Friday, August 29, 2008

Portfolio Update

I've added a box to the right where the "Deep Discount" Portfolio will live. I'm adding three companies -- BBY AEO and APC -- at today's closing prices.

As it stands, the original five stocks in portfolio are up +7.5%. CIT leads with a +15.5% gain; MGM is close behind with a +13.8% gain. Neither is anywhere near done rising and both are still good picks with plenty of upside.

While my picks have done +7.5%, the S&P is up only about +2.1%.

Screen Result No. 4: Anadarko Petroleum

Today is the last installment in my value screen series. If you're just tuning in, check back over this week's posts or ask to borrow a classmate's notes. We've covered three opportunities so far.

Today is the fourth. The last company that met my screen is Anadarko Petroleum.

Its shares are currently selling for about 29 times earnings, the highest multiple in our screen and indeed higher than the S&P 500 overall. They've declined 5.3% % in price since the beginning of the year, though when I ran the screen they'd fallen about 10%. and are trading at about 1.75 times their book value, at a market cap of $29 billion.

Anadarko drills and produces oil and natural gas. It has made a huge bet on natural-gas production with a $23.3 billion acquisitions of Kerr-McGee and Western Gas in 2006. It also has significant deep-water operations in the Gulf of Mexico, where its rigs are scheduled through 2013. The company has 2.4 billion barrels of proven reserves and nearly nine trillion cubic feet of gas.

The company is expected to sell about 210 million barrels of oil this year, though it will add about 225 million barrels to its hoard, partly from some successful finds in Utah's Uinta Basin. This will mean a net gain in reserves. Though about 85% of its wells are right in the U.S. of A, Anadarko has an international footprint, mostly in Algeria. It does, however, also own 28% of the very promising "Jubilee" field in Ghana, which is likely to contain 1.45 billion barrels. Exploration is expanding to nearby Sierra Leone.

Anadarko is the oil business' juggling act. It engineered a massive one-two punch acquisition, and it since has been offloading assets for cash and repositioning its financial footing. Some of those assets are being transferred to a master limited partnership, a separate entity that will generate cash for its owners until the wells literally run dry. With so many balls in the air, this is sort of a rebuilding year for the company, and another is likely in the offing. But Anadarko is certainly benefiting from high oil prices, and though its per barrel finding costs are a little higher than the industry average, it still operates at a higher operating margin than many of its peers. Anadarko is something forgotten amid the ExxonMobils and the Diamond Offshores, but it's a good company that makes a lot of money -- $3.78 billion last year.

The best news of all is that Anadarko just announced a buyback totaling $5 billion. That's a major deal that can seriously alter the company's earnings calculations. I've mentioned buybacks in passing before, so I thought I'd explicitly review what this one means:

Anadarko has 465 million shares outstanding. It's going to buy back 18% of them and basically cancel them. This will reduce the number of shares out to about 380 million.

Now, earnings per share are computed by dividing net profit by the number of shares outstanding. So, say we assume 2008 earnings will be $1.535 billion. If we divide that by 465 million shares, we get earnings of $3.30 per share.

But if we divide that same profit by the reduced 380 million shares, we get $4.04. Same exact profit, but fewer shares to spread it over. Given a constant earnings multiple, reducing the number of shares by 18% actually raises EPS by 22.4%. That should, in turn, raise the price a commensurate amount.

This is a great use of the company's cash. In fact, I'm awarding chairman and CEO Jim Hackett with a pair of Brass Umlauts. He joins Merrill Lynch's John Thain and Harvard Management Company in the hallowed halls of the Order of the Umlaut, my hunble honor for executives who show serious spheres in the management of their companies.

. OK, so let's look at our questions:

How have earnings per share fared over time?
They've certainly been on the upswing: EPS was 45 cents in 1997. Ten years later it was an astonishing $8.08.

Is that likely to continue?
No. And in fact 2008 results are likely going to come in at less than half of that; 2009 earnings will be a little better, at about $5.80. However, if we assume the buyback is completed by then, then EPS will be $7.03.

What is the current earnings multiple?
The current PE is 29.

Where will the multiple be in two years?
Believe it or not, 8 to 10 is typical based on historical average annual PE data. I'm not willing to forecast anything higher than 12.

Given the earnings estimates and PE predictions, what will the fair market value of the stock be for 2009?
12 times $7.03 is within shouting distance of $90. (You'll note I reworded that question for a one-year window; we've projected two years for previous companies.)

Am I willing to accept the risk/reward this potential return represents?
Yes. Shares are at $62. The one-year return could reach 45%, and that's significantly more than I think one can reasonably expect from the broader market. Anadarko is in a volatile industry, yes, but it's a still a stable, $30 billion enterprise with smart management and strong financials.

In conclusion:

I'm buying American Eagle, Anadarko and Best Buy at today's close and will track them with the rest of the "Deep Discount" picks. I'm passing on Valero.

Have a good holiday, and, as always, many happy returns.

Thursday, August 28, 2008

Screen Result No. 3: Valero

The third company that met my value screen -- down more than 10% year to date, excellent financial condition and earnings growth of 30% for the past five years -- is Valero.

Valero makes money by buying crude oil and turning it into gasoline and other products.

Let's look at how that works. A barrel of oil is 42 gallons. Say it costs $110 (see below). Per-barrel refining costs are $5.88, according to VLO's last earnings report, bringing the total per-barrel cost to $115.88. A barrel of oil yields about 19.6 gallons of gas, which, if Valero sells at retail for $3.60 a gallon, brings in $70.56. That same barrel of oil will also yield a little more than nine gallons of diesel. Diesel's selling for $4.25, so that's another $38.50, and Valero's pretty close to being in the black. Happily, it still has four gallons of jet fuel, a little "heavy fuel" and some other products to turn a profit with. All in all, its current "throughput margin" per barrel of oil is $10.82. (That's down from $18,14 a year ago.) Valero can process 3.1 million barrels a day.

Refining is a game of inches. Operating at capacity is unrealistic, and costs fluctuate. So it's a game of inches, and Valero's profit margin is only about 2.5%. Granted, that can add up rather nicely across $100 billion in revenue, and it usually does for this outfit.

Here are some other things to keep in mind about the company:

It uses cheap crude. The price you hear on the news each night is the front-month contract on light, sweet crude. Some crude is so light and nice it could go right into your crankcase. That's the good stuff, black gold. Heavy, sour crude -- so called because of higher sulphur content -- is cheaper.

Other refiners can't use sour crude, but Valero's 16 refineries are designed to use it, and that lowers the oil input cost. West Texas Sour goes for about 3.6% less than West Texas Intermediate. This seemingly small cost savings gives Valero a huge completive advantage. In fact, Valero is actually selling off its "basic" refineries -- the facilities that can only refine more expensive light, sweet crude -- so that it can focus on higher-margin sour refining.

Debt is low. Long-term obligations total $6.4 billion, about 34% of shareholder equity. Working capital was a healthy $2.8 billion in 2007. (If Valero wanted to raise more cash, it should sell or lease its chain of 5,800 gas stations. Its vision to build a high-quality premium gas brand is absolutely ludicrous. Gasoline is a commodity. Consumers are loyal only to location or, you know, price. Gas stations are difficult to manage and have very thin margins, which is already the problem in the refinery business)

Its steel looks like gold. Valero is sitting on extremely valuable assets: As we learned during Katrina, oil refineries are in short supply in these United States. Even so, these refineries can be purchased right now at a discount to rather than a multiple of their book value. You can buy Valero refineries for 93 cents on the dollar -- you sure as hell can't replace them for that, not with the cost of steel and concrete. Oh, and the business that generated a $3 billion profit last year while buying back shares and apying down debt? Investors get that for free.

It has a gun pointed at the CEO. Granted, it's probably the golden one from the James Bond movie of the same name. Nevertheless, Valero should be lauded for tying 82% of its chief's pay to his performance. It also requires the sumbitch to own Valero stock equal to 10 times his base salary. I like that. They paid the dude about $15 mil last year, about what his peers pull down. I'm OK with that if he hits his numbers. This is a company, after all, that turns a roughly $3 billion annual profit. $15 million is statistically insignificant.

Diesel, diesel, diesel. Let's hear this straight from the horse's mouth: "Despite the difficult environment for margins on gasoline and many secondary products, Valero continued to be profitable," Valero chief Bill Klesse said. "Wide differentials for the heavy and sour feedstocks that we can process in our refineries benefited us significantly in the second quarter."

Translation: We bought cheap oil and made it into pricey gas. We hate to be a greedy bastards, but we have an obligation to our shareholders.

"In our refining operations, we've made great progress in shifting production to take advantage of the strong market for distillates. From 2008's first quarter to the second quarter, we increased our distillate production by 110,000 barrels per day while maintaining steady gasoline production. In the same time frame, we increased our use of discounted feedstocks from 66% to 68%, partially due to improved operations at our heavy sour refineries" where we've done a bunch of repairs.

"Looking at market fundamentals, we expect distillate margins should be strong for the rest of the year and next. However, we expect gasoline margins to continue to be weak and industry utilization rates to decline. We expect secondary products to have a margin recovery, particularly if the price of crude oil stabilizes or falls, as the prices of these products lag changes in the price of crude oil."

This means: We're going to make shitload of money off diesel, where the margins are fat, instead of making gasoline, where the margins blow.


The screen establishes that Valero is worth looking at, and what we've heard so far sounds pretty good. Let's answer the questions posed in Monday's post to decide whether to add Valero to our portfolio:

How have earnings per share fared over time?
Valero's earnings grew 507.9% from 2003 to 2007. Revenue increased on 149.0% in the same period. The dividend came in in the middle, gaining 336.4% in the same period.

