Stocks

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“I’m going to put $10,000 in Facebook’s IPO”.

I was having a conversion with a friend of mine yesterday. He’s a reasonably smart guy. He’s a technology manager at a wireless carrier company and does quite well. At least regarding his income. When it comes to his investments, I have my doubts.

“I think it’s over-valued”, I told him.

“I don’t care. I just want to invest in Facebook. It’s a great company. It’s growing”.

“Yeah, but it’s over-valued”, I argued. “You should go work for them. But don’t buy the stock”.

“I think it will do well”, was his reply. “It’s profitable”.

“Do you know how much it’s worth?”, I countered.

“I think its worth $100 Billion”.

“No, that’s the IPO price. What’s it’s worth? What’s the revenue and profit?”

“I don’t know. And I don’t care”, he admitted.

Apparently my friend is so enamored with Facebook that he’s willing to pay any price to own the stock.

It’s widely believed that Facebook will be offered at a valuation of $100 Billion. With about $3.7 billion in sales and $1 billion in net income, it’s a bit to pricey for me.

The fact that it’s being offered at 30 times sales and 100 times earnings is not relevant to my friend’s decision.

Like most people, he doesn’t even understand what it means when a company sells for a 100 times earnings.

Suppose you were going to buy a sandwich shop. You paid $100,000 to own it outright. At the end of the year, the manager sent you a check for your share of the profits — and it was a only $1,000. Would you invest in that sandwich shop? Well, that’s just like investing in a company like Facebook.

Ah, but what about growth? Surely there’s a lot of growth considering that the whole world will eventually be using FB, right?

Well let’s take a look at that.

Assuming the company has 800 million users, their per customer revenue is about $4.65, with a net income of $1.25.

And let’s assume that even if every person in Asia joins in, they’ll have 5 times the customers.

But these customers only have 1/10th the spending power as Americans. But I’ll be generous and say they have 1/5th the spending power.

So basically, FB’s user base will surpass 5 billion, while their net income will only double to $2 billion. In which case their PE will be 50 instead of a 100. It’s still way too expensive! Using the sandwich shop analogy, you’d now get a check for $2,000!

If it was going public at a $10 billion market cap and paying at least a 1% dividend, I think I might be interested.  But as someone already said, Facebook already went public – only you weren’t invited!

What about your friends? Are they falling over themselves to get in on the FB IPO?

The Euro is on the verge of collapse.

Yesterday, the Euro closed below $1.30 – the lowest level all year. And the yield on the 10-year Italian bonds closed above 7%. The last eurozone countries who’s bonds closed at 7% were Greece, Ireland and Portugal.

The market considers these countries to be credit risks. If you have bad credit, you’d pay 30% or more on your credit card. But a sovereign nation has the ability to tax it’s citizens. So the chance for a total loss is remote – which is why it’ll pay a comparatively lower rate.

But even at a low 7%, Italy can’t pay the interest on it’s bonds. At this rate, as more of the debt rolls over at a higher interest rate,  it will eventually have to default on its debts.

The European Central Bank will make some half-hearted effort to bail out Italy and save the Euro. But in the end, the Federal Reserve will have to step in to save Europe. And it will.

The Federal Reserve will print money to buy up Eurozone bonds. This monetizing of debt will eventually result in massive inflation,

Regular readers know I’ve been talking about inflation for a while.

I’ve been moving my assets in to gold coins, silver, and globally-diversified undervalued large cap stocks like Walmart (WMT), Microsoft (MSFT), Cisco (CSCO), Johnson and Johnson (JNJ) and Berkshire Hathaway (BRK-B).

So what else is going to benefit from looming inflation?

Credit card companies like Visa and Mastercard.

These companies provide transaction-processing services. Unlike the banks that issue these credit cards, they bear no risk if the credit card holders default. They’re more like a toll booth on a bridge that collects a fee each time someone drives through.

But unlike the toll booths, which charge a fixed dollar amount, these companies charge a percentage of the transaction amount.

As the amount of money in circulation increases – and the prices of things goes up – they’ll collect more money for doing the same thing. Unlike other service companies, they don’t have to even explicitly increase their fees. Since it’s a percentage, it will automatically adjust upwards.

And if the Euro actually does collapse, travelers to Europe are more likely to use their credit cards for purchases. This is more convenient than exchanging currency at every border.

I looked at four stocks in this sector: Visa (V), Mastercard (MA), Discover Financial Services (DFS) and American Express (AXP).

Visa and Mastercards have significantly greater global appeal and penetration.

And between these two, I liked Mastercard more.

Over the past five years, it’s revenue and free cash flow has been steadily increasing. It’s currently selling for a P/E of 20 and a Price/FCF of 18.27.

