The Great Independent Research Debate

There is a very simple reason why Peridot Capital does its own research; there are very few people I trust more than myself to implement my investment philosophy. As much as so-called "independent" research claims to be such, experienced investment professionals know that research is often far from independent. All you have to do is ask yourself, is there reason to believe that this research is independent?

In the case of a buy-side firm like Peridot, there is every reason to believe that our research is independent because it is solely used internally to make investments on the behalf of clients. If clients do well, the company will prosper, and if they do poorly, clients will leave.

But what if a company doesn't manage money? What if they are solely in the business of selling research? Do they have to be independent? What is keeping them from doing whatever it takes to sell the product? After all, selling research is their only line of business. It's the same reasoning that some journalists print things that might not be completely accurate. They are in the business of selling papers, or magazines, or whatever their product is. How do tabloids stay in business? Is it because their stories are always accurate? No, it's because people buy them.

I decided to write this piece after reading a transcript of testimony given by Kim Blickenstaff, CEO of Biosite (BSTE), a small medical diagnostics company based in San Diego. Her testimony was part of a Senate Hearing this week entitled "Hedge Funds and Analysts: How Independent is their Relationship?" Below is an excerpt:

"In the ten months from February to December 2002, the number of shares [of Biosite] controlled by short sellers increased from 690,000 to 7.1 million shares, which represented nearly 50% of our outstanding stock.

During this same period, Sterling Financial Investment Group, a Florida-based research firm, issued at least seven negative research reports on Biosite, each carrying a Sell/Sell Short recommendation, and an $11 target price. We believe that these reports contained numerous inaccuracies or false and misleading statements, which ultimately lent volatility to the stock's performance, thereby harming many of our long-term, fundamentally-based investors."

There are many issues I have with this testimony from Biosite's CEO.

First, short sellers do not "control" shares of stock. They borrow shares from other investors and immediately sell them in order to raise cash proceeds. The investors who have sold the stock short no longer control the stock, they simply owe it to someone, and will have to buy it back at some point in the future to repay the loan.

Second, Blickenstaff claims that negative research reports issued by Sterling between February 2002 and December 2002 were successful in "harming many of our long-term, fundamentally-based investors." This is interesting given that Biosite stock was $18.37 on February 1, 2002 and closed December 31, 2002 at $34.02 per share. So, even as the number of shares sold short increased more than 10-fold, the stock price soared by 85 percent. How exactly long-term investors in Biosite were hurt by this I'm not exactly sure. Sounds like these types of investors should beg short sellers to target their stocks!

What can we take away from all of this?

One, short sellers do not cause stock prices to go down. If a stock can rise 85% as half the outstanding shares are being borrowed and immediately sold, such as argument is easily discounted as silly.

Two, independent research is not always independent. Merely listening to Sterling's negative view on Biosite stock (which did prove to be inaccurate) would have lost you a lot of money if you were in fact a long term investor who wanted to "invest" (versus "trade") in BSTE shares.

Three, if you are an "investor" then you should, by definition, have a long-term view. Traders focusing on the short term probably were hurt by these negative research reports because they likely caused a quick drop in the stock price upon being published. In the short term, any kind of report can influence stock prices, accurate or not.

Over the long term, however, company fundamentals will matter above all else. Since the research Sterling published turned out to be incorrect, the stock price went up, not down. That is why someone who bought the stock in February before all the short sellers and negative reports came out of the woodwork, and held it throughout all of this sketchy behavior, would have made 85% on their investment in less than a year.

Hopefully you can see why people should do their own research and invest for the long term. If your analysis proves accurate, you will make money, no matter whatever anyone else out there is doing. That is the philosophy I use when managing my clients' money, but it is valuable for anyone who doesn't want to be adversely affected by the inherent conflicts of interest on Wall Street, whether you are a Peridot client or not.

Getting the Froth Out

Over the last year or so the markets have done well despite the rally being very narrowly focused. Consider what was working up until May. International, energy, gold, copper, industrials. The investment banks did great too as M&A activity hit record levels. What about other areas? Healthcare, technology, telecom, media, banks, retail. Not a lot of performance in those areas, even though they make up a huge portion of the U.S. market.

The result of such a narrow market was that everybody began chasing what was working and shunning everything else. The copper move from $3 to $4 a pound was probably solely due to hedge funds piling in. The moves were parabolic, especially in commodities and international stocks. Finally we have reached a point where people are getting nervous, nervous enough to reduce risk. This is leading to extreme selling in the areas that have done best. Basically, we are getting the froth out of the market.

It is this explanation, and not anything fundamentally wrong with the companies, that is causing the massive sell-off. Goldman Sachs (GS) reported a great quarter this morning. The stock is down 6 points. GS is still doing well. In fact, they advised on the Maverick Tube (MVK) buyout announced this morning. The market action has been violent, but prices are getting a little out of whack with reality at these levels, unless the world really is headed for horrible times. Not impossible, but it's tough to make that case at this point.

