Monday, December 31, 2012

Happy New Year!

Though I am no longer managing a mutual fund portfolio, I continue to enjoy opining about investing through writing this blog.  I hope readers find it useful in making investment decisions, whether as professional investors or as amateur investors trying to grow--and protect--one's own portfolio.

This was a year when putting a portfolio in a stocks and bonds using index funds would have produced an excellent risk-adjusted return.  I expect that next year will not be so straightforward and that such an approach will yield much more modest returns.

Bonds have continued to produce amazing returns (except for U.S. Treasuries, finally).  High-yield bonds (actually more like equities than fixed income) and other corporate bonds have been excellent investments in recent years.  The need for investment income has pushed yields to such low levels that further declines in interest rates (which produce capital appreciation in bond portfolios) seem unlikely.

Despite the likelihood of a modest increase in tax rates on corporate dividends, there still are a number of high-quality stocks that have dividend yields that are higher than those on U.S. Government bonds (and shorter-term corporate bonds).  I still think the attractive starting dividend yields and likely dividend increases are attractive for investors who need some income from their investments.

After sharp gains in stock markets over the past six months--and even sharper gains over the past four years--I advocate holding some cash on hand for selloffs (and potential buying opportunities) that may arise.

Best wishes for a healthy, happy, and prosperous New Year!

Steve Lehman

S & P 500:  1405

Sunday, December 30, 2012

Stocks: Too High to Buy, Too Low to Sell

There often are times when the odds do not favor widespread buying or selling in the stock market.  That happens when indicators of valuation, price trends, and sentiment are mixed.  Stocks are not extraordinarily cheap or expensive.  Price trends are not notably depressed (and likely to recover) or sharply higher (and likely to decline).  Investor sentiment is neither gloomy (a good time to buy) nor ebullient (a good time to sell).

At such times, one needs to focus on individual stocks that are reasonably priced or on themes relating to a particular market sector or societal trend.  I think today is such a time.

I still find a small number of stocks that are attractively valued (VOD, AGXXF, AAPL, MOFG, KSS, FDP).  In general though, after the sharp rebound since June of this year and the doubling of major stock indexes over the past four years, I urge caution when considering making large new stock purchases.  This is despite a likely rebound in stock prices if elected officials in Washington make meaningful progress on spending and taxes.

Steve Lehman

S & P 500:  1402

Thursday, December 20, 2012

Depressed Assets After a Strong Year

In a year with significant gains in most U.S. stock prices as well as in other asset classes like corporate bonds and emerging market bonds, where can a contrarian look for depressed assets?  Gold and gold equities would be a place to start.

Though I wonder whether gold's 12-year bull market has ended, from a trading standpoint I think it is worth considering gold and gold equities.  The gold price is approaching oversold levels with fairly wide pessimism among market participants.  Gold equities are even more depressed, with several leading gold equities selling at 52-week lows, at a time when most major stock indexes and leading companies are selling near 52-week highs.

I have serious concerns over the social and environmental costs of gold mining.  Those who do not have those concerns might consider a trade in the SPDR gold exchange traded fund (GLD) or a stock like IAMGOLD (ticker:  IAG).  IAG has fallen 32% in the last three months, and it has net cash on the balance sheet and is trading for close to tangible book value per share.

Steve Lehman

GLD:  159
IAG:  11.17

Growing Caution Toward Stocks

The rebound in stock prices in recent weeks has pushed the market in general near overbought territory.  In addition, key sentiment measures reflect a sharp rebound in investor optimism.  

I recommend paring stock positions here, particularly in cases with sharp gains over the past six months.  I always like to have some cash available for buying opportunities, and now is a good time to begin to replenish cash after reaping significant gains.

Steve Lehman

 S & P 500:  1435

Monday, December 17, 2012

Is the Long Bull Market in Gold Over?

Back in 2000, I said publicly that I'd rather own gold than the Dow Jones Industrial Average.  The Dow was more than 40 times the price of an ounce of gold, which the UK government was selling at roughly $250 an ounce.  (At the peak gold price in 1980, the price of an ounce of gold was about the same at the Dow Jones Industrial Average.)  So it seemed likely to me that the Dow Jones and the price of gold would converge in price, not necessarily ending up at 1:1 but moving well away from 40:1.  Indeed, since the end of 2000, stock prices have had only modest gains, while gold rose more than six fold in price.

With gold headed for its amazing twelfth consecutive annual gain, when will its bull market end?  The conceptual case remains compelling, as central bank monetary policies are about as loose as they have ever been.  Short-term interest rates are near zero, and real interest rates (after subtracting inflation) are negative, which historically has been favorable for gold prices.  Central banks have been net buyers of gold for 19 consecutive months.  And it has become conventional wisdom that most investment portfolios should have a small allocation to gold, as a hedge against various negative outcomes.

But the price of gold peaked more than a year ago (in September 2011) at $1,921 an ounce.  It is now 11% below that.  Even though some esteemed investors, such as John Paulson and George Soros reportedly still have large gold holdings, the huge holdings of gold ETF's make me uneasy.  And in the financial crisis of 2008, gold was anything but a haven, as it plummeted along with other asset markets.

I no longer own any gold, partly because of the human and environmental toll that its mining entails.  I think there are more respectable, cleaner, ways to earn an investment return.

I had expected the end of gold's bull market to be marked by an explosive, "parabolic" spike, which hasn't happened yet.  And for gold to reach a new high on an inflation-adjusted basis would require a price of roughly $2,400 an ounce, 40% above current levels.  Either development would provide a large gain to holders of gold.

But I also wonder whether it is time to look elsewhere for an asset market that is underpriced and unpopular, and which provides favorable odds for significant gains.

