SandRidge Is An IPO To Watch

In general, IPO investing is not a very rewarding experience. If you can get in on a hot deal at the offering price, then obviously you can make good money, but studies have shown that recent IPOs lag the market in general after they are available to the public. The reason is pretty simple. More often than not, corporations will choose to sell stakes in their companies when they think they can get a very good price. If the firm gets a good price by selling, investors certainly can't expect to get a good deal when buying simultaneously.

Now, this is all generally speaking. Of course, there are plenty of IPOs that are selling stock because they have reached a certain size and are seeking a way to fund growth. If they succeed in growing as they plan, investors could make very good money investing early on. A recent IPO that I think is worth watching is SandRidge Energy (SD), a natural gas producer run by Chesapeake Energy (CHK) co-founder Tom Ward.

As I have written here before, I am a big fan of Chesapeake as a long term play on the domestic natural gas market. As far as I can tell, they are the best company in the business, and are currently the leading independent natural gas company in the country. CHK was co-founded by Tom Ward and Aubrey McClendon in 1989 and until last year they ran the company together, Ward as COO, McClendon as CEO.

Initially there was worry when Ward left Chesapeake, but as time went on it became clear that he wanted a new challenge. Now he is running SandRidge Energy, a smaller but rapidly growing firm focused on Texas exploration. Is the fact that a very smart and successful guy like Ward is at SandRidge enough of a reason to buy the stock? In my view, it very well could be. When you have someone who has been as successful as anybody at finding natural gas reserves, it bodes very well for a new company he left a great job to focus on.

If you are bullish on the natural gas market long term, as I am, SandRidge is certainly a company to watch. The stock is up nicely from its recent IPO. The stock was initially indicated to price between $22 and $24 per share. Higher than expected demand pushed the offering price to $26 and the stock opened at $32 on the first day of trading. Today it's trading above $33 per share. I would suggest waiting for a pullback before buying in, but SD is definitely a company to watch as it continues to grow.

Full Disclosure: Long shares of Chesapeake Energy at the time of writing

Forget Writedowns, Bank of America Gets $16B Writeup!

From the Financial Times:

BofA set to gain $30bn on CCB stake

Tuesday Nov 13 2007

Bank of America (BAC) on Tuesday said it was sitting on a potential gain of more than $30bn on its investment in China Construction Bank, highlighting the paper profits some western banks have made on holdings in their Chinese counterparts.

BofA paid $3bn two years ago for an 8.5 per cent stake in CCB and an option to increase to 19.9 per cent at a very low price. The bank plans to record a gain of about $16bn on its existing stake in the fourth quarter.

"On paper we have a potential gain in excess of $30bn," said Joe Price, BofA's chief financial officer, adding that it would be able to cash in some of its holding over the next 2 to 3 years.

Not only does BofA have less subprime mortgage and MBS CDO exposure than other big banks, but they also have done some smart things which will certainly help them weather the storm.

Full Disclosure: Long shares of Bank of America at the time of writing

As Usual, Bill Miller's Letter is a Good Read

I've been a follower of Legg Mason's Bill Miller for a long time. Having grown up in Baltimore, where Legg Mason is based, I was able to learn a lot about him and his investment strategy before most others did so via the publicity surrounding his stunning 15 straight years of beating the S&P 500 index. Miller is a contrarian, value investor, just as I am. And although I don't always agree with his stock picks, his insights into the market and long term investing are particularly well written. I even quote him on Peridot Capital's web site, because he is far more articulate that I am when addressing many important investment concepts. You can usually learn something by reading an article about him, or his actual letters to investors, which are published every 3 months.

Last week, Miller's third quarter commentary was especially insightful, as it addressed many of the turbulent events of the recent past and explained how he views the current marketplace. I've provided a link to Miller's third quarter letter to investors for those of you who are interested. I suggest that long term contrarian investors add the letters to their personal reading list on a quarterly basis.

Crocs Stopped Dead In Its Tracks

If you've ever owned a momentum stock, you know that things are a lot of fun, until the company misses a quarter. Investors' love affair with trendy footwear maker Crocs (CROX) ended last week, as the company's third quarter earnings release left much to be desired for the momentum traders hoping for yet another blowout quarter. The stock has been crushed to the tune of 45% in just 3 trading days and now fetches $41 per share, down from its high of $75.

After such a move, it appears that there might be an investment opportunity here if you have a good understanding and expertise of trendy fashions. For such opinions, I am not your guy, as I have no idea what the future for Crocs will look like and won't even fathom an uneducated guess. Lots of people surely think the company's shoes are merely a fad. However, if you disagree with that, you might want to take a look at the shares as an investment.

