after the spin off. On Monday the Wall St. Journal penned a pieced titled “Altria holders may bet against Kraft shares”, in it they suggested another way to profit from the expected surge of Kraft shares hitting the market. From the article:

“The hedge is on shares of Kraft Foods Inc. that Altria shareholders are about to receive. Altria will spin off its stake in Kraft next month, giving investors 0.7 share of Kraft for every Altria share they hold.

Excitement about the move, which was announced last week, has helped lift Altria’s shares about 13% since the third quarter, as the company overcame barriers to the spinoff.

Shares of Kraft, on the other hand, have lost nearly 5% in the four months as the company has faced competition and cost pressures.

So it is understandable that Altria shareholders might not be that interested in keeping the shares of Kraft they are due to receive, and that has some expecting that a flood of stock for sale will cause a notable decline in Kraft’s share price. “More than $50 billion of Kraft equity needing to find a home all at once will likely cause an extended oversupply of the shares,” D.A. Davidson analyst Timothy Ramey said in a recent note.

Investors worried about this should “go out and buy puts even though they don’t own the stock yet,” said Joseph Palazzola, options strategist at A.G. Edwards & Sons.

By doing so, investors can lock in Kraft’s current $34.03 share price — less the cost of the puts, of course.”

Buying any option entails an investor being prepared to lose all of their money since when you buy an option you do not actually own anything. It’s value is based on the difference between the strike price of the option and the price of the stock it tracks. In theory you could go to lunch, have good news make the stock jump and be left holding an option worth nothing in this case. Add to this options trade on supply demand just like other securities so the price you will be paying for these suggested puts will be expensive. Short term options trading is very volatile and if you cannot watch these trades you could lose your whole bet (notice I said bet and not investment, short term option trading is just that, betting not investing). Unless you own at least a thousand shares of MO and would be receiving 700 Kraft shares, after you figure in transaction costs, the risk you are taking on vs the potential reward is just not worth it. I will not do any of this. I will take my spin off, be happy and not get greedy.

USO:
As of this morning our USO pick is up almost 10% in a few weeks. Remember, when I recommended it I said I thought at that price it was at equilibrium. Any news would cause it to jump either way. The current cold snap in the US has cause upward price pressure. Should this cold last expect this trend to continue. Complicating matters is Iran again. They recently said that on March 11 they will have a “significant announcement”. Who knows what that means. But as that date comes closer speculation will grow rampant. That will lead to fear. Remember, fear in the oil markets acts contrary to fear in the stock market. This fear will cause the price of oil to rise. If the news is rather benign, expect oil to fall (assuming no other major event leading up to it). Should the price of oil run up ahead of the announcement on a worse case scenario and the news is bad, oil may just sit where it is since this news has already been factored in. What am I trying to say? Do not get either to happy or frustrated with this. I said oil is very volatile and the last two weeks have proven that. The long term fundamentals of the investment still remain. Just sit back and hold on.





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The Value Plays Portfolio

I have talked about quite a few stocks here and have been asked by readers, “do you own all these stocks”? Well, no. I have put together an “Official Value Plays Portfolio” so you can track my suggestions and in turn, measure my results against others and the market as a whole. Just so everyone understands what the following chart means and how I am going to measure the results, here are the ground rules:

1- The “buy price” is the price the day my post hits that says “buy”. Even though I write the blog the day before it is published in most cases, in order to make every recommendation verifiable, it will be tracked from the date on the blog. Even though I have owned several of these picks for years, I cannot prove this to you so the date of the blog will now be the “buy price”. For stocks we advise you avoid, we will track those by the price per share the day I recommend you avoid them.

2- Dividends, splits or spin offs will be treated as a reduction in the purchase price to show the “true return” on the investment. For example, I buy a stock for $20 and it pays a 25 cent quarterly dividend. Each quarter I will reflect that payment (gain) buy reducing our purchase price by 25 cents. That reduction will be noted in the “actual cost” category. This will be the same for the upcoming Kraft spin off by Altria, I will reflect the investment gain of the Kraft shares we receive (since I will not keep them) by reducing my purchase price for the Altria shares by the value of the Kraft shares. Should I change my mind and keep the shares, this will be reflected by a decrease in the purchase price of the Altria shares to reflect the gain and then a purchase of the Kraft shares in the same amount.These situations will be footnoted for individual explanation.

3- Should I recommend the purchase of additional shares of a security, that will be reflected by another entry for that security and that price (to assure consistency with the new post).

4- I will update the results the first week of each month. Since I am “long term” oriented, I will not break out results quarterly or annually. If you have read my posts, the conditions that will trigger a security to be sold will not be a temporary drop in the stock price, so monthly and quarterly results are essentially irrelevant. I have found that the shorter I make the tracking time frame of an investment, the more likely people are to make decisions based on short term events and not long term fundamentals. This is counter to my philosophy, so to help prevent that, all results will be “from inception”. By default since this is new, the initial results must be short term but as time goes on this will change. The benchmark I will use for comparison will be the S&P 500. It also will be tracked from the inception of my first post 1/18/2007.

5- I will rarely if ever “short” stocks (sell them first in the hopes of buying them back at a later date at a lower price). I will track the results of stocks I advise you avoid again in the interest of full disclosure and honesty.

6- I may engage in some options purchases or sales. If I do these will also be reflected on the tracking.

7- Portfolio assumes an equal weighting of shares for each security. By default this means I have more dollars invested in higher priced stocks like MO, and SHLD. I am very comfortable with this. Again, should we want to add additional shares of a security, we will note that by another entry.

8- Updates are current prices.

With that, here it is:

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Does CNBC’s Jim Cramer read Value Plays?


Timing is everything in life. Yesterday morning for those of you check the blog you saw a piece I did on Google and it’s prospects. Read it here. Last month, well before Google reported their most recent earnings I said unequivocally that people ought to get off the Google bandwagon (Google, When Will Reality Hit). This view was in direct opposition to CNBC’s Jim Cramer who for years has been a relentless bull on Google. He has been so bullish and blinded by Google’s past success, I swore to people he must have been on Google’s payroll. On Dec. 21. 2006 he predicted “It goes down, does nothing, does nothing – and then boom, it reports a good quarter, and then you just make all your money. That’s going to happen again. We’re just drifting until they report their quarter”. Continuing on the Google magic carpet ride on Jan 12 he said, “$513 is now the magic level. If we take out $513, we should have a quick short squeeze, because the double top clowns, who are technicians, have been saying that it can’t reach $513. When it does, it’s off to the races. That will happen next week. The Google $520 calls are predicting that. Right now, I’d make the move and schnitzel some common. “Schnitzel some common”? I do not know what that means but I think it would hurt. In his opening segment on Thursday, Feb. 1 (he was talking about overpriced SBUX shares and yes I had already blogged the same theme here) Jim said of Google “It can still trade at $600 and not be expensive”. Actually it would make it 20% more expensive than its current $481 price, wouldn’t it? In short, I cannot find anywhere in the past where Cramer has ever called for a fall in the price of Google shares .

You can only imagine my surprise Friday night while watching Cramer’s show I heard my arguments calling for the price of Google shares to go down in the next year coming out of his mouth almost verbatim! At first I thought he was going to mock those arguments and dismiss them (as he always had in the past to any negativity toward Google), but to my surprise he actually embraced them. He called for the price of Google’s shares to fall to around $450. What? He did cover his butt (so as to not pull too big a flip flop in 24 hours) and say it will eventually hit $600. He did not provide a time frame for this though. I do think Google may eventually hit $600 (math check: that is only about 21% higher folks), I just think it will be years from now. This was only 24 hours after he said $600 was “not expensive” and about 12 hours after my second Google blog hit reinforcing the initial one that called for a Google price drop to “about $450”. Let compare both my blog posts on Google and Cramer’s show Friday night.

