More Job Losses

There was a big announcement today as many companies announced job losses due to a declining economy. Home Depot, Sprint, GM, Caterpillar and Pfizer are all planning on slashing jobs.

Of particular interest is Pfizer, who acquired rival Wyeth for $68 billion this weekend and also said it will cut about 8,000 jobs from its current workforce. More cuts are expected once the merger is complete with a few years according to Pfizer management.

One of the main reasons for the acquisition is that Lipitor is worth almost a quarter of Pfizer's total sales and has a looming patent expiry (meaning more competition from generic brands). This is of particular interest to watch as M&A in this environment takes on more of a restructuring and divestiture overtone as cash is tight and companies are looking to improve the bottom line.

Although it could be argued that without a recession, Pfizer would have to have found a solution for its expected decline of it's leading drug one way or another, this seems to also provide additional justification for cutting jobs.

We can expect to see similar types of acquisition activity in the market for several months until earnings begin to pick up.

Defensive Stocks

McDonald's released it's earnings report today and exceeded expectations by about 4c at 87c.

Apparently with the decline in the economy, defensive stocks such McDonald's and Walmart have generally "declined" less than their counterparts (8% versus 30%) and proved that there are some bright spots in a recession.

Sunday Reflection: Chinese New Year

No real reflection for this Sunday.

However, an interesting cultural note, "Happy New Year" in Chinese is (Xīnnián kuàilè - ping ying). The "controversy" is that "kuàilè" (Happy) sounds like "drop fast" and with all the recent turmoil in the market some Chinese have changed it to a different phrase meaning "Improve".

So "Improve New Year everyone!"

GE and the decline of Earnings Guidance

As I am trying to price a sell range for GE in the 3 to 9 month time frame, I'm reminded of the fact that GE recently decided to stop giving earnings guidance. This not uncommon as managers of companies usually hate giving earnings guidance ("I'll manage the company... You manage the stock expectation.").

Here are some great articles on the matter:

Why GE Should Never Give Earnings Guidance Again

General Electric discontinues quarterly earnings guidance

These articles make some good points. However, even if guidance is not given, analysts should still continue to provide guidance of their own based on MD&A and their own analysis. PE ratios as a model requires earnings and has a solid grounding in as a method of valuation.

But beyond "just making the numbers", more important is why they are plus or minus expected EPS and the repercussions on long term business profitability.

GE Earnings Report

GE makes their Q4 target, but as our reader astutely mentioned GE has mentioned (once more) profit smoothing techniques in the form of One-Time global benefits and Other (page 9 of their webcast presentation) which accounts for about 3.68c of their earnings (by my math).

There's also a component called Restructuring and other high tax jurisdiction income. This area might be a bit more grey in terms of it's true impact on EPS.

I'd expect the stock price to come down a bit, however, the management guidance based on the information and projections are moderate. I'd expect some positive news for them in 3 to 6 months which should boost their stock price.

I'd watch this stock price and buy at a slightly lower price. However, It's tough to put in a price (and yesterday's target might be too low). I'd try not to guess the bottom and get in at a price you can sleep at.

Buy range: $11.5 to 13.00

GE @ $13.48

GE's earnings report is coming out early tomorrow morning (8:30am) and people are looking for management guidance regarding their earnings.

I think people who are pushing for earnings guidance outside of 2010 are being unreasonable when management says the outlook is uncertain.

However, I also think that GE is in a great position to take advantage of the infrastructure investments by the government intended to stimulate the economy. Especially in green power, GE has a great advantage in wind energy (solar isn't really all that green yet... the energy consumed in oil used to produce a solar cell is disproportional)

I think that the earnings report will be dim and will probably take earnings down.

Rating:
Buy @ $10.50 (number to be reviewed pending outcome of tomorrow's call)

GE @ $13.03

Kevin O'Leary was on BNN (Squeeze Play) and when asked by a caller about GE, he mentioned that GE management guaranteed the 2009 dividend but not 2010. He then went on to say that GE would test single digit prices and new 52 week lows (which it hit today at $11.88).

