Archive for March, 2013

Facebook Update

Wednesday, March 20th, 2013


Given the big selloff in Facebook today, I’ve gotten a couple of emails from people curious about what is happening.

We don’t own FB in managed accounts, so I don’t follow it daily, but looking at the chart I got interested in what was happening.

In the graph above, I’ve added two indicators that might help us to figure out what is happening from a technical standpoint. Further on, I will give you some of the fundamental analysis.

From a technical standpoint, you can see that I’ve added blue Fibonacci Retracement lines based upon the high price on the day it came public around $45 and the low a bit below $17.50. You can see that FB was not able to hold the 50% retracement level inspite of two attempts by the bulls to do so. That lack of conviction by bullish investors brought us back down to the price level where most of the purchases and sales have occurred. You can tell that by looking at the large red/green bar on the left side of the chart – it represents the Volume By Price and is far larger than the other bars.

The 50% retracement level is an important psychological level for any stock that has had a significant run, either up or down in price. For a company like FB that ran down in price, you want to see it break above that 50% level and hold there, consolidating the move, then move higher toward the 61.8% level [ if you want to learn more about Fibonacci Retracements you can follow this link to Chart School ].

The Volume By Price bars along the left side of the graph show you that the buying volume (the green portion of the bar) is pretty close to balanced with the selling volume (the red portion of the bar) in that large bar. You can see how the stock price bounced around within that bar for about a month, but has moved to the downside.

The bars below that level are much smaller and predominantly green until you get down to the $21 level. That is a big concern as there were more buyers than sellers at lower prices – and some (potentially many) of those buyers will likely be trying to sell their FB to lock in a profit before FB drops in price any further, turning their profit into a loss.

When you get below the $21 level, you can see that there are more sellers than buyers (the bars are more red than green) so that is likely where bullish buyers will step in to accumulate shares.

So, from a purely technical standpoint, I see more near-term downside to the stock based upon the previous distribution of buyers and sellers – absent something fundamental happening or some sort of analyst upgrade coming out to turn sentiment positive.

From a fundamental standpoint, I’ve added my Key Statistics grid (see the blog post a few days ago on Google for more information on why there are key pieces of information for me).

FB Key Statistics

What you can see here is that the numbers look ugly – however, that is not uncommon for a young company like FB. Investors in FB see it for what it could be in the future, not necessarily where it is now. So, applying the same ratio analysis to it that I use for a company like Google does not make sense.

Let’s check out the comparatives:

FB Comparisons

The most striking thing about the comparisons that I see are the growth numbers – sales growth has been instrumental in making this company ubiquitous with the internet. Very few companies can say that they have grown in the same manner as FB. Their key for the future will be finding a way to monetize their users so that their shareholders can benefit from their operations.

Because the company has negative Free Cash Flow, none of my standard valuation measures can be used to obtain a value for the company. The closest I can give you is to tell you the enterprise value (the sum of the value of the equity and the debt for the firm) is $33.46 per share, which is pretty close to the consensus price target that the analysts have placed on it, $33.28 – maybe they also used enterprise value to calculate a target, I have no way of knowing.

So, in summary, if you are an investor in Facebook, you own this company for the potential you see in it several years down the road – you likely see it as the go-to communication platform that will over time fundamentally change everyone’s internet experience (not unlike how consumers transitioned from radio to television as their primary entertainment source) – and that FB will find a way to monetize that macro experience so that their shareholders will profit.

Near-term, the sentiment appears to have shifted on FB and we could easily see continued price weakness – but with a high profile company like this, any sort of positive news can shift sentiment on a dime and push the price back to the 50% retracement level.

I do not see us adding this company to our managed accounts anytime soon – we need to see that the fundamentals are clicking and that it is generating sufficient free cash flow to warrant a purchase.

However, for aggressive investors or for investors with a vision of what the company will become and who have a sufficiently long time frame to hold the stock while they figure out how to monetize their business – this could be a homerun investment.

Remember, IBM started out as a much different company than it is today, and it hit an all-time high within the past few days. Nothing says that can’t happen with FB in the course of time, and make the early investors – even those who bought it much higher than today’s price – a significant amount of money.

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Cypriot Drama Continues

Tuesday, March 19th, 2013


The Russian English Language version of CNN posted the video interview above and I was astounded by it and wanted to share it (if you can’t watch the version here on the blog you can follow the link to YouTube where I found it).

Nigel Farage, the man being interviewed, is an English politician and founder of the Independence Party. He is a member of the European Parliament (MEP) in Brussels, and from the interview it sure sounds like he is the European version of Ron Paul or Ross Perot – telling a whole lot of truth that the other politicians do not want to hear.