Steve Lehman

Gold:  $1,700

Friday, December 14, 2012

Apple Stock--Becoming Ordinary or an Opportunity?

The decision to invest in Apple stock today is not as obvious as it was even a year ago.  The company is one of the most successful in the world, and it recently had the largest stock market value on record.  Great companies are often not great investments, however, because by the time the companies are widely revered their stock prices already have risen amply to reflect that greatness.  Has Apple fallen into that trap of a great company that becomes an ordinary investment?

I noted late in August amid the launch of IPhone5 when Apple set a record for total market capitalization of $625 billion (and a stock price close to $700), that it reminded me of the peak in the technology stock sector in 2000.  As in 2000, at the peak in the share price of Apple stock analysts were scrambling to revise higher their profit and share-price targets.  Price targets of $1,000 or more began popping up, as analysts seemed to want to outdo each other in being the biggest booster of Apple (as they did with Cisco's stock in 2000).

But starting price matters in investing, and despite the current dominance of Apple's business around the world, a starting price of $700 (and a market capitalization of more than $600 billion) for a company whose revenue base had become very large meant that future growth rates of revenues and earnings would inevitably slow in percentage terms due to the huge base.

The stock has since declined 25%, and earnings estimates have become almost ordinary.  The current consensus earnings forecast for the 2013 fiscal year (ending next September) is for earnings growth of 11%.  Have expectations for next year and beyond now become modest enough that the stock at its current starting price of $510 is a good buy?

There are several factors that make this a difficult call.  Though the stock is down nearly 30% since September, it is still up 34% over the past year and 157% over the past five years.  Earnings estimates have begun to trend lower, which is not favorable.  Furthermore, the stock is still very widely held, and if large, momentum-driven fund managers are unloading it because its stock price and earnings momentum have been broken, the selling pressure will be difficult to overcome.

One the other hand, one of the world's great companies now sells at a price/earnings ratio of 10.5 on current earnings, which would be less than 9 times if the company were able to use its net cash on the balance sheet to repurchase stock.  It is in superb financial condition with net cash equal to about 25% of its stock market capitalization, and excess cash flow could be available for dividend increases or share buybacks.

When I was a fund manager, I had little patience for the explanation of "profit taking" when stock prices declined.  I thought it was an excuse when people had no plausible fundamental reason for a decline in stock prices.  But perhaps part of Apple's price decline is indeed due to "profit taking" in anticipation of potentially higher capital gains tax rates next year.  That, plus selling pressure from momentum fund managers--amid recent news stories about greater competitive pressures from Google and others--have probably pushed the stock down to its current $510 price.

If I can invest in a superior company at close to ten times (current year) earnings, I'll typically do it regardless of my hunch about the stock market's overall direction.  Apple is a case where after significant gains in the broad stock market since early summer--and over the past four years--it is still possible to find such a stock.  

Steve Lehman

Apple:  $510

Thursday, December 13, 2012

Take profits in German Shares

For those investors who bought European stocks when sovereign debt crisis fears periodically spiked, notably early this summer, I commend you.  Gains likely range from 20-40%.  However, I now suggest looking to take profits at current levels, particularly in Germany.

The iShares MSCI Germany Index exchange-traded fund (EWG) is up 31% off the low in early June and is up 25% in 2012.  Under any circumstances, those are respectable gains.

However, the European economy seems likely to remain in recession or have sluggish growth next year, and the rise in share prices seems already to reflect improved prospects for economic growth or an abating of sovereign debt problems.

I still think stock markets will continue to rise over the near term, but I would look to rotate out of big winners into depressed shares that remain or start to build cash for those who are close to fully invested.

Steve Lehman

EWG:  $24.17 

Wednesday, December 12, 2012

Value in Retail

The significant rise in stock prices this year--on top of the sharp rebound over the past four years--has left few bargains.  There are, however, still some depressed stocks of good companies whose long-term prospects have become suspect.  Examples are Microsoft, Intel, and Kohl's.

Let's look today at the comparative value of Kohl's stock (symbol KSS).  The stock has recently dropped nearly 20% after the company reported disappointing sales results at its stores.  As a result, the stock has fallen 15% over the past year and 5% over the last five years.  The shares now sell for ten times current-year earnings, growth next year is forecast at 10%, and the company's return on equity is 17%.  Management has steadily repurchased shares, thereby increasing earnings per share and the scarcity of outstanding shares.  On the negative side, its earnings trends are comparatively poor, especially compared to those of peer TJX (parent of TJ Maxx and Marshall's).

But TJX stock is up 35% over the past year and 198% over the past five.  It clearly has earnings and price momentum, which is why it is so popular.  Earnings per share at TJX are forecast to rise 12% over the next year (not much more than Kohl's).  TJX shares seem pricey, at 17 times current-year earnings, versus only 10 at Kohl's.

For investors who pay attention to stock price charts, Kohl's has fallen to its current level of 43-44 several times over the past year and rebounded into the low to mid 50's each time.  I think there is a good chance that this will happen again.  Supported by a likely rise in the broad stock market, the prospect for a 25% gain in KSS seems like a good buy when shopping for stocks during this holiday season.

Steve Lehman

KSS:  43.35
TJX:  42.70

Tuesday, December 11, 2012

Santa Claus Rally to Continue

As a value investor, I find it difficult to participate in the stock market when prices are generally only fair, rather than cheap.  That is how I see the current market environment, with many stocks having risen significantly this year.  Yet, I still expect stock prices to continue to rally.  

During the market decline since September, I constructed a portfolio of undervalued and high-dividend yield stocks.  When I could no longer find individual stocks that met my purchase criteria, I added broad market participation through the SPY S & P 500 Index exchange-traded fund.

