Overvalued Stock Screen

Every once in a while I will run a screen to find stocks that might be overvalued. This can serve to identify candidates for short sales. After a nice upward move in the market, coupled with increased bullishness among market pundits, searching for some shorts to hedge seems reasonable.

I screened for U.S. companies with market caps of at least $2 billion that sport price-to-sales and price-to-book ratios of at least 10. The screen yielded 10 stocks, which are listed below in alphabetical order.

Akamai Tech (AKAM)

Amylin Pharma (AMLN)

CBOT Holdings (BOT)

Celgene (CELG)

Chicago Mercantile Exchange (CME)

Genentech (DNA)

Intercontinental Exchange (ICE)

Las Vegas Sands (LVS)

Ultra Petroleum (UPL)

Vertex Pharma (VRTX)

Full Disclosure: I am short shares of Celgene (CELG) at the time of publication.

Market Struggling to Break Out

The 1,280 level on the S&P 500 seems to be a very difficult area for the market to break through. The fizzling of yesterday's early rally didn't feel very reassuring and again today we have an early morning rally that puts the S&P right around 1,280. If we get more sellers in the afternoon and lose a 100 point advance again, the bears will use it as fuel to remain unimpressed with recent market action.

As for ways to make money in this trading range environment, Sears Holdings (SHLD) reports earnings on Thursday. I would expect a bottom line that exceeds expectations. Whether or not it results in a huge stock price move or not, I don't know. However, the shares are trading $20 per share below the highs made after their last quarterly report. Retail earnings from Target, Kohl's, Federated, and Dillard's have been strong, much to the surprise of those warning of impending consumer doom. This bodes well for the Sears report.

Is Annual Guidance a Reasonable Expectation for Investors?

Regular readers of this blog are aware that I think public companies giving out quarterly earnings guidance is something that should be eliminated in order to ensure that management teams run their businesses for the long term, not with a goal of "hitting the quarter" any way possible.

It is also fairly unreasonable to expect a CFO to be able to predict whether certain expected revenue will be booked in June or July several months in advance. It can make all the difference in the world in trying to meet or exceed previously issued guidance on a three-month basis, but should investors really care if a big order is shipped on June 25th or July 5th? I tend to think not.

Fortunately, many companies have ceased issuing quarterly guidance. Some, however, are taking this practice a step further by halting annual guidance as well. I was listening in on the Affiliated Computer Services (ACS) quarterly conference call yesterday afternoon, and they announced that they will no longer provide revenue or earnings guidance on an annual basis. ACS's 2007 fiscal year began in July, so investors looking to get some sort of idea of how the next year will shape up are at a loss.

So, this brings us to an important point. Should investors be upset if they aren't provided annual guidance? I tend to say "yes." Forecasting an entire year (without breaking it down by month, quarter, or even half) shouldn't be as difficult and unproductive as issuing quarterly guidance. I don't care if some business gets pushed into Q2 from Q1 at the last second, but I still want to have some idea of how 2007 is going to look compared with 2006.

If I don't have any idea how fast a company will grow its earnings, how can I assign the stock a multiple that I think represents fair value? It makes life awfully difficult. Just give us a range of, say 5%, for forward annual growth. If ACS says 2007 growth in earnings will be 5%-10%, I have an idea of how much to pay for the stock. If I don't know if growth is expected to be 0% or 15%, the fair value ranges I could come up with become so wide they are fairly useless. 

Today's Unimpressive Action

The market started out great today, opening up nearly 1% on a weaker-than-expected jobs report, but all of those gains have evaporated. Despite a bet that the NFP data will ensure a Fed pause on Tuesday (I still think the odds they raise are higher than the futures markets are implying), stocks feel like they are topping out again here in the high 1200's on the S&P.

Honestly, we really should not be all that surprised that a Fed pause is already priced into equities. I mean, how many times have we had a huge "Fed is Done!" rally in recent weeks? On at least a couple of occasions we saw big triple digits gains on the Dow following dovish Bernanke comments or economic data. The real story isn't what Bernanke does on Tuesday, but rather, what is next for the U.S. economy? The market doesn't like uncertainty.