However, if you look at PE and yield (as the caller did) you would think that GE is undervalued. He also mentioned that GE was in a strong position to benefit from the infrastructure investment that governments were initiating to boost their economy.

At the very least, GE should be on a watch list despite it's Hold rating.

Barrick Gold (ABX) @ $45.84 CND

Barrick Gold seems to be climbing.

But there are some new problems you should look at:
The PE ratio has now gone to 18.05 and is starting to push being over priced as a stock.

However, the future price of gold as an inverse indicator of the economy can justify a premium. But the question is how much?

Bank of Nova Scotia (BNS) @ $29.70

To buy or not to buy?

Bank of Nova Scotia hit it's 52 week low today at one point (however briefly) trading at $27.86 (but closing at $29.70).

The debate now is if it's hit bottom.

But even at this price, the dividend yield is pretty good (6.6% at the current price).

I'm going to look for a slightly better price before putting my bid in.

Rating:
Buy

Apple (AAPL) New spread

Based on the earnings info, I'm going to expect an annual EPS target of 5.95 and a target sale price of $98.50.

I think the recession effect on iPhone sales (and Mac books and Mac products) will be minimal.

Rating: TBD based on after hours trading but let's face it... It's probably a hold at this point.

Apple (AAPL)

Apple reports blowout quarter: $1.78 versus $1.39

About $8 up from the close in after hours trading according to BNN.

Hope you were more optimistic that I was and got in on the ground floor.

Ethics and Due Diligence

I'm shocked by the number of investors I talk to who don't do due diligence or don't investigate further. What is also disheartening (but maybe not as shocking) is that people put complete faith in their financial advisers. You have to understand the quality of the advice you are given. If you aren't very knowledgeable about the market, here is some advice for choosing a good financial adviser:

1. Know what their position is in the stocks they are recommending. Generally, I won't buy anything that my adviser doesn't already own (at a price similar to what I'm buying at).
   
2. Ask what price they will sell at. If you buy, have a sell price ready. Don't become emotionally greedy. You can re-evaluate your positions, but understand what you're getting into. Also, this is a great lead in to the next question:
   
3. Be aware of conflicts. Some advisers are market makers, part of an underwriting team or make commission based on trading volume or sales. This means that they don't really care if you make money or not (in fact they may never really want you to sell... At least until they've liquidated a signification position). Technically, according to CFA and CSC standards of ethics, advisers are supposed to disclose any conflicts, but often they don't. You aren't supposed to have to ask, but if you care about your money, you will.
   
4. Track the performance of your adviser against relevant indicies or benchmarks. Just because the economy is down 30% doesn't mean that your portfolio should be too. Understand beta, correlation and market risk. Or if you don't, make sure your adviser does.
5. Asset allocation. This is the boring part of investing as people tend to just gamble and shoot the moon when it comes to equities. But understand your financial goals and targets puts things into perspective. A smart CFP will usually sit you down and discuss your life style and retirement goals before even discussing equities. That's actually the *last* piece. The idea is to find investments suitable to your risk tolerance and time horizons. You may not think of this now, but you definitely will when you start to lose money in the short term (which is too late).
   

Advisers must be complete the Canadian Securities Course (CSC) or Series 7 in the US before they can sell securities products. Also, most firms require their advisers to become Certified Financial Planners (CFPs). Check out this great article on selecting a CFP and financial adviser.

Cathay Forest Products (CFZ) @ 28c

*DISASTER*! Sell Sell Sell!

I don't know why anyone would have bought this stock as it's had negative earnings for every year since it's IPO two/three years ago. In the first year, it looked like they had great profit margins but small scale (over 90% margins). However, once they grew their business, their profit margins dropped to reasonable to truly marginal (while maintaining negative earnings).

The only way it's been surviving by issuing more stock. It's cash flows are all negative, and it's only positive cashflows are from financing and diluting equity!

It's equity is so diluted that even if they do start turning a profit, it will take forever for individual stock holders to make any money back. Also note, their EPS doesn't look too bad because their huge losses are divided by huge weighted number of common shares!

I would love to have a chat with some of the management and see what their guidance is (because management will always give relatively optimistic guidance because they want to keep their jobs).