As Warren Buffet demonstrated with his purchase of Lubrizol this year, paying 20 times free cash flow is a fair price to pay for a domainant company.

But unlike Lubrizol, Mastercard isn’t the market leader.  It’s second-place to Visa. But Visa’s cashflows have been somewhat erratic, and it’s stock is a bit too pricey.

So Mastercard is little expensive for my taste. I prefer to buy stocks at a discount. It’s on my watchlist – I’ll pick it up if it trades below 15 times FCF.

In April of last year, I made the case of going long Vodafone (VOD).

Since then, I’m up nearly 44% on my purchase price (including dividends). Vodafone currently yields nearly 7.5%.

Recently, Barrons had a good article on why investors should still consider investing in Vodafone.

Its ADRs, which trade on Nasdaq and each represent 10 ordinary U.K.-listed shares, could rise more than 20%, to $35-$38, over the next two years. Including dividends, the total return could top 35%, with significantly less volatility than the average stock, given Vodafone’s relatively stable business. (Vodafone ordinary shares closed in London Friday at 180 pence. The ADRs finished near $29.)

There were also several quotes from fund managers:

“Vodafone’s stock is significantly undervalued,” avers Bruno Lippens, a portfolio manager with Pictet Asset Management, “essentially because the market still doesn’t appreciate Verizon Wireless” and the way the dividend will translate into reliable future cash. While there’s no formal annual commitment, Verizon Wireless has little net debt and produces about $1 billion monthly in Ebitda. “Absent massive investment needs, I don’t see an alternative” to paying out a regular annual dividend, adds Lippens, who sees some 40% upside in Vodafone.

The author of the article also thinks that a liquidation of Verizon Wireless could occur within five years, which could be as high as 50% of VODs current market cap.

Last week, search engine giant, Google (GOOG) jumped 15% in one day.

About six weeks ago, I wrote a post stating that Google was undervalued by 33%, and worth buying at around $500 per share.

Since then it’s jumped to $600, a whopping 20% jump, more if managed to get in at the low point. Quite a strong move for a large cap stock.

I still think the story for Google is strong, but if I didn’t already own it, I wouldn’t necessarily buy it today. Instead, I’d look for another cheap stock, something a little more boring.

As I wrote about in a previous post on investing in boring stocks, I prefer unloved, boring stocks with no growth prospects over exciting, glamor stocks. Incidentally, the stock I mentioned in that post, Johnson & Johnson (JNJ), is up over 10% in the past four months.

One of the stocks I’d consider is Cisco (CSCO).

This tech giant has lost its luster, with the stock price having gone nowhere for the past ten years.

I blame the poor leadership of the CEO, John Chambers, for the stocks performance. But at today’s prices, it probably doesn’t matter how incompetent the management is.

Cisco currently trades for $15.66 with a newly introduced dividend yield of 1.50%. It trades for a P/E of 12.2 but more importantly it trades for a P/FCF of only 9.2.

FCF or free-cash-flow is one of my favorite metrics when valuing stocks. It’s the cash left over after all the expenses have been paid out, and capital expenditures have been made. Unlike earnings, free-cash-flow is very hard to manipulate. Over the past decade, even though Cisco’s share price has stagnanted, the free-cash-flow has more than doubled from $4.1 billion to $9.2 billion.

For a stable, profitable market leader like Cisco, ten times free-cash-flow is a great deal. As Warren Buffett indicated in his purchase of Lubrizol, it’s okay to pay 20 times free-cash-flow for a great company.

Cisco also has an incredibly strong balance sheet, with about $40 billion in cash or $7.80 per share in cash – that’s almost half of it’s stock value.

Even though Cisco faces increasing competition and has a penchant for wasting money on acquistions that don’t seem to make any sense, it still has a wide economic moat. Cisco makes devices that move internet traffic. And the amount of internet traffic is increasing every day.

It’s only a matter of time before Cisco becomes a $25 stock again.

Disclaimer: I’m long Cisco.

I’m cheap.

I like to buy stuff when its on sale. The same applies to stocks. I recently bought Johnson & Johnson, and Google. Both are trading at historically low P/E and Price/Free Cash Flow ratios.

But, the market for bubble stocks seems to be alive and kicking.

LinkedIn (LNKD) just went public at 1,000 times earnings. Yeah, its trailing P/E is 1,000!

Even some established companies are ridiculously expensive. Salesforce.com (CRM) is currently trading at a trailing P/E of 300 and a forward P/E of 75. I can’t imagine who’s buying the stock at this level.