When technical and sentiment indicators signal that the broad market has become quite popular again with prices up sharply ("overbought"), I'll sell the broad market exposure and keep a core portfolio of individual stocks.  I still have a list of stocks that I intend to buy if they decline enough to reach my target purchase prices.

There are many confusing influences on stock prices at the moment, but I maintain that the likelihood is for a continued rise--though perhaps not new highs--in the major stock indexes.

Steve Lehman

S & P 500:  1430

Monday, December 3, 2012

Hewlett-Packard, "Goodwill," and Investing

Much has been written recently about Hewlett-Packard, once an esteemed leader in the technology sector.  Not only has the company (and its stock) suffered from reports of a huge shift in customer preference toward smart phones and table computers and away from personal computers and printers (Hewlett's most important products).  On top of that, Hewlett recently shocked investors by writing down nearly 90% of the value of its acquisition last year of Autonomy, a British software company.

Hewlett paid $11 billion to buy Autonomy in an attempt to shift its emphasis away from the obsolescent business of personal computers and printers.  Investors were stunned and frustrated by the huge premium HP paid, a price nearly twice what another reported bidder considered the value of Autonomy.  That was bad enough for investors, but last week Hewlett wrote down $8.8 billion of the $11 billion acquisition.  This was the latest example of the generally poor record of major corporate acquisitions that are later written down--or completely written off.

When a company buys another at a premium to the accounting value of its net assets (assets minus liabilities), the difference is put on the acquiring company's books as "goodwill."  Companies such as Procter & Gamble that have grown over the years by acquiring other companies (and products with valuable brand names) have large amounts of goodwill listed among their assets on the balance sheet.  In those cases, the brand value of, say, Gillette razor blades is considerable.  Such brands have maintained or even increased their value over time.  An investor in such a business would justifiably pay for the imbedded goodwill of such key products.

But for a business such as technology, with its risk of rapid obsolescence, it is dubious to pay a high premium.  Hewlett had already stumbled with its acquisition of Electronic Data Systems several years back.  EDS, a former subsidiary of General Motors, was heavily dependent on business from GM, and when GM struggled in recent years, so did EDS.    Such write downs of poor acquisitions result in a reduction of stockholders' equity, or book value.  

I pay attention to a company's book value, or more important, its tangible book value (after deducting goodwill and other intangible assets).  For a company with valuable brand names such as Apple or Coca-Cola, tangible book value might be considered irrelevant in assessing the true value of the business.  But for companies in other sectors with hard assets, or businesses with commodity-like assets like many technology companies, I would not pay a large premium over tangible book value.

In general, the record of large corporate acquisitions is mixed, at best.  I generally prefer a company whose management does not make large acquisitions that dilute the investment of existing shareholders (by issuing large amounts of additional shares of stock to pay for the acquisition).  Managers who behave like owners, rather than highly-paid consultants looking for a quick payout, are better.

The poor decisions at Hewlett were made under the prior CEO, though most the board of directors that approved the deals is still there.  So, it is hard to have confidence in management today.  

Yet, the stock has declined 53% over the past year and 74% over the past five years.  Its price/earnings ratio is now 3.9.  Though it has substantial debt, its cash generation is considerable.  With its total stock market capitalization now down to $25 billion, could it be attractive for takeover by a private equity firm?  Or is it at least now sufficiently undervalued to offer a "margin of safety" in buying the stock?  I'm not ready to go that far, but the stock is worth a closer look at this point for its valuation and 4% dividend yield.

Steve Lehman

HPQ:  $13

Thursday, November 29, 2012

Share Buybacks and Business Fundamentals

When I select stocks, I consider a number of factors including valuation, financial condition, management quality, and attention to sustainability.  When assessing the management, I like to see a protecting the interests of existing shareholders by emphasizing per share measures, rather than just overall growth in the company's revenues or operating profits (which can come through acquisitions rather than inherent growth).  I particularly dislike large increases in the share base for acquisitions, as many acquisitions ultimately prove to be a poor use of capital.  Conversely, I like companies that repurchase their shares with excess cash generated by business operations--or with debt if  balance sheets are strong and the shares are exceptionally depressed in price.

But there are exceptions, and that is why one should use a variety of criteria when choosing a stock.  Share buybacks reduce the number of shares outstanding (and increase earnings per share) all else equal, but one must not lose track of the company's underlying business prospects.

A good example is Best Buy.  This once-dominant retailer of consumer electronics products has repurchased approximately 25% of its shares over the past five years.  That was probably a much better use of cash than if it had been used to expand its store base or acquire other companies.

During this time, however, technological changes have severely impaired the company's business prospects.  The stock is down 53% over the past year as earnings estimates for the latest quarter went from $.50 to an actual break-even quarter.  Cash generation (a crucial factor for stock selection) plummeted from $2.6 billion a year ago through nine months to only $81 million this year.  Since capital spending this year has been $522 million, the company has spent far more than it generated and indicates a severe weakening of its financial condition.

The remarkable deterioration at Best Buy is reflected in a depressed valuation.  It's p/e ratio on this year's earnings estimates is only 5.  I like out-of-favor value stocks where management shrinks the share base, but the alarming deterioration in the fundamentals and finances at Best Buy mean that investors should shop elsewhere.

Steve Lehman

BBY:  $13

An Utterly Indefensible Federal Program

I am not a reflexive critic of government spending, as I believe that government has an important role in society.  But in this era of constrained financial capabilities and the need to cut spending, recent events reveal one program that makes no sense--and is a huge financial risk for taxpayers.  

That program is the National Flood Insurance Program.  Private insurance companies years ago grasped that insuring oceanfront properties is a poor financial risk.  Climate change--as highlighted by hurricane Sandy--exposes the huge potential costs to the Federal government (and taxpayers).  The Federal program now covers an estimated $527 billion of properties, with potential losses to the government of $1.25 trillion.