Is that likely to continue?
Probably. The profit margin in refining gas has always been low, and throughput is off. But Valero is still well positioned: It uses a cheaper input to create the same product, sells it for the same as its competitors and pockets the spread. It magnifies this happy profit algorithm when it cranks up diesel production.

Where does that put per-share results in two years? What do analysts forecast?
It's tough to say, as Valero's refinery roster is losing some players. Given the refinery sales, I'd peg earnings at about $5.75 to $6.25 a share this year and roughly $6.50 next. That's conservative and roughly in line with estimates.

What is the current earnings multiple?
6

How close is it to its historical average? To benchmarks?
Six isn't out of line for Valero. A rich estimate would be 7.

Where will the multiple be in two years?
I'll give them 7 for the target price. Anything more is wishful thinking. Even so, I think investors will like the refinery sales, the capital spending on its remaining assets and the effects of the share buybacks.

Given the earnings estimates and PE predictions, what will the fair market value of the stock be in two years?
$45.50. That's a gain of $10.30. from Valero's current $35.20 ashare price, or 29.3%.

Am I willing to accept the risk/reward this potential return represents?
No. That's not a rich enough gain. True, Valero will make money regardless of the price of oil, but that being said, owning these shares carry the risk of opportunity loss as the market regains its footing.

Though the shares are down -50% for the year and might be a good value based on the underlying assets, I don't see them beating the market for two years based on the fundamentals. Anything down 50% has to rise 100% to get back to where it started. I don't see a significant earnings catalyst to drive that.

Wednesday, August 27, 2008

Screen Result No. 2: American Eagle Outfitters

The second stock that met the criteria of my screen is a company I feel strongly about. I recently did a little intelligence gathering at one of its stores, and I've been immersed in their financials ever since. So I was happy when I saw I would have the opportunity to write about American Eagle Outfitters in this series.

Yesterday I wrote about Best Buy, a store I really like. I can't say that I particularly like American Eagle Outfitters' clothes. I've generally considered them Abercrombie Lite, though that's changing. I've been inside American Eagle stores a few times, though I've never seen anything I particularly wanted to buy. But, alas, I'm not 18 anymore. I'm pretty far removed from American Eagle's target demographic.

I do, however, like Martin + Osa. This is American Eagle's new concept, which target people my age (and, frankly, "size." Did I mention I'm not 18 anymore?). Their clothes are well-made, stylish without being disturbingly metrosexual, and everything is the store is nice to touch, which bodes well for comfort. M+O doesn't sell anything except casual clothes, and I think they hit the mark. Their stores make me feel at home, relaxed; I'm not intimated by the clothes, incredulous at the prices or leery of the help. Think of them as the anti-Banana. That combination of factors gets me into the dressing room. And the dressing rooms are really something to behold. If you haven't been to a Martin + Osa store, go. And take your American Express card.

I think Martin + Osa will do a lot to drive AEO's earnings. I feel the same way about aerie. Let me be clear: I have not ventured into this young women's unmentionables store, and I do not plan to unless my daughter asks me to take her. But the mood is reportedly the same: aerie is designed to be comfortable and accessible. If Mortin + Osa is the anti-Banana, then aerie is the anti-Victoria's Secret. I think this atmosphere is bound to resonate with consumers.

All in all, American Eagle has done an outstanding job offering products for each demographic segment. It targets kids, young adults and the over-25 set. Gap's offerings have no linkage. You never graduate. Gap's smattering of concepts merely attempt to appeal to different price points. AEO is much more strategic. They've created a more refined approach -- and I think that shows in its performance. (Chico's has pulled off the same trick with its Soma and White House Black Market stores.).

Lately, though, the stock has had a rough go. AEO is down -32% for the year, about twice the drubbing the S&P has taken. AEO is trading at a mere nine times earnings. Is this a good value?

Let's consider the questions we're asking of each company that meets this week's screen.

How have earnings per share fared over time?
Earnings per share have grown an average +30.8% for the past six years, and the first few years of that was pretty choppy. On the whole, though, earnings growth has grown faster than revenue growth, which is a good sign.

Is that likely to continue?
Given the growing concepts, new American Eagle stores and an extensive remodeling campaign, I think that growth trend is indeed likely to continue. Each new store adds $2.5 million in sales. Data from the company suggest that remodeling increases sales +33%, earnings +43% in profits and +40% in store space.

Where does that put per-share results in two years?
Thirty-percent growth takes EPS to $3.08 in two years.

What do analysts forecast?
Analysts see a decline in earnings, from $1.82 to $1.52, according to Bloomberg. This is a drop of -16.5%, a little larger than AEO's last earnings slip, a -14.6% slide in 2003.

What is the current earnings multiple?
Nine.

How close is it to the stock's historical average?
It's significantly lower than the average 14 for the past three years. Where will the multiple be in two years? I think the multiple will return to its average when the economy regains its footing. Investors are frightened that consumers are tapped out.

Given these earnings estimates and PE predictions, what will the fair market value of the stock be in two years?
I see a PE of 14 and EPS of $2.90 to $3.00. That gives the shares a fair value of $42 and implies 200% in upside.

Am I willing to accept the risk/reward this investment represents?
I think these shares are being terribly underestimated. I think the remodeling, store openings and new concepts will drive earnings far more than Wall Street is betting. Do I understand the business? I don't know fashion, but I know that American Eagle and Martin + Osa looked better than I have ever seen at the shareholders meeting. American Eagle has come into its own and no longer looks like an Abercrombie knock-off. It also has a strong denim business, and denim is still hot. And aerie is going great guns -- forgive me, I had to say it -- in its attempts to sell comfortable bras, underwear and "dormwear" to young women who want something comfier than Victoria's Secret silky elegance.

Do I want to be an owner of the company? Can I articulate why?
I want to own these shares to capitalize on management's continued success and to profit when the market realizes that AEO is going to maintain its strong history of results. I honestly think that analysts' kids shop at Abercrombie and that that has an effect on Wall Street's perceptions. Bottom line: Revenue will exceed expectations, and the company, which operates at a net margin of 10%, will surprise with strong earnings than expected. Management has achieved nearly a 30% return on equity -- impressive considering the company has no long-term debt -- and is expected to do even better.

If nothing else, you can probably talk your way into a little discount at Martin + Osa by telling them you're a shareholder. What the hell. It works at Nebraska Furniture Mart…

Tuesday, August 26, 2008

Screen Result No. 1: Best Buy

The first company that met the criteria of my recent screen is electronics retailer Best Buy, which trades under the ticker BBY on the New York Stock Exchange. The chain's trademark yellow tag hangs on about 770 U.S. stores and 44 international outlets. It also has about 270 other electronics stores under other brands.

I can do without most big-retailers, but I'm an unabashed fan of this store: There's always something at Best Buy I want, from wicked sweet flat-screen TVs and sound equipment to nifty computer stuff. Plus it is usually cheaper than the competition. Consumer electronics account for about 40% of Best Buy's sales. Home-office products -- I presume this is mostly printer cartridges -- bring in 28%, games are 20%, appliances and services each add 6%. All told, it moves about $40 billion worth of merchandise a year -- fully a third of which comes from Sony, HP, Gateway, Toshiba and, of course, Apple. It boasts a 21% market share.

Here are some things I like about this company:

Directors and officers own 20% of the stock. That's huge to me. The only truly immutable law of economics is that people will always act in their own self-interest. You can be sure that owner/managers are far more likely to make the best decisions for the organization's long-term success than even very well compensated hired help. Best Buy also is buying back its own shares -- and not just a little. The presentation its execs gave at the shareholders meeting noted $4.1 billion in buybacks. That's a big statement. The statement is: "Our stock is cheap. Buying shares is the best way we could find to spend this money."

The looming deadline for digital TV. One of the things I've learned from the marketing staff at my company is that consumers always wait until the last possible minute to make a buying decision. The deadline for digital TV is looming. I think we'll see a stampede to electronic stores for new sets that can receive digital signals and for the set-top boxes that can process them in analog models. That deadline is Feb. 17, 2009. This will bring in millions of consumers who haven't been in the store before.

Services are where the money is. In fact, services account for 78.5% of the U.S. economy. At Best Buy, that's Geek Squad, which contributes 6% of sales. I think that unit will see a huge upturn in business when people start trying to hook up all their fancy-schmancy digital TV stuff. Some may see this jump in revenue as a flash in the pan for Best Buy, perhaps juicing earnings a little for a couple of quarters. I agree with that, but only to a point. I think it will expose this service to millions of people who might never before have considered using it. In fact, I wouldn't be surprised to see Best Buy eventually spin off this unit. (Just as competitor Circuit City did with its CarMax division.)


All of this makes me predisposed to like these shares, which, by the way, are down 14% year-to-date and are trading at about 14 times earnings. This is the lowest earnings multiple since 1997.

Let's consider the questions I posed in Monday's post:

How have earnings per share fared over time?
For the past five years, earnings per share have increased an average of 17.7% a year.

Is that likely to continue?
I think so. People like the gizmos Best Buy sells. It has the iPhone, the hottest video games and gaming systems, flat-screen TVs, laptops and BlackBerries. It has navigational devices, cellphones and stainless-steel appliances. It just hit $40 billion in revenue -- twice what it did in 2003. Its target for 2013 is $80 billion. Revenue is increasing at a 15% compound annual growth rate; earnings are growing even faster, at a 23% CAGR.

Where does that put per-share results in two years? What do analysts forecast?
The last fiscal year saw earnings of $3.12 a share. Analysts predict a 5.5% gain to $3.29. I think this estimate is light. I'm not willing to discount their 17.7% average growth too much -- the stores have done well in a faltering economy, and the first thing a lot of consumers are going to do when they feel things have turned around is to splurge. Plus Best Buy opened more than 200 stores last year. I see earnings at $3.50 for this year (fiscal 2009) and $4.00 in 2010. That is still pretty conservative: Its 15% historical annual growth rate puts earnings at $4.13

What is the current earnings multiple?
14.

