Apple (AAPL, $4??) reported earnings after the market closed today, and they blew away just about every estimate on Wall Street. The company earned $13.87 per share vs. a consensus estimate of $10.08 for the fourth quarter of the calendar year (the company's fiscal year first quarter), and the stock shot up more than $30 in after-hours trading. If AAPL opens above $450 Wednesday morning, it will be the most valuable company on the planet by market capitalization, edging out the former champ, Exxon. The company sold 15.43 million iPads in the quarter, up 111% from last year, and 37.04 million iPhones, up 128% from a year ago. This great news from AAPL has shares of suppliers Qualcomm (QCOM, $58) and Broadcom (BRCM, $35) also indicated higher in the after-hours and may lift much of the technology sector Wednesday morning. Tim Cook, Apple's CEO, noted that the company's pipeline of new products is "amazing" and that iPhone sales in China are staggering, with demand "off the charts." Also, the company mentioned "active" discussions concerning what it may do with its now $97 billion of cash. Those are the kinds of comments that the market loves to hear.
About the only way that Apple hasn't rewarded shareholders is with a cash dividend. That is certainly understandable, since the company has plenty of opportunities to invest in its own innovation and growth, but all that cash gives the company the ability to initiate such a payout or buy back shares. Tonight is President Obama's last State of the Union address before the November election (and maybe his last one, period), and the subject of dividends will be hanging heavy in the air. In a bit of political theater now common to the annual message, President Obama's special guest tonight will be Warren Buffet's secretary, as yet not known by name but surely destined to be the Democrats' "Joe the Plumber." The legendary investor (I first heard of him when I was in college and just assumed he was Jimmy Buffet's dad) apparently couldn't keep busy enough managing his investments, so he ventured into the realm of politics by pointing out that his secretary paid taxes at a higher marginal tax rate than his own. This has been fresh, red meat for the Democrats because it plays perfectly with their class-warfare script. The fact is that, yes, dividends, which constitute much of the income earned by people like Buffet and Mitt Romney, are taxed at a maximum rate of 15%. Governor Romney just released some of his tax returns, and we can expect to hear much howling and moaning about how he doesn't pay enough taxes (does anybody pay enough taxes?). However, political demagoguery has a way of getting in the way of the facts. I honestly doubt that President Obama will offer any attempt at clarification tonight, so we'll just do that here.
Most of the payments that corporations make are tax-deductible. When a company buys office supplies, pays its employees, or pays interest on its loans, those payments are deducted from income before taxes are calculated, just the way an individual would deduct mortgage interest or gifts to charity. When a company invests in a major physical asset, it can depreciate that purchase over time with the annual depreciation amount serving as yet another deduction. About the only payment of money out that isn't tax-deductible is the dividend amount that the company pays to its shareholders--earnings are what the company pays taxes on, so what is left after paying Uncle Sam is what can be distributed to shareholders. The portion of earnings paid out as dividends has already been taxed at the corporate level, so we could argue that dividends should not be taxed again at all at the personal level. That is the argument for taxing dividends at a rate lower than the rate on ordinary income, and that is why it appears that Mr. Buffet and Governor Romney are somehow getting off easy, when in fact their income is taxed twice.
One of the ways to fix this would be to eliminate or drastically reduce the corporate income tax. That would also have the very favorable effect of encouraging more businesses to set up shop in the good old USA. It is a sad commentary on the State of our Union, though, that some of our political leaders stoke the flames of class warfare by portraying successful business leaders as the villains in some economic drama. Most troubling of all, no one really seems interested in acknowledging that many of these dividend recipients are the very entrepreneurs that create the jobs in this country. It is just easier to play this out as a Manichean struggle between Buffet's secretary and the person who created her job in the first place.
I'm just glad I've got Jimmy, not Warren, on my iPod.
Life is short. Get busy.
Jim
Tuesday, January 24, 2012
Saturday, January 21, 2012
Fertilizer!
During the cocktail party scene early in The Graduate, one of the party guests pulls Dustin Hoffman aside and says to him, "I just want to say one word.....just one word: Plastics!" Of course, Hoffman's character, Ben, was about to get too busy with the Robinson women to think about the next big business opportunity--if the story had been about how he made it big in plastics, it wouldn't have been a very memorable movie. If that film were made today, some 45 years after the original, I wonder if the "one word" might be: "Fertilizer!"
One of the long-term investment themes that has investors all excited is the growing worldwide demand for food. While population growth is part of this story, the other aspect involves shifting diets in the developing world. As countries around the world experience more economic development, their populations will demand more protein in their diets. That means a greater need for cows, chickens, and pigs--all of the unsuspecting creatures that have aspiring carnivores all over the planet licking their chops. All of that livestock has to be fed, so that means increasing demand for crops like corn, a typical ingredient for an animal's feed menu.Corn is also the main feedstock used in the production of ethanol here in the United States, so demand for corn has risen as the result of the federal government's mandates to reduce polluting emissions from gasoline. To meet this demand and take advantage of higher corn prices, some farmers have shifted acreage from other crops to corn.
Scarlett O'Hara's father in Gone With The Wind emphasized that "Land is the only thing that amounts to anything, for 'tis the only thing in the world that lasts..." (although Scarlett was more interested in covering Ashley Wilkes's real estate). We might also state the obvious, that land is in limited supply. Farmers, consequently, need to maximize their crop yields, and that's where fertilizer comes in handy. CF Industries (CF, $175) is a major producer and distributor of nitrogen- and phosphate-based fertilizers, and the growing demand for corn has been great for their business (soybeans actually produce their own nitrogen, but corn does not--one of the many fascinating tidbits I picked up in the course of my investment research). The main input used to produce nitrogen fertilizers is, in fact, natural gas, and lately the price of that commodity has been plummeting. The relatively warm winter so far has reduced the demand for gas for heating, while at the same time supply has increased due to the hydraulic fracturing ("fracking") drilling techniques used to unlock natural gas that is embedded in shale formations. (The Marcellus Shale Formation, which covers parts of New York, Pennsylvania, and Ohio, is the largest source of natural gas ever discovered in the United States.) When we put all of this together we find that CF is in the "sweet spot" of supply and demand, where the product it sells is essential to meet the increased demand for corn, while at the same time the cost of its key input is falling. It's no surprise that CF's stock has risen some 26% over the past year.
CF stock is extremely volatile, owing to its being at the mercy of commodity supply and demand. The stock trades at a price/earnings multiple of just less than 10, a valuation that might at first seem low, but is in fact justified by the commodity nature of its business. Despite the long-term positive outlook for agriculture, CF is not a growth stock in the sense that Whole Foods Market (WFM, $76) and Lululemon (LULU, $60) are growth stocks. As you may recall from a previous post here, any number of products (we noted consumer electronics, sans Apple) can become "commoditized" when producers can no longer differentiate their products (and gain pricing power) through branding and marketing. Here, with natural gas, nitrogen, and corn, we are dealing with genuine commodities, where prices are determined almost solely by supply and demand. For example, when the U.S. Department of Agriculture reports the corn stocks-to-use ratio, a measure of the supply of corn relative to demand, a decline in that number can cause corn prices to rise, and vice-versa. When the price of corn goes up, farmers plant more of it and buy more fertilizer. If the Obama Administration were to outlaw fracking, the price of gas would climb, and that would diminish the profit margins at CF. As a result, we can expect to see CF stock fluctuate with every piece of news about natural gas and corn supplies. When you are in the commodity business, you have very limited control of your own destiny.
So, where is there pricing power in the agricultural sector? Perhaps with a company such as Monsanto (MON, $80), which produces genetically-modified seeds that are designed to be resistant to disease and pesticides. MON has patented many seed varieties and is known to go to great lengths to protect its exclusivity rights. A company that I find intriguing here is E.I. DuPont Nemours (DD, $49). DuPont has long been thought of as a cyclical chemical and coating company, but in 1999 purchased Pioneer Hi-Bred, a developer of hybrid seeds. Such seeds can increase crop yields and provide resistance to disease. Finally, in the heavy equipment arena there is Deere (DE, $87), the maker of all those green tractors and combines that are essential for the planting and harvesting down on the farm. These companies, typically considered to be most sensitive to the economic cycle, stand to benefit from long-term, secular trends in agriculture.
It all makes me want to buy some overalls and plant a tomato garden of my own this spring, or at least do some digging in the dirt. As Scarlett proclaimed when she returned to Tara after the burning of Atlanta (and just before intermission if you saw the movie in a real theater), "As God is my witness, I will never be hungry again!"
Life is short. Get busy.
Jim
Disclaimer/Disclosure: Stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing mentioned here should be construed as a recommendation to buy or sell a specific security. My family members and/or I own shares of CF and DD.
One of the long-term investment themes that has investors all excited is the growing worldwide demand for food. While population growth is part of this story, the other aspect involves shifting diets in the developing world. As countries around the world experience more economic development, their populations will demand more protein in their diets. That means a greater need for cows, chickens, and pigs--all of the unsuspecting creatures that have aspiring carnivores all over the planet licking their chops. All of that livestock has to be fed, so that means increasing demand for crops like corn, a typical ingredient for an animal's feed menu.Corn is also the main feedstock used in the production of ethanol here in the United States, so demand for corn has risen as the result of the federal government's mandates to reduce polluting emissions from gasoline. To meet this demand and take advantage of higher corn prices, some farmers have shifted acreage from other crops to corn.
Scarlett O'Hara's father in Gone With The Wind emphasized that "Land is the only thing that amounts to anything, for 'tis the only thing in the world that lasts..." (although Scarlett was more interested in covering Ashley Wilkes's real estate). We might also state the obvious, that land is in limited supply. Farmers, consequently, need to maximize their crop yields, and that's where fertilizer comes in handy. CF Industries (CF, $175) is a major producer and distributor of nitrogen- and phosphate-based fertilizers, and the growing demand for corn has been great for their business (soybeans actually produce their own nitrogen, but corn does not--one of the many fascinating tidbits I picked up in the course of my investment research). The main input used to produce nitrogen fertilizers is, in fact, natural gas, and lately the price of that commodity has been plummeting. The relatively warm winter so far has reduced the demand for gas for heating, while at the same time supply has increased due to the hydraulic fracturing ("fracking") drilling techniques used to unlock natural gas that is embedded in shale formations. (The Marcellus Shale Formation, which covers parts of New York, Pennsylvania, and Ohio, is the largest source of natural gas ever discovered in the United States.) When we put all of this together we find that CF is in the "sweet spot" of supply and demand, where the product it sells is essential to meet the increased demand for corn, while at the same time the cost of its key input is falling. It's no surprise that CF's stock has risen some 26% over the past year.
