Markets around the world ended last week in the doldrums. Japan had tanked all week on the heels of Livedoor being indicted on allegations of securities fraud. The U.S. was concluding a massive sell-off on the heels of lower earnings guidance from tech titans Intel and Yahoo.
Markets around the world ended this week in a party mood. In last weekend's week-in-review, our investments in Japan were down 7.1% and up 21.8% respectively. This weekend, they're up 2.7% and 46.3%. That's a dramatic turn of events.
In the thick of the struggle, we held firm and even started looking for bargains. I spent Monday in Tokyo, talking with investors and brokers at Nomura Securities, and concluded that Japan is still in a bullish mode and that we should hold tight. That was spot-on, as the Nikkei hit a five-year high on Friday. For the week, our aforementioned Japan investments gained 10.6% and 20.1%.
We doubled down on at $22.50, giving us a new average buy price of $25.25. We have an order in place to double down on at $21.50.
We were disappointed by the IPO of Chipotle Mexican Grill (CMG), which was priced at $22 but opened at $45. We did not buy shares at those prices because I sent a note shortly after the stock became tradable to place a limit order at $25.
Before I dive into the week's day-by-day action, I want to take a moment to highlight the excellent long-term pace of our permanent portfolios. They generate little short-term exhilaration because I focus my energies on boosting our returns with smart stock trades.
However, the core of The Kelly Letter remains the permanent portfolios and the star of the group remains Maximum Midcap. The Dow just poked into positive territory for the year, but the midcap index has been positive all along. Double The Dow is up 3% so far and the Dow 1 is up 11%, both decent. The Dow 1 looks fantastic, until you realize that it lost 13% last year and is just finally getting the rebound it's been due for a long time.
Maximum Midcap is up 10% so far this year, and that's after rising 60% in 2003, 29% in 2004, and 19% in 2005. To put that in perspective, since Dec. 31, 2002 the Dow turned $10k into $13k, the Dow 1 turned it into $14k, Double The Dow turned it into $16k, but Maximum Midcap turned it into $27k. You can see the Maximum Midcap performance table here.
I'm very proud of all of these systems, particularly Maximum Midcap. It's an excellent core holding for any long-term investor.
Now, to the daily recap.
Monday While gains in the U.S. remained moderate Monday, equities rebounded from sharp selling action that sunk the previous Friday's market. Buyers scooped up bargains left in the wake of the prior week's average 2.6% drop in the indices.
In Japan, Livedoor executives including president Takafumi Horie were arrested for securities law violations. Economy and banking minister Kaoru Yosano called the arrests "very unfortunate".
I spent that day in Tokyo and sent a report to subscribers saying to hold our positions. You can see the report below.
U.S. President George W. Bush said Monday the United States will work aggressively to reopen the Japanese beef market after Tokyo reimposed a ban on American beef last week, expressing hope that the trade problem will be resolved quickly.
Chipotle Mexican Grill announced plans to offer 7.9 million shares at a range of $18 to $20, with the timing set for a pricing on Wednesday night for trading on Thursday. I sent a note about this on Monday evening.
We had another case of lowered earnings guidance cratering one of our holdings. plunged 15% after hours when the company predicted that quarterly results would fall short of both the company's own prior outlook and the average of estimates on Wall Street. Excluding things like restructuring charges and stock-based compensation, the company forecast that it would earn 25 cents to 27 cents a share for the three-month period ended Dec. 31. The outlook was well below analysts' estimates that the company would earn 38 cents a share on revenue of $274.5 million, according to a Thomson First Call survey. We would take advantage of these cheap prices to buy more shares on Friday.
While that company disappointed, our e-commerce holding delighted. It said that it shaved its first-quarter loss, even as revenue slid more than 12 percent, and its adjusted results handily beat Wall Street estimates. Shares have traded between $5.40 and $14 over the last year and rose 82 cents, or 10.7 percent in after-hours trading from Monday's closing price of $7.69. Excluding one-time items, the company said it earned $10.2 million, or 14 cents per share, compared with adjusted earnings of $1.3 million, or 2 cents per share, a year earlier. Analysts polled by Thomson Financial expected the company to earn 7 cents per share for the quarter on $75.9 million in revenue. This has been a great holding for us from the very day we bought back in mid-September. It would finish this week up 57%.
Tuesday Japanese economic activity rose 0.3% in November, the government said, suggesting that the economy remains in a recovery trend.
The Tokyo Stock Exchange said that it will shorten the trading hours of Livedoor to avoid turmoil on the bourse given a large number of sell orders on the issue.
