Reader Feedback
Posted by Eddy Elfenbein on January 12th, 2006 at 12:18 pm

One of the many benefits of this blog is the feedback I get from my readers. Here are a few interesting e-mails that I received over the past week. If you have any questions or comments, please drop me a line.
The first e-mail is in response to one of my many rants against share buybacks:

Share buybacks give an investor the option to receive cash (by selling some portion of their shares) or to own a larger portion of the company. Pre-tax considerations, it seems that an option to receive cash is superior to just getting the cash, no?

In theory, yes. But keep in the mind an important factor: the shareholder must take on some risk. Money used to buyback a stock will not always have the same effect as getting cash. Over time, it will. But in the short-term, there’s a risk factor that’s not present with a cash payout.
The ROE of a stock will in theory match the stock’s return after awhile. But even the least volatile stocks are volatile, so we have to shoulder some risk in the process. (Of course, sometimes the volatility works in our favor.)
Ideally, I’d prefer to not have to deal with taxes, and get a cash payment. Then I could decide if and when I reinvested the funds in management. I think that would be best for the shareholders, and accountability.
The is in response to my post on valuing Berkshire Hathaway (BRKA):

Berkshire’s non-insurance businesses are much larger than most people realize (e.g. your comment that BRKA is mostly an insurance company). In fact, in 2005, nearly 2/3 of Berkshire’s revenues were non-insurance (~65% thru 9/30/05). The profit contribution varies due to the cat losses on the insurance side, but less than half of BRKA’s recent earnings come from insurance.
If Berkshire’s non-insurance businesses were publicly traded, they would be one of the largest companies in the SP500. One issue the NYT article and yours didn’t mention is that BRKA’s disclosure on these large business – which are now a majority of revenues and earnings – is poor. That, along with the Buffett issue, weigh on the stock’s valuation, in my view.

That’s an excellent point.
In resonse to Mark Stahlman giving Google (GOOG) a $2,000 price target:

I think the most compelling reason behind Stahlman suggesting a target price is also the most compelling reason to sit on the sidelines of Google. It was written in the last paragraph of the article.
“Stahlman said his prediction was designed in part to comfort investors concerned by Google’s rapid ascent.”
Hmmmmm. Will he be there to comfort investors during Google’s rapid decent?

Exactly! Wall Street doesn’t turn to analysts for comfort. That’s been alcohol’s job for over 200 years.
And lastly, here are some comments on the news of the Dow passing 11000:

Could there be any more irrelevant index than the Dow? Made up of basically of 30 behemoths that were yesterdays news. They put stocks like Intel and Microsoft in at the very top of the bubble and have done little sense. They keep companies like GM until it will likely goes bankrupt. A very mismanaged group of 30 stocks that tell you little about where the growth of America is. It does a worse job every year.
I really wish people would stop quoting it.

Agreed!
Here’s my rant on that very subject.

Shares of Gazprom Soar
Posted by Eddy Elfenbein on January 12th, 2006 at 9:21 am

The Times of London reports on the Russian energy giant:

SHARES in Gazprom, the Russian energy company in which the Kremlin owns a 51 per cent stake, have soared 17 per cent in the past three days after Western investors were given the green light to purchase as much as 29 per cent of the business.
From this week foreign investors can trade in Gazprom’s locally listed shares, giving them access to 49 per cent of the company, after President Putin finally unveiled his long-awaited liberalisation of Gazprom’s equity structure. Previously, foreign investors could have legally traded only in the small amount of Gazprom shares listed abroad. Braver investors could have bought and sold locally listed shares through “grey trading schemes”, but big Western investors steered clear of these.
At a stroke, the liberalisation of Gazprom’s equity has created the biggest and most liquid stock in emerging market indices, meaning that billions of dollars from index-tracking institutional investors will now flow into the company. The stock rose 160 per cent last year in anticipation of the move, and has risen a further 17 per cent this week.
Bob Foresman, head of investment banking at Dresdner Kleinwort Wasserstein in Moscow, said: “It’s no surprise (that) foreign investors find the stock so attractive. It’s the biggest hydrocarbon company in the world and, as of this week, foreign investors can finally get proper exposure to it.”

