Andy Obermueller's Brass Umlauts Blog

Why Goldman is a Screaming Buy

2010-04-16T17:09:00.002-05:00

The SEC shocked Wall Street today with its accusation, duly filed in Federal District Court in Manhattan, that Goldman Sachs (NYSE: GS) engaged in fraud during the subprime debacle.

Shares have taken a dive, losing nearly -13% of their value on fantastic volume.

So the question arise: Is Goldman a buy? Or is it lights out for the storied squid?

The answer isn't hard to find. Read the lawsuit. When you're done, I think you ought to respond to your first instinct. (More on that in a minute)

First, stick with me as we break this down piece by piece.

It starts with a home buyer getting a mortgage. The bank, for whatever reason, sells the loan. This happens thousands of times a day.

Those loans are combined into an entity called a "Residential Mortgage Backed Security." This is nothing more than a bond backed by mortgages. Each month, as borrowers make the house payment, a lot of interest is paid and a little debt is retired.

Those residential mortgage-backed securities can be packaged into yet another type of security called a "collateralized debt obligation." To make sure it's even more complicated, these are further divided into sections called "tranches" and are then risk-rated and sold. So now it's a big bond backed by a bunch of smaller bonds.

Let's be clear about who snaps these up. These investments are only bought by major players who are looking for good returns and willing to take the risk to get them. "Qualified institutional buyers" are legally recognized as sophisticated, well informed investors who need less protection than individuals.

Now: Enter Goldman.

The investment bank was asked by a client to put together a CDO. So Goldman did. It loaded a lot of risky residential mortgage-backed securities into a shiny new CDO and then sold pieces of it to investors. Just like it has done a thousand times before. Just like the other major investment banks do all the time. Goldman was paid a fee of $15 million to put the CDO together. For those of you keeping score at home, that's about 0.0003% of its annual revenue.

What happened? Well, as we all know, the housing market went south. As properties lost value, borrowers defaulted with insufficient collateral to cover the debt. The mortgages lost some if not all of their value, and the over-arching CDOs basically became worthless because no one wanted to buy "toxic assets."

Here's the thing, though. While millions of investors lost and some institutions even failed, a few investors did manage to make money on the subprime collapse.

One who did: The client that asked Goldman to put together the CDO. It was a hedge fund called Paulson & Co. After the CDO it sought had hit the Street, Paulson bet against it by buying something called a credit-default swap.

Forgive the lingo, but there's no way around it. A "credit-default swap" is nothing more than a bet between rich dudes. One says something is going to happen and the other says it's not. It's kind of like a private insurance policy. Instead of going to, say, Geico, I pay a rich neighbor $1,000 to cover me for a year. If my car crashes, he buys me a new one. What's "swapped" is risk. I was taking it, then I paid someone else, my rich buddy, to shoulder the burden.

In the Goldman case, the something being bet on was the mortgages. Some bet on them, some bet against them. In banker lingo, a "credit" is a loan. "Default" refers to the risk that a loan might go bad. So all a fancy "derivative" like a credit default swap really is is an insurance policy against a bunch of loans going bad.

That's what Paulson bought. When the loans went bad, Paulson collected on its default swaps.

Not quite as complicated as it sounds in the papers, right?

Paulson made $1 billion on this deal, incidentally. That money came from the rich dudes who thought the mortgages wouldn't go bad. (And if they had, then they would have just kept the premium, just like the insurance company keeps the premium even if you don't wreck your car.)

Paulson, for its part, is not being sued by the SEC.

Only Goldman. And a (now) 31-year-old kid who works there. He made the mistake of writing a couple of damning-sounding emails in which his ego-driven braggadocio far superceded his prudence and intelligence. He knew, as most did at the time, that the mortgage market was imploding and that CDOs were about to take a hit. He said so. And Goldman was still selling these. And institutions hungry for rich returns were still buying them.

Remember: Every one of these CDOs, even, in some cases, with extremely poor credit ratings, were sold. Someone bought them. Someone read the details, took out his checkbook and said, "I will pay for that." And everyone who did, none with a gun to his head, was a qualified institutional buyer who knew exactly what was going on.

The SEC contends that Goldman has some sort of duty to disclose that Paulson was betting against the CDO.

That's nuts.

Goldman should never tell anyone what one of its clients is doing. It doesn't and, I would guess, it hasn't. In other forms, exploiting or divulging clients' positions would be no different from front-running trades, which is and should be illegal.

Remember: Goldman is a broker/dealer. It arranges trades. A buyer wants something that a seller does not, Goldman puts the two parties together. It's not Goldman's role to talk a client out of buying something that it wants. Goldman's role, in this case, was to make a market. Provide the means for transaction between buyer and seller. It did that. It did nothing wrong.

Look at it this way: What if you called your broker and sold 100 shares of IBM. Would you want your broker to tell the world that you no longer wanted to own Big Blue? And if you shorted the shares, does your broker have an obligation to tell the next customer that wants to buy IBM that you just bet against the company?

Of course not.

And, again, we're not talking about the individual investors that the SEC is supposed to protect. We're talking about sophisticated, well informed masters of finance who knew exactly what they were doing. It's ludicrous to suggest otherwise. That a lot of banks lost money on CDOs just means they were all equally stupid and willfully disregarded the risk.

I mean, c'mon: No one buys a debt instrument with a relatively high rate of default (as reflected in credit ratings and in the underlying fundamentals of the instrument, which are available in detail on any Bloomberg terminal) without understanding that somewhere someone might be betting against it. That's just life. Even the best companies have contrarians who bet against them.

As rumors build against shakier companies, of course, investors short it -- betting it will implode. Others buy it, thinking it will make a comeback and they will make a killing.

There isn't any wrongdoing, even if both parties make their trades though the firm that underwrote the initial offering!

The broader context must be taken into account. Goldman Sachs is a great bank. Smart, admirable and decent people work there. They make good salaries, sure. But that just gives every Goldman employee all the more reason to play it straight.

Goldman does complicated stuff and makes a ton of money in ways that most people can't relate to or figure out. They hear words like "derivatives" and "credit default swap" and "collateralized debt obligation" and they're lost. Most people wonder how the housing bubble burst and how everything really went down, and in the end it's easy to blame an institution like Goldman or Skull & Bones or the Castro regime for things that otherwise defy an easy explanation.

The same people who would be mad at Goldman for selling this security at the behest of a client are the same ones who thought the whole financial crisis would go away if we lowered a few CEO salaries. It is naive populism knee-jerking its way to judgment about something it clearly is ignorant of and has no frame of reference to understand.

This lawsuit is about redistributing wealth. It's about criminalizing financial sophistication and punishing size and success.

That's the bad news.

The good news is that the Goldman case will be tried in the most financially savvy court in the land. The truth will come out. Mark my words: Goldman will be fine.

So what's your first reaction?

If it's to buy Goldman shares at today's fire-sale price, then I'd agree. Goldman's a buy.

Two Positions Harvard Should Increase

2010-04-16T10:08:00.003-05:00

Harvard Management Co. has 120 securities in its publicly disclosed portfolio. Its top four holdings, representing 55% of the portfolio's $2.3 billion value, are internationally oriented exchange-traded funds that focus on generating income in emerging markets, China, Brazil and South Korea, respectively.

Given Harvard's clear preference for managing its risk through the diversity afforded by ETFs, I wanted to know which stocks the nation's wealthiest university endowment was holding.

Seven equities comprise at least 1% of the portfolio as of its most recent filing. None are in the same industry, all except one has a multibillion-dollar market cap; most are megacaps valued at more than $40 billion. Three of the companies -- BJ Services, Burlington Northern Santa Fe and Marvel Entertainment -- have since been acquired.

Here are the companies Harvard owns, what the university is betting on, and my take on the investment’s prospects:

The largest stock holding is Barclays (NYSE: BCS). This British bank has seen decent returns since Jan. 1, with a better than +27% gain, and a one-year return of more than +100%. Even so, the bank has lost nearly 50% of its value during the past five years as the global financial system weathered the Great Recession. Investors are still unwilling to pay much for bank assets, which isn't so surprising when you look at the strength of the asset pool that required 8.0 billion pounds in loss provisions in 2009 and 5.4 billion pounds the year before. Investors are only willing to pay 88 pence on the pound for assets, which effectively values the bank's underlying business at zero.

As Barclays and other banks earn their way out of the bad loans they made, their earnings will inevitably rise, as the cash they were allocating to problem loans will flow instead to the bottom line. It's a waiting game. Harvard should keep at it. I'd hold this position.

Teva Pharmaceutical Industries (Nasdaq: TEVA) is an Israeli drug maker that specializes in generics. Sales, earnings and book value have grown every year since 2000. The shares currently command 27 times earnings, a discount to its historical average of about 40. Future profits should be significantly enhanced by a recent acquisition of a German drug maker and by a spate of expiring U.S. patents.

Owning Teva is a bet on cost-conscious consumers in the health-care sector, an economic segment that tends to grow faster than overall U.S. gross domestic product. As recent health-care legislation extends coverage to previously uninsured patients, drugs sales are likely to see an increase. The wager has been a good one so far. Teva has outpaced the S&P this year (Teva +11.4%, the S&P +7.0%) and the company has posted annualized returns of +14.3% for the past five years.

Harvard would do well to increase this position.

BJ Services (NYSE: BJS) is an oilfield-services company, and owning it signifies a belief that drilling activity around the world will remain strong. As oil prices creep closer to the triple digits and each day seems to bring another announcement of a new crude discovery, that appears to be a good bet. The company was recently acquired by Baker Hughes (NYSE: BHI), which trades near its 52-week high at a robust 35 times earnings, a richer valuation than Google.

Baker Hughes is a storied company, and Wall Street likes the story. That's why its valuation has risen to historic highs even despite lackluster 2009 results and ho-hum forecasts for 2010. The longer-term prospects look good, but the company offers a less-than-compelling entry point at these prices.

I see more potential value in offshore players like Transocean (NYSE: RIG), Noble Energy (NYSE: NE) and Diamond Offshore (NYSE: DO), especially as the Obama administration has opened up previously protected U.S. waters for exploration.

Harvard should have some individual-equity exposure to the petroleum sector, but Baker Hughes has limited upside. The offshore drillers are far more promising opportunities: Why buy a company at an inflated price hoping its earnings will rise to lower its earnings multiple when you can buy a company with similar growth prospects but a depressed valuation?

Harvard should close this position.

News Corp. (Nasdaq: NWS) Rupert Murdoch's media empire has about $30 billion a year in annual revenue, but its run of robust profits came to an end in 2009 when it posted a $5.6 billion loss. Yet even those earlier profits haven't done much for the stock, which has achieved an annualized gain of +0.7% in the past five years and an appalling -10.7% annualized loss during the past three years.

Though News Corp. produces news and entertainment, it is primarily in the highly cyclical advertising business. Its recent track record has been rocky, with 2009 earnings coming in below 2008, and its future doesn't look great, with 2010 earnings forecast to come in under 2009's. So the fact that News Corp. is trading at 24 times trailing twelve-month earnings per share of $0.75 is curious. That's higher than the S&P 500, which, as a whole, should be able to grow faster than a $40 billion media company. Its valuation also exceeds the company's five-year average earnings multiple of 18.

Here's the rub: If a company's earnings are worth more than the broader market, then its assets ought to be, too. After all, the premium to book value represents the market's valuation of the business that's going to create those future earnings. But that's not the case. News Corp. trades at 1.9 times its net asset value, a discount to the broader market's 2.2. So News Corp. either needs to somehow erode shareholder equity to lower its book value (unlikely), or it needs to seriously juice its earnings. An increase in earnings, however, is already pretty much priced in.

There's current upside to News Corp. Harvard should close this position.

Pebblebrook Hotel Trust (NYSE: PEB) is an anomaly in Harvard's portfolio. It's a small real estate investment trust as opposed to a large international corporation. It went public in December 2009 and has so far only managed to post a small loss. The REIT received proceeds of nearly $400 million that it plans to "opportunistically" invest in the beaten-down hotel sector, which suffered a -16.7% decline in revenue per available room in 2009, one of the worst years for the industry.

Any wager on hotels is clearly a bet on a strong economic recovery where businesses aren't afraid to spend money on travel and consumers become less discount-focused when booking rooms for vacations. This is an income play that has, of yet, produced no income. Better, more established yields are available.