CF stock is extremely volatile, owing to its being at the mercy of commodity supply and demand. The stock trades at a price/earnings multiple of just less than 10, a valuation that might at first seem low, but is in fact justified by the commodity nature of its business. Despite the long-term positive outlook for agriculture, CF is not a growth stock in the sense that Whole Foods Market (WFM, $76) and Lululemon (LULU, $60) are growth stocks. As you may recall from a previous post here, any number of products (we noted consumer electronics, sans Apple) can become "commoditized" when producers can no longer differentiate their products (and gain pricing power) through branding and marketing. Here, with natural gas, nitrogen, and corn, we are dealing with genuine commodities, where prices are determined almost solely by supply and demand. For example, when the U.S. Department of Agriculture reports the corn stocks-to-use ratio, a measure of the supply of corn relative to demand, a decline in that number can cause corn prices to rise, and vice-versa. When the price of corn goes up, farmers plant more of it and buy more fertilizer. If the Obama Administration were to outlaw fracking, the price of gas would climb, and that would diminish the profit margins at CF. As a result, we can expect to see CF stock fluctuate with every piece of news about natural gas and corn supplies. When you are in the commodity business, you have very limited control of your own destiny.
So, where is there pricing power in the agricultural sector? Perhaps with a company such as Monsanto (MON, $80), which produces genetically-modified seeds that are designed to be resistant to disease and pesticides. MON has patented many seed varieties and is known to go to great lengths to protect its exclusivity rights. A company that I find intriguing here is E.I. DuPont Nemours (DD, $49). DuPont has long been thought of as a cyclical chemical and coating company, but in 1999 purchased Pioneer Hi-Bred, a developer of hybrid seeds. Such seeds can increase crop yields and provide resistance to disease. Finally, in the heavy equipment arena there is Deere (DE, $87), the maker of all those green tractors and combines that are essential for the planting and harvesting down on the farm. These companies, typically considered to be most sensitive to the economic cycle, stand to benefit from long-term, secular trends in agriculture.
It all makes me want to buy some overalls and plant a tomato garden of my own this spring, or at least do some digging in the dirt. As Scarlett proclaimed when she returned to Tara after the burning of Atlanta (and just before intermission if you saw the movie in a real theater), "As God is my witness, I will never be hungry again!"
Life is short. Get busy.
Jim
Disclaimer/Disclosure: Stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing mentioned here should be construed as a recommendation to buy or sell a specific security. My family members and/or I own shares of CF and DD.
Monday, January 16, 2012
The Expectations Game
We are about to be in the heart of quarterly earnings reporting season, the time every three months (commencing in the middle of January, April, July, and October) when companies report their financial results from the just-ended quarter. Prices of individual stocks will rise or fall depending on whether the reported earnings exceed, match, or fall short of investment analysts' (collectively known as Wall Street) expectations, so all eyes will be on the news ticker as these companies roll out their numbers over the next few weeks. The results can set the tone for specific stocks and for the overall market, so we'll take a look here at how the "expectations game" actually works.
The cornerstone of investing is all about determining what something is worth, finding its intrinsic value. When this intrinsic value differs materially from the market value, we have the prospect of an investment opportunity. If I calculate that the intrinsic value of XYZ Corporation is $50 per share and the stock trades at only $30, I need to find out why that discrepancy exists and whether this might make XYZ a compelling investment. If I am buying a house for my family to live in, them I am going to consider what other houses in similar neighborhoods have sold for on a price-per-square-foot basis, so that I have some sense of whether the asking price for a particular house is close to being a fair price. The amount I'll offer and am ultimately willing to pay is going to depend somewhat on how much I really like and want the house (and how my wife feels about it), so that can involve a great deal of subjectivity. However, if I am buying a house to rent out as a piece of investment property, then the price I am willing to pay will be largely determined by the amount of rental income I can earn on the property. Income-producing assets are valued based on the potential they offer for generating income, and that is the simple reason why earnings determine stock prices (even if no dividends are currently paid out of those earnings).
Professional investment analysts develop financial models for the companies they follow, including such factors as a company's sales history, profit margins, and product mix to arrive at a projection of future earnings. This is then expressed as the estimated Earning Per Share (EPS) for each upcoming quarter and for the next year. As we'll see over the next few weeks, the moment of truth comes when a company reports its actual EPS for the most recent quarter. If this number comes in ahead of expectations, then the stock likely will move up on the news. Suppose, for example, that the estimated earnings amount for XYZ Company's Fourth Quarter (Q4) is $.50 per share, with the full or fiscal year (FY12) estimate at $2.00 per share. Last year the company earned, say, $1.74 for the full year, so the expected growth in earnings is 15%--and we'll assume a Price/Earnings (PE) multiple of 15 times future earnings, which puts the stock at $30 per share. If XYZ reports that its actual EPS came in at $.60 instead of the $.50 estimate, then this should be very good news for the stock (assuming that the sales and margins also look good). If business at XYZ is truly that much better than the market expected, then it is immediately apparent that the $2.00 full year estimate is too low, at least by $.10. However, what may happen next is that analysts may start revising upwards their estimates for future quarters, and if they think each upcoming quarter can come in at $.60 instead of $.50, then the full year estimate would go to $2.40. That also means that the growth is better than the expected 15%, so the market may award a higher PE multiple to the shares. If the PE goes to 20 and the expected earnings go to $2.40, then our $30 stock may become a $48 stock. Now, if the EPS had come in at $.40, below the $.50 estimate, just throw all of that into reverse--our $30 stock might belly up as a $16 stock. That is a vast oversimplification, but still the general idea of how the expectations game affects stock prices.
Now let's look at a real-life example. Back in November Dell (DELL, $15) reported quarterly EPS of $.54, versus a consensus expectation of $.47. That looked good at first, but the problem was that the company's top line revenue growth was weak, meaning that the improvement in earnings was mainly due to margin expansion and not to higher sales. The stock sold off and has been trading in the $15 range ever since. When companies report their results, the investment community is looking at all sorts of information besides the "headline" EPS number. The market, as in the DELL example, does not like to see earnings growth without sales growth, because profit margin expansion is not sustainable over the long term. Conversely, great sales growth that doesn't translate into earnings can mean that the company has lost control of its expenses, another unwelcome development. Another thing to which the market pays rapt attention is the "guidance" issued by the company regarding their future prospects. If a company reports blowout, consensus-beating earnings but goes on to say that the next quarter looks lousy because their business in Europe is weak, that's going to be bad for the stock. As we have emphasized before, investing is all about expectations for the future, so if tomorrow looks grim it really isn't going to matter much how great yesterday looked. As companies report earnings, everyone will be paying attention to such comments, especially guidance about Europe.
The earnings reports of some companies will have implications for the broader market and for particular sectors. Apple (AAPL, $420) will report earnings next week (1/24), and this report will be a "bellwether" for the technology sector and likely the overall market. AAPL's last earnings report was their first disappointment in quite some time, but investors have come to understand that the shortfall was due to consumers delaying purchases in anticipation of the new product release. The report next week will be critical because the quarter includes the Christmas shopping season. The consensus estimate is $9.93, with a high estimate of $11.26 and a low of $8.88. Another element to the game here is what is known as the "whisper" number, meaning the amount some analysts truly expect the company to report. The analysts haven't gone "on the record" with that number because it could be too optimistic. I actually expect that AAPL will report an outstanding quarter in both sales and earnings, well above all expectations, because all of the checks indicate a huge demand for iPhones and iPads over the holiday season. If I am correct, this will lift the shares of AAPL and its suppliers, such as Qualcomm (QCOM $56) and Broadcom (BRCM, $32). The important thing to remember, though, is that AAPL is going to have to beat the official estimates by a wide margin for the stock to rally, because the higher "whisper" number is probably already priced into the stock. This does sound more and more like a game, but we just have to understand the rules.
It is important to remember that just meeting expectations is not enough. If my wife goes off to work expecting that I will, in her absence, take out the garbage, feed the dogs, and change light bulbs, then I will receive no accolades for doing what she expected me to do. If I fail to do those things, of course, I am in trouble. However, if I do the expected chores plus wax the floors, wash the windows, and polish the silver, then my stock is going to go up in her eyes, and things will be quite pleasant in the Taylor household. (Actually, if I did all of that, she would probably have a heart attack and drop dead on the kitchen floor. In the interests of her health, I must refrain from overdoing the housework.) As my father used to remind me, no one gets special rewards for doing what they are supposed to do anyway.
Can we use any of this to make better investment decisions, or do we just have to wait for great earnings reports and then pay more for a stock? Actually, there is a way here to make the "expectations game" work for us. Analysts often make revisions to their estimates throughout a quarter, and the direction of those revisions is a pretty reliable precursor to earnings surprises. When we see that the revisions are going up, that can be a signal that business is better at a company than what the analysts had captured in their models, and that often leads to a positive earnings surprise (the reverse is true as well). In his Upside column in The Wall Street Journal ("How to Profit From Analysts' Stock Recommendations," January 14th, 2012), Jack Hough points out how studies have shown that stocks with lots of "buy" ratings from analysts don't, as a group, tend to do better than the overall market. However, another study has shown that when an upgrade to "buy" is accompanied by increases in earnings estimates, a strategy of buying those stocks can lead to improved performance. Earnings estimate revisions are, in fact, a key part of my own investment selection process. At the very least, the next time your broker recommends a stock, you might want to ask him or her about the recent history of earnings revisions. That information can be obtained from the brokerage firm's research reports or accessed on the newswires.
Keep an eye on Wall Street over the next couple of weeks. There will be winners and losers, especially in retail and technology, and these earnings reports will set the market's tone, probably for the next few months. Time to separate the men from the boys (or the women from the girls, if you prefer).
Life is short. Get busy.
Jim
Disclaimer/Disclosure: This blog is not intended to serve as specific investment advice. Stocks are mentioned here for the purpose of illustrating investment concepts, and nothing stated here should be construed as a recommendation to buy or sell any security. My family members and/or I own shares of AAPL, BRCM, and QCOM.
The cornerstone of investing is all about determining what something is worth, finding its intrinsic value. When this intrinsic value differs materially from the market value, we have the prospect of an investment opportunity. If I calculate that the intrinsic value of XYZ Corporation is $50 per share and the stock trades at only $30, I need to find out why that discrepancy exists and whether this might make XYZ a compelling investment. If I am buying a house for my family to live in, them I am going to consider what other houses in similar neighborhoods have sold for on a price-per-square-foot basis, so that I have some sense of whether the asking price for a particular house is close to being a fair price. The amount I'll offer and am ultimately willing to pay is going to depend somewhat on how much I really like and want the house (and how my wife feels about it), so that can involve a great deal of subjectivity. However, if I am buying a house to rent out as a piece of investment property, then the price I am willing to pay will be largely determined by the amount of rental income I can earn on the property. Income-producing assets are valued based on the potential they offer for generating income, and that is the simple reason why earnings determine stock prices (even if no dividends are currently paid out of those earnings).
