Friday edition: Role of inflation and interest rates in market valuation.

I’ve been thinking of doing or highlighting a thoughtful piece every Friday. So here’s a start!

Vitaliy Katsenelson recently came out with a postscript to his excellent book, Active Value Investing in Range-Bound / Sideways Markets.  I’ve read parts of it, and thoroughly enjoyed it. I admire Vitaliy as one of the few people who have the uncanny ability to think “outside the fog”. (You can check out his blog to know exactly what I mean.)

Vitaliy makes some great points and I particularly wanted to highlight this one regarding the role of interest rates and inflation in determining market valuations.

Let’s take a look at the role interest rates and inflation play in market cycles… My thoughts on the role of interest rates and inflation have changed since the book came out.

Let’s divide the interest/inflation chart into three zones: 1, 2, and 3. Zone 2 is the zone of peace. When interest rates and inflation are in this zone or thereabouts, they have little positive impact on P/Es. However, whenever inflation crosses into zone 3, investors become concerned about inflation, as they should. Inflation erodes real returns from stocks. Interest rate is a significant part of the discount rate investors use to discount future cash flows. A higher discount rate means companies are worth less, thus lower P/Es.

Zone 1 is a tricky zone. In that zone the Fed-model argument falls apart. When inflation falls below a certain level, let’s say 1%, investors become concerned that we’ll slip into deflation –a prolonged decrease in prices. Deflation brings very different risks to the table: it drives corporate revenues down while costs, which are often fixed, lag behind. Corporations start losing money; some go bankrupt. Also, unlike inflation, the Fed has few weapons to fight deflation; thus companies are for the most part on their own.

Though the discount rate used in discounted future cash flows benefits from low interest rates, the risk premium, an integral part of that equation, skyrockets. This to some degree explains why the Japanese market’s P/E collapsed while interest rates were declining. Low interest rates were a product of a very sick economy – not of strength.

Movements between these zones are very important, too. Movements towards stability(towards Zone 2 from Zones 1 and 3) are very positive for P/Es. Movements away from stability (Zone 2) are negative for P/Es.

Hmm..So are we still in a range bound market? When can we expect the next secular bull? He offers the following framework:

Good stuff!


I’ve uploaded the complete document for your perusal. (RSS/Email subscribers might have to come to the website to view the document)
Active_value_investing_range_bound_markets

Read the rest of this entry >>

Interesting interviews with Tobias Levkovich.

As far as investment bank strategists go, I actually enjoy listening to Tobias Levkovich. I had written about him more than a year back here, where he argued for a W-shaped downturn, a collapse in commodity prices, emerging market declines, higher taxes and other interesting stuff.

Perfect for a hopefully slow Friday, here are some of his interviews on CNBC these past 2 months. I've posted my notes as well. Enjoy!

Interview 1.

Notes:

• Production will climb in H2 and into 2010.
• Increase in production rates drive earnings growth. Could provide bump to GDP data. Cost control merely provides operating leverage to the upside.
• In last 30 years, all growth in consumer expenditure as a percentage of GDP has come from health care expenditures.
• Our debts went up, but so did our wealth. When the debt went up by 6 trillion dollars, consumer assets went up by 24 trillion. They’re still up about 14 trillion.
• Strength of Q2 earnings and probability of H2 earnings power supportive of further gains.
• Possibility of a correction later in the year. Issues:
  -2010 earnings estimates are too high.
  -Some companies like mortgage insurers are in trouble, hitting the European banks.
• Overshoot to 1100 on the S&P 500 possible.

Interview 2.

• We’re still going somewhat higher. Still an environment where people doubt that stocks will be moving higher, and earnings will be going up.
• The big discussion is this whole cost cutting, not revenues driving earnings thing.
• We’re also at a stage where production has to tick up as we have been destocking at a severe rate. Inventories will not build up. Only destock at a more moderate level.
• CEO confidence is a great inverse indicator.


• Mutual funds and pension funds have performed better than hedge funds in this environment.

Click here for Interview 3.

• This is a cyclical bull not a secular bull. Next secular bull will launch around 2012-2013. Secular bull markets have to break above the previous highs.