The last two stocks that made the list are Marvel Entertainment, which was acquired by Disney (NYSE: DIS), and Burlington Northern Santa Fe, the railroad, which Warren Buffett's Berkshire Hathaway (NYSE: BRK-B) bought. After approval by BNI shareholders -- with 70% voting in favor of the $26.4 billion deal -- Berkshire said 40% of Burlington shareholders wanted to be paid in cash and 43% wanted Berkshire stock.

Which leaves one final question on this exam.

Will the smartest university join forces with the world's smartest investor?

To be sure, Harvard got it wrong the first time. The university turned Buffett down flat when he applied to its graduate business school in 1950. If Harvard wants to see serious returns on its assets, however, then it might want to rethink that decision. After all, its investment managers achieved a stunning -27.3% loss on their portfolio in the fiscal year ended June 30, 2009, while Mr. Buffett, who, despite his Columbia MBA, ended 2009 with a +19.8% gain in Berkshire's book value.

The long-term picture is even better with Buffett: He has delivered a +20.3% annualized return vs. Harvard's +11.7% annualized growth, which roughly matches the market.

Here's the crib sheet for the exam: You have to generate some returns in excess of market gain if you're ever going to get ahead. Let's check the numbers: Invest $100 million with Buffett and you'll end up with $4 billion after 20 years. Invest with Harvard and you'll arrive at a $914 million balance during the same time period, less than 25% of what Buffett earned.

Let's hope Harvard got it right this time and took the shares instead of cash. We’ll find out in about a month, when the next filing is due. The cash would have earned nothing, but Berkshire has returned +22.1% year-to-date.

More of the Web's best invesmtn commentary can be found at www.streetauthority.com.

How Obama Instantly Created $2.2 Billion in Investor Wealth

2010-04-01T07:48:00.005-05:00

With a stroke of his pen -- and after a hellacious fight with the Congress -- President Obama brought massive change to the health-care industry.
He's doing the same with another industry today. The industry is different and he doesn't need Congressional approval. And the plan has already created $2.2 billion in wealth for investors.

So what's going on?

Would you be surprised if I told you it was politics?

Presidential power, some would argue, is cumulative. It builds. Winning presidents tend to keep on winning; losing presidents tend to keep on losing. After more than a year in office, the verdict on whether Mr. Obama will turn out to be a perpetual winner like FDR or a chronic loser like Jimmy Carter has yet to be determined.

Making such predictions is dinner-table sport inside the Beltway. Everyone has an opinion these days, but even the cagiest political operators should be loathe to make too bold a forecast. Today's supercharged political climate is full of surprises.

The fact is no one knows how the Obama administration ultimately will be judged.

But I can tell you what's coming next. As you know, health care was a cornerstone of the president's agenda. With the bill signed, Mr. Obama is wasting no time. He took a quick victory lap to Afghanistan to change the focus, came back and met with the French president for the same reason, and now he's ready for a new storyline.

He's got it. If you saw the news yesterday you know what it is.

Mr. Obama is clearly moving on to another key element of vision: The environment.

We've all heard stories about how smart Mr. Obama is. And though the president is undoubtedly very intelligent -- and calmly disciplined -- both of those labels undersell him. In addition to his brain power and temperament, Mr. Obama is also very shrewd.

You see, though I would suspect he would agree that presidential power is cumulative, I think he also knows he can't just ram through another bill without any support from the other side of the aisle. That's not a purely political calculation, it's bowing to the unavoidable reality that Senate rules don't allow for another reconciliation process this year.

But with the midterm elections coming up, it's unlikely that the White House would railroad through more legislation even if the option were available. Mr. Obama and his advisers know that if you engage your enemy in the same way too long, he will adapt to your tactics. So the president is switching gears. That's why he's been talking about bipartisanship again, going so far as to quote the old Ronald Reagan line about "disagreeing agreeably." It's also why he's been supporting the construction of new nuclear power plants, a key Republican energy priority. The fact is Mr. Obama is priming the political pump.

And what's going to come through the pump next?

Crude.

The President is flip-flopping on a longstanding policy and opening up nearly 300 million acres -- or about 480,000 square miles -- for offshore oil exploration, some of it for the first time.

The action added at least $1.5 billion in market value to the offshore drilling industry's major players. President George W. Bush might have been an oilman -- and, to be fair, he did try to open up some areas for drilling -- but it's Barack Obama who today snapped his fingers and added nearly $1 billion in market cap to Transocean (NYSE: RIG), the leading offshore drilling company.

The president didn't stop with offshore drilling. To placate supporters who are bound to be aghast at the drilling, he threw environmentalists a bone and announced he will also increase the military's use of biofuels and add hybrid vehicles to the government's fleet. He made his announcement in front of a fighter jet that will run on biofuel -- not because that was the most important part of the announcement (it wasn't) but because he wanted a better visual on the news than offshore oil platforms, which would incense Greens.

Investors who own offshore drillers should hang on to them. And all growth-oriented investors should consider them: Offshore drillers are trading at very low valuations -- Noble Corp. (NYSE: NE) sells for 6.5 times earnings; Transocean for 7.3. Diamond Offshore (NYSE: DO) for 9.0. Part of that is uncertainty: No one knew what the Administration was going to do, especially after Mr. Obama said in his State of the Union address that some hard choices about drilling were going to have to be made. Now that those decisions have been made, all three of those industry-leading companies are steals. That's not just because of their long-term prospects but also because of their recent performance.

Transocean, for example, which operates 138 mobile offshore drilling rigs, grew its earnings from $0.22 a share in 2003 to an astonishing $12.48 last year, a gain of +5,572.7%. That's reflected in its historical earnings multiple, which is more than 40 times earnings for the past five years. That kind of earnings growth is possible again. The shares are up nearly +47% in the past year. Diamond Offshore has had similarly strong earnings growth, with an average price-to-earnings ratio (P/E) of more than 30 during the past five years.

Noble has had the most measured results, posting good steady growth, and should be able to regain its typical valuation of about 17 times earnings. Even before the president's landmark announcement today, Noble was worth $108 a share based on its current earnings. That's +157% upside even before new business juices earnings in the years to come.

Investors should and must go into the oil patch with their eyes wide open. First, oil investors have to be comfortable with volatility -- there isn't a "safe" place to stand anywhere in the industry, which is subject to every kind of risk actuaries calculate, and then some. That's not to say there aren't great petroleum investments -- in fact, no sector has ever achieved a better return on equity than the oil business -- but understanding the risk is the first step toward understanding whether any investment is suitable for your portfolio.

Second, even though the president reversed the moratorium instantaneously, the returns are going to take time. The intricate offshore survey work required to find suitable exploration sites will take months and years.

For risk-tolerant investors looking to take advantage of Mr. Obama's bold new energy direction, the offshore drilling space is a great place to seek growth. The president has added billions to this sector today. It's likely just the beginning.

More of the Webs best investment commentary can be found at StreetAuthority.com

Turning $25,000 into $3.2 Million

2010-03-16T15:57:00.004-05:00

This week Wall Street has had a lot of its usual fare to digest: Retail sales, housing starts, petroleum inventories, mortgage applications, some minor earnings reports. Those data points are important enough to keep track of, but none is likely to move the market.

What could? Well, some would argue that the most important thing on the calendar will be today's interest-rate announcement from the Federal Reserve.

But I would argue differently.

I don't think the most important thing for U.S. investors is happening in these United States.

I think it's happening in Amsterdam.

The World Biofuels Markets conference will draw more than a thousand of the foremost experts together for three days ending Wednesday in The Netherlands. Nearly 300 speakers will talk about the industry's latest developments.

This isn't some ho-hum annual confab of the Midwestern Regional Widget Alliance going on at some down-market Vegas venue presided over by Wayne Newton. Rather, the World Biofuels Markets conference is a meeting of the men and women who are inventing a new industry, who are using cutting-edge science to harness new forms of energy that could not only reduce the world's dependence on OPEC but that could help reduce harmful pollutants while opening new markets and creating scores of thousands of jobs.

Among the sponsors: Petroleum giant and clean energy pioneer BP (NYSE: BP), as well as agricultural titan Archer Daniels Midland (NYSE: ADM) and the European Commission's Directorate-General for Energy & Transport.

The guy I want to hear most: Dyadic International (OTC: DYAI.PK) CEO Mark Emalfarb.

Dyadic is a leading enzyme company whose technology is vital to the white-hot cellulosic ethanol industry. Cellulose is a type of sugar found in all plants that can, with the help of special enzymes, be turned into ethyl alcohol -- ethanol -- which can be blended with gasoline and used as a motor fuel.

U.S. federal law codifies the nation's output targets for renewable fuels. For instance, the timetable, which covers 2008 through 2022, calls for 12 billion gallons of traditional corn-based ethanol this year. That slowly ratchets up +25%, to 15 billion gallons, in 2015. But that's the ceiling.

Now, a lot of businesses would be pretty happy to have +25% growth built into federal law. But the upside is much higher for cellulosic ethanol. The output target for 2010 is 6.5 million gallons. But there is no ceiling. The timetable continually increased the cellulosic target through 2022, when it will stand at 16 billion gallons. That's not +25% growth spread over five years. That's more than +90% annual growth during each of the next 12 years.

There is nothing out there with similar long-term growth prospects. And this growth is written into federal law.

Investors who back the right companies could well see similar returns in their portfolios. I don’t want to gloss over what that means. A +50% rate of return over a dozen years turns $25,000 into $3.2 million. A +91.7% growth rate -- the actual compound annual growth rate built into the output timetable -- turns $25,000 into $61 million.

Do I really think that's likely? No. I'd be a fool to seriously suggest it's even possible to turn $25,000 into $61 million -- that violates the law of large numbers. But even if I'm off by an order of magnitude this investment still has more upside than anything else.

Dyadic has gained nearly +200% since I first added it to the Government-Driven Investing Portfolio. I think it and a handful of other cellulosic ethanol companies have the potential for strong triple- and double-digit returns for the long-term.

Here's why:

1. Dyadic's Emalfarb has already signed deals with some of the world's largest ethanol players.
Spanish conglomerate Abengoa, for instance, is a Dyadic customer. And Royal Dutch Shell (NYSE: RDS-B) just cut a $12 billion ethanol deal with Brazil's Cosan (NYSE: CZZ). Shell has an interest in an entity called Codexis that will be part of the Cosan venture. Codexis also uses Dyadic's technology. In fact, Codexis said in an SEC filing that one of the risks it faces is losing its access to that Dyadic technology, which would have a material impact on its ability to continue its business.

Let's face it: Big companies like Abengoa and Shell don't mess around with penny-ante companies that can only talk about how great the future will be. They instead partner up with serious vendors that can deliver results and actually make the future happen. Dyadic is one such company. I expect more big deals.

2. Dyadic never limits its ability to make money.

Emalfarb doesn't have any inclination to let any customer have control of his technology. If Company A wants to rent it -- that is, pay a royalty on its use -- that's fine, but Emalfarb retains the right to license Dyadic's enzymes to anyone willing to pay for them. Dyadic's deals are nonexclusive, and that is one reason the potential for the shares is so high. It is possible that the company could receive a royalty on a significant percentage of the cellulosic ethanol that the world produces. There's no ceiling and Emalfarb has wisely chosen not to build one and limit his company's ability to make money.

3. The company focuses on its core competencies.

Emalfarb has no intention of burning through Dyadic's cash by building company-owned cellulosic ethanol plants. Why deploy scores of millions of dollars to build the plants when he can derive a significant income stream from them without committing a dime? Emalfarb is a compelling CEO because he has faith in his company's products and in his ability to develop more. He's not evenly remotely interested in expanding into areas he doesn’t know anything about. The company knows enzymes and monetizing those products is its core competency. That is Emalfarb's laser-like focus. He'll deliver the enzymes. Someone else can write the check to build the plants.

Dyadic is a clear leader in two areas: It's showing the world how to make cellulosic ethanol and meet the U.S. government's ambitious targets for its production. But Emalfarb is also showing the world the smart way to run a company. His shareholders have been handsomely rewarded, and I think they will continue to be.

