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February 28, 2005

No Pain - No Gain

Solving “Big Problems” is at the heart of the largest market opportunities. Great businesses are often built upon systematic and strategic approaches to solving others’ problems; where being systematic creates a discipline of execution and leads to consistency, and being strategic is where the “Big Ideas” get generated.

We made the trek to Boston last week, in part to find out what smart guys in Bean-town were up to and to somehow tap into the magic that has led to sequential World Championships in baseball and football. (We want to be having whatever they're having!)

As part of our tour, we stopped up to Bain Capital, the $24 billion in assets powerhouse that was founded by now Massachusetts Governor Mitt Romney in 1984. Bain’s roots go back to the consulting firm Bill Bain started in the early 1970s that took the novel approach that its value would be driven by results for its clients – not the voluminous theoretical reports which main value was often to serve as a doorstop.

In fact, Bain Consulting’s track record shows its clients have outperformed the S&P 500 by a whopping 3 to 1 margin since 1980.

Bain Capital’s results have been nothing short of spectacular and now have funds across the capital market spectrum from buy out, venture capital, fixed income, international, to its $4.5 billion hedge fund – Brookside.

We have said that great businesses are systematic and strategic in how they operate. Being systematic creates a discipline of execution and leads to consistency. Being strategic is where the “big ideas” get generated. Bain has been systematic and strategic on its approach to investing and building its business.

The recipe we have developed for identifying great growth companies - the “stars of tomorrow” - that have high and sustainable earnings growth, have the ingredients of the 4Ps: (1) great PEOPLE, (2) leading PRODUCT, (3) huge POTENTIAL and (4) PREDICTABILITY.

Bain has their own 4P’s (my translation - not theirs).

What they described they were looking for was a company in an industry where there was:

(1) PAIN. Due to competitive, structural or regulatory PROBLEMS (another “P”); there was significant pain being experienced by participants within an industry.

(2) PRODUCT (same as our 2nd P). Identifying companies that have a compelling product to eliminate or reduce the pain. The classic solution for a problem – the bigger the problem or pain, the bigger the opportunity.

(3) PRICE. How much does it cost to have the pain go away? Many “pain” solutions are so expensive, they are prohibitive to implement on a scale basis.

(4) PAYBACK. What’s the ROI on the product and how fast will we see it? Obviously the clearer, more tangible and faster the payback, the more likely the solution will be implemented.

Using the Think 4P’s framework and our liberal interpretation of what I call Bain’s 4P’s, and you have a pretty systematic way to hunt for the most important future winners. Finding companies with characteristics like these is like finding rare and swift moving elephants; extremely difficult to do, but when we find one, we should know it!

We remain positive on the outlook for stocks in general and in particular small cap growth companies. Fundamentals for the market are good and getting better. Valuations are attractive with the S&P 500 is selling at 16.3x 2005 estimates and the TEP Growth Index at 22.4x and a P/E/G of 73%. Small cap stocks continue to outperform, with the Russell 2000 up 1.2% versus the S&P 500 advance of 0.3% last week. Moreover, there continues to be a demand imbalance for equities with $2.0 billion of inflows into mutual funds last week.

Posted by Michael Moe at 11:03 AM | Comments (1)

Payrolls Paradox

Less than a year ago the monthly payrolls surprised investors when it posted an increase of more than 300K, sending long-bond yields higher by 50 bps. Today, some are speculating February’s payroll growth could top 300K, reigniting memories of last year, as well as inciting concerns over what a rise of this strength might imply about the inflation outlook…not to mention Greenspan’s recent “conundrum.”

When Fed Chairman Greenspan recently referred to the “conundrum” of low long-term interest rates in the face of Fed rate tightening, he effectively shifted the market’s focus back to inflation and interest rates and away from the remainder of earnings season. This week, Greenspan’s “conundrum” will take center stage, with a heavy economic calendar that includes expectations for a strong February payrolls increase.

It was less than a year ago that monthly payrolls surprised investors by posting an increase of more than 300K, sending 10-year yields substantially higher over the following months and in the process creating the first widespread conviction that the Fed would begin raising rates. With the consensus now looking for the strongest increase in payrolls in four months, and some speculating the increase could top 300K (we’re looking for 150K), memories of last year's surprise increase and what a similar report this month would suggest about economic growth and the inflation outlook will be this week’s primary focus.

When the Information Changes, So Do Positions
During Greenspan’s recent Senate testimony on monetary policy, he cited the current “conundrum” of low long-term interest rates. The explicit “conundrum” he was referring to wasn’t that the interest rate curve had flattened, which is pretty typical during a period of rising short-term rates, but that long-bond yields had actually declined. The Fed has now raised short rates by 150 bps since June, yet 10-year Treasury yields are lower by nearly 75 bps. Historically, as goes the Fed, so go long rates.