Livedoor President Takafumi Horie stepped down, a day after he was arrested on suspicion of violating securities laws. The company named Kozo Hiramatsu, its senior vice president, as president.
Analysts weighed in on our computer security company's bad report, as the stock dropped almost 18% in a day.
"[This company's] fourth-quarter preannouncement had a bark that may ultimately prove to be worse than its bite," wrote Bear Stearns analyst Sarah Friar, in a client note issued on Tuesday. "With some time to digest and the stock already trading at a significantly discounted valuation of just 8 times enterprise value-to-adjusted free cash flow, we see room for recovery." She speculated that [the company], which did not provide details regarding the earnings shortfall, may have been unable to book sales for some larger deals due to the deferred structure of these contracts. "We are maintaining our 'in-line' rating on the stock, but our key message to investors would be not to panic given that the bookings number was not bad and should provide increased support to revenue estimates in 2006," said Friar. I agree, of course, which is why we bought more shares.
Wednesday In Japan, a Liberal Democratic Party committee met Wednesday and agreed to call for stricter monitoring of the securities markets by the Securities and Exchange Surveillance Commission (SESC) in response to the recent turmoil instigated by Livedoor. This is the silver lining in the Livedoor cloud. The short-term pain of sudden losses last week should be replaced by the long-term gain of a steadier, more fully-disclosed market.
Thursday The U.S. markets rose all day to their best performance in weeks. Suddenly, last week's high-profile earnings slowdowns have been forgotten in the face of bargains and overall improvement in reports.
Shares of Chipotle Mexican Grill, the stock I wanted to buy at the start of its initial public offering, debuted. We missed out because the stock opened at twice its expected price. The mainstream media breathlessly reported that shares in the IPO were priced at $22 Wednesday evening, but that they doubled that to close at $44 on the NYSE. Ahead of the pricing, the company had increased the expected range by $2.50 to $18 to $20.
This is an absurd take on the IPO. The stock may have been "priced" at $22, but it opened to individual investors at $45 and never dropped below $39.51. With a close at $44, the very best the individual investor could have done was an 11.4% gain from $39.51 to $44. With a market order at the first available prices, most investors got in between $43 and $45, making the first day breakeven money. That's not terrible, but it's a far cry from the media shriek of a one-day 100% gain.
On Friday, shares of CMG would fall 4%.
Friday Stocks opened sharply higher on the Tokyo Stock Exchange on Friday, with the Nikkei recovering the 16,000 line. The Nikkei closed at 16,461.
Regarding Japan's Livedoor Shock, I wrote in a note sent to subscribers on Jan. 18:
The end of Japan? Not at all. . . .Livedoor is popular but not very important. Ask yourself how much the company has changed the world in the last fifty years. Then, ask yourself how much Nissan, Toyota, and Sony have changed the world in the last fifty years. The contrast is striking, and the important companies are in no trouble whatsoever. . . .the factors that I outlined in the January edition of The Kelly Letter pointing to a positive Japan in the near future are still in place. . . .If you were waiting for a nice dip to get into the Japanese stock market, now's your chance. I suggest buying into [our market investment] at this discount. If you invested along with The Kelly Letter last fall, then just sit tight.
Evidence supporting that note came to light on Friday.
First, Sony's shares soared in heavy trade after the company sharply lifted its full-year forecasts and posted a record net profit and sales in the quarter ended Dec. 31.
Second, Japan's core nationwide consumer price index grew 0.1 percent in December from a year earlier for the second straight monthly rise, the government reported. This is a compelling sign that deflation is finally coming to an end.
In the U.S., a solid round of earnings reports maintained a bullish mood Friday. The lower than expected read on fourth quarter GDP growth didn't interrupt the upward trend.
Earnings have been strong so far, the blow-ups I highlighted last week and this week notwithstanding.
Of the 241 members of the S&P 500 that reported earnings as of Friday morning, 155 companies, or 64 percent, surpassed Wall Street analysts' forecasts. Another 42 companies, or 17 percent of those reporting, matched estimates, while 44 companies, or 18 percent, had lower-than-expected earnings. According to Thomson Financial, that's well above than the S&P 500's long-term average of 59 percent better-than-expected earnings. Profit growth remained strong, with the average company posting 13.2 percent year-over-year gains, Thomson said.
Despite that, I still remain cautious about this year. I've been warning of an earnings slowdown since December. Now we're seeing it in the form of lower guidance that hit investors hard two weeks ago. Part of that is that the economy is widely expected to slow down this year.
In fact, we received evidence to that effect on Friday. The gross domestic product grew 1.1% in Q4, less than half of the projected 2.8% increase.