From the Mad Money recap (2/2 show) on The Street.com “However, Google, which had 99% growth last year, is now decelerating, demonstrating 40% growth, Cramer said. Even though 40% growth is still “remarkable,” money mangers make the rules and they don’t go after decelerating growth,” he said.

From Value Plays on Friday morning “The first thing that sticks out is the deceleration of both revenues and profits. This means that the premium (PE ratio) investors will pay for the stock must fall also.” and “Investors rarely pay a premium over the current growth rate for a company with decelerating earnings. This means that 40 times earnings and under is the more likely scenario.”

From Mad Money on CNBC Friday: “Google has gotten so big its revenue and earnings have to slow down, the law of large numbers”

From Value Plays on 1/22: “Google cannot continue to grow at this clip. The law of large numbers tell us that at a certain point, percentage growth cannot continue.”

Again from The Street.com “Google should go down to $450 before it bounces back, Cramer said.” Again, no time frame on when it will bounce back.

On 1/22 from Value Plays “If that rate this year is around 30% expect the pe to shrink to about 30 times 2007 earnings. That gives us a price for Google shares of about $450 a share.”

You are probably thinking my post is just “common sense”. Of course if earnings and revenue growth slow on a high priced stock, the premium on it must fall and by default so will the price. Cramer was just stating the obvious. I would answer that most things that eventually turn out correct usually are “common sense” in hindsight but were not necessarily though to be so at the time. Consider, at least eight analysts raised their price targets for Google shares on Thursday after earnings were released. Included in this group were analysts at Goldman Sachs, Merrill Lynch, UBS, RBC Capital Markets and Prudential. So, we would have to conclude that my “common sense” conclusion that Google shares are over priced is not all that “common”. Let’s also not forget that in the shows leading up to Friday’s these views had not been espoused by Cramer.

Now, as I said in the beginning, timing in life is everything. Had Jim done this same show a month from now I probably would have not noticed or just chastised him for finally “seeing the light”. However, the timing of the show and it’s identical reasoning have me wondering. I know all the information is public and anybody could come to the same conclusions (although they aren’t, maybe that is another post). But, to have Google’s #1 cheerleader do an about face in 24 hours…. what is that they say about “walking like a duck”? You know Jim, what you may have done probably saved a lot of people money since I am guessing more people see your show (and act on your recommendations) than read my blog but you could have at least given me some credit. Fear not, Monday will feature the Official Value Plays Portfolio, just in case you need more show talking points….

PS. Can I at least get an on air booyah?

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When 177% Growth Disappoints..


Another look at Google. I am focused on Google here not to trash the stock or the company. The company itself is phenomenal. I also am not trying to hurt existing shareholders by being negative about the stock and in the spirit of the full disclosure era we now live in I have no position in Google. I do hope to make people think twice about what I believe would be a poor investment at this point. I think even Google’s management may agree with me. I read in their earnings conference call they are changing the employee stock program to allow employees to sell their employee options. Could this mean even they recognize the lofty price for the shares and are letting their employees cash out now? The buyers of these options will have it’s expiration date shortened and will not be able to re-sell them. This will lead to an acceleration of these options being exercise and by default an accelerated dilution of shares. Again, very employee friendly of them and if you work for Google, it is nice to know they are looking out for you. As for the average investor at home? Not so much.

Google 4th quarters numbers came in and profits jumped 177% and shares sold off. Why?

The story here is NOT, a failure of management, a bad business decision or even an internet search slow down. What is the story then? The inevitable growth deceleration of a maturing company and and resulting effect on it’s overpriced shares. Investors needed a surprise here to continue to justify these price levels, when they didn’t get it, reality set in.

Some numbers:

Revenue (growth):
2004 – $3.1b (121%)
2005 – $6.1b (96%)
2006 – $10.6b (73%)
2007 – $15.8b Needed to attain est. earnings

EPS (growth)
2004 – $1.46 (256%)
2005 – $5.02 (243%)
2006 – $ 9.92 (97)
2007 – $13.92 (40%) Est.

The first thing that sticks out is the deceleration of both revenues and profits. This means that the premium (PE ratio) investors will pay for the stock must fall also. I arrived at Google’s 2007 revenue requirement to achieve the $13.92 a share in earnings by taking the $13.92 a share times the shares outstanding of 329 million, that gives us total earnings. Currently there are only 309 million shares outstanding but there has been about a 20 million share a year dilution since they went public so I have added it in for 2007. (VERY important note here: Should employees increase their selling of options, this will cause an acceleration of this effect, further diluting earnings per share next year.) You then take their 29% profit as a percentage of revenue, do the division and you arrive at our $15.8 billion (49% growth over 2006) in revenue necessary to achieve our 2007 estimate eps. I also assume no deterioration of their ratios (this could very well happen, but I am assuming a consistent scenario so as not to be accused of “fudging” numbers to make a point).

Currently Google trades at 50 times 2006 earnings that grew 97% over 2005. What would you be willing to pay now that it is only going to grow earnings 40% next year? Let’s run more numbers, if you pay:

40 times earnings we get a price of $556 or 11% higher than its current price
30 times earnings we get a price of $417 or 16% LESS than its current price

Which is more realistic? Investors rarely pay a premium over the current growth rate for a company with decelerating earnings. This means that 40 times earnings and under is the more likely scenario. As far as a “price prediction”, I won’t even guess. I do know that Google’s earnings growth (while still stellar) must decelerate, its size now dictates it must. As that growth shrinks so will the multiple on its shares. This will lead to a stagnation or decline in its share price from its current inflated levels. I won’t guess an exact number, there are way too many factors involved, I can only dictate a range based on the info and that range does appears to be flat to negative.

So what to do? If you are thinking of buying, don’t. You already missed the boat on this one. Move on (and I would say stay away from tech). If you are thinking of selling, do what you want. The price should bounce around here for a while with the pressure being downward.

I repeat my prior statement. Google is a great company with great product, it’s stock is just overpriced.

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Altria Shareholders (MO)- Dump Your Kraft Shares

I know, I know, typically in a spin off situation the shares of the company being spun off outperform the market. But, this is no typical situation. In a normal spin off the parent company feels the segment being spun is not being fully valued in the price of the parent companies shares (see the McDonald’s (MCD) and Chipotle (CNG)) so they spin it off in an effort to return this value to shareholders and raise additional cash. These spin offs are usually fast growers than then begin trading at relatively inflated pe values and their stock tend to outperform the market on a percentage basis until their growth slows as they mature. Here we have Altria (Phillip Morris), whose stock has performed better than any stock in the history of the market getting rid of an albatross.

The acquisition of Kraft was an ill conceived plan to diversify away from the business of tobacco. It accompanied the name change from Phillip Morris to Altria. Kraft does business in a low margin low growth arena and this never meshed with the highly profitable tobacco segment. This became a drag on the shares of Altria. Kraft’s shares were hurt due to it’s association with tobacco by both the stigma on it products and the potential for the tobacco litigation effects to spill over onto Kraft.

After the split Altria shareholders will get .7 Kraft shares for each Altria share they hold. In Kraft you will hold shares in a mature company that will begin a restructuring process (shedding brands) to return to more acceptable profit levels. Plus, very important here, Kraft has no durable competitive advantage (see earlier post). Brands can make for a durable advantage (Nike, McDonald’s, Marlboro, Coke to name a few) but when you associate Mac & Cheese with tobacco, it disappears. You must be careful with your brand and nurture it, Kraft failed to do so. I am running from this stock. Who knows, it may end up turning thing around and be a success, but given the choice of owning MO or Kraft, to me it is a no-brainer.