Uptrend Intact, For Now

If you look at the last month or so, you might want to quit the market entirely. However, it's always a good idea to put things in perspective. An easy way to do that is to take a longer term view and see where we've come from in order to gauge how bad a pullback really has been.

Here is a three-year chart of the S&P 500.

As you can see, the uptrend has not yet been broken, even though we are pretty darn close. I don't know if we'll hold and make a bottom around this level or not (by me putting this chart up, it could jinx that scenario a little bit), but it is an interesting chart, especially for any of you that like technical analysis.

As far as what could help us in the quest for a near-term bottom, I really think it is in the hands of Bernanke at the upcoming Fed meeting. My thesis for why the market made new highs in April, despite many apparent headwinds (soaring commodity prices and rising interest rates), was that equities were pricing in an end to the rate rising cycle.

As soon as it became clear that 5% might not be the top in Fed Funds, we lost nearly 100 points on the S&P 500. As you know, the market hates uncertainty, which is what we have right now. Some are predicting a Fed pause in late June, whereas others are calling for 5.5% or even 6% Fed Funds this year.

If Bernanke would just quit it already, we could very well hold the trend line in the above chart and make our way back to where we were the last time investors thought rates were finished going up. Conversely, if we get another rate increase and more uncertain talk from the Fed in a couple of weeks, it's unlikely we'll see better times on Wall Street anytime soon.

How Low Do We Go?

Lots of emails coming in saying "good call on the correction." Perhaps, but there's nothing "good" about it if you are long stocks, that's for sure. No matter how many times you've experienced nasty pullbacks in the market, and no matter how well you understand that we need to see this kind of action every once in a while, it still isn't fun to sit through.

When will it stop? I don't know, nobody does. I do think, though, if you had to pin me down, that we will continue to go lower. In fact, I almost prefer to get the whole 10% correction thing out of the way (we are halfway there so far). Let's just take the pullback that we know is coming at some point, and move on to brighter skies.

Three and a half years is a long time to go without a 10% drop. Sure, we went 7 years in the mid 1990's without an official correction, but that ended badly. Heading into 2006, Peridot was up 72% over the prior 3 years. That's a lot. I'm more than willing to concede a pullback, and then we can run again.

As far as how to play this market, I'm not doing anything dramatically different. I did raise cash when I sensed we were setting up for a drop and posted such on this blog, but since I'm a long term investor and not a trader, I'm still very much net long. An above-average cash position for me is between 10 and 20 percent, since despite a near term bearish call, I still like the stocks I own looking out 2 or 3 years, and my investing time horizon is even longer than that.

I have sold my metals stocks (gold and copper) while holding tight on energy because of the upcoming summer driving and hurricane seasons. Economically sensitive areas will get hurt most as GDP growth slows, so try to focus on stocks that have secular trends behind them. Aside from that, relatively cheap (below-market multiples) stocks with solid longer term growth outlooks are the kinds of positions that you should feel okay holding through the correction and for the months and years ahead.

Is The Correction Finally Here?

Here I sit with the Dow down 130 points, oil up more than $1, and gold jumping $16 an ounce. It has been more than three years since we have had a 10% correction in the market. Is this the start of it? Nobody knows for sure, but it could be.

If you think about it, the 6% rise we have seen in less than 5 months of 2006 defies traditional investment logic. Consider the current economic environment. Interest rates are rising, commodities are soaring with gold at 26 year highs and oil at record highs. Investor sentiment is very bullish. We are a country at war. And yet, the stock market has rallied strongly.

Given that official corrections (10%+) in the market occur about once a year, you would not expect three years to have passed since the last meaningful drop, given what the country is facing and what economic indicators are showing. For some reason stocks have ignored this backdrop. It is a combination of things; strong corporate profits, balance sheets flush with cash boosting M&A and buybacks, many hope that the Fed will stop hiking rates and prevent a recession.

Whatever the reason, it is hard to argue that we are not overdue for a pullback. Our economy is unlikely to withstand all of these pressures forever. Who knows if today is a sign of more things to come in the short term, but I would not surprised if it is, and investors should be on the lookout. There is no need to panic, just be prepared.

M&A Not Slowing Down

Another "Merger Monday" is shaping up nicely today, as deals continue to pour in at record levels. Wachovia (WB) buying Golden West (GDW) for $25 billion is by far the biggest deal of the day, but perhaps the most interesting is the bidding war for Aztar (AZR), casino operator and owner of the Tropicana Casino in Las Vegas.

In March, Pinnacle Entertainment (PNK) agreed to acquire Aztar for $38 per share, more than 20% above where AZR stock was trading at the time. Late Friday, the two parties agreed to a revised price of $51 per share. It's not often that a company has to increase the price of a friendly takeover bid by 34%, but in this case, three other suitors emerged and a bidding war began.