• Production of cars in North America is 4 million units, with sales of 7 million units. Under producing very severely to reduce inventories. Car makers can increase production by 75% and not build a stitch of inventories.
• Historically production rates drives earnings. Every cyclical recovery has started that way. Not generated by end market sales but by production increases.
• Bullish but realizes that there will be setbacks along the way.
• Labor costs are a major part of inflation, and with unemployment at 10% and global labor losses, unless we put in major protectionist measures, hard to see inflation.

Dated but still good fourth interview presented without comment.

Read the rest of this entry >>

Festival of Stocks #153

Fundamental Insights is proud to host the 153rd edition of the Festival of Stocks. The Festival of Stocks is a blog carnival dedicated to highlighting bloggers’ best articles on stock market related topics. This will include research and commentary on specific stocks, industry analysis, ETFs, REITs, stock derivatives, and other related topics.

Before reviewing submissions from some of the best financial blogs on the web, I wanted to introduce new readers to Fundamental Insights. Here you’ll find investment and trading ideas discussed using fundamental and technical analysis. Please look around at our recent posts or the favorites section to get an idea. For fresher insights, stay updated via RSS feed, email or twitter.

Now, onto this week’s submissions.

Steve Alexander presents an interesting article on Goodwill Accounting and MFI, Part 1 - MagicDiligence. He writes: "Goodwill is an accounting concept used to track the purchase price of acquisitions. It is a fairly involved concept, and one that MFI largely ignores. This first of two articles describes Goodwill, how it is accounted for, and a simple example."

Michael Johnston presents Why Everything You’ve Heard About Leveraged ETFs Is Wrong at ETFdb. Good read.

Value Investing Pro discusses David Dreman's CNBC interview on August 05,2009.

Zach Scheidt presents Home Inns Vulnerable to China Lodging posted at ZachStocks. Ctrip.com Results pushed HMIN higher. The China lodging firm is vulnerable because of its high stock multiple and the potential letdown after the Shangai World's Fair.

Steve Patterson cautions against investing in Cisco Systems (CSCO).

Dividends4Life analyzes Becton Dickinson & Co. (BDX). Becton, Dickinson and Co provides a wide range of medical devices and diagnostic products used in hospitals, doctors' offices, research labs, and other settings.

Right Price Investing presents an Investment Manifesto 2.0. It's good!

The Viewspaper presents FIIs and the Indian Stock Market.

My Wealth Builder speculates on Expecting Another Bubble The basic premise? Low interest rates are bound to create another bubble. Hopefully, by expecting another asset bubble, you can protect your savings better than was done during the recent housing and financial crash.

Investing School presents a primer on What is Net Working Capital..

Forexoma presents a helpful primer on Money Management skills in Forex Trading Money management is the most important part of forex or for that matter any type of trading.

Darwin's Finance presents a primer on How Stock Options Work? .

Money Smart Life discusses Actively Managed Exchange Traded Funds.

Dividend Growth Investor presents a Dividend Stock Analysis on Supervalu (SVU).

Silicon Valley Blogger reviews Zecco posted at The Digerati Life.

The Smarter Wallet presents Trend Analysis For The US Dollar Index and Crude Oil Market.

The Canadian Finance Blog presents The Kondratieff Wave: Tracking The Past Or Predicting The Future? The Kondratieff Wave was created in 1926 but may be a sign of what will happen in today's economy.

Sun shares his trading experience with OptionsHouse posted at The Sun’s Financial Diary.

Stock Pursuits presents his 2009 Net-Net Stocks Performance.

Associate Money warns against using home equity loans to invest in the stock markets.

Money Ning points out that 401(k), Traditional IRA and Roth IRA have different tax implications..

Doug reviews Some Bank Stocks That Might Be Worth Watching.

That concludes this edition of the Festival of Stocks. Be sure to leave comments as you visit each of the blogs that participated in this week’s Festival of Stocks. They’ll appreciate knowing folks are reading their articles.

Submit your blog article to the next edition of festival of stocks using the carnival submission form. Past posts and future hosts can be found on the blog carnival index page.

Read the rest of this entry >>

Emerging markets: the starting valuation issue.

