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January 28, 2008

Two Sides of a Coin

In formal education, there are precise definitions for occurrences which are meant to make things black and white.

For example, a "correction" is when stocks fall between 10-20% from their 52-week high. A "bear market" is when stocks fall more than 20% in a year. A "bull" market is defined as a period when the market has increasing investor confidence, motivating investors to buy in anticipation of further capital gains.

This week we experienced all three types of markets with the NASDAQ hovering around 20% decline looking as if it will fall further into the Abyss - especially after Ben "Crash" Bernanke lowered rates on Tuesday morning by 75 basis points and stocks proceeded to drop like a rock. Wednesday, through no magic other than the natural contra move to pure panic, stocks swung from the Dow being off 300 points to closing nearly up 300 points.

The classical definition of a recession is a decline in Gross Domestic Product - GDP - for two or more successive quarters. A depression is a more sustained period of negative economic activity - for example the Great Depression that lasted from 1929 until 1933 and resulted in a GDP drop of 33%. The last depression that the United States experienced was from 1937 to 1938 when GDP dropped 18.2%.

The man-on-the-street definition of the difference between a recession and a depression typically is: a recession is when your neighbor loses his job; a depression is when you lose your job.

The academic definition of "volatility" is "the pace at which stock prices move higher or lower." If a stock is more volatile, it is also more risky. The real world definition of volatility is the market that we are in.

To give some perspective of this, a 1% move in the market in a day is usually considered significant. The point is obvious but consider if the market was up 1% a day for a year - it would be up a total of 1,242%, conversely, if the market was down 1% every day, it would be off 93% for the year.

In 2006, the market had 18% of its days with 1% or greater movement. In 2007, it was 33%. In 2005 it was 22%. Year-to-date, 74% of the days have had 1% or more movement. In this past ten years, only "crazy" year 2000 had more 1% or greater days at 76%.

The Chicago Board of Trade has a Volatility Index which shows the market's expectation of 30-day volatility. The VIX is a widely used measure of market risk and is often referred to as "the market fear gauge."

In the past five years the VIX average was 17.9% and the ten-year average was 20.4%. Currently, it's at 29.08%, or nearly 50% above the ten-year average and 43% above the five-year average.

Most people typically look at volatility as being negative and scary. While extreme volatility definitely is a "courage call" - it really creates opportunity and is a friend of the long-term investor, in our opinion. We believe having deep knowledge on the fundamentals of companies is a key asset during periods like the one we are experiencing.

We believe the problem for most people is that they have superficial knowledge of stocks they own; therefore when the prices drop they may think that others know something that they don't - they may extrapolate their worst fears into what might occur and they sell precisely when they should be buying. The things that I ask our analysts when we go into periods like this are:

• Forget about valuations for a minute!
• Focus on companies that we have the strongest confidence in based on fundamentals; which companies have the best management team, which have the best products, the highest potential, and the greatest predictability - the four Ps!

The follow-up question we ask is on which companies they have the least amount of confidence in, or in other words, which companies have the "poorest" four Ps?

Buying the best companies "on sale" is usually always a great long-term strategy, in our opinion.

Looking at the final score card for the week one may not appreciate the extremes that went on. For the week, Russell 2000 advanced 2.3%, the Dow was up 0.9%, the ThinkGrowth Index was up 0.8% and the S&P 500 was up 0.4%. NASDAQ and NASDAQ 100 finished both negative, down 0.6% and 3%, respectively.

In our opinion, we are definitely in a period where one has to fasten the seat belt and make sure the hands are firmly on the steering wheel; but opportunity abound for the long-term growth investor.

Posted by Michael T. Moe at 07:43 PM | Comments (1)

January 21, 2008

3 Below at Lambeau

Having grown up in Minnesota, I used to look forward to football in December when the wimps from a southern team like the Cowboys would come up to the frozen tundra to play my Vikings.

While both teams had to deal with the brutal conditions, the advantage was always to the home team - partially because Bud Grant and the "Purple People Eaters" knew how much the opponents hated dealing with the cold (and often snow).