The CEO and other insiders are dumping stock like its going out of style. In the past year, they’ve sold $234 million worth of stock. And they’re continuing to sell it. Reminds me of CountryWide insiders selling the stock before the real estate bubble burst in 2007.

Here’s a funny video by someone who shares my disbelief about investing in Salesforce.

I remember being in college back in 1998, when Yahoo! (NYSE: YHOO) was the leading search engine.

Around the same time, two graduate students at Stanford came up with a better way to search the internet. They started Google (NYSE: GOOG).

Now, Google is the number one internet search engine. Every day, Google processes 1 billion search requests. It’s also the leader in online advertising.

And Google’s always looking for new opportunities. Over the past decade, they’ve bought nearly 100 companies Almost every time they enter a new market, they become the dominant player.

Three things contributed to their success…

1. They buy the best company in the sector.

In 2006, they paid $1.65 billion for YouTube. It seemed like a lot of money at the time for a free service. But they’ve been able to monetize it with online advertising. YouTube also started renting movies, just like Netflix and Amazon.

2. They develop or buy the technology cheaply, and give away the service for free.

Google paid $80 million to buy internet telephone technology. They got the technology by buying Grand Central and Gizmo5. That’s 1/100th of what Microsoft recently paid to buy Skype. And they’ve already merged the technology with Gmail, and Android OS. The technology is Google Voice. It’s free for U.S. calls.

3. Google make its services easy to integrate with other software.

Microsoft, Apple and Sony don’t do this. They keep their technology secret, and it hurts them in the long run.

Google takes a different approach. For instance, Google opened up their mobile phone platform, Android OS to programmers, manufacturers and carriers. And they gave it away for free. Within 18 months, Android OS-based phones have become the largest segment of smart phones. With 33% of the market share, they’ve even overtaken the Apple iPhone.

And unlike Apple, they’re giving a third of the application revenue to the telecomm carriers. Understandably, the telecom companies are falling over each over to support Android phones.

Now Google is entering the laptop sector. It’s releasing the Chromebook, a Google OS-based laptop. It plans to rent it out to students and businesses on three year contracts.

Google has seen amazing growth. But the stock is cheaper than it’s ever been.

Google is valued at $172 billion. It has $36 billion in cash, and only $5 billion in debt. In the past twelve months it generated over $31 billion in revenue.

Over the past five years, revenue grew at an average rate of 35%, and net income at 42%. But the stock sells for less than 14 times next year’s earnings. Growth companies like these, with little debt and large cash reserves, usually sell for 20-24 times earnings.

The market is undervaluing Google’s future growth. Even at 18 times earnings, Google’s stock is worth 33% more.

I just bought two shares of Google for my Roth IRA account at $525. The only thing preventing me from buying more is the lack of dividends. But the growth is compeling at this price. If the share price drops below $500, I might pick up a few more.

I remember the good ol’ days of the Internet Bubble in late 1999, early 2000. I bought Qualcomm (QCOM) at around $300 a share and watched it skyrocket to $800 a share in less than a year. Valuations didn’t matter, only the stories behind the stocks. I had lofty ambitions of early retirement and life of luxury. Warren Buffett was widely derided (amongst my friends) as an old fool who didn’t understand the new economy – this time it was surely different.

Sadly, no one told me the party was going to end and I rode that pony all the way back down the hill.

And then my brokerage called me and informed me that not only was my investment account worth zero, I also owed them an additional thousand dollars! Yeah, leverage works both ways.

That’s when I realized that investing isn’t about excitement, it’s about buying dull, income-generating stocks and as Buffett would say, sitting on your hands for extended periods of time.

I realized that I didn’t need to be invested in growth stocks that double every year. I just need to find stocks that generate 8-12% a year in capital appreciation and dividends, and I’ll be able to beat 90% of money managers on the planet.

So why am I bringing this up today? I recently read an article about how an investor was abandoning his position in Johnson and Johnson (JNJ), citing lack of growth as the main reason.

I am not suggesting that JNJ is about to collapse or slowly fade into the background. As I said, JNJ is a strong cash flow generator and the company does generate very strong returns on capital. With such a large amount of reinvestable cash, there will always be at least the hope of better days.

The problem, though, is that JNJ just isn’t a dynamic player. If you want a company that will produce large amounts of cash, and send a fair bit of it back to shareholders in dividends and buybacks, JNJ is a fine choice. But if you really want to harness the growth potential of the healthcare market with a top-notch operator, JNJ simply does not fit the bill.

Based on the 150+ comments, it seems like the investor and numerous readers were tired of the lack of stock performance of JNJ. How anyone would mistake a humongous, global conglomerate for a growth stock is another story, but is it really a dog of a stock?