So with talk about budget cuts and the need to curb entitlement spending dominating the discussion, it seems that reform of this program requires immediate attention.  The program should be phased out or else the perverse financial incentives for building in some of the highest-risk areas of the country should be removed.  Most of us would be delighted to be able to live along the coast--but doing so should be on one's own--not with the backing of U.S. taxpayers.

Steve Lehman

Wednesday, November 21, 2012

Stock Market Likely Headed Higher (Cont.)

Another reason for stock prices to rise from here--aside from very positive contrarian market sentiment indicators and the oversold nature of the market--is recent behavior by corporate insiders.

The latest insider sales/purchases ratio is 1.58:1, which is extraordinarily low.  Over the past decade, the insiders on average sold 3.4 shares of their own company's stock for every share purchased.  So corporate insiders are now historically quite optimistic about their own company's shares.   

At the high in the stock market a couple of months ago, insiders sold 6.86 shares for every one they purchased.  Good call.  Stocks have had a significant decline since that point.  The current level of insider sales to purchases is only the fourth time since the market bottom in March, 2009 that the ratio of sales to purchases has been below 2:1.  Each of the other three times marked a significant interim low in the stock market.

I reiterate:  buy more stocks.

Steve Lehman

S & P 500:  1387

Monday, November 19, 2012

Will the Cliff Become a Trampoline (for the Market)?

I've suggested recently that alarm over the "fiscal cliff" has driven stock prices lower and investor pessimism higher to an excessive degree.

Today's stock market gains have been attributed to encouraging comments from political leaders about overcoming the fiscal gridlock.  I've thought that if there is substantive action by the two political parties on that issue, stock prices could explode higher.

Given that potential, I have urged reducing substantial cash reserves and increasing equity allocations.  I stand by that.

Steve Lehman

S & P 500:  1380

Friday, November 16, 2012

Apple--What Now?

I suggested some weeks back that Apple stock, and the market overall, appeared to be topping out.  Since then, Apple has declined a stunning 26% ($170 billion of market value) and the S & P 500 is down 8%.  I think the market--and the stock--are now oversold.

Apple now sells for approximately 12 times current year earnings, or only 9 times if the company's net cash balance were assumed to be used to repurchase shares (and consequently increase earnings per share and reduce the price/earnings ratio).

There are, however, two aspects of the stock that concern me.  First, the trend of earnings estimates seems to have topped out and begun to decline.  The shape resembles a frown, which for earnings or a stock's price chart, is not a good sign.  (In contrast, a "smile"-shaped curve that can indicate a bottoming out and beginning of an uptrend of earnings or the stock's price chart is a favorable sign.)

Second, despite Apple's enormous commercial success, it does not generate excess (or "free") cash to the extent one might expect.  Based on the latest fiscal year, the free cash flow yield (cash flow after capital spending and dividends divided by the stock market capitalization of the company) after assuming a generous dividend payment was 4%.  That's not bad.  But in the company's latest quarter ended September 30, the free cash flow yield was -2%.  That is a function of two things.  One is the available cash flow and the other is the share price.  I consider a free cash flow yield of 10% or more to be attractive.

So while on a p/e basis, Apple is undervalued especially for such a globally dominant company, and the stock is oversold and likely to rebound, there are troubling signs that warrant monitoring.

Steve Lehman

Apple:  515
S & P 500:  1355

Thursday, November 15, 2012

Market Sentiment (cont.)

Despite my unease over the obvious problems around the world, I continue to expect a rebound in stock prices.  The two main reasons are:   investor sentiment seems quite depressed, and the market's technical condition is oversold.  

One measure of individual investor sentiment, the AAIA Survey, is now at the highest level of pessimism since August 2011.  In that case, it took stock prices two more months to bottom out, but after that the S & P 500 gained 27% over the next six months.

I still think that for investors who have ample cash reserves and have a below-average allocation to equities, it is worth buying stocks on the current weakness.

Steve Lehman

S & P 500:  1356

Wednesday, November 14, 2012

Market Sentiment (cont.)

I do think that stock prices are oversold and likely to rebound, partly because of the gloom over the "fiscal cliff" issue.  I noticed yesterday, however, that fourteen prominent Wall Street strategists are forecasting a 14% rise in stock prices by the end of next year.  That doesn't seem like gloom, does it?  Perhaps it simply reflects the enormous career pressure on strategists to be optimistic (at least publicly) each year.

On the other hand, the put/call ratio has been a reliable indicator of sentiment, and it now is bullish for stocks.  The ratio of put options on the S & P 500 relative to calls has risen sharply during the recent market correction, and it is now approaching the level of early June that preceded a sharp market rally.  Though today's continued market weakness concerns me, I reiterate my recommendation to be positioned for higher stock prices.

Steve Lehman

S & P 500:  1375

Tuesday, November 13, 2012

Is the Cliff in the Price?

I pay a great deal of attention to market sentiment, as decades of investing have provided evidence that buying amid gloom and selling amid euphoria leads to investment success.  It is often tricky, however, to ascertain what the true mood of market participants is at any given time.  Surveys are helpful, and actions are even more so.

In addition to the concern--even gloom--over conditions in Europe, investors are alarmed at the prospect of the U.S. going over the "fiscal cliff" of automatic spending cuts and tax increases scheduled for January 1. 

But the dire fiscal situation is widely known--and may already be discounted--by investors.  The latest issue of Barron's is titled, "Are We Headed for a Recession?," based on the economic impact of not reaching a political deal to avert the "fiscal cliff."