The playbook that had been used the whole season could basically be thrown out the window as just snapping the ball could be a challenge - forget about a wide-open offense or anything that required precision.

From 1970 to 1977, the Vikings played in four Super Bowls and lost them in warm weather venues. In perhaps one of the dumbest strategic moves, the owners of the Vikings moved the team into the climate controlled Metrodome in 1982 and haven't been to a Super Bowl since.

The weekend's NFC Championship matching the New York Giants versus the Packers at Lambeau Field in Green Bay is a flashback to the epic battles I remember as a kid. It's forecasted that game-time temperature is expected to be around zero with a possibility of snow. Usually in these types of situations, you "win" by not "losing." No fumbles. No interceptions. No foolish penalties all trump trying to be a hero.

So far in 2008, the market has been frigid with blizzards and avalanches being an everyday occurrence, in our opinion. Stocks have corrected 14% since December 26, 2007. The S&P 500 is at a 15-month low, and the Dow and NASDAQ are at 10-month lows.

We believe the overarching culprit is the fear of a recession and everyday's gloomier data confirms this probability. Bearish data included the Philly Fed Factory Index which sank to the lowest level since October 2001. Fed Chairman Bernanke's testimony to the House Budget Committee didn't help as investors want the action as opposed to words, in our view.

Part of what's frustrating for us is our thesis that during a slowing economy, companies with the strongest organic growth will be awarded a premium. This has worked out well until recently. Analyzing companies that in our view have superior growth characteristics have been hit especially hard. Since January 1, Google is off 13.2%, Apple is down 18.5%, First Solar has collapsed 34.2%, and GigaMedia is down 15.7%.

While it's tempting for us to get more conservative in our stock selection or to go to the sidelines until the future looks clearer, we believe the hard fact is that the future is never clear and that opportunities are created when people are the most negative. People couldn't be more negative than they are right now, in our opinion.

For the past twelve years, I have published an annual study that lists the top 25 performing companies over the last ten year time period. We use the FactSet database that includes over 10,000 stocks from 1997 to 2007. While it's interesting who makes the list, what's more interesting is how they got there.

For the second year in a row, Hansen Natural (NASDAQ: HANS, $40.97 - Not Rated) was the top performing stock rising a staggering 19,449%. Amazon (NASDAQ: AMZN, $79.76, Buy - Price Target: $110), Business Objects (NASDAQ: BOBJ, $61.39, Accumulate - Price Target: $45)

Amazon (NASDAQ: AMZN, $79.76, Buy - Price Target: $110), Business Objects (NASDAQ: BOBJ, $61.39, Accumulate - Price Target: $45)

The average stock on the top 25 list appreciated 39% per year, or more than doubling every two years, and was up more than 35x since 1997. The average P/E for the top 25 companies was 31.2x, or more than double the current market P/E. What offset the absolutely high P/E was earnings growth that averaged 36% CAGR for the top 25. The average market cap at the beginning of the period was $382 million and the median market cap was $130 million.

Our conclusion is that if we are trying to pick the companies that will appear on this list 10 years from now - as always - we should:
1) Focus on companies with the highest growth potential, not the bargain basement; companies with the best growth fundamentals are often expensive.
2) Focus on small cap companies as size forges an anchor.

What do we like as companies we think have the potential to be in the class of 2007 to 2017?

Posted by Michael T. Moe at 11:41 PM | Comments (0)

January 14, 2008

Cha Cha Changing

It seems the dominant theme of the moment is change.

Being "on message" for a presidential candidate means talking about change. Barak Obama's campaign slogan is "Stand for Change" and Hillary Clinton's is "Ready for Change." Debates center on who will really be for the most change which Senator McCain latched onto ceding Mitt Romney as "truly the change candidate," but not for flattering reasons.

2008 to date has reflected a significant change in the market. We believe that while 2007 was an Alfred E. Newman "what, me worry?" market - 2008 is a Henny Penny "sky is falling" market. Issues that have been in full sight but largely ignored have now become the villains for falling stocks. Year-to-date, the previously leading NASDAQ 100 is down 8.3% and cash has become king.