How close is the PE to its historical average? To benchmarks?
It's low. Last year's average annual PE was only 15; but Best Buy shares hovered around 18-19 times earnings for the four years before that. The S&P 500 is trading at 26 times earnings, both of which make Best Buy look worthy of its name. Some say investors only reward fast-growing companies with high PEs. Well, fine. Doubling your revenue between now and 2013 is a high-growth strategy.

Where will the multiple be in two years?
I think its PE will trend upward, to 18-20. If it hits its revenue target, 22-25 may not be out of line.

Given the earnings estimates and PE predictions, what will the fair market value of the stock be in two years?
20 times $4 in EPS is $80 a share. That's a gain of $34.84, or 77.4%. We'll call that 38% a year, far better than the S&P's recent performance and superior even to its long-term average. In fact, the S&P hasn't posted a gain like that since 1995. And Best Buy also pays a little 1.5% dividend along the way.

Am I willing to accept the risk/reward this potential return represents?
Absolutely. I like Best Buy shares. It's a category leader with a strong earnings history and good prospects to continue it. It has $625 million in long-term debt -- roughly half last year's bottom line. Management has proven capable -- returning more than 20% on equity for the past decade -- and executives have a vested interest in ensuring the(ir) company's continued success.

Saturday, August 23, 2008

The User's Guide to This Week's 'Value' Screen

This week we'll be taking a look at some potential investments I found using a stock screener.

If you've never used one of these nifty online gizmos, you should give it a whirl. They're an efficient way to sift through the vast equities universe and find companies that meet your specific criteria. It's also a good mental exercise, especially with a really powerful screener that can scan using scores of variables. Keep an eye on yourself: What you wind up looking for will tell you a lot about your investing style, and that can be every bit as valuable as a good stock tip.

I, for one, love to buy stocks on sale. The more insultingly low the price, the better.

Now, this sort of "value" investing can be a little risky, because prices are usually low for a reason. (Though that reason might not have anything to do with the company itself.) So the trick to mitigating the risk of any value strategy is to refine it. To do this, we add what Ben Graham calls a "margin of safety." In this case, that could mean looking for companies with low stock prices AND a record showing historical outperformance -- beating peers and benchmarks -- while delivering ever-increasing earnings.

So I ran a simple screen of U.S. equities using three criteria -- no fancy indicators or mathematical sleight of hand. I sought:

Companies that were down at least 10% for the year, and

Companies that had increased their net earnings at least 30% for the past ten years, and

Companies that were in exceptional financial health.

This screen yielded four companies. That's good: The fewer results, the better.

Now, look, any knuckle-dragging bohunk laborer can bust up a rock with a chisel. That doesn't impress me in the slightest. But a skilled craftsman can use that same tool to construct a stone wall that will last a thousand years. An artist might use a chisel to fashion a sculpture so beautiful as to make a man weep. The tool is only a device to save labor; it is the skill of the user that determines the results. The point: Building a great screen is the first step, not the last.

So we will attempt to add intelligence to our screen by asking the following questions:

1. How have earnings per share fared over time? Is that likely to continue? Where does that put per-share results in two years? What do analysts forecast?

2. What is the current earnings multiple? How close is it to the stock's historical average? Where will the multiple be in two years?

3. Given these earnings estimates and PE predictions, what will the fair market value of the stock be in two years? What sort of growth is this? Given post bear-market rbounds, is this price target realistic?

4. If the price target is realistic and the upside presents a premium, am I willing to accept the risk/reward this investment represents, or would I be better off in a low-cost index fund? Do I understand the business? Do I want to be an owner of the company? Can I articulate why?

All of the information I'll use is available from free sources like Google Finance. And I'll try to figure out how to put some of this data in tables to make it a little easier to digest. If I find satisfactories answers to these four questions, I'll add the company to my general portfolio.

In the meantime, here is where my "Deep Discount" picks from two weeks ago stand as of Friday's close. All in all, I'm pleased with these results: They didn't double overnight, and I wasn't expecting them to. These stocks may take a year or more to recover to where I think they should be. I remain confident they will.

If you're interested, look back at the past month's chart for MGM -- it's nuts. Beta is 2.18 -- meaning MGM's price sginificanly magnifies the market's swings. When I see choppy trading like that, I get happy. And I tend to take "fast gains" and then wait for another opportunity to re-purchase the shares.

CIT 8.76, 9.70 +10.7%
MGM 29.79, 33.25 +11.8
KMX 14.10, 15.11 +7.2%
MER $26.85, 25.22 -6.1%
GM 10.23, 10.44 +2.1%

Now, I want to say something about Merrill Lynch. I have to be very careful about this stock. Why? Because I really admire the CEO. I have a lot of faith in him. The danger when that happens is that I run the risk of running over the cliff with him. Now, I certainly don't think Merrill is in danger, I just have to make sure I'm not making my investments show friends when this here is show bidness. I have established $22 as the point where I decide to double down or close the position. The third option -- sit still -- is not available. Yes, I set the rule, and I suppose I could ignore it. But the hallmark of a great investors is -- wait for it -- discipline.

If you want to check out a good stock screener, click here.

Tomorrow: Screen Result No. 1

Friday, August 22, 2008

Lessons Learned

Last night I attended the screening of a truly fine motion picture at Austin's premier art-house cinema. The film was a subtly nuanced perspective on the absurdities of racial injustice and a scathing, unwavering attack on the potential destructive power of the dark side of capitalism.

Not only that, but Blazin' Saddles is a hoot.

A little low comedy never put anyone's eye out, and this movie is still hysterical and dead on, even after 30 years. You just don't see any good racist westerns anymore. It's a damn shame.

But this blog is about bidness, so let's get down to it.

Here are the lessons investors can glean from this classic movie:

The townsfolk's first reaction is always to lynch the sumbitch.
Sheriff Bart rides into town to a hero's welcome and finds himself looking down the barrel of a gun less than a minute later. We see this all the time on Wall Street: A white knight will appear to save the company, and by the end of the next quarter he's the most hated man in town. Not because of what he's done but for what he is -- a savior, maybe, but also the embodiment that something is wrong, and it shouldn't be.

Surely this happened -- and is happening -- to Merrill Lynch CEO John Thain.

Thain -- a shrewd operator -- did the exact same thing Clevon Little does in the movie. When everyone points their guns at him, turns his own gun on himself, too. Thain waded in like John Wayne and bet $11.5 million on himself, buying MER shares at their ebb just days after selling a huge asset at 22 cents on the dollar. Wall Street was ready to string him up. In the end, though, it was obvious Bart was the right sheriff, and I think that's the unmistakably conclusion with Thain. He's done an admirable job looking over the lynch mob's pitchforks and seeing what the real goal is.

Government can solve nothing. It will only make matters worse.
Hedley Lamarr was obviously corrupt and sought only to exploit his office for personal gain. He wanted the town of Rock Ridge to make a fortune and used his position as attorney general to advance his nefarious scheme -- willing to sacrifice his office, the law and even the lives of others. We've seen this time and time again in 72-point type above the fold.

Now, low scandals and base motives are one thing, but the real problem with government is not corruption, it's incompetence. The federal machine is too awkward, clumsy, tone deaf and stiff to execute a perfect pirouette in Wall Street's ballet and pull off a true command performance. When government is not tripping over its own shoelaces, it's missing its cues.

We should be thankful for this -- it keeps Uncle Sam's brain trust from mucking too many things up too often. But when things get really tough, we have to know that when we ask the government for help, we are putting ourselves at the mercy of its corrupt Hedley Lamarrs and the incompetent William J. Lepetomanes.

The marketplace has to solve its own problems. Government cannot provide solutions, it can only attempt to postpone the inevitable.

Railroads are good investments.
Hedley Lamarr was corrupt, but he could still spot a good investment when he saw one.

Railroads make money. Ask Warren Buffett. His latest SEC filing shows that Berkshire Hathaway's stock portfolio is in the proverbial shitter. The only bright spots are his relatively recent stakes in Burlington Northern, Norfolk Southern and Union Pacific.

BNI, the only major play of the three, increased $500 million in the second quarter, almost enough to staunch the bleeding from Buffett's (I'll say it: "idiotic") holding in American Express. That position took a $896 million bath in the last quarter alone, half the $1.6 billion shellacking Wall Street gave Buffett's Coca-Cola stake.

The last point I learned from Blazin' Saddles:
It's completely absurd, it's totally shocking and the ending doesn't make any sense.
This is always a good thing to keep in mind, both in investing and in life, such as dealing with one's former spouse. But I digress. You've got to deal with whatever happens, regardless of how crazy, zany or nonsensical. It's easier if you keep a sense of perspective -- and a sense of humor.

In the end, Clevon Little and Gene Wilder are whisked away in a limousine.

May it happen for you, too.

Wednesday, August 20, 2008

The Bank Job

I like banks. They tend to smell good inside. Many have free popcorn in their lobbies. Most have a few attractive tellers, and there's nothing quite like a beautiful woman handing you a stack of crisp fifties. Plus banks have a financial model that really appeals to me.

Consider how they make money:

1. Banks offer to hold your cash at a very low rate of interest. In some cases, they pay no interest at all.

2. The bank, using your cash, makes loans at a significantly higher rate of interest.

All the bank has to do is lend at a high enough average rate to allow it to pay its lenders, meet its expenses and cover bad loans. That's it. Borrow low, lend high, pocket the spread. Simple but elegant.

On the whole, banks are extremely good at this. Damn good.