Purple haze all in my brain

Lately things just dont seem the same

Actin funny, but I dont know why

scuse me while I kiss the sky




Jimi Hendrix and Purple Haze might conjure up images of pot smoking beach bums, but it’s emerging markets investors whom I’m thinking of right now (especially India and China). Unless you’ve been living under some rock, you are probably aware that there has been some concern that the emerging markets might be suffering from some speculative froth. BRIC 2050 indeed! I've written about emerging markets valuations before here and here. Interestingly, similar arguments would hold true even today.

Exhibit 1: This excellent presentation on investing in emerging markets which had this interesting slide:



While they make some excellent points on emerging markets, historical returns, diversification and high GDP growth rates, I thought they missed out on one HUGE one. In any market, in any situation, the starting valuation is the most important determinant of your subsequent (ex-ante) returns. (Here are three excellent pieces by Hussman on how valuation is a solid predictor of ex-ante returns in the US markets. )

The data presented in the slide is obviously about a month or two old. Book value for India’s BSE Sensex 30 is currently 3.7 with a dividend yield of 1.2%. Price-earnings ratio for China is 35-40. Buying an index, any index, at 4 times book value or 30-40 times earnings is a recipe for disaster.

Note to Jeremy Grantham: No need to worry about blowing an emerging markets bubble. We’ve already gone ahead and done that. What’s even more astonishing is that this bubble has formed in the middle of the Great Recession. (Interestingly, GMO’s emerging markets fund is underweight India and China).


Valuations. Valuations. Valuations. That’s what investing is all about. It’s not about market timing, but market and stock pricing. Stock markets sell at 40 times earnings or 4 times book towards the END of bull markets. I realize some bubbles have ended in 60-70 P/E multiples, but irrational parabolic blow offs are very hard to time at the top – the markets could go up another 50%, but it’ll still qualify as a bubble. Bubbles tend to last longer than you can stay solvent.

Stocks in India and China are priced to deliver disappointing returns. Even if these countries grow like rock stars, much of that is already priced in. Investors banking on emerging markets for their mojo might get neutered in the process.

Read the rest of this entry >>

GMO's Jeremy Grantham July Newsletter

Jeremy Grantham just came out with his latest investment newsletter. These 2 charts best quantify the speculative nature of the latest rally:






Read the full thing here:

Grantham GMO July 2009

Read the rest of this entry >>

Festival Of Stocks #142

Fundamental Insights is excited to host the 142nd edition of the Festival of Stocks. Surveying the blogosphere for the best articles on investing and stocks, this weekly blog carnival highlights the best submissions of the past one week. If a submission was not closely related to investing in stocks it was excluded. Click here to find out more about this festival.

If this is your first time on Fundamental Insights, please feel free to explore this blog. You can read the favorite posts section, review the news section, follow Fundamental Insights on Twitter, or subscribe to this blog's feed.

Stocks

The DIV-Net website has a very nice review of Bristol-Myers Squibb(BMY) as a possible acquisition target.

Dividend’s Value reviews Illinois Tool Works Inc (ITW)

One Family’s Blog does a stock analysis on Ebay(EBAY) with a good discussion on PayPal

Stock pursuit points out that cheap micro cap oil stock HKN Inc. (HKN) is doing a stock buyback.

Investing

Old School news has some insightful reflections on stock market investing.

I take a detailed look at the Dow index, discussing the decreased importance of several low priced stocks in the price weighted index.

Magic diligence on the importance of stock selection in an out of favor sector. "While buying into a sold-off sector is good strategy, buying only the very best players in that sold-off sector is an even better one."

"You cannot simply decide if a company is a good buy or not just by looking at its price." Moolanomy.com on the dangers of penny stock investing for individual investors.

The SmarterWallet on developing an investment plan.

Trading

Jeflin suggests taking some profits. He argues that the bears might reassert their presence soon.

Sir Forex reviews the moving average convergence divergence( MACD) technical signal.

Forex and Currencies Explained has a primer on forex scalping.

Does CNBC know what a bid and ask are? You decide after reading this, courtesy the Political and Financial Markets Commentator blog.