With the "unofficial" economist of the U.S., Goldman Sachs (NYSE: GS, $198.74 - Not Rated), changing its economic outlook to now forecasting a recession, the official Fed chairman, Ben Bernanke, said that he was ready to "take substantive additional action as needed to support growth (and avoid a recession)." Investors believe this means a 50-basis-point change in the discount rate this month. When investors see Bernanke "walking the walk" instead of just "talking the talk," it might mean something. In the meantime we are likely to have more choppy waters.

Speculators have been putting on "recession trades" for the past six months. For example, a group we have liked for more than a decade is the education sector and for the past six months, this historically recession-hedge group has traded up 11%. Leading education stocks, which include Apollo Group (NASDAQ: APOL, $76.81, Accumulate - Price Target: $80), DeVry (NYSE: DV, $55.42, Accumulate - Price Target: $58), New Oriental Education (NYSE: EDU, $79.61 - Not Rated), Capella Education (NASDAQ: CPLA, $66.38, Accumulate - Price Target: $78), and American Public Education (NASDAQ: APEI, $42.03, Buy - Price Target: $55) are up 25%, 61%, 37%, 56% and 17%, respectively.

As John Authres noted in his Short View in the Financial Times, going long bonds would have netted 10% and shorting the S&P 500 would have returned 9.5% since July 19, 2007. Going long utilities and shorting financials would have provided a 31.3% return in that period. Alas, if past was prolonged for future, the Forbes 400 would be made up of librarians.

In fact, we believe looking at the past three recession periods doesn't provide any clear patterns for stock action, except for the six month after the recession, when stocks have gone up. During the recession, we think it's anybody's guess to mark a direction from the historical data, and before the recession we are provided with mixed data as well.

In our opinion, it would be untrue to say that the undesirable action in leading stocks, the talk of a recession or even a depression, and other perils in the world cause us to question our bullish bias - they do. But before we sell Google (NASDAQ: GOOG, $638.25, Buy - Price Target: $800) to buy Gold, it is important to remember that when the pain is the greatest, it is the time when we get the greatest gain.

In our view, investors' sentiment is awful (which is good). We believe valuations are attractive on an absolute, relative (and in some cases revised) basis and the fundamentals for leading growth companies generally are still very good.

As we said for some time, an economy which is slowing down and perhaps in recession, companies that have strong organic growth should receive outsized investors' attention. In other word, in a world where growth is scarce, it will receive a premium. The fact that many of the companies with the most outstanding growth fundamentals were put on "discount" at the beginning of the year - like an unsold Christmas sweater, provides long-term investors with a post-holiday gift, in our opinion. Accordingly we continue to recommend buying growth companies with the strongest fundamentals that were put on "sale."

Posted by Michael T. Moe at 06:50 PM | Comments (0)

January 02, 2008

Inside the Sausage Factory 2008

I always look forward to New Years as it represents a fresh start and a time to make new resolutions and predictions for the upcoming year. To look ahead, it's important to review where we've been; and 2007 was quite a year.

It's unlikely that many market prognosticators would have predicted that we would have an up market for the fourth year in a row if they knew that we would experience: 1) the bursting of the housing bubble; 2) a credit crisis driven by subprime lending debacle with over $100 billion of loan write downs; 3) the financial services sector being off over 20%; 4) a plunging dollar; 5) corporate earnings that were negative for the third and fourth quarter; 6) oil prices at $100 per barrel; 7) inflation proxy gold at record levels; 8) economists handicapping a recession at nearly 50% probability; 9) the President and Congress with all-time low approval ratings; 10) continued chaos in Iraq, Afghanistan, Israel, Iran, Palestine, Pakistan, etc.

In fact, if we would have known that going into 2007 and believing the aforementioned would be what we would experience, a betting person would have shorted the world. Heck, I might be one of the most optimistic people you could find anywhere, and I may have shorted the world if I knew then what I know now. We believe the market - in its classically perplexing nature - acts in a way that confounds most people and inflicts the most pain. In our view, 2007, as we know now, was a good year for equities and a great year for growth stocks.

