It was a relatively flat week that saw our portfolio make steady progress.
Our Dow 1 strategy is up 13%, Double The Dow is up 6%, and Maximum Midcap is up 11%. I'll send a reminder note next week that Tuesday is the last day of the month and that you should make your monthly buys on that day.
Ariba hit our stop-limit order to sell at $9.60 last Tuesday. We gained 60% since buying at $6 on Sept. 14. The stock continued rising throughout the week, however, and closed at $10.33 on Friday. It's always frustrating to see that. With the company's own outlook for a few flat quarters, I hope that the stock settles back and that we have a chance to buy in again at a lower price to participate in the company's long-term changeover to a subscription-based business model. Even if we don't get that chance, though, a 5-month, 60% gain is nothing to sneeze at. As my grandfather used to say, if I could make that mistake over and over again, I'd be a happy man.
Our longtime buy target, , closed the week at $18.80. I'm bullish on the semiconductor capital equipment sector and this company leads the list of participants. I've moved the stock from our watch list to an open limit order to buy at $18.
Remember last week's falling oil prices? They turned up again this week. Oil rose from $61 a barrel at the end of last week to almost $63 at the close of this week. We have the nutcases to blame again. There was an attempted suicide bomber attack on a Saudi oil facility on Friday, and oil production in Nigeria was threatened by insurgents. Saudi Arabia is OPEC's biggest producer and more than half of its output comes from the area in which the attack took place. That sent crude up nearly 4% on Friday. Of course, high energy prices fan fears of inflation, the monster nobody wants to appear because it'll bring out the Fed's higher interest rates.
Speaking of inflation indicators, we received the Consumer Price Index (CPI) data on Wednesday. The core rate rose 0.2% last month, a tame figure that was widely expected. Compared to last week's surprisingly strong rise in the Producer Price Index (PPI), this week's report came as a relief.
One modest reading doesn't leave me sanguine, though. We cannot lose focus on the Fed's intent to curb inflation. The tightening rates to this point have been just getting back to neutral from the very accommodative low rates following the Sept. 11 attacks. Now, though, we're at the edge of neutral and heading into restrictive.
Restrictive on what, you ask. Earnings. You'll recall from my writings at the end of last year and earlier this year that I expect earnings to slow down in 2006. I'm not alone in that forecast. The problem is that street estimates for the second half of the year, while lower than late last year, are still not low enough. That leaves the market ripe for downside earnings surprises, and sinking stock prices. We're not there, yet, and nothing terrible is imminent. I want to be clear that I'm not forecasting a crash next month.
Nonetheless, events are unfolding to support my thesis that we're going to see a buying opportunity in late summer or early fall before a rally through year-end and into early 2007. Late summer is about the time that the realization that second-half earnings will slow to single digits will kick in. If we continue down this path, you can be sure that The Kelly Letter will raise cash before that time and prepare to take advantage of buying opportunities.
Let's take a closer look at .
Brean Murray upgraded the company from Hold to Accumulate, sending the stock up 7.6% on Thursday and another 2.4% on Friday.
On Thursday, the company reported that fourth-quarter profit tumbled due to charges related to investments in several large wireless telecom portfolios last year. This was already known from an earlier update and was already priced into the stock. Profit fell to $6.1 million, or 16 cents per share, compared to $12.6 million, or 34 cents per share a year ago. The decline was blamed on impairment charges of $15.3 million, which cut profit by 24 cents per share.
Revenue fell to $53.8 million from $57.5 million a year earlier. Analysts, on average, projected profit of 16 cents per share on revenue of $56.7 million.
This turnaround story is progressing as planned.
We initiated our position on Feb. 10 at $18.45. After dropping immediately following our investment, the stock is now up 3.5% for us after this week's 9.5% gain.
If you'd like to read reports on Anheuser-Busch (BUD), Dell (DELL), Intel (INTC), and RadioShack (RSH), please sign up for a free one-month trial. Your welcome notes will contain the reports.
We sold half of our position in the Japanese market on Feb. 16 at $64.55, a 37% gain. The fund dropped after that, but then rebounded this week and is now sitting at a 37% gain for the remaining half as well. Our Japan bank also had a strong week but is up just 3% for us so far. I'm still looking to pare back our Japan investment for the short term. The bank has been fluctuating around the unchanged mark for us since we first invested on Nov. 3. With the whole Japanese market looking ripe for a short-term setback as fickle foreign money leaves, I'm itching to get out and get back in when the Nikkei 225 drops below 14,500. It closed this week at 16,102. Subscribers, keep checking email.
If you've been watching the Olympics, you know that Japan had won zero medals until women's figure skating on Thursday. Suddenly, out of nowhere, Japan's Shizuka Arakawa skated her way to a gold medal when the top contenders from Russia and the United States each fell during their routines. It's a moment in history as Japan's first-ever Winter Olympics figure skating gold medal. The unexpected triumph set a festive mood on Friday that's still lighting the air over the weekend as I write.
