My View of the Stock Market

The direction of the market on a daily basis is set by short term traders. They digest the news in the market that day and then trade based on it. This is not a conspiratorial view of things, it's not as if I believe that they all gather in a room somewhere and decide on where the market goes that day, but it reflects the old Warren Buffett cliche - in the short term the market is a voting machine, in the long run it is a weighing machine. Every day there is an informal vote by short term traders. Keep in mind that these traders can change their mind very quickly, as evinced by the volatility lately in the market.

So what has changed recently is that the voting has been for an up market, and we have seen a rally from 11,500 to 13,000 in the DJIA. The media has proclaimed this to mean that the "worst" of the crisis is over, but in reality nothing has changed except the optimism of the market. In March the market was overly pessimistic, imputing a worst case scenario and now it is doing the opposite, imputing a best case scenario.

We still face the same problems that we had before with Housing, the Economy, the credit crunch, the high price of commodities, etc. So what is the point of this diatribe? Stop listening to the market, because to paraphrase Mr. Bumble in Oliver Twist.

"The market is a ass."

Futures Down 466?

Dow futures are now down 466, the NASDAQ down 75 and the S and P 500 down 65. Tuesday morning will be something.

Futures down 350?

I turned on the Fox Business Network this morning just to see what was going on overseas, and noticed that the futures market in the United States was down 350 points this morning. I am hoping that this is the result of a thin market and not indicative of what will happen Tuesday morning.

"No Mas"

I have just one thing to say about this market - and that is "No mas." That famous and disputed line supposedly uttered by Roberto Duran in the eighth round of the second Sugar Ray Leonard - Roberto Duran Boxing match in 1980, sums up my feelings on this grim day.

Sallie Mae (SLM) - The Conference Call from Hell

It will go down in history as the conference call from Hell, displacing Jeff Skilling and the famous Enron Call from 2001. I am referring, of course, to the conference call conducted yesterday by Sallie Mae (SLM) and Albert Lord, its CEO.

First, he slams down the ancient sell side practice of asking a "multi part" question to conform to the single question requirement of most managements. The victim was Jason Miller.

"All right. This is the last question I answer that’s more than one part. We will look at the dividend in the second half of the year.."

And then Lord begins to display either his total contempt for the analyst community or his total ignorance of the company he is running.

Analyst

"And you didn’t mention how much equity you were going to need to get back up to the single A rating."

Albert L. Lord

"You’re talking to the wrong guy. I don’t know that answer."

Then an analyst begins to question him about access to the pass through market.

Analyst

"Okay, but clearly you’ve been talking to the arranging banks and they must be telling you something."

Albert L. Lord

"I’m not sure what you’re talking about. I’ve been talking to whom?"

Analyst

"We’re trying to make -- we’re trying to figure out what your stock is going to be worth and you’ve got to give us some guidance, you’ve got to give us some numbers. I don’t even seea margin number here for the stuff that you’ve done. Can you give us some handle on what your stock is worth?"

Albert L. Lord

"You should give Steve a call."

Analyst

"But you’re the CEO. You’re the guy who just took over the company."

Albert L. Lord

"Yeah, that’s exactly right. I’m the CEO. You should give Steve a call. Next question."

And then the grand finale, after no more questions from the analyst crowd:

Albert L. Lord

"How good is this? Steve, let’s go. There’s no -- no questions. Let’s get the fuck out of here."

A Threat to Value Strategy?

One of the bedrocks of Value Investing is margin of safety, which is sometimes manifested by owning a company with a large cash balance relative to its market capitalization. Most investors lump cash and short term investments into one figure, owing to the alleged safety of these investments. What if that cash wasn't really cash?

The latest hint of this problem comes from Palm Inc. (PALM) which stated during its conference call that $75 million of its cash balance has been reclassified to non current due to a "limited market" for these auction rate securities. The full quote from management, courtesy of Seeking Alpha:

"We also reclassified approximately 75 million of our investments to non-current. These are AAA and AA rated auction rate securities that currently have a limited market and are not needed to meet all liquidity needs for at least the next twelve months. As a result, they have been reclassified to non-current."