Now, this is a mixed bag. In the short-term, it's probably good news because it might signal the Fed that it's time to stop raising interest rates after one more increase at next week's meeting. An end to interest rate increases would be good for stocks. However, a slowing economy is ultimately not good for business (by definition) and therefore not good for stocks.
My December forecast for the 2006 market was for single-digit gains, mildly bullish. Somewhat anecdotally, the "January Barometer" looks set to give a positive signal on the year. According to The Stock Trader's Almanac, "as the S&P goes in January, so goes the year. The indicator has registered only five major errors since 1950 for a 90.9% accuracy ratio." It doesn't speak to the size of gains or losses to be had, just whether the market will end the year up or down. As of last Friday, the S&P 500 is up 2.8% so far this year, indicating a positive signal.
Whatever gains 2006 produces won't happen in a gentle upward-sloping line, though. I anticipate that we're going to see a valley pattern with a strong beginning to the year, a weak middle, and a strong end. That would make midyear a ripe hunting ground for bargains.
It's not midyear yet, though, and we're enjoying the good times.
Our big pharma holding continues recovering well. Diabetics are getting an alternative to the regular needle jabs of insulin they've endured since the discovery in the 1920s of the hormone that controls blood sugar levels. This company hopes to begin selling Exubera, the first inhalable version of insulin to win federal approval, by summer. The FDA approved Exubera on Friday, a day after the multinational European Commission did so. Our investment in the company has had a rough go of it, but we're now just 2% below our average buy price. The stock is also this year's Dow 1 holding.
Long-time holding climbed $1.29 to $27.79 after seeing its profits grow 5 percent for the quarter. The company said new server products helped boost sales. Contrary to the recent trend, the company increased its full-year earnings outlook because it has high hopes for the new software coming later this year. Our position is now up 23.5%.
That'll do it for this weekend. A lot of hard work has paid off for us and I'm confident that it will continue to do so. The market is a turbulent place, but when approached with a steady hand and an eye on value, it can be rewarding.
Just as rewarding for me is the pleasure of continuing to navigate it with you.
I woke before dawn this morning and caught an early train to Tokyo. After continuing to read and watch news surrounding the Livedoor scandal, I decided to spend Monday among investors during market hours. I went to the Nomura Securities office in Shinjuku, where there is a large lobby with live news feeds. Anybody can enter and talk investing with other people gathered there, including the Nomura employees.
The market opened down and continued fluctuating in the red all day before closing another 2% lower. Individual investors appeared edgy, but not panicked. The prevailing theme in conversations was that Livedoor doesn't matter to the economy and that its contagion is a real head-scratcher. Who cares if some tiny internet start-up with a CEO who goes on TV regularly is under investigation?
Nobody, actually, but the market needed an excuse to sell off. That's the take of Sarah Whitley, a fund manager at Baillie Gifford & Co., a U.K.-based investment firm. The Livedoor situation brings nothing to bear on the economic recovery or Japan's long-term uptrend. This down leg is merely a correction of last month's impressive rally.
Hakan Hedstrom, a senior economist at Deka Investment GmbH of Germany, also thinks Livedoor's troubles are its own and do not mean anything to the rest of Japan's companies. He agrees with me: there are no changes in the upward momentum created by government reform, the end of deflation, and increasing land prices. He said that if Livedoor Shock sends short-term speculators to the exits, stability will return to the market.
Zenshiro Mizuno of Marusan Securities Co. said that "Individuals are starting to move on their long-awaited bargain hunting opportunity."
Takanori Tanabe, head of Tanabe Economic Research Institute, feels that the Nikkei will bottom at 15,000. That's 2.4% below today's close.
Tsuyoshi Nomaguchi, strategist at Daiwa Securities Co., says the market will stay flat for a while until the scandal dissipates, and then the Nikkei will advance to 18,000 when Japanese companies report fiscal 2005 Q3 results (through December 2005). That would be a 20% recovery from 15,000.
Finally, I refer you to comments from Takehiro Sato of Morgan Stanley. He wrote:
. . .the underlying scandal does not reverse our scenario and we maintain our constructive stance toward Japan's asset markets.
First, the scandal is unrelated to the basic economic fundamentals. Consumption and capital investment environments are unprecedentedly healthy, and we expect Oct-Dec GDP data released next month to considerably exceed our existing estimate (+2.5% annualized) with special factors such as a seasonal lift for the consumption of winter items from cold weather and a retracement of real imports. Now Japan's F2005 real GDP growth is not only within reach of 3%, but also it is increasingly headed toward beating this level.