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News reports state that Cyprus and ECB are said to be working on a capital control plan as a contingency plan against bank runs ahead of bank reopening; Banks may stay closed until Tues 26th instead of this Thursday in light of the “No” vote by the Cypriot parliament to not agree with the plan to “tax” deposits.

Their plan – thus far – is:
– To issue an official statement is expected later tonight with details;
– It is likely to introduce border checks for cash over certain amount not being able to leave the country;
– ECB may fly euro notes from other countries to feed Cyprus ATMs to meet anticipated withdrawal demand;
– The contingency plan said to include daily limits on withdrawal transactions to limit the amount of money citizens can access each day; and
– The anticipate that these restrictions and others will be in place for weeks, until the threat of a bank run is past.

There are lots of stories floating around about how this is a tempest in a teapot – but given the tenuous situation in Europe, it is something we need to watch. No one in our government thought that allowing Lehman Brothers to go bankrupt would be a big deal, and it almost brought down the entire global financial system. I AM NOT saying that big of a problem is possible with the situation in Cyprus – what I am saying is that it is smart to watch what is happening (I prefer the European news agencies perspectives on YouTube) in order to manage the risk for our clients.

At the top of the page, you see the chart of the TED spread – I haven’t posted this on the blog in a few years (since the stock market crash in 2008). At that time, I wrote that this chart tells me if there is a significant chance for some event that will seriously impact the global financial system (generally a liquidity event or a solvency event). The key levels to watch are 1.000 and 2.000, and the direction of the line as it moves.

You can see right now that we are very low so the markets are not anticipating any sort of event that would negatively impact the global financial system – based upon this very reliable indicator, maybe it is correct that we are seeing a tempest in a teapot – however, I will keep track of this indicator and post it here periodically so that you are aware of what it says.

If you were a reader of the blog in 2006/7, you will recall that I got concerned with this indicator based upon the initial issues with the sub-prime market, and in the summer of 2006 we sold all of our stocks and bonds issued by banks. That turned out to be a very good move (although it was 18 months before the crash) – I just didn’t think that the policy decisions made by Washington and Brussels would add to the problems (like letting Lehman Brothers fail when they were so interconnected to the global financial system) and cause a liquidity problem worldwide. I want to make sure that if the indicator jumps up this time, we view it more globally and not just as it might impact financial service companies here in the US.

We have gotten increasingly conservative as the market has moved higher – and I see no reason to change that posture when we are so close to an all-time high in the S&P 500.

Listening to MEP Farage put me in the mood for a scene from one of my favorite movies…

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But can the politicians in Brussels handle the truth? We’ll see (and we will see it before anyone else by keeping track of the TED spread).


You Can’t Insure Against a Tax

Monday, March 18th, 2013


If you ask most Americans, my guess is that they would not be able to find Cyprus on a map. Russians, however, have deposited a whole bunch of money in this tiny Mediterranean island (see the map above to give you a feel for where it is and its size in relation to Europe/Asia/Africa).

Why is this important? Over the weekend, it was announced that Cyprus had received a bailout from the European Union, and one of the conditions was that a special “tax” was being levied on bank depositors to offset the cost of bailing out their banks. Bank depositors in Cyprus have a 100,000 Euro deposit insurance guarantee, much like the US FDIC coverage. So, in spite of having a fully insured deposit under 100,000 Euros, depositors will have 6.75% of their deposit deducted from their account and handed over to the government. Depositors over 100,000 Euros will see 9.9% of their deposit turned over to the government.

In a strange turn of events, bondholders in those banks (in otherwords, the creditors of the banks who generally would be next in line after the stockholders to lose money when corporations fail) will be made whole and not lose anything.

Banks in Cyprus are closed through Thursday at which time it wouldn’t surprise me to see a massive exodus of deposits (particularly the Russian deposits which make up the bulk of the Cypriot bank deposit base) and a liquidity crisis as the next issue.

If you remember, when Lehman Brothers failed in 2008 and kicked off the stock market crash, a liquidity crisis was the proximate cause. Cyprus is just 0.02% of European Union GDP, so it is very small – however its banking system is 13 times greater than its GDP (I can’t find a source for this other than an interview I listened to earlier today – don’t place reliance in that number but rather in the fact that the banking system was a lot bigger than the country itself).

Last night, the Dow Jones Industrial Average futures were down 200 points, but as I write this, we are down 3 points. Volume, today, is lower than recent trading sessions, and in general for most of the increase in prices recently volume has been well below normal.

So what is going on? The stock market continues to be strong in price despite being weak in participation – that is not a situation that is durable and I wouldn’t expect it to last.