Macro News

Harley-Davidson is up 140%+, Winnebago:170%+. Does that mean the recession is over? Mark Perry asks this question.

Reviving animal spirits is a necessary condition to reviving economic growth. Talk Money Blog discusses the role of confidence in recovering from a recession.

Firefinance points out that the current headline inflation numbers have been negative.

Reviews

Book review: Dividend Growth Investor reviews Dave Van Knapp’s book “The Top 40 Dividend Stocks for 2009”. It would be interesting to get the names for these 40 stocks!

Brokerage reviews: The Money Blue Book Blog reviews TradeKing, Silicon Valley Blogger does the same with Etrade, and CashMoneylife discusses some parameters to use while evaluating online brokerage firms.

Morningstar: Investing school compares the free versus paid memberships at Morningstar.


That concludes this edition of the Festival of Stocks. Submit your blog article to the next edition of festival of stocks using the carnival submission form. Past posts and future hosts can be found on the Festival of Stocks home page.

Read the rest of this entry >>

Gary Shilling: inflation or deflation and outlook on economy.

There’s been considerable debate on the inflation versus deflation issue. Last year, this was a little more contentious. (The deflation camp has been right so far and it looks to continue that way). The biggest deflation prognosticator has been "Mr. Long Bond" Gary Shilling. In fact, there was a link to an earlier interview on this blog. If you shorted commodities and went long bonds around then, you would have done well. For the record, he had a 100% accurate record for 2008. Shilling's forecasting an annual deflation of about 2% over the next few years, as consumers save more and the "overall supply of goods and services exceeds demand."

Anyways, came across a recent Bloomberg interview by Gary Shilling. Here's what he had to say. ( Click here or on the image.)





Outlook: His outlook is for a continuing weak economy:

• Consumer spending in recessions even in real terms seldom declines. We’ve had the worst decline in consumer spending since any post world war recession.


• PPI numbers clearly suggest we’re in deflation


• Inventories are only beginning to be liquidated. Going to take economy down for at least next 2 quarters.

On being asked to choose between deflation or inflation, he is sticking to his deflationary thesis:

• Economy will experience slow growth in the long run.


• Consumers are on a savings spree after 25 years.


• The corporate sector is deleveraging.


• Commodity producers will have less money to spend.


• Government involvement will slow us down further because of inefficiencies and protectionism.


• No strong loan demand for a long while. Lenders are not going to lend.


• So much liquidity has been destroyed in the private sector. Credit default swaps have been cut in half, taking them from 60 to 30 trillion. The total money supply M2 in the G-7 is 25 trillion. So much liquidity is being destroyed in the private sector that it dwarves what the central banks can do and have done.

On the new normal for the US economy:

The 1982 – 2000 period was a solid up phase with a big 3.6% average annual growth. He’s looking at 2% for the next 5-10 years, which is basically the secular down phase of the supercycle.
His recommendations:

• Still likes long treasuries offering 3% yield on a 2-3% deflation for a 5-6% real return.


• Likes US dollar as a safe haven.


• Recommends high quality corporate and muni bonds.

I first came across the works of Gary Shilling(and many others) through John Mauldin’s Just One Thing which I highly recommend :





I’ll be especially interested in following him and watching when he stops recommending long bonds. This is something he’s been doing for over 25 years. It’s been the call to define a lifetime. Long bonds outperforming equities in the great equity bull of 1982-2000 has been a solid sucker punch to the “stocks for the long run" camp in my opinion.

Read the rest of this entry >>

Missing the early bull market can be costly.

The bull-market versus bear-market-rally debate has been going on for a while. A few analysts have been advising caution and riding out the current uncertainty, suggesting investments in gold, TIPS or some fixed income /cash variant. For instance, this Yahoo video featuring John Mauldin has him suggesting that new bull markets go on for years and years (suggesting we’ll have plenty of time to be sure). Thus it’s better to be a few months late than a few months early.

Here’s what he says:

The great bull markets last for decades, so you'll have plenty of time. Those who bought at "the bottom" in 1974 had to suffer through the rest of the 1970s. So stop sitting on the edge of your seat waiting for that perfect moment to buy and just remain cautious for a while.