Professional investment analysts develop financial models for the companies they follow, including such factors as a company's sales history, profit margins, and product mix to arrive at a projection of future earnings. This is then expressed as the estimated Earning Per Share (EPS) for each upcoming quarter and for the next year. As we'll see over the next few weeks, the moment of truth comes when a company reports its actual EPS for the most recent quarter. If this number comes in ahead of expectations, then the stock likely will move up on the news. Suppose, for example, that the estimated earnings amount for XYZ Company's Fourth Quarter (Q4) is $.50 per share, with the full or fiscal year (FY12) estimate at $2.00 per share. Last year the company earned, say, $1.74 for the full year, so the expected growth in earnings is 15%--and we'll assume a Price/Earnings (PE) multiple of 15 times future earnings, which puts the stock at $30 per share. If XYZ reports that its actual EPS came in at $.60 instead of the $.50 estimate, then this should be very good news for the stock (assuming that the sales and margins also look good). If business at XYZ is truly that much better than the market expected, then it is immediately apparent that the $2.00 full year estimate is too low, at least by $.10. However, what may happen next is that analysts may start revising upwards their estimates for future quarters, and if they think each upcoming quarter can come in at $.60 instead of $.50, then the full year estimate would go to $2.40. That also means that the growth is better than the expected 15%, so the market may award a higher PE multiple to the shares. If the PE goes to 20 and the expected earnings go to $2.40, then our $30 stock may become a $48 stock. Now, if the EPS had come in at $.40, below the $.50 estimate, just throw all of that into reverse--our $30 stock might belly up as a $16 stock. That is a vast oversimplification, but still the general idea of how the expectations game affects stock prices.
Now let's look at a real-life example. Back in November Dell (DELL, $15) reported quarterly EPS of $.54, versus a consensus expectation of $.47. That looked good at first, but the problem was that the company's top line revenue growth was weak, meaning that the improvement in earnings was mainly due to margin expansion and not to higher sales. The stock sold off and has been trading in the $15 range ever since. When companies report their results, the investment community is looking at all sorts of information besides the "headline" EPS number. The market, as in the DELL example, does not like to see earnings growth without sales growth, because profit margin expansion is not sustainable over the long term. Conversely, great sales growth that doesn't translate into earnings can mean that the company has lost control of its expenses, another unwelcome development. Another thing to which the market pays rapt attention is the "guidance" issued by the company regarding their future prospects. If a company reports blowout, consensus-beating earnings but goes on to say that the next quarter looks lousy because their business in Europe is weak, that's going to be bad for the stock. As we have emphasized before, investing is all about expectations for the future, so if tomorrow looks grim it really isn't going to matter much how great yesterday looked. As companies report earnings, everyone will be paying attention to such comments, especially guidance about Europe.
The earnings reports of some companies will have implications for the broader market and for particular sectors. Apple (AAPL, $420) will report earnings next week (1/24), and this report will be a "bellwether" for the technology sector and likely the overall market. AAPL's last earnings report was their first disappointment in quite some time, but investors have come to understand that the shortfall was due to consumers delaying purchases in anticipation of the new product release. The report next week will be critical because the quarter includes the Christmas shopping season. The consensus estimate is $9.93, with a high estimate of $11.26 and a low of $8.88. Another element to the game here is what is known as the "whisper" number, meaning the amount some analysts truly expect the company to report. The analysts haven't gone "on the record" with that number because it could be too optimistic. I actually expect that AAPL will report an outstanding quarter in both sales and earnings, well above all expectations, because all of the checks indicate a huge demand for iPhones and iPads over the holiday season. If I am correct, this will lift the shares of AAPL and its suppliers, such as Qualcomm (QCOM $56) and Broadcom (BRCM, $32). The important thing to remember, though, is that AAPL is going to have to beat the official estimates by a wide margin for the stock to rally, because the higher "whisper" number is probably already priced into the stock. This does sound more and more like a game, but we just have to understand the rules.
It is important to remember that just meeting expectations is not enough. If my wife goes off to work expecting that I will, in her absence, take out the garbage, feed the dogs, and change light bulbs, then I will receive no accolades for doing what she expected me to do. If I fail to do those things, of course, I am in trouble. However, if I do the expected chores plus wax the floors, wash the windows, and polish the silver, then my stock is going to go up in her eyes, and things will be quite pleasant in the Taylor household. (Actually, if I did all of that, she would probably have a heart attack and drop dead on the kitchen floor. In the interests of her health, I must refrain from overdoing the housework.) As my father used to remind me, no one gets special rewards for doing what they are supposed to do anyway.
Can we use any of this to make better investment decisions, or do we just have to wait for great earnings reports and then pay more for a stock? Actually, there is a way here to make the "expectations game" work for us. Analysts often make revisions to their estimates throughout a quarter, and the direction of those revisions is a pretty reliable precursor to earnings surprises. When we see that the revisions are going up, that can be a signal that business is better at a company than what the analysts had captured in their models, and that often leads to a positive earnings surprise (the reverse is true as well). In his Upside column in The Wall Street Journal ("How to Profit From Analysts' Stock Recommendations," January 14th, 2012), Jack Hough points out how studies have shown that stocks with lots of "buy" ratings from analysts don't, as a group, tend to do better than the overall market. However, another study has shown that when an upgrade to "buy" is accompanied by increases in earnings estimates, a strategy of buying those stocks can lead to improved performance. Earnings estimate revisions are, in fact, a key part of my own investment selection process. At the very least, the next time your broker recommends a stock, you might want to ask him or her about the recent history of earnings revisions. That information can be obtained from the brokerage firm's research reports or accessed on the newswires.
Keep an eye on Wall Street over the next couple of weeks. There will be winners and losers, especially in retail and technology, and these earnings reports will set the market's tone, probably for the next few months. Time to separate the men from the boys (or the women from the girls, if you prefer).
Life is short. Get busy.
Jim
Disclaimer/Disclosure: This blog is not intended to serve as specific investment advice. Stocks are mentioned here for the purpose of illustrating investment concepts, and nothing stated here should be construed as a recommendation to buy or sell any security. My family members and/or I own shares of AAPL, BRCM, and QCOM.
Saturday, January 14, 2012
Yoga Pants, Healthy Burritos, and Fancy Mattresses
Chip Wilson, the founder of Lululemon Athletica (LULU, $61), had been in the snowboard, skate, and surf business for twenty years when he took his first yoga class. According to the company's Website, the post-yoga feeling reminded him of the exhilaration he felt from riding the waves and the slopes, and Wilson subsequently directed his energies towards designing performance athletic fabrics. He started LULU in 1998 and opened the first store in Vancouver in 2000. As of May, 2011, the company had 142 store locations in the United States, Canada, and Australia. Over the last three years the stock is up over 1,000%.
A common question raised by skeptics is, Who would pay $100 for a pair of yoga pants in this economy? To understand the company's success we really have to break that question down into two parts. As for the high price tag, that's the same question people asked about the $5.00 Lattes at Starbucks. American consumers have a way of confounding the skeptics, because we don't seem to mind paying up for quality and fashion when there is a product we really desire. I have noticed that women, especially, are often attired as if they were on their way to or from a workout even when they are just grocery shopping or driving carpool (it may be true of men also, but I tend to notice women, especially the ones who have been sticking to their fitness regimen, like my wife). The yoga pants and other accoutrements are not only highly functional, they are also stylish, and that means people are sporting them as every day causal wear. A price tag of $100 doesn't seem so outlandish when it's a piece of clothing that you can wear at places other than yoga class or the fitness center. As for the second part of the question, in this economy, we need only remember our "Tale of Two Cities" reality. Not everyone is buying those yoga pants (and it's pretty obvious that not everyone is working out, either), but the people who do are fiercely loyal. And there is no contradiction at all in putting on those high-dollar pants for a bargain-hunting trip to the Dollar Tree or T.J. Maxx. So maybe that is what is meant by those "Co-exist" bumper stickers: a thriving Costco and Dollar Tree in the same economy as the prospering Coach and Lululemon.
There are no freezers, microwave ovens, or can openers at Chipolte Mexican Grill (CMG, $354) restaurants. Because Mexican food tastes so yummy, I have never thought of burritos and tacos as being particularly healthy. CMG, however, has created a new niche in the restaurant sector by emphasizing Mexican fare that is made with fresh ingredients. CMG is really a south-of-the-border version of Panera Bread (PNRA, $146) in terms of its place in the restaurant market--fast, quality food that is reasonably priced and offered in a casual setting. Both CMG and PNRA stand to benefit from consumers who are "trading up" as well as those who are "trading down." My wife and I eat at Panera a few times a month, but it's been years since we darkened the door of a Red Lobster or Olive Garden, two restaurant chains owned by Darden Restaurants (DRI, $44). Shares of DRI are down about 3% over the last year (Warning: Bear Trap). While we are happy saving a few bucks by dining on the quality food at Panera instead of our favorite gourmet spot, I would certainly find myself sleeping on the couch if I told my wife I was taking her out to Red Lobster. Success is at the high-end and low-end, with the middle shrinking. And speaking of co-existing in the Tale of Two Cities, my favorite restaurant stock is Yum! Brands (YUM, $61), the owner of Taco Bell, Pizza Hut, and Kentucky Fried Chicken. (You don't have to eat it to invest in it.) Like McDonald's, YUM is executing successfully with their international expansion. So, pass the tacos, pizza, and chicken wings, and we'll see how much stretch is in those yoga pants.
If The Three Bears had slept on Tempur-Pedic mattresses, then Goldilocks probably wouldn't have cared whose bed she picked for her post-porridge nap. My wife and I are in the market for a new mattress, and we recently paid a visit to the Relax the Back store here in Memphis. I could spend an entire day in there, because they have just about everything imaginable to make you feel comfortable and relaxed (except the drugs). I like both the mattresses and Tempur-Pedic (TPX, $59) stock. When we looked at the potential for a recovery in the housing market, I suggested that one way to play this is to invest in companies that will likely benefit from a robust housing recovery, but are doing just fine with the status quo. TPX would fall into that category, along with the previously-mentioned Stanley Black and Decker (SWK, $71). Once again, not everyone is going to be forking over $2,000+ for a new mattress, but people who can afford to upgrade their sleeping experience are probably going to be checking out the Tempur-Pedic, maybe taking one for a "test nap." TPX stock is up about 600% over the past three years.