In Altria you will have the best performing stock in the history of the stock market, paying a great dividend who is getting back to just doing what has made it great, selling cigarettes. Thanks to the Master Tobacco Settlement in 1998, the tobacco companies lawyers duped the states into essentially giving Altria a state sponsored monopoly (Marlboro has 50% market share). The states have become slaves to the tax revenues and “penalties” the tobacco companies who signed the settlement must pay (these have been easily passed on to smokers). It now behooves the states to protect the companies market share, sales and profits as their compensation is tied to these metrics. Should the companies lose ground (market share), they are entitled to refunds from the states. It is ironic, the states are trying to “stop smoking” but cannot live without the revenues those smokers provide via the tobacco companies. We are talking billions of dollars here, not millions. The tobacco companies in essence made the states defacto shareholders. Brilliant. Is it just me or did the tobacco industry’s “legal environment” suddenly begin to change after this agreement was signed and the states realized that bad legal outcomes for the companies were in turn bad for them? Beginning in 2000 Big Tobacco began racking up one legal victory after another in the courts. It is to the point now where they are exposed to almost no credible legal challenges. To quote MO CEO Louis Camilleri yesterday “This is the best litigation environment ever for tobacco companies”. Straight from the horses mouth. I am really not one prone to these conspiracy theories but sometimes “if it walks and quacks like a duck then….”.

I would expect MO to spin off Phillip Morris International soon after the Kraft spin off is done at the end of March. Then I would look for huge dividend increases (maybe a special one time dividend) and massive share buyback to reward shareholders. To quote Sinatra “the best is yet to come….”

For those “morally opposed” to owning tobacco stocks. Don’t be foolish. Why not own them, make gobs of money with them and do something good with it? Donate it to a charity, your church, pay off your kids school loans or even give it to “stop smoking” programs.

MO shareholders are going to make a lot of money for a long time, be one of them and do what you feel is the “most moral” thing with the proceeds. Maybe you can do more good in your corner of the world with it than they can do harm with their products. I am going to try….

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Ethanol – Here to stay


Why? You say. Haven’t you read all the nay sayers on ethanol Todd? What makes them wrong and you right? My answer? 2008…..

In 2008 we have another battle for the White House. The “flyover states” (FOS) have decided the past 2 presidential elections. Yeah, I know Florida in 2000 but had Gore been able to get anybody who did not live on a coast to believe in him (or his home state for that matter) those results would have been meaningless. What is the #1 economic driver in the FOS? Agriculture…

Currently billions of dollars of profits and investment are flowing into the FOS at a rate never before seen. Ghost towns are enjoying a renaissance as people and money are moving back there to compete in this industry. Once poor corn farmers are staring ethanol production facilities in coops and now are millionaires. They are buying new equipment, new cars and the value of their homes and land have been jumping. After decades of population declines, the rural FOS are finally enjoying growth. In short, the American Heartland has not had an outlook this rosy in generations.

So, let’s pretend I am a self serving politician (as if there any other kind) running for the White House in 2008. My message is going to be :

Let’s get rid of the ethanol tariff on imported ethanol from the state sponsored Brazilian ethanol industry so they can undercut our prices. We need to put a cap on the ethanol mandate in fuel, I know you have met the current goal 2 years early (nice work) but isn’t 3% enough?. Let’s not get too aggressive here. We do not want to upset Exxon. There is no reason to continue to offer tax breaks for those service stations who install E85 (85% ethanol) pumps to spread its use and no reason to require the majors to install them at their stations. As far a Detroit goes, despite the fact that it only cost $100 extra to build flex fuel engines that can run on either fuel or any mix in between, I see no reason for us to require Detroit actually make their cars with this option (like we do seat belts), they know best. In short, we have this budding industry at a tipping point to where it may or may not eventually become the way we fuel our cars, so let’s sit back and see what happens.

ps. Can I have a ticket to my opponents inauguration?

OR

Why are we shipping our hard earned dollars overseas to Arabs who want to do us harm? Why don’t we spend those dollars here supporting farmers and hard working people and at the same time begin to assure our independence from foreign oil? If I am elected I will immediately request congress pass legislation mandating the installation of E85 pumps at all gas stations. If Big Oil wants tax breaks and the ability to pump oil out of Federal lands at a pittance, they ought participate in the security of this nation. Exxon makes over $35 billion a year in profits and has paid their former CEO $400 million in retirement benefits, can they not afford the $20,000 it takes to install these pumps? For only $100 per vehicle, we can guarantee the ability of our drivers to have choice in the fuel they use in their cars. All new vehicles should have flex fuel capabilities. If we can legislate the use of seat belts, anti lock brakes, emissions standards, gas mileage and shatter proof glass, why can we not require our drivers be able to support our nations efforts at independence from foreign oil if they wish? I am calling for the immediate doubling of the renewable fuel standard from 7.5 to 15 billions gallons annually. We are confident that the ethanol industry, which has already met its current goal two years early can achieve this level. Cellulose ethanol is right around the corner, it has the potential to eliminate all oil imported for gasoline in the US by boosting current ethanol production to 100 billion gallons annually and I am calling for a doubling of Federal research funds available for this technology…

Now, which candidate is going to win votes west of Pennsylvania and East of the Rockies with these messages? The example might be extreme but it does illustrate that the current legislative conditions in place for ethanol are not going away any time soon. The reality here is there will be a competition to see what party can deliver the “best package” to the FOS in return for votes in 2008. The timing is perfect for ethanol and the nation is ready for it. Every poll taken has reinforced the fact Americans would gladly pay more for home grown fuel (ethanol) if it would help ween us off foreign oil.

Saab already makes an engine that get comparable mileage on ethanol vs gas (it is a simple process) and the studies that claim ethanol takes more energy to make that it produces have been proven false time after time. The fact is it takes exponentially more energy and dollars to drill for oil, ship it on a boat, refine it and transport it to the market than it does to grow and harvest corn. The studies that claim ethanol is energy negative actually have the audacity to claim the sun’s energy as an energy input for ethanol, like were it not for corn the sun would not shine??? It’s called renewable for a reason folks. They also take into account the material necessary to make the tractors that harvest the corn as if farmers would not be using tractors for crops were it not for ethanol. They based their findings on corn yields (they are 30% higher today than even a decade ago and growing almost daily) from data decades old while using today’s cost structure for the inputs. These studies are flawed on such a scientifically rudimentary level to be laughable.

So, if you believe the above to be true, how do we profit from this? There has been an explosion of ethanol companies that have begun trading publicly in the past year. I believe that if you believe in the biofuel revolution your investing begins and ends with one company. Archer Daniel’s Midland (ADM). With $35 billion annually in sales ADM is the world’s most prolific biofuel producer. After their current expansion, they will produce over 1.5 billion gallons of ethanol a year (#2 Verasun comes in at 300 million) for over 20% of the US market. They are also the world’s #1 producer of biodiesel. Only 1/2 of their profits come from biofuels so they will be not as volatile as the “pure play” ethanol companies who have this as their sole revenue source. They are the #1 processor of oil seeds (for cooking oils), coco (chocolate), bio plastics (these degrade in landfills) and high fructose corn syrup. Visit their website to further see the scope of their businesses. The stock of ADM has fallen sharply from its euphoric highs early in 2006 to a level more than acceptable for investors who now want to invest in biofuels.

Remember, ethanol and biofuels are not new. Henry Ford designed the Model T to run on it and even Rudolph Diesel ran the first diesel engine on peanut oil. For generations oil was just cheaper to use so these biofuel options faded away. With the world as it is today, can we afford to continue our blind allegiance to oil or must we find a better option? ADM has pioneered ethanol in the US and will be the leader for generations. Buy it’s stock and enjoy….

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Oil -Time To Buy?


