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