Market Loves GM Bankruptcy

I kid, of course. The market is up 200 points today, not because GM is filing bankruptcy, but rather because investors seem to understand that the event itself is not at all catastrophic. After all, Chrysler is emerging from bankruptcy shortly and actually saw sales go up after they filed. It seems that most people, investors and car buyers alike, understand that Chapter 11 is a legal corporate process first and foremost and should be an afterthought to car buyers. Still, who would have thought the market would react quite so well initially?

Two short points on GM. First, the stock is up 20% today to about 90 cents. It's worthless, folks. Those who still grip their "efficient markets hypothesis" tightly can use this as a perfect case study against the theory.

Second, how will we be able to judge whether "New GM" is viable long term after they emerge from bankruptcy (which many say will be before summer ends)? It's all about cost structure. Many attribute their latest woes chiefly to the weak economy and lack of credit, but they seem to have forgotten that GM was a money loser in 2006 and 2007, when credit was flowing more freely than any other time in our history.

Consider the chart below, which shows how far from profits GM has been over the last three years:

As you can see, GM needed a near-10% mark-up over cost to breakeven on their vehicles. They never hit that goal in 2006-2007, even before they started selling cars for less than they built them for in 2008. If "New GM" can get their costs down, and have them be predictable and stay low, the company might be able to make a comeback down the road. It won't be easy, but Chapter 11 was the only way to make it even a reasonable possibility.

Full Disclosure: No position in GM, past or present.

Why Selling Your GM Stock Makes Sense, Even If Bankruptcy Is Averted

General Motors (GM) is working with bond holders to try and avert a bankruptcy filing. There are reports this morning that an agreement on a proposed debt for equity swap may have been reached. For current GM shareholders the question is pretty simple, should you sell at the current price of $1.35 per share?

Well, if GM files chapter 11 shareholders will very likely be wiped out completely (there have been a few cases when they aren't, but it's very unlikely). But what if the bond holders agree to certain terms and the company avoids bankruptcy? Isn't that possibility the sole reason GM shares trade at more than $1 right now, even though the company is effectively bankrupt?

The short answer is yes, but consider another fact. In the latest proposal made to bond holders, current GM equity holders would retain 1% of the newly restructured company's stock. In order to make the case to hold onto GM stock today, one has to argue that General Motors equity, after the restructuring, will be worth at least $80 billion (100 times the current $800 million market capitalization). How would one even begin to make that case?

Update: Smart Phone Makers Ripe for Profit Taking

Earlier this year I wrote separate pieces highlighting both Research in Motion (RIMM), maker of the Blackberry and smart phone staple, and Palm (PALM), the turnaround story trying to get their name back into the mix. In the four months or so since then both stocks have soared, nearly doubling in each case (PALM from $6 to $11 and RIMM from $44 to $78). Not surprisingly, these are instances when taking profits makes sense.

The competitive landscape for Research in Motion really hasn't changed since February. The stock move is based on two things; the overall market advance, as well as renewed optimism that Blackberries remain popular devices and profit margins will hold up nicely even in this heightened period of competition and economic challenges. RIMM has seen its P/E ratio on 2009 earnings estimates jump from a very meager 13 times to a more reasonable 20 times, which seems more appropriate to me.

In Palm's case, the stock has moved in anticipation of their new device, the Pre, set to debut June 6th. While the prospects remain bright for both the Pre and subsequent devices Palm is sure to launch in coming quarters, we often see a sell off in the stocks of tech companies heading into or right after major product releases (so called "buy the rumor, sell the news"). In order for Palm shares to make new highs above the recent peak of $14 $12 per share, the Pre launch really must go perfectly. However, as is the case with many new product launches, expectations are high and there can be hiccups along the way. Therefore, there will be opportunities for investors with big gains to take profits and put selling pressure on the stock.

In both of these cases, investors who have sizable gains and still believe in either or both of these companies longer term can have their cake and eat it too by taking some chips off the table and keeping a smaller position to profit from if their instincts are right about the future.

Full Disclosure: Peridot Capital was long shares of Palm at the time of writing, although the position has become smaller in recent weeks, and positions may change at any time

NYT Economics Reporter Details Personal Credit Crisis

An interesting story of how even those who follow the financial system intimately on a daily basis can get pulled into the mess.

From the 5/14 edition of the New York Times: My Personal Credit Crisis by Edmund Andrews

Do Americans Want To Buy Fuel Efficient Cars?

There appears to be debate on this question, which is puzzling to me. I think many people are mistakenly under the assumption that "small, fuel efficient" cars equate to miniature so called "smart" cars that we see every so often on the road and in Europe, as opposed to simply something other than a gas guzzling SUV or crossover vehicle. In fact, most sedans today are very fuel efficient.

Will U.S. consumers buy these cars? Well, that question has actually already been answered. As you can see from the chart below, the top 5 best selling cars in the U.S. get more than 30 miles per gallon on the highway, and #6 on the list isn't too far behind:

"Buy and Hold" Doesn't Work If You Completely Ignore Valuation

The current bear market resulted in the first negative ten-year period for the U.S. stock market in a long time. This has prompted many people to declare that the investment strategy of buying and holding stocks for the long term ("buy and "hold" for short) is all of the sudden "dead" or no longer viable.