My sense is that stock prices are oversold after the recent correction and are likely headed higher, especially if the president and congress take meaningful action on fiscal issues and taxes.

As I recently suggested, now is a good time to compile a purchase list (such as AGXXF, GLW, MOFG, MOS, TOT, and VOD) with target purchase prices.  If I am wrong and stock prices resume their decline, the available cash that I've advocated accumulating can be used to add to equity holdings.

Steve Lehman

S & P 500:  1387

Friday, November 9, 2012

Stocks Are Oversold, But Is That Enough?

The 6% decline in stock prices since mid September has left major indexes oversold.  Two key indicators, the Money Flow Index and the Relative Strength Index, have reversed from their mid-September levels and now show stocks to be oversold.  

Both indicators showed the market oversold in early June, and the S & P 500 gained 15% from that point.  After those indicators showed the market overbought in September, the S & P declined 6%.  

The S & P 500 now has declined back to its 200-day moving average, which last happened in early June, before a 15% rise in the index.  Has the recent decline in stock prices merely corrected an overbought condition that will soon lead to renewed gains in stocks?  Or, will the decline continue below the moving average, which would likely lead many momentum investors to sell and exacerbate the decline?

I think the odds favor a rebound, with the possibility of an explosive rally if elected officials take meaningful action on fiscal issues.  I would not be short the market here, or even hedge long positions.

Steve Lehman

S & P 500:  1384

Thursday, November 8, 2012

Hello, New Hampshire!

Last week I (and Nancy) moved from Pittsburgh to New Hampshire.  The frenzy of sorting, discarding, and packing up years of accumulated possessions took my mind off the markets for a bit.  Now, while aspiring to a simpler way of life, I feel renewed and excited about this next phase of my life.

As for the stock markets, I wonder how healthy the overall market is when the stock that has dominated the performance of key indexes and many portfolios for the last three years--Apple--is demonstrably not healthy.  Apple has declined 22% from its intraday high of $705, while its market capitalization has declined $110 billion in less than two months.  In addition, the stock is down 18% since my post of October 5th in which I wondered again whether the stock of this now dominant company had topped out.

As I urged in a recent post, now is a good time to do the necessary research (with the latest third-quarter profit updates) to compile a list of stocks to buy, as well as target entry prices.

Steve Lehman

Apple:  $545

Tuesday, October 30, 2012

Compile Your Shopping List

It is difficult in this era of instant gratification and immediate, numerous sources of information to be patient, especially concerning investments.  This is a time, however, to be disciplined and patient in making investment decisions, as the sharp rebound in stock prices has left them vulnerable to a significant decline.

The release of interim profit reports by companies provides fresh information about the financial state of  companies and the investment appeal of their stocks.  While many investors focus on revenue growth (since growth can make currently expensive stocks much cheaper in only a couple of years), I favor the balance sheet and cash flow statement.  I especially seek companies in sound financial condition, with managements that behave like investors themselves, and who manage their companies in a sustainable way for the benefit of their shareholders and for other stakeholders around the world.

Companies with little net debt and surplus cash flow from business operations (after deducting funds for capital expenditures and sizable assumed dividend payments) are most appealing to me.  When their stock prices are selling at modest valuations relative to earnings and "free" cash flow (after capital spending and sizable dividends), I'll buy them almost regardless of my view of the overall stock market.

So now is a good time to do the necessary background research to compile a list of stocks to buy.  Then decide on what is a reasonable price to pay (less than fair value of course!).  You can then follow the practice of the late, great investor John Templeton, who set limit orders to buy stocks at prices significantly below the current price.  And he waited.  If the order was filled, he was pleased.  If not, he remained patient.  So as in other areas of life, position yourself to take what opportunities are presented and be patient.

Steve Lehman

S & P 500: 1414

Friday, October 19, 2012

Raise Cash

If my repeated suggestion over the past month or two hasn't been enough, I reiterate my position on global stock markets--raise cash.  

This is no time to be complacent, yet I think that is exactly the position of many investors after the substantial gains since early June--and over the past three years.  Professional investors have enormous career risk in not keeping up with market index benchmarks and peer comparisons (I know from experience).  Individuals, who earn almost nothing from savings and short-term government bonds, have been driven into high-risk bonds and the stock market.

I've thought for a while that stock prices would likely decline, even though there were no obvious catalysts.  (Quite often, stock prices decline just that way.)  The surprising earnings declines at major U.S. corporations that were reported this week may be such a catalyst to a significant decline ahead for stock prices.

It makes sense to take some profits and hold cash for better entry points.

Steve Lehman

S & P 500:  1443

Operation Barn Door Again?

A common pattern of behavior by Wall Street analysts is to recommend a stock for some time as it slides in price, until a negative company announcement causes them to abandon the stock after it drops sharply on the announcement.

Marvell Technology is the latest example.  The stock is down 12% today on the announcement of an earnings shortfall and the resignation of the CFO (which is usually a bad omen for a company).  The stock is now 44% this year.  Until recently, a majority of analysts who cover the company recommended buying the stock.  Today, there is a wave of ratings downgrades by stock analysts.  

At its current price, cash on Marvell's balance sheet equals 47% of the stock price, which would seem to make the company, now with a stock market value of $4.4 billion, a cheap takeover by another company.

I have long said that I would never want to work as a technology stock analyst, as the risk of rapid--even immediate--obsolescence of a company's products make it an extremely difficult job to analyze the companies and make recommendations on the stocks.  But another wave of downgrades by analysts after a stock has already fallen sharply is frustrating to observe.

Steve Lehman

MRVL:  $7.80

Tuesday, October 16, 2012

Coca-Cola: Lacking Fizz

Coca-Cola (KO) is a revered brand, and its stock has long been popular as well.  I'm not a fan of its sugar water, or its stock.