Without much confidence about what the next catalyst could be to get us back over S&P 1,300 and toward the old highs, stocks likely continue in their 1,225-1,280 trading range. Essentially, we need a lot of things to go right for the rally to gain steam. After the Fed pauses we need inflation to stabilize and GDP to remain in the 2-3% range, avoiding a recession.

Since rising costs are leading to company price hikes as a method of expense pass-through (which causes core inflation rates to rise), we also need commodity prices to stabilize or perhaps drop a bit. A slowing international economy would certainly curtail demand, and therefore allow for cost input prices to come down, but we would be walking a fine line between a global recession and merely more tepid growth. Until we see evidence that most of this scenario could play out, a "soft landing" so-to-speak, I can't get excited about near-term stock market returns.

Analysts and the Fed

Two completely separate points I'd like to make this morning.

The first is regarding an analyst call on Garmin (GRMN) yesterday, one day before the company was slated to report second quarter results. As many of you know, GRMN is the leading maker of global positioning systems (GPS). American Technology Research decided that it was a good idea to initiate coverage of the stock yesterday, ahead of earnings, with a "sell" rating and a $75 price target, with the shares trading at $95 per share.

These types of calls are always intriguing to me. First, Garmin has blown away numbers for the past couple of quarters. The company is taking market share and the GPS business is growing rapidly. If anything, the company would have better odds of having a great quarter than a poor one. It's true that Garmin's competitors posted bad quarters already, but that is likely due to Garmin kicking their butts.

Second, why would you want to make a call without any information on Q2 or the outlook for the rest of 2006? With Reg FD in effect, there is no way a company is going to leak to anybody how the quarter went. Essentially, the analyst is completely in the dark about current fundamentals at Garmin and yet still is sticking his/her neck out to recommend investors sell.

This is yet another example of why investors shouldn't worry if an analyst issues a negative report on a stock they own. If you have done your homework and believe in your investment thesis, use the weakness generated by these analysts (Garmin was down $5 per share yesterday to close at $90) to buy the stock at a cheaper price.

Garmin's Q2 report this morning was another blowout. Earnings per share came in at $1.10 versus estimates of $0.94 and the company raised guidance for all of 2006. The stock has traded up as much as $15 per share in pre-market trading this morning.

On a completely unrelated note, the Fed Funds futures market is now indicating that traders are pricing in a 34% chance that Bernanke will raise interest rates on Tuesday. I am afraid that this assumption is highly optimistic. I would take the "over."

So Far, So Good on the Earnings Front

We still have a lot of reports to come, but so far second quarter profit reports have once again come in very strong. Aside from the obvious, a fairly strong economy, I think there are two key reasons why we are seeing strong corporate results.

The first is clean corporate balance sheets. Public companies are flush with cash which gives them a lot of flexibility in managing their business. Excess cash has been used for acquisitions as well as share repurchases quite heavily in recent quarters. M&A can be very accretive if done right, and buyback programs can add a penny or two to the bottom line in any given quarter.

The second reason earnings have been so strong, in my opinion, is because managements have finally figured out that the key is to under-promise and over-deliver. This is true in any business, public or private. However, in the go-go days of the late 1990's, stocks would only rise if the firms beat numbers and raised guidance every three months. CEOs had to be overly optimistic in everything they said in order to prop up their already richly valued stocks. As a result, expectations got way out of line and eventually the bar had to be ratcheted downward.

I think today is different. The trend has been to beat numbers and issue cautious guidance. This serves to hurt share prices right after results are released, but it brings expectations down for future quarters. Then, the company beats the reduced expectations the next quarter and again issues cautious guidance. The cycle simply repeats itself over and over again. Executives have finally figured out that hyping their company's future prospects can end badly if they fail to deliver on the lofty promises.

Readers of this blog know that I'd prefer companies shun quarterly guidance completely. However, if they insist on giving out financial projections every three months, at least most are setting the bar low enough that they can at least hit, and often even surpass, their projections. 

Will Earnings Help Alleviate the Geopolitical Selling?

Geopolitical concerns always spook the markets short term, but longer term investors most likely shouldn't panic by making bold changes to their overall investment strategy. The situation overseas can change nearly overnight in some cases, and history shows that lost ground due to panic selling is often made up within several weeks or months.