While we can’t speak for others, the actual decline in long-term interest rates since mid-2004 has been a long-standing marvel, with 10-year yields remaining well below our end of 2004 and current quarter forecast of around 4.50%. However, by the time Greenspan formally gave it a name, we were pretty much over it. More important to us now is the relative price change between end-market and input price inflation, suggestive of an impending reduction in profitability (not necessarily profit growth), and which we believe is more consistent with one of the factors that both the bond and equity market have been increasingly discounting.

The recently reported January rise in core producer prices, the largest monthly increase in more than six years, has placed even greater emphasis on the inflation outlook as well as the prospects for rising interest rates. While the subsequent tame increase in core consumer prices eased immediate investor concerns, it is in large part due to fact that input prices are rising more rapidly than end-market prices that has our attention.

We, like many others, expect the Fed to raise their target rate as high as 4% by the end of 2005. Against this expectation, the current 10-year yield of 4.25% leaves a scant quarter of a point spread versus future overnight rates. One explanation for this relatively slight discount has been that perhaps the economy is not as healthy as many believe it to be, and that the bond market is “telling us something.” While the bond market probably is “telling us something,” we believe it is reflective of the larger supply-demand backdrop for credit; a backdrop that we don’t see being meaningfully altered for a while, and certainly not by the outcome of this week’s payroll numbers.

Historically, corporate America isn’t sitting on a pile of cash and generating massive cash flows – which they are now and which is reducing the need for external financing. More typical is that companies begin investing and financing investment externally as economic activity improves.

Another factor keeping rates lower appears to be the unobvious result of consumers spending out of rising home equity. With a large portion of consumer goods being imports, this has sent dollars into foreigners’ hands. Since many of our trading partners’ economies remain relatively weaker than here in the U.S., and with foreign businesses not doing much investing despite surging export growth (profit margins shrinking due to strengthening currencies), foreigners appear to be plowing money into increasingly longer dated Treasuries (up nearly $400 billion in the past year), and increasingly into corporate bonds (up more than $250 billion). In other words, despite the recent concerns over the dollar and foreign central bank portfolio reshuffling, foreigners have been purchasing large amounts of U.S. debt.

While this week’s nonfarm payrolls report may introduce a new concern for the longer-term prospect of interest rates, we don’t see it changing what we believe are the larger fundamental factors behind keeping interest rates on the lower side of "historically normal": (1) reduced need for companies to fund investment with external financing, and (2) the relative strength of the U.S. economy vis-à-vis trading partners, which continues to draw in the financial flows into the U.S. capital markets as a byproduct of consumer-led import growth.

Parting Shot – February Payrolls Perspective
Though we remain optimistic that 2005 hiring will show marked improvement, we don't yet expect to see the pace of hiring quicken in the February report. Labor force utilization measures remain slack, while rising employee benefit costs continue to work against more hiring. As with the relatively faster rise in producer input costs, benefits cost increases continue to outstrip end-market pricing, which should continue to moderate any desire by companies to aggressively add to payrolls. While productivity has shot higher in the past several years, benefit costs have been growing 7% annually - leaving total compensation growth virtually unchanged. In essence, strong productivity gains are doing little better than absorbing the rise in benefit costs. Against this backdrop, businesses are more likely to view capital equipment investment as the preferred choice of expanding output versus more aggressive hiring.

Posted by Mat Johnson at 11:02 AM | Comments (0)

February 23, 2005

Top 100 Gadgets

Mobile PC Magazine recently published the "Top 100 Gadgets," a "what's what" list of the gadgets that made a mark on the timeline of gadget history. It's no surprise that Apple's iPod has already earned a spot on the list, but how did it rank versus the original Sony Walkman?

Notable gadgets making the list include:

98. Pez Dispenser (1927)
89. Rubik's Cube (1974)
76. HP Omnibook 300 (1993)
65. Mattel Football II (1978)
61. Motorala Bravo Pager (1986)
48. Sony Digital Mavica (1997)
43. Handspring Visor (1999)
29. The Clapper (1982)
25. Nintendo Game Boy (1989)
15. HP-35 Calculator (1972)

See the rest, then tell us what gadgets and gizmos will make the next Top 100 list.

Posted by ThinkEquity News at 02:00 PM | Comments (1)

February 22, 2005

Smarter, Smaller, Simpler

Will the rapid growth in IT investment ever return? Probably not - at least not as traditionally measured. Many of today’s “new” technologies are little more than smarter, smaller and simpler variants of what already exists. A possible result is that the greater opportunities in IT will be less about what can be “sold to companies” and increasingly about what can be “provided” to help them de-lever from their past investments.