As an American living in Japan, I take pride in the accomplishments of both countries. So far in the Olympics, Germany is in first place and the U.S. is in second. Japan is nowhere near the top. Yet, there's something charming about an entire country turning out to celebrate its one victor, a lovely woman who was not considered a possibility. Even Prime Minister Koizumi, the man whose reforms have led the economic recovery from which we've benefited so handsomely, celebrated by calling to congratulate Miss Arakawa over the phone.
As a global investor, I noticed something little mentioned in the fanfare. Yes, Miss Arakawa is Japanese, but she trains at a rink in the United States and her coach is Russian. Even in the Olympics, the world is shrinking. Interconnectedness is everywhere. The only abiding trait to which we can attach value is quality. We'll seek it wherever it's available.
I hope you're enjoying the weekend in your part of the world.
The Kelly Letter's stop-limit order to sell Ariba (ARBA) at $9.60 filled today. We gained 60% since buying at $6 on Sept. 14.
Our last three sales have resulted in these gains:
Ariba +60%
Maxtor +60%
Decker's Outdoor +40%
If you'd like to receive notes telling you exactly what to buy at what price, and when to sell at what price, please try The Kelly Letterfree for a month.
We started the week off cautiously waiting to hear new Fed Chairman Bernanke's Wednesday testimony to Congress on monetary policy. When the testimony came, the market rallied for two days.
It's hard to see why, though. He said that the Fed is continuing to watch economic data for signals on what to do next. If the numbers are too robust and inflation is seen to be heading higher, the Fed will continue raising interest rates. That would put a damper on stocks, of course. Most investors now expect at least two more rate increases, one on Mar. 28 and another on May 10. The discussion from here is on the odds of a third increase.
How's the economy looking? Pretty strong, according to this week's reports. January retail sales climbed 2.3% and January housing starts leapt 14.5%. Inflation's telltale signs popped up, too. January's core PPI clocked in at 0.4% on Friday, the highest gain in a year. For the past three months, it's declined. If the Fed concludes that an upward trend is forming, it will probably keep hiking rates.
Our permanent portfolios are cooking along steadily. The Dow 1 is up 11%. Double The Dow is up 7% and Maximum Midcap is up 10%. All three had a good week.
Let's take a look back day-by-day, and then spend some time discussing investments of particular interest to us.
Monday The Nihon Keizai Shimbun (literally "Japan Economy Newspaper", the Japanese equivalent of The Wall Street Journal) reported that our Japan bank, , will revise its projection of consolidated net profit for the year through March 31 to about 1.1 trillion yen, an increase of more than 100 billion yen from an earlier forecast. Profit increases are always music to the ears.
The U.S. market trended lower in the afternoon, and we took some big hits in our portfolio. There was a cloud of uneasiness over Wall Street as investors waited for Mr. Bernanke's Wednesday testimony.
Tuesday We got a nice jump in our Japan investments as news of our bank's profit increase registered, and the Nikkei rose.
Back in the U.S., stocks rallied around falling oil prices. Crude hit its low for the year, dropping 2.7% on Tuesday alone, and piercing the $60 mark.
The Commerce Dept. reported that retailers had their best January sales gains since May 2004, showing that consumer spending is back on track. The Dow closed above 11,000 for the first time since Jan. 11.
Microsoft said it hopes to have the new version of its Windows operating system, called Vista, available in time for the U.S. holiday season. Microsoft has long said that Vista would be available in the second half of 2006, but is now getting specific. Expect Vista sometime in November.
Wednesday Finally, Fed day.
New Federal Reserve Chairman Ben Bernanke's testimony before the House Financial Services Committee put a hush across Wall Street. Not a keyboard clicked as the broadcast came live into every office. Then, as the testimony progressed, it slowly dawned on everybody that the chairman said nothing surprising and that he would continue doing business the way Mr. Greenspan had done it. That sounded fine, until people recalled that business as usual prior to the testimony was...uncertainty. So, we're all still uncertain about what's going to happen.
I've got a lifelong tip for you: it's always uncertain. You know what's going to happen after it happens and by then it's too late to act in advance. So we muddle along, doing the best we can with whatever limited foresight we can manage. The day you figure out the future, email me. I have a few questions for you.
The main nugget to take away from the chairman's testimony is that the Fed is watching the same data that we're all watching, and that if it spells I-N-F-L-A-T-I-O-N, we should expect further interest rate increases as a countermeasure.
With all the Fed-watching in progress, some hardly noticed that oil kept heading south. On Tuesday, it fell below $60. On Wednesday, it dropped another 3% to close at $57.83. The most likely explanation was a better than expected inventory report from the Department of Energy. Last week, crude supply increased more than four times as much as the market had expected.