After holding it for a decade (like some of the readers claimed they did), should you sell it now in favor of a tantalizing growth stock, like maybe SalesForce (CRM) that sells for 260 times earnings?

The problem with growth stocks is that everyone knows they’re a growth stock destined for great things, and investors usually overpay for this privilege, or should I say, excitement.

Studies have shown that over the long run, growth (or glamour) stocks underperform boring, value stocks.

So are people correct in giving up on boring, no-growth JNJ?

Well, JNJ’s story sure isn’t getting any more interesting. In fact, the 100+ year-old stodgy company is so unexciting, I can’t even be bothered to read what it does on its profile page on Yahoo! Finance. I know it makes medicine and related products. It had a slew of recalls and maybe it even makes Splenda. But seriously, who cares?

I don’t need to be swayed by some BS management story. I went to business school, I know how those yarns are spun! Just show me the numbers…

JNJ has a market cap of $166B and it has zero net debt – always a good sign.

Over the past decade (2001 through 2010), income has almost doubled from $33B to $61.6B. Operating cash flow has almost doubled from $8.8B to $16.38B. And most importantly, free cash flow (or as Benjamin Graham would say, the Owners Share of Income) also nearly doubled from $7.1B to $14B.

In terms of valuation metrics, the P/E fell from 32 to 12.7 over the same time period, and the P/CF fell from 20.5 to 10.3. Which meant that it went from being grossly overvalued in 2001 to being favorably-valued in 2010.

At today’s prices, the P/FCF is currently 11.84, which is quite cheap for a blue-chip stock and it has a projected yield of 3.6%, which incidentally, puts in on par with the yield of the 10-year US Treasury.

However, JNJ has been growing its dividend around 9-10% every year since 1972. In fact, it has increased the dividend every single year for 48 years!

If you had invested in JNJ 10 years ago, your entry price (adjusted for splits and dividends) would be about $37. It’s currently trading around $60.50, so while a 64% increase over a decade may not be the dreams that growth stocks are made of, at least your initial quarterly dividend payment of 0.16 cents has more than tripled to 0.54 cents.

And even though you made the wrong decision in buying an overvalued stock a decade ago, you’re still not doing too badly. At your entry price of $37, you’re almost making a 6% yield today.

Buying this boring, no growth stock today gives me an annual yield of 3.6%. If it repeats its performance over the next decade and the dividend triples again, I’ll be making 12% annual yield from the dividends, based on my purchase price. I can live with that sort of sub-par performance!

And if the P/E expands to growth-stock levels, causing the share price to soar and the dividend yield to drop back under 1% like it did 2001, I’ll be happy to sell it to some growth-story-chasing investor.  But until then I’m happy eschewing the glamor stocks in favor of the cheap, boring, no-growth, value stocks.

Disclaimer: I bought some JNJ for my retirement account yesterday around $60.50. I’m happy to keep it for a decade, or until they cut their dividend. I also shorted CRM at the same time.

In my last post, I hinted at using QE2 to your advantage by investing in companies that benefit from a steepening yield curve. But I didn’t have time to get in to specifics. Which is what I’ll do right now, seeing that I have a couple of hours to spare at the Fort Lauderdale airport.

The Federal Reserve let the market know that it plans to keep short term interest rates at extremely low rates for the next few quarters (if not longer). Companies that can borrow short term, can do so at very low rates. So long as you have AA-rated collateral, you can borrow money at about 0.30% on a 30 day basis. If you plan to borrow for a longer term, you just need to keep “rolling” your loan every 30 days or so.

So if you can invest in a AA-rated bond that pays say 3% or 4% and borrow money at 0.30%, you’re going to profit from the spread. Do such bonds exist?

They do – they’re called Agency RMBS and they’re just large pools of single-family residential mortgages that are bundled together in to large multi-million dollar securities and guaranteed against default by a government sponsored agency such as Freddie Mac or Fannie Mae. They also yield about 3.75% or higher.

So you can borrow money at 0.30% and invest it at 3.75% and you’re guaranteed against loss of principle by a government agency! Sounds too good to be true? Well it gets better!

Companies that use this business model to make money are set up as REITs and pay out a hefty dividend to shareholders. Companies like Annaly Capital Management (NLY),  Hatteras Financial Corp (HTS), Cypress Sharpridge Investments (CYS) are mortgage REITs that are set up to do exactly this. And they all pay approximately 15% in dividends.

An RMBS is basically a bond and all bonds have 3 types of risk:

  1. Credit Risk
  2. Prepayment Risk
  3. Interest Risk

Companies which invest in Agency MBS don’t suffer from credit risk. If the borrower of the mortgage defaults, the government-sponsored agency just buys it back and you get your money back. There is no fear of loss of principle!