In order to have this discussion we have to do one thing first….. Stop calling it oil. As soon as the word is mentioned, people’s emotions take over and rational analysis stops. Emotion is the enemy of any investor. When people either sell due to fear or make buying decisions out of greed, the results are seldom stellar. This is exacerbated when the discussion turns to oil. The conversation will inevitably turn from oil fundamentals to conspiracy theories about Bush keeping the price of oil high to help his “oil buddies”, the oil companies manipulating the price of oil for profits, the Saudi’s funding terrorists with oil profits, Iran building “the bomb” with oil money, the drilling, refining and use of oil is ruining the environment (the irony here is that the oil industry argues that corn based ethanol is more harmful to the environment but that’s another post) and the list goes on. In order to have a conversation that allows us to get anywhere, we need to strip away the fear. This will allow us to see “what is” with oil and come to decision on its value, we can then add the fear back in to see its effect on the market for it. Fear, in the oil markets has the inverse relationship it does in the stock market. When fear is present in stocks, it drives their prices down, fear in the oil markets drives its price up.

So, lets refer to oil as wood blocks (WB). There is a worldwide market for WB. As a matter of fact, people cannot live without them. They use it everyday in their life and there is no widespread substitute for it. Now, the supply of wood for the blocks is finite, it is very expensive to get and the easy access to it is diminishing, causing only the more expensive wood to be available. Once we get the wood, we have to process it into blocks. There are only so many centers in the US to process the wood into blocks, so we have a finite capacity to supply the finished products despite growing demand (there are no plans to expand this capacity anytime soon and as a matter of fact it has not been expanded in over 30 years). As developing countries grow, their demand for WB is growing exponentially along with them. This puts more strain on the supply – demand equation that is currently just about equal (meaning our supply is about equal to demand).

Now as we look at the market for wood and its blocks we really cannot see downside price risk for it. Right now the market is at equilibrium and the supply – demand equation tilts toward demand overcoming supply which will lead to a price increase. When you have growing demand and a supply that is virtually maxed out you must have a price increase for the product, whatever it is.

Back to reality. Let’s talk about oil. The fundamentals of oil dictate price increase in the future. But, if we want in invest in oil, we must do so at a time when the fear factor of it has moderated and the “fear premium” is mitigated in its price. In the spring of 2006 oil prices surged past $70 a barrel. The fears that drove it was a hurricane forecast that predicted a hurricane season greater than the 2005 one that crippled refining & drilling capacity in the US, tensions with Iran (second largest OPEC producer) were escalating and fears grew that they would restrict oil from the market, and the US was rapidly filling its strategic oil reserves (adding to demand) after they were irresponsibly depleted in the 90’s (this artificially lowered the price of oil in the 90’s as it dumped excess supply on the market). What has happened since then? The hurricane season was not only not as bad as 2005, but was one of the most benign in history (bettors should get these folks Super Bowl prediction and bet the opposite). Iran is still making threats to destroy the western world and Israel but it is doubtful they actually have the ability to so. This has caused the world to just stop listening to President Ahmadinejad’s rantings. If I tell you the first day of school I am going to bring a stick in tomorrow and beat you with it, you would be scared. After months of me making these threats and failing to produce the stick or even try to beat you, your reaction would be to dismiss me as a nut. It is no different with world leaders (It reminds me of the old SNL skit about “Generalissimo Fransisco Franco is still dead” substitute “President Ahmadinejad’s today again promised to destroy the world”). Add to this the realization that Iran cannot restrict their oil from the market. Their economy relies wholly on oil revenues and even with oil at$70, they are struggling. While a prolific producer of oil, they have no ability to refine it into anything. They rely on the rest of the world to do it and ship it back to them. Result? When it comes to oil, with our reserves now filled at 700 million barrels, up 160 million barrels from when George Bush took office, (he has asked congress to double this capacity) they need us more than we need them when it comes to oil. How is that so you ask? Iran produces about 14% of the world’s oil. We currently have 57 days of total US imports in our reserves. If we import from Iran at same percentage as they produce for the world markets what would their elimination of oil exports do to our reserves and how long could we go without? I will use this 14% for the comparison, the actual amount may be more or less but there would be vast debate on it were I to “assume” a number. If we released oil from the strategic reserve to eliminate the effect of Iran’s stoppage, in 406 days the reserves would be empty. Iran’s economy would have collapsed well before then. Translation? This threat is a non issue. Would it be easy and pleasant? No, but they have far more to lose in this scenario. We would survive this event, they would not.

If you want to invest in oil, I would argue it is fairly priced now. We have had a very mild winter, the Iran issue has subsided, the reserve is filled and hurricane season is 6 months away. We are in a lull in the “fear factor” for oil. The price has cooperated and fallen to around $50 a barrel and bounced around there for a while now. Even the announcements from OPEC that they will cut production have only lead to small price increases. What does this tell us? The supply demand equation is equal, the diminished supply from OPEC is being offset by the diminished demand from the mild winter. $50 seems to be the “fair value” of oil. So, how to get in. You could buy stock in one of the oil majors, Exxon (XOM), Chevron (CVX) or BP (BP) but I would advise against it now. Why? One word, Democrats. They are in charge of congress and love to vilify oil companies. They will take aim at them and try to grab their profits where they can. Until this issue is settled I would avoid these stocks. It may amount to nothing but why risk it? If you want to go the oil route go with USO, the US Oil Fund ETF. It tracks the cost of a barrel of oil.

Caution: Oil is very volatile, especially when supply and demand are equal. Picture a piano wire pulled tight, if you hit the wire you get a sound, the harder you hit it the louder the sound. That sound is the price movement of oil. Impacts (news events) will make the price jump either way, dramatically at times. You must set your time frame and parameters for the investment. If you are long term (years) you are really only looking at supply and demand, as long as it does not change from its current long term trend, the price must go up. There will be daily or hourly prognostications that will make you doubt your choice, just stay focused and ignore the noise.

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When To Sell? The Case Of Coca-Cola

So, we have discussed what types of stocks to buy and that our holding period is measured not in days or months but in many times years. The question now begs us, when should we sell? There are a couple of scenarios.

Deterioration of Business Environment: Let’s compare Coke (we will use Coke (KO) here since it is #1 but any soft drink will do) with tobacco. Currently soft drinks are under fire by health conscious politicians as our national obesity epidemic grows. Pretend for a minute (this is not such a big stretch) that in order to pay for “the health effects and costs of obesity” soft drink makers (like the tobacco companies) are ordered to pay billions to the states. Congress eliminates the companies ability to advertise their products to stop their use by minors and levies oppressive taxes on them to help pay these health costs. This causes the cost of a can of soda in a vending machine (when you can find one) to go from the now $1.50 to $2.50 or more. All soda is eliminated from schools or anywhere a child under 18 can easily purchase it. Unlike tobacco, whose users are addicts (and who seem more than willing to let these costs be passed down to them), the soft drink industry would collapse under this strain as people stopped buying them and switched to cheaper options. Any hint of this scenario would be time to sell any soft drink maker in your portfolio.

Valuation: During the frenzy in stocks that precluded the inevitable crash in 2000 Coke’s valuation became, in a word insane. Coke hit a high of $83 a share at the end of 1998 and sported a pe of over 50 times earnings. This is irrational for a company like Coke (I would argue it is irrational for ANY company but that is another post). Coke was a mature company growing in the teens (growth rate) and had typically only ever had high price to earnings ratios in the low 20’s. Investors were paying over twice that! Had you considered buying shares of Coke at the time I would have argued that it was too expensive (overpriced) on both a historical and absolute level. Now, if it is too overpriced to buy, ought not we consider selling it if we own it? Our own rule tells us the price must fall to a level commensurate to its growth rate. It did, to about $45 a share and now trades at a pe ratio of 20 times earnings, in line with historical averages. Why not sell it then and wait patiently for it to come to an appropriate valuation and purchase shares again? In this case it would have taken until Jan 2003 until its valuation was something that I would be willing to invest in (it would have been fairly priced, not a value). Coke’s largest investor Warren Buffett has several times in interviews lamented the fact he did not sell his stake in Coke during this period.