Since early 2004, broader business investment has managed to sustain double-digit rates of growth, following several years of decline. This shift in the underlying economic backdrop has occasionally garnered some attention, though it has also been frequently trumped by one survey or another that declares business spending on information technology (IT) will be flat, or grow at a single digit pace—a disappointment to those looking for a return to the heady days of the past decade.

With IT investment now accounting for 50% of total business equipment outlays, these all too frequent IT surveys carry substantial weight—perhaps too much, however, since they largely focus on the largest investors in IT and seem to give too little weight to emerging technologies and business models.

That Was Then, This is Now
"Faster, better, cheaper" was an apt rallying slogan for the past twenty years in the IT industry. New information technology after all was in fact faster, better, and cheaper than the technology available before it. As a result, the perpetual IT adoption-improvement cycle consistently drove sales up, and to the right, as businesses faithfully followed the "build it and they will buy" curve. This appears to no longer be the case however; and that is a good thing.

As information technology has matured and decisions to upgrade have become more objective, it's apparent that the future of IT won't be driven by IT companies ability to deliver faster, better, and cheaper products (the infamous "upgrade"). This is a sign of healthy maturation and is a true benefit to companies as leveraging information technology becomes less about investment and increasingly about how IT and IT-related services are consumed.

The past twenty years of IT sector growth have been widely recognized as a period of adoption, though the reality is that adoption served to replace older technologies and business processes. Today there seems to be more concern than optimism about history repeating itself. The concern appears to stem from cannibalization fears, where commoditizing technologies antiquate earlier technologies and ultimately results in companies being able to reduce outlays on IT.

The apparent presumption surrounding business investment on information technology is that the past adoption and proliferation was the best way. At least this is what we infer from the persistent focus on IT budgets and CIO surveys of large corporations.

We’re All Tech Companies Now
In a world where focus remains on market size forecasts and IT budget surveys, commoditizing technology is understandably a disappointment. A good question to ask, however, is why it's viewed positively if a large retailer, drug company, or bank is increasing their IT budget? The standard answer is because it leads to an increase in industry revenues. The problem is, for non-IT companies their business isn't IT. Despite this obvious fact, due to the sheer pace of past adoption, not to mention the accompanying growth in IT complexity, it has become a not-insignificant cost of running a business. In other words, while businesses were busy adopting productivity-enhancing technologies and reorganizing their operations around technology-enabled processes, companies wound up becoming partial IT companies.

This is the realized negative side effect of rapid IT adoption, where companies from all walks now possess sizable IT infrastructure; are managing complex networks; have become inundated with security threats; and then are essentially forced to upgrade out of concern their systems will no longer be supported. If this is the single best way, then the IT industry has some pretty serious growth impediments ahead of it.

Our view is, so what if firms lower their IT bill through commoditizing technology? This simply implies that they will be able to devote fewer resources to infrastructure and activities that are peripheral to their business anyway. If they can get more for less by investing in commoditizing IT, they will likely find more places for technology to be profitably utilized elsewhere. Better yet, new companies built to service companies’ IT needs will increasingly make economic sense—thanks to commoditizing technology—and likely emerge to disembowel IT infrastructure from within corporate America. In the process, this should result in more competitive companies—by allowing them to focus on what they do best—and in turn result in a broader leveraging of IT to sustain and expand the growth in their business.

An improvement in technology should result in firms being able to grow their IT budgets at a slower pace than the overall growth of their business, and certainly slower than the growth in profits. During a period of adoption, this clearly wouldn’t be (and wasn’t) the case, as evidenced by business IT investment growing at a compound annual growth rate of 10% between 1982 to 2000, versus nominal GDP growth of 6% and corporate profit growth of 8%.

The bottom line is that commoditizing technologies are a necessity, representing real progress. Without them, companies are relegated to remain in substantial part "tech companies," even when their business has virtually nothing to do with technology.

Who today bemoans that companies aren't investing heavily in electricity, or that there aren't chief utilities officers at every firm? Would it really be a good thing if we measured business investment by the fluctuation in electricity budgets? No, it's far better that companies rely on electricity to run their business, but increasingly (then purely) as consumers.

On a number of fronts, the past is already giving way to an evolved path of companies better leveraging technology. In fact, many of the companies whose products are driving the IT evolution have an interesting goal; to shrink the total amount spent by companies on their industry’s technology. Technologies that are now emerging to deliver solutions with higher value-add to businesses, as well as helping to unlock latent demand for smaller or newly forming businesses, are already occurring in on-demand software; a number of open-source fronts (web browsers, email clients, databases, the desktop and syndication (RSS)), as well as the more talked about adoption of VoIP. Each of these represent the commoditization of what existed before it; lowering user costs (disinvestment), adding increased user value (higher ‘consumption’) and being driven by new companies with entirely different business models focused on leveraging technology on behalf of their customers.