Personally, I find this death pronouncement a bit odd. Just because stocks went nowhere from 1999-2008 means that investing in stocks for ten years is flawed generally? Since when does one instance of something not working render the entire concept flawed? I don't think a 100 percent success rate is required for one to declare it a viable strategy.

The reason "buy and hold" became popular is because, over long periods of time, stock prices mimic corporate earnings, which have risen over business cycles since the beginning of our economy. Legendary fund manager Peter Lynch continually reminds people that it is no coincidence that over decades the gains in the U.S. stock market are practically identical to the gains in corporate earnings (stock ownership represents a proportional share in profits generated by the firm).

The key point here is that the relationship only holds over long periods of time. In any given year, there is virtually no correlation between earnings growth rates and equity market gains. That is why "buy and hold" is a widely accepted investment strategy. If you invest over the long term, the odds are extremely high that earnings and stock prices will rise, and do so at higher rates than other investment alternatives.

I bring this up today because a former CEO of Coca Cola was a guest host on CNBC this morning. He and the CNBC gang discussed the fact that shares of Coke are actually down over the last ten years (since this person left the CEO post), as the chart below shows.

The CNBC commentators were quick to point out that Coke's earnings have more than doubled over the past decade, but the stock has actually lost value. Does this example support the idea that "buy and hold" is a flawed strategy, or is there something else at work here?

The latter. Coke stock carried a P/E ratio above 50 back in the late 1990's, during the blue chip bull market. Even when earnings grow dramatically, if P/E ratios are in nose bleed territory, "buy and hold" may not work, as was the case with Coke.

As a result, "buy and hold" does not work blindly. If you dramatically overpay for a stock, there is a good chance that you won't make any money, even over an entire decade. From my perspective, this does not mean that "buy and hold" is dead (the long term relationship between earnings and stock prices is unchanged), it simply means that valuation is important in determining future stock price returns (statistics show it is the most important, in fact).

The takeaway from this discussion is that "buy and hold" investors are likely to do very well over the long term, as long as they don't grossly overpay for an asset. The U.S. stock market in the late 1990's was more expensive, on a valuation basis, than at any other time in its history. Buyers during that time can't be saved from their own poor decision of paying too much for a stock, even by a proven long term investment strategy. Unfortunately, most non-professional individual investors don't focus on valuation when picking stocks for their portfolios, and often pay the price as a result.

Full Disclosure: No position in Coca Cola at the time of writing, but positions may change at any time

After Huge Rally, Market Digests Earnings Season and Bank Capital Raises

With most first quarter earnings reports having already been released, along with bank stress test results, the action in the market has died down considerably. After a 40% rally, the S&P 500 has been consolidating between 875 (a key technical support level) and 930 (the recent high). Such backing and filling is a strong sign. One would expect a pause after such a huge move, and despite the fact that the banks are rushing to issue billion of dollars in new shares, the market is absorbing that new supply fairly well (the stocks are down from their highs but they seem to be building a base and fear has subsided).

As for earnings season, first quarter results largely exceeded reduced expectations. Bulls and bears will continue to debate whether beating those low estimates was a positive or not, but merely stopping the earnings decline would serve to put a floor on stock prices. If the rate of decline in both the economy and corporate profits can decelerate, we could very well see sideways market action for a while. With the S&P 500 up from 666 to nearly 900, that would be welcomed by most investors.

The recent rally has been predicated on the idea that Q4 2008 and Q1 2009 will turn out to be the worst quarters for the economy. If GDP can rise sequentially throughout the year, and turn positive on a year-over-year basis by the fourth quarter, corporate profits will likely have hit a bottom. This scenario is priced into equities, so we really need it to play out that way for the S&P to hold the 900 area in coming months.

There are still plenty of people who are negative on the economy and either don't think a rebound will occur later in 2009, or if it does, it will be short-lived and we will see even worse times in 2010. If that proves true, we could very well see a retest of the March lows, as the bears are expecting.

Where do I come down? I think there is a decent chance we do not see 666 on the S&P 500 again. By "decent" I mean, say, between 50% and 67%. The rest of 2009 could very well be rocky though, so we could certainly get a correction or two, especially after a 40% rally in the market. As a result, I am holding some cash (10-20% right now in many cases) in order to take advantage of any other leg down if we get it. That cash number will likely increase if the market rally continues and we approach my own fair value estimate (1000-1050 on the S&P).

In general, I think a solid path would be for the market to trade sideways for a while. Digesting the big move we have made, rather than simply seeing another large sell-off (which was the typical course over the last year or so) would send a signal that the worst may be behind us and we can slowly recover. I agree with many who believe an economic recovery will be neither particularly fast, nor violently strong, but simply muddling along with little or no GDP growth would go a long way to supporting stock prices at their current level and take the calls for 600 on the S&P off of the table.

