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