Posted by Mat Johnson at 10:24 AM | Comments (0)

Investor Sentiment: Still A Market Headwind

Investment Advisor sentiment moved higher for the second straight week, with the percentage reported as being “bullish” rising to 56.6%, up from 54.6% in the prior week – nearing the historically high-end of “bullishness” and a contrarian red flag. The percentage “bearish” on the market fell to 21.2%, down from 23.2% the prior week. The result is a Bull-to-Bear ratio of 2.7x, the highest since the week of January 5th.

Individual Investor sentiment turned lower in the latest week, after rising sharply during the two previous weeks. Individual investors “bullish” on the market fell to 36.4%, versus 43.8% being “bullish” in the week ending 2/10. The lower level of sentiment follows “bullishness” rising 17 percentage points in two previous weeks (from the lowest level on record since the market bottom of March 2003).

As we mentioned at the end of January, the decline in Individual Investor “bullish” sentiment is encouraging, however, we remain concerned about the high level of Investment Advisor sentiment. Accordingly, it is important to note the historical observations that we had highlighted:

The bottom line is that while economic and market fundamentals remain healthy; having actually improved since the market bottom back in August, the degree of investor “bullishness” leaves the market with a near-term headwind.

Posted by Mat Johnson at 07:10 AM | Comments (0)

Equity Fund Flows: Last Week's Net Inflows Totaled $2.7 Bln

Equity mutual funds reported net inflows totaling $2.7 billion in the week ended 2/16/05 with non-domestic funds recording the bulk of the inflows at $2.1 billion. This represents a slowing from the prior two week’s reported net inflows of $4.5 billion and $4.3 billion. Also of note, the bulk of net inflows continue to be skewed toward funds investing internationally – at best only benefiting the largest companies within the U.S. equity market.

AMG updated its January net flows into equity mutual funds last week, providing a monthly estimate for January of more than $14 billion. This represents an increase from the preliminary December total reported by ICI ($10.0 billion), and is substantially better than the $300 million indicated by the sum of the weekly AMG reports for January. While this is now dated information, it does suggest that taken in combination with the market selloff in January, the implied liquidity ratio of equity mutual funds is now slightly above average.

While estimated total inflows for January remain well below the January 2004 reported $43 billion in new net inflows, the dependency on new inflows appears to be substantially lower than last year. We currently estimate that the total equity mutual fund industry is working with a cash liquidity ratio just above 4.6%, just slightly above “normal” (4.5%) and meaningfully better than the average liquidity ratio of 4.3% that prevailed from December ’03 through September ’04. Accordingly, unlike our concerns last year, continuing net inflows should flow more freely into the equity market and be gated less by managers desire to restore liquidity positions as funds come in – as well as provide some dry powder for fund managers should the market selloff over the near-term.

Posted by Mat Johnson at 05:14 AM | Comments (0)

February 14, 2005

And the Winner Is...

On February 27th, more than 50 million will tune into the 77th Annual Academy Awards to see who will take home the entertainment industry’s top prize. In our own annual awards tradition, we look back this week at the top performing stocks of the past 10 years - and how they got there.

We love the movies. So much in fact that Americans spent $10.2 billion at the box office last year and $25.9 billion on movie videos and DVDs. We love the movies so much we have elected an actor President of the United States and Governor of California two different times.

On Sunday, February 27th, 50 million people will tune in for the 77th Annual Academy Awards to see who will go home with Oscar. The favorite to win Best Picture is “Million Dollar Baby” (to show how in touch we are – the two movies we liked best, “The Passion” and “The Incredibles” weren’t even nominated!) The odds on favorite to win Best Actor is Jamie Fox (Ray), for Best Actress Annette Bening (Being Julia), and the real horse race is for Best Director between Clint Eastwood (Million Dollar Baby) and Martin Scorsese (The Aviator). “Accidentally in Love” (Shrek 2) is this critic’s choice for Original Song.

In contrast, we have a love-hate relationship with stocks. So much in fact that investors buy and sell over $36 billion worth of stocks on the NYSE and NASDAQ EVERY DAY! It’s a struggle to think of an investor that’s been elected to a significant office – generally, they need to be appointed.

This year marks a milestone in that it’s our 10th Annual Stock All-Star Survey which identifies the top-25 performing stocks over the past 10 years. Previous award winners include Dell Computer (DELL), Cisco Systems (CSCO) and UnitedHealth Group (UNH).

For the 10-year period ending December 31st 2004 (1994-2004), the top performing stock was Apollo Group (APOL), where $1 invested in the company in 1994 is worth $120 today. I was personally lucky enough to both follow Apollo Group from the beginning and Starbucks (SBUX), which is #10 on the list.

Apollo is the text book example of “under promise and over deliver.” When the company went public in December 1994, it promised Wall Street 25% EPS growth, it delivered 34% and its stock appreciated at a 59% CAGR. Moreover, in the past 39 quarters it never missed a consensus estimate and actually beat estimates 37 times.

