With Apple (AAPL) garnering only 3 percent of the U.S. personal computer market in 2005, it's not hard to see why the company's shares are surging 7 percent today. With news of a software program allowing users to run Windows XP on Macs released this morning, all of the sudden the company can go after much of that other 97 percent. Apple's design team certainly has a unique opportunity here. I don't see why they couldn't get 10% of the U.S. market within 5 years with the right new products.
Analyzing Gradient Analytics
Surely you've heard of Gradient Analytics by now, as it's all the Wall Street media outlets have been talking about lately. In case not though, let's recap. Gradient is a research firm based in Scottsdale, Arizona. They focus on forensic accounting analysis of public companies.
The latest issue that has been getting all the attention has to do with negative reports Gradient issued on Biovail (BVF), a poorly run Canadian drug company. Biovail is suing Gradient claiming their inaccurate and misleading reports caused a 50 percent drop in BVF stock during 2003 and 2004. News broke that Steve Cohen, hedge fund manager at SAC Capital and Gradient customer, actually requested a report from Gradient that focused on negative aspects of Biovail's business. SAC was interested in shorting Biovail shares, or perhaps they already were short at the time of request. Gradient did produce a report, and subsequently distributed it to the rest of its customers.
On the surface, this kind of thing looks very suspicious. If SAC Capital was short BVF and asked Gradient to write a negative report on it so they could profit from their short position, it certainly appears that so-called "independent" research is far from independent. Even still, a Gradient report is not responsible for a 50 percent drop in BVF stock, as the company contends. The company's financial results account for the drop.
In response to the lawsuit, Gradient has said that SAC was requesting a follow-up to a previous report it published about Biovail on its own. If that is true, and SAC was not ghost-writing these reports with false information (as some are contending), then it is hard to reach the conclusion that any law was broken. Unless Gradient and/or SAC knowingly disseminated false information in order to profit from existing short positions, this issue seems to be blowing way out of proportion.
Most are screaming for disclosure of these types of relationships. As a result, Gradient should add some fine print at the end of its reports saying that they might have been published based on a client's request, not because it was the research firm's original idea. I have no problem with such disclosures, but don't think for a second that it will change anything.
Sell side research now discloses how many buy, sell, and hold ratings they have on all of their investment banking clients, but we still see mostly buy ratings on stocks of banking clients. I recently read a report from a boutique firm specializing in healthcare stocks. They had a buy rating on the small cap biotech company I was reading about. In fact, at the end of the report they disclosed that their research analysts cover 11 companies with whom their firm has a banking relationship. All 11 stocks are rated "buy".
How much stock should investors put on Gradient's research anyway? Last week shares of Rackable Systems (RACK) dropped 6 bucks temporarily after Gradient's computer model spit out a negative red flag about increasing inventories. They postulated this was a sign of poor earnings quality.
Unfortunately for Gradient's clients, the computer program wasn't able to research Rackable's business model. Had it done that it would have learned that Rackable, much like Dell (DELL), builds product only after it is ordered. So, all of its inventory has already been sold, thereby making increasing inventory levels a signal of stength in the business, not the opposite as Gradient concluded.
First Quarter Comes to a Close
For me it's very tough to be disappointed in any way with the market's performance in the first quarter. I have been pleasantly surprised at how well stocks have acted throughout 2006 thus far. The S&P 500 index rose by 3.7% for the period, even as 10-year bond yields jumped substantially, from 4.40% to 4.85%.
It was an excellent backdrop for stock pickers, and the performance of my 2006 Select List echoes those sentiments. The 10 stock list has posted a gain of 12.2% since the beginning of the year. The group was led by 4 stocks that jumped more than 30% each, including Lionsgate (LGF), the movie studio behind Crash, the Oscar winner for Best Picture.
Heading into the second quarter, my outlook remains as it was on January 1st, cautiously optimistic. I still think we are set for mid-to-high single digit returns on the S&P 500 in 2006. Earnings should continue to be strong, but without multiple expansion, huge gains in the indexes are unlikely. Low double digit gains are not out of the question, but we would need many things to fall into place, including a Fed that stops raising rates soon and oil prices that are subdued. Possible, but not probable in my view.
Given that we got nearly a 4% gain in Q1, I can't help but think we are overdue for a market correction. We haven't seen a 10 percent drop in more than 3 years, which is very unusual. Market momentum is very strong here and first quarter earnings reports this month will likely be solid, but as we enter a seasonally weaker period for stocks, I am still expecting a pullback even if it doesn't seem like the market wants to go down right now.
That said, there are still many individual stocks that are attractive. As share prices have rallied the list of undervalued names has undoubtedly gotten smaller, but values can still be found by those who look hard enough. And I would suggest holding some cash because when a correction comes, the list of bargains will once again expand.
Best of luck to all of you in the second quarter.
