The Dow staged a late day rally today, closing up 75 points to 10,750, despite the fact that oil prices have once again cracked through $50 per barrel. Many would expect that with oil at $51.39, stock prices would have suffered. After a 170-point Dow drop on Tuesday (oil soared more than $2 that day, to over $50), we have recouped most of those gains already without a pullback in the oil market.
From this, we see that the relationship between oil and stock prices can get pretty interesting. Many economists hate to see increasing energy prices, fearing it will cripple any moderate economic growth we do have in this country. They see higher gas prices at the pump as an indirect tax on consumers, curbing their disposable income. Since the consumer represents two-thirds of the U.S. economy, stock prices generally falter when gas prices head higher.
While I won't argue there is some connection, I have long thought that the impact higher energy prices have is somewhat exaggerated. After all, if the average consumer fills up his or her 15 gallon tank once a week, a 25 cent increase in the per-gallon price of gas costs that person about $195 per year extra. Hardly insignificant, but not enough to cripple an economy by any means, in my opinion.
Another interesting thing is how energy prices are affecting corporate earnings. While many will make the case that high gas prices will hurt the profit of consumer-related companies, earnings estimates have actually risen since the beginning of the year, even though oil prices have gone up as well. Growth in earnings for the S&P 500 was initially expected to be in the 7 to 8 percent range in 2005. Estimates have creeped up to between 9 and 10 percent already in the first two months of the new year. This has mostly been driven by the energy sector, whose profits are through the roof, and show no signs of slowing down.
As a result of higher profit estimates and a stock market that is down 1% thus far in 2005, the forward P/E on the S&P 500 has fallen to 16.2 or so. With the 10-year bond only yielding 4.29%, investors probably feel pretty comfortable buying stocks at these prices. The risk of course, is that energy prices fall meaningfully from here. The stock market might react postively to that initially, but don't forget that such a move will lower corporate profit estimates, leaving stocks relatively more expensive than they are now.
P&G Purchase of Gillette Continues Merger Mania
The Oracle of Omaha has to be very happy today. His holding company, Berkshire Hathaway, owns a 9 percent stake in Gillette (G), a stock that rose $6 today on word that consumer products giant Procter and Gamble (PG) will buy the company for about $11 billion in stock.
Fortunately for Mr. Buffett, he is on the receiving end of this deal. While he is publicly raving about the prospects for the combined P&G/Gillette, it is fairly obvious that this is not the kind of purchase Buffett himself would ever make. Procter is paying a whopping 28 times forward earnings for Gillette. With P&G shares fetching about 20 times earnings, this merger is extremely dilutive. Analysts estimate earnings per share will drop 15 to 30 cents in the upcoming fiscal year, as much as a 10 percent dilutive effect.
Company executives will clearly try and mask the dilution by praising its plan to buy back billions of dollars in stock, but that doesn't change the fact that P&G paid 28 times for a mature, slow growth, cash cow business. Sure there will be some synergies, but like with most deals, they will be overstated from the outset. It will be very interesting to see how well P&G stock does for Buffett and Co. over the next 5 or 10 years. I suspect despite all of the rave reviews presented today, actual stock price appreciation long term won't be all that impressive, given current valuations.
Last Year It Was Interest Rates, This Year It's Oil
Think back more than a year ago. At the time, market predictions for the coming year centered around one major theme; interest rates. The consensus opinion was drilled into our heads for months, namely that interest rates would have to rise in 2004, and the housing market would cool off. Some even called for the bursting of the housing bubble, even though there wasn't a bubble at the time that could be burst. Investment strategists warned their clients to avoid stocks of mortgage lenders and home builders.
Believe it or not, the consensus for 2004 was wrong (okay, this is very believable). Despite the fact that the Fed did start raising their lending rate from 1% to 2%, market rates didn't budge. In fact, in many cases they actually dropped. Mortgage rates were steady, and bond rates fell. What were some of the best performing stock groups in 2004? You guessed it.. mortgage lenders and housing stocks.
Okay, so that is in the past and just serves to prove that the consensus is usually wrong. With 2005 having just begun, what was everyone saying just before year-end, and how can we bet against it this year? Without a doubt the 2005 theme that received the most airtime was oil. After falling from its peak price of $55 per barrel, oil was hovering in the $40-$42 range at year-end 2004, and most were predicting a drop back to a "more normal" $28-$35 per barrel price tag.
So here we are, on January 18th and oil prices hit $49 this morning, knocking on the door of $50 for the second time in recent months. A move down to the high twenties or low thirties would surely ignite the market a bit, and the airline stocks even more dramatically, but don't count on it. Oil is to 2005 what interest rates were to 2004.
Taser Shareholders Stunned
Let the class action lawsuits begin. It appears the party for stun gun maker Taser (TASR) is ending. Two years ago, TASR stock traded at $0.35 (split-adjusted). After rising to more than $33 in 2004, the stock fell 30% today, to close at $14 per share. Taser is down 55% so far this year, and it's only January 11th. As a result, lawsuits will be filed, lots of them. And soon, very soon.
Shareholders will scream of being had. Taser didn't adequately update the public about its business, they'll say. They will point to the company's management; a father (Chairman) and two sons (one is CEO, the other is President). The trio sold more than $100 million worth of stock in 2004, all while touting their stun guns' safety and growth potential to any TV station or reporter that would listen.
They will be accused of insider trading because they were selling stock as they were hyping their company's prospects. Class action lawyers will conclude they knew business would fall short of their rosy projections, hence they sold, but didn't tell anyone, leaving shareholders with a 55% loss in 11 days.
Can you blame them? Not the shareholders, they are to blame, but rather Phil, Tom, and Rick Smith. Are they bad people for taking $105 million in profits off the table when their company was being valued at nearly $2 billion, despite only having $68 million in sales? Are they crooks? No. Actually, they are smart. They didn't know ahead of time when orders would be delayed or exactly when competitors would bring new products to market. What they did know was that companies aren't worth 30 times revenues very often, and when they are, it's not for very long.
How about Mark Cuban? Is he a crook? Most people (including myself) think he was a genius when he sold his Internet broadcasting company, Broadcast.com, to Yahoo! for billions of dollars. He got Yahoo! shares in exchange, and even knew to sell those too. Mr. Cuban didn't sell because he lost interest in his business, or because he doubted whether radio signals would be broadcast over the Internet. He sold because he knew Broadcast.com was not really worth the $7 billion the equity market was pricing it at.
It's the world we live in today. We do something stupid, lose money because of it, and we sue. We don't admit we made a mistake and learn from it; vowing never to make the same mistake again. That's what we should do, but not what most of us will do. Taser shareholders who will choose to join the class action suits are a perfect example.
If you paid 30 times sales for an overhyped pipedream company, you probably will lose money. It happens. We all mess up sometimes. But do yourself a favor. Learn from the mistake. Learn how to value companies properly, so as to avoid losing any more money. But please, don''t sue the people who understood concepts you failed to grasp.
The Smiths may be very guilty of overhyping their company. But not once did they hold a gun (no pun intended) to somebody's head and force them to buy Taser stock. When they saw an asset they owned become grossly overvalued, they sold. They did what every good investment manager would have done, and is heralded for doing.
We shouldn't sue people just because they're smarter than us. I'm not against giving every human being their fair day in court. The problem right now, in 2005, is that we don't only sue when somebody breaks the law. We sue when we mess up, to get revenge.