In the era of the hype of the Internet, Apollo had a rapidly growing online university. Wishing to draft off net frenzy, I started calling Apollo – APOL – “A Professor On Line.” Far from being supportive of this, the management of Apollo asked me to stop as they didn’t want hype around their stock. Classy group.

With Starbucks, there isn’t a better leader, a person with greater vision or a person that gets brands better than Howard Shultz. Period. Starbucks is the story of the relentless pursuit of excellence by people of passion.

What’s interesting isn’t as much who made the list – most knowledgeable people could have identified many of these winners in hindsight. What’s noteworthy is how each company got here.

While the average stock appreciated 33.7% per year – that’s not so surprising – after all that’s why you are an All-Star out of over 10,000 publicly traded stocks. What’s interesting is that the average P/E for these 25 super stocks was 24.8x at the BEGINNING of the period of outperformance – in other words – they were hardly “cheap” stocks. The average EPS growth was 28.9% for the 10-year period – which is what drove the share prices. Also to note, the average market capitalization at the beginning of the 10-year period of outperformance was $350 million – small cap to micro cap.

What’s our conclusion? If we are trying to identify the companies that will appear on this list 10 years from NOW, we need to:

  1. Focus on companies that have high earnings growth and not in the bargain basement. Companies with the best earnings potential are often not cheap.

  2. Focus on small cap companies. Size forges an anchor – as a company becomes bigger, it’s harder to achieve high earnings growth.

The “Stars of Tomorrow” will have the 4Ps in a great growth company: Awesome People. Leading Product. Huge Potential. Predictability of growth.

Posted by Michael Moe at 10:52 AM | Comments (14)

February 07, 2005

The Natural

It’s the nature of stocks to move up with earnings. Despite the Fed raising rates for the 6th time since last summer, stocks moved up nicely last week. While there are always things to get excited or worried about, over time earnings growth drives stock prices and earnings continue to be strong.

Once upon a time, in a land far away, there was a wicked forest fire which destroyed everything in its path. Trapped between the blaze and safety on the other side of the river was a scorpion who couldn’t swim. Desperate to save his life, the scorpion befriended an alligator hoping to persuade him to carry him across the river to the other side and safety.

The alligator, knowing a thing or two about scorpions was highly skeptical about his new friend's motives and called him on it. “Why should I give you a lift across the river – you’ll sting me and I’ll die.”

With all the sincerity the scorpion could muster, he put forth his case. “Why would I sting you, friend? If you carry me across the river, you would save my life. I would be indebted to you forever.”

So with that, the alligator said “fine” and carried his new buddy across the river. As the two amigos got across to the other side, the scorpion stung the alligator.

As the double-crossed alligator was slinking to his watery grave, he looked up and asked, “Why did you sting me? I saved your life.”

The scorpion replied, “Nothing personal – it’s my nature.”

This weekend, our cute little beagle puppy “Bruiser,” brought the not so cute, bottom half of a squirrel home to show off. As my daughters were shrieking I had to explain to them that Bruiser couldn’t help it – he is wired to be a “hunter” so that’s what he does. It’s his nature.

Despite the Fed raising rates for the 6th time since last summer and growth bellwethers eBay, Amazon.com and Starbucks being off in earnings related news, stocks moved up nicely last week. In particular, small cap stocks screamed, evidenced by the S&P 600 hitting all time highs, up 4.7% for the week – the best week since last August.

Some pundits sited last week’s elections in Iraq as the positive catalyst for stocks. Others saw President Bush’s State of the Union being positive for business and Social Security reform as constructive for equities. While still more viewed the lower job numbers as favorable in that it’s less likely the Fed will need to be aggressive with rates in the near future. Additionally, $4.3 billion of inflows came into mutual funds last week, contributing to a persistent demand imbalance for stocks.

Our view is that while there are always things to get excited or worried about, over time earnings growth drives stock prices and earnings continue to be strong. With 75% of the S&P 500 having reported earnings, growth is up 22% versus the 17% that was forecast. Small cap stocks are even stronger, with fourth quarter earnings rising 40% versus last year. It’s the nature of stocks to move up with earnings.

Moreover, small cap stocks which have been outperforming large cap stocks since March 11th, 2003, are approximately in the 3rd inning of their historical 5-7 year outperformance (underperformance ) cycle. The fact that small cap stocks have been outperforming and should continue to outperform is predictable. It’s their nature.

Accordingly, we remain bullish on stocks and small cap stocks in particular. Valuations remain attractive for stocks with the S&P 500 selling at 16.2x and -30% undervalued. Small cap stocks are even more attractive given a P/E multiple only slightly higher than the S&P 500, 2x faster EPS growth and the aforementioned bull cycle for small cap outperformance. Moreover, there continues to be a strong demand imbalance for equities.