Odd Merger’s: There are many times mergers make sense. Proctor & Gamble (PG) buying Gillette, for instance. Two large consumer products companies coming together to make a stronger one. Then there are merger’s that make you scratch your head like AOL (AOL) and Time Warner (unmitigated disaster), Kraft Foods (KFT) and Phillip Morris (MO) or RJ Reynold’s Tobacco (RAI) and Nabisco Foods which have not worked out fully for either companies investors. Currently Altria (Phillip Morris) is in the process of spinning off Kraft Foods to “unlock value for investors” (translation: undoing the merger). This merger has dampened the appreciation of the stocks of both companies. The price investors are willing to pay for Altria stock is depressed because the low margin food business was seen as a drag on the highly profitable tobacco business and the tobacco business’s constant litigation woes are seen as a drag on the food business depressing the impact of Kraft’s contribution to the whole company. Now, contrast this to Altria’s purchase of 30% of SAB Miller (Miller beer) which has been a huge success for both companies (booze and cigarettes go together better than cigarettes and mac & cheese). Now, Altria’s stock has been one of the best market performers in history but even conservative estimates today place a 20% value appreciation from its current levels to investors after the spin off. Yes I own and would recommend you buy shares of Altria (MO). Coke, and even Pepsi for that matter have been very smart here . They have expanded their product lines in what they do best, non alcoholic beverages. Pespsi (PEP) ventured outside this with its purchase of Frito Lay but I think we would all agree that chips and soda mesh perfectly. Were ether to venture outside of this arena to an area wholly unrelated to their current businesses, red flags for investors should go up.

Note: The merger discussion does not apply to Holding Companies. By their very nature, holding companies set out to acquire a wide variety of unrelated business, take the profits from them and acquire more business. They have mandates from their board of directors to do this as their growth strategy.

I hope you can see that there really aren’t many reason to sell a stock IF you purchased it correctly. If you buy a good company with a durable competitive advantage and at great price there are only two real reasons to sell it. A fundamental change to the company (poor merger) or its business that negatively alter its future prospects, or its stock price becomes irrational overvalued. Be careful on price induced selling, there are always tax implications to consider when selling. The level of excess valuation must be far greater than the tax you will be forced to pay on your profits for this to be worthwhile. A poor quarter is not a reason to sell and in all actuality if the underlying business is still strong and the reasons you purchased it still apply, this is a perfect time to purchase more shares if their price falls.

If the stock price stays stagnant for an extended period of time, this too is no reason to sell. During the tech bubble of 1998-99 Berkshire Hathaway (BRK.A) shares fell almost 40%. Investors fled to tech shares and the latest “hot stock” they heard about at cocktail parties. Most of these companies had not yet figured out how to make money but did have fancy websites and a whole new vernacular to impress potential investors. Yet, there was nothing wrong with Berkshire’s businesses. They were all performing well and growing. Buffett was called “out of touch” with the new business paradigm because he felt paying 140 times earnings for Yahoo was a bad idea. The inevitable happened, there was no new paradigm, earnings still mattered and Berkshire stock has more than doubled off its lows while tech investors are still underwater with their picks.

The business matters more to you than the stock price. There will be times when there is a disconnect between the current state of the business (its actual value) and its stock price. Both the Coke and Berkshire examples above illustrate this. Do not get caught up in the hype either way. As Buffett likes to say “buy fear and sell greed”. When prices are unjustly inflated (Coke in 1999) sell and when they are unjustly depressed (Berkshire in 2000) buy and thus a value investor you shall be (wealthy too).

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Owens Corning- Thinking Pink Will Stuff Your Wallet With Green


Owens Corning is another company that recently emerged from the desolate wasteland of asbestos bankruptcy. OC (not the TV show) emerged in Nov. 2006 and its shares, after an initial run have settled around $28-$30 a share. I believe this is a mere pittance of their true value.

Disclosure: I currently hold OC warrants on 1000 shares. These warrants allow me to purchase 1000 shares of OC at $45 a share at any time in the next 7 years.

Why is OC trading so cheap? Let’s look at it.

Housing Market: When most of us think of OC, we only think of home insulation (we “think pink” as their commercials tell us). Let’s look at how this slowdown in new construction will effect OC.

Insulation: (30% of total revenue) OC is the world leader in both commercial and residential construction, BUT only 60% of this segments earnings come from new construction. The rest is from repair and international sales.

Asphalt roofing: (28% of total revenue) Only 21% of this segments sales are from new residential construction. The rest is commercial as residential repair.

While these segments will be affected by the new construction slowdown, the market is pricing this effect to be absolute rather the smaller effect it will be. Let’s not forget, the repair business should see no slowdown, if you need a new roof, you need a new roof, there is no putting it off. Also, tax changes (Energy Policy Act of 2005) have assured a market for insulation upgrades in existing homes.

Analyst Coverage: Currently coverage of OC is non existent. This has the effect of keeping it out of the news and off potential investors radar screens. The only time we do hear about it is in an asbestos article and in relation to the housing slowdown, neither of which will make people want to purchase shares. When a curious potential investor cannot even find an earnings estimate for the company, it scares them away.

Bankruptcy Comparisons: If you pull up OC on any of the major finance websites to get info on it, you will most likely decide it is not a good investment. The results they give for OC include bankruptcy items. You need to be able to pull these charges out of the numbers to see how the actual businesses of OC were performing. This is very laborious and most people will not bother or simply do not understand that these charges are now eliminated. The actual business of OC has always been very profitable, it shows huge accounting losses due to asbestos write offs, now that these are gone, paper profits will resume.

These factors are all depressing the stock of OC. However, if we dig we find that the perception of the limited scope of their business is wrong and the companies various segments are performing extremely well. So, when we have a good company with a temporarily depressed stock price due to conditions not totally related to its underlying business performance what do we have? A value play!

Let’s find out what the other’s seem to be missing:

Building Materials Business: (19% of total revenue) Through a series of acquisitions, OC is N. America’s leading supplier of exterior siding and exterior/ interior stone (think patio’s and interior stone walls) for both residential and commercial construction. Only 55% of this segments business is from new residential building. Included in this business is the OC Basement Refinishing franchise. Both these these segments were added during the bankruptcy process so its results are “hidden” when one does a cursory look at OC’s eps the past 3 years due to massive asbestos write offs.

Composites: (23% of total revenues) Here is the hidden gem and a double digit grower. OC’s composites are used in everything from boats, planes, military Hummers, RV’s, high speed trains, the auto industry and more. OC is the world’s number one producer of this stuff. The fastest growing sector? Composites for wind turbines (growing 15%-20% annually). I would bet painfully few potential investors are even aware this housing proof segment not only exists in OC, but is the fastest growing division!!

I will do the work for you on earnings (minus bankruptcy charges). They have grown from 300 million in 2002 to 550 million in 2005 and look to go to 600 million in 2006 (that is a cool 100% growth in 4 years). Now take the roughly 130 million shares outstanding and you get $4.61 a share in earnings (although this is the only actual earnings estimate you will be able to find) for a current PE of 6.2!! No wonder the CEO and Chairman of The Board recently ponied up 1/2 a million of their own dollars each to buy shares in the open market (various other insiders have purchased another $700,000 worth)!

Let’s take this one additional step. Let pretend we had the money to buy all of OC. What would we get? For our $29 a share price we would receive the $12 a share in cash OC currently has, plus another $4.60 a share in earnings during the first year. So let’s get this straight, for $29 a share we would get $16.60 (57% return in year one) back immediately and this does not even include the value of its assets or earnings past the first year!!

They call it value investing for a reason……….

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Dow Chemical – Update – Full steam ahead


Dow released earnings for the fourth quarter this morning. Earnings came in as expected. They were down from last year but for a very good reason. People had stocked up earlier last year after hurricane forecasters gave us the end of the world scenario. When that did not develop (sarcastic surprise inserted here) they have spent the last two quarters working off the excess inventory. The good news? This will lead to increased demand in the first half of 2007 boosting results.

So, has anything changed from the reasons I espoused you should buy DOW in Saturday’s post? In a word, NO.