Here's why. Last week Crocs issued 2008 guidance of 35-40% sales and earnings growth but that was not enough to keep the stock from tanking. If you believe in the Crocs story (that the company can continue to grow from here), the stock is only trading at 15 times the $2.70 earnings guidance the company has issued for next year. If 2008 will indeed bring investors 35-40% earnings growth as predicted, and the company can grow (at all) in the years after that, buying Crocs today around 40 bucks will actually prove to be a wise decision. I don't know enough about shoes to feel confident in that view, but I bet some people do. If so, the stock might finally be reasonably priced.

Full Disclosure: No position in CROX at the time of writing

Mobile Phone Initiatives Help Google Become 5th Most Valuable U.S. Company

Google's plans for a strong push into the mobile phone market has excited investors enough to not only push the stock over $700 per share, but perhaps even more startling, the Internet search and advertising giant is now the fifth most valuable U.S. company. For a firm founded in 1998, this is an astounding ascent in less than a decade. My initial thought when seeing this list was to simply conclude that it is really ridiculous, and hence time to unload every single Google share I own. If you just look at the numbers and the other names on the list, it is hard to justify Google coming in at number five, no matter how dominant, profitable, and fast growing they are. But then I started thinking about other ways to put this list into context, and began to able to justify their position.

Let me give a brief explanation and then please feel free to give both sides of the argument from how all you see it. I have said before (and maintain) that investors need to compare similar companies when making valuation calls. They are called "comps" for those of you who have worked, or do work in the investment banking industry. If you are taking a firm public, you look at comparable publicly traded competitors to get an idea of how much investors are willing to pay for your client's shares, which aids you in determining an IPO price. It is the same process when you are selling your home. The comps your real estate agent uses to come up with an initial asking price is based on houses in your neighborhood, similar to yours in size and amenities.

This is important because we need to compare Google to other technology companies. In this case, the comps would be the likes of Microsoft, AT&T, and Cisco. Does Google belong on a list with those other leading tech firms? Well, Microsoft owns the operating system and business software space, AT&T leads in telephony, as well as Cisco in networking equipment. All of these areas have become crucial to everyday life and represent huge market opportunities. Is Google really any different? Sure, the Internet has really only been mainstream for ten years or so, but think about how crucial it has become in most people's everyday lives. Compare how much time you spend on the Internet to the time you spend on the phone on any given day, or using Microsoft Office at work. I bet it is comparable for many of you. For me, it trounces those two.

Some mistake Google for “just a search engine” but we do many more things on the Internet than use it to look something up. Email is a core communication tool, moreso than the telephone, for many of us. Just thinking about what I do online now, the list is quite long. I pay my bills, maintain my address book, get weather forecasts, go shopping, manage my fantasy football team, trade my stock portfolio, check movie times, read blogs, get news reports, get driving directions, book airline tickets, archive my photo collections, balance my checkbook, manage a to-do list, etc. I could go on, but you get the point. Before the Internet I did all of those things via the television, the newspaper, the telephone, through the mail, or at my desk. Now I do them all digitally over the Internet, in many cases with the help of Google software.

If the Internet has transformed our daily lives this much in ten years, isn't it safe to assume that it is not going away? If Google is going to be a leader in providing many of these services, and can make money on them through advertising (much like your local newspaper or television station), then I can completely understand why they would be joining the likes of Microsoft, AT&T, and Cisco in terms of market value. Obviously, things can go wrong and new companies can take over an industry. After all, for every AT&T, Cisco, and Microsoft that has continued to lead despite intense competition, there is a Digital Equipment, Silicon Graphics, or Polaroid that has practically vanished because of it. Google's fate is unknown, but people are betting that they maintain their lead, and I do not think that is such a ridiculous belief to have.

In my mind, if the Internet continues to change the way we live and help us accomplish tasks more quickly and efficiently than prior tools such as TV, phone, mail, or print media, and Google continues to be a leading software company focused on enabling all of these things, who is to say they should not have a seat at the head table with everybody else?

Full Disclosure: Long shares of Google at the time of writing

Alright Bernanke, Enough with the Rate Cuts

Do you get the feeling that FOMC Chairman Ben Bernanke is lowering interest rates more because that is what the markets want, and less because it is actually helping the problems we have in the housing and credit markets? The debate has long been whether or not the mortgage crisis will be contained or spread into the rest of the economy and cause a recession. With third quarter GDP growth coming in at 3.9%, the highest rate since early 2006, it is clear that the economy is a lot more than just the housing market.