Posted by Michael Moe at 09:12 AM | Comments (0)

When a Bear is a Bull

What does it matter what is “priced-in” to the market? In our view a lot, though it’s often more important to recognize the potential inaccuracy of what is “priced in” as investors digest the concerns of the moment and dismiss the opportunities that lie ahead.

The fourth quarter earnings season is winding down to a close. Through last week, 80% of companies have met or beat earnings estimates, while two-thirds have met or beat on earnings. This is about par for the course. All in, fourth quarter earnings are tracking to 22% above last year, versus the 17% expected prior to earnings season beginning. Some of this upside has been the result of blowout energy sector earnings, though by our estimates, ex-energy sector earnings are still up 18% versus a year ago compared to the 14% expected.

What is not par for the course is that despite equity valuation appearing attractive prior to earnings season, all of the major indices are lower following stronger than forecast earnings. Had investors really "priced-in" the reported strength in earnings by this much; or, have investors recently been discounting factors that will ultimately serve to enhance longer-term investor’s performance?

One year ago forward 12-month earnings were expected to be 20% above earnings reported during the prior twelve months. It turns out expectations fell short by 1/3rd! This is despite the oil thing, that “soft patch,” decelerating earnings growth and the dollar “collapse.” Nonetheless, stock prices only managed to gain traction on 9%, or less than 1/3rd, of the total growth in earnings. This begs the question, what does it matter what is “priced-in?”

In our view a lot, though it’s often more important to recognize the potential inaccuracy of what is “priced in” as investors digest the concerns of the moment. Last year serves as a good example of an over-discounted future based on the news flow of the present. Despite all that did go wrong, it was the resilience of earnings that provided a fulcrum for reduced investor fear and uncertainty to leverage off of heading into the end of the year. Without the surprising strength and resilience of earnings, there would have been little reason for investors to bid up equities at the end of the year. In effect, what was discounted in future earnings would have been correct.

More recently we have seen the short-term downside to not discounting the present by enough. From August to December, measures of investor sentiment went from being extremely bearish to reaching the highest level of bullishness since 1987. During this time, just over $50 billion flowed into the market via equity mutual funds. However, individuals did the unthinkable in January; they pulled money out of the market. In what is typically a seasonally strong month of new net inflows into equity funds, investors withdrew $850 million and even more from domestic equity funds. By comparison, last January saw $43 billion in new inflows. This had to be a disappointment to institutional investors anticipating seasonally strong January inflows.

Perhaps it's little wonder then that investors pulled $33 billion out of just three companies this earnings season (Qualcomm, eBay and Amazon.com) – essentially getting “rotated” after failing to meet up with investors’ expectations.

So in essence, what is "priced-in" matters, though it is also important to recognize whether the risks being discounted are short-term or long-term in nature. In our view, recent economic data and company fundamentals suggest that the longer-term backdrop remains as healthy, if not healthier, than it has been in the past several years: inflation is poised to moderate, business are becoming more offensive - as evidenced by higher levels of investment as well as sustained hiring; even long-term interest rates, much to our surprise, remain very low as confidence grows in the Fed’s aim to reign in inflationary pressures before they get a head start.

The short-term market backdrop however, has been less than ideal. Investor optimism has been complacent and equity demand nonexistent. Unfortunately optimism can only underwrite rising stock prices for so long. Recent data points have been encouraging however. Investor sentiment has been on the wane (contrarian indication), while this past week inflows into equity funds rose by the largest amount in six weeks, rising $4.3 billion. These inflows are instructive as despite recent individual investor sentiment falling to the lowest levels since the market bottom of March 2003, they are nonetheless sending money into the market.

Also notable last month was the ratio of insider selling to purchases. While total dollar figures were relatively low, the ratio of sales to purchases was $55 to $1. A similar ratio was reported for December. To put this into context, $20 in sales versus every dollar of purchases as historically been seen as a “bearish extreme.” While this doesn’t portray a lot of confidence by insiders, it should be noted that with earnings season winding down, insiders should be less constrained by trading rules; possibly doing as individuals have done and renew equity purchases in February.

Our only reservation, though increasingly marginal as new money flows into the market, is that investment advisor sentiment has remained at relatively lofty levels; with the percentage of investors bullish on the market compared to those that are bearish at a ratio of 2.3x. This is well below the 3.2x seen in late December, though above the individual investor ratio of 0.9x last week. It should be noted that we have yet to see a solid market advance with advisor sentiment as high as it remains today. This said, both levels of advisor bullishness and bearishness have returned to levels not seen since early October – just ahead of the bulk of the year-end market rally. Ultimately we give more weight to the former since bullish sentiment remains high and is still trending lower.