Emalfarb presents at the biofuel conference Wednesday. I'll be listening then. Today, however, I'm buying more Dyadic shares.

Disclosure: Long Dyadic.

Advice I Give Rich Friends

2010-03-15T17:03:00.000-05:00

Say you and I are friends.

And let's further assume you're fabulously wealthy.

You've come to me for advice. What would I tell you to do with your money?

I'd tell you to do three things.

The first: Buy farmland.

Sounds nuts, I know. Farming is technical, labor intensive, highly risky and remarkably capital intensive. But mark my words: Agricultural economics are going to undergo a sea change in the next 20 years.

The reason: Biofuel.

Right now, "biofuel" means corn-based ethanol. That's changing -- fast. Chemists and biologists are engineering what will amount to no less than an agricultural revolution.

They've figured out how to unlock the sugar found in all plant material and turn it into motor fuel.

That means it's now possible for the United States, long dependent on sometimes hostile and always volatile foreign powers, to grow its fuel rather than to buy it for cash. Dozens of pilot-scale projects have been built, and thousands of commercial-scale biorefineries will spring up across the nation and use plant waste -- corn cobs, rice straw, corn stalks, wood scraps and so on -- as feed stocks to create cellulosic ethanol. Federal timetables call for 16 billion gallons a year by 2022, up from 6.5 million today.

The result of this will be a massive upward revaluation of cropland that accompanies a huge uptrend in the land's ability to generate returns.

This will be Norman Borlaug (the American Nobel laureate known as the father of the Green Revolution) to the fifth power. It will also foster an urban exodus, as families return to the nation's small towns to take advantage of good wages and high quality of life. Owning farmland is a great way to play the inevitable and irreversible trend toward biofuel.

(If you're not ready to make a seven-figure commitment to a parcel of ground in, say, Lincoln County, Kansas -- where I'm from -- then you need to own shares of the biotech company that makes the enzymes that enable the biochemistry behind cellulosic ethanol. That company, Dyadic International (OTC: DYAI), has already delivered a triple-digit gain to readers of my exclusive Government-Driven Investing newsletter. I think it's just getting started!)

The second thing I'd tell you to do with your fortune: Get your hands on the hottest commodity in the world.

It ain't gold. It's not silver. It's not even uranium. It's lithium.

This lightweight metal is used in the battery in your cell phone and your laptop, in your iPod and your Kindle. Highly efficient lithium-ion technology is also what's going to deliver the energy that propels the drivetrain in battery-powered cars.

If you want to get rich, then hear my phrase and heed these words: This is the inevitable future.

Electric cars are unavoidable. A recent article in The Economist explained why: "In the next 40 years, the global fleet of passenger cars is expected to quadruple, to nearly three billion. China, which will soon overtake America as the world's biggest car market, could have as many cars on its roads in 2050 as there are on the planet today; India's fleet may have multiplied 50-fold."

The thing is, India and China have been dependent on the rest of the world forever. They're not going to be eternally hamstrung by oil sheiks or tin-pot dictators like Venezuela's Chavez or even Russia's Putin. The developing world wants green cars.

And they can have them. There's no incumbency to the gasoline-powered car in most of the world because most of the world doesn't even own cars now. But as China and India grow wealthier, that will change. The governments there (and here) will see to it that electric-vehicle technology is embraced, and huge markets for electric cars will develop. That means huge profits to be made by the smart investors who control the world's supply of lithium.

Who's that going to be? Let's ask The New York Times. In an article published Tuesday, it said: "The industry leader … is Sociedad Quimica y Minera (NYSE: SQM), a Chilean fertilizer company."

I agree. That's why I made this exact recommendation to Government-Driven Investing subscribers. Last November, in fact, five months before The Times took notice.

Third strategy for the uberwealthy: Head to the emerging world.

Don't go there for telecom, high debt yields or even consumer products, but for oil. A recent oil discovery in Uganda, for instance, could mean billions for its developer. And a handful of teeny British petroleum upstarts look like they've hit a gusher in the Falklands Basin, an offshore field that could contain billions of barrels of crude. (They've managed to shake up a diplomatic hornets' nest and now the U.S. State Department, the British Foreign Office, Argentine President Cristina Fernandez and even Hugo Chavez have entered the fray. The smart money -- that is, yours -- should bet that the Falklands will stay decidedly British and that these little oil companies will become decidedly delectable takeover targets.

As I look at these three strategies, I notice a common thread.

Government action.

Only governments can incentivize electric cars on a national level. Without tax breaks for research, subsidies for green-collar jobs and huge tax credits to early adopters, electric cars would be exorbitantly pricey and the exclusive purview of Hollywood liberals, well-heeled environmentalists and rich college kids in Berkeley and Boulder. But with the leader of the free world actively selling the Chevy Volt -- produced by a company his administration bailed out just for that purpose -- you can bet buyers will line up.

Result: Lithium booms.

Only governments can write laws that mandate the output of biofuel grow from 6.5 million gallons to 16 billion gallons. It takes the U.S. Department of Agriculture and Energy working in concert to make sure that the crops can be grown, the plants can be built and the companies have enough capital. That's what's happening now: The government is using stimulus money to provide grants and using Uncle Sam's credit to provide loan guarantees for cellulosic ethanol plants. The EPA had to adjust this year's output target down, from 100 million, but you can rest assured the government incentives will bolster output in short order.

Result: Huge returns for enzyme makers, plant builders and even seed companies. (You watch: Having made major advances in crop yields using genetics, smart companies like Monsanto Co. (NYSE: MON) will begin to introduce seeds in the next few years that also boost the sugar content of their plants. This will mean refineries can tease more ethanol from crop waste, boosting ethanol production, lowering our dependence on foreign oil and adding to the return on that section of ground you bought.)

Finally, only government action can resolve international disputes such as the diplomatic donnybrook raging in the South Atlantic over the oil in the Falklands. You can bet that Britain, which has controlled the island since 1833, will prevail and pave the way for substantial profits.

Result: Huge gains for shareholders of the companies involved.

If you're Big Rich, or aspire to be, then it only makes sense to follow Big Money. I'd suggest you always align your financial interests with the various interests these and other governments go to great lengths to support and protect.

The Gamestop Gambit -- Is It a Takeover Target?

2010-03-12T08:11:00.000-06:00

OK, so shares of Gaemstop rallied yesterday on takeover rumors.

No one knows where they came from or who the buyer is.

More than a year ago, I said Microsoft should be Gamestop to build out its retail footprint. And a couple of months ago, when Gamestop took a dive, I said it was a buy again.

Here's the piece from February 2009:

Microsoft (Nasdaq: MSFT) said Friday it had hired a veteran Wal-Mart executive, David Porter, to oversee the development of brick-and-mortar retail stores. He will report to Kevin Turner, Microsoft's COO, who also has ties to Bentonville.

Apple (Nasdaq: AAPL) changed computer marketing with its hip advertising. It changed the computer market with its nifty devices, and it changed the computer marketplace with its stores. Microsoft sees the writing on the wall, and these hires underscore how serious Microsoft is about regaining any of the ground it has lost to Apple. Porter and Turner aren't show horses -- they're work horses. Wal-Mart executives get things done fast and cheap, and they never lose focus on the customer. That core competency will be vital to Microsoft's retail execution. Here are four reasons I think Porter's first step will be to engineer a merger with software retailer GameStop (NYSE: GME).

1. Microsoft Is Always on the Hunt for Deals
Though the ill-fated Yahoo merger is the most well known, Microsoft has put its vast cash hoard to work by acquiring companies that have something it needs. Over the past two years, MSFT's shopping cart has been loaded with search, voice and advertising technology. Certainly Microsoft has the human capital to develop new technologies on its own, but it's cheaper -- and far faster -- to simply buy it. The same is true with its stores.

And the fact is, Microsoft can quite literally buy anything it wants. The Redmond company is one of seven U.S. corporations to have a triple-A credit rating. It has cash on hand totaling $8.3 billion, and it has no long-term debt.

2. GameStop Has a Huge Footprint
GameStop has an international presence that includes 5,264 stores. GameStop's stores tend to be in urban areas, in shopping centers and strip malls. These aren't destination stores like Wal-Mart; they are located where people already eat, shop and work. This is precisely where Microsoft will seek to extend its reach and build its brand. A GameStop deal would give Microsoft an instant competitive advantage over Apple, which has only 250 stores. Many of GameStop locations are near existing Apple stores.

3. GameStop Is Cheap
GME is trading for only 12 times earnings. As the chart shows, that's near the ebb. GME's two-year average earnings multiple is 27.

Though a dramatically reduced P/E usually signals concerns about future earnings, GameStop doesn't have that worry.

Sales continue to be brisk. It even did well during the holidays, posting sales increases most retailers would have killed for. GameStop's EPS has never declined, and even in the current economic climate, earnings are forecast to rise.

4. GameStop Stores Meet Microsoft's Needs
GME's relatively small stores -- already clean and well-lit -- are ideal for Microsoft. They're less than crowded and could easily make room for Microsoft products, display kiosks and demonstration models. Maximizing store efficiency is something that Porter and Turner learned at Wal-Mart, which tracks revenue by square inch of shelf space. What's more, GameStop existing staff would gel nicely. They tend to be avid computer users, fluent in the lingo and up on the latest products.

GameStop Would be Acquired at a Premium
The vast majority of these shares are held by institutions, who have held on through GME's -46% decline in the past year and are unlikely to approve a merger that doesn't help make them whole, especially from a company that absolutely can afford to pay. GME's current market capitalization is roughly $4.3 billion. Microsoft would be getting a steal at $10 billion -- the footprint it wants and a business that produces tons of cash without any debt and doesn't have to burn cash to develop products. An acquisition at $45 a share would represent a +70% premium and still value the company at less than its historical valuation.

Think that's too rich of a premium for GameStop? Consider: Microsoft offered $31 a share for Yahoo last year when its shares were trading at $19.18. Yahoo rejected the +61.6% premium as too low, and after one of the strangest negotiations in corporate history, Microsoft raised its offer to $33 -- +72% over Yahoo's pre-merger offer price.

A Microsoft-GameStop deal makes sense financially for GME, MSFT and investors. It achieves overnight a footprint that otherwise would take years to build. And it marries two compatible cultures: Apple users aren't gamers, but Windows users are.

Here are the two ways you can play this, depending on your risk tolerance:

1. Go Long
Buy GameStop and hope for a takeover announcement that includes a rich premium.

The upside: It happens and the stock skyrockets to the takeover price.

The downside: The merger doesn't go through. What then? Well, it's not exactly bleak! All that happens is you will own shares of a successful earnings machine that you bought cheap yet is continuing to post ever-improving results.

2. Position Yourself for Huge Gains with Call Options
A call option gives an investor the right to buy a stock for a certain price during a certain time.

The Upside: Huge if the deal goes through.

The Downside: IF the options expire before you exercise or sell them, you're out whatever they cost you.

The Only Company Left Standing in a $40 Billion Battle

2010-03-11T09:40:00.000-06:00

Know when to hold 'em, Kenny Rogers taught us.

Know when to fold 'em. Know when to walk away.

And know when to run.

Northrop Grumman CEO Wes Bush evidently knows the song. Mr. Bush has decided to fold and walk away, if not run, from the U.S. Department of Defense's multibillion-dollar contest to build the Air Force's new tanker.

Northrup Grumman (NYSE: NOC), one of the top defense contractors in the world and the third-largest in the United States, announced Monday it was abandoning its bid for the new plane, clearing the way for rival Boeing (NYSE: BA) to win the $40 billion contract.

Boeing shares rose slightly on the news, though the stock is a clear winner so far this year. Shares are up +25% in 2010, utterly thumping of the Dow Jones Industrial Average's +1.4% year-to-date gain and thoroughly trouncing the broader S&P 500 Index, which Boeing has outpaced by an eye-popping 22.8 percentage points.

The path to this point has not been one of the great stories of American business. In fact, it's been a long-running and wholly disastrous soap opera, a cheap melodrama that has kept the military using refueling aircraft that were built during the Eisenhower administration. (No joke: The first of the 803 KC-135s the Pentagon bought took off on Aug. 31, 1956. That's five years before the current commander-in-chief was even born.)