The graph above shows you the secular bear market we have been navigating since 2000. The S&P 500 is roughly 10 points from an all-time high, or 0.63%, and it has been trying to break through that upper resistance level for several days. Readers of this blog know that I have been very cautious and have been selling stocks into this year’s strength. BUT, the question is what will send the market into correction mode?

So far, investors have shrugged off this event and are focused on the wonders of Fed monetary policy keeping stock prices moving ahead. That will work until something happens to spook people into selling, much like last summer, sending the market down 10% to 15% – a healthy consolidation that shakes out those with short-term horizons but allows those with cash on-hand (like us) to buy solid companies at cheaper prices.

What seems most insane about this whole situation in Cyprus is that the EU officials are publicly stating that this is a one-time event and that it won’t be repeated. If you were a depositor in a Cypriot or Greek or Portuguese or Spanish or Italian bank, would you believe that? Or, would you want to move your deposit to a German or Swiss bank where the risk of confiscation, or “tax” as its being called, is less. I know what I’d do – buy a Rosetta Stone and learn to sprechen sie Deutsche pretty darn quick. Obviously I am not alone in this assumption as yields on both German and Swiss debt have turned negative (meaning people are willing to lose money on a 2-year bond just to avoid bigger potential losses in other investments).

And, we have to ask: if it can happen in Europe, can it happen in the USA? (ignoring the obvious that it already did happen in the USA during FDR’s first 100 days when physical gold was confiscated by the US government)…

We normally don’t listen to rap here on the blog, but given today’s topic, I couldn’t resist something from the early 90’s:

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For those of you who don’t like rap (that generally includes me) here is a story from Russia about the Cyprus situation:


Can Google Do What Apple Couldn’t?

Thursday, March 7th, 2013


We’ve started to see the Wall Street Analysts come out with $1,000 target prices on Google, much like we say with Apple last Summer as it was heading higher. Obviously, with Apple’s 40% correction in price, those analysts are feeling a bit embarrassed – much like the guys predicting $250 oil a few years ago. However, I wanted to go through the numbers on Google and let you make up your mind on whether you think Google can make the $1,000 per share price or whether this is another head fake to avoid.

I thought we would kick it off with our price analysis that we do for each company that we own:


This summary represents hundreds of calculations based upon a company’s balance sheet, income statement and cash flow statement. The summary first looks at some external sources for target prices set by the analysts. You can see that the consensus price is around $850 per share versus the current price of $836, or a roughly 2% upside.

However, when I calculate valuations based upon several different methodologies, you can see that the potential appreciation is quite higher – but we have to keep in mind that the calculations are really longer term in nature than the 6-month or 1-year price targets analysts use. When I calculate a value, I want to determine the intrinsic value of the company so I know whether I want to be an owner and not just a trader of the stock.

One method I like is to calculate the Net Present Value of the Free Cash Flow and add that to the current Book Value. This method tells me what the current assets and operations of the company are worth; the result is $978 so its not too far off from the $1000 the news making analysts have stated.

I also calculate two different versions of Discounted Cash Flow – each is an accepted methodology but attacks it from a different angle. Discounted Cash Flow calculations discount a company’s free cash flow and add to it a terminal value for that cash flow. It is similar to the calculation above except instead of using the current book value for the company it places a value on the cash flow into perpetuity.

DCF #1 uses trailing twelve month actual free cash flow along with analyst projections for growth. DCF #2 uses trailing ten year cash flow and calculates growth rates based upon historic data. Both discount at a Weighted Average Cost of Capital that we calculate at 8.66%. I like using the two methodologies, but in a case where the results are so different, such as this, I tend to average them: $1,297.90 + $849.52 = $2,147.42 / 2 = $1,073.71, also not too far off from the analysts.

There are also several other calculations I perform which I rely on less than the top three, but they still provide useful information. Calculations, like the Dividend Discount Model can be good for companies for whom you rely on the dividend stream for a significant portion of your expected total return – but in the case of Google, that just does not apply.

But, when I average all of the calculations out, I get an average valuation for the company of $1,034.20.

Let’s take a look at the company from an operating standpoint. In the graphic above, the final two line items represent my proprietary ranking system. I use a series of calculations that when aggregated and applied to the universe of 6,000+ companies in our data download, gives me a ranking based upon a normal distribution, with 0 as the worst and 100 as the best. One system provides a rank based upon earnings growth and one is based upon the quality of its financials.