Consider: If a bank makes $1 billion in loans at 8.25% and pay 4.50% in interest -- holding back 2% of the total to cover any loan losses -- it will turn a gross profit of $17.5 million. That's before it has touched expenses, sure, but it's also before it has collected any service fees. (And my friends, banks across these fruited plains collected $9.9 billion in fees on deposit accounts last year alone.)

But a billion dollars in loans is chump change. Banks have $6.5 trillion in outstanding loans. That's half the U.S. gross domestic product and about a tenth of the entire world's. This is what the business gurus at the Wharton School and the Friedman disciples at the University of Chicago refer to as a shitload of money.

But investors who own bank stocks are having a tough slog. Even though a mere two-point spread on $6.5 trillion in loans is $130 billion in net interest income, no one cares. No one is focusing on the overall health of the banking sector only on the ravages of subprime. To wit: Keefe Bruyette & Woods' Bank Index is off -30.6% year to date and off -43.4% from a year ago.

The biggest banks -- J.P. Morgan, B of A and Citi -- have seen scores of billions in market capitalization evaporate as the financial sector reels from the subprime mess, credit crunch and resultant stagnant economy. Citi is off -40% for the year, B of A -30% and JP Morgan about -10% Banking is ultimately risk management, and the best risk manager in the game is Wells Fargo. Wall Street has rewarded Wells, which had almost no exposure to subprime, with a flat stock price.

Consider "beta." This metric uses a bunch of whiz-bang statistical applesauce to compare a stock's price volatility to the broad market. A beta of 1.00 means a company's stock moves in lockstep with the market as a whole. It is a measure of relative risk. Citi's beta is 1.48. So is Wachovia's. That means that investors consider two of the largest banks in the country to be half again as risky as they overall stock market. That's amazing. Without knowing any of the details, would you rather bet on the bank you trust your money to or any stock in the S&P 500?

Now, admittedly, not all banks have a huge beta, but the sector is unquestionably decimated -- "quadrimated," for the literal. The reason is simple: Investors are simply scared shitless of banks. (It's mutual: Banks are scared shitless of investors right now. And a lot of banks are scared shitless of borrowers right now) Investors are terrified that major financial institutions are going to announce more losses and writedowns. The No. 1 most-read story on the Bloomberg yesterday was about the possibility of a big bank failure.

With prices in the toilet, bottom-feeding speculators move in to take advantage. But these guys are basing buy decisons on price alone -- they're just looking at a price chart. So when some sort of bad news or rumor hits the Street, they bail. Prices start to fall, and this leads other investors to dump shares, which pushes prices down further.

So for every step forward that the financial sector manages to take at the beginning of the week, most issues seem to wind up knocked back at least as far by the end of the week. Bank shares can't gain traction because no one knows what is going to happen.

Well, I do.

That business model I showed you? Banks really aren't any more complicated than that. Oh, sure, there are some nuances, but the question of whether banks' business model is sustainable has long been settled. Banks will do just fine. In fact, banks are doing just fine -- in aggregate.

True, some banks made lousy lending decisions, and they will fail. Hey, life's rough in the aluminum-siding business. Other banks will tread water indefinitely. But many banks, perhaps even the majority of banks, will see their stock prices regain their footing. Just putting the index back where it was a year ago implies a +56% gain. Some say that may take two years. Hmm, OK. I'd sure be satified with +28% a year -- that's twice the S&P. That's better than the Harvard Endowment. (See yesterday's post)

Let's look at the numbers. I went to the FDIC and reviewed bank financial data to see what was going on. Banks have to report everything to the FDIC. It tends to keep a close eye on the details, as it's on the hook for trillions in deposits. According to the FDIC, banks have $11.5 trillion in assets and $6.5 trillion in net loans -- in fact, banks have 11.2% more loans now than they did at this time last year.

$106 billion in credits were classified as noncurrent, while $102 billion in cash was held in reserve to cover uncollectible loans. That means banks have less cash on hand as they have classified loans -- it should be the other way around. Even last year, banks had 1.4 times classified loans in reserve. Two things have changed that: More bad loans and more conservative classification.

But that's glass half-empty. Glass half-full: Not all classifed loans will go belly up, and banks still have $6.4 trillion in performing loans that are generating serious income.

Now, additional loan losses are inevitable. Classified loans are up +115%, and that's serious. Banks have upped loss reserves +48% since last year to deal with this, and they may need all of that and still more. We'll see. But bad loans and asset writedowns, which have the same effect on the bottom line, are a cost of doing business. Both of these factors will affect earnings for a while.

But did I mention the $6.4 trillion in loans that's still doing just fine? Isn't that the real point here? Banks are fundamentally sound. Banks have a solid, proven business model. Banks can still generate a lot of cash. As bank shares fail to gain traction and continue to move sideways, smart investors should take advantage. The prices are just too low to resist. Citi, JP Morgan, B of A, Wachovia, CIT they are trading for less than the value of their assets -- you can buy assets at Wachovia for 47 cents on the dollar. If that were true at the Lexus dealership, you'd show up with a fleet of semis, right? To sell the cars later? That's exactly what you should be doing with bank shares right now.

It doesn't take a lot of looking to find a bank with appealing fundamentals and a ridiculously low price. Large banks, small banks, super regional banks -- all are target-rich environments. Even so, I'm not going to recommend a specific bank because we looked at aggregate numbers. If we buy the thesis from aggregate data, then we need to play macro rather than micro and buy the sector. The best way to do that is an ETF that owns a basket of bank and financial stocks.

I like the Financial Select Secotr SPDR, which trades under the ticker XLF. It owns about 90 stocks, and it's down -31% year to date and -41% for the past 12 months. This gives it +45% in upside just to get back to where it was on Jan.1.

Tuesday, August 19, 2008

A Harvard Education

I've never been ashamed to tell people I went to the University of Kansas.

I had a helluva lot of fun in Lawrence. I have the legal documentation to substantiate some of these shenanigans, and the statute of limitations is waning on the others, which I still categorically deny. In the interludes between these various lowjinks, I did my best to learn as much as I could from the smartest people I could find.

It's a good strategy. I still use it. Which is why I like to keep an eye on Harvard.

Harvard's endowment is somewhere in the neighborhood of $35 billion. That's a nice neighborhood. About a tenth of that trove is invested in equities, or roughly $3.5 billion. (How's that for an impressive financial calculation? My dad was absolutely blown away when I came home from my first semester with an A in math. I opted not to tell the old man that my instructor for that particular class also happened to be a bartender at The Wheel, where I pulled a series of impressive all-night "study sessions.")

Anyway, I dig the Harvard portfolio. It's run by obviously intelligent people, not just because they are from Harvard, but because this is the big leagues of financial management. Indeed: Harvard Management has a five-year annualized rate of return of about 23 percent, which is enough to double any investment in a little over three years.

But most of all, I like Harvard Management Co. because they hold only about 200 stocks, and nearly half of the portfolio is in its top ten holdings. To that end, I'd like to present the managers of the Harvard Management Co. with a pair of Brass Umlauts -- a far more exclusive honor than membership in the Porcellian Club. Its managers are only the second inductee into the Order of the Umlaut. (John Thain, the excellent chief of Merrill Lynch, was the first, for buying MER shares in the face of scathing criticism of his perforomance.)

Harvard's top ten holdings are almost entirely held in exchange-traded funds that focus on foreign markets. (It also owns shares in Weyerhauser and Clear Channel Communications. Radio has been one of the biggest losers this year, according to data from Morninstar, which suggests this is a wicked ballsy value play.)

Exchange-traded funds, if you've never heard of them or think they sound scary, are actually pretty easy to understand. They are similar to mutual funds -- both hold baskets of securities -- but ETFs carry significantly lower fees and are priced throughout the trading day as investors buy and sell them. Mutual fund prices -- "net asset values" -- are calculated only once a day, after the market closes, and their shares are not "bought and sold" but "issued and redeemed" by their investment companies. Mutual funds are not traded.

ETFs offer supereasy access to markets that would otherwise be out of reach -- it's possible but a pain to buy stocks on foreign exchanges. Most domestic brokers don't offer the service, and those who do charge relatively high fees. ETFs get around that. ETFs also overcome the far bigger hurdle when investing abroad: They pick the stocks in those markets, usually by mirroring a major index.

You get this expertise and avoid fees by investing in ETFs using your Scottrade account. If you don't have one, then for God's sake click here and open one. I don't get a kickback, I just think Scottrade is a good outfit, and it's a good idea to have the artillery ready. You'll need a brokerage account when you're ready to raid Wall Street, so you might as well open one.

Harvard recently reallocated it portfolio. (It has to report to the SEC, and I snagged the filings.) It dumped shares in its emerging-markets income fund and reduced its holdings in South Korea and Mexico. It added shares to its positions in Brazil, China and South Africa. And it took a massive stake in an ETF based in Taiwan.

Taiwan? Yes. The market hasn't been stellar. Its five-year annualized return is +6.8%, its 10-year performance is +2.0%. Hey, you can get shitty returns like that right here at home with the good old S&P 500, which is at +5.5% for five years and +2.9% for the past ten. But Brazil? Try +46.8% annualized reeturn for the past five years. China posted 15%.

When I see smart people with a track record like Harvard's making bets like that, I have to think that the time has come to consider mirroring the trade. Now, there are some good things to consider: Taiwan's index has a PE of half the S&P, and it pays a higher average dividend. But given a global economic slowdown and shares that have been battered along with everyone else's ... and Taiwan doesn't look like a particularly great buy.

Those of you who know me will know that those are the exact market conditions I look for. Undervalued and overlooked.

Here are Harvard's picks: IWN, EWZ, EEM, FXI, EWY, EWW and EZA. The Taiwanese ETF is the iShares MSCI Taiwan fund. You can buy 100 shares for about $1,400, and I'm recommending this play. If you've never invested abroad, you're closing the door on countries with far higher growth potential and markets with far richer returns than the United States -- our stocks haven't been the world's best performer in about 60 years.