The troubled tanker contract has encompassed more than just harsh criticism from lawmakers like Sen. John McCain, who objected to the terms of the initial deal, which was for the Pentagon to lease the planes; it has at times degenerated into outright scandal. A Boeing chief financial officer and a senior Pentagon buyer involved in the deal actually went to jail over illegal employment talks. Then, in 2008, Northrop won the deal. Boeing complained and won a do-over. Finally, after years of wrangling, Northrop bowed out.

Wall Street and Washington had been prepared for the possibility of a single-vendor contract. The question is not what this deal means for Boeing, the question is what comes next for the aerospace giant.

One possible answer could be India.

India is shopping for a fleet of 126 fighters to defend it from potential threats in Pakistan or China. The $11 billion deal has drawn serious competition: Lockheed Martin's F-16, Dassault's Rafale, the latest Russian MiG-35 and even Sweden's Saab. Boeing's F/A-18 Super Hornet is also a contender, as is the Eurofighter Typhoon, a joint project of Germany, Spain, Italy and Great Britain. The Eurofighter is considered the frontrunner to win the contract, according to India's ambassador to Italy, though Russia is typically India's main arms supplier.

We'll know which company will have the contract soon enough: Late last month, India said it was fast-tracking its procurement efforts and that the testing phase, during which time the country's military puts each company's plane through the paces, should wrap up by the middle of the year.

A handful of emerging countries have made it a top order of business to bolster their national defenses. India is a particularly dramatic example given sometimes troubled northern neighbors like Afghanistan and Pakistan, but the fact is the world grows smaller and more dangerous every day. This threatens the wealth and improved standards of living that dozens of small countries have toiled for decades to achieve. As more countries seek to protect themselves from aggression, business will continue to boom for Boeing.

And it's not like business is bad here at home. A $40 billion contract is a material chunk of business -- Boeing had $68.3 billion in revenue in 2009 -- but even that's a drop in the bucket. President Obama's overall defense budget for fiscal 2011, which Congress has yet to finalize, calls for $708.3 billion in Pentagon appropriations. Or, to put bring the number a little closer to home, Obama is calling for $7,083 per U.S. household in defense spending.

Only governments can spend money like that.

And companies like Boeing -- the only competitor left standing for the tanker and one of the finalists for the Indian fighter contract -- will profit from increased defense spending, both here and abroad, this year and next, to the benefit of shareholders who understand how government actions can deliver such strong returns.

Increased Profits are a Lock for the Industry

2010-03-06T08:14:00.000-06:00

Interesting data from your federal government:

The average wage of the 15.2 million employees in California, according to the U.S. Bureau of Labor Statistics, is $48,090. That's about $23.12 an hour.
Very low on the scale: Private security guards, at $25,950. Also bailiffs, who earn just under $49,000.

Yet relatively high on the scale is state prison guards, who can, with overtime, easily earn more than $100,000 a year. By contrast, a kindergarten teacher in the Golden State can expect to pull down an average $56,540.

If that makes you crazy, try this statistic on for size: Fully 9.5% of the California state budget is allocated toward prisons. Only 5.7%, by comparison, goes to universities.

Twenty-five years ago, prisons were 4% of the budget. Higher education represented 11% of the state budget.

The prison guards union has historically been one of the most powerful in the state. No one pays guards more. And these jobs are very secure: If Sacramento is facing the squeeze and has to furlough state workers, prison guards are one of the few groups that are exempt and must stay on the job.

Wages are only the tip of the compensation iceberg: Guards also receive generous health care and retirement benefits. You won't get 90% of your salary in retirement. A prison guard in California, however, absolutely will.

The Governator is not happy with this.

His administration has been plagued by budget crises. The current budget proposal creates a $20 billion deficit, which half of Californians -- according to a poll released today -- say should come not from more taxes but from spending cuts.

(The half that doesn't think that way were among those who sued the governor for exercising his line-item veto last year. The courts ruled on Tuesday that he had the authority to reduce or eliminate state programs.)

Mr. Schwarzenegger is sponsoring a ballot initiative that would automatically give more money to higher education than to prisons. He has also said he wants to build jails in Mexico to house the 20,000 or so illegal immigrants in California prisons. That suggestion, however, raises constitutional questions and is unlikely to gain traction as a serious solution.

What's left?

Well, the governor could let people out of jail. The politics of this are dicey, as anyone who remembers Willie Horton can attest.

There are other practical considerations as well. In some cases, release isn't even an option. California has a "three strikes" law. Since 1994, three felony convictions have put offenders in jail for the rest of their lives, with scant chances for parole. The law, upheld by the Supreme Court, is wildly popular. After 15 years, one study suggested it has saved the state $54 billion and prevented 10,000 murders.

I'll give you three guesses which lobby pushed that bill through the statehouse.

If you said "the California Correctional Peace Officers Association," you're right.
Mr. Schwarzenegger's only serious alternative is to find a cheaper solution than putting these inmates in prisons with platinum-paid guards. The governor can outsource the problem to companies with lower costs. Private prison operators pay security guard wages rather than correctional officer wages, which gives them a significant pricing advantage. (Wages represent 70% of a prison's budget.)

What's more, private business is far more adroit at building prisons than the slow ship of state can, especially during a financial crisis. And while there is some question as to whether it's kosher to ship inmates to Mexico, it's perfectly all right to ship them to another state.

All that is why 25 U.S. states have deals to outsource prisoners.

The leading vendor is Correctional Corporation of America (NYSE: CXW), a $2.4 billion company that operates 65 private prison facilities with 87,000 beds in 19 states and the District of Columbia.

Corrections revenue, not surprisingly, has not decreased since 2005. And the future looks bright for the company, not just because of the problems of Mr. Schwarzenegger, but because of the long-term trend toward harsher incarceration in this country. In 1980, 319,598 people were in prison. At the end of 2008, the latest year for which the Department of Justice has data, the total U.S. prison population stood at 1.5 million, a gain of +375%, exceeding the growth in the general population -- +32.4% -- more than tenfold.

The bottom line is that Corrections can't build prisons fast enough, and it will never run out of supply. Even given its status as the No. 1 operator of private prisons, its bed count is equal to a mere 5.7% of the total inmate population.
Given this immense growth potential, CXW is exceedingly cheap. Shares trade for a mere 15.5 times earnings, a significant discount to its historical average earnings multiple of 18.5 and a -13.9% discount to the broader market.

Low costs, strong margins and an endless supply of "customers" is as good as business models get. As governments, like Mr. Schwarzenegger's, seek to find ways to reduce spending, CXW's services will look very appealing. If his ballot initiative wins passage, the state will have no choice but to outsource massive amounts of prisoners.

These government actions are very good news for the company's shareholders -- and very good reasons to become one today.

Government actions mean big money.
More investing content is available at StreetAuthority.com

EPA Ruling Could Mean a +50% Increase in Biofuel Demand

2010-03-04T15:20:00.000-06:00

Wednesday I told you what an EPA rule change regarding cellulosic ethanol could mean for the Obama White House and, more important, what it could mean for the shareholders of an ethanol-industry leader.

That EPA ruling is a done deal.

Another proposed EPA rule is not a done deal, but investors should be aware of what could happen nonetheless.

What could happen is a +50% increase in the demand for ethanol.

The EPA -- that is, the Environmental Protection Agency -- was created in December 1970 by an executive order from President Richard Nixon, who also created the Occupational Safety & Health Administration (OSHA) later that same month. The EPA has since come to have a pretty wide regulatory throw. The agency oversees air and water quality, hazardous waste, land use (scenic rivers, surface mining, etc.) and endangered species. Most recently, the agency has been in the spotlight for adding carbon dioxide to its list of regulated air pollutants as part of President Obama's environmental agenda.

In December 2009, the EPA said initial tests had concluded that vehicles made after 2001 likely could burn gasoline that contains up to 15% ethanol, a fuel blend sometimes called E15. Take a look at the pump next time you fill up your tank: You'll likely see a sticker that says the gasoline you're buying is 10% ethanol.

This government action would increase the market for ethanol by +50%.

That's a nice number. But what does it mean? Well, according to the Renewable Fuels Association, it could mean an additional 5.38 billion gallons in demand. That's what adding 50% to the nation's current output would mean.

At the average rack price for ethanol of $2.72 per gallon, that's $14.5 billion in new ethanol dollars.

And that brings me to a point that all investors should realize. Yes, the government spends a lot of money. It's the most powerful financial force on the planet. But its regulations, which "cost" nothing, have a huge impact on the economy. The amount of new ethanol dollars this rule change would create is larger than the budget for the U.S. Treasury. It's also more than Mr. Obama has requested for the Social Security Administration, the Departments of Interior and Commerce, the Army Corps of Engineers or even the entire EPA itself. The total value of our nation's ethanol production is roughly the same as what Uncle Sam will spend on the Department of Justice in fiscal 2011.

U.S. Ethanol Production
Year	Gallons	Year	Gallons
1980	175 million	1995	1.4 billion
1981	215 million	1996	1.1 billion
1982	350 million	1997	1.3 billion
1983	375 million	1998	1.4 billion
1984	430 million	1999	1.5 billion
1985	610 million	2000	1.6 billion
1986	710 million	2001	1.8 billion
1987	830 million	2002	2.1 billion
1988	845 million	2003	2.8 billion
1989	870 million	2004	3.4 billion
1990	900 million	2005	3.9 billion
1991	950 million	2006	4.8 billion
1992	1.1 billion	2007	6.5 billion
1993	1.2 billion	2008	9.0 billion
1994	1.3 billion	2009	10.8 billion

Why is the EPA suggesting this rule change? It's not, really, the agency is simply looking at the potential environmental effects of burning more ethanol. What's behind the change is not the chart above, which shows the long-term historical uptrend in ethanol output, but about the chart below, which shows the 2010-2022 output quotas for biofuels written into federal law.

You'll note that the demand for traditional corn-based "renewable" ethanol limits out at 15 billion gallons, a little less than the total the new 15% rule would necessitate. (Current 2009 production of 10.8 billion gallons plus 5.4 billion more = 16.2 billion gallons.) The ceiling on corn based-ethanol, as the chart shows, is only +25% above projected 2010 production.

Year	Corn Ethanol (gallons)	Cellulosic Ethanol (gallons)
2010	12 billion	65.0 million
2011	12.6 billion	250.0 million
2012	13.5 billion	500.0 million
2013	13.8 billion	1.0 billion
2014	14.1 billion	1.8 billion
2015	15.0 billion	3.0 billion
2016	15.0 billion	4.3 billion
2017	15.0 billion	5.5 billion
2018	15.0 billion	7.0 billion
2019	15.0 billion	8.5 billion
2020	15.0 billion	10.5 billion
2021	15.0 billion	13.5 billion
2022	15.0 billion	16.0 billion

However, that is not true for cellulosic ethanol, a biofuel that can be derived from any plant material -- not just corn. Its output is expected to go from this year's federally mandated 6.5 million gallons -- recently lowered from 100 million gallons -- to 16 billion gallons by 2022. That's a gain of +24,515%.

No other industry has this kind of growth potential.

And let's remember where that growth potential comes from. Not from fickle consumers but from federal law. This timetable was established by an energy bill passed by Congress and signed by President Bush in 2007.

So if corn-based ethanol roughly meets the existing demand and the demand with the revised 15% figure, where is all the rest of the ethanol going to go?

Answer: Right into your tank. Sen. Ben Nelson of Nebraska has already asked the EPA to look at E20 or E25 -- gasoline blends that contain 20% and 25% ethanol. He noted that that's the standard in Brazil -- the world's largest ethanol producer -- and that it has reported no damage to cars or even to small engines that power boats or chainsaws. EPA Administrator Lisa Jackson said EPA staff was already studying the data from Brazil.

And then there's E85. Some 2,233 gas stations in 1,586 U.S. cities sell motor fuel that is nearly pure ethanol, with only 15% gasoline. (You can find where to buy E85 in your neck of the woods here, but don't put it in your tank unless your car is designed to use it. E15, on the other hand, can go into any vehicle.) E85 is a great idea: It's the only type of fuel that could totally and permanently end U.S. dependence on Middle Eastern oil. We could literally grow all of our gas.

I'll be honest with you. For years all of this has been pie in the sky, the sort of stuff that a college professor said would one day be possible.