Well, maybe not. Here’s a few facts courtesy Fidelity:

• While bull markets have often lasted for multi-year periods, a significant portion of the gains have typically accrued during the early months of a bull market rally.


• Within six months, more than one quarter (27%) of an entire bull market’s performance (on average) was already in the books.


• The first 12 months of the average bull market has provided more than 40% of an entire bull market’s price appreciation, yielding on average 45% for investors.


• Those who choose to re-enter after a few months of positive performance—when the climate feels “safe”—may miss a sizable portion of a bull market’s overall gain.

Here's a chart showing the huge returns in the first few months of a new bull market.



Investing from the mid contraction point versus the mid expansion point can lead to very different results.



At the beginning of this bear market, when sentiment was bullish and this was just a bull market correction, charts like this were all over the place, warning investors against trying to time the markets. It’s a telling sentiment indicator that one does not hear too much from the long term buy-and-hold investors. This bear market has been hard on investor psychology.

Stock markets reward investors precisely because the investors are willing to invest despite the uncertainty. Hence the equity risk premium. In fact, if you miss the beginning of a new bull market, investing in bonds will outperform buy-and-hold indexing over the economic cycle.

Market timing is hard! Precisely because you need to get it right twice: knowing when to sell, AND when to buy back. Investing for the long term during volatile times like these feels hard. But this is exactly when one needs to be focusing on the long term.

Read the rest of this entry >>

Contrarian pick: Buy flash memory vendors because of elasticity.

The investment thesis in flash memory vendors consists of the following:

• Memory prices are in the dumps.
• The creation of newer markets due to price erosion.
• Increased demand due to higher memory capacities and new markets, more than offsetting any price per bit declines.
• Memory vendors currently trade at rock bottom valuations.
• Most existing players are looking to divest or merge. The survivors should be great investment candidates.
• The trend towards mobility and computing convergence will drive growth towards newer markets and higher capacities.
  

Moore's law has been a constant guiding light over the last 30 to 40 years in the semiconductor industry. Gordon Moore made this observation thirty years ago, and it has held true ever since. This basically predicts the shrinking of transistors, thus doubling performance every 18 months, with reduced costs and area. The reduced cost and added functionality facilitates their use in a wider array of markets and applications.

As the average selling price (ASP) continues to plummet, elasticity dictates that newer markets and applications would be discovered, which would simulate sales growth. Andy Kessler discovered the same phenomena with EPROMs in the 1980s. Really, nothing has changed in terms of demand supply curves. Elasticity is the guiding investment principle in this sector.

Right now, as memory prices collapse and vendors bleed red, people are scared from investing in companies like Micron Technology, Inc. (NYSE:MU) and SanDisk Corporation(NASDAQ:SNDK). A slump in demand, coupled with an oversupply, has forced vendors to sell memory chips below cost. Many have predicted an impending shakeout with the smaller players either exiting or being bought out. Most chip companies like Intel Corporation(NASDAQ:INTC), Advanced Micro Devices, Inc. (NYSE:AMD), Infineon Technologies AG (NYSE:IFX) and STMicroelectronics N.V. (NYSE:STM) have spun off or merged their 'undesirable' memory divisions, or are in the process of doing so. The memory sector has been left for dead, which is exactly the best time to get in from a contrarian perspective. A similar shakeout took place in the mid 1980s, when Intel exited the DRAM sector. That turned out to be a good time to invest.

The number one use of flash right now is in Apple Inc.’s(NASDAQ:AAPL) iPods. Just contemplating the possible markets where memories could be widely used gets me excited.

• Think of the growth in feature rich cell phone markets. Multiply that growth with the increasing memory capacities for each of those cell phones. You get the picture.
• The introduction of the high memory capacity iPhones by Apple Inc.’s(NASDAQ:AAPL) should drive other phone providers to beef up the memory capacity in their phones, thus accelerating the trend towards higher capacity phones.
• While everyone is anticipating a faster 3G rollout because of the iPhone, fewer analysts are anticipating the growth in memory usage. Broadband and wireless just gets wider coverage than the commoditized memory sector.
• In 2007, 271 million PCs (laptops+desktops) were sold. In contrast, a mind boggling 1.15 billion cell phones were sold last year (and growing fast). As these become more feature rich and pack in higher capacity chips, the memory vendors who survive the current shakeout are in for a bonanza.
• Solid state drives in laptops are on the cusp of mass adoption. Five years from now, most of us would be toting around flash enabled SSD drives. Flash memories would be faster, less noisy, more power efficient and increasingly a preferred usage choice for even high capacity drives.