Prepayment risk is when the borrower pays off the loan early and returns your principle back to you. This usually happens in environments when interest rates are dropping and borrowers can refinance their mortgages at a lower rate. If you get your money back early, you need to reinvest the money, typically at a lower rate. Given that mortgage rates are so low and refinancing is much more difficult than it used to be, the risk of prepayment is limited. There are some always some prepayments though which occur as regular amortization of the loan. Some companies will calculate how much of their portfolio and try to enter forward contracts to purchase more RBMS and thus mitigate the prepayment risk. CYS is one company that does this.

The third and major risk is interest rate risk. As the cost of borrowing increases, the spread between borrowing and invests decreases. Your profit margins drop and are no longer able to make the kind of returns you’re used to. Again some companies hedge against this event, and incur some cost in doing so. But hedging maintains long-term predictability of cash flows and may be worth the drop in potential yield. Again CYS does this and it’s net spread after hedging is 2.55%. It also uses 7.5:1 leverage to maintain a $4.5 billion portfolio against $600 million equity position. When you earn a 2.55% spread and can leverage up 7.5%, that’s a whopping 19% yield! CYS has about a 17% dividend yield.

Disclosure: I bought a 33% position in CYS on Friday and am going to be buying more under $13.50.

The QE2 leaving Southhampton

The QE2 leaving Southampton

Today the Federal Reserve launched the highly anticipated QE2, announcing that it will buy $600 million of Treasuries in 2011 ($75 million per month). It will also continue to reinvest payments on its securities holdings which could bring the total capital injection closer to $1 trillion dollars.

I’m still waiting to see any evidence of  “Change You Can Believe In” and for the $8.5 trillion bailout to kick in and create jobs. But since Bernanke seems that it hasn’t been working too well, we’re going to do exactly the same thing that got us in to this mess – keep interest rates low and turn on the liquidity spigots!

One point of interest is these policies seem to benefit banks the most. Here’s an excerpt from an article on Yahoo! News:

Meanwhile, market watchers noted the Fed’s plan is to focus its QE2 purchasing power on the middle of the Treasury curve, i.e. securities from 2.5 years to 10 years. As a result, prices of shorter-term bonds rose while the price of the 30-year bond tumbled, sending its yield sharply higher.

So the real result of the Fed’s action today is a steepening of the yield curve, which most benefits (wait for it)…the banks. The ability to borrow from the Fed at effectively zero and then reinvest in “risk-free” Treasury securities at a higher yield is a huge reason why bank profits rebounded so quickly from the depths of the 2008-09 crisis.

Despite loads of evidence to the contrary (and very little lending) the Fed is effectively doubling down on its bet that boosting the banks’ balance sheets is the best way to revive the economy.

I can’t believe that this is the best policy to revive the economy. However, it definitely makes sense to align yourself with the Federal Reserve’s determined course of action. Seems like there are 2 things you should do:

  1. If you’re currently unemployed, find a job at a bank. Most banks are hiring like crazy. Bank of America has thousands of job postings (I’m not making this up)
  2. If you’re looking to invest, look for companies that benefit by borrowing at zero interest and reinvesting in risk-free Treasury or Treasury-like products.

There are several companies that fall in this category. Not only do they benefit from the current scenario, but they also pay high dividends and enjoy REIT status (meaning there’s no double taxation of profits) without actually investing directly in real estate.

Any guesses? I’ll talk about them in my next post.

Almost exactly a year ago, I mentioned a paired-trade investment between the long-term Bond ETF (TLT) and short-term corporate/sovereign bond ETF (AWF).  I went long AWF and shorted an equal dollar amount of TLT. Last week, I closed the position after holding it for just over a year.

When I entered the trade, AWF was trading for $8.29 and had a yield of 13.4%, while my short position in TLT was trading at $112.10 and had a yield of 3.5%.  When I close out my position a year later, AWF had a price of $13.10 and a yield of 8.6%, while TLT was going for $91.65 and yielding 3.9%.

I made about 63% on the long AWF position and 18% on the short TLT position. Coupled with the 9.9% net dividend yield, that trade made me ~91%. Not a bad return for a year and 4 days.  Bond yields don’t usually move 500 basis points in a year. No point being greedy. Time to bank some profit!

paired-trade-awf-tlt-returns

A drop in the stock market will cause the price of bonds to move up, since they typically are inversely correlated. Similarly a sharp rise in in yields would cause bonds price to drop. I expect a move in TLT to about roughly $96 at which point I might renter the position depending on the larger macro-economic picture.