Google Beats Me to the Punch
Just as I was readying a blog posting concerning the $50 jump in Google (GOOG) shares since news hit last week that the Internet search giant would be added to the S&P 500, the company beats me to the punch. I was going to point out that the more than 15 percent jump in Google stock was based solely on index fund buying, and therefore upward pressure would likely dry up next week. I was even considering a small short trade in my personal account. Looks like Google beat me to the "sell" button.
Wednesday afternoon we hear that they plan to sell 5.3 million shares of stock, in part to accommodate index fund demand. Don't let this announcement fool you. These Google guys (and gals) are very smart. What better time to announce a big share offering than right after your stock has moved up more than 50 points without any fundamental change in business prospects?
Whether the offering halts the S&P 500 related rise or not we'll just have to wait and see, but don't think for a second this announcement is coming out of the goodness of Google's heart to help some index fund managers out with extra shares. They're just looking to cash in on the S&P 500 inclusion like everybody else.
Shareholders Sue No Matter What
From the Chicago Sun-Times:
Judge OKs lawsuit by those who lost money during Kmart takeover
A federal judge in Chicago has given the green light to plaintiffs who charge that Sears Chairman Edward S. Lampert and former Sears CEO Alan Lacy failed to tell shareholders they were plotting Kmart's takeover of Sears Roebuck and Co.
The plaintiffs making the complaint sold their Sears stock between Sept. 19 and Nov. 16, 2004, and lost out on a spike in Sears' share price that occurred when Kmart and Sears announced Nov. 17, 2004, that Kmart would acquire Sears.
U.S. District Judge Robert W. Gettleman ruled that the aggrieved shareholders cited sufficient facts so they can try to prove that Lampert and Lacy violated securities laws by failing to fully disclose their negotiations.
The shareholders allege that Sears, with Lacy's knowledge, was repurchasing shares at what they contend was an artificially low price, effectively increasing the interest of Lampert's hedge fund and making Kmart's takeover of Sears easier.
Now not only do we have shareholders who sue when stocks they own take a tumble, we also have those who sue when stocks go up after they sell? Lawsuits in this country are really getting out of hand. Let's go through a few reasons why this story is ridiculous.
First of all, the headline doesn't even make sense. You can't "lose money" on a stock you no longer own. Missing out on profits and losing money are not the same thing. If you thought about buying a Powerball ticket when the jackpot hit $200 million but decided not to, you didn't lose out on a chance to win the lottery. You simply chose not to play.
The basis of the lawsuit is that Kmart management failed to disclose they were in merger negotiations. What company in their right mind would disclose this? As soon as news of such talks hit, Sears stock would have rallied, raising the price Kmart would need to pay. This would hurt Kmart shareholders, not help them, making the deal less attractive financially. Arguing somebody broke securities law by not disclosing buyout negotiations, which could easily have broken down, is preposterous.
They go on to say that Sears was repurchasing stock at low levels to make Kmart's takeover easier. There would be no reason for Sears to do this, it would not have a meaningful effect. Sears stock was cheap. That explains why Sears was buying back shares and why Kmart was interested in a business combination. That is just a good use of capital by both sides. Shareholders of both Sears and Kmart should be happy about that. In fact, the reason the stocks soared once news of the merger broke was because it was perceived as such a good move. Both retailers were struggling and this was seen as a way to get smaller, leaner, and more profitable.
Current Sears Holdings shareholders need not be worried. This Chicago Sun-Times article is the second I've read in recent days that sharply criticizes and questions the current retailing strategy of Edward Lampert and company. As long as people are still negative and focused on retail strategy and not economic value, I'm happy to be a shareholder of Sears Holdings.
Bernanke Era Begins
Just how different will today's Fed meeting be compared with those of former FOMC Chairman Alan Greenspan? Will the Fed's all important statement be a lot more clear and straightforward, or will it be only slightly tweaked from those used over the course of the last several years? These are the questions investors and economists are eagerly anticipating getting answers to as we await the outcome of Ben Bernanke's first meeting as head of the FOMC.
I think the wording might be slightly different under Bernanke, but those looking for bold shifts in policy wordings might be disappointed. We will get a 25 bp hike today, but where do we go after that? Will 4.75% be the end, or are we going to 5.00% or 5.25%? I think the case can be made that 4.75% is enough. Surely anything above 5%, given the current economic climate, will spook many investors.
Most importantly, what does this mean for the stock market? The market has been acting very well lately, and in my mind that signals we are pricing in the end of the rate hike cycle. If that's the case, those expecting a huge rally when the Fed does get around to stopping will likely be met with sellers looking to book the gains earned in recent months.
An Apple To-Day?
I've been out of Apple (AAPL) stock for the entire run over the last couple of years. I looked at it many times back then given its insanely low valuation but never liked the business. They had half the market cap in cash on hand with no debt, but I never could figure out what the catalyst might be.
Then the iPod happened and the run began. Two years later the stock is 600% higher, hitting a high of $86 in early 2006. I haven't chased the stock on the way up, but for the first time in a long time AAPL shares appear reasonably priced. In case you haven't noticed, the stock is down 30% from its high to a current $60 per share.