KU's colors are crimson and blue, the colors, ahem, of Harvard and Yale. I checked Yale's portfolio and it's loaded up with blue-chip stocks. Boo! I don't know how things are going to turn out on the football season this year, and to be honest, I couldn't care less. I'll be warching KU football (proud motto: "A tradition since last year"). But when it comes to Harvard and Yale's respective portfolios, Harvard is right on the money. The lads at Cambridge are going to absolutely shellack the boys from New Haven. To that end, go Crimson!

If you want to learn more about ETFs, click here.

Friday, August 15, 2008

"No Money"? No Problem

I wish I had come up with ShareBuilder.

If you visit financial Web sites, you've probably seen ads for this outfit, which offers to let you buy stock for $4. I have no doubt ShareBuilder is honest and capable of delivering every service it offers. But they do leave out a very important detail: Investors don't need to pay anything for the services ShareBuilder provides. They're available for free.

The $4 fee is not only a ripoff, but it's substantially higher than what you'd pay an actual broker. And an actual broker can actually execute a trade. ShareBuilder can't. (Its owner, ING, can, but for more money) Sharebuilder can help you buy and sell stock, sure, but it uses an alternative to the traditional stock excahnges.

We all know that billions of shares are traded each day on the Big Board and the Nasdaq. But a handful of other companies traffic in stocks, albeit an relatively eensy volume. They're called "transfer agents."

A public company might have millions or even billions of shares. Each share carries a vote. When the company has an issue that shareholders must decide -- like electing the board of directors -- it's critical that the vote is fair and accurate. (Admittedly, I've never seen the need for this in elections myself, but that's another story for another day.)

So, anyway, the company uses the services of a transfer agent to keep track of who owns the shares at any given moment. And as part of the service package that a transfer agent will offer a public corporation, many manage something called a direct-purchase plan. These plans were originally created by public utilities, to let customers buy stock a little at a time, in small amounts, often fractions of shares at a time. Over the years, these accounts caught on. And you can see why: Socking away a few bucks at a time is an easy way to build a tidy nest egg -- something to help fund retirement, say, or get the kids through college. Some of these plans can be started for as little as $100.

(One of my most successful investments, on a percentage basis, was in one of these plans. I started the account with a hundred bucks to show a coworker how easy the plans were. I funded the initial deposit and put maybe $50 in a month later to show my colleague how to do it. Then I forgot all about the whole thing. After a few years, I got a statement in the mail and discovered I'd tripled my money. I blew it on cigars. I still don't have the slightest clue what that company actually did.)

These plans are why I don't buy it when I hear someone say they don't have enough money to invest in the market. Bullshit. They totally do. They might not be able to buy a round lot of Monsanto, but they can buy a few dollars' worth at a time. And time, as I believe has been noted elsewhere, is money.

But wait. There's more. The niftiest thing about these plans is the dividend option. Companies that pay a dividend will usually allow direct-purchase plan participants to choose how they want their dividends paid -- either in cash or in additional shares of stock. The dividend election option is a great way for an individual investor of modest means to build significant wealth over time -- and never pay a dime in fees or commissions. Most plans will even save you a stamp and draft the cash right out of your checking account.

That's why ShareBuilder is both a genius business and a complete ripoff at the same time.

Say you use this service to help you invest $50 a month. In the course of a year, you'll pay $48 in fees -- 8.7% of the $552 that will make it into your account. It doesn't seem like much, but it adds up to thousands in not very many years. That's a complete waste: You can set up a direct-purchase plan for free on most transfer agents' Web sites in less than 15 minutes.

If you and your spouse each were to put just $125 a month each into a direct stock-purchase plan that delivered an annual return of 12%, you'd have $125,000 in fifteen years -- triple your contribution. A more significant allocation -- say $500 a month -- is even more dramatic. And best of all, these plans take no effort, no brains and no discipline. Smart investors even use them to "time" the market, buying more heavily when share prices are low than when they are relatively higher. (You typcially buy at a monthly average price, not the current real-time market price.)

Most of these plans can be used to set up a Uniform Gift to Minor account, which is handy to plan for a child's college education. After 18 years of $500 monthly contributions, your son or daughter could elect to take the 12% dividend in cash, which at that point would be roughly $45,000 a year. Why pay for college yourself when Johnson & Johnson or Philip Morris can take care of it?

Smoke 'em if you got 'em. Have a great weekend.

You can check out these plans here.

Wednesday, August 13, 2008

The Myth of Investor Understanding, Part Two

Yesterday I rambled on about stock prices (meaningless) the earnings multiple (useful). Now it’s time to add additional variables to the mix -- terms you will run across in the financial press and certainly in this blog.

But before we go over the vocab test, however, we have another questions to consider. Steven Covey, (The Seven Effects of Highly Habitual People), admonished his readers to always begin with the end in mind. That means we need a goal.

[Offstage]
"Hey! Numbnuts! It’s investing. The goal is to make money."

Right. But how?

You can seek companies that are rapidly increasing their earnings. This is called growth investing. People buy shares of growing companies under the notion that their prices will rise when their earnings increase. Growth investors are going to look at the income statement for ever-increasing revenue -- the “top line” in industry parlance -- and profit, or “the bottom line.” The basic tenet here is the greater fool theory.

You might want to make money by generating cash. Growth investors make money through capital gains -- they buy an asset and resell it for a higher price and keep the difference. Income investors are searching for dividends. These are cash payments companies make to shareholders. Companies that pay dividends are generally done with large-scale growth, so instead of deploying their cash on new plants or research or whatever, they just give it to shareholders. Income investors are primarily looking for one thing: Stability. They want companies with a long history of steady earnings, good management of expenses, marginally higher bottom-line results and big cash payouts in the form of dividends. Income investors like the rule of 72.

The third method of equity investing is the value school. Practicioners of this art subject companies to a ruthless fundamental inspection of their assets, debt, earnings and business model. These investors are looking for companies that are undervalued, either because of difficulty or unrealized potential yet unseen by the broader market. How do you tell if you are hanging out with value investors? The shrimp are very large and the scotch is very old. Value investors hold the efficient market theory dear.

Which is right for you? Your 401(k) probably should be allocated among all three strategies, which, happily, correspond to mutual funds your plan offers. (Your retirement portfolio also should include an allocation to bonds that increases as with your age.) But your discretionary investing style should be whatever you’re most comfortable with. If you like The Next Big Thing, go with growth -- you’ll understand it. If you like cash, there’s absolutely nothing wrong with a fat, double-digit dividend yield. And if you actually enjoy looking at earnings releases and poring over balance sheets -- and like it when the market suddenly discovers that you;ve been right all along -- then you might want to have a go at some value plays.


Now, look, I know this stuff is a little on the dry side. But the potential for reward here is remarkable, and a little math won’t kill you. I have a journalism degree, for Pete’s sake, and I can do it. I promise it’s not difficult.

Take the crash course.

Assets. These are things the company owns that have value. They are found on the balance sheet, which is a snapshot of a company’s finances at a given point in time. “Current” assets can be converted into cash in a year.

Liabilities are debt. "Current" here indicates debts that need to be paid in a year. Assets minus liabilities is shareholder equity. Equity is the piece of the company the shareholders actually own free and clear -- it is what you would have left if you liquidated the assets and paid the debts. The equation is usually written as ASSETS = LIABILITIES + EQUITY.

This gives us several financial elements to work with:

Book value is shareholder equity divided by the number of shares outstanding. Most companies trade at a multiple to book. When share prices are extremely depressed, however, it’s possible to buy a company for less than the “tanglible” value of the shares. GM is such a case. If you bought all of GM, liquated al its assets and paid all of it’s bills, you would still have more money than all of those shares cost to buy. This is actually a pretty rare financial phenomenon.

The other measure we can introduce here is the return on equity, which is calculated by dividing the total net earnings by shareholder equity. Think of this like you would the interest on a bank account: It’s a very rough way to measure what the dollars you put in are earning.

The trick here is to remember what increasing debt or increasing expenses can do to equity and thus to ROE. Borrowing a ton of money will reduce equity and perhaps deceptively increase ROE. As a rule, ROE is best evaluated over time.

Dividend yield is the amount of cash that’s paid to you relative to your investment. Right now, aggregate dividend yields are high because stock prices are low -- they always move in opposite directions. If you buy a stock for $10 a share that offers a 12% dividend, you effectively lock in that dividend. If the price goes up and the dividend, thus, goes down, your rate of return stays the same as the day you bought it -- assuming the dividend remains constant. Most companies are loathe to cut dividends -- that’s a not-so-subtle sign the company is in trouble. Still, it happens all the time. Dividends are dangerous for new investors: You should never buy a stock just for the dividend. Why? Because the board of directors is always just one vote away from ending the dividend on common stock.

Many screeners will also let you search for companies by their rate of growth, either in revenue or earnings, as well as by the change in their share price over a certain period. The other criteria you will see screeners employ is profit margin, which can either be “operating profit” -- also known as EBIDTA (earnings before interest, depreciation, taxes and amortization) or “net profit” -- the bottom line.

Start by choosing a a strategy:

Growth investors might look for small-cap and midcap companies with earnings multiples higher than 25.

Income investors should look for midcap or large-cap stocks with PEs below 15 and dividend yields of greater than 7%.

Value investors should look for any size company trading at a low PE, low price-to-book, positive earnings growth (or the near-term prospect of it) a robust net margin (+/- 15%) and a longterm ROE uptrend.