Our brewer rose 1.7% to $41.68 after Warren Buffett's Berkshire Hathaway reported substantial holdings in the company on Tuesday as part of required filings detailing Berkshire's $42.7 billion stock portfolio. The documents filed with the SEC show that Berkshire owns more than 5% of the company. It's good news when a stock in your portfolio is also in the portfolio of the world's most successful investor. We're down some 8% since investing, so there's still time to get this long-term winner cheaper than both Mr. Buffett and I paid.
Thursday At 8:23 a.m. New York time, I sent Note 23 specifying two actions to take:
--> ACTION: Stop limit sell $9 (not filled) --> ACTION: Sell 1/2 (filled at $64.55, a 36.8% gain)
The former rose 4.8% to $9.45, making our day. At 8:08 p.m. New York time, I sent Note 24 revising the order to sell at $9.30, which would lock in a 55% gain for us. Did we get it? Keep reading.
The outlook for Japan banks continues to look good. The six major Japanese banking groups are expected to see their combined group net profit surge 280% to about 2.83 trillion yen for the year ending March 31. That's even higher than the record high set 17 years ago. We have increased commission revenue and fewer bad loans to thank.
Foreign investors are showing more caution toward Japanese stocks as they become pricier relative to those in the U.S. and Europe. Japan's Ministry of Finance reported that foreign investors last week turned net sellers of Japanese shares after 19 straight weeks of net purchases, prompted by weak overseas markets. This, more than any other concern, is what lead me to take half of our Japan market profits off the table. More on Japan below.
U.S. market closed Thursday near their best levels of the day. Hewlett-Packard (HPQ) rose 7.4% to a five-year high after issuing a solid report with positive guidance. That hurt our computer maker, though.
The Dow closed at its highest level since June 2001.
My longtime buy target, Applied Materials (AMAT), not only beat first quarter earnings projections on greater than 20% order growth, but guided up second quarter projections as well. It now sees orders up 15-20%, an increase from its previous estimate of 7-10%. Applied Materials' earnings and guidance is consistent with my bullishness on the semiconductor capital equipment industry in 2006. I'm maintaining as a good price target for buying AMAT.
Friday Japan's economy achieved spectacular growth in the October-December quarter, as strength in exports added to hearty private consumption and capital spending.
One of my favorite Japan analysts, Takehiro Sato at Morgan Stanley's Tokyo office, wrote:
The Japanese economy is on a sustainable growth trajectory near a 3% real expansion pace led by domestic private demand. With the economy performing as robustly as noted above, we look for the core CPI inflation rate to expand further into positive territory, leaving timing as the only problem for the ending of quantitative easing (QE) [that means the end of low interest rates, i.e. the beginning of higher rates]. We continue to expect this to come near the April 28 [Bank of Japan] Outlook Report.
We believe that the stock market is in the process of shoring up the bottom after already reaching our projected level of 1,700 points (TOPIX; ¥16,500 for the Nikkei 225 Average) based on investor euphoria in response to the "end of deflation" theme (namely, we take a neutral view from achievement of the target level). Although the market might temporarily soften in Apr-Jun on increased volatility for interest rates, we retain our favorable bias, and think that dips during Apr-Jun should offer excellent buying opportunities, given our bullish corporate earning outlook.
I agree. My decision to sell now is a short-term, tactical one. I believe we'll have a chance to buy in again later this year at lower prices, and repeat our satisfactory performance from last fall. Japan is doing very well, but its stock market is in the hands of a fickle foreign investment crowd that will bolt the moment it looks like the easy money has been made. That moment looks to be about now.
When we invested, Japan was not a popular place to be putting money to work. That was good. Now, everybody's talking about it. Six months ago, three investment newsletters recommended Japan. Last month, fifteen recommended it. That's a sure sign of a short-term top. When we get the sag that Mr. Sato noted to be likely soon, a lot of that fickle money will leave, stocks will drop, the fundamentals will remain the same, and we'll have a chance to buy back in at cheaper prices.
On Friday in the U.S., the market traded in a narrow range modestly lower.
As noted above, the core (that is, excluding food and energy) Producer Price Index rose 0.4% in January. That's twice what we expected, and it broke a string of low figures. You know who else saw that report? The Fed. While one tick higher is not an alarm bell, every trend begins with a step. Will this step higher firm into a trend against which the Fed will feel compelled to act?
We don't know. What we do know is that we have something to put on the calendar for next week. On Wednesday, the January Consumer Price Index will be reported. In light of the higher PPI, the CPI will be watched closely to see if it, too, ticked higher. If so, that will add to the risk of an additional rate increase.
That was the week.
Now, let's look at four companies of interest to us in more detail.
E-Commerce Leader ($9.85) Very occasionally in this business, things go exactly right. The past two days have shown us that rare experience with .
We bought the stock on Sept. 14 for $6 as a turnaround. It's an e-commerce survivor from the dot-com washout and is gradually realigning its business from permanent licenses, with upfront revenue, to subscription licenses, with revenue spread out over time. This change caused license revenue to decline in the quarter ended December 31, 2005.