Here’s a three-year price chart for Gazprom.

SEC opens informal probe into Home Depot
Posted by Eddy Elfenbein on January 12th, 2006 at 9:15 am

From Reuters:

The U.S. Securities and Exchange Commission has opened an informal investigation into charges that Home Depot Inc. (HD) inflated profits through supplier payments meant to cover the cost of damaged merchandise, the New York Post reported on Thursday.
The top home improvement retail chain is accused of inappropriately using so-called “return-to-vendor charges” by overbilling suppliers for goods damaged during shipping, the newspaper said.

Update: HD says that it’s “simply not true.”

The Alito Volatility Index
Posted by Eddy Elfenbein on January 12th, 2006 at 5:43 am

Time for a really geeky post! Feel free to skip if you’re a mathphobe.
As I’ve mentioned before, I’m a fan of TradeSports.com. This Web site let’s investors buy “futures contracts” on real world events. In addition to many sports and political events, they also have contracts on the nomination of Judge Samuel Alito to the Supreme Court.
There are currently two sets of contracts on Alito. One is simply “Will Alito Be Confirmed?” That contract is currently running at 94.5%. So the market seems pretty confident that he’ll pass.
The other is a set of six contracts asking how many votes will he get (over 40, 50, 60, 70, 80 and 90).
What I find interesting in these markets is that you can look at two different contracts and find an “implied contract” for a separate event.
For example, Donald Luskin and I discovered that during the (brief) Meirs nomination, the contract for her getting more than 50 votes was trading much higher than the contract for her passing. The reason is that the number-of-votes contract was only if she came up for a vote. That means that there was an “implied withdrawal contract.” (Details here.) And withdraw she did.
These sorts of number games are actually quite common on Wall Street. That’s exactly what the volatility index (or VIX) is. It tells us the implied volatility of the S&P 500. In options pricing, volatility is a key variable. So we can look at the price an option and work backward to the volatility number that traders are using.
Personally, I don’t take these futures markets too seriously. Mostly, I think they’re just for fun. Real markets need to be much more liquid. Also, there’s too great a temptation for partisan interference.
Having said that, we can look at the futures for how many votes the market believes that Judge Alito will get. Plus, we can find some interesting observations.
Let’s look at two of the contracts: Alito receiving over 60 votes, and Alito receiving over 70 votes. The contract that Alito will get over 60 votes is priced at yesterday’s close at 74, meaning that the market believes that there’s a 74% chance the Judge Alito will get 60 or more votes. The 70+ vote contract is currently priced at 16.
Using these two numbers we can find the market’s mean and standard deviation for Judge Alito’s final confirmation vote. (Warning: math ahead!)
Here’s what we do:
Since there’s a 74% chance the Alitio will get 60 or more, the normal distribution tells us that a 74% chance is equal to the mean plus 0.64 standard deviations. A 16% chance works out to the mean minus 0.99 standard deviations. So the 10 votes between 60 and 70 is equal to 1.63 standard deviations. Ten divided by 1.63 equals 6.1 senators which is the standard deviation. That’s our Alitio Volatility Index, or ALIX (copyright, me!).
The mean number of votes is 60 + (0.64*6.1) or 63.9. So the market believes that Judge Alito will get 63.9 “aye” votes with a standard deviation of 6.1 senators. Assuming a normal distribution, this means that there’s a 68.3% chance that Alito’s vote total will fall between 57.8 and 70 votes.
Here’s a chart of the implied standard deviation of the Alito vote. This line will probably fall as senators gradually make up their minds:

Here’s the mean vote (black line). The red lines represent plus and minus one standard deviation:

I downloaded the price data off TradeSports’ Web site. You can download my excel file here.
Since the vote on Judge Alito will eventually come (assuming these windbags finally stop talking), the standard deviation number should gradually fall. This can happen even though the mean doesn’t change much. Every day on Wall Street, billions of dollars is invested in volatility. There are investors who don’t give a fig where the market goes, but they’re passionate that it does it smoothly (or erratically).
(Technical note: The real VIX is a weighted-average of several options contracts. I’m only using the 60+ and 70+ contracts.)
It seems that there’s a fairly solid bloc of about 35 votes dead set against Judge Alitio. However, the one-standard-deviation-below-the-mean line has nudged up a little since the hearings started. This may indicate that a few “maybe” votes have drifted over to the “aye” camp.
See, I told you this was a geeky post.
Update: Thanks, Ramesh! The 60+ contract moved up to 75 (a recent high), and the 60+ contract is now up to 22. That moves the mean vote total up to 64.7 with a standard deviation of 6.9 votes.

The Market Today
Posted by Eddy Elfenbein on January 11th, 2006 at 5:00 pm

Today was a perfect lesson on the benefits of diversification. We beat the market for the third straight day. The S&P 500 went up 0.35%, and our Buy List was up 0.56%. Ten of our 20 stocks went up, but the individual performances were very uneven. Biomet (BMET) was up 2.4%. Home Depot (HD) and Golden West (GDW) both rose about 2.8% (GDW made another new high). And Varian Medical (VAR) was our big winner, rising 4.2%.
Outside our Buy List, Genentech (DNA) fell 4.4%. Frontier Airlines (FRNT) continued to plunge. It’s now down to $7.89. The stock is probably trading around 10 times next year’s earnings. Google (GOOG) made finally cracked $475 a share today. General Motors (GM) fell 20 cents to $21.86 a share.

Mylan Labs and Cogent
Posted by Eddy Elfenbein on January 11th, 2006 at 3:17 pm

Here are two stocks that I’ve been keeping an eye on lately, Mylan Labs (MYL) and Cogent (COGT). I’m not recommending them, but I think both have compelling stories, and they’re well worth watching.
Mylan is one of the largest generic drug companies. If you’re not familiar with the generic drug biz, the people who work there print money all day, then they go home. I’m skipping over some details, but that’s the basics.
Mylan has been a huge winner of the past few decades. You could have picked up a share of MYL for less than a penny 30 years ago (post many splits). Since then, the stock is up over 200,000%. Today, the shares are about 30% off their all-time high. By my estimate, Mylan is going for about 18 times this year’s earnings. Not bad.
The company has had some sluggish earnings reports lately. Sales dropped slightly as increased competition has squeezed prices. Sounds a lot like Dell (DELL).
Cogent is normally the kind of stock I avoid. The company makes fingerprint identification technology. I hate “story” stocks. The only story I want to hear is “they make gobs of money.” Cogent does that too.
This is from Gene Marcial in Business Week:

Business at Cogent, a provider of automated fingerprint and other biometric identification gear to law-enforcement agencies, has been on a tear: Sales vaulted from $13 million in 2001 to $88 million last year—and are estimated to have nearly doubled, to $160 million, in 2005. But the stock has been in a downspin since August when it was at 33. Now at 25, the stock was hit when Cogent failed to win some contracts in Latin America. But the drop, says Marion Schultheis, managing director at J.&W. Seligman, is a classic buying opportunity thanks to Cogent’s long-term growth potential. She expects it to win new contracts this year. Cogent, she notes, has a chance to be awarded a part, if not all, of a major four-year biometric upgrade at the FBI valued at several hundred million dollars. Julie Santoriello of Morgan Stanley, who rates the stock “overweight,” notes in a report that she sees $203 million in new contracts in 2006. She expects Cogent sales to jump to $251 million this year. Some 66% of Cogent’s estimated 2006 sales are already booked, she says. She figures Cogent earned 71 cents a share in 2005 and should make 95 cents in 2006, up from 38 cents in 2004.

Cogent is definitely one to watch.