Today, it's the hard reality of the new energy economy that Mr. Obama has been talking about. It's no longer the fancy of utopian dreamers, it's the inevitable future of U.S. energy.

And the whole shooting match depends on one thing.

Enzymes.

Enzymes are compounds that help certain chemical reactions take place. Special enzymes make your jeans softer, for instance. In fact, one of the leading producers of denim-aging enzymes has become one of the leaders in the production of cellulosic ethanol.

His name is Mark Emalfarb. His fascinating biotech company is Dyadic International (OTC: DYAI). And its shares have already meant a triple-digit gain for readers of my premium Government-Driven Investing subscribers. Not only are these shares held in the newsletter's portfolio, I personally own them.

You see, cellulosic ethanol production isn't possible without these designer enzymes. I'll spare you the arcane chemistry behind what happens, but suffice it to say that Dyadic is a clear leader. Such a clear leader, in fact, that Royal Dutch Shell's (NYSE: RDS-A) $12 billion cellulosic ethanol deal with a Brazilian sugar company depends on it. At least that's what the new venture told the Securities and Exchange Commission. It noted that losing Dyadic's technology would have a materially deleterious effect on its business model.

The bottom line is that Dyadic, with a market cap of about $55 million, has an exclusive right to an enzyme that is crucial to a $12 billion deal. And it should be pointed out, as Mr. Emalfarb surely would, that this is a nonexclusive licensing agreement. Dyadic is free to rent its technology to anyone it sees fit. Anyone who might be scrambling to gain a share of the +50% increase in business that the new EPA rule, expected in late summer, could mean. Or anyone looking to take advantage of the +24,515% increase in business that Uncle Sam is guaranteeing.

The EPA -- and here I am just being honest -- typically doesn’t do anything to business but add cost. For Dyadic, however, it's creating a vast new market with nearly unlimited profit potential. No investor who wishes to reap a windfall from the green energy economy can afford to ignore Dyadic.

You can access more content at streetauthority.com.
To learn more about Government-Driven Investing, go here.

Decoding Obamaspeak

2009-08-24T15:58:00.000-05:00

The time has come, the president says, for a serious debate.

So I guess all of the kidding around about health care is over.

Mr. Obama said Saturday that health care was “an issue of vital concern to every American.” He’s glad so many are engaged and said the debate should be honest. He sought to spend his weekly radio address “debunking some of the more outrageous myths” about health care.

Which interested me. I myself have been working on a similar project. Not debunking health-care “myths” but decoding Mr. Obama‘s health-care rhetoric.

The president is lauded as being remarkably articulate. He isn’t as folksy as his predecessor. He speaks actively, not in the passive-apologetic of the Clinton era. Mr. Obama tends to use a thrifty, declarative present tense.

“History is clear,” Mr. Obama might intone. Listeners, who assume the president knows more history than they do -- and presume he always tells the truth about it -- tend to give him a free pass on whatever he says next. But what comes next is not an inarguable historical conclusion but a highly debatable interpretation of it.

Sometimes Mr. Obama seeks to build a rhetorical consensus before his pronouncement. “I think we can all agree,” he’ll say, “that the time to act is now.” This puts two human tendencies into play: The desire to be in agreement and the necessity of responding to problems that need to be solved. Listeners nod -- "Yes, we must agree! Yes, we must act! -- before they think. Many, if asked about the issue, would never describe it as requiring imminent action.

Or Mr. Obama might begin a sentence with: "Those who seek to divide us say ..." Instead of putting everyone in the same category, as he does with the first example, he now asks listeners to pick one. He's asking for action. He doesn’t just want you to nod, he wants you to join him. Do you want to side with the dividers (bad), or the uniter (good)? That’s easy: Unity is something we’re taught to value; division is not. Don't we all want to be on the side of unity and goodness?

Yes, we do!

Sound familiar?

Each of those rhetorical devices prove this president a master of presenting his opinions as inarguable fact. And yet despite the presentation, what Mr. Obama says after these little verbal “tells” is usually far from factual.

I don’t know who falls for this, but the Jedi mind trick doesn’t work on me. And the more I hear this oratorical gimcrackery, the more I train my ears to parse whatever comes next.

Here are a few other telling phrases the president used at his town-hall meeting in Grand Junction, Colo.

"This is a legitimate debate to have."
Classic Obama-speak, a present-tense declaration. This may work when Mr. Obama is on offense, but they’re far more telling when he’s playing D. When a defensive Mr. Obama says these things, he typically means the opposite. He doesn’t think this debate is legitimate, he thinks it’s disruptive. What’s more, he knows and anyone who watched them know they were anything but a legitimate debate. They were scripted events full of sympathetic audiences asking softball questions. There was no clash over any meaningful ideas.

When you’re forced to say something as inherently healthy as public debate is “legitimate,” you’re in trouble. Tiffany doesn’t have to advertise that it sells genuine diamonds.

"I just want to be clear what this debate is about."
This is another example of the president meaning the exact opposite of the words that just came out of his mouth. The last thing Mr. Obama wants to do is be clear as to what the debate is about. He might as well say, “Let me make sure I have sufficiently clouded the issue so that you think this is about health care and not about a takeover of 20% of the national economy.”

"There's been a lot of misinformation."
Misinformation is when the other side says something you don't want to hear, when the opposition brings up -- to borrow a phrase -- an inconvenient truth. Such as the fact that an overwhelming majority of Americans are completely satisfied with their health care. (And a growing percentage are growing ever more disillusioned with Obama’s policies.)

"I just want to be completely clear about this; I keep on saying this but somehow folks aren't listening."

So it turns out it’s pretty easy to wave to adoring crowds during a campaign. It’s a lot harder to persuade the opposition once you’re in office. The problem here is that this new president, when put on the defensive, shows he is completely out of touch with the mainstream. The folks can hear you just fine. It’s not that folks aren’t listening, it’s that they disagree. That is, after all, their right.

After all that -- and much, much more -- Mr. Obama seemed slipped up. No one reported it, of course, but he did utter one completely true sentence, one that could be taken at face value. It was this president’s favorite opportunity, the teachable moment. "If you just believe the government shouldn't be involved in health care, period, then you're right that you can't support the kind of reform that we're proposing."

Andy Obermueller lives in Austin.

Check the Fine Print on the Bailout: It Has Some Good News

2008-09-29T08:24:00.000-05:00

No one ever gives anything away, not even the federal government.

If you think the $700 billion bailout amounts to a mere windfall for the idiotic risk-management practices of a few, consider: Banks must give the federal government common or preferred stock to participate in the rescue. No CEO wants to be the guy who took "free" money and further eroded shareholder value after an already lousy year, which issuing new shares or preferred would certainly do.

Bear in mind also that the government is actually getting something for your money in this deal: Mortgage-backed securities. Just because these assets are too toxic to trade (right now) doesn't mean that they aren't performing. They are. These assets might not be saleable, but they're still earning money. That's because most homeowners are in fact paying back their loans. The feds will use this cash -- billions of dollars in interest payments -- to either buy more mortgage-backed securities or simply to recoup our investment.

The government's main asset in this deal isn't cash, it's time. It doesn't have to please or at least placate Wall Street like public banks do. Uncle Sam can afford to wait things out -- and I wouldn't be the least bit surprised if the secondary market for these assets reappears. Soon.

I also think you'll start to see ads in the Wall Street Journal in short order from banks advertising the fact that they are NOT participating in the bailout.

Watch List: National City

2008-09-28T12:41:00.000-05:00

So it looks like we have a deal. Policy-makers, doing the job they're paid for, have created a compromise plan to bail out financial markets.

The rescue is too late to save Washington Mutual, which was seized late Thursday by federal regulators. That news sent its stock to the floor. It also did a number on Ohio-based National City.

NCC lost -25.7% Friday to close at $3.71. The shares have traded between $2 and $27.21 for the past 52 weeks. Shares are down -77.5% year to date. I think they're a buy. Here's why:

(1.) Banks make money by lending. That's also how they lose money. NCC's "classified" loans total $3.7 billion, or about 3.2% of NCC's total. These are credits more than 90 days past due.

Every bank has classified loans, even in the best of times. To cover these losses, bankers set aside cash in a reserve fund. NCC's loan-loss reserves, according to the latest data from the FDIC, total $3.4 billion.

Not every classified loan will go bad. In fact, the FDIC's Quarterly Banking Profile for the period ended June 30 says the net chargeoff rate for banks with more than $1 billion in assets was 1.32%. NCC's reserves are higher than that -- it can cover 3% of its loans, or 92.6% of its classified loans. So if every classified loan goes bad, NCC will need to come up with $316 million to cover them.

National City can do this very easily: The upside to having 3% of your portfolio classified is that 97% is not. Those loans are still earning interest. Consider: $112 billion at 8% earns $9 billion a year in cash. Even if the cost of funds behind those loans -- what it had to pay to borrow the money to lend it -- is 5%, or $5.6 billion, then NCC is still turning a gross lending profit of $3.4 billion, and that's before it earns a dime in fees.

(2.) National City has no option-adjustable mortgages on its books. These loans allow borrowers to pay less than their full monthly interest payment, and they've caused banks no small amount of consternation. Anyone worried that NCC is the next WaMu should write this down: WaMu's option-adjustable mortgages alone were larger than NCC's entire mortgage portfolio. WaMu made billions in loans and let borrowers pay no interest. Smart move? You be the judge.

(3.) NCC has a huge stake in Visa it could sell to raise cash -- in fact, it has very strong assets. And they're selling for very cheap -- NCC is trading for a fifth of its tangible book value. Its market cap is $2.9 billion. From a purely fundamental perspective, this bank strikes me as being worth more than that -- and that was true with or without a bailout.

Those are all good reasons to buy these shares. But this is a market where good reasons won't get always you very far. Nevertheless, NCC presents a potentially good short-term trade: Assuming a sub-$4 entry point, I like the idea of a laddered exit prices of $4.75, $5.50 and $6.25 covered by a trailing stop to contain downside. Granted, that's academic if the shares open at $8.25, and that's not out of the question as Wall Street responds to the bailout. With any luck, it won't be signed into law until Tuesday, and National City will drop back down to $2 in the interim. Hey, I hate to be a greedy bastard, but I do have an obligation to shareholders.

A rising tide lifts all boats, and the bailout is sure to bring back investors who sold off on Friday. We'll see…

The Case for Netflix, Part 1

2008-09-21T12:50:00.001-05:00

Boss Hoover smelled trouble.

The automobile was on the rise, and Hoover he knew it was only a matter of time before his profitable Ohio saddle shop would go on the wane. His sickly tinker of a cousin, James Murray Spangler, had recently taken out a patent on a gizmo he'd invented to help him clean the department store where he worked. Hoover bought the rights to the machine in 1908 and went on to make the vacuum cleaner an essential household tool.

True story.

Hoover had the vision not only to foresee that his saddle shop would falter but also to exploit a new technology. When I think of Hoover, a similar episode comes to mind. In this case, a company that remade a failing industry, then lassoed a developing technology to enhance its strong competitive advantage and position itself to dominate its market.

That company: Netflix.

I'll soon begin a series about this company, which has proven adept at seeing the future and profiting from it. The video-rental company, which mails movies to customers on a subscription basis, foresaw the widespread adoption of the DVD and then revolutionized the way America rents movies, much like iTunes changed how people buy music (and how Amazon's Kindle will change how people buy books).

Netflix took everything that was wrong with conventional movie rental and leveraged it to its advantage. It countered the inconvenience of a round trip to the video store with
free home delivery and return. It didn't just eliminate late fees, it gave customers total pricing control. It built a vast library of movie titles that no brick-and-mortar competitor could match, and then it developed a proprietary system for suggesting movies for its customers. You don't need a membership card. You don't need cash. You don't even get a bill -- payment is automated.

Have you ever met a brand ambassador? Someone so sold on a product that you can't get him to shut up about it? Some people feel this way about their iPhones or BlackBerries. The zeal of the Netflix user comes close.

And, in that vein, the only figure I could find that was higher than Netflix's customer satisfaction rate was the performance of its stock. The company incorporated in 1997 and sold shares to the public in May 2002 for $7.72. They now trade for $32, a gain of +314.5%.