While GDP growth should slow meaningfully in Q4, it does appear the mortgage problems are contained. Unless rate cuts will help stabilize the housing market, which is not a likely result, I don't see the need to go ahead with them just for the market's sake. After all, commodities like gold, oil, wheat, corn, etc are soaring. The result will be higher prices for consumers, which we have already begun to see as companies like FedEx, Colgate, and Procter & Gamble are all raising prices to maintain their profit margins and stock prices.

In the face of apparent inflation pressures, interest rates could ultimately be headed higher, which would make the recent cuts even more baffling. It's true that the government's inflation data doesn't seem to jive with reality, and maybe that will reduce the likelihood that rate increases are in our future, but when press release after press release announce price increases from major manufacturers due to record commodity prices, it's hard to deny inflation is real.

So what will cure the housing market's woes if rates cuts won't do the trick? Honestly, just the laws of supply and demand. The housing market is still falling with no signs of stability in sight. As long as delinquency and foreclosure rates continue to rise, and home prices continue to fall, the credit market issues (loan losses and asset backed securities writedowns) will continue. The value of loans won't stop falling until the performance of such loans improves, or at least stop deteriorating.

Rate cuts won't help because they have no direct impact on home prices or mortgage delinquency rates. This will be apparent when we see fourth quarter loan performance continue to get worse, not better. As home inventories are worked off and more home owners refinance into fixed rate loans, the markets will eventually stabilize. It will take time though. I don't know when, nobody does, but hopefully we can get there by the end of 2008.

As for whether the housing market weakness has spread to other areas, this debate obviously will continue. From third quarter earnings season we see that the weakness has really been contained to home builders, mortgage lenders, banks and investment firms that own securities backed by mortgage loans, and companies that provide insurance for mortgages and mortgage backed securities. It is my belief, and many will certainly disagree, that consumer spending is not as bad as some would have you think, and the fact that growth in spending is lackluster has much more to do with the face that real wages have been stagnant for years, and not because of the housing market. In addition, the fact that consumers are staying current on all their other monthly bills, even when they are delinquent on their mortgages, shows that the housing market's issues really are fairly well contained.

As for policy moves, I think actions should be focused exclusively on stabilizing the housing market. While pleasing to the markets, I don't see any direct impact on housing from rate cuts. Just imagine how great it would be if we could get back to a "normal" housing market. People would have to get used to not making much money on their homes (real estate returns historically don't outpace inflation), but the credit markets would stabilize and corporate earnings could resume their growth trend. Even a flat housing market would be welcomed by investors, to say the least.

Full Disclosure: No positions in the companies mentioned

The Implications of Negative Earnings Growth

Undoubtedly, the underlying driver of the U.S. stock market in recent years could be summed up in two words; earnings growth. Equities now face a hurdle, however, as third quarter profits for the S&P 500 could very well decline year over year for the first time in five years. The implications for the market are pretty important.

At the outset of the year, market forecasters were calling for low to mid double digit returns for the market, supported by rising earnings and slight multiple expansion. It was my view that multiple expansion was unlikely (due to a lack of low P/E ratios to begin with, coupled with decelerating economic and earnings growth rates), so market returns would more likely track earnings advances, which would put us up in the mid to high single digits for the year. The S&P 500 is slightly above that pace right now, but it will likely be an uphill battle from here.

The reason is that without multiple expansion or earnings growth, there is no way for the market to advance meaningfully, by definition. The end result is likely to be a range-bound market as judged by the major indices. In fact, as the chart below shows, we have already begun to see this scenario take shape.

S&P 500 Index - Last 6 Months

From an investor perspective, this infers that stock picking will be all that more crucial to achieve investment gains. Not surprisingly, I would suggest focusing on individual situations where either multiple expansion or earnings growth are largely assured. The ideal investment candidate would be set up nicely for both, which would allow for solid gains regardless of whether or not the overall market advances meaningfully in coming months.

Countrywide Predicts Trough, Shares Soar 24%

Gauging the outlook for pure mortgage lenders like Countrywide (CFC) is a tough game and one that I am choosing not to play. The company is predicting that the third quarter was the trough and profits will return in Q4 and 2008, but nobody really knows for sure. Delinquency rates are still rising at CFC, standing at 7.1% as of September 30th, up from 5.7% three months before.