Whither GM?
Posted by Eddy Elfenbein on January 11th, 2006 at 1:28 pm

In 1979, the British economy was in free fall. Inflation was spiraling out of control. The unions were demanding commensurate pay increases, and when they didn’t get them, they struck. The country that had stood up to the Luftwaffe was failing apart. The garbage men went on strike and soon piles of “rubbish” dotted the countryside. Even the gravediggers went on strike and corpses were gruesomely left unburied.
The winter of 1978-79 was called the Winter of Discontent, echoing the opening lines of Richard III. The situation was so bad that Her Majesty’s government had to apply for a loan from the IMF. This was back in the days when that had some sense of shame to it. You were even expected to pay it back.
A reporter asked the Prime Minister, James, Callaghan, his opinion of the “the mounting chaos in the country.” Callaghan said: “Well, that’s a judgment that you are making. I promise you that if you look at it from outside, and perhaps you’re taking rather a parochial view at the moment, I don’t think that other people in the world would share the view that there is mounting chaos.”
That was it. British socialism died right there. The commanding heights were nothing more than a literal heap of trash. The next day, The Sun‘s headline read: “Crisis? What Crisis?”
I can’t help but think of the similarities between British socialism and General Motors (GM). Once upon a time, GM ruled the world. Today, it’s an embarrassment. What’s good for GM, is largely irrelevant to America.
For reasons unclear, billionaire Kirk Kerkorian sunk a good part of his fortune in GM’s stock. His investment has been a disaster. Now’s he’s sent his aide, another son of York, Jerome York to be exact, to Detroit to tell the automaker everything they’re doing wrong. The New York Times quotes York as saying: “The time has come to go into crisis mode and act accordingly.”
No, the time to go into crisis mode has long since past. GM is a fiscal black hole. The company burns through $24 million a day. That’s more than the Yankees. Yet the company still pays out $566 million a year in its dividend. Crisis? What Crisis?
Talk about unburied corpses. I honestly don’t think GM will survive this decade. Even if it does, it will hardly be recognizable. Any future GM will merely be a Commonwealth living in the shadow of a by-gone Empire. York’s plan is to get rid of the dividend and reduce the pay of senior management. Well…that’s a nice start, but I think GM will have to go a lot further; perhaps ditching some of its key brands like Hummer.
The New York Times quoted Frederick A. Henderson, GM’s new CFO:

“To be honest, I am in crisis mode. So I agree with him,” Mr. Henderson said. In December, he succeeded John M. Devine, now a G.M. vice chairman, who accompanied him to Mr. York’s speech. Like Mr. Devine, Mr. Henderson watched impassively while Mr. York spoke.

Impassively? Ha! I bet they were ready to toss him out the window. I’d actually feel much better if GM were really in crisis mode. They’re not. They’re sleepwalking. Perhaps now, they’re sleeprunning. This is a company that plainly refuses to see reality. They’d be plenty happy to go on ignoring the mess they’ve made, but high oil prices forced the issue. The long-run was much shorter than any of us expected.
The idea that GM can discount its way home is a foolish illusion. The facts are clear. Every GM car carries about $1,500 in health care costs. The employees’ health care trust has over $20 billion, and GM had to tap it twice recently. For $1 billion each time. Retirees outnumber current U.S. employees 2.5 to 1. The company has stopped providing earnings guidance.
GM’s problem isn’t cars or legacy costs. Companies can deal with those. What GM has is a leadership crisis. They need to make major changes soon. If not, the Winter of Discontent will last a very long time.

Oracle’s Debt Offering Is a Hit
Posted by Eddy Elfenbein on January 11th, 2006 at 7:16 am