Second, we expect the lessons from this scandal to enhance the quality of the Japanese stock market gain. Recent rallies have included undisciplined run-ups for stocks with comparatively weak financial standing and profitability alongside of high-quality stocks amid fierce expansion of trading volume from rotating intra-day transactions by individual investors. However, we think this incident has altered investors to the importance of compliance and proper disclosure. Although the stock market's upward pace might slow somewhat, we are even relieved by the correction to a more suitable level from the overshooting territory. Going ahead, we hope to see rallies that are aligned to improvements in corporate profits. As for this, we have an out of consensus view, looking for more than 20% growth in recurring profit for F2006.
Also the Japanese market has a surprising track record of rapid recovery from recent dips on the scale of a few hundred yen, setting new highs just a few days later. We think the market will remain firm with risk still on the upside.
Let's stay put for now.
Jan. 28, 2006 Update: This call was spot-on. By Friday, Jan. 27, the Nikkei had fully rebounded and closed at a 5-year high of 16,461. The Kelly Letter's two Japan investments, a bank and a leveraged market mutual fund, ended the week up 10.6% and 20.1% respectively.
It was a crummy week around the world, though not entirely surprising to us. I wrote last weekend in the January issue:
It does seem prudent, though, to curb our enthusiasm for this great start to the new year by remembering that:
- Corporate profits are bound to slow. - The Fed is entering a new leadership phase. - High housing prices are destined to settle back. - Lower housing prices could sputter the economy's spending engine.
I prefer finding ourselves happy in the market when others are not. Looking around these days, I see a preponderance of happy people among us. Always a tad frightful, that.
Those comments came not a moment too soon, it appears, as Japan melted down on Monday, Intel (INTC) dropped an earnings bomb on Tuesday, and Iran looks determined to bring the world to a nuclear showdown. Any funny business from that part of the world inevitably leads to higher oil prices, something I'm sure you've grown used to reading about.
The main trouble, though, is the first point I warned about: corporate profits are bound to slow. We knew this coming into this year (see my December article on market timing.), but that never matters. Slowing earnings lead to lower prices, period. Now the reports are coming in, they're showing an earnings slowdown, and prices are reacting predictably. You'll see plenty of evidence to that effect as you continue reading.
Yet, as always, we can delight in a few tasty morsels amid this spoiled smorgasbord. We didn't buy anything during January's opening party. We set reasonable price targets on and all have come below those initial price targets. Our permanent portfolios remain on track. Finally, some of the good positions we hold may soon give us a chance to buy more shares at lower prices, a perennial favorite among The Kelly Letter's strategies. Lest you just joined or memory fails to serve, both of last month's successful sales (DECK +40% and MXO +60%) came after lower prices following the first investment. We bought more DECK at 26% below our initial entry. From there, it recovered 65% to our sale price...and then kept going up. Falling prices on stocks that we believe in can present us with more joy than pain when all is said and done.
Let's take a look back at this tumultuous four-day trading week.
Monday Although U.S. markets were closed, Japan's were not. Prosecutors accused popular internet company Livedoor of violating securities laws, and that seemingly unimportant tidbit tanked the Nikkei. This issue clouded the entire week in Japan and has come to be known here as "Livedoor Shock". By the end of the week, Livedoor's shares would lose 52% and an investment firm executive linked to the controversy would hang himself in an Okinawa hotel room. I sent a note to subscribers on Wednesday evening addressing this issue, and will provide more details below.
Tuesday The UN threatened possible sanctions on Iran to restrain the country's nuclear plans. Oil hit a three-month high of $66.30.
Ahead of Intel's evening earnings report, analysts downgraded Advanced Micro Devices (AMD) and Applied Materials (AMAT). Suddenly, semiconductors weren't looking as attractive as they looked just last week.
Then came the doozy, Intel's earnings report after hours. The company fell three cents short of estimates. Although sales increased 6.3% year over year, that was also below estimates. Shares immediately fell 9%.
Wednesday Still reeling in shock from Livedoor, the Nikkei plunged 3%. The selling became so intense that it overwhelmed the system and the exchange closed early.
Japan coupled with Intel's bad earnings report weighed heavily on U.S. stocks. Yahoo (YHOO) didn't help when it provided disappointing Q4 results and lower Q1 guidance. There are those slowing earnings again.
But how bad are things at Intel and Yahoo? Intel had a 21% year-over-year increase in per share earnings, and Yahoo was up 23%. Do those figures look catastrophic to you? They don't to me.
What's actually going on is an adjustment in expectations. People expected the recent good times to continue forever. They can't. They can continue being pretty good, though, and that's what we're seeing. A slowdown, yes, but not a halt.