Until there are signs of stability and that stability hangs around for a while, I'm not going to bottom fish in mortgage-related companies like pure lenders or mortgage insurers. Honestly, those stocks are down so much, trading far below even recently slashed book values, that I think eventually there will be plenty of upside without even needing to time the bottom of the cycle.

Until then, I continue to like the bigger diversified banks with fat dividend yields. With these stocks yielding more than treasury bonds, I think you can justify buying low and being patient, knowing that calling a bottom is essentially impossible. I would, however, start making a list of the kinds of stocks you might want to target when things start to rebound. You won't be able to time a purchase perfectly, but there is no way that most of the home builders, mortgage insurers, and big lenders won't survive and be consistently profitable when the markets get back to some sort of more typical environment.

There will be money to be made, but I'm not comfortable jumping into pure plays just yet. Hopefully by sometime in 2008 things will stabilize and we'll have a better idea of what "normal" conditions look like. At that point, making bets will be much more prudent.

Full Disclosure: No position in Countrywide at the time of writing

Google Shows Restraint, Fails to Outbid Microsoft for Facebook Ad Deal

With a flurry of deals in recent months, Google (GOOG) has seemed willing to pay handsomely for attractive companies and contracts. The online ad leader has received mixed reviews for acquisitions of Doubleclick, Feedburner, and YouTube, as well as their exclusive ad deal with MySpace. With news that Facebook was negotiating with both Google and Microsoft (MSFT) on an international ad deal and a minority investment, it would not have been surprising, given their cash hoard and past deal history, to see Google outbid Gates & Company for the deal, even though Microsoft currently runs ads on Facebook's domestic site.

In a shift for Google, reports are hitting the wires that Facebook has secured a $240 million investment from Microsoft, in exchange for an expanded ad deal that covers Facebook's foray into the international market. MSFT is getting a 1.6% stake, which values Facebook at a whopping $15 billion. All this for a company that supposedly is on track for 2007 revenue and profits of $150 million and $30 million, respectively. That's right, Microsoft is paying 100 times 2007 sales and 500 times 2007 earnings!

There is no doubt that adding Facebook to its arsenal of web advertising properties would have been a boon for Google, but given that Microsoft already has a relationship with them, it is not too shocking that they would expand their existing deal. While prices of less than $2 billion for YouTube and $100 million for Feedburner will likely turn out to be bargains, it was likely tougher to justify a $15 billion valuation for Facebook. Many Google shareholders are probably happy to see the company show some sort of financial restraint, even though Facebook is clearly a hot property in the social networking space.

As for Google stock, the shares have soared to $675 on the heels of another strong quarterly earnings report from the company. I still believe the stock will continue its rise, but future gains will likely be far more limited. I will likely want to sell stock when the forward P/E approaches 35 times, which right now would equate to about $718 per share.

For the bears who continue to point to the fact that Google's market cap has irrationally matched or exceeded that of blue chip companies like Citigroup (C) and Wal-Mart (WMT), I would caution people against such comparisons. Lining up a software company side by side with a retailer or a bank really is comparing apples to oranges. Instead, I would suggest you compare Google's valuation with other software companies.

With a low 30's forward P/E ratio, given Google earnings growth projections over the next 3 to 5 years, I think investors will conclude that Google's share price is not only quite reasonable, but will continue to rise if the company can deliver earnings growth rates in the 20 to 30 percent range annually for the next several years. Even if you factor in decelerating profit growth as well as continued P/E contraction, you can still project a stock price meaningfully higher than current levels over the longer term.

Full Disclosure: Long shares of Google at the time of writing

A Trade Idea As Another Bank of America Entry Point Presents Itself

On July 30th I mentioned how I thought Bank of America (BAC) stock at $47 was attractive with a 5.4% dividend yield. The shares moved above $52 since that post, but today are falling back sharply, to $48 each, after the company posted poor third quarter results, just like every other bank has thus far. The dividend now stands at 5.3%, and I think it is very safe.

If you want to generate even more income on this trade, you could buy the stock to collect the dividend and any capital appreciation, while simultaneously selling out of the money call options on the shares to collect more cash. For example, the May 2008 52.5 calls are selling for about $1.75 each right now. Buying the stock and selling those calls would result in a breakeven point of ~$45 per share over the next 7 months or so. Conversely, your upside would be up to $52.50 on BAC stock, plus dividends and option premiums of around $3 per share (up to 15% in total gains).

If you think the stock will trade within the recent range of the high 40's to low 50's, this trade would be a great way to make a double digit percentage profit if BAC can make up the few points of recent losses in coming months.

Full Disclosure: Long Bank of America at the time of writing