This looks to be classified on the PALM balance sheet as "other assets" which is now at $92.2 million. I am not sure what the other $17 million is.

There were no questions about this during the call.

PALM a Net Current Asset Value Play?

A number of bloggers have been pushing Palm, Inc. (PALM) as a "cash equals current market cap" play. This is not correct. PALM did report $622 million in cash and equivalents as of 8/31/07 compared to a current market cap of $573 million. However, they recently received a $375 million investment from Elevation Partners, and then promptly paid out a $900 million dividend to shareholders.

I don't usually bash fellow bloggers, mostly because one day I will make a mistake and don't want to be bashed myself, but this PALM investment theme was reported on Silicon Valley Insider, the blog authored by Henry Blodget, the former Wall Street super star analyst.

Here is an excerpt:

"Yes, we think Palm sucks. But it's worth observing that the company is trading for cash value.

At $5.50 a share, Palm has a market value of about $550 million, and at the end of August, it had about $550 million of cash. Thanks to its disastrous quarter, the company will undoubtedly take a restructuring charge, but it will still have a meaningful pile. And the 10% holiday headcount reduction should stem any cash burn for a while.

So the question is this: Can Palm be salvaged? Can it blow out its incompetent management team and recruit a better one? Can it be taken over by Research in Motion, Nokia, Motorola, or another gadget maker desperate to have a chance to compete with Apple?

If you think the answer is "yes," now is the time to look at the stock. Now, when everyone else is filled with feelings of love and admiration for Research in Motion and Apple and disgust and loathing for pathetic Palm."

Are We There Yet For Homebuilders - An Update?

In September we blogged about the dangers of using stated book value as a buy signal when evaluating Homebuilders for purchase. The original post is here at this link:

Are We There Yet for Homebuilders - Part II?

My advice was not to believe the book values being used in quarterly balance sheets.

"do not use price to book yet as a buy signal. Book value is in flux and will continue to go down quarter after quarter. The safest thing to do is take the latest quarters book value and write off 30% and then slap a .75 multiple on it and then buy them there."

Well, it seems that a 30% haircut is not enough. Lennar Corp filed an 8-K disclosing that it sold some of its lot and land inventory at a haircut of 55% off the book value that Lennar thought it was worth just eight weeks ago.

The full filing can be read here at the SEC site.

The relevant quote is:

"As of September 30, 2007, the acquired properties had a net book value of approximately $1.3 billion and the sales price was $525 million."

The Next Shoe?

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is one scenario.

Ambac Financial Group, Inc. (ABK) is at a 10 year low. ABK insures billions of dollars worth of Municipal Bonds. Small investors basically treat this guarantee from ABK and other insurers as gold. It lets them sleep warm and comfy at night knowing that their nest egg is secured.

The Stock Market panics further and drives down the price of ABK even more after further disclosures on its exposure to risky securities, and ABK loses its ability to provide a AAA credit rating to the bonds it insures. Municipal Bond funds, some of which must hold only AAA or insured bonds according to its prospectus, start selling ABK backed bonds. There are few buyers for these bonds. The market for these bonds shows sharp declines in price since the Municipal Bond market is a fairly illiquid market. Auditors, not wanting to end up like Arthur Andersen, insist that the muni funds mark the bonds down based on the few forced sales out there.

The bond funds holler and scream but they price the bonds at the end of the month based on the few comparable sales out there and on the underlying credit assuming no insurance.

The retail investor opens the statement and sees its fund or individual bond marked down 5 to 10%. A wave of panic selling ensues as they call their stockbroker and tell them to sell. Prices decline even further. Since there is too much supply and not enough demand, public finance slowly grinds to a halt as States and Municipalities can't roll over existing debt or start new projects.

While this scenario sounds like a little bit of a stretch, who knows? If someone had told you six months ago that the largest bank and the largest brokerage firm in the United States would sack its CEOs, that would have sounded a little crazy also.