Regarding Intel, I refer you to this snippet from Wednesday night's note:
But let's not lose perspective. Intel makes 80% of the world's processors. It has some great new products in the offing, notably dual-core processors that should inject some excitement into the desktop market. It's also about ready to roll out some digital consumer product chips that'll be used in a slew of new gadgets. The company didn't die last night.
With Yahoo, too, the company did pretty well but not as well as people expected. Although I don't own Yahoo or consider it a buying candidate at this time, I think cheaper prices down the road could make it a compelling investment. It's a good company and its business has a bright future.
Thursday Finally, a little relief in Tokyo. After losing 1,100 points in the previous three days, the Nikkei rebounded 2.3%. This was not to last, though. On Friday, it would fall again.
We had some great news from long-time holding Disney (DIS). It's trying to acquire Pixar (PIXR), the company behind such recent animated hits as Finding Nemo and The Incredibles. Acquiring Pixar would mean that Disney would get CEO Steve Jobs on its board. That would be great. Mr. Jobs is also the head of Apple Computer (AAPL) and few people have their finger on the pulse of entertainment and technology more firmly than he. Currently, Disney's largest shareholder is former CEO Michael Eisner at 1.8%. Mr. Jobs could gain as much as 6%. If Disney succeeds in buying Pixar, its animation strength would increase dramatically.
The Kelly Letter has owned Disney for years and I am happy to continue holding. Nobody makes better content than Disney. It's no slouch at marketing. Its distribution channels are unmatched. Plus, everywhere you go on the planet it's a well-known brand. Here in Japan, girls wear Mickey ears as headbands, carry Disney pencils in Disney pencil cases, and pass out Disney cookies and chocolates to their friends every time they make a trip to Tokyo Disney Resort. I've seen a businessman on a train pull out a file folder sporting a picture of Donald Duck. Disney has double-digit earnings growth and steady cash flow. It has a good lineup of movies ready to go, an interesting plan to syndicate more of its TV shows, and a profitable DVD-release strategy. We're already up some 72%. That will surely become a double in the future.
Q4 profit fell 3%, but topped estimates. Revenue fell 9%. It also raised its dividend 26%, always nice to see. While beating estimates is good, the reason is a little troubling in this case. The company said the better result was due to its cost-cutting efforts. Overall, it saved $800 million this year, more than twice what it thought it would save. However, the biggest savings happened in research and development costs, which fell 13% to $2 billion. R&D strikes me as being rather important to a drug company. With one eyebrow cocked, I continue holding the company because of its improving numbers and great dividend yield.
In contrast to Intel's bleak report on Tuesday, Advanced Micro Devices delivered a superb report that showed earnings 19 cents per share higher than estimates. Revenues exploded 45%. The company has its eyes set on a 25-30% share of the processor market by 2009 and expects itself to grow at twice the 10% rate of the overall PC market. A year ago, AMD commanded just 9% of the market, last quarter 12%, and this quarter 15%. That's phenomenal progress and by all counts the company should be commended.
This directly relates to Intel because the two firms are arch-rivals. AMD's successes are Intel's losses. This week, AMD is the clear winner. Intel's shares dropped 11% Wednesday after its report. AMD's shares rose 11% Thursday after its report.
What makes Intel interesting? In a word: valuation. AMD has done very well and now its stock is expensive and expectations for the company are high. That leaves it vulnerable to disappointment. Intel has done badly and now its stock is cheap and expectations for it are low. That leaves it primed to delight and surprise. AMD trades at a forward P/E of 48; Intel at 17.
Don't write off Intel just yet. It's not the whimpering also-ran that it looks to be in comparisons involving only the events of this week. Don't forget that it controls 80% of the processor market. It also listened to AMD's report and I can assure you that it noted its rival's successes more carefully than any stock analyst did. Intel will leverage its overwhelming market dominance to keep its smaller competitor in check.
Friday A lousy end to a lousy week. Continued downward guidance in earnings reports kept the markets heading lower, to their worst performance in three years.
Iran's ongoing nuclear shenanigans drove oil to a four-month high over $68 per barrel. It looks like the country is taking its money out of Europe to protect it from a potential U.N. sanction. It said that it might cut its oil production or withhold supplies from the market. Why oh why must the world's most important commodity be located below the world's most volatile countries? Think how different events would be if, say, Canada, England, France, Germany, Japan, and the U.S. each controlled an equal portion of the supply. Perhaps we should just thank our stars that North Korea is not an oil producer.