Oracle (ORCL) made its first trip to the bond market this week, and its debt quickly sold out. That’s good news for Larry & Co. I admire Oracle a lot but I’m nervous about its growth-through-acquisition strategy. That almost always means trouble, still I think Larry Ellison is one of the few people who can turn the trick. But it ain’t gonna be easy.
The software giant has been on a buying binge lately (Seibel, PeopleSoft, Retek, and that other one). Oracle is a truly remarkable company. It generates ginormous amounts of cash. They don’t pay a dividend, and the stock hasn’t done much of anything for the last few years. I think they saw that they had to do something. And quick.
The acquisitions went well, but now Oracle has to pay for them. The company’s debt offering came in three sections. The first part was for $1.5 billion at three years. The next was for $2.25 billion of five-year bonds, and finally $2 billion of 10-year bonds. That’s’ called laddering—it lowers your risk. In the secondary market, the bonds traded at a premium. This is clearly a vote of confidence in Oracle.
As I’ve mentioned before, there’s a bear market going on in the price of risk. The bond market is notoriously splenetic. If they saw something they didn’t like, you’d know about it. I think the bond traders jumped at something—anything that was paying a premium over government debt. It looks as if Oracle picked the right time to issue its debt. I can’t think of a similar tech stock that has had a major bond offering.
Oracle’s game plan still has a ways to go, but this debt offering is a good start.

Google Watch
Posted by Eddy Elfenbein on January 11th, 2006 at 6:43 am

Robin Arnfield writes that Google (GOOG) is being criticized (rightly) for using its own digital-rights management system to control the distribution of copyright-protected videos in its new Google Video Store:

Google announced the Google Video Store last week at the Consumer Electronics Show (CES) in Las Vegas, Nevada. Google’s own proprietary DRM technology represents a challenge to existing DRM systems from Microsoft and Apple, also used to control video distribution over the Internet.
By creating yet another DRM system, Google is restricting rather than enabling the distribution of content over the Internet, critics say.
Commercial Content
DRM is necessary to protect commercial content that Google intends to sell via Google Video Store. CBS shows, National Basketball Association games, Charlie Rose interviews, and vintage episodes from old television series are among the content that will be on sale once the store opens.
To use Google Video Store, viewers will need to install a Google Video application on their Windows-based computers.
The use of yet another DRM scheme would not have generated such a debate were it not for the growing desire of consumers to watch video on devices other than their computers. While a personal computer can carry many kinds of programs to play videos using content-protection software from most any provider, playing video content on mobile devices is impossible if that content is protected by a particular DRM scheme that the mobile device can’t understand.
Mobile phones, iPods, game machines, and portable-DVD players all are being used for viewing videos. These portable devices are hard-coded in their firmware to accept certain kinds of DRM-protected files. If the player does not have the DRM framework already built in to read, for example, DRM-protected Windows Media files, then it cannot play those videos.

The Market Today
Posted by Eddy Elfenbein on January 10th, 2006 at 5:43 pm

The five-day rally came to an end. Alcoa’s (AA) lousy earnings weighed on the Dow as it slipped below 11000. This was the first down day of the year.
Once again, the energy sector led the market and most everything else was flat. The Energy Spyders (XLE) were up over 1%. A few other spyders were barely higher, but the non-energy sector had a rough day. The two-tiered market continues. We have energy, and everything else. The news out of Iran has been the latest catalyst for higher oil prices. I don’t see how it can last. As long as you steer clear of energy, you’ll have a good 2006.
Normally, when energy leads the market, the Buy List lags. Not today. This was a very good day for our Buy List. The S&P 500 dropped 0.04%, but we edged up 0.34%.
Of course, Home Depot (HD) did well for us. Also, Harley-Davidson (HDI) had a very nice day, and Golden West Financial (GDW) hit a new high.
By the way, one of our former Buy List stocks is now trading at a great price. Frontier Airlines (FRNT) fell all the way to $8.47 today. Last week, the company reported that its passenger count for December jumped by 12.8%, and passenger miles rose by 16.2%. The next earnings report will probably be pretty bad (the company has already lowered the bar for expectations), but I think the quarter after that could be very strong.
The big news from the tech sector came from Apple Computer (AAPL). The company unveiled its new computer with Intel’s (INTC) chips. The stock broke $80 a share today. Three years ago, you could have bought Apple for under $7. Apple will report next Wednesday, one day after Intel.
After the bell, Genentech (DNA) reported earnings that were inline with expectations. I was wrong. I thought they would easily beat the Street, but I was right that the stock would fall. Shares of DNA (love that symbol!) are trading lower after hours. Genetech was also named the best company to work for by Forbes.