Then, make a list of potential investments by using a stock screener (here, here or here) to seek companies with the appropriate criteria. When you have fewer than 20 names, you’ve got a reasonable screen. From there, you can decide how detailed your analysis of each company should be. And the lesson you might well learn is that you'd rather leave this sort of stuff to a good adviser -- a real brass umlauted mensch -- or whether you simply want to go with a certain style of investing and choose a good low-fee fund that employs it.

Friday: Why “I don’t have enough money to invest” is a copout.

The Myth of "Market Understanding" -- Part One

The two reasons I hear otherwise intelligent people give for not investing are 1) that they don't have enough money and 2) that they don't understand the market.

Not having money, surprisingly enough, is the easy part. I'll deal with that Friday. Today and Thursday I'll focus on understanding the market.

You don't have to understand the market to be a successful investor. In fact, I'd venture to say that people who think they understand the market are far more likely to lose their ass than those who accept a certain level of indifferent ignorance.

The market, like God, women, racehorses, can only be understood to a point. You can comprehend -- at least insofar as the market is concerned -- that there are buyers and sellers. You can accurately presume a general correlation between market movement and major news events or, say, the underlying economy. And one can, over time, extrapolate a few trends. Beyond that, "understanding the market" is a fool's errand. You don't need to understand gravity, Jell-O or prayer. They all work. Move on.

That being said, you can and should cultivate an understanding of stock fundamentals. Once you've developed and honed that skill, you can participate in the market with a great deal of success.

The first thing you must know is the role price plays in evaluating an investment.

Answer: None.

Price, in and of itself, has nothing to do with whether a stock is a good value. The price of a stock is determined by the initial offering price, and that's determined by the amount of capital a company seeks to raise. (Market forces can play a role here, too.) Most companies are set up as corporations, and their stock is held by a few individuals -- the owners. If that company seeks to make a significant growth push, it could offer all or a portion of that stock to the public for cash.

If the corporation wants to raise $500 million, it can sell 500 million for a buck each, or it can sell a million for $500 a crack -- or any combination thereof. The company gets the money and does its thing and that's really the end of the transaction as far as the company goes -- after that, it is revalued by investors every time they trade shares at a new price.

The only price consideration that is sometimes reasonable to take into account is a company's market capitalization, the number of shares multiplied by the share price. There are some generalities that investors can make about companies based on size. But price on its own means nothing. It's just a number.

Prices, like most numbers on Wall Street, are useful only when they can be contextualized with another data point. The most common way to contextualize price is by comparing it with earnings. This is called the price to earnings ratio or the earnings multiple. It's determined by dividing the price by the net earnings per share and can be based on either the previous 12 months earnings or the earnings estimates for the upcoming year.

A stock with a high PE ratio is said to be more expensive that a stock with a lower PE, though that's most true when you compare companies within industries. The higher the potential for earnings growth, the higher the PE tends to be. Google and Apple have been growing their profit -- they have high earnings multiples, 33 and 35. Banks and utilities, which operate in more "mature" industries, tend to see slower growth and, as such, have lower PE ratios, usually less than 15.

Consider: Berkshire Hathaway trades at about $115,000 a share. Seems a little on the pricey side, no? But it's cheaper than White Mountains Insurance, which is in the same primary business but trades at a PE roughly the same as Google's. So White Mountain's shares can be bought for less money, but they are actually more "expensive."

Try an experiment: Call your broker and ask him how much any stock is trading for. If he gives you a price, hang up and then close your account. And don't open a new account until the financial adviser responds to your query with a PE. If he quotes a price, he's just a salesman. That's what salesmen do. If he gives you intelligent information, he is an adviser and a quite possibly a mensch.

Low PE ratios do not mean a stock is a good investment. High PE ratios don't mean a stock is a bad investment -- Apple and Google, for instance, have done pretty well. And it's important to note that some companies that have hit a rough patch might not have any earnings at all and thus have no PE ratio to even look at. Some value investors, like me, might consider some companies like that to be truly excellent investments.

That's where the second number comes in. The PE ratio, like price, also should be balanced against another number or even a series of numbers. We'll get to that tomorrow.

Monday, August 11, 2008

Portfolio Update: A +9.03% Return

It's been more than a week since I started unveiling my "Deep Discount" portfolio.
Let's take a look at how things are shaping up:

Merrill Lynch
Entry point: $26.85
Monday's close: $26.49
Gain/Loss: -1.34%

Former CEO Daniel Tully, who tripled Merrill's stock price in the 1990s, said current CEO John Thain was right to offload $31 billion of mortgage securities for a fifth of their face value, Bloomberg reported. Another former Merrill exec, Winthrop Smith Jr., the son of a Merrill CEO, made similar comments last month. Thain's got brass umlauts. I feel like buying more Merrill.

CIT Group
Entry point: $8.76
Monday close: $9.45
Gain/Loss: +7.88%

The business lender said it would sell its rail-car leasing business. In markets like these, traders like to see companies sell assets to raise cash because it decreases the likelihood that they will try to sell more shares, which dilutes all shares value a smidgen.

CarMax
Entry point: $14.10
Monday close: 15.62
Gain/Loss: +10.76%

The car retailer said sames store sales fell 17%, and it's slowing its expansion plans. It's also scheduling fewer staff and trying to cut other expenses. That's all smart, and the Street knows it. That's why investors came in Monday morning and started buying -- shares had simply gotten too cheap. I may well have called this one at the bottom.

MGM Grand
Entry point: $29.78
Monday close: $36.52
Gain/Loss: +22.63%

You see a stock ink a gain like this and there's only one response: "Holy balls! Fire up a Monte Cristo!" What happened? Earnings came in, down 69%, but analysts see a rebound later this year. That being said, traders were cautious. Shares hit $38 today but gave much of it back. So if you're day trading my picks, you owe me for this one. Say a box of Monte Cristo No. 2's.

General Motors
Entry point: $10.23
Monday close: $10.76
Gain/Loss: +5.18%

GM said it's going to spend about a billion smackers to restructure, which is code for closing plants. Wall Street likes the closures, four of which are truck plants.

Overall, my portfolio has achieved a 9.03% advance in a week. That is, of course, dynamite. But it's also atypical and certainly not sustainable. In the name of full disclosure, if I could extract gains like that every week, I sure as hell wouldn't write about it.

Sunday, August 10, 2008

Fund Watch, No. 1

This is about the American Balanced Fund, which is not an investment so much as merely a place to park cash.

These rants will be in no particular order:

If you drop $10,000 into this mutual fund, it immediately swallows 5.75% in fees, which investment companies call "loads." That leaves you with $9,425 exposed to the stock market's potential returns.

Or does it?

No. You don't need to look any further than the fund's name -- the "balanced" part -- to see that this fund invests in bonds as well as stocks. It turns out the fund has about 60% in stocks, 30% in bonds and 10% in cash.

"OK," you say. "Fine. So I have $5655 of my hard-earned $10,000 in the market. That's good. That's where the returns are."

Well, maybe. It certainly can be.

First, let's look at what the fund owns. We'll start by examining its top ten assets. All of these holdings are 1.5% to about 2% of total holdings. The number to the right is their year-to-date return.

IBM 20.6%
Wal-Mart 22.8%
Chevron -8.2%
GE -18.4%
AT&T -23.0%
Oracle 4.2%
Berkshire -18.3%
Treasurys 2.1%
Cisco -10.4%
Microsoft -20.4%
AVERAGE -5.5%

This chart makes one thing abundantly clear: The fund mangers ought to be thanking their lucky stars for IBM and Wal-Mart. Without them, the fund would be lagging the S&P.

IBM is, admittedly, doing great, but Wal-Mart is a perennial dog. The S&P 500 has blown Wal-Mart out of the water for the past five years -- it's notched a gain of +32.6% vs. a teeny +0.15% for the retailer. Wal-Mart has only shown life recently, as investors bought shares to hedge against a slowing economy. (When the economy starts to pick up, Wal-Mart will stumble as shoppers start to return to stores they actually like rather than a store they're being forced to shop at. (Wal-Mart's a good short at $58.)

This fund has $54.6 billion under management. Wal-Mart makes up 2% of that. In my mind, Wal-Mart -- except for the past six months -- is a wholly lousy place to invest. Assuming the fund has owned Wal-Mart for five years, which is likely given a cursory glance at its regulatory filings, then this holding alone has actually cost investors $311 million.

How can an investment that's in the black cost investors, you ask? Answer: When another comparible alternative could have made more for equal cost and risk. In this case, that's the S&P 500. And $311 million, amazingly, is the difference between Wal-Mart's crappy five-year return and the performance of the S&P. The fund managers might as well have bought the SPDR, which tracks the benchmark index, and left the retailer's shares in some other sucker's portfolio.

Without Wal-Mart and IBM, however, the fund would be down -13.2%, and that's worse than the S&P. But that's not really fair, because the fund does own IBM and Wal-Mart, and the top ten holdings are, in fact, beating the S&P by a factor of two. In a year like we're having, that ain't bad. (The overall portfolio isn't faring as well, though it's still better than the S&P)

But even so, looking at this fund's top ten holdings pisses me off. The fund has holdings up 20% in a bear market. What the hell is it thinking? Does it honestly think that those shares -- especially in those two megacap companies -- are going to go still higher? It ought to sell those winners, take the gains and start buying the losers -- which do have a legitimate shot at gaining 20%. Even if it's too chickenshit or tax-averse to do sell the winners, the fund is still sitting on $5.6 billion in cash, for heaven's sake! Warren Buffett's Berkshire Hathaway is a steal. GE is a good value. Or even Target, which is down -2%. Buy it now while it's cheap -- before the economy turns and people quit going to Wal-Mart. And those are just three stocks the fund already owns!

Oy. Let's look at sectors before I have an aneurysm.