I am not recommending that you buy any of these stocks, but they do illustrate some of the truths about high-growth companies. All three of these fall into the category of what I call "enhanced lifestyle experience"--staying fit, eating healthier, and sleeping better. Their results in sales and earnings indicate that a lot of people like what they have to offer, and the market has rewarded them for their success. LULU trades at a price/earnings multiple of about 53, CMG at about 54 times earnings, and TPX at a less-lofty 20 times. Those multiples seem high, but not really outrageous if the companies can continue to deliver the growth that the market expects. However, should any of these companies fail to meet--actually, if they fail to exceed--the market's expectations, their stock prices will fall drastically, enough to scare the yoga pants right off of you. Just take a look at shares of Netflix (NFLX, $94) if you need a reminder of how brutal the market can be to a stock. As a general rule, however, most investors need some exposure to high-growth stocks, but we should limit that exposure to a certain percentage of our portfolios, depending on our overall financial picture and risk tolerance. Remember: no risk, no return; no guts, no glory.
I also have a very unscientific bit of analysis that I like to apply to stocks in the retail and restaurant sectors, and I call it the "Memphis test." I love my hometown, but this great city is not exactly ground zero for the latest trends in fashion and dining. By the time some "new thing" really catches on in Memphis, that can be a red flag that the concept may be running out of steam--reaching a saturation point for future growth, in other words. LULU has one location here, above the Ben and Jerry's behind Houston's Restaurant near Poplar and Mendenhall. It is open only Thursday through Saturday. My wife knew about LULU because she owns a retail clothing store, and I found out about the company solely through my investment research. (I know, I am not a good example, since I am not exactly sitting here every morning with my Yogini, practicing our asanas and watching CNBC.) As anecdotal as this may be, LULU passes the Memphis test with flying colors, although the company does a lot of business online, and that is making the test less relevant. CMG has only one location here, so I'll say they pass the Memphis test as well. TPX has been around longer, so the test really doesn't apply to them.
Even if you don't invest in these companies, you can still enjoy their quality offerings. So, let's get dressed up for yoga class and grab some guacamole. Then, as Sonny said in The Godfather, "we go to the mattresses."
Life is short. Get busy.
Jim
Disclosure: My immediate family members and/or I own shares in LULU, TPX, SWK, and YUM.
A common question raised by skeptics is, Who would pay $100 for a pair of yoga pants in this economy? To understand the company's success we really have to break that question down into two parts. As for the high price tag, that's the same question people asked about the $5.00 Lattes at Starbucks. American consumers have a way of confounding the skeptics, because we don't seem to mind paying up for quality and fashion when there is a product we really desire. I have noticed that women, especially, are often attired as if they were on their way to or from a workout even when they are just grocery shopping or driving carpool (it may be true of men also, but I tend to notice women, especially the ones who have been sticking to their fitness regimen, like my wife). The yoga pants and other accoutrements are not only highly functional, they are also stylish, and that means people are sporting them as every day causal wear. A price tag of $100 doesn't seem so outlandish when it's a piece of clothing that you can wear at places other than yoga class or the fitness center. As for the second part of the question, in this economy, we need only remember our "Tale of Two Cities" reality. Not everyone is buying those yoga pants (and it's pretty obvious that not everyone is working out, either), but the people who do are fiercely loyal. And there is no contradiction at all in putting on those high-dollar pants for a bargain-hunting trip to the Dollar Tree or T.J. Maxx. So maybe that is what is meant by those "Co-exist" bumper stickers: a thriving Costco and Dollar Tree in the same economy as the prospering Coach and Lululemon.
There are no freezers, microwave ovens, or can openers at Chipolte Mexican Grill (CMG, $354) restaurants. Because Mexican food tastes so yummy, I have never thought of burritos and tacos as being particularly healthy. CMG, however, has created a new niche in the restaurant sector by emphasizing Mexican fare that is made with fresh ingredients. CMG is really a south-of-the-border version of Panera Bread (PNRA, $146) in terms of its place in the restaurant market--fast, quality food that is reasonably priced and offered in a casual setting. Both CMG and PNRA stand to benefit from consumers who are "trading up" as well as those who are "trading down." My wife and I eat at Panera a few times a month, but it's been years since we darkened the door of a Red Lobster or Olive Garden, two restaurant chains owned by Darden Restaurants (DRI, $44). Shares of DRI are down about 3% over the last year (Warning: Bear Trap). While we are happy saving a few bucks by dining on the quality food at Panera instead of our favorite gourmet spot, I would certainly find myself sleeping on the couch if I told my wife I was taking her out to Red Lobster. Success is at the high-end and low-end, with the middle shrinking. And speaking of co-existing in the Tale of Two Cities, my favorite restaurant stock is Yum! Brands (YUM, $61), the owner of Taco Bell, Pizza Hut, and Kentucky Fried Chicken. (You don't have to eat it to invest in it.) Like McDonald's, YUM is executing successfully with their international expansion. So, pass the tacos, pizza, and chicken wings, and we'll see how much stretch is in those yoga pants.
If The Three Bears had slept on Tempur-Pedic mattresses, then Goldilocks probably wouldn't have cared whose bed she picked for her post-porridge nap. My wife and I are in the market for a new mattress, and we recently paid a visit to the Relax the Back store here in Memphis. I could spend an entire day in there, because they have just about everything imaginable to make you feel comfortable and relaxed (except the drugs). I like both the mattresses and Tempur-Pedic (TPX, $59) stock. When we looked at the potential for a recovery in the housing market, I suggested that one way to play this is to invest in companies that will likely benefit from a robust housing recovery, but are doing just fine with the status quo. TPX would fall into that category, along with the previously-mentioned Stanley Black and Decker (SWK, $71). Once again, not everyone is going to be forking over $2,000+ for a new mattress, but people who can afford to upgrade their sleeping experience are probably going to be checking out the Tempur-Pedic, maybe taking one for a "test nap." TPX stock is up about 600% over the past three years.
I am not recommending that you buy any of these stocks, but they do illustrate some of the truths about high-growth companies. All three of these fall into the category of what I call "enhanced lifestyle experience"--staying fit, eating healthier, and sleeping better. Their results in sales and earnings indicate that a lot of people like what they have to offer, and the market has rewarded them for their success. LULU trades at a price/earnings multiple of about 53, CMG at about 54 times earnings, and TPX at a less-lofty 20 times. Those multiples seem high, but not really outrageous if the companies can continue to deliver the growth that the market expects. However, should any of these companies fail to meet--actually, if they fail to exceed--the market's expectations, their stock prices will fall drastically, enough to scare the yoga pants right off of you. Just take a look at shares of Netflix (NFLX, $94) if you need a reminder of how brutal the market can be to a stock. As a general rule, however, most investors need some exposure to high-growth stocks, but we should limit that exposure to a certain percentage of our portfolios, depending on our overall financial picture and risk tolerance. Remember: no risk, no return; no guts, no glory.
I also have a very unscientific bit of analysis that I like to apply to stocks in the retail and restaurant sectors, and I call it the "Memphis test." I love my hometown, but this great city is not exactly ground zero for the latest trends in fashion and dining. By the time some "new thing" really catches on in Memphis, that can be a red flag that the concept may be running out of steam--reaching a saturation point for future growth, in other words. LULU has one location here, above the Ben and Jerry's behind Houston's Restaurant near Poplar and Mendenhall. It is open only Thursday through Saturday. My wife knew about LULU because she owns a retail clothing store, and I found out about the company solely through my investment research. (I know, I am not a good example, since I am not exactly sitting here every morning with my Yogini, practicing our asanas and watching CNBC.) As anecdotal as this may be, LULU passes the Memphis test with flying colors, although the company does a lot of business online, and that is making the test less relevant. CMG has only one location here, so I'll say they pass the Memphis test as well. TPX has been around longer, so the test really doesn't apply to them.
Even if you don't invest in these companies, you can still enjoy their quality offerings. So, let's get dressed up for yoga class and grab some guacamole. Then, as Sonny said in The Godfather, "we go to the mattresses."
Life is short. Get busy.
Jim
Disclosure: My immediate family members and/or I own shares in LULU, TPX, SWK, and YUM.
Sunday, January 8, 2012
Avoiding Bear Traps
When was the last time you bought a roll of film? I am no Luddite, but I am typically the last among my friends to adopt the latest technology--and even I haven't bought any film in at least two years. That explains, in part, the epic decline in the shares of Eastman Kodak (EK, $0.46), which, in the 1990s, traded at over $80 and are now priced at about 46 cents. While we could roll the stock into the CSI lab for a full head-to-toe autopsy, instead we'll look at how the investment community--or at least part of it--viewed the stock throughout much of its fall. Some research analysts and other market observers continued to insist that the stock was a good value for investors because it was cheap--It has fallen from its highs, it has a low P/E, it pays a good dividend, people won't stop buying film, it's an iconic American brand, blah, blah, blah. As it turns out with the distinct clarity of hindsight, the stock was cheap, but it was cheap for a reason--and it was going to get a whole lot cheaper.
EK is a rather extreme example of a "bear trap" or "value trap," extreme because most companies that could be setting up as such traps aren't actually facing the near-obsolescence of their core product. Instead, most suspected cases of value traps come on more subtly, like that first cough or body ache that may signal that you're coming down with a full-blown case of the flu. Investors love to find stocks that are truly cheap, values because the stock price does not fully reflect the growth opportunities that may lie ahead for the company. Successful investing requires that we distinguish between stocks that are undervalued for that reason and those that just appear to be undervalued but actually deserve to be cheaper. Would you really want to invest in a company that makes typewriters, regardless of how cheap the stock is? We'll look at some suspected cases of value traps and pose two questions to conduct our diagnosis: Is the company's product or service gaining or losing relevance for its customer market? And what is the catalyst that is going to make the stock go higher?
Our first patient is Radio Shack (RSH, $9.85). I have read numerous research reports claiming that the stock is a buy--at $15, then at $13, then at $11, and so on. As a teenager I would buy blank cassette tapes there so I could record my albums to listen to in the car. On my last trip to Radio Shack, some time last year, I bought some fuses for my stereo system--total sale less than $10. The company is trying to keep its stores relevant by emphasizing more wireless products, services, and accessories, but the only company that really seems to be thriving selling consumer electronics at a bricks-and-mortar location is Apple. Radio Shack may be around for a while, but its relevance does not seem to be growing.