Current earnings estimates stand at $2.25 for 2006 and $2.75 for 2007. With $10 per share in cash and no debt, investors are getting the business for 22x current year profits. Looking out to 2007 the P/E drops to 18x. If any of you are out there wishing you hadn't missed the run, the stock is down 26 points from its high and looks appealing if you think growth will continue for some time.
Lagging Fidelity Fund Seeks to Change Benchmark
In the latest example of how mutual fund companies couldn't care less about their long suffering shareholders, consider Fidelity's recent announcement that it will be recommending its Blue Chip Growth Fund (FBGRX) change its benchmark from the S&P 500 index to the Russell 1000 Growth index.
As soon as I read about the proposal I knew a little research would yield some interesting findings. Sure enough, the Fidelity Blue Chip Growth fund has trailed the S&P 500 for six straight years.
In the real world such pitiful performance would result in the manager of the fund getting fired. But who are we kidding? The mutual fund world is nothing like the real world. Fund managers hardly ever get canned, even though 80 percent of them fail to beat their benchmark. So what does Fidelity decide is the proper course of action? Well of course, change the benchmark!
You guessed it, the Russell 1000 Growth index has lagged the S&P 500 over the last five years, so the switch will make it look like Fidelity Blue Chip Growth has done better than it actually has. Interestingly, the fund has also lagged the Russell 1000 Growth index over the last five years, just not by as wide a margin as it has the S&P 500.
Alright, so maybe you're thinking I'm being a little too cynical here. Maybe the Russell 1000 Growth index really is a better benchmark for this particular fund, based on the companies it invests in, and therefore such a change can be adequately defended. I admitted that was a possibility, so I did a little more digging. If Fidelity Blue Chip Growth is really quite different from the S&P 500 index, I'll be happy to get off their backs.
The top five largest holdings of the Fidelity fund are Microsoft, GE, Johnson & Johnson, AIG, and Intel. Sounds like the S&P 500 to me. What did I find when I peaked at the Vanguard Index 500 fund (VFINX), the largest S&P 500 index fund in the country? GE is the fund's 2nd largest holding, followed by Microsoft at #3, Johnson & Johnson at #5, AIG at #8, and Intel at #10.
Let me throw one more statistic out there that I find too amazing to ignore. In case it was just the largest holdings of Fidelity Blue Chip Growth that overlapped almost exactly with the S&P 500, I decided to look at the market cap of the fund's average holding versus the average market cap of the S&P 500 index fund. Guess what? They're exactly the same... $46.9 billion versus $47.1 billion!
And yet Fidelity is trying to get away with saying they think the S&P 500 isn't a good benchmark for the fund? Investors should not tolerate this. Unfortunately though, most of them probably have no idea it's even going on. Fortunately, that's one of the purposes of this blog.
Capital Depreciation
Shares of Capital One (COF) are continuing to fall after news of their nearly $15 billion bid for North Fork Bank (NFB). After hitting new highs at $90 per share, COF stock has dropped more than 10 percent to $80 and change. This sell-off is exactly what we saw after the company announced plans to buy Hibernia a year ago. History tends to repeat itself, and this instance should reinforce that view. Patient buyers will be well rewarded once the deal closes and investors realize how strong of a move it was. Momentum traders and merger arbs are causing longer term investors such as myself to salivate at the stock's current price.
Another Blowout Quarter at Sears
Long time readers of this blog know that I've been bullish on Sears Holdings (SHLD) for a long time. I've repeatedly made the case that bears focusing on same store sales were missing the point. Chairman Eddie Lampert's strategy with prior retail endeavors, as well as with Sears Holdings, has been to not focus on overall sales, but rather on profitable sales.
Sears' financial results have shown that this strategy is coming to fruition, but the bears have been winning with SHLD as of late. In fact, the stock has been amazingly range bound for months, hovering between $115 and $125 per share, as the chart below shows. Despite the pattern of higher than expected profits, the stock has been stuck. It manages to open higher after posting quarterly results, only to see the gains vanish by the end of the day.
This morning Sears reported fourth quarter earnings of $4.03 per share, 41 cents ahead of estimates, which stood at $3.62. Again we see the stock rallying in pre-market trading, rising $9 right now to $126 per share. If the recent past repeats itself, the stock won't hold those gains and will continue to trend in its narrow trading range. This result would not be surprising if we continue to hear about falling sales.
However, I am still holding out hope that today's gains hold and we get a breakout above $125. It's amazing to me that the company is purposely trying to reduce sales by only selling products that they can earn a profit on, and yet when they deliver such results, people complain of market share losses.
Investors need to realize that over the long term earnings drive stock prices. If sales were all that mattered, not profits, then the Internet bubble never would have burst. Consider how many dollar bills I could sell if I only charged 95 cents for them? My sales would great, sure, but my stock would be worthless without profits.