That's all fine. When the realignment is complete, the company should benefit from a steady flow of cash in the form of subscription payments. That makes financial planning much easier than when a company receives lump sum payments on a sporadic basis. Plus, while license revenue was down last quarter, the backlog of subscription contracts that will turn into revenue later this year, increased.
I like the turnaround story a lot, I just think the stock may be getting ahead of the fundamentals. The company said that it expects declining license revenue to be offset by subscription revenue kicking in later this year, but that the overall growth of the company will remain essentially flat for the next few quarters.
That takes us to the end of the year, before which I think we'll see a significant market correction. The street tires of long-term forecasts quickly, particularly when panic settles in. We often get a summer/fall panic before a year-end rally. I don't want to see our 50% gains evaporate in the heat.
Therefore, I've decided to lock in profits.
The stock closed Wednesday at $9.02. On Thursday, prior to the open, I set a stop-limit order to sell at $9, locking in a 50% profit. It opened at $9.08, hit a low of $9.02, then rose all day to close at $9.45. Great!
On Friday, I moved the stop-limit order up to $9.30, locking in a 55% profit. The stock opened at $9.32 and went straight up to $9.94 before settling to close at $9.85. That puts us up 64%.
Volume was heavy the last two days as the stock rose 9%. It seems that big money is acting on something that is not widely known. I decided to pick up the phone and send some emails to see what I could find.
There's no official news, but I've caught rumor of German software giant SAP acquiring this company. The pairing would make sense, as the two announced last December an agreement to work together to enable SAP's applications to run across this company's supply network. Although it wasn't clear, it seemed that this company might also build software to work with SAP's NetWeaver, a platform that combines various web applications. NetWeaver is the soul of SAP, akin to what Windows means to Microsoft.
Red Herring reported on Dec. 5:
SAP's goal is to build an "ecosystem" of customers, partners, and ISVs (independent software vendors) around the NetWeaver platform to create a suite of applications that will become a one-stop shop for customers.
The Walldorf, Germany-based company has partnered with over 30 industry heavyweights to build composite applications that will integrate partners' offerings with SAP's software products. These partners include IBM, Computer Associates, Intel, Cisco Systems, and Symantec.
"We believe that customers want to buy suites because they want to solve end-to-end problems," said Shai Agassi, president of SAP's product and technology group.
The company, which is trying to fend off competition from its largest rival Oracle and Oracle's upcoming Fusion platform, has been criticized in the past for not being partner-friendly and collaborative, a process that has now become important if SAP wants to create a NetWeaver ecosystem of partners.
With our company's growing list of subscribers bulking up its supply network, it's easy to see why SAP would be interested in not just working with the company, but owning it.
This puts us in an interesting spot. You may recall that we gained 60% on Maxtor, but sold in December just before Seagate announced that it was acquiring it. That took Maxtor up significantly higher and we missed out on extra profits. Are we facing the same situation again?
Perhaps, but there's no telling. If the rumor fades away and there is no buying interest from SAP, the stock could head south again and the 9% gift over the last two days could disappear. Does anybody have a friend in SAP's finance department whom I could call? Just kidding.
The prudent move is to act on what we know, so let's move the order up to $9.60 to lock in a 60% gain. As always, we'll hope the stock just keeps going higher from here.
To read the three additional reports on Dell (DELL), PXRE Group (PXT), and RadioShack (RSH), please sign up for a free trial to The Kelly Letter.
did not hit our stop-limit order at $9, but instead rose 4.8% to close at $9.45. That's excellent news. I'm raising the stop-limit price to $9.30, locking in a 55% gain. Let's hope it rises further.
We sold one-half of our Japan market investment today at $64.55 for a 36.8% gain. Good work so far. Let's hope for further gains on the remaining half.
It was a trendless week for the market, but an eventful week for us. Stocks remain subdued now that earnings season is winding down and the Fed's next move is unclear. This type of malaise is typical for February, and is often followed by strength in March and April.
The listlessness was clear in the up, down, up, down pattern of the averages. The S&P 500 rose Monday, fell Tuesday, rose Wednesday, fell Thursday, and rose again Friday. Where does it want to go?
Whichever way interest rates don't go, and since we can't get a read on them, the market is scratching its head, glancing up and down.
We have to take one more step back and admit that we don't even know whether inflation is picking up. Neither does the Fed. If more evidence comes to light showing that inflation is on the upswing, then new Fed Chairman Bernanke will move swiftly to keep it in check. That means further rate increases.
There's wide agreement that the Fed will raise rates on March 28. The question is whether that will be the last time for a while. If inflation colors the data, then there could be another ratcheting up on May 10.
This coming Wednesday, Mr. Bernanke will address Congress on monetary policy. You can be sure that all market ears will be tuned in and eyes will be scanning the chairman for body language clues. We want to know how aggressively he intends to ward off inflation.
Think about the situation for a moment. If you were the new chairman of an organization whose primary role is fighting inflation, you would probably want to immediately establish your credibility by striking a strong inflation-killing pose. That's most likely the way Mr. Bernanke will handle Wednesday, too. That means the odds favor the market interpreting the presentation as a harbinger of two more rate hikes ahead, rather than just one. If so, the markets are likely to continue treading water or sink a little.