Google, as you can see, ranks very highly on both measures. We use these rankings as a jumping off point and as a way to track a company over time. So, lets take a look at some of the factors we use as inputs to the rankings:


This chart shows you the down and dirty of investing according to me: the Key Statistics are a dashboard that show you at a glance how the company is operating and where it stands from a valuation perspective:

> In any company I own, I want to make sure that the Return on Invested Capital is well ahead of its Weighted Average Cost of Capital. This tells me how the company management is using the money its shareholders have entrusted to it.

> The Earnings Yield needs to be greater than the corporate bond yield so that I know this equity security is, from an asset allocation standpoint, a better allocation of capital than a fixed income security.

> I also like the Free Cash Flow Yield (whether on Market Cap or Enterprise Value) to also be above the Corporate Bond Yield to tell me how effective it is in its operations in generating cash for its shareholders.

> From a valuation point of view, I prefer to buy companies when their Enterprise Value is less than 5 times its EBITDA. When I already own a company, if I see it getting too high it tells me that it is awfully close to its intrinsic value and that appreciation could potentially be limited until EBITDA increases or until after the price corrects. If I am a buyer, 5 is a key level where other companies, particularly private equity, looks for take over candidates.

> Like any good investor who grew up marveling at the work of Peter Lynch, we want the PEG Ratio to be less than two. Or, in other words, we don’t want the P/E Ratio to be more than twice the Earnings Growth rate for the company.

> I have a target for earnings growth of 15% for companies. Historic earnings growth is important, but what I really want is to see the next 5-years earnings growth exceed 15% particularly if the past year has not done so (this is the case with Google).

> And it is always important for me to own companies whose earnings are growing faster than the broader market.

It is always important to me to know where the companies I own are compared to their competitors:


You can see that Google excels at growth rates, profitability and financial strength – and is represented fairly well by valuation compared to competitors.

For me, I want to own this company. I don’t know whether Google will hit the $1,000 mark in the next 6 months as the analysts who’ve stuck their neck out believe, but I am fairly comfortable that the value for Google is certainly higher than it is today.

The stock market will go up and down in price, but we try to focus on owning a wide variety of companies that have strong fundamentals (cash flow is king, valuation is critical, earnings growth is vital, and strong financial position is key). Sometimes Value investments are in favor but other times Growth investments are in favor – by having a 7 to 10 year horizon for an investment we try to make sure we own those that have the fundamentals we believe represent the best investments for our clients.

Our holding period is rarely the full 7 to 10 years – if we experience big gains in a shorter time frame we may sell and try to buy it back if the price goes down (and we can get it closer to a 5 EV/EBITDA) but we may hold it even if we have big gains depending upon our view of the macro events in the world and the position of the company relative to various catalysts driving stock prices.

Google is a great holding and we plan to hold on to it as we definitely believe it will reach an intrinsic value over $1,000 at some point based upon its operations. Not many companies can say that, but we will discuss others here in coming posts.


Dow Jones Industrial Average Hits a Record

Tuesday, March 5th, 2013

Industrials Graph - Past 20 Years

2013 has started off very strong for the stock market as money has started to flow into the stock market nearly four years into the rally from the post-crash low in March, 2009. For the first time in several years, money is leaving bond investments and flowing into stock market investments in quantity.

If you look back at the level of the S&P 500 Index at the March 2009 low, the index read 666 compared to today’s 1541. That is an increase of 131% – now is not the time to get aggressive investing in the stock market after such a big run higher. Looking at many of the indicators I follow, what I see is a stock market that needs to correct a bit as valuations have gotten somewhat stretched.

Please note that when I do my analysis, I use the S&P 500 Index to represent the stock market, not the Dow Jones Industrials. The S&P 500 is a much broader index and I think it represents the stock market better.

If you look at the chart that follows you will see a list of significant economic data points that compare where we are today in 2013 with where the economy was in 2007 when the DJIA was last at this level. These data points come courtesy of the Stanley Druckenmiller via Jim Cramer as quoted on Zero Hedge.

Economic Data Comparing 2007 and 2013

Our economy is significantly worse off today than it was in 2007 – but the difference is corporate earnings. The trailing twelve months earnings per share for the S&P 500 Index in 2007 when we were last at these levels was $84.92 with a P/E ratio of 17 compared to today’s EPS Estimates for the coming year of $97.70 and P/E ratio of 15.50.

It is clear today that in 2007 the stock market had gotten ahead of itself as the economic issues related to the the subprime mortgage crisis were just beginning to assert themselves. Investors were not anticipating the impact that such an event would have on the economy and corporate earnings. For the year ended in March 2009, at the bottom of the crash in stock prices, actual trailing twelve months EPS for the S&P 500 were $6.86 per share with a P/E ratio of 116.31.