Hoover saw the writing on the wall about the advent of the automobile, and he realized the potential of his janitor cousin's contraption. Netflix, similarly, foresaw the adoption of the DVD and had the vision to change the way people could rent movies. And it is doing it again. Netlfix knows video-on-demand is next. And the company has begun to position itself as a market leader of this new technology. As competitors like Blockbuster are scrambling to catch Netflix in rental by mail, Netflix is partnering with manufacturers to build set-top boxes that will allow downloads on demand. Netflix's real revolution -- and real financial performance -- hasn't even started yet.

I'll lay out my case for this longterm play over the next few days. Stay tuned.

Closing MER

2008-09-18T09:11:00.001-05:00

I sold all my MER shares for $27.05 about an hour into the trading day.

I bought this stake on the premise that the firm was undervalued on Aug. 1. I still think it is, but that just means Bank of America got a good deal, not that a better offer is possible.

I paid $26.85. As Merrill began to slide last week it dipped my "floor" price, and I doubled down at $19.43. Over the weekend, when everyone -- including me -- expected, BAC to make a run for Lehman, it instead bought Merrill for $29 a share in an all-stock deal worth $50 billion.

BAC subsequently took a little hit, so MER's shares didn't rise to the merger price, as is typical in cash deals. The stock has since seen extreme volatility.

I may well have sold too early, but trying to buy every bottom and sell every top is a fool's errand. Sometimes brass means having the presence of mind to walk away with a profit.

And I did, ahem, make +16.9% in 49 days, and that ain't bad.

The Successful Investor

2008-09-18T09:11:00.000-05:00

Last night I ate at a barbecue joint. I'm fond of this place. They don't have plates and you sit at metal folding chairs around long tables that both remind me of the parish hall of the church I attended as a kid. It's a family place where families eat. I held the door open for the woman behind me. Wouldn't have seemed right if I hadn't. That kind of place.

I typically eat with an exceedingly literate and well-informed companion -- The Wall Street Journal. The paper's news was exceedingly grim. I pushed it aside and sat back to think about the day. Friends had called and emailed to ask what I thought, what they should do. Some I told to do nothing. Some I told to start buying. The right thing to do in this market is what you feel most comfortable doing.

Come to think of it, that's the right thing to do in every market.

We're hearing a lot about the business of risk these days. It's been around for centuries, but now it's on page one. We hear the people on the news try to say "credit default swaps" and "delevering" as though they've been saying them for years. They haven't been, of course, and they're clearly not comfortable with the terms.

But you don't have to understand these terms to be a successful investor.

You do have to understand what the term successful investor means.

It doesn't have anything at all to do with beating the Street, earning X return or timing the market. It's wholly unconnected from your account balance. Being a successful investor means you can sleep at night. It means you've put your money into securities that you understand and have confidence in -- and that's the sort of advice I try to give. And when the financial waters roil and the Journal prints articles vaguely suggesting an imminent financial apocalypse, what do you do?

Well, I went to eat barbecue and watched a little baseball on TV.

Treasury Secretary Hank Paulson and Fed Chair Ben Bernanke, among others, aren't getting a lot of sleep or time off these days. Nor are their counterparts in Japan, England and the rest of the Group of Eight. That's as it should be. Together, those men and nations have the tools to stave off a meltdown -- not a crisis, but a meltdown -- and the smart move is to sit still and give winds and tides time to change.

That's my take, and this: A weekend off is going to do a lot of good.

In the meantime, I'm doubling down on CIT.

"It Was Funny the First Time" Dept.

2008-09-11T10:52:00.001-05:00

Citigroup downgraded embattled Lehman Brothers today, from "buy" to "hold."

As with its recent move to remove its "buy" rating from failed Fannie Mae and Freddie Mac, Citi's Lehman downgrade not the most prescient call. After all, Lehman shares have lost -92.5% for the year. Was this is first time it thought, "Yunno, this might be a good stock for our customers to get out of."

Upgrading Lehman from "buy" to "strong buy" actually would make a lot more sense. Heaven knows I'm tempted to grab some of this storied company at this insultingly cheap price.

"Yeah, But You Heard It Here First" Dept.

2008-09-10T15:33:00.000-05:00

Banc of America Securities upgraded its view of American Eagle Outfitters shares from "neutral" to "buy."

Analyst Dana Cohen credited "offensive" promotions (I presume that means "aggressive") and conservative inventory management. Her new price target is $20.

"Gee, Thanks a Lot" Dept.

2008-09-08T14:40:00.000-05:00

The genuises at Citigroup and Lehman Brothers downgraded Fannie Mae and Freddie Mac this morning.

What makes this particularly egregious is not that this downgrade is so obvious, it's that Citigroup had a "buy" rating on both companies. Lehman rated them "overweight."

That's like saying it might not be a good idea to buy a ticket on the Titantic's next voyage -- after she had already sunk! "Tulips? Yeah, they look like a pretty good investment to us, duh..."

Not everyone on Wall Street was so bloody stupid. Merrill Lynch, for one, was at least neutral. That's a defendable position. Neutral means, "We'll see." But a buy is simply inexusable, and a serious blow to both outfit's already reduced credibility.

I Love the Smell of Opportunity in the Morning

2008-09-05T10:54:00.001-05:00

The unemployment numbers this morning didn't help anything, and Wall Street is taking it on the chin. For serious investors, though, it's time to quit whimpering, get off the damned sidelines and start looking at the down market as the good thing it is.

The stocks I've chosen haven't plunged, but they've given back some of their gains. So if you failed to heed my advice on these companies, now is a great time to correct your lapse in judgment.

Consider this market's aggregate buying opportunities. Of the 30,000 or so equities that trade on U.S. exchanges, 4,000 of them are down more than 40% so far this year. That's almost as good as the end-of-season blowout at the Polo store -- and some stocks have declined to the point where even that sale looks pricey.

These drops hurt. I understand that. I've had friends retire as the market bled, and that's noting to make light of. Certainly I remember what 2001-2003 felt like. But Wall Street always bounces back after a decline. (See the S&P performance table in Buffett's annual shareholder letter.) And if the market fails to bounce back, then, hell, your portfolio is the last thing you need to worry about.

The Dow shed 344 points yesterday and is off another 100 points as I write this. I'm not at all concerned. I feel like Gen. George S. Patton Jr., strolling through enemy territory on a French battlefield in World War I, dodging shells as I check my beloved tanks' progress. Just a nice night for a walk...

Those tanks, the eight stocks in my portfolio, have held up extremely well during this past two-day drop. In fact, they remain in positive territory. They are up an average 2% since I bought them last month versus a drop of more than 3% for the S&P. This gap is only going to get wider, as investors come around and begin to see the true value of these outstanding companies.

Two Stocks on Sale

2008-09-04T10:23:00.000-05:00

I took a spin through the bargain bin this morning to see if any interesting companies had hit 52-week lows. I love doing this.

Here are two I like:

Corning
The glassmaker is trading at less than five times earnings. It cut its 3Q profit outlook and Wall Street couldn't sell Corning fast enough. Shares fell the most they had in two years. But here's what the company said: Earnings per share (ex items) will be between 43 cents and 45 cents a share on sales of $1.58 billion to $1.62 billion.

Hmm. Those look like decent numbers to me, especially when you consider that its previous forecast was a profit of 48 cents to 51 cents on sales of $1.65 billion to $1.72 billion. Even the worst-case revenue number is better than last year. Lots of companies would be thrilled with just being able to use that color of ink.

Shares closed Friday at $20.54 and are currently at $16.75., a drop of 18.4%%. Even if profit comes in at the low end of Cornings' revised guidance, that still only a decline of 11% on the bottom line. The market has overreacted to this news, and this presents a good buying opportunity.

iShares MSCI Taiwan
I recently wrote about Harvard Management's Co.'s addition of 7.2 million shares of iShares Taiwan, a stake worth $102 million and equal to 3.2% of Harvard's publicly reported portfolio. Shares of this exchange-traded fund (Ticker: EWT) are at their 52-week low.

Not surprisingly, the market this ETF tracks is also in the toilet, having lost 24.6% so far this year. It is also at its 52-week low.

Now, lest you think I'm recommending a purely "technical" move, let me add this: The TAIEX is trading at 10 times earnings. Taiwan is expected to post 4% annual growth through 2012. The Standard & Poor's 500 Index, the U.S. benchmark, is trading at 25 times earnings -- and we're only going to see 2.5% annual growth through 2012. Taiwan is cheap, and this ETF is a shrewd play.

An exchange-traded fund acts like a mutual fund but trades throughout the day like a stock. It's a great way to participate in the Taiwan market, which you otherwise wouldn't be able to access without a bunch of hassle and a shitload of fees. You can buy EWT using a discount broker like Scottrade.

Portfolio Update

2008-08-29T11:37:00.000-05:00

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

2008-08-29T08:38:00.000-05:00

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.

Screen Result No. 3: Valero

2008-08-28T09:05:00.000-05:00

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.

Screen Result No. 2: American Eagle Outfitters

2008-08-27T13:06:00.000-05:00

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…

Screen Result No. 1: Best Buy

2008-08-26T08:25:00.000-05:00

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.

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

2008-08-23T13:56:00.000-05:00

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

Lessons Learned

2008-08-22T11:03:00.000-05:00

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.

The Bank Job

2008-08-20T07:40:00.001-05:00

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.

A Harvard Education

2008-08-19T09:14:00.000-05:00

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.

"No Money"? No Problem

2008-08-15T08:35:00.001-05:00

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.

The Myth of Investor Understanding, Part Two

2008-08-13T21:15:00.000-05:00

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

2008-08-13T08:52:00.001-05:00

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.

Portfolio Update: A +9.03% Return

2008-08-11T16:56:00.000-05:00

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.

Fund Watch, No. 1

2008-08-10T17:45:00.001-05:00

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.

The Fifth Portfolio Pick

2008-08-08T10:00:00.000-05:00

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

Portfolio Pick No. 4: MGM Mirage

2008-08-07T09:07:00.001-05:00

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.

It's Fun to Be Right

2008-08-06T11:41:00.001-05:00

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

2008-08-06T10:07:00.000-05:00

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.

Portfolio Pick No. 2: CIT Group

2008-08-05T09:20:00.000-05:00

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.

The Revolution is Just a T-shirt Away

2008-08-04T09:23:00.000-05:00

The Economist's recent article outlining Vladimir Putin's continued efforts to strongarm Russian business leaders was published July 31. That was, ahem, two days after mine.

On Aug. 1, Russian President Dmitry Medvedev outlined a plan to tackle corruption that analysts think could define his administration.

Incidentally, a Russian court has scheduled an early-release appeal hearing for jailed oil tycoon Mikhail Khodorkovsky for Aug. 21, a clerk said today.

Power to the people, y'all.

Portfolio Pick No. 1: Merrill Lynch

2008-08-03T13:55:00.000-05:00

I'm fond of bear markets for the same reason I like to visit Brooks Brothers at the end of the season: It's the perfect time to score a ridiculously good deal. And, like the timeless elegance of Brooks, a fat triple-digit return never goes out of style.

I once bought a green camel-hair sportcoat for $99 that I had tried on and nearly bought when the price tag read $575. There are tons of bargains like that in today's market. In fact, I think investors have a far better chance of inking 100% or 200% returns in this market than when times are "good" -- whatever that's supposed to mean.

To that end, I'll post five picks this week, one each day. These are my "Deep Discount" value picks. Each of these companies have been shellacked by the market and are on the sale rack. They're suitable for shorter-term trading, and when they hit my price target, I'm out. (If they drop beneath a certain level, I'll either double down or close the position.)

Later, I'll reveal five other buys for investors with a longer time frame.

Today, let's talk about Merrill Lynch, which is my first pick. Shares are down 50% year to date and are 66% off their 52-week high. I've assigned MER a $53.65 price target, or an even 100% higher than its $26.81 close on Aug. 1. Merrill's an outstanding buy to $30, a great deal to $40 and even at $50 the shares would be trading for less than their fair value. Merrill's 52-week high is $79.72, so I'm not trying to take you up a road the Thundering Herd can't climb.

Merrill Lynch is a beacon of global capitalism. It's a city on a hill; a pillar of the American financial system. (If they had a theme song, I would play it here.) It manages $1.6 trillion in assets, which is more than one-tenth of this nation's annual gross domestic product. Merrill is a great company, the third-largest securities outfit in the country, but it's languishing, along with many of its brethren, in a tepid economy and global credit crisis caused by a meltdown in subprime mortgages.