Campbell's Tomato Soup and a grilled cheese sandwich may be the best comfort food ever invented. That's what I enjoyed as a kid, and it's what we'd serve our kids when they were home from school on snow days. (M'm M'm Good!) When my wife went shopping to load up on the condensed soups that go into the Thanksgiving and Christmas casseroles, I noticed that my value maven brought home the store brand, not the Campbell's. When I asked her about this, she explained that it really didn't matter since the soup was going into the green bean casserole. M'm M'm Bad for Campbell's--that's the last thing a company wants consumers thinking about its branded products. We are not health nuts at our house, but we still don't have that much use for a can opener. While I sill eat the Campbell's (CPB, $32) Tomato Soup on occasion, I really can't imagine chowing down on something like seafood gumbo out of a can. There are plenty of options for freshly prepared soups--or at least something closer to fresh. CPB also owns Swanson, Pepperidge Farm, Pace Salsa, Prego Pasta Sauces, and V8 Juice Drinks--an impressive portfolio of brands, in other words. That is why the diagnosis here is not terminal. Food is not film. However, the trend toward healthier eating habits is a headwind for the company, so while its relevance may be stable, it's not likely to grow. More than a hundred years ago, CPB figured out the way to remove half of the water from its soups. This meant that shipping costs were greatly reduced (water weighs a lot), so the company was able to charge a lower price point for their soups and capture a huge share of the market. That's called innovation, and if the company wants to see its stock price move up, it had better get busy innovating.
A Wall Street Journal headline from December 15, 2011, proclaimed, "Hasbro Falls Prey to 'Angry Birds'" (by Ann Zimmerman). The article details how Hasbro (HAS, $32), known for board games such as Monopoly, Battleship, Scrabble, and Operation, has suffered because they haven't done much to update those classics or introduce new games. Sales of Hasbro's boards games are down 9% over the last three quarters compared with last year, with the stock price down 30%. The company is also not clicking with its foray into online games--there are one million monthly Facebook Scrabble users compared with the 13 million users of Zynga's "Words with Friends." Hasbro is now focusing on movie tie-ins with its stable of toy characters. Kids will always play with toys, but the preference seems to be gaining for World of Warcraft over G.I. Joe. I can only wonder what Henry and Helal, the Hassenfeld brothers (Has-Bro), would think about their company today, some 60 years after they gave birth to Mr. Potato Head. Sorry, Bro.
Another early warning for value traps surfaces when a company's product starts to take on the characteristics of a commodity. The key aspect of a commodity, at least for our purposes here, it that the seller cannot differentiate the product to gain pricing power. If I am a corn farmer, I have to accept the price of corn that is determined by supply and demand in the commodities markets--that is what is known in economics as being a "price-taker." I can't differentiate my corn by branding it as "Jim's Corn" and charging a higher price. If I have an orange grove in California and a freeze destroys much of the orange crop in Florida, then the price of oranges will go up, and I'll benefit by realizing a higher price. That will be due to the changes in supply and demand, though, and not to any special feature that differentiates my oranges.
Televisions have become "commoditized" in this way, and that's part of the reason why shares of Sony (SNE, $17) have been in the dumps. When most people shop for that new flat screen television, they are looking for the combination of features and price that best suits them, and they are not as concerned as they once might have been with any particular brand. This was happening with cell phones before Apple redefined the landscape with the iPhone. Part of the genius of Apple, as we have noted before, is that they were able to avoid the commodity trap by branding their products and creating a technology ecosystem based on their operating system. It's part of the reason people are so excited about the possibility of an Apple television, because that could have the same effect. Just about every type of consumer electronics product out there has fallen victim, at least to some extent, to commoditization. IBM, the second-best performing stock in the Dow Jones Industrial Average for 2011, has been successful lately because they have shifted away from making computer hardware and focused on technology and software services.The last year saw shares of IBM up 22%, while shares of Dell were up 7% and shares of Hewlett Packard were down 40%. Unless you are part of the Apple ecosystem, do you really care who made your computer screen or printer? When everything is perceived as being more or less the same, the only competitive arrow left in the quiver is price.
I am not suggesting that any of these companies will go the way of Eastman Kodak. The point we need to take away as investors, however, is that it is not enough for a company merely to be stable. That's survival mode, at best. The stocks of Whole Foods Market and TJ Maxx are doing well, in part, because what they offer is growing in relevance, at least for now. The same could be said of companies that enhance the efficiency and effectiveness of healthcare delivery. As for any possible catalyst, there is always the potential for a company to unlock value for its shareholders by breaking itself up, selling off brands, or being bought outright. Radio Shack would be the loser here, because the only assets they really have are their store locations. Campbell's and Hasbro have valuable brands, and they both pay a nice dividend in excess of 3.5%. Some investors will say that these stocks are cheap, but we can find other cheap stocks that just might move in the profitable direction. And even if I am wrong about my specific value trap candidates, the overall warning about those traps remains valid. Finally, as much anguish that we feel when we're seeing our stocks drop in a declining market, it's also pretty frustrating to watch the market soar and have our stocks not participate in the rally. Over the last three months, the S&P 500 is up 7%, with HAS and CPB each down about 5% and RSH down almost 20%. Nobody likes to miss the party.
As for Eastman Kodak, the company now faces possible bankruptcy and a delisting of their stock. Maybe things would have turned out differently if they had realized sooner that they were not really in the film business, but in the business of archiving memories. The irony here is that Kodak actually invented the first digital camera. Thanks for the memories, EK.
Next time we'll look at the opposite situation, stocks that are firing on all cylinders because of their growing relevance. Until then.....
Life is short. Get busy.
Jim
EK is a rather extreme example of a "bear trap" or "value trap," extreme because most companies that could be setting up as such traps aren't actually facing the near-obsolescence of their core product. Instead, most suspected cases of value traps come on more subtly, like that first cough or body ache that may signal that you're coming down with a full-blown case of the flu. Investors love to find stocks that are truly cheap, values because the stock price does not fully reflect the growth opportunities that may lie ahead for the company. Successful investing requires that we distinguish between stocks that are undervalued for that reason and those that just appear to be undervalued but actually deserve to be cheaper. Would you really want to invest in a company that makes typewriters, regardless of how cheap the stock is? We'll look at some suspected cases of value traps and pose two questions to conduct our diagnosis: Is the company's product or service gaining or losing relevance for its customer market? And what is the catalyst that is going to make the stock go higher?
Our first patient is Radio Shack (RSH, $9.85). I have read numerous research reports claiming that the stock is a buy--at $15, then at $13, then at $11, and so on. As a teenager I would buy blank cassette tapes there so I could record my albums to listen to in the car. On my last trip to Radio Shack, some time last year, I bought some fuses for my stereo system--total sale less than $10. The company is trying to keep its stores relevant by emphasizing more wireless products, services, and accessories, but the only company that really seems to be thriving selling consumer electronics at a bricks-and-mortar location is Apple. Radio Shack may be around for a while, but its relevance does not seem to be growing.
Campbell's Tomato Soup and a grilled cheese sandwich may be the best comfort food ever invented. That's what I enjoyed as a kid, and it's what we'd serve our kids when they were home from school on snow days. (M'm M'm Good!) When my wife went shopping to load up on the condensed soups that go into the Thanksgiving and Christmas casseroles, I noticed that my value maven brought home the store brand, not the Campbell's. When I asked her about this, she explained that it really didn't matter since the soup was going into the green bean casserole. M'm M'm Bad for Campbell's--that's the last thing a company wants consumers thinking about its branded products. We are not health nuts at our house, but we still don't have that much use for a can opener. While I sill eat the Campbell's (CPB, $32) Tomato Soup on occasion, I really can't imagine chowing down on something like seafood gumbo out of a can. There are plenty of options for freshly prepared soups--or at least something closer to fresh. CPB also owns Swanson, Pepperidge Farm, Pace Salsa, Prego Pasta Sauces, and V8 Juice Drinks--an impressive portfolio of brands, in other words. That is why the diagnosis here is not terminal. Food is not film. However, the trend toward healthier eating habits is a headwind for the company, so while its relevance may be stable, it's not likely to grow. More than a hundred years ago, CPB figured out the way to remove half of the water from its soups. This meant that shipping costs were greatly reduced (water weighs a lot), so the company was able to charge a lower price point for their soups and capture a huge share of the market. That's called innovation, and if the company wants to see its stock price move up, it had better get busy innovating.
A Wall Street Journal headline from December 15, 2011, proclaimed, "Hasbro Falls Prey to 'Angry Birds'" (by Ann Zimmerman). The article details how Hasbro (HAS, $32), known for board games such as Monopoly, Battleship, Scrabble, and Operation, has suffered because they haven't done much to update those classics or introduce new games. Sales of Hasbro's boards games are down 9% over the last three quarters compared with last year, with the stock price down 30%. The company is also not clicking with its foray into online games--there are one million monthly Facebook Scrabble users compared with the 13 million users of Zynga's "Words with Friends." Hasbro is now focusing on movie tie-ins with its stable of toy characters. Kids will always play with toys, but the preference seems to be gaining for World of Warcraft over G.I. Joe. I can only wonder what Henry and Helal, the Hassenfeld brothers (Has-Bro), would think about their company today, some 60 years after they gave birth to Mr. Potato Head. Sorry, Bro.
Another early warning for value traps surfaces when a company's product starts to take on the characteristics of a commodity. The key aspect of a commodity, at least for our purposes here, it that the seller cannot differentiate the product to gain pricing power. If I am a corn farmer, I have to accept the price of corn that is determined by supply and demand in the commodities markets--that is what is known in economics as being a "price-taker." I can't differentiate my corn by branding it as "Jim's Corn" and charging a higher price. If I have an orange grove in California and a freeze destroys much of the orange crop in Florida, then the price of oranges will go up, and I'll benefit by realizing a higher price. That will be due to the changes in supply and demand, though, and not to any special feature that differentiates my oranges.
Televisions have become "commoditized" in this way, and that's part of the reason why shares of Sony (SNE, $17) have been in the dumps. When most people shop for that new flat screen television, they are looking for the combination of features and price that best suits them, and they are not as concerned as they once might have been with any particular brand. This was happening with cell phones before Apple redefined the landscape with the iPhone. Part of the genius of Apple, as we have noted before, is that they were able to avoid the commodity trap by branding their products and creating a technology ecosystem based on their operating system. It's part of the reason people are so excited about the possibility of an Apple television, because that could have the same effect. Just about every type of consumer electronics product out there has fallen victim, at least to some extent, to commoditization. IBM, the second-best performing stock in the Dow Jones Industrial Average for 2011, has been successful lately because they have shifted away from making computer hardware and focused on technology and software services.The last year saw shares of IBM up 22%, while shares of Dell were up 7% and shares of Hewlett Packard were down 40%. Unless you are part of the Apple ecosystem, do you really care who made your computer screen or printer? When everything is perceived as being more or less the same, the only competitive arrow left in the quiver is price.