For the year, the proxy for global technology, the NASDAQ 100, led all domestic indices we track and was up 18.7%. The ThinkGrowth Index - made up of the 300 fastest growing projected companies - advanced 16.9% and the Investors Business Daily 100 (for $1.25, we think the IBD is the best bargain anywhere besides ThinkThougths!) was up a staggering 44%. NASDAQ advanced nearly 10% followed by the Dow at just over 6%, the S&P 500 was up 3.5% and the previously leading Russell 2000 was actually down for the year off 2.7%.

As we are becoming accustomed, while the U.S. had a pretty good year, the action was really outside of the United States and particularly in the B.R.I.C.s. For 2007, China's Shanghai exchange was up 96.7%, Hong Kong advanced 39.3%, India's BSE 30 was up 47.1%, Brazil's Bovespa was up 43.1% and Russia's RTS advanced 19.2% - another good reason for Time to name Tsar Putin "Man of the Year". We think, while it's quaint, especially at this time of year, to long for the good old days when the United States was the only place you needed to invest and you could find all the opportunities that mattered between San Jose and San Francisco, those times are as historic as a typewriter. One only has to look at the economic growth of counties around the world and soaring GDP per capita versus the pedestrian growth in the United States and stagnant per capita GDP growth to understand the reality.

Looking at individual top-performing stocks and groups, we observed that the dominant themes were Solar, China and the Internet, with First Solar as the MVP up 791% for the year and SunPower was a "distant" runner up advancing 260%. Looking at the worst performers, obviously companies that had exposure to home lending or real estate were negatively affected but the worst performers mainly were due to company specific issues and not the macro environment surrounding them - in other words - bad execution.

Analyzing the IPO market can provide valuable clues to what is "hot", coming up over the horizon and the general sentiment for investors at buying "futures," in our opinion. Despite 2007 being what we think was a great year for growth companies, it was just a pretty good year for IPOs, with 284 new issues with only 54 (19%) of those being VC backed. For historical reference, the last time we were in a bull market for growth companies - the 1990s - there were over 500 IPOs a year on average and about 50% of those were VC backed. The good news is that the market receptivity for many of the 2007 IPOs has been strong with the average IPO trading up 9.1% in the first 30 days following its offering and up 13.5% on average offer-to-current. Moreover, rocket ships such as JA Solar (+365%) (NASDAQ: JASO, $69.81 - Not Rated), Yingli Green (+252%) (NYSE: YGE, $38.70 - Not Rated) and VMWare (+193%) (NYSE: VMW, $84.99, Source of Funds - Price Target: $90) are new leaders that provide oxygen for the market to move higher.

The historical context creates a base to develop a forward framework. Before we look at 2008 trends and themes, I do an exercise of thinking of what's hot and what's not - usually I don't take my readers through the "sausage factory" but this might be the start of a new holiday tradition. So here we go with our view of what's hot and not:

We believe the next stop in the sausage factory for great ideas in 2008 is to evaluate what the megatrends in the marketplace are and how these megatrends impact the emerging trends that we see in the growth sectors we focus on; this is where we will likely find the biggest ideas of opportunity. As Dick Clark of American Bandstand fame said, "I don't set trends. I just find out what they are and exploit them." Megatrends are powerful technological, economic and social forces that develop from a groundswell (early adopters), move into the mainstream (mass market) and disrupt the status quo (mature market) - driving change, productivity, and ultimately growth opportunities for companies, industries, and entire economies.

In our view, megatrends play a key role in how social, economic, technological and political changes take hold and as we look backward through history, their effects can be easily seen. We believe the key part about a megatrend is that it is long lasting and has consequential impact. For example, globalization is not a new megatrend but its impact on business, politics and social issues is growing.

We believe the largest market opportunities are those that are creating on the frontier of the economy, where change at the edge leads to wide-scale change within the economy. Megatrends effectively create a tailwind at the back of emerging industries. The tailwinds typically accelerate the opportunity and provide fundamentals to grow at a high rate for a long time. The megatrends we see today include: globalization, the knowledge economy, the internet, consolidation, branding, demographics, outsourcing and green.