After a nice rally off the June lows (around 1,225 on the S&P 500) it appears we will retest those lows, which would not be a bad thing. Rather than try and predict what will happen in the Middle East, I will instead be focusing on Q2 earnings reports. The three or four dozen companies I follow begin reporting on Monday. Recent stock price action suggests the numbers will be weak, but I am not convinced quite yet that will be the case, despite the negative reports thus far from the likes of Advanced Micro Devices, 3M, EMC, and Alcoa.

If we look back three months ago, I was pleasantly surprised by how well the companies I owned did. Stocks were mostly flat to slightly down after reporting profits in-line or above expectations. Several blowout quarters were rewarded nicely by the Street, and most importantly, there were only a handful of poor reports.

I don't see a lot that has changed over the last few months, so my gut says that the reports won't be as bad as stock prices are currently indicating. Of course, that doesn't mean they will all pop to the upside if numbers are solid, but it would give me comfort in an otherwise tough market environment. In addition, there have to be at least some cases where stocks will react very well to decent reports, just because the shares were pricing in bad results.

If I am right and this earnings season turns in a fairly decent performance, hopefully the market will stabilize. Right now I have no reason to believe we are heading below the 1,200-1,225 range on the S&P 500, which is 1%-3% lower than current levels. The low end of that range represents an official 10% correction from the highs, and the high end signifies a successful retest and holding of the aforementioned June lows.

Heading into Earnings Season

This week marks the start to earnings season. Much will be made of the possibility for yet another quarter of double digit gains in profits for the second quarter. Still, I would not expect a meaningful market rally as these reports come in, even if we do end the quarter with 11 or 12 percent growth, which I think is likely. The bulls screaming that the market is cheap at 14 times forward earnings are overly optimistic, in my view.

First of all, you can only get a P/E of 13 or 14 if you use operating earnings, which is basically the number companies report after stripping out many various items that negatively impact earnings. If you use GAAP numbers, the S&P 500 is trading at 16 times this year's estimates, and 15 times 2007 projections. That makes the market fairly valued, based on historical context, not cheap. With double digit profit growth in 2007 unlikely, you can see why I don't think this market will soar to new highs anytime soon.

Okay, so how do investors play this market? I would focus on stocks that have below-average valuations and with whom you have a high level of confidence that they will at least hit, if not beat, their numbers. Such a strategy gives you the potential for either multiple expansion (which the S&P 500 will not provide) or earnings per share revisions to the upside (which can lead to share price gains even if multiples stay where they are). Obviously, the double play would be to get both.

Finding names that fit this description is not an easy task, but it's really the only way to make good money in this range-bound market environment.

As Second Quarter Ends, IPO Market Heats Up

Investors had a tough second quarter as the S&P 500 closed June up a mere 1.8% for the year. Unlike prior periods, where the IPO calendar slows dramatically in dicey markets, we have actually seen a pickup in IPO activity in recent weeks. Why the sudden interest?

With the average stock not doing much of anything, investors seem to be looking anywhere for places to make money. New offerings, whether well-known consumer brands like J Crew or Mastercard, or much hyped ethanol plays like VeraSun and Aventine, offer the potential for a quick payoff, something that has been lacking for several months in the market.

The retail investor seems to be jumping in with both feet to the IPO market, which I would use as an indication that it's time to tread carefully. Despite lackluster financials, small investors jumped all over the J Crew deal, causing a huge spike. On a valuation basis though, the stock does not appear cheap. The ethanol plays are also expensive, with the Aventine deal actually dropping more than 10% on its first day of trading last week.

History has shown that IPOs are some of the worst investments around. Just think about why this is likely the case. Companies don't sell shares to the public unless they think they can get a great price. Why are ethanol companies going public now, even though oil prices have been high for a fairly long time? Perhaps they are sensing that speculative interest in the industry is at elevated levels and they want to take advantage of that.

The fact that many deals, including J Crew, are being brought to market by private equity firms is another red flag. These buyout firms bought companies years ago when prices were depressed. Now the so-called "smart money" is selling their stakes to the retail investor via IPOs. Which side of that trade do you think is going to come out on top?

Of course there will be exceptions, but I would caution investors to be careful when venturing into the IPO market. There is a reason why someone has decided this is the right time to sell. With initial public offerings having been relatively poor investments over time, make sure you pay attention to the stock's valuation, not just what company you are dealing with.