Today the company reported its third-quarter earnings, and the results do not justify its valuation in the stock market.  Its profit rose only 3.9%, and revenues increased less than 1%.  Its dividend yield is 2.7%, somewhat above the average of the S & P 500 Index.  But its dividend payout ratio is 54% of trailing net income and 51% on estimated profits for 2012.  A stock with a payout ratio above 50% should have a much higher dividend yield than only 2.7%.  

Its valuation in the stock market is well above average, at 19 times estimated 2012 profits.  Yet, an analyst at a major investment firm stated that the stock could have multiple expansion, meaning it is worth more than 19 times earnings.  Really?

Furthermore, the company's cash generation is mediocre.  Cash generation, which is the essence of the value of a business, is mediocre relative to Coca-Cola's reported net income.  And after allowing for a generous dividend (larger than what KO currently pays), there would be no cash left over.  "Free cash flow" after capital spending and dividend payments is one of the most important ways to value a stock.

On cash flow, dividend yield (and payout), valuation, and current growth, KO should be left on the shelf.

Steve Lehman

KO:  $37.60

Monday, October 15, 2012

The Share Buyback Paradox

When it comes to individual companies, many experienced investors often favor companies that repurchase their own shares.  There are two reasons for this.  One, managements on the whole often make poor capital-allocation decisions, such as overpaying for other businesses, or expanding near the peak of the business cycle.  Many investors would prefer that especially for mature businesses, managements would use surplus cash not to expand operations or acquire other businesses, but instead increase dividends or purchase the company's own shares on the stock market (thus reducing the number of shares outstanding and increasing earnings per share).  Two, a large buyback program can provide additional demand for a company's stock and help to drive its price higher. 

But are large share buybacks across the market good for stock prices?  The record is mixed.

Since the dividend payout ratio for the major indexes has been historically low, along with the dividend yield, many Wall Street strategists have argued that large share buybacks should be counted as dividends, because companies are supposedly returning cash to shareholders they way they do with dividend payments.  The dividend yield on the S & P 500 Index, for example, has been at 2% or less for much of the last decade, which is about half its long-term norm of nearly 4%.  

Adding the cash spent by companies on share buybacks to the amounts paid in dividends produces a new number, "net shareholder payout," which is now about 4.5%.  That looks much better than 2%, doesn't it (especially when government bonds yield only 1.6% to 2.8%)?

There are two problems with this argument.  One, cash spent on shares bought on the open market provide no additional cash to shareholders who continue to hold the stock.  It is even questionable whether the buyback program drives the stock higher, depending on the size of the buyback relative to the average daily volume of shares traded in that stock.  

Two, periods of high buyback activity have tended to coincide with market peaks, as managements are often most optimistic about their stock when the economy is strong and share prices have already risen sharply.  Net shareholder yield peaked at close to 6% in 2007-2008, which was soon followed by a decline in the S & P 500 Index of more than 50%.  The net yield hit on the S & P 500 bottomed at the market bottom, early in 2009.  (This was probably because financial companies, particularly banks, issued massive amounts of stock in 2009.)

So while share buybacks for individual companies can still be a positive sign for its stock (when done my astute, shareholder-friendly managements), remember that it is not necessarily favorable for the market as a whole.

Steve Lehman

Tuesday, October 9, 2012

Are Apple--and the Stock Market--Topping Out (Cont.)?

Stock prices are weak again this morning.  It's remarkable that Apple stock, which has led the stock market for the past three years, continues to decline.  It is now down 6% over the last week.  

Company news doesn't necessarily cause movement in a stock, but first the problem with Apple's new mapping application on its iPhone and then a strike by workers at its primary Chinese manufacturing facility could explain the recent decline in the share price.  Or the stock--and the market overall--just might in the early stages of a meaningful decline.

The early stage of a market decline is typically met by the comment by market observers that it is a healthy "correction" after prices had risen too much in a short time.  When the decline persists, however, it is dubbed a "bear market" (after the meaningful decline has already occurred).

Whether there is a more meaningful decline in Apple--and the stock market as a whole--ahead, I stand by my position that one should try to be patient in holding cash until better valuations are available for the market as a whole.  There are (as usual) specific exceptions to this, such as VOD or MOFG, but I like cash here.

Steve Lehman

S & P 500:  1445

Monday, October 8, 2012

Warning on Gold

Enthusiasm has returned to the gold market--though not for a key group.  Commercial participants, considered the "Smart Money," are now positioned at the most bearish level in nearly thirty years of data.  Over this nearly 30-year period, when the Commercial participants have been this bearish, the price of gold has fallen by more than a 10% annual rate.

Furthermore, the price of gold has had a strong seasonal tendency to rise through the late summer into September.  That period is now over.

Third, I suspect that many gold enthusiasts are expecting central bankers around the world to spread liquidity around the world, boosting the prices of assets, particularly gold.  That already is widely expected.

So to those readers who have the impulse to jump into the gold market after its recent double-digit rebound, I urge you to reconsider.

Steve Lehman

Gold:  $1,777

Saturday, October 6, 2012

Bad News--and Good News--Are Good for Stocks

Once again, it seems to be a time when bad is good--and good is good.  Throughout the summer, problems in Europe, economic sluggishness in the U.S., and slowing growth in China were considered by most investors to be good news because that would cause central bankers to ease monetary policy.  So the worse things got the better it would be for stocks?  Apparently so.

But now the opposite also seems to be true--that good news is good for stocks once again.  Yesterday's unemployment report was met with rising stock prices and the explanation that the report indicated that the economy was doing better and that corporate profits would improve.

After 25 years of observing financial markets, I feel like I've learned almost nothing.