CEO Andrew Liveris said on CNBC that DOW was:

-The low cost producer in it lines of business
– After 17 consecutive quarters of increases, feedstock and energy prices dropped and look to remain low, this both increases demand for its products and lower its costs. Result? Continued margin improvement
– Reduced it’s “cyclical” business to 47%, he declared “we are no longer a cyclical company”
– Had record revenue and earnings
– Balance sheet is “very, very strong” – Cash is increasing and debt decreasing. This can be used for more stock buybacks, increasing the dividend or purchases
– Looking for “acquisitions at the right price and synergies”. Translation: If it will not add to earnings this year they will not do it.

In short there is nothing happening at DOW that should dampen our enthusiasm for the company (if anything we should be getting more excited). Liveris has done a masterful job positioning DOW for the future. Each quarter DOW is creating more value for shareholders. It will not be long before Wall Street recognizes this and jumps on the bandwagon. Please be there first…

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Durable Competitive Advantage – Why it matters

It sounds nice but what does it mean and as an investor why do I care about it? Durable competitive advantage is sometimes referred to as a “business moat”. In its simplest term, it means the scale of a business in its field vs it peers. That is its “competitive advantage”. But, what makes it durable? What make an advantage durable is the cost and time it would take a current or potential competitor to grow large enough it this area (high barrier of entry) to adversely impact our business. A high level of durability allows us with a greater degree of accuracy to predict future earnings and thereby arrive at a price we are willing to purchase a piece of the business (share of stock). Now, how do we recognize those businesses that have this (or don’t) and how we look for it. Strict adherence to the “durable” portion of the phrase enables us to do one thing before we even begin to look at possible stocks to invest in: eliminate whole sectors of possible investment. This makes our investing easier by shrinking the field of candidates and reduces the chances of us making the mistake of investing our money in a good company in a lousy business.

Some examples of sectors that lack the “durable” portion:

Airlines: Investing history is littered with airline bankruptcies. Once high fliers fall victim to either high or low jet fuel prices or a recession and go under. After 9/11 were it not for the US Gov’t bailout of the airlines, most of them would have failed despite only being out of business for less than a week. High union costs, fickle customers and volatile fuel prices make any accurate assumption of future profits by investors impossible. Why would you buy into a company in which you have no idea of its future profitability? Southwest Airlines is a great company and the best managed of all the airlines but investing in it is akin to having the best lounge chair on the Titanic, eventually you’ll be sorry.

Tech: We have to be careful here and not throw the baby out with the bathwater. Not all tech qualifies here but let’s look at it generally and you will have to decide on a case by case basis. Warren Buffett of Berkshire Hathaway (BRKA) said it best about tech investing. I will paraphrase “I cannot invest in something that two teenagers with a pc in a garage can destroy”. What? Simple, Micheal Dell started building pc’s in his Texas dorm room, Bill Gates started Microsoft in his garage, Ebay was launched in a weekend from a living room after a labor day conversation and Google was a research project by two Stanford University students. All these businesses toppled industry leaders at the time and Google is in the process of doing it to several now. How can you be confident about an investment that an 18 year old writing code in his family room before he takes out the trash could make obsolete? This industry must constantly reinvent itself almost yearly in order to survive. The pace of the necessity of this change is accelerating every year. Look at the ipod, its success has exploded the last 3 years and in 6 months the iphone comes out. Having an ipod and a phone and having to carry both around will be a thing of the past. Competitors will flood the market with similar products and the stand alone ipod will be history. It will be relegated to the “remember when” conversations. This is how fast things change in tech and all these companies make missteps along the way and when they do, investors pay the price, heavily. Remember, since 2000 when investors thought these companies reinvented the rules of investing, Microsoft (MSFT), Dell (DELL), Amazon (AMZN), Yahoo (YHOO) and other are all still down over 40%. When is the last time you did not buy a bag of M&M’s because they “were so yesterday”, searched for the “newest version of Arm & Hammer baking soda” or would not be caught dead eating a Hershey’s candy bar? Me either..

You have to wade through the tech field carefully (I personally avoid it) and if you do decide to jump in, please do not do what most tech investors do, overpay for your shares (see yesterday’s Google post).

Auto Industry: See airlines

Pharmaceuticals: Decades ago these were great investments. However, the advent of generic drugs has turned this into a simple commodity business. They used to enjoy the financial fruits of new drugs for decades, now the exclusive locks up are shorter and increased competition means competitors have similar products in the market almost simultaneously with the generics undercutting profits. This industry is under attack by govt’s and now in the courts by users of their products. The economics of their industry have permanently changed for the worse and it should be avoided as they are spending more and more money to develop drugs with smaller profits potential. Bad equation.

So, now we have a brief idea of what to avoid it would be nice if I gave you some ideas of companies that have a competitive advantage that IS durable.

McDonald’s (MCD)- The turn of the century was hard on the golden arches. They had the perfect storm of bad events and the stock was punished over the next two years from almost $50 down as low as $14. Some of the mistakes were theirs and others were from events beyond their control. The turn of the century began with a heightened interest by consumers of what they put into their bodies. McDonald’s was slow to recognize this and their sales began to suffer. Then came mad cow. The whole fast food industry suffered as consumers began to look for options other than meat products to eat and McDonald’s was once again slow to react. Then the Jack In The Box chain in the pacific northwest began serving ecoli burgers and killed several people. These events lead people to fear the drive thru window. But, what was really wrong with McDonald’s that a menu fixin‘ wouldn’t cure? Nothing! Because of the durable competitive advantage it held over the rest of the industry and the value the McDonald’s brand held worldwide, after some menu tampering McDonald’s was once again off to the races. It has a worldwide distribution system second to none. It has since survived the premature death of 2 CEO’s and share are up 214% from their lows. Recent proof of McDonald’s advantage has been the introduction of coffee at its locations (good coffee I should say). It has been a huge success and chains like Dunkin‘ Donuts and Tim Horton’s have noticed sales declines were McDonald’s competes. At is low McDonald’s was a value investors dream…

John Deere (DE) / Caterpillar (CAT): If you are either farming or in construction your search for equipment most likely begins and ends at either of these companies. Both basically invented the industries in which they operate and by far are the world leaders in them to this day. Both stocks are up over 125% since 2000.

Walt Disney (DIS): When you think of your childhood or amusement parks does anything other than Disney come to mind? After stumbling at the turn of the century the House of Mouse has righted its ship and shares are back on the march. If you are my age and your folks had bought you Disney shares when you were born you would be sitting on a 5000% gain.

Hershey (HSY): The Hershey Company markets such well-known brands as Hershey’s, Reese’s, Hershey’s Kisses, Kit Kat, Almond Joy, Mounds, Jolly Rancher, Twizzlers, Ice Breakers, and Mauna Loa, as well as innovative new products such as Take 5 candy bar and Hershey’s Cookies and is the largest chocolate manufacturer in N. America.

Coke (KO)/ Pepsi (PEP): The two dominant worldwide soft drink makers. If you really think about it, they are really the only two of any significance. Their products are known worldwide and both stocks have produced. Had your folks bought you share in either when you were born in the early 70’s you would be sitting on in excess of 3000% gains.

All of these companies have rewarded loyal shareholders with great gains. The important thing to recognize is all have had their problems and because of their durable competitive advantages, have not only weathered the storms but emerged stronger companies.

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TIME FRAME VS. RISK – The Inverse Relationahip

All investments have risk. No matter how safe they look and feel, there are risks involved. Let me get that out of the way first. You can never eliminate the risk you assume when you plop down your money on an investment. The question then becomes, how do we minimize that risk? There are many alleged ways, do exhaustive research, only buy bonds or CD’s, avoid tech stocks, etc, etc, etc. Many of these “risk avoidance” options also come with the “return avoidance” result. Yes, you can almost totally eliminate all risk by buying a cd at your local bank but in today’s low interest rate environment you are barely making a return in excess of the inflation that is eating away at those dollars. Also, you have now locked those funds away and can only get YOUR money back should you need it by paying the bank a hefty penalty. There is risk.