I am not suggesting that any of these companies will go the way of Eastman Kodak. The point we need to take away as investors, however, is that it is not enough for a company merely to be stable. That's survival mode, at best. The stocks of Whole Foods Market and TJ Maxx are doing well, in part, because what they offer is growing in relevance, at least for now. The same could be said of companies that enhance the efficiency and effectiveness of healthcare delivery. As for any possible catalyst, there is always the potential for a company to unlock value for its shareholders by breaking itself up, selling off brands, or being bought outright. Radio Shack would be the loser here, because the only assets they really have are their store locations. Campbell's and Hasbro have valuable brands, and they both pay a nice dividend in excess of 3.5%. Some investors will say that these stocks are cheap, but we can find other cheap stocks that just might move in the profitable direction. And even if I am wrong about my specific value trap candidates, the overall warning about those traps remains valid. Finally, as much anguish that we feel when we're seeing our stocks drop in a declining market, it's also pretty frustrating to watch the market soar and have our stocks not participate in the rally. Over the last three months, the S&P 500 is up 7%, with HAS and CPB each down about 5% and RSH down almost 20%. Nobody likes to miss the party.
As for Eastman Kodak, the company now faces possible bankruptcy and a delisting of their stock. Maybe things would have turned out differently if they had realized sooner that they were not really in the film business, but in the business of archiving memories. The irony here is that Kodak actually invented the first digital camera. Thanks for the memories, EK.
Next time we'll look at the opposite situation, stocks that are firing on all cylinders because of their growing relevance. Until then.....
Life is short. Get busy.
Jim
Thursday, January 5, 2012
Rolling The Dice
I've never been really much of a gambler, but as an investor, I am intrigued with a business where the house always wins in the end. I am even more intrigued when a company's competition is limited by government fiat. I have invested in the casino and gaming companies in the past, and some circumstances today are leading me to give them a fresh look. As Michael Corleone lamented in The Godfather III, "Just when I thought I was out, they pull me back in."
Despite its name, Las Vegas Sands (LVS, $43) derives about 85% of its revenue from its Asia resorts and casinos.The government of China apparently does not want the country overrun with blackjack players and slot machine junkies, so they have limited legalized gaming to the small region of Macau. LVS has one of six licenses to operate casinos in Macau. Two of the other licenses are held by Wynne Resorts (WYNN, $111) and Melco Crown Entertainment (MPEL, $10). LVS also holds one of only two licenses to operate casinos in Singapore.
Las Vegas Sands has a colorful history that goes back to the glory days of the legendary Sands Hotel on the Las Vegas Strip. The original Oceans 11 was filmed there in 1960, and the Rat Pack (Frank Sinatra, Dean Martin, Sammy Davis, Jr., Peter Lawford, and Joey Bishop) performed in the hotel's Copa Room. Howard Hughes owned the Sands at some point during the 1960s. The property's next owners decided that nostalgia needed to give way to more glitz and glamor, so in 1996 they imploded the Sands to make room for The Venetian. When the company set its sights on Macau, it realized that land was too limited to develop something on the scale of the Las Vegas Strip, so they created more land by filling in the bay between Coloane and Taipa Islands. That is now the Cotai Strip, home to one of the world's largest inhabited buildings, The Venetian Macao. LVS now has several casinos in Macau, and its newest resort/casino is the Marina Bay Sands in Singapore.
Back here in the U.S.A., the Department of Justice announced in December that it has changed its position on how the Wire Act of 1961 applies to online gaming. Previously, the DOJ held that the act prohibited all forms of online gambling, but now is taking the position that the act prohibits only sports-related gambling. The removal of the federal prohibition means that states may be free to legalize forms of online gambling that do not involve wagering on sporting events. The immediate effect likely will be to allow states that already have lotteries to sell lottery tickets online. It's now all up to the individual states, but states are hard-pressed for new sources of revenue, and it is conceivable that the lifting of the federal ban will lead to other forms of online gaming in states where lotteries are already legal.
As investors, we always need to respond to any trend, change, or development by asking, Who stands to benefit? When we looked at the trend in online shopping, for example, we noted that UPS and FedEx are beneficiaries of that trend because someone has to deliver all those packages. When the casino business was booming in the 1990s, I invested in a company called International Game Technology (IGT, $17), a maker of slot machines and other gaming equipment. One of the ways that casinos compete with each other for customers is to always offer the latest, state-of-the-art machines and gaming systems, and this competition among the casino operators just meant more business for IGT. I did well with IGT then and really haven't followed the company since. They made a few missteps several years ago and lost ground to their competitors, but now they may have their act together. IGT has developed something called "IGT Cloud," which is aimed at helping individual casinos better manage and offer more varied gaming content. If the company can leverage its cloud presence into some form of online gaming, that could be an opportunity for them. I'll be keeping an eye on IGT.
As for LVS, the company has been under investigation by U.S. authorities (the Securities and Exchange Commission and Department of Justice) and the Hong Kong securities regulators based on bribery allegations made by a former company executive. The Hong Kong authorities have concluded their investigation and will be taking no action against the company, but the U.S. investigation is still ongoing. That has put a cloud (a dark one, not an Internet one) over the stock that may remain until these issues are resolved.
I saw the stock's weakness as an opportunity to invest in a strong growth story at an attractive price, but some investors may want to steer clear. Doing business in a country like China adds another layer of risk to what is already a risky business. Michael Corleone might have been spared his tragic, King Lear-like fall if he had just stayed put in New York and avoided Las Vegas entirely. When it comes to investing, what happens in Vegas definitely does not stay in Vegas.
Just when I thought I was out............
Life is short. Get busy.
Jim
Despite its name, Las Vegas Sands (LVS, $43) derives about 85% of its revenue from its Asia resorts and casinos.The government of China apparently does not want the country overrun with blackjack players and slot machine junkies, so they have limited legalized gaming to the small region of Macau. LVS has one of six licenses to operate casinos in Macau. Two of the other licenses are held by Wynne Resorts (WYNN, $111) and Melco Crown Entertainment (MPEL, $10). LVS also holds one of only two licenses to operate casinos in Singapore.
Las Vegas Sands has a colorful history that goes back to the glory days of the legendary Sands Hotel on the Las Vegas Strip. The original Oceans 11 was filmed there in 1960, and the Rat Pack (Frank Sinatra, Dean Martin, Sammy Davis, Jr., Peter Lawford, and Joey Bishop) performed in the hotel's Copa Room. Howard Hughes owned the Sands at some point during the 1960s. The property's next owners decided that nostalgia needed to give way to more glitz and glamor, so in 1996 they imploded the Sands to make room for The Venetian. When the company set its sights on Macau, it realized that land was too limited to develop something on the scale of the Las Vegas Strip, so they created more land by filling in the bay between Coloane and Taipa Islands. That is now the Cotai Strip, home to one of the world's largest inhabited buildings, The Venetian Macao. LVS now has several casinos in Macau, and its newest resort/casino is the Marina Bay Sands in Singapore.
Back here in the U.S.A., the Department of Justice announced in December that it has changed its position on how the Wire Act of 1961 applies to online gaming. Previously, the DOJ held that the act prohibited all forms of online gambling, but now is taking the position that the act prohibits only sports-related gambling. The removal of the federal prohibition means that states may be free to legalize forms of online gambling that do not involve wagering on sporting events. The immediate effect likely will be to allow states that already have lotteries to sell lottery tickets online. It's now all up to the individual states, but states are hard-pressed for new sources of revenue, and it is conceivable that the lifting of the federal ban will lead to other forms of online gaming in states where lotteries are already legal.
As investors, we always need to respond to any trend, change, or development by asking, Who stands to benefit? When we looked at the trend in online shopping, for example, we noted that UPS and FedEx are beneficiaries of that trend because someone has to deliver all those packages. When the casino business was booming in the 1990s, I invested in a company called International Game Technology (IGT, $17), a maker of slot machines and other gaming equipment. One of the ways that casinos compete with each other for customers is to always offer the latest, state-of-the-art machines and gaming systems, and this competition among the casino operators just meant more business for IGT. I did well with IGT then and really haven't followed the company since. They made a few missteps several years ago and lost ground to their competitors, but now they may have their act together. IGT has developed something called "IGT Cloud," which is aimed at helping individual casinos better manage and offer more varied gaming content. If the company can leverage its cloud presence into some form of online gaming, that could be an opportunity for them. I'll be keeping an eye on IGT.
As for LVS, the company has been under investigation by U.S. authorities (the Securities and Exchange Commission and Department of Justice) and the Hong Kong securities regulators based on bribery allegations made by a former company executive. The Hong Kong authorities have concluded their investigation and will be taking no action against the company, but the U.S. investigation is still ongoing. That has put a cloud (a dark one, not an Internet one) over the stock that may remain until these issues are resolved.
I saw the stock's weakness as an opportunity to invest in a strong growth story at an attractive price, but some investors may want to steer clear. Doing business in a country like China adds another layer of risk to what is already a risky business. Michael Corleone might have been spared his tragic, King Lear-like fall if he had just stayed put in New York and avoided Las Vegas entirely. When it comes to investing, what happens in Vegas definitely does not stay in Vegas.
Just when I thought I was out............
Life is short. Get busy.
Jim
Sunday, January 1, 2012
Investment Themes and Dreams For 2012, Part Two
Happy New Year! I hope that 2012 is a year of health, happiness, and prosperity for all of you and those you love. We'll continue here with our look at some investment themes and trends for the coming year.
As The Great One, Jackie Gleason, used to say, And Away We Go.........
Doctor, Doctor, Give Me The News.........
Just about every scene in The Godfather is a classic, but the last time I watched the movie (my annual viewing) I took particular note of the hospital scene where Al Pacino comes to check on Marlon Brando, who is recovering after being gunned down on the streets of New York by a rival family. I was intrigued by Francis Ford Coppola's depiction of a late-1940s hospital setting, totally lacking in all of the monitors and technology gizmos that seemed to fill my daughter's hospital room when she gave birth to my first grandson almost four months ago. Hospitals and health care delivery facilities have come a long way with technology since Don Corleone needed their services, but one area in health care has lagged behind. When I visit my doctor's office, the nurse still places the manila folder containing my charts and patient records in a tray on the examining room door so that my physician can peruse it before telling me that it is time for my annual prostate exam. It's the same type of manila folder my pediatrician would carry into the examining room when I was just a little tyke back in the 1960s.