I mentioned in the February issue that the out performance of small cap stocks over the past few years is probably due to end, with large caps taking the lead. Last week settled out that way. Disney gave a strong earnings report and that helped the Dow come out on top. It's too soon to call it a trend, but if it is the beginning of a trend, it wouldn't be surprising.
Let's look back at the week.
Monday It was a narrow range market with most talk on, naturally, the Fed.
One thread that's still running through the discussion is earnings. Investors are adjusting to lowered guidance, but not quickly enough. The street is still predicting double-digit earnings in the second half, but companies are hinting at single-digit. If this over-optimism persists, it could set us up for disappointments in the seasonally-weak summer months, further bolstering my case for a buying opportunity later in the year.
Tuesday Or, maybe we won't have to wait that long. Tuesday's downward slope was almost entirely due to earnings concerns. I detected no whispers of inflation or rate increases.
For us, though, as holders of , it was a golden day. The company reported strong earnings and the stock rose 7%. We're now up 78% since investing and I expect more upside from here.
In other news, our long-suffering electronics retailer, down 13.5% since we invested, is still trying to get back on its feet. Mostly in New York and Pennsylvania, 54 stores will start distributing Cellular One wireless products and services from Dobson Communications.
It's easy to dismiss this firm as a dud, but it's a good company striving to recover. Its profit margin is a solid 7%, impressive for a store. Management has achieved a 53% return on equity. It does carry more debt than I'd like to see, but that's not unusual in a turnaround situation. Insiders own nearly 10% of the stock.
Finally, it's cheap. I should add in a lower voice, even cheaper now than when we first bought. Earnings are growing at 56%, yet the forward P/E is just 13. That gives a P/E to growth ratio (known as the PEG ratio) of 1.1, pretty low.
By comparison, Circuit City (CC) has a PEG ratio of 2.2 and a forward P/E of 25. Its profit margin is a razor thin 0.8% and it has no meaningful earnings growth.
Yet, in the past year Circuit City has risen 72% while has fallen 33%. This will be corrected at some point. The stock closed last Friday at $21.63. A year ago, it was at $34. We bought at $25. I'm keeping an eye out for a potential chance to buy more shares before a rebound back above $30. Even if we don't buy more, though, I expect to make at least 20% on this eventually.
Wednesday The average daily balance of Japanese bank lending expanded 1.3% to 389 trillion yen in January from a year earlier for the sixth straight monthly increase, the Bank of Japan said Wednesday. One of these days, we're going to see get going. So far, we're down 1.3% as the stock has fluctuated around the flat line since we bought last fall.
In the U.S., the market took a break from inflation worries to cheer Cisco (CSCO) for strong earnings and our pharma holding for the potential divestiture of its low-margin consumer healthcare business. Also, we got a nice boost from an upgrade to our computer maker.
For some time now, I've been watching the fiasco at General Motors (GM), content to not even try to call the bottom. It's disheartening to see an important American icon under such atrocious management. Does anybody remember how Japanese car makers trounced Detroit back in the 70's with fuel-efficient cars that didn't break? The U.S. automakers so thoroughly blew it that decade that they let in fierce competition that has never gone away. Prior to that colossal blunder, foreign cars were a fairly small part of the U.S. market. Now, they dominate.
Well, if you missed the drama of the 70's, don't fret, because it's being re-run right now. At the Detroit auto show, it was almost comical to see among headlines of declining oil reserves the new fleet of gas guzzlers from Detroit. On the other side of the show, Toyota was proud to show its latest hybrids and promising results from all-electric and solar platforms. One had to wonder, is there a problem with newspaper delivery in Detroit?
There must be, because it seems impossible for a car company to keep making last decade's trucks in the face of rising oil prices, increased political instability in the oil-producing regions of the world, and declining reserves worldwide.
Back to the 70's for a moment. Chrysler almost went bankrupt. Its shares dropped to $2 and that's where Warren Buffett invested, riding it back to $70 per share. Will we see a similar lifetime opportunity with GM? As incredible as it seems, the company is still the largest car maker in the world. It could still get itself back on track, however embarrassingly late. If it ever looks like that's imminent, we'll take a closer look.
For now, though, it's mismanagement as usual. Profit margins are negative, return on equity is negative, revenue is shrinking, and debt is 17 times equity. I've seen lemonade stands with better numbers. A year ago, the stock traded above $37. Now, it's below $22.
On Wednesday, Deutsche Bank downgraded the stock to Sell from Hold and cut their target to $17 from $22, citing continued disappointment in the limited cash savings targeted by the company's current restructuring efforts. The stock got down to $18.33 in December. A bottom of $17 might be generous. There's a chance that we could follow in the great Buffett's footsteps and buy into the world's largest auto maker at single-digit prices. In the meantime, the only opportunity regarding GM is to shake our heads and wonder when it will occur to the geniuses in charge that making cars people want to buy would be a marvelous first step for a car maker.