Given where we are on the scale of “bearishness,” we should increasingly be looking for the “what could go right” scenario. In an environment where economic and earnings fundamentals remain robust and sentiment toward equities is nearing extreme pessimism, this sets up small-cap, and small cap growth stocks in particular, to benefit from their expected relative earnings growth (20% vs. large-cap’s 10% in 2005) as well as the valuation leverage as investors unwind today’s perceived downside risks in favor of “tomorrow’s” opportunities. Against this backdrop, we expect the companies that will benefit most are those expected to deliver the greatest growth in the future as investors time horizons begin shifting outward. In this light, we once again are highlighting our growth themes for 2005.

Themes for 2005:
Unwired – Mobile Wireless Remains Hot! The inflection point for the wireless food chain is just now being achieved. The continuing proliferation of wireless technologies, widespread adoption in emerging markets and the integration of more features is driving rapid handset growth. As consumers increasingly rely upon their mobile devices as complete personal communications devices, the need for more bandwidth, capacity and capabilities will drive increasing growth for handset vendors and leading component suppliers, as well as for companies providing innovative wireless applications and services.

VoIP – Leveraging the IP network. Total U.S. business adoption of voice over IP has risen from just 3% in 2003 to 12% in 2004. Among larger businesses adoption ranges from 34% in middle-market enterprises to as high as 43% at large businesses. Consumer adoption continues to lag, with just 2% of households currently subscribing to a VoIP service. By 2010 however, household VoIP adoption is expected to reach 75%. Businesses have been quick to recognize the cost savings and enhanced services of VoIP, while consumers have only recently begun to be targeted by advertising. In 2005, VoIP deployments should broaden and deepen within businesses, as they recognize the initial cost savings and move to adopt more IP based services such video conferencing, then user-to-user video calls (leading to XoIP, “everything” over IP). Consumer adoption should meaningfully accelerate as greater consumer recognition of potentially lower communications bills materializes as well as nascent demand for new IP-based services develops.

Nanotechnology – Emergence of the “Mini Me” Economy. Nanotechnology is being driven by the needs of several industries to tackle growing technology bottlenecks. In microelectronics it will be the only way to get more storage, memory and computational capacity in less space using less power. Industrial markets are requiring stronger and lighter materials. Medical markets are looking to nanotechnology for the delivery of medicine and diagnosing diseases. While in energy markets, nanotechnology-based products are already saving the U.S. 400 million barrels of oil a year.

Biotech – Turning “data” into Medical Solutions. Biotechnology continues to make sizable strides in the understanding and nature of complex biological phenomena, resulting in medical treatments and solutions for some of the largest problems in medical ailments. This remains an emerging opportunity, though even today increasing numbers of biotech firms are achieving profitability which is leading to increased interest by the mainstream investment community.

On-demand Software – Empowering Users, Delivering ROI. On-demand software is enabling companies to leverage outsourced applications and “pay-as-you-go” to cost effectively deploy software throughout businesses. This model has already gained substantial traction in CRM and is now poised to tackle increasing numbers of critical functions within the enterprise.

Consolidation – Eliminating the “One Product Wonder.” The consolidation trend will continue, most visibly in the software sector following the Oracle-PeopleSoft clearance in 2004. There simply remains too many publicly traded “products” in the sector which should continue to consolidate around suites of solutions to meet today’s business demands.

Social Networking – Peer Power! Creative mass marketing and peer-to-peer social networks continue to be on fire. Friendster, MySpace and LinkedIn continue to demonstrate the power of “peer power” and are redefining how companies target attractive market segments.

New Media – “My Media!” New consumer digital markets are being created and catalyzed as broadband, powerful but cheap devices and innovative business models digitize the consumer. The iPod, iTunes and the explosion in digital consumer devices are driving this trend, in the process opening new opportunities in areas such as “podcasting” and “podvertising.” Blogs are creating an explosion in user created content, “citizen journalism” and communities built by users, for users. RSS feeds are bringing web content directly to users without having to surf the net and finally empowering the elusive “push power” of the Internet.

Education – The Knowledge Economy. Education companies should continue to flourish as the knowledge economy continues to develop. The pay gap between somebody who has a high school education and a college education has more than doubled over the past 20-years, yet only 25% of the U.S. adult population has a college degree or better. Online education offers a unique and huge opportunity to close this gap through easier access to furthering educational attainment.

Open Source – Bust it Open, Watch it Grow! Linux traction in servers and data centers continues to proliferate, as “linux-based” technologies lower costs, reduce security risks and add stability to computing. This year, open-source applications built on the LAMP stack (Linux, Apache, MySQL, Perl/Python/PHP) will further drive open-source adoption. Mozilla Firefox is leading the way in consumer usage of “open source” with more than 23 million downloads of the browser since November 9th, and taking an estimated 5% market share from Microsoft’s Internet Explorer. The big surprise of next year could very well be the increased market share of open-source “office applications,” bringing open source desktop software to a “computer near you” as well as reinvigorate demand for Apple computers among those that “really want one, but can’t because of work.”