Trucker YRC Applies for TARP Funds, Don't Hold Your Breath

For those who don't know, YRC Worldwide (YRCW) is the former Yellow Roadway. Here is some of what the Wall Street Journal is reporting:

"YRC Worldwide Inc., one of the nation's largest trucking companies, will seek $1 billion in federal bailout money to help relieve pension obligations, the chief executive said Thursday. Chief Executive William Zollars said the company will seek the money to help cover the cost of its estimated $2 billion pension obligation over the next four years. Under a complicated system that Mr. Zollars labeled unfair, roughly half of YRC's contributions to a multi-employer union pension fund cover the costs of retirees who never worked for the Overland Park, Kan., company."

Awfully presumptuous of him, don't you think, applying as a trucking company without any indication Treasury would ever widen TARP to include any U.S. corporation? I would be shocked if this were approved, and if somehow it is, TARP would be completely out of control.

"Mr. Zollars declined to comment on YRC's specific strategy in seeking the funds, other than to say the company shouldn't be forced to pay the pension benefits of employees who never worked for YRC."

This seems like an odd explanation. I don't know the details of the "complicated, multi-union" pension plan in question, but it strikes me as probable that if half of YRC's contribution goes to people who didn't work for YRC, then the other truckling companies are in the same boat and are paying for some of YRC's former employees. Does Zollars want to stop paying for non-YRC pensions while still having his competitors subsidize YRC's pension obligations? The whole thing is bizarre, to say the least.

Full Disclosure: No position in YRCW at the time of writing, but positions may change at any time

Meredith Whitney Quitting Oppenheimer Helps Show Contrarian Indicators Still Work

As my clients know well, I am a contrarian when it comes to investing in the market. To me, buying a stock is no different than shopping for a new house, car, or wardrobe at the mall. You get your best deals when you are either buying things other people don't want (store sale racks, foreclosed properties), or buying things when other people aren't shopping for them (winter coats well into the season).

As a result of natural human behavior, many market participants use contrarian sentiment indicators to guide their investment strategy. Measures of investor bullishness and consumer confidence, for example, are proven contrarian indicators. Sometimes certain events can even mark emotional extremes.

Consider banking analyst Meredith Whitney's decision on February 18th to leave her sell side job at Oppenheimer to start her own firm. Prior to October 2007, few people even knew who Whitney was, but after she became one of the first analysts to point out a possible capital shortfall at Citigroup (C) she immediately became the face of the banking crisis (thanks to the financial media) and has been extremely bearish on the group ever since.

So, we have a relatively unknown banking analyst make a good call on a large bank stock, the media picks up on it and runs with the story for months, and less than 18 months later she has enough of a following to start her own firm. These kinds of events often mark extremes, in this case, the depths of the banking crisis. For an analyst who made her career by being unrelentingly bearish on banks, it stands to reason the banking sector would be struggling mightily around the time she quit her job to go out on her own. It makes sense to question whether negative sentiment would be peaking around that time.

Of course, I wouldn't have used this example if it didn't serve as a positive data point for the contrarian indicator thesis. We won't know for another year or two if Whitney quitting actually was a great contrarian indicator or not (it's too soon to call the bottom in the banks), but it took only 12 trading days for the bank stocks (and the market itself) to put in a fierce and dramatic bottom on March 6th. Since then the market has risen 36%. Financial stocks have fared even better, soaring 105%.

Another contrarian indicator I follow is the number of worried emails and phone calls I get from my clients about their investment portfolios. If I get a few clients expressing concern over a period of days, that signals to me that sentiment is extremely negative and a bottom may not be far off. This personal indicator of mine peaked on March 2nd, merely four days prior to the market's bottom.

All in all, contrarian indicators measuring sentiment among investors and other market participants can still be a very valuable tool when managing one's investments. I recommend keeping them in mind as you continue to follow the market and your portfolios.

Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time

U.S. Bank Stress Test Cheat Sheet

All we've heard about this week has been the stress tests, so I figured I would summarize the important aspects for everyone. Hear is what you need to know if you are following the large cap U.S. financial sector.

Capital Ratio Requirements: Banks must have enough capital to maintain the following ratios:

*Tier 1 Capital of 6.0%

*Tangible Common Equity (TCE) of 4.0%

Deadlines: For banks that need more capital, here is their timeline:

*Articulate plan for raising capital by June 8th, 2009

*Implement plan by November 9th 2009

*Maintain target capital ratios through December 2010

Sources of Additional Capital:

The regulators have indicated that raising private capital is the preferred source of raising capital. The banks may also choose to sell certain assets and use cash earnings to reach the targets. If those options are not sufficient to reach the desired capital levels, the banks may convert their TARP preferred capital into mandatory convertible preferred stock, which can be converted, on as needed basis, into common equity in order to boost capital levels to the needed levels.

Here are the results:

As for individual stocks, I have long been writing positively about COF, PNC, and USB on this blog. COF and USB passed and PNC needs to raise the least of all the banks, a meager $600 million. These results are not surprising to me, and I continue to like all three stocks long term.

Full Disclosure: Peridot Capital was long shares of COF, PNC, and USB at the time of writing, but positions may change at any time