The federal government would like to see more pervasive adoption of Electronic Health Records (EHR), and to that end they're offering up both a carrot and a stick. This is part of the Health Information Technology for Economic and Clinical Health Act (HITECH), which is part of the American Recovery and Reinvestment Act (ARRA). To put it more simply, there are positive incentives for health care providers to adopt the technology now, but penalties for those who fail to get on board by 2015. A recent study estimated that only about 20% of doctors' offices and 10% of hospitals currently utilize some form of Health Care Information Technology (HCIT). The idea behind all of this has to do with efficiency (cost-savings) and improved quality of care. If I check into a hospital with this technology, everyone in the health care food chain can tap into my medical records on a computer screen or wireless device instead of having to wait for the contents of the manila folder to be delivered or faxed. Two of the companies that provide the systems are Cerner (CERN, $61) and Allscripts Healthcare Solutions (MDRX, $19). The technology such companies provide has been around for some time, but their business may get a boost from the federal mandates. They'll also benefit from service and upgrades to the installed base.
Falling Off A (Patent) Cliff
Big pharmaceutical companies such as Merck (MRK, $37) and Pfizer (PFE, $20) saw a long period of glory days as investments when they were coming out with patented blockbuster drugs (Pfizer's Lipitor is one example). Many of those drugs are now going off patent (this is known as the "patent cliff"), and there don't seem to be many promising new drugs in the pipeline that would restore the luster of blockbuster status. Generic versions of the once-patented drugs are either here or on their way, and that means major price competition for the "big pharma" drugs that once were monopolies for their developers. Patent protection is crucial for the development of new treatments, because companies wouldn't take the risk of spending hundreds of millions of dollars on research and development if they couldn't have the pricing power that comes with temporary monopoly status.
There are a number of companies in the drug delivery chain that stand to benefit from the onslaught of generics--basically, everyone except the pharmaceutical companies that developed the drugs in the first place. Obviously, a company such as Mylan Labs (MYL, $21) that specializes in generic drugs will see more business to the extent that they roll out inexpensive new versions of drugs that are already widely prescribed. Companies in the wholesale drug distribution business will benefit also, because they tend to make higher profit margins on generics than they do on the patented drugs. The three main players in drug distribution are AmerisourceBergen (ABC, $36), McKesson (MCK, $78), and Cardinal Health (CAH, $41). I tend to favor ABC because it is the purest play here, likely to see the most benefit to its bottom line from generics.
Also involved in this drama are the Pharmacy Benefit Management (PBM) companies that administer and process prescription drug claims for health plans. Express Scripts (ESRX, $44) plans to buy rival PBM Medco Health Solutions (MHS, $56), and if the deal is approved it will create the nation's largest PBM. The arrangement between ESRX and Walgreens (WAG, $33) ended at the end of 2011 when the two companies could not agree to terms for renewing their contract. Starting January 1, 2012, Express members will not be able to have their prescriptions filled at Walgreens. This likely will benefit WAG's chief competitor, CVS (CVS, $41), which a few years ago bought its own PBM, Caremark. This makes for a lot that is yet to be resolved, but some time during 2012 we will know whether the ESRX/MHS deal will go through and what will happen with ESRX and WAG. Shares of WAG have taken a hit recently due to the earnings that the company will likely lose with the loss of ESRX customers.
Finally, I'm not counting out the big pharmaceutical companies. Merck bought Schering Plough in 2009, and this combination will help beef up Merck's formerly weak pipeline of new drugs. I also like MRK's "paid to wait" dividend yield of 4.5%.
Waiting For A Housing Recovery
I don't know when we will see a truly strong housing recovery, but I am certain of one thing. By the time a genuinely robust recovery in housing is underway, it will be too late to buy many of the stocks that will benefit. The housing stocks will rally in anticipation of a recovery, just as stocks always move in anticipation of what is expected to happen in the future.We are already seeing some signs of life here, as the economic numbers are showing some improvement and the homebuilder stocks are showing strength. Just because the worst may be over, though, does not mean that the best is knocking at the door. My strategy is not to buy the homebuilder stocks, but to seek out those companies that will further benefit from a housing recovery but are doing well with the status quo. One such company might be Stanley Black and Decker (SWK, $67), the combination of the old Stanley Works and the Black & Decker corporation. They make and market tools for the retail consumer and industrial markets. I may not be very handy with a toolbox (my wife reminds me of this constantly), but everything in mine comes from Stanley. SWK has further diversified with the recent purchase of Niscayah, a European security-systems company.
What is interesting right now is that in many markets it is becoming cheaper to buy than to rent. Mortgage rates are at historic lows, with rates for a 30-year mortgage around 4%, and house prices remain depressed. Of course, home ownership comes with many other costs (insurance, property taxes, maintenance), but comparing the monthly payment (principal and interest) on a mortgage with monthly rent is getting pretty compelling. We've also seen a collapse in the rate of household formation. The number of U.S. households increased by 600,000 in 2011, compared with an increase of 1.5 million in 2006. Grandpa and Grandma are moving in with the kids, and the kids' kids are moving back home after college (they can't find jobs, partly because they majored in gender studies instead of getting engineering degrees). If this keeps up, we'll be a nation of The Waltons (Goodnight, John-Boy!). What we are experiencing is a classic supply/demand imbalance, where the market has to absorb the "shadow inventory" of distressed properties that will be coming on the market post-foreclosure. This will still take time to work through.
My wife recently was shopping for our youngest daughter, who graduated from college in May and has her first apartment, in New York. I learned that Dollar Tree (DLTR, $83) is a great place to get things like Pyrex dishes and spatulas on the cheap. At the higher end, continuing with our "Tale of Two Cities" theme, Williams Sonoma (WSM, $38) sells all kinds of products for feathering the nest. I expect that whatever housing recovery we have will proceed along the lines of a thriving high-end market with a middle that continues to struggle.
Cloud Nine
The world is getting smaller, or at least it seems that way as we now have the potential to be connected to everything, all of the time. I am not even going to pretend to know everything about the trend in cloud computing, but I read so much about it that I am compelled to issue a "Hype Alert." I can foresee stocks that claim to be associated with the cloud trading the way stocks with a "dot com" name worked their way into a speculative bubble before crashing in the early 2000s. Here, though, is what I do understand about the cloud. IBM introduced the first Personal Computer (PC) in 1981, while I was a junior at Rhodes College (then known as Southwestern at Memphis). I was majoring in economics and business administration after a very successful attempt my first two years at majoring in Jack Daniel's. To work on our econometrics projects, we would go to the computer room in the basement of the library. Running a program for, say, regression analysis required some rudimentary knowledge of a computer language, such as BASIC or FORTRAN. The computers, which were really just screens and keyboards, were hooked up to the mainframe computer, which was the brain, in another building. We had to go to that location to retrieve our printouts (on big green and white sheets). The PC revolution moved the power of the mainframe to the desktop, and the advent of Microsoft's Windows and other software meant that you no longer needed to write your own programs. The overall trend in technology has been for computers to get smaller at the same time they are getting more powerful. This is what is, roughly speaking, known as "Moore's Law": the number of transistors than can be placed on a given integrated circuit doubles every two years (named for Intel co-founder Gordon Moore). The big shift now is that computing power is moving away from the desktop, not back to a centralized mainframe, but to a dispersed network of servers that collectively constitute the "cloud." A very simplistic example is the difference between Microsoft's Outlook Express and Google's Gmail. Outlook Express is software installed on my computer, and it downloads my emails from the mail server at my Internet Service Provider (ISP), Comcast. My wife, on the other hand, uses Gmail, which involves no software on her computer. All she needs is an Internet connection to send and receive emails. It's all "out there" in the cloud.
The Cloud is not something some company invented and owns, but instead just a way that everything is connected and accessed. What is does mean, though, is lots and lots of data, so a company that interests me here is EMC (EMC, $21). EMC is the leading data storage company, so they should benefit from the shift towards the cloud, as all that data needs to be stored, accessed, and protected. EMC also owns 80% of VMware (VMW, $83), which specializes in "server virtualization." The cloud makes computer processing function more like a utility, where users pay for what they use, accessing it over the Internet instead of having it installed on their computers. Not surprisingly, the enthusiasm over the cloud has hurt the stocks of Microsoft (MSFT, $26) and Intel (INTC, $24) because those two companies together made for the dominant standard in personal computing. I wouldn't expect the companies to just stand still while the market moves away from them, but it is just not clear at this point how--or if--they will regain their status as technology leaders.
Pay As You Go
The wireless revolution is about everything being connected without being tethered. The next big thing in wireless, it seems, it that your smartphone is going to be your credit or debit card. Mastercard (MA $373) and Visa (V, $102), we should note, are payment processors, acting essentially as toll collectors. If you look at your credit card, it's the issuing bank that's taking the credit risk, not MA and V. (American Express [AXP, $47], on the other hand, does take credit risk.) Believe it or not, cash is still the most widely used payment instrument around the world, so there is plenty of room for growth here. Verifone (PAY, $36) now has its point-of-sale terminals in taxi cabs, and pretty soon, at least in major cities, you'll be able to watch television and buy theater tickets while sitting in the back seat of a cab. The more people use forms of electronic payments, mobile or not, instead of cash, the more fees the processors will collect.
Are You Talkin' To Me?
I am very excited about the prospect of my grandson saying his first words, probably about a year from now. I wonder, with wild anticipation, what his first words will be to me (maybe, "Buy some more Disney, Pops!"). Unlike my grandson, smartphones and other technology devices are already starting to talk, and no review of such trends would be complete without a mention of Nuance Communications (NUAN, $25), a leader in voice-recognition and speech technology. I think we can expect to see a lot more of this. I do think, however, that if my smartphone is going to talk to me, I should get to choose its voice. I want either the raspy and sexy Lauren Bacall or the authoritative James Earl Jones, depending on the setting. (Great. Now Darth Vader is telling me about that prostate exam.)
As The Great One, Jackie Gleason, used to say, And Away We Go.........
Doctor, Doctor, Give Me The News.........
Just about every scene in The Godfather is a classic, but the last time I watched the movie (my annual viewing) I took particular note of the hospital scene where Al Pacino comes to check on Marlon Brando, who is recovering after being gunned down on the streets of New York by a rival family. I was intrigued by Francis Ford Coppola's depiction of a late-1940s hospital setting, totally lacking in all of the monitors and technology gizmos that seemed to fill my daughter's hospital room when she gave birth to my first grandson almost four months ago. Hospitals and health care delivery facilities have come a long way with technology since Don Corleone needed their services, but one area in health care has lagged behind. When I visit my doctor's office, the nurse still places the manila folder containing my charts and patient records in a tray on the examining room door so that my physician can peruse it before telling me that it is time for my annual prostate exam. It's the same type of manila folder my pediatrician would carry into the examining room when I was just a little tyke back in the 1960s.