In my opinion, we are not likely to see this deep of a drop in corporate earnings (from $84.92 per share to $6.86 per share for the S&P 500 Index) so I am not looking for a correction as huge as the 2008 crash – we should not expect the end of the world like we thought when the banks needed TARP and General Motors nearly filed for bankruptcy; however, the market as represented by the S&P 500 Index has moved up from 1,343.35 on November 16, 2012, to 1,541.07 today in a mostly straight up trajectory. This big move came in spite of a slowing economy, new manufacturing orders that continue to decline, and falling orders for non-defense capital goods.

I think the most likely scenario is that we correct back toward the November low – maybe not all the way but half to two-thirds of it – before the stock market moves back toward the current highs at year-end.

In the year-end Investment Commentary our clients received, I wrote that we were raising cash in client portfolios to protect against the financial risks coming from policy decisions (or failures to make decisions) by our government.

Even though we made it past the December 31 fiscal cliff deadline with tax and spending increases agreed to by our political leaders, and we made it past the sequester with $85 billion cut from discretionary spending, we still have two additional major fiscal events to deal with in coming weeks: March 27th is the expiration of the Continuing Resolution that has been funding our government in absence of an adopted budget; and mid-May brings another Debt Ceiling discussion as the country will again run out of borrowing authority once we reach the currently approved cap.

Given the fiscal issues facing our country, many of which are detailed on the chart above and combined with the various critical deadlines, it seems sensible to have an above average level of cash equivalent and short-term bond holdings in client portfolios when we get the inevitable correction so that we have cash available to reinvest in some of our favorite companies or funds at prices lower than today.

By raising cash on roughly 15% of our equity positions and locking in gains that we’ve experienced since the November low, and then subsequently reinvesting those proceeds later after the market corrects, we will be maximizing return and managing risk – two keys of successful investment management.

It is tough to not join the crowd as it is throwing money at the new high in the stock market, but as investors learned (or should have) in the past, it is better to be prudent and operate according to a plan – like one of my clients says on a regular basis “buy low sell high” as he pops into my office.

There is more truth to that kernel of wisdom than most investors understand – many of them sold out of the market in 2008 during the crash and only now are getting back in after the market has more than doubled. Our plan is to protect the gains we’ve earned since the March 2009 low so that we have cash available to reinvest when the correction comes; it is our plan to act wisely on that buy low sell high idiom and not follow the crowd that is buying at the top.

There is no date certain for when the market will pull back, but we will be ready with our list of companies to buy when it does. Famed investor Art Cashin was on TV today stating that from a historical perspective that markets very often act in a self-fulfilling prophesy manner when nearing new highs as investors come off the sidelines to add money to stock positions only to see a correction shortly thereafter.

As I look at many of the indicators I follow, I see a market that is weakening in spite of new highs. These indicators give me a feel for how the market is reacting internally separate from the price action of the index.

Check out the chart of company trading above their 50-day moving average:


Notice how it has rolled over and there are now significantly fewer stocks trading above their 50-day moving average – and see how we have fallen below the upper threshold we have held for so long as the market moved higher.

Now, take a look at the graph of stocks trading above their 200-day moving average:


This is a more intermediate term sort of indicator, but you can see that it is also rolling over and showing that stocks are weakening.

The next chart is the Bullish Percent Index – you can see that it has been jumping above the upper threshold for sometime indicating too much bullishness (its a contrary indicator – when too many people are bullish, that means its time to get conservative) but is also rolling over.


This chart is of the Hi Lo Index and shows you the number of new Highs versus new Lows in stocks.


You can see that it has been above the upper threshold for a long time, indicating caution, but that in spite of the market at current highs, the indicator is rolling over and showing weakness.

And our final chart is of the VIX volatility index.


You can see that this indicator is trading below the lower threshold (the upper one does not even show on the graph in this view) which tells you how complacent the market has become). Investors have become accustomed to the market going up, so there is no fear – this is a big contra-indicator and for me is always a reason to go against the grain.

So, based on the fundamental analysis that shows our economy in much tougher shape than it was back in 2007 when the stock market was at this level, based upon the political uncertainty in Washington relative to how we will fund our government and how we will reorganize our fiscal picture so spending and revenues are more in line with each other (stock market investors hate uncertainty and tend to lower P/E valuations because of it), and based upon the weakening internals of the stock market in the face of new index highs, I am very comfortable with an above average level of cash and short-term bonds on hand as a risk management tool.

I will be writing to you soon about some of the companies we are looking to add when the market correction arrives. We are focused on strong earnings growth and quality balance sheets, and I will detail for you some of the analysis we perform to select our holdings.

Until then, we will be monitoring our indicators and possibly expanding our cash and short term bond holdings if the market meanders higher.

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