Steve Lehman

Tuesday, October 2, 2012

Are Apple--and the Stock Market--Topping Out?

Stock prices around the world got a recent lift from central bank actions.  That was a nice cap to a strong quarter.

There are troubling signs, however.  Apple has driven the market for the past three years, and as analysts seemingly outbid each other in setting the highest target price for the stock (some have said $1,000), the stock has softened recently.  The stock is still up 63% this year and 256% over the past three years!  Until this year, the stock's 200-day moving average was a support level for when the stock became temporarily overbought.  The stock is well above the 200-day moving average of $580 now, however, so it could correct nearly $100 and still be at its moving average.

It's not just Apple that is showing technical troubles.  Market action the last two days was troubling.  Stocks were up sharply yesterday morning after an unexpectedly good report on manufacturing activity, but prices sold off in the afternoon.  Today's market opened higher but is selling off again.

This is on top of marked weakness in the transportation stocks, which did not share in the sharp gains of the past two months (non-confirmation of the advances of the Dow Jones Industrial Average).

I normally don't pay much attention to the market's technical patterns, but they are to me further reason to reduce stock holdings and to look for better values later.

Steve Lehman

S & P 500:  1,444
Apple:  $665

Monday, October 1, 2012

Insider Warning

It's not too late to trim stock holdings and raise cash.

The latest warning is from corporate insiders, who have been selling their own company shares at an extraordinarily heavy level.  

Insiders typically sell far more shares than they buy, as executive compensation usually has a large stock component.  Some shares are necessarily sold to raise cash for income tax payments, others for family expenses such as tuition, and some for prudent estate planning.  

The typical range of sales to purchases by corporate insiders in aggregate is from 12:1 (twelve times as many of their own company's shares sold as purchased) to 20:1 (twenty times as many shares sold as purchased).

When the ratio of insider sales to purchases is less than 12:1, it is considered bullish for the stock market, since insiders are selling relatively less of their own company's shares.  (The insiders are assumed to be optimistic about the prospects of their company's shares.  Why would they sell if they think the stock is going up?    

Conversely, when the ratio of sales to purchases exceeds 20:1, it is considered bearish for stocks, as insider selling is relatively heavy.  (The insiders are assumed to be more pessimistic about the prospects of their own company's shares.  If they are selling to an unusually large extent, they must think that the stock is overpriced and likely to decline.)

The latest reading showed aggregate insider sales to purchases to be more than 40:1.  The message from corporate insiders is caveat emptor (let the buyer beware)!

Steve Lehman

 S & P 500:  1444

Friday, September 28, 2012

Verizon Vs. Vodafone--Go With the Brits

Verizon has been a widely popular income stock in the U.S.  Until its rise this summer, the stock's dividend yield was more than 5%, at a time when cash yields almost nothing and bond yields have been near record lows.

Its Verizon Wireless business is an effective duopoly with AT & T in the U.S. wireless communications business.  However, closer examination reveals a stock with little appeal, particularly compared to Vodafone of the U.K., which owns half of Verizon Wireless.

After rising 23% over the past year, Verizon shares now have a dividend yield of 4.5%.  But the dividend payout ratio (as a percent of earnings per share) is an extraordinarily high 80%.  (I generally avoid income stocks with dividend payout ratios above 50-55%, unless earnings are temporarily depressed or earnings growth is expected to accelerate.)  In addition, the valuation of Verizon is quite poor.  Verizon trades at 18 times estimated 2012 earnings per share, a substantial premium to the market despite having profit declines in two of the past three years.

Verizon's balance sheet also is quite poor.  When adding the company's $32 billion of unfunded pension obligations to its outstanding debt, its debt/equity ratio is 200%.  But Verizon also has $103 billion of "goodwill" and other intangible assets on its balance sheet.  When subtracting this amount from its shareholders equity (or net worth), the company's tangible book value per share is minus $23 (half of the share price).  On the plus side, the cash generation from its businesses is quite good, and the free cash flow yield after capital spending and paying a sizable dividend is 7% (quite high relative to other stocks currently).

Vodafone, the owner of the other half of Verizon Wireless, seems a superior investment to Verizon.  Its dividend yield is 5.2% with a dividend payout ratio of 57%. That dividend could be supplemented by another special dividend paid later this year or early next year if Verizon Wireless pays another dividend to its owners, Verizon and Vodafone.  

Vodafone's valuation is quite good, at only 11 times estimated 2012 earnings per share.  Expectations for the stock are low, with earnings expected to be flat for the next two years because of the company's European exposure.  Unlike Verizon, Vodafone's pension is effectively fully funded.  Its debt ratio is only 34% of shareholders' equity, and after subtracting intangible assets, it has a positive tangible book value per share.  The company generates less free cash flow than Verizon, but Vodafone's CEO intends to sell assets, increase the dividend, and repurchase shares on the open market to help the stock, which has been a laggard.

At a time when a surge in stock prices over the summer has left few remaining good values, Vodafone is an exceptional value--and it is one of the best dividend-paying stocks in the world.

Steve Lehman

VOD:  $28.40
VZ:  $45.40

Nike--Another Earnings Decline for Corporate America

There has been a disturbing trend of declines in corporate profits among leading American companies.  Intel, Norfolk-Southern, 3M, and FedEx are recent examples among varied industry sectors.  Yesterday, Nike, a leading consumer products company that has been one of America's esteemed growth stocks, reported that profits declined 12% in its recent quarter.

Profit margins at American corporations have been near record highs in recent years, and they have provided valuation support to stock prices.  But with stocks generally up sharply this year (the S & P 500's total return is 16%), I think the risks to equity holders have risen significantly.  High levels of investor sentiment (a contrary indicator), the potential for significant earnings disappointments, and troubles in Europe and China that are likely to persist or worsen lead me to reiterate my advice to pare stock holdings and build cash reserves for better opportunities to come.