The last stop at the sausage factory is where we develop investment themes which typically are the result of what's been going on previously. The 2008 investment themes we highlight are Solar/Green Technology, China, Web 3.0, Software as Service, Open Source, Healthy Wealthy and Wise, The Phone is My Life, Knowledge Power, Whole Health, L.E.D. and Virtualization - it's from these themes or scenarios that we think the biggest winners will be found.

Solar/Green Technology - great investment opportunities are generally found where there is a problem. The bigger the problem, typically the bigger the opportunity; whether oil prices are $100 or $60 or 20$ per barrel, the fundamental problem is that there is a finite amount of oil. Additionally, being dependent on foreign suppliers for our energy needs is unacceptable, especially when you consider the suppliers are in some of the most volatile/hostile places on the planet. In our view, this and global warming and you have a gigantic problem with dirty, old oil and a gigantic opportunity with green alternatives.

The Phone is My Life - If you want to understand where the future is going, study your kids. The cell phone is how many teenagers express who they are. Increasingly, we see that the cell phone is replacing the computer as kids' means to get information, entertain themselves, and communicate - basically how they live. In fact, the phone has become the computer.

Software as a service - the ubiquity of broadband and wireless networking has changed the nature of how people interact, and they're increasingly drawn toward the simplicity of services and service-enabled software that "just works" - in our opinion. We believe, always having the latest and greatest for the customer and the predictability for the company and you have a better model and better company.

China - ambitious young people from around the globe are flocking to Shanghai and Beijing, in our view, much as they did to San Francisco in the California Gold Rush of 1894 or the Internet frenzy of the 1990s. The upcoming summer Olympics coming in Beijing will provide one more reason for China to be on the forefront of tomorrow. 1.3 billion Chinese with a rapidly growing middle class and this is going to be an important investment theme for the next 50 years.

Healthy, Wealthy, and Wise - with a population that's getting older, is more affluent, and is more knowledgeable as a nation, there will likely be increasing opportunities for service and product companies that help people feel younger. Life-long learning, financial services and travel are all part of this demographic theme.

Knowledge Power - in today's economy, knowledge workers typically form the cornerstones of successful businesses, emerging industries, and economic growth. In this new environment, however, the labor force is presented with an unprecedented challenge as it must continuously upgrade its skills to keep pace with innovation as companies increase their R&D expenditures. We think human capital replaces physical capital as the competitive advantage for knowledge businesses.

Virtualization is a broad term that refers to the abstraction of computer resources. One useful definition is "a technique for hiding the physical characteristics of computing resources from the way in which other systems, applications, or end users interact with those resources. This includes making a single physical resource (such as a server, an operating system, an application, or storage device) appear to function as multiple logical resources; or it can include making multiple physical resources (such as storage devices or servers) appear as a single logical resource." It can also include making one physical resource to appear, with somewhat different characteristics, as one logical resource. VMware is in our opinion the poster child for this theme.

A light-emitting diode (LED) is a semiconductor diode that emits incoherent narrow-spectrum light when electrically biased in the forward direction of the p-n junction, as in the common LED circuit. This effect is a form of electroluminescence. We think LED also plays into the broader greentech theme.

Open Source is somewhat inevitable, in our view. It returns the control to the customer and the code is open and transparent. Hence, users can see it, change it, and learn from it. User-generated content and social networking are a major part of this theme. In our view, it's all about the wisdom of crowds or the network.

Web 3.0 is a term that is used to describe various aspects of the evolution of Web usage and interaction along several paths. These include transforming the Web into a database, a move towards making content accessible by multiple non-browser applications, the utilization of artificial intelligence technologies, the Semantic web, the Geospatial Web, or the 3D web. We think web 3.0 obviously builds off of the success of Web 2.0 which is that the internet is becoming the dominant platform for information, commerce, education, communication and services.

Whole Health is a theme about people wanting to live more natural, spiritual, and satisfying lives; this includes trends such as a combination of eastern and western medicine, the growth in religious products, wellness, and wellbeing. We believe the growth in Yoga, organic food and Christian music are all evidence of this theme.

Here's to a healthy, happy and prosperous 2008!!!!

Posted by Michael T. Moe at 04:59 PM | Comments (1)