Japan's troubles with Livedoor continued and it added a new factor when beef inspectors found a vertebral column imported from the U.S. That violated the agreement that the U.S. struck with Japan after a two-year beef import ban following the discovery of mad cow disease in America. One of Japan's largest fast food restaurants, Yoshinoya, depended almost entirely on American beef. It was sent reeling two years ago when imports were cut off, and changed its menu to pork almost overnight. That has not been as popular. Finally, in December, the ban was lifted and that contributed to a rise in Yoshinoya's shares and a strengthening of the sentiment in the stock market. Now, less than a month later, the ban is back, Yoshinoya is staggering, and the already shocked stock market took another hit.
What's frustrating about this is that it was so avoidable. The two countries worked hard for two years to hammer out an agreement that worked both ways. That agreement clearly banned certain beef parts that Japan considers to be most vulnerable to mad cow disease. "Our agreement with Japan is to export beef with no vertebral column and we have failed to meet the terms of that agreement," U.S. Agriculture Secretary Mike Johanns said in a statement. Mr. Johanns said the U.S. is taking the matter "very seriously" and the department plans to take "appropriate personnel action" against the food safety inspector who approved the shipment to Japan.
Cattlenetwork.com reported: "In an uncommonly swift move that underscores the seriousness of the problem, Johanns also said the meat processing plant that shipped the product has been delisted, meaning it will no longer be allowed to export beef to Japan."
For two years, the U.S. beef ban has been one of the most frequent topics of discussion between foreigners living in Japan and Japanese people. Restaurants quickly placed "Aussie Beef" stickers in windows to assure customers that poisonous U.S. beef was not being served. It was an embarrassment for Americans, to say the least. Jokes were common. Whenever I'd visit the U.S., people would ask prior to my departure if I would dare to eat any beef during my trip. When at last the ban was lifted last month, it was a point of pride among Americans, a flag-raising event at Yoshinoya, and just plain good news for inter-country relations. To see it dashed on the rocks within a month, thanks to carelessness at one processing plant and an undedicated U.S. food safety inspector, is humiliating.
It's also bad for the stock market. The Nikkei 225 lost 4.6%, the biggest weekly drop since May 2004. We, however, are staying put in our investments here. In the midst of this hot week, I re-checked the health of Japan and found it to be as solid as I wrote about in the January issue.
In the January 11 edition of Nikkei Net, I found the following encouraging excerpt:
Tired of doomsayers' foreboding about Japan's future? Turn to Yuji Shimanaka. "We are entering a 'Golden Cycle' in 2006," said the chief economist and head of research at Mitsubishi UFJ Research and Consulting.
All four key business cycles, with different lengths, will turn up in 2006 for the first time in 60 years, he forecasted. The four cycles are: the three- to four-year inventory cycle; the capital spending cycle of some 10 years in length; the 20-year construction investment cycle, and the 60-year Kondratyev Wave. This means that in addition to inventory and private business spending, land prices and the official discount rate have also hit bottom, only to rebound in unison in 2006. A boom awaits us, he said.
We are now experiencing the third phase of expansion since the bubble's collapse. And this one is showing every sign of extending its growth streak at least until October of this year, when it comes abreast of the 57-month-long Izanagi Boom, recorded in the 1960s and so far the longest since the war's end.
While I don't necessarily agree with cycle analysis, it's nice to see it on top of the more compelling fundamental analysis that I outlined last weekend. Livedoor Shock will fade. The U.S. will finally get its act together regarding beef exports and slowly regain the trust of the Japanese. The improving balance sheets at banks will eventually boost shares, helping our investments in both . While we had a rough week, we are still ahead overall and the year is still young.
It was a volatile week that saw markets come down a lot.
Our portfolio, though, came down just slightly. Japan fell, fell, but Disney and rose. Maximum Midcap is still positive so far this year. Double The Dow is down just 1%. We remain in a good long-term posture.
As always, I'll keep watching prices and let you know when to take action. I'm encouraged to see some good companies like becoming potential bargains for us.
We're off to a grand start in the new year. The markets have been on a tear, taking most of our positions higher.
The malaise at the end of December was lifted by comments from the Federal Reserve's minutes last week giving hope that the long campaign of interest rate increases may finally be coming to a close. There was nothing definitive, of course, but hope was enough to keep the mood cheerful. On Monday, the Dow cleared 11,000 for the first time since 2001.
Thursday and Friday saw lower volumes and narrow range markets as that cheer faded a bit ahead of earnings season, scheduled to begin in earnest next Tuesday after the Monday holiday to observe Martin Luther King Day. Earnings reports should be positive. The S&P 500 overall earnings will be about 13% higher than they were in the same quarter a year ago.
However, growth will probably slow later this year, and investors will be looking for forward guidance to that effect. We've had double-digit increases for three years in a row. A fourth would be quite a feat, and most likely won't happen.