It's got all the markers of a company on it's way out with no bailout in sight. Unless there is some brilliant light at the end of the tunnel I don't know about. Otherwise, this is a great case study for careless speculation by naive investors.

Rating: Sell... Short sell!

MGO Investment Presentation

I just attended an evening investment presentation with the CFO and VPF of MGO. They reiterated their strong growth and future development plans.

Target price for MGO is currently ranging between $15 and $17 according to analysts tracking the stock from various firms.

Also, apparently my estimate on EPS is about right based on their revenue and margin projections. So if they hit their targets (which it looks like they will based on their capacity growth and marginal demand) they could easily start climbing towards their price targets next quarter. Also keep in mind that this price is calculated with the current conservative PE ratio.

Just reconfirming my previous rating and time frame.

A Cautionary Note

While watching the inaguration of the 44th US President, I've been scouring the web for value buys of good companies. Companies that are:

• Based in NA
• Stocks are fairly liquid (good trading volume)
• Strong book values
• Strong earnings
  

I've noticed many young investors (not from a finance background) making statements thinking that it would be a good time to get into the market (as early as a few months ago) after the big crashes. However, if recent history is any indication, just because stocks are off their 52 week highs doesn't mean they'll they can't drop further. Don't fall into the confirmation bias trap!

I've been looking at stocks across the board and the majority of them seem to be "adequately" valued (which in this economic situation is still rather optimistic). Dumping your money in the market now in the hopes of making a profit from a big recovery is a bit premature at this point. Do your homework!

There are a lot of stocks that I saw which I would rate Hold (but didn't bother, because a Hold rating doesn't really inspire any form of action... Just as a point of information).

My advice: Keep a bunch of stocks on a Watch List, stay current and pre-compute a buy price so when the time comes, you have an relatively objective and unemotional reference point for when you need to make a buy / sell decision.

RIM @ $63.75 and RBC

RBC Analysis said this morning that RIM is expected to be "Outperform" (a buy rating) and have set a price target of $75 (sound familiar? It's what I had as my upper bound for a sell target). A price of $75 implies a PE of 19 (which implies people expect heavy growth).

I'm not sure if I would endorse chasing the stock up, but people seem to be optimistic. However, key notes to address before you buy:

Understand that RBC isn't entirely neutral when it comes to RIM. After all, RBC manages RIM's newly created Venture Partners fund and they have a fairly strong relationship (not sure what percentage of RBC funds are composed of RIM stock).

I'd say if you have it hold it. I don't know that I would buy to get in.

Bank of Nova Scotia - A Case Study of PE

Often you have to be careful with PE analysis. For example, Bank of Nova Soctia is currently trading at $29.86 and has a PE of 9.77 (EPS of $3.05).

On the surface, it would seem that BNS is undervalued based on PE analysis.

However, if you look at their annual reports, the reason for the heavy discount is (as everyone knows) that the banks have been suffering more than most in this economy because of the credit crisis. Their EPS in the last quarter was only 28c ($315 m) and they had $642 m in write offs which hit the bottom line very hard. However, the weight of the last dismal quarter is (obviously) just one quarter of the EPS.

EPS here looks to be in decline. But this is the point of importance is that people aren't sure how much (hence lack of confidence) and the earnings (although reported at $3.05, I would estimate for short term valuations should be more likely closer to 2.5). Having said that, suddenly the PE ratio is closer to 12 given the current economic estimates (not just historical EPS) and BNS is not as discounted as you would think.

The result? It's still an "ok" buy. But will probably drop a bit more as people expect bad news (6 to 9 months). Hence the 3 - 5 year out look for most Canadian banks.

Barrick Gold (ABX) @ $41.95 CND

For you technical analysis people, I think I've found a GREAT case studies for a reverse head and shoulders formation.

Left shoulder: Late Sept early Oct
Head: Early Nov
Right Shoulder: Late Dec

Check out Barrick gold (ABX) and it's chart for the last 6 months. You can see the dramatic plunge in the stock price leading into Aug and recovery early Sept.

Don't forget that Gold is one of the sectors people go to in a "flight to quality" and is inversely related to the performance of equities in general.