This discussion will focus on stocks. While the reasoning I will illustrate does apply to most investments, the discussion will focus on the effect on common stocks and their investors. Let’s look a two charts and try to decide which looks like the better investment:



A quick look would have us saying chart #1 is the far superior investment. Here is the thing though, both charts are of Sears Holdings (SHLD). Chart #1 is SHLD since its inception and chart #2 is its chart for the past 3 months. Same investment and depending on your time frame, two very different results.

When you have a very short time frame, your attention to every minutia of information that may effect the stock is mandatory. Let’s use the 3 month chart above. This investor bought SHLD in October hoping to capitalize on the typical holiday bounce retailers seem to enjoy. What “risks” are there to his investment? Off the top of my head I can think of same store sales at Kmart fall, same store sales at Sears fall, warm weather keeps people out of the mall, snow keeps them from getting there, an “analyst” downgrades the stock out of the blue, the Fed decides to raise interest rates, Iran cuts off oil and it spikes to $80 a barrel and the whole market falls while investors sort it out, Lampert loses money that quarter in his investments (it is bound to happen) or a fire at the Land’s End factory destroys the winter line and quarterly results are adversely effected etc, etc. There are dozens more but those are just a few I came up with without really thinking about it. All of these have no long term effect on SHLD but in the short term would be negatives to the price of the stock (not the value of the company). What should he do? If he reads news articles on SHLD he becomes more confused, one says buy, on says sell and a third chastises him for even buying it in the first place! This investor has probably become frustrated and sold for either a loss or no gain.

Now, investor #2 has held the stock for 2 years now. He sat back and watched during the summer and fall of 2005 when the stock fell from $160 to $120. As he looked at the company he could see no fundamental reason for the dip. Nothing had changed with SHLD and the reasons he bought it were still valid. This being said he decided people were wrong for selling and bought more during this drop (many smart Berkshire Hathaway (BRKA) shareholders did the same during the tech bubble in the late 90’s and have been richly rewarded). The stock has since rebounded and broke through the $160 level up to the near $180 it stands at today. Why was he so confident? He bought SHLD not as a trade but as an investment. He saw SHLD as an investment in Eddie Lampert. He saw increasing profitability in retail operations and a growing cash hoard for Lampert to invest. Based on the 16 year track record Eddie has, that cash is in excellent hands. During the summer of 2005 none of these parameters changed and in fact he had good company as Lampert was in the market buying the stock with him!! The only risks to his investment are a fundamental change in the company’s prospects (retail operations cease to be profitable) or Lampert leaving (unlikely since he owns 60% of the stock). In this investors mind, bad news or an “analyst” downgrade that causes the stock to dip are no big deal since it then allows him to buy more at cheaper prices. All of the risks that investor #1 has are meaningless to #2. They make no difference to the long term prospects of SHLD only the price the stock trades at today. If he plans on holding this investment until one of those fundamental factors changes, the weather this winter which is negatively effecting investor #1, will be meaningless to him.

The shorter your time frame of any investment, the increased risk you face that elements having nothing to do with the fundamentals of that investment will adversely effect the value of it. As you lengthen your time frame you diminish the importance of these short term events (risk).

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GOOGLE- When will reality hit?

Yesterday I wrote about the valuation of Starbucks, a great company that is costing shareholders money not because of any management failing but because investors had bid up the price of SBUX shares to levels that are sure to disappoint. Now we turn to another high flyer, Google (GOOG).

After a 2004 IPO Google has exploded to the upside with shares going from $100 a share to the $489 they sit at today. Revenues and earnings have also jumped. Earnings grew 243% in 2005 and in 2006, it looks like earnings will grow about 75%. Revenues doubled from 2004 to 2005 and are up about 65% from 2005 to 2006. The stock was a world beater in 2005 jumping $222 (115%) but in 2006 just meandered along up only $17.92 for the year or a pedestrian 3.8%. It has a pe in the stratosphere at 62 times 2006 earnings.

Thinking of jumping on this ship? Please don’t. Why, you ask? Let’s look.

Google cannot continue to grow at this clip. The law of large numbers tell us that at a certain point, percentage growth cannot continue. At this rate Google will equal the $44 billion in revenue Microsoft took 17 years to achieve in the next 2. Won’t happen. But, Google’s stock is priced for this event. What happens when Google does not deliver this growth? The stock gets a haircut, not a trim but a haircut, who knows, maybe even a shave. Now, just because Google does not deliver this growth is not by any means an indictment of managements ability. Quite the contrary to take a company from $1.4 billion in revenue to approx. $10 billion in 3 years is quite a feat. To go from that $10 billion to $17 billion to justify the 65 pe ratio based on current growth would require a revenue increase in dollars equal to the increases in 2004 and 2005 combined! If we extend this current growth out to 2008, that would require 2008 earning to grow an additional $11.4 billion dollars (more that all the revenue from 2006).

Management is not really helping its cause here either. In 2004 when it went public Google had 277 million shares outstanding, now today we stand at 311 million. That is a 12% increase in the shares outstanding which further dilutes results on a per share basis. In this respect they are slowing their per share growth due to the dilution. These factors are headwinds working against share appreciation.

Managements actions have assumed an overvaluation of the shares. When a company believes its stock to be undervalued, they will take excess dollars and buy those shares back believing that to be the best use of that dollar. The true value of the dollar of stock is greater than the cost of one dollar. When they believe the stock to be inflated, they use it for acquisitions, the thinking being that a dollar of stock has more purchasing power than a dollar of currency due its inflated level. Google recently purchased You Tube in a $1.5 billion stock transaction.

What does all this mean? Simple, the growth rates for both revenues and earnings for Google must diminish very soon. When that happens the multiple that buyers of Google’s stock will pay will diminish with it. This will cause the price of Google’s stock to fall and fall hard from its lofty levels. I want to stress that Google is NOT expensive because it is $489 dollars a share, it is expensive because that $489 in relation to its earnings and future growth is just too much.

The average of the estimates I can find for Google for 2007 are in the range of $13.85 per share. when you consider 2006 looks to end up around $10.30 a share, kudos to management, they are delivering 33% growth. Here is your problem. The stock price has growth of 60% factored into it. What does this mean? If investors will pay 60 times earnings for a stock growing 60% a year, why would they pay that for a stock growing 1/2 that? Answer? They won’t……..

You should expect the multiple for Google to contract to a range commensurate with its growth rate. If that rate this year is around 30% expect the pe to shrink to about 30 times 2007 earnings. That give us a price for Google shares of about $450 a share. In other words, Google is overpriced. It is priced for its current growth rate, when that rate slows as it must (law of large numbers) its price will fall.

Google is a great company with a wonderful product, its stock is just too expensive.

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Why Price Matters- A case study SBUX & SHW

First things first. When I discuss “price” I do not mean the “price per share”exclusively, I mean the price per share relative to the earnings per share. After all, aren’t earnings what really matters? For instance, take companies “A” and “B”. Company A earns $1 a share and trades for $14 dollars a share (PE ratio of 14). Company “B” earns 25 cents a share and trades for only $10 a share (PE ratio of 40). A cursory look would have people think that “B” is cheaper, a share cost less. But, what are you getting for the cost of that share? Let’s pretend rather than keeping the earnings, both companies pay out all of them to shareholders at the end of the year. Company “A” would give you $1 back for a earnings yield of 7.1% ($1 in earnings / $14 price). Now company “B” does the same thing, at the end of the year you get your quarter from them for a yield of 2.5% (.25 earnings / $10 price). Per share prices aside, which stock would you rather own? Think of it this way, in order to get the same $1 back from company “B”, you would have to buy 4 shares for every one of company “A”.