Steve Lehman

S & P 500:  1438

Wednesday, September 26, 2012


Even the best investors make mistakes.  Some make the same mistakes repeatedly, as a result of behavioral biases.  That is the premise of Behavioral Finance, which identifies common, repeated behaviors that impede sound investment decision making.  While we can strive to identify which behavioral missteps each of us is prone to, it often is too much to ask of us humans to overcome those tendencies.  Instead, the best approach in overcoming these flaws is to use disciplined valuation approaches, such as stock prices as multiples of book value, revenues, or trailing earnings.

Being human myself, I keep making mistakes despite more than 25 years as a professional investor.  I tend toward "confirmatory bias," which is to seek information that confirms my existing view instead of seeking opposing views that might expose flaws in my reasoning.  The one that continues to bedevil me is my reluctance to admit a mistake and sell a losing position.  A Wall Street adage is to "cut your losses (promptly) and let your profits run."  Too often, I do the reverse, citing a different adage (by a former colleague), "You never go broke taking a profit."

There are two types of losses on a stock.  When a stock declines from the purchase price, it could be the result of negative news from the company that might be at odds with the original reason for buying the stock.  In this case, then it probably makes sense to take the loss.  The other type is for no company-specific reason, other than perhaps an overall market decline.  In this case, if the stock was at an attractive price in the first place, I'd be inclined to add at a lower price--or at least hold.

When speculating on an instrument or a commodity (or even a stock), however, there isn't the valuation support to justify holding a losing position.  In that case, the challenge is to get a sense of whether it is a temporary decline or the beginning of something longer and more substantial.  

A number of investors use "stop-loss" orders to sell out of losing positions at preset prices, in order to limit losses to a specified percentage.  (Abrupt price declines might skip over the stop-loss price and result in an even larger loss, however.)

I have had a longstanding bias against using stop-loss orders.  , If I like the price I paid and the stock price drops, I'm inclined to buy more as long as the valuation is better and the fundamental case is the same.  But after a sizable recent loss on a speculative instrument, I have reconsidered using stop loss orders and now recommend them in that type of situation.  I'm not ready to advocate their use in long-only investments in stocks that are based on solid financial conditions, good business prospects, and favorable valuation.

Successful investing requires continual efforts at improvements in market knowledge, as well as in trading or investing techniques.  I'm still learning.

Steve Lehman

Tuesday, September 25, 2012

Gannett--Follow the Insiders

Gannett (GCI) has been an intriguing investment over the past year.  As the publisher of USA Today, the company has faced challenging conditions from the declining newspaper business, which has forced many newspapers to curtail operations or even shut down.

Gannett, however, has other assets (such as television stations) that have considerable value.  As an indication of management's confidence in the company's prospects, earlier this year the company more than doubled its dividend.  A few months ago, the stock was attractively valued at about six times earnings and a free cash flow yield of about 12%, even after paying a large dividend.

The stock has surged lately.  It had been rising steadily this summer, presumably because its tv stations would benefit from massive political advertising this year.  In addition, Warren Buffett revealed that he had increased his company's investment in the newspaper business.  Any Buffett investment still seems to have spillover effects on other companies in the same industry.

But with Gannett's stock up 33% in about a month, I think holders of the stock should follow the actions of company insiders, who have sold meaningful personal stakes in the company.

Steve Lehman

GCI:  $18.45

Monday, September 24, 2012

Is the U.S. Stock Market Expensive or Cheap?

The most important determinant of long-term returns from the stock market indisputably has been valuation.  When entering the stock market at times of cheap valuations, subsequent long-term returns have been the highest.  And vice versa.  But valuation is useless in the short-term, as momentum tends to drive stock prices higher than one would think even after they have become historically overvalued.  And prices have fallen lower over short periods despite historic undervaluations.  But over time, valuations have reverted to their long-term norms, or means.

But it's not as simple as that.  Valuation is not always straightforward.  Valuations compared to various historic periods can appear quite different, depending on which time period is being measured.  

And the basis of valuation can make a difference.  On a book value or price/sales basis, historic valuation comparisons seem straightforward and quite reliable.  On these measures, stock prices today are historically high.

Valuations based on earnings measures, however, are more challenging.  Most professional investors use forecasted operating earnings.  This is a dubious practice, as the practice overstates earnings and understates p/e ratios.  A better approach is to take actual earnings that are based on Generally Accepted Accounting Principles (GAAP earnings) and to use earnings over the prior ten years, not a forecast for the next twelve months.

There are two primary ways of using 10-year GAAP earnings, both of which are intended to remove the effect of the business cycle on valuations.  The first is to use cyclically-adjusted, or "normalized" earnings, which are essentially the long-term trend of earnings.  On this basis, the current p/e on the S & P 500 is 20 times.  Using market history back to the 1920's, this is comparable to valuations at historic market peaks, before the 1987 crash and in the 1960's, before  a 16-year period of basically no gain in stock prices.

But going back only to 1990, 20x times is comparatively low, with only early 2009 at 12x significantly cheaper than today.  Confusing, isn't it?

The other major way of using 10-year earnings is to use average earnings and to deflate them for the level of inflation.  On this basis going back to the late 1800's, the current 10-year inflation-adjusted p/e (also known as the "Shiller p/e" after economist Robert Shiller)  is 21x.  This is near historic peaks of 23x, with market troughs typically near 8x.

Using these alternative p/e measures, today's stock market is historically quite high.  So new investments from today's starting point would likely have poor returns on a valuation basis.

Steve Lehman

S & P 500:  1458