Thursday The markets stood still, but beat its previously reduced profit forecast. That would send shares up 18% on Friday. Great!
I sent a note to buy at $18 and at $34.
Friday It was another go-nowhere market that ended with modest gains.
The December trade deficit climbed to $65.7 billion from a revised $64.7 billion in November. That was just about what most people expected (isn't that what your family discusses at dinner every night?), and therefore made little difference.
guided EPS lower, continuing that recent trend.
I changed Thursday's limit orders to buy at $18 and at $34 to market orders, meaning we would buy at current prices. Thanks to all of you who emailed me your execution prices. The average buy price on the former was below $18.40, but I'm tracking $18.45 as The Kelly Letter's buy price. The average buy price on the latter was below $35, but I'm tracking $36.75 as The Kelly Letter's buy price. I lean conservatively when we have a range like this, meaning that most if not all subscribers will actually perform better than the letter.
We can feel good owning both of these companies. Their statistics are excellent with low valuations, good margins, high insider ownership, and healthy growth.
I made the right call to change the debt collection company's limit order to a market order as it looked like it had already bottomed out and was in a firm up-channel. It closed the day at $18.66, giving us a small 1.1% gain.
I made the wrong call to change the student loan company's limit order to a market order. It broke above its resistance on Thursday and looked poised to break out higher. I wanted to capture that, hence the quick buy. It then proceeded to reverse course almost immediately, giving Yours Truly another chance to practice humility. The stock came down to below $34, where we would have bought had I simply left the limit order in place. That was a technical error on my part.
I feel in both cases, though, that I got the fundamentals right and that we own two good companies. As with almost all of the eventual profits achieved by Kelly Letter stocks, these two may see more downside before getting to the upside. We might even have a chance to buy more shares at lower prices. As with Maxtor and Decker's recently, and others before them, I'm confident that we have the right companies if not the perfect entry prices.
In fact, we don't have to look back farther than Friday to see this very technique at work. We paid $28 for on Nov. 28, then watched it drop. We doubled down at $22.50 on Jan. 27, nearly 20% below our initial entry price. That gave us an average buy price of $25.25. The stock closed Friday at $25.90, up some 18% that day alone, putting us up 2.6% so far.
More often than not, getting the right stock is more important than getting the right price. If the company story is correct, the price should eventually match. Of course I wish I'd bought the student loan company at $34, but if my target of recovering to the 52-week high of $73 is hit, we'll still make 99% and probably won't be too upset at having missed it at $34.
That'll do it for this week. Good work, everybody. Congrats to those of you who bought at lower prices than those tracked here. For those of you who haven't bought yet, you still have a chance to get on the cheap.
Now, take a break and watch the athletes in Torino. Best of luck to all of them.
February is seasonally a weak month, and last week showed all signs of continuing that tradition. We used weakness in to double down on our positions. That lowered our average buy prices so that we'll make higher profits when the stocks eventually recover. There's no doubt that these two will recover, there's just the question of when.
Let's take a look back at last week.
Monday Very little happened on Monday as investors sat still ahead of Tuesday's Fed meeting, almost universally expected to produce another 1/4% interest rate hike. The attention would be paid to the language accompanying the hike. Would there be an indication that rates will stop rising soon?
Wal-Mart said that its January same-store sales clocked in at a preliminary 4.7% gain. Thanks to gift card redemptions, the gain topped estimates. It also gave hope that other stores would see a similar January boost over December.
Tuesday The controversial Alan Greenspan retired after serving 18 years as chairman of the Federal Reserve. In his last major piece of business, Mr. Greenspan raised rates a 14th consecutive time by 1/4% to 4.5%.
The language everybody watched so carefully disappointed. It said that "some further policy firming may be needed" to keep economic growth and inflation balanced. May be needed or will be needed? As ever, it wasn't clear. That mystery, along with the statement that, "Although recent economic data have been uneven, the expansion in economic activity appears solid," leaned a little more toward further increases than investors had hoped for. There's probably another rate hike in the cards for the March meeting.
Last week, I wrote:
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.
Indeed we got one. The S&P enjoyed its best January since 2001. It ended the month at 1280, up 2.6%, making the January barometer positive on the rest of the year.
While our Dow and Midcap index investments rose 2.5% and 11.7% respectively in January, we'd have done even better in small caps. The Russell 2000, which measures stocks with market caps between $100 million and $2 billion, rose 8.9 percent. The S&P Midcap 400, the index followed by our midcap investment, gained just 5.9%.
Just as they did this same time last year, analysts expect the performance to shift from small to big any day now. Historically, it should happen, but historically it should have happened last year. Whenever it does finally happen, Double The Dow will shine again.