The federal government would like to see more pervasive adoption of Electronic Health Records (EHR), and to that end they're offering up both a carrot and a stick. This is part of the Health Information Technology for Economic and Clinical Health Act (HITECH), which is part of the American Recovery and Reinvestment Act (ARRA). To put it more simply, there are positive incentives for health care providers to adopt the technology now, but penalties for those who fail to get on board by 2015. A recent study estimated that only about 20% of doctors' offices and 10% of hospitals currently utilize some form of Health Care Information Technology (HCIT). The idea behind all of this has to do with efficiency (cost-savings) and improved quality of care. If I check into a hospital with this technology, everyone in the health care food chain can tap into my medical records on a computer screen or wireless device instead of having to wait for the contents of the manila folder to be delivered or faxed. Two of the companies that provide the systems are Cerner (CERN, $61) and Allscripts Healthcare Solutions (MDRX, $19). The technology such companies provide has been around for some time, but their business may get a boost from the federal mandates. They'll also benefit from service and upgrades to the installed base.
Falling Off A (Patent) Cliff
Big pharmaceutical companies such as Merck (MRK, $37) and Pfizer (PFE, $20) saw a long period of glory days as investments when they were coming out with patented blockbuster drugs (Pfizer's Lipitor is one example). Many of those drugs are now going off patent (this is known as the "patent cliff"), and there don't seem to be many promising new drugs in the pipeline that would restore the luster of blockbuster status. Generic versions of the once-patented drugs are either here or on their way, and that means major price competition for the "big pharma" drugs that once were monopolies for their developers. Patent protection is crucial for the development of new treatments, because companies wouldn't take the risk of spending hundreds of millions of dollars on research and development if they couldn't have the pricing power that comes with temporary monopoly status.
There are a number of companies in the drug delivery chain that stand to benefit from the onslaught of generics--basically, everyone except the pharmaceutical companies that developed the drugs in the first place. Obviously, a company such as Mylan Labs (MYL, $21) that specializes in generic drugs will see more business to the extent that they roll out inexpensive new versions of drugs that are already widely prescribed. Companies in the wholesale drug distribution business will benefit also, because they tend to make higher profit margins on generics than they do on the patented drugs. The three main players in drug distribution are AmerisourceBergen (ABC, $36), McKesson (MCK, $78), and Cardinal Health (CAH, $41). I tend to favor ABC because it is the purest play here, likely to see the most benefit to its bottom line from generics.
Also involved in this drama are the Pharmacy Benefit Management (PBM) companies that administer and process prescription drug claims for health plans. Express Scripts (ESRX, $44) plans to buy rival PBM Medco Health Solutions (MHS, $56), and if the deal is approved it will create the nation's largest PBM. The arrangement between ESRX and Walgreens (WAG, $33) ended at the end of 2011 when the two companies could not agree to terms for renewing their contract. Starting January 1, 2012, Express members will not be able to have their prescriptions filled at Walgreens. This likely will benefit WAG's chief competitor, CVS (CVS, $41), which a few years ago bought its own PBM, Caremark. This makes for a lot that is yet to be resolved, but some time during 2012 we will know whether the ESRX/MHS deal will go through and what will happen with ESRX and WAG. Shares of WAG have taken a hit recently due to the earnings that the company will likely lose with the loss of ESRX customers.
Finally, I'm not counting out the big pharmaceutical companies. Merck bought Schering Plough in 2009, and this combination will help beef up Merck's formerly weak pipeline of new drugs. I also like MRK's "paid to wait" dividend yield of 4.5%.
Waiting For A Housing Recovery
I don't know when we will see a truly strong housing recovery, but I am certain of one thing. By the time a genuinely robust recovery in housing is underway, it will be too late to buy many of the stocks that will benefit. The housing stocks will rally in anticipation of a recovery, just as stocks always move in anticipation of what is expected to happen in the future.We are already seeing some signs of life here, as the economic numbers are showing some improvement and the homebuilder stocks are showing strength. Just because the worst may be over, though, does not mean that the best is knocking at the door. My strategy is not to buy the homebuilder stocks, but to seek out those companies that will further benefit from a housing recovery but are doing well with the status quo. One such company might be Stanley Black and Decker (SWK, $67), the combination of the old Stanley Works and the Black & Decker corporation. They make and market tools for the retail consumer and industrial markets. I may not be very handy with a toolbox (my wife reminds me of this constantly), but everything in mine comes from Stanley. SWK has further diversified with the recent purchase of Niscayah, a European security-systems company.
What is interesting right now is that in many markets it is becoming cheaper to buy than to rent. Mortgage rates are at historic lows, with rates for a 30-year mortgage around 4%, and house prices remain depressed. Of course, home ownership comes with many other costs (insurance, property taxes, maintenance), but comparing the monthly payment (principal and interest) on a mortgage with monthly rent is getting pretty compelling. We've also seen a collapse in the rate of household formation. The number of U.S. households increased by 600,000 in 2011, compared with an increase of 1.5 million in 2006. Grandpa and Grandma are moving in with the kids, and the kids' kids are moving back home after college (they can't find jobs, partly because they majored in gender studies instead of getting engineering degrees). If this keeps up, we'll be a nation of The Waltons (Goodnight, John-Boy!). What we are experiencing is a classic supply/demand imbalance, where the market has to absorb the "shadow inventory" of distressed properties that will be coming on the market post-foreclosure. This will still take time to work through.
My wife recently was shopping for our youngest daughter, who graduated from college in May and has her first apartment, in New York. I learned that Dollar Tree (DLTR, $83) is a great place to get things like Pyrex dishes and spatulas on the cheap. At the higher end, continuing with our "Tale of Two Cities" theme, Williams Sonoma (WSM, $38) sells all kinds of products for feathering the nest. I expect that whatever housing recovery we have will proceed along the lines of a thriving high-end market with a middle that continues to struggle.
Cloud Nine
The world is getting smaller, or at least it seems that way as we now have the potential to be connected to everything, all of the time. I am not even going to pretend to know everything about the trend in cloud computing, but I read so much about it that I am compelled to issue a "Hype Alert." I can foresee stocks that claim to be associated with the cloud trading the way stocks with a "dot com" name worked their way into a speculative bubble before crashing in the early 2000s. Here, though, is what I do understand about the cloud. IBM introduced the first Personal Computer (PC) in 1981, while I was a junior at Rhodes College (then known as Southwestern at Memphis). I was majoring in economics and business administration after a very successful attempt my first two years at majoring in Jack Daniel's. To work on our econometrics projects, we would go to the computer room in the basement of the library. Running a program for, say, regression analysis required some rudimentary knowledge of a computer language, such as BASIC or FORTRAN. The computers, which were really just screens and keyboards, were hooked up to the mainframe computer, which was the brain, in another building. We had to go to that location to retrieve our printouts (on big green and white sheets). The PC revolution moved the power of the mainframe to the desktop, and the advent of Microsoft's Windows and other software meant that you no longer needed to write your own programs. The overall trend in technology has been for computers to get smaller at the same time they are getting more powerful. This is what is, roughly speaking, known as "Moore's Law": the number of transistors than can be placed on a given integrated circuit doubles every two years (named for Intel co-founder Gordon Moore). The big shift now is that computing power is moving away from the desktop, not back to a centralized mainframe, but to a dispersed network of servers that collectively constitute the "cloud." A very simplistic example is the difference between Microsoft's Outlook Express and Google's Gmail. Outlook Express is software installed on my computer, and it downloads my emails from the mail server at my Internet Service Provider (ISP), Comcast. My wife, on the other hand, uses Gmail, which involves no software on her computer. All she needs is an Internet connection to send and receive emails. It's all "out there" in the cloud.
The Cloud is not something some company invented and owns, but instead just a way that everything is connected and accessed. What is does mean, though, is lots and lots of data, so a company that interests me here is EMC (EMC, $21). EMC is the leading data storage company, so they should benefit from the shift towards the cloud, as all that data needs to be stored, accessed, and protected. EMC also owns 80% of VMware (VMW, $83), which specializes in "server virtualization." The cloud makes computer processing function more like a utility, where users pay for what they use, accessing it over the Internet instead of having it installed on their computers. Not surprisingly, the enthusiasm over the cloud has hurt the stocks of Microsoft (MSFT, $26) and Intel (INTC, $24) because those two companies together made for the dominant standard in personal computing. I wouldn't expect the companies to just stand still while the market moves away from them, but it is just not clear at this point how--or if--they will regain their status as technology leaders.
Pay As You Go
The wireless revolution is about everything being connected without being tethered. The next big thing in wireless, it seems, it that your smartphone is going to be your credit or debit card. Mastercard (MA $373) and Visa (V, $102), we should note, are payment processors, acting essentially as toll collectors. If you look at your credit card, it's the issuing bank that's taking the credit risk, not MA and V. (American Express [AXP, $47], on the other hand, does take credit risk.) Believe it or not, cash is still the most widely used payment instrument around the world, so there is plenty of room for growth here. Verifone (PAY, $36) now has its point-of-sale terminals in taxi cabs, and pretty soon, at least in major cities, you'll be able to watch television and buy theater tickets while sitting in the back seat of a cab. The more people use forms of electronic payments, mobile or not, instead of cash, the more fees the processors will collect.
Are You Talkin' To Me?
I am very excited about the prospect of my grandson saying his first words, probably about a year from now. I wonder, with wild anticipation, what his first words will be to me (maybe, "Buy some more Disney, Pops!"). Unlike my grandson, smartphones and other technology devices are already starting to talk, and no review of such trends would be complete without a mention of Nuance Communications (NUAN, $25), a leader in voice-recognition and speech technology. I think we can expect to see a lot more of this. I do think, however, that if my smartphone is going to talk to me, I should get to choose its voice. I want either the raspy and sexy Lauren Bacall or the authoritative James Earl Jones, depending on the setting. (Great. Now Darth Vader is telling me about that prostate exam.)
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Speaking of the movies (and I know, I'm always speaking of movies), Lauren Bacall is still around and still one of my all-time favorite actresses. She was great in those movies with her real-life husband, Humphrey Bogart--To Have and Have Not, The Big Sleep, and Key Largo (that one even inspired a song). I may just have to conclude my New Year's Day as a couch potato by popping The Big Sleep in the dvd player. Lauren Bacall's last major and memorable film was in a supporting role as James Caan's agent in Misery (1990), based on the Stephen King novel. James Caan, of course, was Sonny in The Godfather. And Kathy Bates is from Memphis. You see, Uncle Walt was right: It is a small world, after all.
Life is short. Get busy.
Jim
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