Symetra Financial IPO - White Mountains Insurance

The long awaited initial public offering of Symetra Financial Corp. has finally arrived. An S-1 filed by the company this morning has put a price range of $18-20 per share on the 39.5 million shares being offered in the IPO. Symetra was created in 2004 by an investment group led by Berkshire Hathaway and White Mountains Insurance. Both entities own 26,887,872 shares of Symetra. WTM will be selling from 9,870,306 to 11,350,852 shares.

If we assume a pricing of $19 per share then WTM will receive from $187 to $215 million in the IPO. Its remaining stake in Symetra Financial, which will trade under the symbol SYA, will be worth $295 to $323 million.

Book value per diluted share for Symetra as of 9/30/2007 is $15.10, so the IPO is being priced at 1.25 times book value assuming a final price of $19 per share. In my blog post from June I used 1.5 times book value so the value comes in a little less than I thought.

This was still a good deal for White Mountains Insurance as the investment group purchased these assets from Safeco at less than book value in 2004, and they have also withdrawn capital since the original purchase. Here is the lead paragraph from the WTM press release in 2004:

"HAMILTON, Bermuda, Mar 15, 2004 /PRNewswire-FirstCall via COMTEX/ -- White Mountains Insurance Group, Ltd. (NYSE: WTM) announced today that it and Berkshire Hathaway Inc. are leading an investor group that will acquire the life and investments business of Safeco Corporation for $1.35 billion, subject to adjustment based on June 30, 2004 adjusted statutory book value.

Safeco Life and Investments, with headquarters in Redmond, Washington, focuses mainly on group insurance, individual life insurance, structured settlements, retirement services and mutual funds. As of December 31, 2003, the business had approximately $22.5 billion of total assets and $2.57 billion in GAAP book value ($1.74 billion excluding FAS 115). President Randy Talbot and his management team will continue to run the business following the acquisition."

The S-1 is here at the Edgar web site.

Is the Energy Cycle Over?

I know its heresy to even suggest that a hot sector has seen the peak and I will no doubt be greeted by a chorus of cat calls and boos from the rafters, but is it possible that the Energy Cycle is rolling over? The market was down big on Friday, but the Energy stocks really got hit hard, spooked by an earnings report by Schlumberger. The market bounced back on Monday but Energy did not share in that rebound.

So what spooked the market so badly? Here are some excerpts from the call courtesy of Seeking Alpha:

First up were management comments on the North American market:

"North America pre-tax margin declined 427 basis points sequentially, to 26.9%, due to weather-related disruption in the Gulf of Mexico, the continued erosion of pressure pumping stimulation pricing on land in the US, and a reduction of exploration activity in the Alaska, partly compensated by re-bound in Canada after the second quarter Spring break-up. In North America, activity increased in Canada, but this was off-set by weaker pricing for pressure pumping on land in the US, and by a sharp revenue drop in the Gulf of Mexico, due to the departure of several rigs to overseas locations, and a loss of approximately 15 operating days, due to weather."

This wouldn't have caused a 10% decline in the stock. The market knew that pressure pumping pricing was weak and the down time from the Gulf was also common knowledge.

And then the first bombshell hits:

"In the immediate future, while there will be some recovery from the low activity levels in the Gulf of Mexico, natural gas activity in both Canada and the US is likely to stabilize, as production remains relatively strong and gas storage approaches winter at comfortable levels."

"As a result, pressure pumping pricing deterioration will continue. This situation, however, does not change our view that North American natural gas supply will require sustained activity to combat production decline, and advanced technology, to increase production rates from poorer-quality reservoirs."

I will post again tomorrow on the rest of the Schlumberger call. It will be interesting to see if the Energy Sector will catch a bid from the Apple earnings blowout from last night.

Crash of 1987

The popular media is full of reminiscing about the crash of 1987, replete with touching stories about what people were doing at that particular time. This is our generations version of where were you when Kennedy was shot. So here is my story.

I was working for Olde Discount at the time. Olde was the 1980's version of the pre Internet, low cost discount broker where they charged $40 a trade, a level that would be laughable now of course. They had just opened a new office on Long Island, and I was the only broker in the office, fresh from Series 7 school. It was a frightful day watching just about every stock ticker go down, while contemplating that maybe I had chosen the wrong career.