The economy, though, is looking healthy. The holiday sales period was good. The Producer Price Index (PPI) measures the average change over time in the selling prices received by domestic producers for their output. Recently, you'll recall, the Fed has been on a mission to keep inflation at bay. That means they want such prices to remain low, not to increase dramatically. We, too, want them to remain low because if they do then maybe the Fed will stop raising interest rates, which would be good for the stock market.
Guess what? The core PPI for December came out last week at an increase of just 0.1%. That's the fifth month in a row of 0.1% or less. The year-over-year gain is just 1.7% and the annual rate over the past six months is just 0.8%. Inflationary pressures are nowhere to be found, giving stock investors reason to smile. This on the back of last week's Fed minutes is making the end of rate increases look likely.
It's also making my stop-loss orders on Decker's Outdoor (DECK) and Maxtor (MXO) last month look premature. Both enjoyed amazing run-ups from November and had started settling back toward the end of December. Just in case, I set stop-loss orders at gains of 40% on DECK and 60% on MXO. Both filled. Since then, each stock has moved higher in this New Year's rally.
To be sure, booking gains of 40% and 60% in three months is excellent work. I wish all of my problems could be so good as wishing to have made more than we made. Nonetheless, I'll seek to capture a greater share of future strong performances from our holdings. If you rode these two investments to solid profits along with me, congratulations. If you passed them over or are a new subscriber, don't worry, we'll find new opportunities.
Then, too, in the spirit of "I made a fortune by selling too early" we can look at the Jan. 12 edition of The Economist for a dour take on the American economy. They believe that departing Federal Reserve Chairman Alan Greenspan's low interest rate policies created first a stock bubble and then a housing bubble, and that Americans have overextended themselves by borrowing against the paper equity in their homes to keep shopping. That has boosted GDP growth, but at what risk?
When house-price rises flatten off, and therefore the room for further equity withdrawal dries up, consumer spending will stumble. Given that consumer spending and residential construction have accounted for 90% of GDP growth in recent years, it is hard to see how this can occur without a sharp slowdown in the economy.
Which would naturally bring a sharp downturn in the stock market. This risk is further exacerbated by the handing over of the Fed to incoming chairman Ben Bernanke. Handovers are always tricky. They have often been followed by financial trouble, like the 1987 stock market crash just two months after Mr. Greenspan took over. Nobody knows how Mr. Bernanke would respond to plummeting house prices and a screeching halt in the economy.
By nature, I tend to look on the bright side. It does seem prudent, though, to curb our enthusiasm for this great start to the new year by remembering that:
- Corporate profits are bound to slow. - The Fed is entering a new leadership phase. - High housing prices are destined to settle back. - Lower housing prices could sputter the economy's spending engine.
I prefer finding ourselves happy in the market when others are not. Looking around these days, I see a preponderance of happy people among us. Always a tad frightful, that.
Let's take a look at some individual stock action.
said its full-year earnings won't meet previous forecasts, although its total sales rose 5% in the fourth quarter. The sales growth came through low-margin products, while high-margin sales declined. I was looking to double down on our position at $20, but the stock never fell below 20.55. It has now rebounded sharply from there to nearly $23, putting us down 8%. While the company is transitioning and exhibiting all the usual pains associated with doing so, revenue is still growing at 8.5% a year, quarterly earnings are growing 56% a year, the forward P/E is just 12.5, and insiders still own 10% of the company. I feel comfortable holding on, and will consider buying more on significant weakness.
Japan remains the hot place to be. So far, our overall market investment has outstripped our banking investment. The former is up 41%, the latter down 5%. The media have been calling for an end to the rising Nikkei average since October, but what's hot has just gotten hotter. It bears watching closely, though. The beauty of The Kelly Letter being entirely email-based is that I can notify you immediately of sudden changes.
However, I remain optimistic. Prime Minister Koizumi is in office for just nine more months. His success at reforming Japan's politics and economy has made the idea of reform very popular. That has created two positive influences. First, there's an urgency in the air to enact the final pieces of PM Koizumi's agenda before he leaves. Second, there's a litmus test in place to elect the next PM based on how compelling his own agenda appears. All reforms point to a faster growing, leaner Japan and that can only be good for both stocks and real estate. Also, the yen will most likely strengthen and that will further boost corporate profits in this export-driven economy.
Beyond our current holdings, I'm watching a broad list of potential investments. For now, only three are near a price where I'd like to buy. They are . In addition, I'm interested in the upcoming initial public offering (IPO) of . Let's look at all four.