SECTOR Weighting YTD
Software 5.24% 0.13%
Hardware 12.59% -4.91%
Media 3.94% -9.18%
Telecom 5.21% -17.28%
Healthcare 12.53% 3.86%
Consumer services 9.62% -0.10%
Business services 5.50% -2.52%
Financial services 9.62% -13.88%
Consumer goods 7.08% -6.50%
Industrial materials 15.62% -7.41%
Energy 11.54% -8.33%
Utilities 1.51% -8.02%

This was a lot prettier in Excel. Even so, it was still a tough chart to make anything out of because assets are so spread out. Investors should always remember Obermueller's Oscillation Principle: That which hits the fan will not be evenly distributed. And spreading out your portfolio too far can create its own risk: It may protect you a little in bad times, but it will hurt you in good times. (This is a good reason to invest in ETFs and not funds, but we'll get to that another day.)

Make sure you look at the sector breakdown for funds you're considering. Compare them to the fund's prospectus and to your investment objective. If you want growth and the fund is holding a lot of utilities, then it might not be the best match, as utitilies usually don't post much relative growth. Also sectors give you a rough idea of performance and potential. Only two sectors are lagging the S&P -- financial services and telecom.

Look at this chart, but don't stare. It's a little misleading. The weighted aggregate return for a portfolio containing this weighting of the sectors would be -5.6%. But the fund is down -9.1% for the year. That means it picked the losers in each sector -- which is different from "is picking" the losers, which would least imply some upside. If I were the fund manager, I would be selling healthcare and consumer services and buying phone companies and banks.

Besides its shattershot approach, I guess I really have five major problems with this fund.

I just don't like funds with front-end loads. The only way they work is if you hold the fund for a long time. This fund dings you for 5.75% right off the bat and charges an annual fee of 0.58% on top of that. (Which means you're going to need one heck of a first year -- at least 20% -- to beat the market and make back your fees).

If I absolutely have to pay a fee, I don't want it to be higher than the average 1.50% that ETFs charge. That means I have to hold this fund for at least six years. I don't like being forced into that kind of commitment.

I don't like "balanced" funds. If you're gong to invest in funds and want to own stocks and bonds, then pick a stock fund and a bond fund -- no investment can do everything. I'm 32 and have a long time horizon. My 401(k) is diversified, and my home and cash savings will vouchsafe some wealth. For my discretionary investment portfolio, I need to be investing in aggressive growth and value.

Bonds are safe, sure, but I have safety in other part of my portfolio, and bonds just serve to water down the returns. Bonds can be used to generate cash, but in this case they aren't even doing much of that: The fund yields a mere 3.2%; the S&P does 2.4% on its own, and it at least has the potential for additional gains. The only function bonds have in this fund is asset protection, which is not the purpose of discretionary investment at a young age. In this case, bonds just create an opportunity loss and force your equities to work harder to pick up the slack.

I don't like big funds with holdings in lots of big companies. Big companies, as a rule, lose ground far faster than they gain it. I also don't like big funds that own big companies and don't trade them. This fund owns 112 stocks and only turns 35% of the portfolio over in a year. An enterprising eight-grader could run this fund. If you're paying the managers to spot winners, make sure they're doing it.

I like transparency. I go the SEC web site and download filings to track holdings over time. Try doing this with "American Funds." I had to go to American Funds' site, fiddle around and find out that they're owned by The Capital Group Companies and then read a timeline on the history page to find the name "Capital Research and Management Company, which is how I found their ownership information. This strikes me as hinky. Plus, funds only have to report holdings four times a year. (ETFs report daily.)

I don’t like funds with crappy returns. If this fund is earning 6.8% a year and costing 2% to own, then I'm only up 4.8%. Inflation is going to erode 2.5%, so that brings my return down to 2.3%. We haven't talked about taxes. We should be talking about a jumbo CD or even some tax-free munis. They're going to do better than this fund, and we haven't even talked about the possibility of a down market.

Every mutual fund investment needs to be made after answering the following four questions:

1. What is my goal with this investment? Can the security I am considering meet that? How does its purpose line up with my needs?
2. Do I have confidence in management to deploy assets in such a way that balances prudence and potential to achieve the maximum return? Am I comfortable with the risk?
3. Do I know what the fees are? Am I bumping up against the law of diminishing returns?
4. Have I considered my exit strategy?

I said I wouldn't buy this fund. And I wouldn't. That's only my assessment based on my situation. But over the long term, this fund likely will serve its purpose. If your investment needs line up with its purpose and you hold it for a sufficient length of time, then you likely will have been served well. If not, hey, lesson learned.

Friday, August 8, 2008

The Fifth Portfolio Pick

It doesn't make sense to me to seek significant returns from stocks everyone already thinks are good investments. I do see some intelligence, however, in the practice of finding stocks that are underappreciated and then waiting for the rest of the market to come around to my way of thinking. This contrarian approach is usually called "value" investing.

I want securities that have these five characteristics.

A cheap price. I like to look for companies trading at or below their book value. I like stocks with very low earnings multiples. I want to look at stocks that are at least 25% off their 52-week high.

Trouble. Nothing makes me happier than seeing a perfectly good industry take it on the chin, especially if its difficulties arise from trouble most people don't understand. Why? Fearful investors sell valuable things for less than they are worth. Embattled industries are target-rich environments.

Prospects. Times change, and some sectors won't ever bounce back, The financial sector, for example, absolutely will survive in its current form -- it's just temporarily out of favor. Newspapers, on the other hand, aren't going to make it in their current form. Look for companies with good prospects.

Position. If you're going to go Dumpster-diving, you might as well do it in a nice neighborhood. It makes sense to buy the leaders in a market: Don't buy Pepsi if you can get your hands on Coke. (If you're looking to buy an up-and-comer, you're not oriented toward value but toward growth. That's perfectly fine, it's just a different approach.)

Management. I want managers who can make tough decisions, weather criticism with Bush-like resolve and who have sweet dreams about building shareholder value. When their stock tanks, they buy it with their money and with the company's.

Pick Five: It's General Motors.

The General meets all of my criteria. It's cheap -- down 60% year to date -- it's hated, it has strong long-term prospects and it has the enviable position of being the No. 1/No.2 automaker in the world. Saying GM is in an enviable position takes some brass, but don't you think it makes sense? Honda and Toyota have nowhere to go but down. GM and Ford have nowhere to go but up. (And Ford has the benefit of a CEO with a degree from the University of Kansas.)

GM chief Rick Wagoner, for his part, has done a brilliant job hoeing a tough row: He axed the dividend, cut jobs, is buying out Hummer, and he's been positive in the media no matter what happens, including a full-throated counter to a bunch of bullshit bankruptcy rumors. He just keeps getting better at a hard job. (He should also kill Saturn, by the way, which has never made a dime of profit.)

Design czar Bob Lutz --a true automotive genius -- is building cars people want to drive, and GM has decided to sell them for more than it costs to make them. (Amazing what passes for revolutionary thinking in Detroit.) Labor has lost a lot of its bargaining power, which could go a long way to smoothing out the global playing field. And GM's so-called "legacy costs," the huge expense of paying and caring for retirees, is only going to get better in the next five years -- call it a "positive actuarial tilt."

GM has inked some serious losses, but it also has some serious cash on hand to withstand them. In fact, GM has $32.22 in cash on hand for each share! You get the GM brands, its assets and $22.22 for free when you buy a share for ten bucks. That's my kind of deal.

For the very patient and risk tolerant, GM's a great hold to $30. For active investors, GM's immense volatility -- its beta is 2 -- makes it a great stock to trade in the meantime.

Here is my entire "Deep Value Portfolio" and the entry price for each (as of last Friday):

Merrill Lynch $26.85
CIT $8.76
CarMax $14.10
MGM Grand $29.78
General Motors $10.23

Thursday, August 7, 2008

Portfolio Pick No. 4: MGM Mirage

Lesser writers would be unable to resist the temptation for a cutesy pun were they to write about a gaming company.

I'm going to lead instead with a fact I think is far more urgent: The Gambling/Hotel Casino industry is down -37% year-to-date. MGM Mirage, which represents the high end of that space, is off -56.3% in the same period. It's trading at roughly 6.9 times earnings.

It's too cheap to resist. It's pick No. 4 and I think it's good for at least a 100% gain. I'll sell half at $70 but will hold on to the rest. (Jefferies has a $92 price target on these shares.)

Reasons to Buy:

Position. MGM has the most swankalicious casinos -- the Borgata, the Bellagio -- and it spends a ton of money making sure they stay that way. It controls the top half of the Vegas strip, where more than three-quarters of its revenue originates and has destination properties in Mississippi and Michigan. Despite a difficult economy, MGM maintained a 97% occupancy rate in the second quarter, and it did so at a higher average price than its peers, $155 a night. (The company has 49,574 rooms and booked $523 million in room revenue in the 90-day period. Gaming revenue was $773 million.)

Strength. Net gaming revenue was down, though net non-gaming revenues were flat. Given its occupancy rate, the conclusion has to be that consumers came to the hotel, paid good money to stay there and simply ate, drank and saw shows instead of hitting the tables. So as is always the case, the house figured out a way to win, and it doesn't mean you didn't have a good time. The company, for its part, says it expects things to pick up in the fourth quarter, and for what it's worth analysts concur. Even if not, MGM should have about $8 billion in revenue, and it booked $2 billion in the first half of the year.

Fear. People are scared silly because Nevada gaming officials data show a drop in gambling. Take a lesson from Buffett, who says he's fearful when others are greedy and greedy when others are fearful. That's where we are, sports fans. Don't buy into the prevailing anti-Vegas fear. Why? Because the sort of American consumers who enjoy Vegas will go there whenever they can. So gaming is in a little slump. Fine. We all know gaming is tied to the broader economy, and that consumer confidence is low. That's cyclical; it will come back. In the meantime, MGM is performing like the market leader it is, and the stock can be had for half price.