Wednesday The Tokyo Stock Exchange announced plans to adopt a new order-processing system under which a large transaction equivalent to 20-30% of a firm's outstanding stock would be automatically rejected. This is to prevent another shutdown like the one that happened during Livedoor Shock two weeks ago. In retrospect, the incident was good for Japanese stocks. Not only have they already fully recovered and gone higher, the market has become more transparent and the exchange more stable. So far, we're up 2% on our Japanese bank investment and 46% on our Japanese market.
Tech darling Google finally failed to meet expectations and dropped 12% for the week. That didn't tank the overall market, though, and the relief turned into a mini rally.
Thursday An ugly down day to follow Wednesday's strong showing. The purported reasons were reflection on the Fed's policy statement indicating more rate hikes, adjustment to lower earnings projections, and a terrorist threat.
There are always reasons given but you can generally just choose from the usual list of culprits on any given day. Oil is up, stocks are down. Terrorist threats are up, stocks are down. People believe that interest rates are going up, stocks go down. Then, on up days, the reasons are often just reversed. Oil is down, stocks are up. Terrorists are silent, stocks are up. People believe that interest rates are staying firm or going down, stocks go up.
This week's down performance looks to me like the continued realization that profits are slowing this year, something I've been discussing for the better part of two months. Once all the reports are in, that adjustment should be taken care of without too much damage. Earnings are coming down a notch from their recent high levels, but they're not dropping into the mud. They're still healthy.
Friday Another down day.
That old bugbear, inflation, came 'round again, this time in the form of a 0.4% increase in hourly wages for December. It was expected to be only 0.3%.
Why are higher wages bad? They're not when you receive your paycheck. However, when everybody's paycheck grows too quickly, sellers are quick to notice and prices can be quick to rise. That's inflation. How does the Fed combat inflation? By raising rates. What happens when rates rise? Stocks fall.
This cycle is as much a part of stock market investing as flour is a part of baking. Get used to reading about it. The tone of the market is set by interest rates. The Fed determines interest rates. The U.S. stock market has a huge influence on markets around the world. That's why some people consider the chairman of the Federal Reserve to be the most powerful man in the world.
With the language from Tuesday's Fed meeting already having investors on edge, the higher wages goosed fears of further rate hikes.
That was the week.
There's nothing terribly disconcerting about any of it. It's just the normal fluctuation of the market and, seasonally, the market often struggles through February before giving a strong performance in March and April. You should expect more volatility dead ahead, but nothing to sicken the stomach.
I'm happy to have picked up additional shares of , and to see that prices on our target stocks are coming into range.
I've added two new names to the Watch List, both in the debt business. They are . Let's take a look at each.
The first one buys bad debt from credit card companies, banks, telephone companies, and others. All companies have customers that do not pay. They follow some basic debt collection procedures to recoup what they can, but eventually the situation becomes too time-consuming to be worth the eventual outcome. That's when companies bundle their uncollectible debt together and sell it as a package to bad-debt collectors like this one. The firm strives to pay as little as possible for the package, then focuses all its efforts on recovering the entire amount of debt owed. That's its business, so it does not lose patience nor quickly run out of techniques.
For example, it might pay just $10,000 for $50,000 of debt owed to a credit card company. It knows that it's very unlikely to collect the full $50k, but what if it can collect $20k or $30k? That would be a 100% or 200% return on investment (not counting expenses like collectors' salaries, etc.). Consistent returns like that can add up to a pretty healthy business, and they have.
Management has achieved a 27% return on equity. It's sitting on $52 million cash with just $227,000 debt, giving it a debt/equity ratio of essentially zero. Never forget, you can't go bankrupt if you don't owe any money. I find it fitting that this debt collector has no debt. Follow their example in your personal life and you'll be happy. Never assume debt. The fact that so many people fail to follow that age old, widely-advised, and indisputably correct advice is what keeps this company profitable. Its profit margin is a fat 23% and its quarterly revenue growth is 15%. The financials are solid.
What puts a glimmer in my eye, however, is the insider picture. The company is 81% owned by insiders. I find that comforting. If they don't do a good job, they're going to lose a great deal of money. You learned in your first economics class, if it was anything like mine, that people act on incentives. When the people in charge of the company own the company's stock, they have a powerful incentive to keep the company profitable and growing.
The stock closed last Friday at $18.22 with a forward P/E of just 10.5. A year ago, it traded right around $20 before rising to $32 in October. Then, the company started hinting that its experimental acquisition of cellphone debt was not proving to be as easily recoverable as it had initially thought. That led to a sharp sell-off at the end of October and into November, all the way down to below $20 again. The stock made a steady march up to $25 at the end of January, then had a preliminary conference call last Thursday confirming that the slowly-recoverable and unrecoverable cellphone debt would hurt earnings, to be reported at the end of this month. That bad-debt bad news sent shares plunging to a 52-week low of $17.51 on Thursday.
The company said that quarterly earnings would plunge as much as 55% year-over-year. Management put the blame squarely on those larger-than-expected write-offs for unpaid cellphone bills that it has given up on collecting.