The first one has been in my sights for a couple of months now, as longtime subscribers know. I've set various price points to watch between 18 and 20, waiting for a definitive break one way or the other. We have finally gotten it to the upside, which is good. The semiconductor industry is entering a retooling phase which will see large capital expenditures on new equipment. If the recent upsurge in the semiconductor sector -- up some 10% so far this year -- continues, that will help this company a lot. It closed last Friday just above 20, so there's a good chance we'll be able to buy it below 20 before it embarks on a solid uptrend to 30.
The next one looks to me like the best-priced of the niche clothing retailers. It competes with Abercrombie & Fitch, American Eagle Outfitters, and Urban Outfitters among others for the dollars of teenage fashion buyers. This store's unique take is a focus on the sporting lifestyle, particularly the "rebel" sports of snowboarding, skateboarding, and surfing. There's a trend in America toward longer childhoods with people staying single into their 30s and continuing youthful sports well into maturity. The company boasts some nice numbers including a 9% profit margin, 20% earnings growth, zero debt, and a forward P/E of 12. Shares have fluctuated between about 21 and 28 over the past year, and closed Friday at $23.58.
The third one is like Yahoo, but in Chinese. It's the sixth-ranked site in the world by monthly page views. That's despite less than 10% of China's population being online.
The company takes a broad portal approach with many revenue streams rather than focusing on just advertising. For instance, it offers subscription services for news, dating, games, and mobile fortune-telling. (I'd sign up for the latter if it could tell me the future price of the stock.) Its portal network consists of four destination websites to users in Greater China, including mainland China, Taiwan, Hong Kong, and overseas Chinese in North America.
Now, this is a risky investment.
China is a communist country and the government can do whatever it wants to this company. So far, it's left well enough alone, but there are no guarantees that it won't decide down the road that this kind of broad information sharing is just not good for the people.
Beyond that, the company is young and exhibiting the same kind of lousy numbers that U.S. internet companies exhibited several years back. Its revenue and earnings growth are currently negative, and it has $100 million in debt.
So, why the interest? Because the company has a forward P/E of just 21 and has $289 million in cash. Top-ranked Chinese portal Baidu, by comparison, has a forward P/E of 142. While our pick is not squeaky clean, it looks like the most solid bet on a fast-growing sector in the fast-growing economy of the most populous country.
Shares pushed above 34 last March, but have steadily moved downward since then to Friday's close at $22.44. When the stock moves up, it does so in dramatic fashion. The stock's 52-week low of 20.18 came less than a month before the high of 34.25. That's a quick 70% gain. The stock is heading downward recently, but I think we could be nearing such a dramatic turnaround point again. I will watch carefully and let you know.
Finally, there's the upcoming IPO of one of the most delicious new restaurants to hit America in years. You may have seen its famous foil-wrapped logo by now. It pioneered back in 1993 the concept of fast-casual food. The segment didn't even have a name then, but it does now as the restaurant's success has attracted competitors. The menu is simple, the ingredients are fresh, the workers are cheerful, and the atmosphere is upscale.
You've probably heard of the company behind this restaurant. In fact, I know you have. It's one of the most powerful restaurant companies on Earth, and that kind of backing will help a lot after the new company goes public. You are who you know, and the company behind this restaurant has opened a lot of doors for the startup and will continue to do so.
Several members of senior management served for years at the parent company. Others on the management team are no slouches, either. The founder and CEO holds a degree from the Culinary Institute of America. That never hurts in the food business.
I'm encouraged by the restaurant's pre-IPO business success. It had revenue of $471 million in 2004, up 49% from 2003 and 130% from 2002. The increases came from new store openings and higher average store sales.
Net income has improved from a loss of $8 million in 2003 to income of $6 million in 2004 and $33 million (including a nonrecurring $20 million tax benefit) in the first nine months of 2005.
Earnings before interest, taxes, depreciation and amortization, or EBITDA, were $7 million in 2003, $28 million in 2004, and $44 million in the first nine months of 2005.
The restaurant says it intends to use money from the IPO to repay the balance left on its $30 million revolving line of credit with its parent company, as well as for long-term capital to support the growth of its business. And what growth it should be. There were 489 stores on December 31, 2005, 184 of which were opened since January 1, 2004, and 80 of which were opened in 2005. The company expects to open between 80 and 90 new stores in 2006 and continue significantly expanding in 2007 and 2008.
The IPO is not officially scheduled yet, but is expected sometime in the first quarter. It should be priced between $15.50 and $17.50. I'm looking to pick up shares immediately.
If you'd like to see some of the company's advertisements and read one of the best-written, plain English prospectuses I've come across in a long time, stop by the IPO website at .