The second part of the reminiscing stories ask whatever pundit happens to be on TV the question - Could it happen again? The usual answer is no, because of "liquidity," and the regulation/circuit breakers that have been put in place since then. I will take the contrarian opinion, because, after all that is the point of this blog.

Yes, it could happen again. Liquidity is a specious argument. Liquidity can evaporate in an instance, as we saw over the Summer. Liquidity is there until its gone. There is nothing magical about it. It's like saying that humans can breathe because the earth has an atmosphere that contains a Nitrogen/Oxygen mix. Well, duh.

The second argument is also flimsy, as circuit breakers, while closing the market for various amounts of time, can actually accentuate the panic as sell orders queue up with nowhere to go. Also, more volume trades off the exchange now than in 1987 so the "market" will really not close at all.

I would say that it is not very likely that it will happen again.

Enough is Enough

I've had it with all this talk about emerging markets and how great they are and how nothing can go wrong. Everyday these markets make new highs. Everyday some other talking head is on TV regurgitating some Groupthink on the Emerging markets.

I lived through a previous era where pundits said the same thing about a different market. When I first started working on Wall Street, the Japanese and its markets were like gods. Nothing could go wrong. They were like Supermen destined to take over the world economy. They made marquis purchases of our domestic assets - Rockefeller Center and Pebble Beach, etc. The Japanese Stock Market hit a new high everyday.

I was working in Fixed Income at the time at Chemical Bank in New York City, selling short term money market products. All you needed was a Letter of Credit from a Japanese Bank and it was like gold to a customer. We had another unit at the bank that sold only two funds to retail customers - the GT Global Asia Pacific and the GT Global Japan Fund. Want to guess how those funds did once the boom ended in the late 80's?

Oh I know, it's different this time. I forgot.

Are We There Yet for Homebuilders? - Part VI

Since I mentioned the California unemployment rate as it relates to Housing in my last post, I figured I would post it here. The chart is from Economagic, a great resource for economic data.




As you can see the unemployment rate has started to tick up, but it is nothing compared to the last downturn.

Are We There Yet for Homebuilders? - Part V

One fact that argues for investing now in Homebuilders is the strength of the general economy currently as compared to economic conditions back in 1989 to 1991. The chart below from Economagic shows the decline in non farm payrolls during the last great Housing crisis. The revision this morning to non farm payrolls for August from a previously reported loss of jobs to a gain, is more evidence of general economic strength. I seem to remember back in the early 1990's California had an unemployment rate around 9%.



Just think how bad things would be for Housing if another 2 million Americans lost their jobs.

Are We There Yet for Homebuilders? - Part IV

Another issue to grapple with when buying the Homebuilders is the number of new home sales relative to previous peaks. As you can see in the chart below, if you declare a bottom for housing at the current level, one of the assumptions that you are incorporating into your analysis is that you are comfortable with the fact that the number of new home sales will trough above the peak of the last cycle.

New Home Sales Monthly (January 1963 - August 2007)




This is an important decision because during the last three cycles, new home sales never went above a 900,000 annual rate. During this cycle, they went much higher and peaked at an annual rate of 1.389 million in July 2005. If this extra demand was real demand, due to higher population growth or a more affluent population buying second homes, then this is fine. If it is speculator demand, then we are in big trouble.

So it remains to be proven whether the trough of this cycle should be above or near the peak of the last three when referencing new home sales. Months supply of new homes solves this problem in some ways since it transforms the data into time. If that is the case then we may not be at the trough yet as months of inventory peaked at much higher levels at the troughs of previous down cycles. (9.4 in January 1991, and 11.6 in January 1980.)

Facebook equals Broadcast.com equals Geocities?

It was reported a few days ago that Microsoft is considering buying a minority stake in Facebook, the social networking site. The investment implies a value for Facebook of $10 billion. So what can $10 billion buy you these days?

Facebook, according to the Wall Street Journal, will have revenues of $150 million, and profit of $30 million in 2007. That gives us a multiple of 67 times sales and 333 times earnings. This assumes that the $30 million are actual “earnings” and not “adjusted” or “non-cash” earnings.