John Thain, the firm's chairman, has been the subject of intense hurumphing since he agreed to sell $30.6 billion worth of CDOs last week for a measly $6.7 billion.

CDOs are collateralized debt obligations. They're bonds backed by assets, in this case a whole bunch of mortgages. These loans (ideally) generate cash from borrowers' monthly house payments, which pays back the CDO holders over time. If those homeowners default, the CDO loses value.

You know where this is going. The housing market is in the toilet and lots of people are defaulting on their mortgages -- at least, more people than usual. At the end of June, not six weeks ago, Merrill said its CDOs were worth $11.1 billion. Now, that's roughly $20 billion less than their original value. But Thain sold them for $6.7 billion, or 22 cents on the dollar.

Thain took decisive action, ate the loss and moved the most problematic asset off Merrill's books. If a drunk won't sober up, then you've got to throw the fucker out. That's what Thain did, and half of Wall Street has been excoriating him for it. In three years, he'll be giving lectures on the move to MBA seminars at the Wharton School.

But Thain's real coup de grace came a few days later, when Merrill sold stock at $22.50 and Thain, bless him, bought $11.3 million worth. A host of other executives joined in.

When executives sell stock, it's time to leave. Thain & Co. bought. Wall Street skeptics have been wondering when Thain will signal that the worst is truly over for Merrill. And to be sure, he has made those sorts of comments before -- nine times, by one count -- only to come back and say, "Oh, and another thing."

But friends, that's over. Merrill's going to be all right. Thain just said so 11.3 million times. He'll make $10 million on the deal, and he deserves every dime. I'm awarding Thain and every Merrill Lynch executive who cast their lot with him honorary brass umlauts with a fig leaf cluster.

But investors should never confuse the CEO with the stock. Thain could get run over by a Maybach tomorrow and Mother Merrill would be just fine. I hate to be an asshole (OK, so I don't, really), but such as unfortunate turn of events would probably do wonders for the shares. I'm not sayin' that's right, I'm just sayin' that's where we are right now.

A stock isn't just a certificate that sits in your safe-deposit box. It represents a business, and you've got to think like an owner of that company. So while the CEO has to be considered when you evaluate a company, its business and its assets are far, far more important. CEOs come and go, but balance sheets are forever. Or something.

As I noted, Merrill closed at $26.81 on Friday, which means the market valued the company at $26.4 billion. That is too low. That is a fire-sale price. Merrill's brokerage business alone is worth $30 million, and that's if you value it vis-à-vis its peers, without assigning it a premium for being the market leader.

So are we buying a $30 billion asset for $26 billion? That's not a bad deal...

But wait, there's more. Merrill's stake in BlackRock is worth $10 billion. Its private-equity investments are worth $5 billion, and its merger-advisory service is worth $3 billion, according to Morgan Stanley. That gets us $48 billion worth of assets for $26.4 billion. (Plus it has $36 billion in shareholder equity on the balance sheet, which ain't exactly chump change.)

Thain, who did a stint at Goldman, is smart. I think he's good for Merrill, but this is really as asset play. Merrill is grossly undervalued. The market will -- eventually -- get past subprime. The market, indeed, will get past subprime faster if other institutions follow Merrill's lead and relegate the issue to the past tense so we can focus our energy on bitching about gasoline prices.

I'll re-evaluate this pick if Merrill drops below $22.

How to Save Starbucks, or, "It's the economy, stupid"

2008-08-01T10:24:00.000-05:00

Today is the birthday of the first great American novelist, Herman Melville, and in honor of his masterwork, Moby-Dick, I'm going to write about Starbucks. (If you do not, alas, understand the connection, then our public school system has failed you. Click here.)

Starbucks is off 28.2% for the year. Its nearest competitor, McDonald's, has managed to eke out a 1.5% gain for the year, which ain't too bad in this market. Starbucks, for its part, has announced it will close 600 underperforming stores, and the costs associated with that move led to the company's first quarterly loss, posted yesterday. The red ink, which came amid a $200 million increase in revenue, amounted to a nearly invisible $6.7 million -- more symbolic than anything else.

Wall Street's open for business every weekday. It picks up on symbolism and it doesn't take much of it to give investors a reason to sell, especially these days.

There is a very simple reason these shares are down. Management hasn't figured out how to respond to softening consumer demand, and investors have lost faith. Starbucks executed its explosive growth well -- and investors who have held shares for 10 years have done pretty well -- 25% annualized returns. But the company hasn't been able to stay ahead of the day-to-day macromanagement curve.

Now, I'm willing to give credit where it's due. The store closures were a painful defeat, but they were a good move. An executive shakeup that's in the works already may prove worthwhile, too. And efforts to reduce nonstore headcount by 15% is also wise. The jobs section of Starbucks' Web site lists no open executive positions. That's good.

But if this is the entire turnaround plan, Starbucks is screwed. As smart as these moves may be, they can only be considered a good start -- they just don't go far enough.

Since 1998, Starbucks investors have seen per-share earnings and revenue increase an average of 25% a year. To accomplish that this year, Chief Barista Howard Schultz needs to add $2 billion to the top line. So that $200 million revenue bump was really only 40% of what was needed.

Bloomberg says analysts are forecasting per-share earnings of 74 cents. That would be the fourth year in a row earnings growth has slowed and would translate into a more-than-symbolic loss: It would mean earnings declined more than 15%. That's why Starbucks shares are already down more than twice the S&P 500.

Starbucks executives clearly need to do more, because even despite its abysmal performance year-to-date, Starbucks still has a lot of room to fall. Its earnings multiple, at 19, is still higher than McDonald's, which is kicking ass even as Starbucks gets its kicked. I don't think that Schultz is really in touch with what dramatically increased energy and food prices are doing to consumers discretionary spending. He says the store experience is paramount and he won't compete on price.

Here's what he said in a conference call yesterday after one analyst asked about some kind of value or combo pricing:

"We have no intention of doing things that would dilute the integrity of the premium position that Starbucks occupies, and what I mean by that specifically is we are not going to go down the fast food lane and do things that are what I believe not in the interest of, long-term interest of the value of the brand and the experience. We’ve been testing a number of initiatives in many markets over the last I’d say two months or so, and some of those initiatives are proving to be interesting. We’re gaining as much insight as possible but you are not going to see us bundle product in a way that would be consistent with fast food."

This will be Starbucks downfall. If Schultz can’t grasp that high prices are in no way part of the vital Starbucks experience, then he needs to step aside and let someone else save the company. A chief executive, trial lawyer or general must know that all options are always on the table.

If customers are coming in because of high price, you can't just wait until they can afford to come back in on their own, because they'll either find someplace else to get a similar experience, or they'll realized they can live without you. Those sorts of problems can impact annual revenue, not just quarterly results.

Here's my take on righting the Pequod:

Refine the mission.
The Pledge of Allegiance has 31 words. Starbucks mission statement has 109. Customers aren't brought up until the sixth sentence. Profitability is the last thing mentioned. The current mission is all about playing nice and making great coffee. Well, bullshit. To quote Bob Sugar, "This ain't sho' friends, this is show business." The new mission should be three words: Sell more coffee. Everything else will take care of itself. It's already part of the corporate culture anyway.

Cut costs.
McDonald's and Tim Horton's operating margins are 24% and 20%. Starbucks is 10%, half what it ought to be. Reducing headcount and closing stores will help a lot here, but I say turn up the thermostat two degrees and cut part-timer's benefits if that's what it takes to turn a bigger profit. Again, everything has to be on the table.

Announce a buyback.
Starbucks shares are a bargain! Well, maybe not. But putting your money where your mouth is can make people believe that. Starbucks could tighten its cash conversion cycle and use come of the $280 million in cash it has on hand to buy back shares. Wall Street tends to like this, and in the long term it can do a lot to boost earnings. SBUX has 700 million shares out. It could buy back 1% of those with no sweat.

Focus on revenue.
This is the most important, and it means cutting prices. Then, advertise it with no fine print. Then consumers think: "Whoa! You're cutting the price a buck? Hey, that's a good value! I get the Starbucks experience for a reduced price? You know, I haven't been there in a while -- a little short on folding money there days -- maybe I should drop in. Everyone else is raising prices."

Coffee is a volume business. I'm no expert in economics, but I'm pretty sure that I'd rather sell 1000 lattes for $3 than sell 200 for $4. Also, if I feel like I'm not getting hosed on the coffee, I'm more likely to buy a slice of that lemon pound cake.

If Starbucks really, really can't stomach an actual price cut, then it should use its rechargeable Starbucks cards to create some sort of value. Buy a $100 card, get $125 worth of credit, that sort of thing. These cards are very popular. And -- to be fair -- Schultz did hint about this in the conference call.

Starbucks needs a major shift in managment thinking to focus less on experience and more on revenue. Revenue is the rising tide that will lift all boats. If people aren't coming the the store because the prices are too high, then experience isn't just moot, it's nonexistant.

Mr. Starbuck questions the captain's judgment in Moby-Dick. It's time for Starbucks' board to do the same with its captain. Admittedly he has made some good steps. But I fear Schultz thinks he has had the entire vision. Until price is no longer sacrosanct, he hasn't.

And Schultz shouldn't be so quick to disparage fast-food. Their stocks are doing better, their sales are higher, their earnings are stronger and, in the case of McDonald's, they're taking your market share. Oh, and how are they doing it? Offering the McDonald's experience, or some such pretentious bilge? No. Turns out they're selling premium coffee at a reduced price point. Pretty smart. Take a lesson.

Buy Buffalo Wild Wings

2008-07-30T16:31:00.001-05:00

Restaurants come in two flavors: They either lose a fortune or make a mint. It's hard to tell which outcome is most likely just by eating the food. Bennigan's, for instance, was decent pub fare but a lousy investment, at least if you believe the Chapter 7 filing. Great places to eat can be lousy, cash-bleeding businesses, while eateries you might not trust to pour you a glass of sink water stack up fat profits.

Even a popular restaurant can go from one extreme to the other almost overnight, and this makes restaurants a fickle (Read: "volatile") sector. The risk for many is that their earnings will stall before they have repaid the cost of their fast growth. The risk for some others is that they can manage growth but can't manage operations. After all, it's easy to please Wall Street with ever more revenue as long as you're opening stores. Take Starbucks. And even a great restaurant that's well run can find itself in dire straits if customer tastes change and its food falls out of favor.

Yet despite the massive capital needs, commodity risk and the vagaries of catering to the public's ever-changing taste, restaurants are a gigantic business. The National Restaurant Association pegs total sales at $558 billion. Nearly a million U.S. eateries serve 70 billion meals in a year and rack up 4% of the nation's gross national product. Growth is expected at 4.4% in 2008, far more than the estimated 1.5% growth in the broader economy.

The Bureau of Labor Statistics has determined the average American spends a little less than 11 percent of after-tax income on food. In recent years, the amount of cash spent on dining out has been increasing at a faster pace than total food expenditures.

Average spending on food has more than doubled from $1,320 in 1984 to nearly $2,700 today, a rate of increase faster than the overall rise in consumer prices during that time. Spending has accelerated at a particularly rapid pace since the mid-1990s. In fact, growth has accelerated from an annualized pace of about 2.6% from 1984 through 1994 to about 3.9% annualized since.

Even better, the restaurant business is relatively defensive during economic downturns: Dining out is one of the last areas consumers cut back on. If things are tight, you might not splurge on a new flat-screen, but you might take the family out to dinner as a treat instead. During the last U.S. economic slowdown, from 2001-2003, consumer spending on food away from home only dropped for a year, then quickly hit a new high in 2004 as Americans started to feel more flush.

With absolutely none of this in mind, I recently ventured out to 50-cent wing night at a Buffalo Wild Wings restaurant that had just opened. The price was right, so I left the office at five with my usual dinner companion, the Wall Street Journal. My perfect dinner party is two -- me and an attentive waiter.