Check out the graph below. While I agree with the growth projections, I’d just like to add that it probably underestimates the cannibalization of MP3 player growth rates due to integrated phones with music capabilities (like iPhones), and underestimates the erosion in USB Drives due to online storage and cloud computing applications.

Here would be the top three names to play the memory sector:

• Sandisk(SNDK): A strong patent portfolio in flash, good management, a visionary CEO in the form of Eli Harari, and an innovative marketing and design strategy makes this a buy. Should come out very strongly through the current downturn.
• Micron(MU): One of the strongest patent powerhouses in the world. It’s resilience to past downturns and current scale makes it a buy.
• Samsung: A low cost structure due to geographical location and scale gives it a serious competitive advantage. Should survive any shakeout and continue to do well in an economic upturn. This is not a pure memory sector play, as it has several product lines.
• Bonus: iShares MSCI South Korea Index Fund (NYSE:EWY) would be a diversified way to gain exposure to Samsung (14% of the ETF). Moreover, valuations for Korea are attractive, as suggested by Warren Buffett recently.

Caveat: There is a potential threat from newer memory technologies (FeRAM, MRAM, phase change RAM), but their commercial deployment and proven success is still many years away.

In short:

• We are truly on the cusp of a phenomenal growth cycle in memory chip usage.
• The best part is that people absolutely hate the sector right now.
• This makes it a classic contrarian pick.
• The current carnage would scare away incumbent semiconductor players toying with the idea of an entry.
• Demand-supply elasticity tells us that the memory sector should scale beautifully over the next few years.

To conclude, buying the discounted memory chip vendors close to the bottom of the economic cycle sounds like an excellent investment proposition.

What say you?

Stocks mentioned: MU, EWY, SNDK, AAPL, INTC, AMD, IFX, STM

Full Disclosure: No positions.

Read the rest of this entry >>

Why you should short companies doing a share buyback.

Am I the only guy who believes that stock buybacks are a waste of shareholder money and a management diversion?

Theoretically, if the earnings yield (inverse of P/E) is higher than the after tax interest rate, buybacks add to the EPS number. Buybacks are dilutive otherwise. (This provides no information on the value of the company.)

Here’s why I don’t like buying companies doing stock buybacks, and would rather short some of them:

• Some of the announced buybacks never happen.
• P/E multiple compression. A dividend or a buyback is a cash flow to the investor right now, versus a possible higher return later on through future profitable growth. According to the classic Gordon growth model, a company’s price earnings multiple is proportional to the retention ratio. Well, a buyback is another way to return cash to the shareholders (or a lower retention ratio). Lower rates of reinvestment suggest lower future growth rates, and hence a lower multiple.
• Implicit recognition that the avenues for internal growth through reinvestments are not that high as returning cash to shareholders through buying back ‘undervalued’ stock. Let’s say you have a debt-free company with a 20 P/E doing a buyback. Does this imply that the company cannot find enough investable projects with returns in excess of 5%? Would you want to invest in that kind of a company? The company might be signaling a lack of investment opportunities above the cost of capital.
• Buybacks are effectively a leverage on the EPS numbers. In good times, profitable growth leads to aggressive buybacks, further magnifying EPS numbers. During a downturn, a negative growth with reduced buyback would amplify the EPS compression. Cyclical companies with huge buybacks are the best short candidates for this.
• If the management thinks that the stock is undervalued, why isn’t a value investor or activist hedge-fund buying your stock? Palm(PALM) and Motorola(MOT) are two companies which had huge buybacks when the stock price was a lot higher. Even the activist funds have lost money on their initial investments so far.
• A lot of tech company buybacks are to offset equity dilution due to stock options, and the net buyback is minimal. (BIG short). I’ve seen companies with 5-10% annual stock dilution. (Let’s not even get into the whole option expensing debate!) . Yahoo(YHOO) and Nvidia(NVDA) are examples of companies with a sizable equity dilution.
• Buybacks to combat short sellers is a questionable tactic with dubious merits. This gets into the whole ego turf. Good short candidate. (Example: Overstock(OSTK))
• Buybacks followed by heavy insider selling are a big red flag.
• Possible internal management conflict to boost EPS numbers for executive compensation, instead of long term shareholder growth. (This paper suggests that the combination of a share buyback, insider selling, and a high ratio of incentive compensation is a high risk event.)
• Cost cutting and restructuring: Increasing cash flows through temporary cost cutting measures don’t really add to the firm's innovativeness. Using that cash to buy back shares instead of reinvesting is a good short candidate, since the uptick in cash flow is temporary.
• If you pay more than your book value, you reduce your book value effectively.
• As investors, you care for the “intrinsic valuation” of the company. This doesn’t change with a buyback. By pandering to short term speculators, management risks alienating value investors.