Although Pinnacle has a signed merger agreement with Aztar at $51, it might not be done yet. Two of the bidders appear to be out of the mix, as Ameristar Casinos (ASCA) officially dropped out, and Colony Capital hasn't been heard from since their $41 bid was trumped. Columbia Entertainment, however, saw their $50 cash bid expire Friday afternoon, and could very well come over the top sometime this week.

What is all the fuss over Aztar about? The Tropicana, although fairly old in Vegas terms, sits on prime real estate on the Vegas Strip. The buyer would like to knock it down and build another brand new casino, much like the newest hot spot, Wynn Las Vegas. Vegas is hot, and as a result, Aztar's real estate appears to be worth far more than shareholders thought a couple of months ago when the stock was trading at $30 before the initial bid from Pinnacle.

Not only will it be interesting to see how the Aztar situation is resolved, but the overall theme of an immensely robust M&A market should be a focus for investors. The best way to play this, aside from speculating on which firms get bids next, is to go with the investment banks whose advisory fees are sky-high with the current deal flow.

Analysts Continue to Boggle the Mind

There are 3,400 sell-side research analysts in the United States. No matter what they do, they're not going to get too many flattering comments from me on this blog. First off, don't get me wrong, there are some good analysts out there. They are tough to find, and likely only number in the dozens, but they do exist. But for the vast majority, they baffle me. Let me explain two extremes.

First, we have Sears Holdings (SHLD), one of the largest retailers in the country with more than 3,000 stores and $50 billion in annual sales. Guess how many analysts cover SHLD? (Hint: take the "under"). The answer is 6. That compares with 23 for Target (TGT), 24 for Wal-Mart (WMT), 28 for Bed Bath & Beyond (BBBY), and 29 for Best Buy (BBY). How can this be? The sell-side is not shy about telling you that it's because Sears doesn't give guidance.

Without guidance, how can they possibly know how to project sales and earnings on a quarterly basis! It's ludicrous, really. After all, a research analyst's job is to research, analyze, and make projections. Heaven forbid should they actually be forced to do their job! So what we have on Wall Street are people who take numbers companies give out on conference calls and plug them into their own Excel spreadsheets. Not exactly quality due diligence.

But then we have the other end of the spectrum. It occurs a lot less frequently, but it does happen, as Wednesday's trading action in Cigna (CI) stock shows. Cigna shares fell $15 after reporting first quarter earnings. What happened, you ask? They missed estimates, right? Nope, they reported EPS of $2.11 on $4.1 billion in revenue. Consensus estimates were $1.89 and $4.1 billion.

Oh, well then they lowered guidance for 2006, right? Wrong again. Cigna actually raised 2006 EPS guidance from $7.25-$7.70 to $7.50-$8.00 per share. Well then why on earth did the stock drop $15? Amazingly, it was because analysts had been projecting 2006 earnings of $8.07 per share (estimates ranged from $7.50 to $9.10). Why would the average Wall Street projection be for EPS of more than $8.00 when the company 's management thinks they are going to earn less than $7.50?

As stated before, I'm all for analysts doing extra work on their own outside of conference calls and press releases from companies. However, when a stock drops $15 after the company raises their guidance for the year, something isn't right. Such a huge discrepancy between what management teams project and what analysts project should be a red flag. If the analysts are more accurate, then they are doing their job well, but such instances are rare. After all, CEO's and CFO's should certainly know more about their company than the analysts who cover them.

Now for the only really important question with respect to all of this: is Cigna a buy at $90 after the $15 drop?

Companies Shunning Quarterly Guidance?

I've said here on several occasions that giving earnings guidance does two things, and neither one is beneficial to shareholders. One, it puts management's focus on short term results, not a long term strategic plan for boosting shareholder value. Two, it does Wall Street analysts' jobs for them so they can avoid having to do any real legwork on their own.

An interview on CNBC last Friday afternoon was centered around how some companies have begun to stop issuing quarterly guidance in favor of annual projections. Evidently the number of company giving guidance for three-month periods has dropped from over 60% to slightly more than 50%. I don't expect most firms to take the Sears Holdings/Google approach of not issuing guidance at all, but this is certainly a good start. A company should never be put in a position to feel compelled to ship product on the last day of a quarter just to hit their numbers, appease shareholders, and prevent a one-day stock price blowup.

One ramification of this shift is that quarterly earnings results will be more volatile. Rather than coming in right on target or a penny ahead of consensus every quarter, there will be a lot more instances of big upside surprises and large shortfalls. This will undoubtedly make share prices more volatile during earnings season, but it will also make my job as a money manager much more fun and important as more surprises require more analysis and decision making.

Fortunately, there seem to have been relatively few earnings warnings this quarter (this is a trend I began to see last quarter as compared with prior periods), so I would guess results will be pretty good when companies begin announcing their first quarter results later this month.