Note: This stock has no rating. It is listed here for interest only as what happens here tells an interesting story about what's going on in the economy.

Bank Stocks

I've heard many people talking about US Bank stocks being a good buy for people with a 3 to 5 year outlook and that seems to be the case. But you have to watch the news and act quickly.

Consensus on Canadian economy is that it hasn't totally felt the effects of the US slowdown and will still experience more declines over this next year recovering towards the end. Commodities sector will probably see the most volatility.

Apple (AAPL) @ 82.33 USD

PE is currently 15.36 within my 14 to 17 range. Although I think people are getting into Steve Job's face a little about his health which is a shame. I also think they are exaggerating the effect it's going to have on Apple.

However, if you really want to get into Apple, now is the time. I don't think the stock will be dropping much further (it's at it's very near it's 52 week low of $79.14)

Rating:
Overall - Buy / Hold

Trading spread:
Sell @ $95.85

GM @ $3.93 USD

Ok, so it's up 7.38% since I last reported on it as a sell. However, I maintain that this is a long term losing position. Don't make the same mistake most major hedge fund managers regret (which is not unwinding losing positions fast enough).

If you are one of those traders who knows better and feels comfortable trading and making money off of this volatility, be my guest. But any day (actually, I'm thinking in March) this stock is probably going to take a big hit when people start to realize that this stock isn't going anywhere. Then we'll start to see the mechanics of a company being dismantled.

Even if this company gets government assistance in whatever form it takes, the only practical good it will serve is to "alleviate" the pain of workers and suppliers as this company makes its way out (pulling the band aid slowly). Essentially, it will only delay the envitable and make the current economic climate slightly more bearable as workers start to lose their jobs.

Also, be cautioned. I'm sure that most technical analysis would tell you that the price is below the moving average (depending on your time horizon), however, I think this is an environment where this type of analysis might not be prudent. Any slight bit of news can cause major mood swings in the stock price.

Rating:
Long term sell
Short term - too unpredictably volatile

Kodak (EK) @ $7.25 USD

Ok, I've hit the $7 to $9 price target for Kodak (18.7% capital appreciation) well before my "6 to 9" month time frame (less than one month). I guess it's not really hard to find an undervalued stock which will recover quickly in these volatile times. Also, don't forget that this stock has recently been giving a regular bi-annual dividend of $0.25c since late 2003 (so consider this in your valuation).

However, my 6 to 9 month outlook remains optimistic. My rating:

If you are looking for divdend income (as many are in the current environment) I'd rate this a buy (yield is currently at 6.9, but will probably drop - hopefully due to stock price increase rather than dividend drop).

If you are looking for capital gains, I'd rate this a hold. *AND* watch the news on their printer product development and sales. It's the only thing that can save them or make them different from everyone else.

Trading spread (unchanged):
Sell @ $9 (based on yield and PE)

Sunday Reflection: Behaviour of "The Market"

There are many fundamental or technical analysis techniques for stocks and investors have different models for understanding pricing behaviour.

But one interesting characteristic I've noticed is that in bullish times, stock behaviour can seem to defy gravity and analysts are carried along for the ride. Suddenly PE ratios soar into seemingly unreasonable numbers like 30 or 40. Conversely in bearish markets, if investors become nervous and start dumping stock, prices can go into free fall (PE of 2 or 3 for strong companies?).

What exactly is a PE ratio? Well it's literally the price divided by the earnings. But what does it mean? Well consider if you bought any sort of income earning investment. Let's say a house. Let's say you bought it at $150k. Let's also say that you can rent it out for $15k per year. That's a PE ratio of 10 (Price / Earnings = $150k / $15k). Anyone with basic math skills can tell you that you will pay off the house in 10 years (for simplicity this example excludes TVM, mortgage interest, taxes etc). Imagine if you could own something that would pay for itself such a short (speaking in terms of investment horizons) time span as 2 or 3 years! It's like buying the same $150k house and being paid $50k to $75k in rent per year!

Or for a high PE ratio: Imagine having an asset that would pay for itself after 40 years! Most of us would probably be dead by then (or basically, you'll never see your money again).