Hey if buybacks are such a great thing, how come Berkshire doesn’t have one? That’s because it chooses to reinvest earnings in profitable enterprises, thus increasing intrinsic value, and consequently the share price. Gaming and managing quarterly earning numbers through buybacks is not a good long term investment thesis. It doesn’t matter if the stock is trading at half the intrinsic worth. The company should essentially ignore what the market thinks in the short term.

If the company is returning all that operating cash flow to the shareholders, aren’t you better off just buying a conglomerate like Berkshire(BRK) or Luecadia(LUK) which reinvests that cash in profitable enterprises for you? They effectively take away any reinvestment risk.

The implicit assumption in a buyback is that the company feels that the stock is undervalued. The belief is that insiders know something that Mr. Market doesn’t. Often times, this is not based on a strong order book, or an increasing sales profile. More often, an overly optimistic and rosy outlook leads to the buyback. Given the folly of forecasting beyond a few quarters, that’s questionable.

Sometimes, the announcement is made after an earnings shortfall, or if the company has some future negative outcome which the market is possibly 'discounting'. For example, even right now, the average analyst estimates for the last two quarters of 2008 are too high. From a bottom-up analysis, companies feel that even though there is a general economic downturn, they won’t be affected. Some of them have buybacks in place.( This 2005 article from the McKinsey Quarterly provides some further food for thought)

I’m not saying that buybacks are bad per se. There are genuine occasions when Mr. Market throws a temper and gives us a steep discount with a nice margin of safety. Just that there are situations where shorting companies doing buybacks might actually be a profitable strategy. Using the guidelines above can help us in reaching this decision.

Ticker symbols discussed: BRK, LUK, OSTK, YHOO, MOT, PALM, NVDA.

Full Disclosure: Long LUK since 2005.

Read the rest of this entry >>

Analyzing TI's current quarter

This is the first of a three part series.

This post discusses Texas Instruments Incorporated (NYSE:TXN) just concluded F1Q08 quarterly results. A later follow up post will discuss TI’s product offerings and a SWOT analysis of their competitive strengths based on their technology and market strategy. Finally, I’ll discuss TI as a stock investment thesis.

In the current quarter just concluded, TI reported revenues of $3.27 billion and an EPS of $0.49. The highlight was the growth in their high-performance analog segment, with revenues up 20% year-over-year (YOY). Overall, revenues declined 8 percent sequentially primarily due to weaker sales into cell phones, especially in the high-end segment.




Expenses: R&D expenses were down 6.8% YOY, primarily due to sourcing of the digital process technologies from foundry partners.
-SG&A was up 7.4% as they have been investing in Field Applications Engineers and customer support to accelerate analog sales growth, especially in the application specific area.

Margins: Gross margins were up due to higher sales of high margin analog products.
- Management has set a long term goal of achieving gross margins of 55% and operating margins of 30%.