China – The Waking of Billions of Opportunities. 1.3 billion reasons to be excited about prospects in China. The sleeping giant of Asia continues to make economic and social progress, rapidly creating a mass of purchasing power in the region. There will be growing pains, but the opportunity ahead remains massive across virtually all sectors.

Posted by Mat Johnson at 08:57 AM | Comments (4)

February 04, 2005

ThinkMobile Services: Industry Update

The Chinese Internet – 2004 was a year that the chortals would soon like to forget. Marked by sanction after sanction, there was plenty of bad press to spread around and little to cheer. We are optimistic that 2005 will see far fewer negative events and investors will regain focus on the profitability and growth of the sector. The introduction of new rules and regulations enforced with harsh sanctions has substantially improved not only the quality of the content, but the business practices in the wireless VAS market.

SMS and the MISC Platform Transition: Despite its meteoric rise in 2003 and early 2004, SMS remains a challenging platform for the sector. The transition to the new MISC billing platform has resulted in increasing churn for the service providers. We believe that about half the provinces have transitioned already, but we do not expect to see a full transition until mid-2005. Despite this timeline, we believe that the majority of the damage to the industry is behind us and the remaining provinces are secondary and tertiary regions that will not result in substantial hurdles for the service providers. Even with some remaining transition risk to the SMS market, we believe that the SMS VAS market will return to moderate growth in 2005 and beyond. While the pundits predict the continued decline of SMS, we believe that looking at more advanced data markets worldwide will show that despite the adoption of new technologies, SMS DOES continue to grow, albeit at more conservative rates. We remain committed in our belief that 2004 was a transition year and that 2005 will see the return of modest growth.

2.5G Services: With the slow-down in growth of 2G SMS services, the industry is looking to new services and applications that leverage new 2.5G network technologies to reinvigorate growth into the sector. Despite this promising market, there is much speculation that the carrier will once again, look to grab a greater portion of the pie resulting in a smaller revenue share for the service providers. While the current revenue split is about 70/30, with 30% going to the carrier, it is important to understand that this split is off of the revenue generated by the subscription of the service. What this number does NOT include is the network access fee that is generated by the consumer. For example, WAP services require the consumer to go ‘online’ and that also generates revenues that are not part of the revenue split. If you include the network access charges generated by the consumer, the revenue split for that entire service shifts dramatically to 60/40, with 60% going to the carrier. It is important to remember that this is NOT a shift from the current revenue split, but adding incremental color to the existing revenue sharing relationship that is already in place. The carrier is already keeping the majority of the revenue and we believe that there needs to be incentive for these VAS providers to keep generating new content.

New MMS Regulations: China Mobile has instituted a new policy regarding the billing of MMS services. When a MMS message is sent from the wireless VAS provider to a consumer and the handset is not on (or in coverage), the message will reside in a mailbox for several hours and then be deleted. Wireless VAS providers will not be able to charge for the ‘undelivered’ messages and as a result, could potentially impact revenues from this service. As KONG has indicated, this could mean a substantial hit to revenues in the March quarter as these new policies take hold. We believe that the long-term effects will be nominal. These messages are delivered to consumers that have ‘opted-in’ for the service and we expect that consumers will most likely retrieve any awaiting messages once notified. Companies with the greatest amount of MMS exposure include KONG and SINA, but again, we would not view this as a long-term negative for the sector.

Carrier Revenue Share: While the revenue split between the carrier and the service providers have traditionally been set by China Mobile Corporate, this is now shifting to the provincial carriers. Going forward, it is expected that the provincial carrier will have the ability to negotiate with the service providers on the revenue split for these value-added services. While the critics have indicated that this would be negative for the group, our conversations with management have indicated that this would be neutral to positive for them. It gives them much greater flexibility in negotiating their revenue sharing, in particular, at smaller provinces where they have more control. We would not view this as a negative, but a neutral for the sector.

For the full report, please contact your ThinkEquity Partners sales representative.

Posted by Research at 11:52 AM | Comments (2)

February 01, 2005

IPO Dashboard - February 2005

We remain very positive on the IPO market for all the reasons we’ve written here in recent months and in our last issue of our Software Scorecard. In summary, these highlights are: strong recent operating performance from software companies, excess demand for new growth investments from the buy-side, and strong performance of recent tech and software IPOs.

We expect to see two or three software IPOs price this quarter and are aware of numerous software companies that are currently actively planning to kick off the IPO process very soon in order to price a deal this summer. We are watching carefully for any signs of change, but we still believe 2005 will be a breakout year for software IPOs.

IPO Dashboard

Posted by ThinkEquity News at 02:14 PM | Comments (0)