Consider also a loan. Imagine that you gave someone $100 and had annual interest of $5 (5%). If you were to use a "PE" calculation, you would get 20 (you paid $100 and receive "earnings" of $5). So this way you can see that PE's can be converted into yields (inverse relationships).

They only way to justify these extreme ratios is if there is something going on with the growth (hence many fund managers use PEG - Price to earnings growth where PEG is usually equal to PE / Growth rate and is normally equal to 1, usually regardless of asset class).

In other words? The only reason why companies should have such extreme PE ratios is if they are about to close shop / declare chapter 11 or they are experiencing explosive growth. Otherwise, they should act as red lights that a major change in the market is about to occur.

There is a big difference between trading within a reasonable spread and extreme over(under) subscribing.

I think what many people forget is that the stock market is a market like any other and that the securities products (like any other products) are limited in nature. Because securities aren't physically manifested, many investors forget that there isn't an infinite amount of stock in the market place and at the extreme bearish or bullish markets securities behave as any microeconomic supply and demand curve would anticipate. Just as companies can struggle to find capital, savers can also struggle to find good places to put their capital.

Often, the intrinsic value of investment grade products change and with large swings disproportionate to their actual value. However at that point, what you have to realize is that you are not longer just making money off of the success of the company, but also the foolishness of greedy investors. When you sell at a high price, part of what is built into that price besides the actual success of the company are the expectations of overzealous buyers. And visa versa.

There is only a certain amount of value that is retained (or lost) in a company in good or bad times and a smart investor understands when they are only making money "on paper". Holding on at that point becomes a gamble that has less to do with quantitative analysis of stocks than it does on human behaviour.

I think the most reasonable solution is for smart people to make money at either end of the spectrum and follow the old adage: Buy low sell high and to intercept stocks at extreme prices. The problem is that people become emotionally involved with their stock. The trick is not only to do fundamental analysis, but also understand human behaviour when it comes to stock highs and lows.

"You can make your twenty percent at the start or at the end,
but I prefer to make my 60% in the middle."

Migao (MGO) @ $5.49 CND

I would rate Migao stock a buy at $5.49 a share. However, whoever thinks it will hit $20 is dreaming (You'll have to reevaluate at the next quarterly report before you can start guessing these numbers). Here's why:

The reason the stock price is so low is that the EPS has been volatile over the last two years. However, in the last year, it's been fairly strong and steady it seems. Plus, indications is that business is strong and growing.

However, the risk with the new plant they are building (and operation in this month) is that the new capacity they have built might not sell (however, that doesn't seem to be the case). Having said that, let's take a look at the numbers:

I've looked at their operating ratios and everything seems to be in order. MGO reported an EPS of 67c last year (with major growth over the last five quarters) and is trading at $5.49 or a PE of about 8.19. Using some fairly optimistic estimates, I'd guess a maximum EPS of 44c per quarter next year or 177c (assuming they continue to sell out their inventory at the same margins with the new capacity in their plant in Sichuan). At a generous EPS in the order of magnitude of 9, that indicates a price of $15.93. However, more realistically, in this economic environment, I'd say a more reasonable EPS target closer to a stable (but growing) 128c and a price target of 10 to 12 dollars.

But if it starts wandering to 10 to 12 dollars, I think you should start selling. That's a 100% growth target for a six month outlook.

Research in Motion (RIM) @ $63.75

Ouch. Ok, so I knew it was going up, but not by this much and not this fast. I still have to get better at anticipating how fast things will rise (especially based on the nature of the stock and industry). Also, I was a little cautious given the market.

RIM stock has a PE of 16.56 which is where I think it should be. It is a strong growth stock that is fairly stable in its growth.

Rating: Hold

Trading spread:
Buy - $58
Sell - $75

Sunday Reflection: A Theoretical Model for the Value of Derivatives

I was developing a model for understanding prices of options based on the betting system at a race track.

Consider European options (because they are easier conceptually and can only be exercised at expiration) on a stock selling at $50 with an excise price of $50. Assume a call is $5 and a put option is $2.

Also assume that the standard deviation for the stock is $2.