Growth you say. “Don’t forget about growth,” you scream at the top of your lungs. “I worship the god of growth.” Let’s do a discounted cash flow model and see what those earnings have to grow at, that when discounted to the present, justifies a valuation of $10 billion.

If we use the following assumptions

Growth Rates

Years 1-5 40%
Years 6-10 25%
Years 11-15 15%

Terminal Growth Rate of 2%
Discount rate of 7%

We get a present value of cash flows of $10.1 billion. Zuckerberg….take the money and run.

Lennar Earnings Call - No Bottom Yet

I just got off the Lennar call and wanted to share these highlights regarding the housing markets. Management has not yet seen the bottom in the markets they build in.

During the call, Lennar said that they would need to see three things before there is a recovery or stabilization in the market:

1) Inventories of both new and existing homes will have to stabilize first and be absorbed.

2) Mortgage markets will need to settle.

3) Consumer confidence is going to have to be restored.

Lennar said that there was no sign during the quarter that any of these occurred, and that in fact they had deteriorated further during the quarter.

General Market Conditions

“These continue to be very difficult times for the homebuilding industry”

“Current market conditions are primarily defined by the overhang of inventory in those markets which is comprised of completed homes on the ground, spec homes that are back on the market and owned homes that are up for sale. The overriding sentiment in our reviews is that the market has continued to become more and more competitive as inventories are managed and there continues to be a great deal of downward pricing pressure through the use of incentives, price reductions and incentivized brokerage fees."

On Signs of the Bottom

“Overall the supply of homes to sell continues to climb in many of our markets and we are not able to get a good reading how quickly this inventory will be absorbed or whether it will continue to increase as foreclosures increase and add to inventory.”

Mortgage Markets

“Adding to the sluggishness on the demand side is the continuing deterioration of the mortgage market as an additional component of demand has been sidelined.”

“We have not yet seen stability in the mortgage market either.”

On the Arrival of Helicopter Ben

“While the recent cut in interest rates by the federal reserve will began a process of rebuilding confidence it will most certainly not be a panacea for conditions as they exist.”

Wilbur Ross Speaks and You Damn Well Better Listen

I just listened to a great interview with Wilbur Ross on Bloomberg which was brought to my attention by the people at Vinvesting


Wilbur Ross Bloomberg Interview

The interview is 25 minutes long and goes into good detail on the issues of the day, including the sub prime lending fall out, brokerage earnings, the growth of the hedge fund industry and the inherent weakness of quantitative "black box" investing.

Why I Hate EBITDA - Part III

The street has slowly shifted over time to using Enterprise Value to EBITDA (EV/EBITDA) as a measure of valuation for a stock. The ostensible reason given is that EV/EBITDA takes into account the entire value of the firm. The real reason is that since so many companies are unprofitable, there is no "E" to put in the price to earnings formula. Wall Street had to come up with another measure to use.

So what is wrong with EV/EBITDA? It gives a false sense of cheapness – I can still hear the voice of the sell side analyst ringing in my ear

"The stock only trades at 5 times EV to EBITDA – my god that’s cheap."

But is it really cheap. Here are two companies, which one do you think is cheaper?

Company 1

Mkt Cap $ 60.0
Bond Value $ 40.0
EV $100.0
EBITDA $ 13.0

EV/EBITDA 7.7

Company 2

Mkt Cap $ 60.0
Bond Value $ -
EV $ 60.0
EBITDA $ 6.0

EV/EBITDA - 10.0

Well come on Eric, you say to me, the first one is cheaper you idiot. Well look again below.

Company 1

EBITDA $ 13.0
Interest $ 8.0
Free Cash $ 5.0

Price to FC 12.0

Company 2

EBITDA $ 6.0
Interest $ -
Free Cash $ 6.0

Price to FC 10.0

It doesn’t really matter what the EBITDA is because we all know that what really matters is the cash a business produces after it reinvests to maintain its business.

Don't be fooled by EBITDA. Wall Street hates you. Don't ever forget that their job is to separate you from your money.