I had been to a Buffalo Wild Wings store before, and the new restaurant was a carbon copy. It was a relatively large, stand-alone building. The parking lot, which had looked oversized while the building was being built, was full. There was a wait for a table -- this on a Tuesday night during the school year -- so I opted to sit at the bar, where there was no wait. I scanned the menu. The bartender asked me for my order, and I told him I wanted to start with eight "Blazin' " boneless wings -- their hottest -- and I opened my paper and started to read.

"I can't do that," he told me.

"I beg your pardon?" I said, looking up.

"I can't bring you eight Blazin' wings, sir. That'll put you in the hospital." He looked grave.

"Oh, c'mon." It was the best argument I could manage.

"No way," the kid said. "One, maybe. But I've never seen anyone who could handle eight."

"Don't worry about it, junior. Eight Blazin' wings."

"Well, I better bring you something to drink, then. You want a beer?"

It was either a test of my manhood or this young hustler was trying to upsell me a little high-profit draft beer with my low-margin wings. I wasn't about to cave on the wings, nor do anything to impede a $4 dinner like spring for a beer. Besides, I eat lunch once a week at a Thai joint that serves absolutely fabulous but thermonuclear food, so my taste buds are acclimated to levels of spiciness that would outright kill the average diner.

"Nah," I said. "I'm OK." He departed with my order. He'll be pushing timeshares in a few years, I thought. Well, good for him.

Presently the wings arrived, and the fumes from steaming, tangy hot sauce hit me like pepper spray at a World Trade Organization protest. I momentarily worried I might be in a bad fix: The kid was watching from a few feet away -- I was surprised he hadn't thought to grab a fire extinguisher. I stabbed a wing with my fork and casually popped it into my mouth. It was spicy, though far from debilitating. I ate the eight wings without breaking a sweat -- and without touching the villainous glass of water that had materialized while I was ensconced behind the WSJ. The bartender, who seemed a little defeated, thank you very much, sheepishly asked if I wanted anything else.

"I dunno," I said triumphantly. "You got anything hot?"

The kid, who had obviously been raised right by his folks and trained well by his managers, said nothing.

"Tell you what," I said, a little conciliatorily. "How about four of those Caribbean Jerk boneless wings? And a Diet Coke, please."

He nodded and said yessir. The wings showed up minutes later.

I am here to tell you the Jerk wings knocked my socks off. Those little firecrackers packed a wallop. I thoroughly enjoyed them, left the up-and-coming waiter a nice tip and headed home.

I was back at Buffalo Wild Wings every Tuesday for the next six weeks, and I came in a few times in between. Their marketing ploy had gotten me in the door and gotten me to come back. I wasn't alone. The SRO crowds abated a little after folks in town had tried the food for the first time, but even 60 days after the restaurant was open, it was tough to just walk in and get a table right way during the lunch or dinner rush, especially if a popular sporting event was being shown on the countless TVs.

BWLD serves other dishes besides wings, which bring in about 36% of sales. Booze is roughly 30% of the top line, and "other," which encompasses a good kids menu, is 35%. BWLD breaks down revenue by time of day, too: Dinner accounts for 39% of revenue; late-night for 26%, and lunch is a fifth of the business. Its average weekly sales at franchise stores are $46.439 -- $2.4 million a year -- which is a 32% rise from 2003, the year it went public. Panera Bread, a popular gourmet sandwich shop that makes its own artisan loaves, is scrambling to boost sales to $40,000 a week.

Buffalo Wild Wings sells food that tastes good in a family-friendly setting with attractive prices at a restaurant that's clean, comfortable and conveniently located. This is a recipe for success in a very competitive business. There are only about 500 of these stores; the company thinks the domestic market can support 1,000 -- or one for every 13 McDonald's. Growth has been more methodical than explosive, and the franchise model reduces the company's per-store investment, so BWLD has very little debt and lots of cash. This is good management. (My favorite fact about the company: Its executives and suppliers have to sign iron-clad confidentiality agreements to protect their sauce recipes.) They've recently -- and wisely -- taken steps to hedge their chicken prices -- previously they just instructed waiters to push higher-margin menu items when chicken prices were high.

Investors have rewarded Buffalo Wild Wings for all of this. A dollar invested in its shares after its November 2003 IPO has grown into $2.88; a buck dropped into the S&P during that time would be worth only $1.31 today. BLWD shares have appreciated 186.7% while the broader market has advanced just 31%.

This puts Buffalo Wild Wings at the head of the pack -- and by a wide margin -- since its shares went on the block. If they could make wings as hot as these returns, I'd be in heaven.

Restaurant Performance Since Buffalo Wild Wings' IPO
Buffalo Wild Wings 186.69%
McDonald's 147.04%
Yum Brands 144.85%
Jack in the Box 127.72%
Darden Restaurants 72.81%
Wendy's 62.56%
Panera 33.35%
S&P 500 Index 30.95%
Starbucks 14.52%
Calif. Pizza Kitchen 12.00%
Brinker (Chili's, etc.) 4.30%
Bob Evans Farms 1.64%
CBRL Group -24.68%
Cheesecake Factory -31.61%
Landry's Restaurants -31.61%
Triarc (Arby's) -34.68%
PF Chang's -50.34%

Prices are from late May.

2008-07-29T16:56:00.001-05:00

And now, friends, a brief look at what's coming up next in Russia.

But first, a quick review:

Alexander Litinenko, a former KGB colonel and outspoken critic of then-Russian President Vladimir Putin, was minding his own business in London when he fell ill. From what quickly became his deathbed, he accused Putin of sending operatives to zap him with polonium-210, a radioactive isotope. Scotland Yard investigated. Her Majesty's security officials are convinced Russian operatives were involved. Relations between London and Moscow have since markedly cooled.

Mikhail Khodorkovsky was the boss of oil giant Yukos before he got crossways with the Kremlin and was arrested on charges of tax evasion and fraud. He was summarily tossed into a gulag, lost most of his fortune and saw his company evaporate. A series of minor and by most accounts trumped up prison-conduct violations have made him ineligible for parole. Khordorksky -- who bought Yukos at a state auction in 1995 for $350 million, was a generous contributor to political campaigns. He had gained control of a prestigious newspaper and hired a serious investigative reporter -- then he was arrested.

Robert Dudley, chief of TNK BP, left Russia last week amid a host of official harassment and worries that his visa would not be renewed. BP is a 50 percent shareholder in the oil venture. Mikhail Fridman, German Khan and Viktor Vekselberg -- Russians worth a combined $45.9 billion -- own the rest and have demanded BP pick a new CEO. What they really want is to be bought off with fat payouts rather than to follow Dudley's plan to invest the cash in developing production. TNK BP is worth about $45 billion and accounts for 13 percent of BP's earnings. Dudley escaped with his freedom and his life, but BP isn't saying where he'll be working from. Wise move.

Now comes word that Putin is at it again. He went after Mechel, a Russian coal and steel concern, earlier this week, alleging it fixed prices. Shares lost more than 30 percent -- which is no surprise given what usually happens when Putin takes aim at a company or an executive.

The wingtips on the ground in Russia don't think that the government will try to give Mechel the Yukos treatment. The Kremlin merely wants the company to hold down steel prices instead of charging what the market will bear and, you know, make money. Russian leaders want to control inflation -- currently at about 13.5 percent -- and this is how they're going about it.

Imagine Ben Bernanke telling Wal-Mart to cut prices or he'd send Henry Paulson over with some heavy hitters to fuck up the place, then throwing CEO Lee Scott in the hoosegow.

Well, that's what's going on here, isn't it? It happened to Khordorkovsky. It happened to Dudley. That's exactly the sort of "pressure" being applied to Mechel, and it's the same deplorable, dirty tactic the Red Thug Brigade recently exerted on food company Wimm Bill Dann, and for the same reason.

Mechel shouldn't have to do as it is told. Mechel should do whatever it jolly well wants for the benefit of its shareholders. Mechel should be able to tell Putin to take a hike. Only the market should be able to dictate prices, period, amen.

Sure, the Kremlin is under pressure to control costs. Well, hey, governing is a bitch. One UralSib analyst downplayed Putin's comments as merely "a firm slap on the wrist for a company that is taking advantage of the high prices to boost its bottom line." Analysts usually like that sort of thing to happen to the bottom line. Welcome to free markets, Vladimir. Why not use fiscal policy and monetary tools to manage your economy? Turns out is works OK here in the developed world.

Putin, doubtlessly in the voice my dad used to use when he would threaten to pull this car over -- has already told Russia's oligarchs what's what. He did it at the first so-called "oligarch meeting" in 2001. And he made the point again after Khodorkovsky was arrested, just to make things abundantly clear. The rule: Big Russian companies have to put national interests above their shareholders' interests, and their plans require a certain social element.

This is immensely ludicrous. No one in the Western world -- with the possible exception of long-haired Berkeley undergrads -- would support this sort of wacko commie horseshit. Cubans in Miami would still -- justifiably -- cut Castro's throat for "nationalizing" their homes and businesses. Zimbabwe's Robert Mugabe was vilified for redistributing white-owned farm land to blacks. This Robin Hood-style approach to economic policy isn't only morally wrong, it also doesn't work.

Anyway, Putin called for an investigation: "I'm asking the Federal Anti-Monopoly Service to pay special attention to the problem -- and maybe even the Investigative Committee of the Prosecutor General's Office," the Moscow Times reports Putin as saying. Whatever. Putin'll send in the hall monitors from Moscow High if he thinks it will get him what he wants.

Igor Zyuzin, Mechel's owner, called in sick. I admire the sheer ballsiness of this tactic.

Putin, for his part, obliquely threatened to put said balls on the block.

"The director has been invited, and he suddenly became ill,'' Putin said. "Of course, illness is illness, but I think he should get well as soon as possible. Otherwise, we will have to send him a doctor and clean up all the problems."

My guess is the doctor Putin has in mind is familiar with what constitutes a lethal dose of polonium-210.

My prediction: Igor will get the what-for, his company will get hosed and shareholders will have to eat the losses. And Putin will keep bullying the oligarchs instead of addressing the roots of the economic problems his country faces.

That's a shame. There are a lot of great companies in Russia. Just don't buy them until Putin is gone.

Incidentally, Mechel's first-quarter net earnings rose 162% from year-ago levels.

Designer Detergent: The Next Big Thing

2008-07-14T15:34:00.001-05:00

My boss has encouraged me to be more forward-looking. He wants us to think about What's Next and figure out how to invest in it. What's the next Google? The next Starbucks? Who's making the next iPod, and where do we buy the shares?

I dunno.

But I do have an idea whose time has come.

Every department store in these United States has a couple of dozen Ralph Lauren fragrances.
You can also buy Ralph Lauren towels. But you can't buy anything to make your towels smell good. For that you have to use Tide.

Now, even though Tide is admittedly the Rolls-Royce of laundry detergents, it still strikes me as hugely downmarket. So is that damn Snuggle bear.

Surely Ralph Lauren can come up with a laundry detergent that smells perfect. My flannel sheets would afford me a better experience if Martha Stewart sold a detergent that made them smell like Christmas. Even the cleanest sheets would seem all the more fresh were one to toss them into the dryer with an Hermes D'Orange Verte dryer sheet.

I once dated a girl in New York who worked for International Flavors & Fragrances. I told her this idea and she said it would never work because fragrances are divided into consumer and industrial uses, or some such that basically struck me as, "No, that's not the way the industry does things."

Which is, of course, silly.

The thing is, Tide isn't any better than the stuff you can buy for a tenth the price at Sam's. It does exactly the same thing. I'll admit that Dreft makes a difference for babies, but other than that, all detergents are the exact same, other than the way they -- wait for it -- smell. Tide sure as hell knows that. Its manufacturer, Procter & Gamble, is banking, wisely, on the fact that consumers will pay a premium for the perceived safety and quality we associate with our mothers' brands.

I hate spending $17 on a box or bottle of Tide. I don't get anything for the money that I don't get with a cheaper brand. And I don't care what my Mom used, as I know that the real reason the sheets smelled good when I was a kid is because she hung them outside to dry. Still, I don't have a clothes line, and I might well spend twice the amount on the same quantity of a designer detergent if it smelled Just Right.

That is, of course, also very silly. But I'd do it and I'd feel good about it. When a company can get its consumers to say that, it won't be too long before the trucks carrying profits start dropping off piles of cash at the bank. Because you have just come up with The Next Big Thing.