Bears -- such boors -- are quick to point out MGM's troubled multibillion-dollar CityCenter venture with Dubai World. The drop in aggregate gaming scares the hell out of them. And yes, the overall market is down, credit is tight and the consumer is squeezed.

Ain't it great? You just don't find sales like this in bull markets. The bondholders aren't nervous, and neither I am.

Wednesday, August 6, 2008

It's Fun to Be Right

Yesterday's piece about CIT evidently reverberated through the market. Shares rose +10.6% after the post was published and has held on to them today. (You can see the intraday chart here.) Not bad for a day's work, if I do say so myself.

CIT is still cheap. It'll go higher.

Portfolio Pick No. 3: Carmax

My previous two picks, brokerage Merrill Lynch and commercial lender CIT Group, are undervalued because of a variety of economic undercurrents affecting the broad financial-services industry. And though there are a host of compelling buys in that arena, I thought it might be a good idea to take a look a another category.

So let's talk about the auto bidness.

Detroit, as you may have read in the newspapers, has been pulverized roughly to the same degree as, well, newspapers. Auto suppliers have been hit, too. And even though an American public shocked at $4 a gallon gasoline is opting to trade in its Suburban, people are still buying cars and trucks.

Not as many, true. Automakers' July sales, reported earlier this month, are a 16-year low, led by a 27% drop at GM, a 15% falloff at Ford and a 12% drop for Toyota. But people are still buying cars: Automakers are having a helluva time keeping up with demand for hybrids and other fuel-efficient vehicles. Honda, a leader in this area, reported only a 1.6% sales decrease. Overall, Americans will buy an estimated 12.55 million vehicles this year.

If we assume a new car costs an average $20,000, that means the new car side of the auto business alone is still a $251 billion industry. The National Automobile Dealers Association says 19.2 million used cars were sold in 2006, which likely doubles sales to a nice, round $500 billion.

That's a lot of jack.

Which brings us to Carmax.

Carmax sells used cars in 89 "used-car superstores" in 41 metro markets. It had $8.2 billion in revenue last year, which is maybe 3% of the market. Earnings for the past twelve months are 78 cents, which gives the shares an earnings multiple of 18 based on Friday's close of $14.10. The company has relinquished about 20% of its market capitalization this year, with shares ranging from a low of $10.53 in mid-July to a high of $25.55 about a year ago.

I like Carmax for four reasons:

It's independent and nimble.
Other public vehicle retailers have dealerships -- licenses from the automakers to sell their vehicles. If you're a BMW dealer, you carry BMW. If you're a Hummer dealer, you carry Hummer. (You get the idea.) The signs in front of Carmax say -- wait for it -- Carmax. They're not beholden to GM, Ford, Benz or Honda. They can stock what the market is buying and can adjust their inventory far more adroitly than a traditional dealership. Even if you're a high-volume metro Toyota dealer, you're only going to get so many Priuses. Carmax can get as many as it wants.

Smart people own it.
Most shares are held by institutions. Mutual fund managers and other big money players own 95% of the shares. Dodge & Cox is one of its largest shareholders. Its stock fund is a perennial winner whose total returns have beat the S&P by 6.4 points for the past 10 years. When smart money managers with a record like that buy a stock, I'm interested.

Oh yeah: Warren Buffett. He's also a major shareholder, which is nice. In fact, he's even been adding to his stake -- currently 21.3 million shares -- and I'll bet you a Cherry Coke that his next 13F filing will show he added more shares in the second quarter when Carmax's price ebbed. (That filing is due on or about Aug. 15.)

A superlative shopping experience
Carmax is the opposite of every used-car stereotype. It's as orderly, clean and well lit as a Lowe's. The stores are large and have vast inventories, ten times larger than the average used-car lot. It has no-haggle pricing. Financing can be done in house with absolute transparency -- you see the same results the salesman does, and at the same time. Carmax guarantees clean titles. It backs up its vehicles with a five-day return policy and a 30-day warranty. It won't sell flood- or frame-damaged vehicles. Its Web site is the best in the business, and dealers can take advantage of each other's inventory. My favorite: The company recently won the Better Business Bureau's International Torch Award for Marketplace Ethics, which means the exceedingly uptight BBB thinks as highly of Carmax as it does of companies like Kraft and IBM.

It's growing.
Carmax is expanding its footprint, but it's not going gangbusters. It has 89 stores, but it's only opened in 41 cities. It likes to focus on markets and develop them before moving on to the next one. It may take a set of brass umlauts to make money in the stock market, but discretion is the better part of valor when it comes to managing growth. That's a big part of the reason its bankers just increased its credit line from $500 million to $700 million. They've seen the books, they know the company and they are 1) still willing to lend money in a tight credit environment and 2) still willing to lend it to a car dealer. That's nothing short of amazing. Frankly, that's as compelling a buy sign as Buffett.

In 2004, Carmax had $5.2 billion in sales. That rose to $8.2 billion last year, which is a gain of about 58%. But quarterly earnings doubled or very nearly doubled in each quarter. That means the company, even as it grows, is extracting an ever-higher profit from its revenue. That's the ball game in a low-margin business like auto sales.

Carmax has been upfront about its sales outlook, which recently came in lower than analysts expected. But it is still growing, and it can whether the economic downturn. The dollar will gain value, the price of oil will fall and Chevy is unlikely to discontune the Suburban. If you assume Carmax can maintain its average growth, then sales should be at $14.3 billion in 2011 and EPS should come in at about $1.86. At 20 times earnings, that would put Carmax at $37.20, or 163% above its Aug. 1 close.

Carmax has a presence in 41 cities, which means it can more than double in size and still stay within the top 100 metro areas. I'll hold these shares indefinitely. I think it will be the Wal-Mart of used cars.

Tuesday, August 5, 2008

Portfolio Pick No. 2: CIT Group

The market is down and the financial sector is under a lot of pressure. Investors are skittish -- the returns, shittish -- and lenders' shares have been extremely volatile. CIT's are down 65% year-to-date and have swung from a high of $44.50 to a low of $5.80 in the past 52 weeks. They closed Friday at $8.76. They're a steal -- a serious opportunity for a 500% return.

CIT used to make some home loans, including mobile-home financing, which gave investors a reason to sell. That business is toxic, regardless of the extent to which it remains a profitable endeavor. So CIT bailed out of mortgages on July 1, selling the unit for $1.8 billion. Shares rallied on that news. CIT's $62 billion loan portfolio is now mostly business loans.

The subprime mess is hurting banks and other financial companies because of two things. Risk managers, nervous after watching subprime collapse, are loath to approve any loans because they're simply not sure what's going to happen next in this economy.. They're simply too scared to lend, so credit is pretty tight. The second way subprime is hitting financial shares is that lenders have been raiding their earnings for cash with which to shore up reserves for bad loans. For instance, even though CIT's 2007 operating income in 2007 fell by about $400 million, it still earned that cash. It just went to the loss reserve instead of to the bottom line. Earnings fall, investors panic. Rinse and repeat.

CIT has $831 million in cash sitting around to cover bad loans. It may well need every dime of it, and that's fine -- that's why it's there. A bank has to stash money away for bad loans even in a good year, just as an insurer has to save for a hurricane even when the skies are clear. Even Wells Fargo, which is as tight as bark on a tree when it comes to issuing credit, has to sock away a few shekels for bad loans.

Things were great for CIT in 2005. It was trading for $35 and it earned $4.24 a share. But it still had to set aside $217 million in the "Just in Case" fund to cover bad loans.

I pulled aggregate banking data from the FDIC: Banks have a collective $6.5 trillion in outstanding loans, and they keep $102 billion in the vault for charge-offs. That's 1.55% of loans. CIT has enough cash on hand to cover 1.33% of its loan, which is less than average but about the same, in fact, as Wells Fargo.

CIT earned $7 billion in interest income in 2007 and had borrowing costs of $3.8 billion, leaving it with $3.2 billion in net interest income and an even $1 billion in operating income (even with that additional $400 million on the loss provision line).

But get this: The assets that earned CIT all that money? They're still there -- except for the nettlesome home mortgages. (CIT shuttered its subprime unit more than a year ago.) The big losses are behind CIT -- in fact, I think it's possible that earnings will artificially jump in the coming years as CIT benefits from being over-reserved -- and a couple of quarters of solid earnings will do wonders for this stock. Investors are sitting on the sidelines. They're dying for a reason to wade back into the financial sector.

Lenders generally have low earnings multiples, but even a PE of 12 gives CIT a fair value of $57.60 based on 2006 earnings. That was then, this is now, sure, but I still think that's ultimately a low estimate. Why? Because CIT has 13.5% more loans now than it did then. All other things being equal, that should scale out to a stock price of about $65.

Brief tutorial: The "earnings multiple" or "PE ratio" quantifies the relationship between a company's earnings and its stock price. It is computed by dividing the stock price by the per-share earnings. This allows investors to compare companies based on their relative performance. Earnings multiples vary by industry. As a rule, higher growth means higher PEs. Utilities, which grow very slowly, have tiny PEs. Google's earnings multiple is significantly higher, which means investors expect its earnings to rise.

CIT shares are a buy up to $30. I'll sell my shares when they hit $40. That's a nearly 500% gain, and, shucks, I just hate to be a greedy bastard. I'll double down if CIT drops below $7.50.

Hey, incidentally, I saw on the Bloomberg yesterday morning that CIT director James S. McDonald bought another 5,000 shares. Insider buying is always a good sign, as directors and officers know better than anyone else what's really going on. McDonald also sits on the NYSE board and is chairman of its audit committee, so I think it's safe to assume that he can read financial statements. So even if you don't buy my arguments for CIT, then listen to the guy who voted with his wallet.