From SmartMoney magazine:
" has been out buying this nontraditional paper away from its core asset base [of credit-card debt and student loans], and it's had aggressive collection assumptions on that paper," says Dan Fannon, an analyst at New York investment bank Jefferies & Co. "It's a function of the asset pricing going up and the company's outlook for this asset class being more optimistic than it is proving to be. The company is confident it will make money, but not at the pace originally expected."
"The company suggests it's not a trend, that they are taking care of it and we should not expect it in the coming quarters," says Mark Hughes of Suntrust Robinson Humphrey, an Atlanta investment bank. "But the collection environment seems tougher now. The company has benefited from an improving job market, tax refunds and mortgage refinancing. But perhaps now the incremental benefits have been achieved and now you are looking at a more stable environment. And if you're not getting the improvement that you had and business is flat to down on collections, that may contribute to more write-offs."
My take is different from Mr. Hughes'. The company has clearly mastered its traditional asset base of credit cards and student loans. It needed to find new ways of making more money and that entailed expanding its range of collection targets. It has discovered the new, juicy realm of unpaid cellphone bills and moved aggressively into it. However, cellphone debt is not the same as credit card debt and student loan debt, so the company got its forecasts wrong. The president said in Thursday's conference call that he is very disappointed and that management is working hard to see that this doesn't happen again. Perhaps they'll pay less for cellphone debt in the future, build in a longer collection time frame, or scrap it entirely in favor of something else.
In any event, the bad news is out and it's recovery time. Given this company's successful history, its solid finances, its 81% insider ownership, and the technical support around $18, I am placing a buy target of $18 or lower. If the stock can merely regain its previous high of $32, we'll see a 78% gain.
The second company I added to the Watch List is a student loan outsourcing service. It offers a suite of program design and marketing, borrower inquiry and application, loan origination and disbursement, and loan securitization services for student loan programs tailored to meet the needs of the respective customers. Those are usually universities and colleges themselves as well as financial institutions that work with the education market. The company primarily focuses on loan programs for undergraduate, graduate, and professional education, but also offers programs for the primary and secondary school markets. Since 1991, it has completed 28 private student loan securitizations totaling $7.5 billion.
There are three reasons that the private sector student loan market is poised for growth.
The first is that tuition is rising. Over the past ten years, it's more than doubled the rate of inflation. If you or your children are or were in school recently, this is no news to you.
The second is that the number of students is rising. Children of baby boomers are reaching college age and the need for a college degree is widely known. It's not just for the elite anymore.
The third is that the government has not raised federal student loan borrowing limits. Students quickly hit the federal ceiling, but don't have enough funding to finish their education. That's when they turn to the private sector, where this company plies its trade.
And plies it well, I should add. The numbers are swell.
Management has achieved a 47% return on equity. The company has $156 million cash and $16 million debt for a debt/equity of 10%. Its quarterly revenue growth is 57%, it's profit margin is 37%. These figures are the equivalent of straight A's, with perhaps a B+ in the debt department.
As with the first company, we're looking at a heavily insider-owned company. A full 61% of the stock lies in the hands of insiders. Last quarter, the company repurchased 4% of its outstanding stock, a positive sign.
The stock hit $73 on Mar. 4, 2005. It then steadily deteriorated to $21 on Oct. 7, mostly due to being overvalued. It had more than doubled in 2004 and was primed to disappoint. When it did, the downgrades came pouring in. As recently as August, it reported earnings below expectations.
The crowning gem of bad news came in September when the former chairman and CEO resigned over allegations that he gave $32,000 in gifts to a former employee of a major client of the firm. That's a big no no. The company derives 80% of its work from only three clients, so the prospect of losing one of them in a bribery scandal was pretty grim. However, like so many scandals that sell newspapers and sell-off stocks, this one proved unimportant to the company. The relationship with the client remained intact.
The sun shines a bit brighter around the company these days. From its Jan. 26 fiscal 2006 Q2 report:
Total service revenues for the second quarter of fiscal 2006 increased to $230.5 million, up 48% from $155.8 million in the second quarter of fiscal 2005. During the second quarter of fiscal 2006, the Company securitized approximately $1.3 billion of private student loans in its largest securitization transaction ever, which generated $189 million in service revenues. During the same fiscal quarter last year, the Company securitized $807 million of private student loans, which generated $132 million of service revenues.
Insiders, ever confident, have been buying. On Dec. 15, the CEO bought 10,000 shares at $28.69. On Aug. 30, the vice chairman bought 10,000 shares at $29.54. On May 2, the president bought 1,290 shares at $38.60 and the CIO bought 500 shares at $39. On April 29, the executive vice president bought 2,000 shares at $39.
The stock closed last Friday at $32.25 with a forward P/E of 9. I'd like to buy at or below $31.50. If the stock recovers to $73, we'll gain 132%.
As always, I'll let Kelly Letter subscribers know if and when these two new stocks-to-watch reach my price targets, and if and when I place live orders.