Now, typically those who are invested in company “B” will say that the growth prospects for “B” are better than “A”. That while “A” may be a better value that “B” now, “B” will grow so much faster that not only will it close the gap , but the share price appreciation that will accompany this will make “B” a superior investment down the road thus it deserves the high valuation. They will cite you many examples from the 90’s where stocks like Microsoft, Cisco, Amazon, Dell and Google today and others trounced boring old companies that were bought at fair valuations. You then have to ask what happens when the music stops and the explosive growth becomes… normal?

Let’s look at how high valuations can lead to hard times for investors:

Starbucks (SBUX):

Starbucks has been one of the best performing stocks of the past 10 years. It’s growth has been extraordinary and its logo and coffee have become American icons. They provide health insurance for all their employees, use recycled paper for their cups and buy “free trade” coffee beans. In short, their is nothing not to like about the company. The stock however is another story. This past summer all was well for shareholders. The stock hit an all time high of $39 and the future looked very bright. Then a bump. The company announced its same store sales would fall well short of estimates because it had problems implementing ice new iced drink offerings during the hot summer. Rather than wait outside in line, people sought coffee from other places. Trading at over 50 times earnings at the time, investors panicked and acted first before they asked any questions and took the stock down to $29.55 a share for a 25% loss. The stock has since recovered half the loss and trades at $35 a share. Those who bought before the summer swoon are stuck holding the stock of a great company at a loss to their purchase price. Those who did not own SBUX but after the summer drop bought it are sitting on a 17% gain. Two investors, two very different situations. What happened? In a word:Fear. When you pay that much for the company, at the first sign of bad news you sell just in case the other shoe drops and that news is worse. That is what happened to SBUX. What did SBUX actually say? They had problems serving all those people fast enough. They didn’t say that there were no lines, that people only wanted the cheapest coffee they had, that they were losing market share.They only said that they could not make coffee drinks fast enough for all the demand. Now you have doubt in the stock. What if there are other problems? What else is there? Are people tired of Starbucks coffee? Despite earnings estimates for 2007 from the company that are in line with analyst’s expectations, investors are only paying 38 times 2007 earnings now (still too much). That means the stock price is falling as people are not willing to pay over 50 times earnings now that they realized SBUX is not perfect. Another misstep, not matter how trivial will lead to its multiple to shrinking again and its stock dropping more. Has anything fundamentally changed about the company? No…. It is the mindset of investors that has. If you were not smart and overpaid for SBUX, you now own a piece of a wonderful company purchased at an awful price.

Sherwin-Williams (SHW)

In a word: BORING!!. They make paint, so what? No Hollywood actors carry their cups around and you really cannot look cool ordering a gallon of red semi-gloss no matter how hard you try. Their shares have always seemed to trade in a pe range of 10 to 15 times earnings. In early 2006, a Rhode Island jury found that SHW was a “public nuisance” due to lead paint they stopped producing 50 years earlier. A judge ruled they had to share the cost of cleanup of lead paint in homes and estimates ran up to $4.5.billion in costs. Instant memories of asbestos came to investors minds and the share were punished 22% over the coming days. Investors feared a landslide of lawsuits from lead paint poisoning. After cooler head prevailed, people realized that there have only been about 2,000 cases of lead paint poisoning EVER. Once the asbestos analogy was diminished the shares resumed their normal trading at around a pe of 14 times earnings. Shares have not only recovered but are up 56% from their post Rhode Island ruling low as they have followed the earnings.

Why the difference? Valuation. SHW shares are fairly priced, bad news only effects them to the extent of the news. SBUX shares are overpriced, bad news effects them by illiciting fear and uncertainty and investors react to uncertainty by selling. Look at the two situations, SBUX is down 10% from its peak due to rather benign news, they just could not make enough coffee fast enough to satisfy the hoards. SHW is up 17% from its high water mark before the ruling, a ruling that has significantly more impact to the bottom line at SHW than SBUX’s news does. Had you paid 50 times earnings for SHW (like many did for SBUX) shares before the bad news, you would have been paying about $200 per share and would be in the hole on this stock now too. Two good companies, two negative events but for investors, two very different outcomes because of the price they paid for their shares.

Those stocks I mentioned earlier? Since 2000, the approximate top of their valuations: Dell (-44%), Amazon (-42%), Micrsoft (-45%) and Cisco (-52%) have all been losers for those who bought in…

Oh Yeah..Boring old Sherwin-Williams, whose investors never overpaid for it ? UP 240%

Buy stocks in great companies, just do not pay too much for them.

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DOW CHEMICAL (DOW) – Why Don’t You Own This?

The most fundamental tenet of value investing is buying a good company that is currently out of favor with a depressed stock price and waiting for its true value to be realized. This summer when I started looking at (and buying) DOW I just could not understand what the problem was? Why is it so cheap? What was I missing? Turns out nothing, it was everybody else who was (and still is) missing the boat here. I now wish I had done more than just dip my toes in the water then. Lesson: if you do the research, learn to trust yourself (I have bough much more since then). This summer it was disgustingly undervalued, after a 20% run since then it is only alarmingly undervalued with plenty of room to go. You can buy DOW now for the same share price you could have bought it for in 2004 despite eps more than tripling since then. Let’s discuss DOW:

Before we discuss DOW on it own merits, let just compare where it is now to its peers and see if it seems “cheap”.

—————-PE:———-Div.Yield
DOW ———-10 ————–3.7%
BASF ———-12————– 2.1%
DD ————19————— 3.0%
BAY ———–24 —————1.7%
HUN ———-31 ————–2.9%
EMN ———-13 —————2.9%

It would appear on just a simple pe level DOW is at least 20% cheaper than its closest peer (BASF) and has a dividend yield that is 23% higher than its next most generous peer (DD). The skeptics would say that the pe is low because earnings are expected to fall and the price is anticipating that. Makes sense except when you consider no analyst nor the company itself predict a decline in 2007 eps over 2006. All expect an increase. So now we have a conundrum. Why then is DOW so cheap? It must be the financials, so lets look at them:

Let’s take some 5 years averages and then look at 2006 and see how we measure up:

———————5 Year Avg. ———–Current
Net Margin ———–3.8% —————–9.7%
LTD to Cap ———–49% —————–37%
Return on Equity ——14% —————-32%
Dividend Payout ——58% —————–29%
Cash Flow Per Share –$3.76————– -$6.77

Ok, so it is not that because on those metrics, the financial engines at DOW are running full speed. So if its not the current situation at DOW then it must be something in its future prospects that we do not know. Something management is not telling us. Lets look at managements actions and see what they ARE telling us since we all know actions speak louder than words.

In July 2005 the company announced its first buyback since 1999. It said it would buy back 25 million shares before the end of 2007. DOW was so cheap in 2006 they purchased 16.8 million of the 25 million allowed (700,000 shares were purchased in 2005). In October 2006 they announced that they were adding another $2 billion to the buyback for roughly 5 million more shares. Is that all?? Of course not. In July when the stock tanked to $34 a share management stepped in with $3.5 million dollars of their own money and scooped up shares. So I guess management thinks that the future is bright, either that or you have to believe they enjoy watching their money evaporate. Doubtful.

Now we hear that private equity may be interested in DOW. Who can blame them? What do the private guys look for? They want companies that can be bought that are currently priced below their true value, even after the premium they would have to pay for DOW to shareholders. Then they can them either sell off pieces or hold it for a few years and let its value be recognized and then spin it off for a handsome profit.

Let’s take a step back now and look at what we have. We have a company trading at a discount to it’s peers, whose financial condition is the best it has been in decades, who is buying back billions of dollars of its stock, who has management spending millions of its own dollars to buy the stock, who has private equity rumored to want the whole company.

Do I really need to go any further? Next week place your buy orders for DOW please. Priced where it is, you can still get a bargin but with the private equity guy sniffing around the chance will not last long.

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