DSP revenues: Declined due to lower sales into cell phone applications (75% of the DSP revenue is through handsets).
- DSP security and surveillance market sales were up 63% YOY.
- Their ultra low power microcontroller product line MSP 430 should potentially deliver higher revenue growth going forward due to its prevalent use in an increasing number of new applications. (They didn’t break out the revenue component)

Analog: Their analog revenues were up 6% YOY, driven by stronger demand for high-performance analog products. 45% of their analog revenues were from the high performance analog segment, which grew 20%. This was across all major product categories: amplifiers, power management, data converters and interface. There were gains in hard disk drives, automotive as well as battery management products.

New product introductions included medical ultrasound diagnostic equipments, Class-D audio amplifiers, and a prototype cell phone based on Google’s Android using TI’s OMAP processor. TI entering the application specific space in a big way is definitely not good news for smaller players in niche analog markets.

Raw material costs: I see a risk here of high raw material costs impacting their gross margins.

Cashflow: Business is throwing off nice cash flow and rewarding patient shareholders with buybacks and dividends.

Share count: Diluted share count down 8.3% YOY (Nice!)

Auction rate securities alert! Time for the “Oops! I know what you did last summer” moment!


TI had invested approximately $1 billion in auction-rate securities, essentially student-loan pools. They could offload only $473 million, and are left with $551 million. To avoid taking a mark-to-market hit on their quarterly profit reports, they reclassified these securities from short-term to long-term investments. These will be held to maturity at their cost value, which will be checked periodically for an impairment charge. Their net income could have taken a $20 million hit had they not done this. (They’ve already recognized a $20 million impairment on their balance sheet). Assuming a worst-case situation of a 20% hair cut on the ARS securities and TI's inability to offload the remainder of the ARS, you're looking at a $100 million loss which investors should watch out for in the shareholder equity on the balance sheet. Definitely not chump change!

- Herb Greenberg had an article about this discussing a Merill Lynch report in February, which was categorically denied by TI's investor relations department as 'superficial'. I thought TI gave a very reassuring reply to this situation.

-Auction rate securities information was mentioned in the press release for the quarter, but no mention of any impairment charges. In the conference call remarks, they did disclose the impairment charge to the shareholder equity.

- I did not see a separate line item on the balance sheet for breaking this out. If you look at Palm's 10Q, they have a line item for this impairment in both the income statement and the balance sheet. (TI didn't release their 10Q yet though, so this might change.)

-While reclassification to long term debt is ok, just want to point out that Palm and MetroPCS took an income statement hit from the ARS impairment. On the other hand, TI's ARS are mostly student loans and so they really should be fine. My 2 cents: the due diligence at TI was more rigorous.

High inventory risk alert! TI reported inventories of $1.58 billion. A third of the inventory build up was related to the wireless business, due to unexpected build to plan changes (not good). Translation: A customer just backed out/delayed their order. We hope they’ll be back and not go to the second source for their supplies! In their defense, this sounds like a softness-in-the-market issue.

“As we explained in our mid-quarter update that product was already being manufactured when we received the changes so we carried more inventory of this product than we had initially expected at the end of the quarter.”

That’s about $526 million. Even a 20% inventory writedown would imply a $100 million charge: something investors should keep an eye out for. While too early to speculate, it’s important to factor in a possibility of that in your valuation models, and hence demand the appropriate risk premium for it in your DCF valuation.

(Note that two thirds of their inventory (the analog inventories) should be fine, as analog products tend to be stable with long life cycles. )


Outlook: Hold recommendation on TXN. With Nokia Corporation (NYSE:NOK) and Ericsson(ERIC) looking at second source suppliers for their chips, it’ll be difficult to model TI’s wireless revenue stream. That, coupled with the difficult macroeconomic environment, colors me cautious on their near term to intermediate term prospects. Caveat: Since analog revenues tend to be more resistant to fluctuations in the economic cycle, TI's revenue stream might be less volatile than some of the other chip vendors.

Ticker symbols mentioned : TXN, NOK, ERIC

Full Disclosure: No positions in any of the securities mentioned above. Opinions expressed are my own.

Read the rest of this entry >>

Warren Buffett.

Unbelievably great interview/chat with Warren Buffett.


Oh.. and in case you missed his annual letter, here's the link:

Every para is filled with wisdom, and it always amazes me how easy it is with
Warren.

Very interesting!

Read the rest of this entry >>