Race tracks can guarantee their profits because they will adjust the ratios in such a way that no matter who wins the race, the race track will take profits on all bets. But for simplicity sake, let's say that we can analyze this system as a snap shot in time first (an assumption we can remove later to strengthen our system).

First, let's say that for every call option you sell a put option (another assumption we can relax later).

So you sell 1 call for $5 and 1 put for $2 for a total premium of $7.

Note that with a standard deviation of 2, the following probabilities are likely (majorly oversimplified, but if you want to crack open a spreadsheet to do this properly, be my guest). Each set is one interval or between standard deviations:

E1 - P(X>56) = Negligible
E2 - P(56>X>54) = 2%
E3 - P(54>X>52) = 13.5%
E4 - P(52>X>50) = 34%
E5 - P(50>X>48) = 34%
E6 - P(48>X>46) = 13.5%
E7 - P(46>X>44) = 2%
E8 - P(X>44) = Negligible

However, because of the options, the relative values of each event are:

E2 - Ct = 50 - 56 = -6, Pt = 0, prem = +7, VE2 = -6 + 0 + 7 = +1
E3 - Ct = 50 - 54 = -4, Pt = 0, prem = +7, VE3 = -6 + 0 + 7 = +3
E4 - Ct = 50 - 52 = -2, Pt = 0, prem = +7, VE4 = -6 + 0 + 7 = +5
E5 - Ct = 0, Pt = 0, prem = +7, VE5 = +7
E6 - Ct = 0, Pt = 48 - 50 = -2, prem = +7, VE6 = -2 + 0 + 7 = +5
E7 - Ct = 0, Pt = 46 - 50 = -4, prem = +7, VE7 = -4 + 0 + 7 = +3

So the total expected value is:
E1 = 0
E2 = +1 x 2% = 0.02
E3 = +3 x 13.5% = 0.405
E4 = +5 x 34% = 1.7
E5 = +7 x 34% = 2.38
E6 = +5 x 13.5% = 0.675
E7 = +3 x 2% = 0.06
E8 = 0

E(R) = SUM(E1:E8) = 5.24

Notice a few key things... There are no events with a negative return (you are guaranteed to make profits) and for selling two options, you are expected to make $5.24 per pair.

Now, let's slowly start to remove some key assumptions and point out a few key points.

1. You can't actually sell (a large volume) of options (in pairs) to make this kind of profit. Usually, call options will be MUCH more popular than puts.

I simulated the above results and instead of having them in pairs, I tried saying that if a call is $5 and a put is $2, then a call is 2.5x more popular than puts ($5/$2). A HUGE assumption, but it turns out the expected value is still positive (although lower... Where as you are expected to profit $5.24 per $7 pair of premiums you sell, I worked it out to about E(R) of $2.10 per $20 of premiums you sell - in other words, still profitable, but less so... which makes sense). It doesn't really much ratio of sales of Call to Put you use as long as you calculate the Ct and Pt properly to understand your potential loses in all scenarios. But, obviously, as you start relaxing your assumptions to reflect "real life" your margins get smaller to reflect investor behaviour. GIGO.

Also to note, in the model where you sell more of one option than another and the underlying asset of that option suffers from extreme deviations from the expected mean, you can lose a LOT of money because the premiums from one type of option don't nearly cover the losses from the other.

2. For a stock trading at $50 (or there abouts) with an excise price of $50 (or there abouts) the Call will cost $5 and the Put will cost $2. Going back to Put Call parity, reducing arbitrage and finding the intrinsic / time value of options, you can adjust these values accordingly, however, they will directly affect your expected value. As you can see, the premiums carry directly to the "bottom line" (expected returns) proportional to the number of options sold.

3. You don't have to know the exact price of the stock nor be certain if it will be above or below that price any degree of certainty. You only need to know approximately where it will be (know the standard deviation).

4. You can make even more money if you take the premium and invest it in at the risk free rate (reinvestment in a T-bill) over the holding period.

5. You didn't actually invest any money. As long as you have money to cover "potential losses" you are fairly safe.

6. Every time you sell an option, you can raise the price to increase the spread to reflect demand. Of course, if the price rises too fast, you'll limit the multiplication factor to leverage your expected return.