The S&P 500 Set to Music
Posted by Eddy Elfenbein on January 21st, 2014 at 9:56 am

Last year’s market set to music. Good beat, kinda hard to dance to:

The Piotroski Nine-Point Test
Posted by Eddy Elfenbein on January 21st, 2014 at 7:36 am

I’m not a big fan of stock screens but I admire the work of Joseph Piotroski.

Dr. Piotroski is an accounting professor at Stanford. In 2000, he wrote an academic paper, “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.”

Basically, he wanted to find what works with value investing. His strategy was to first find stocks with low valuations, then sort what cheap stocks would likely rebound.

Here’s the secret formula. Piotroski first takes stocks that have the lowest Price/Book Ratios. Then the stock has to pass eight of the following nine tests:

*The return on assets for the last fiscal year is positive.

*Cash from operations for the last fiscal year is positive.

*The return on assets ratio for the last fiscal year is greater than the return on assets ratio for the fiscal year two years ago.

*Cash from operations for the last fiscal year is greater than income after taxes for the last fiscal year.

*The long-term debt-to-assets ratio for the last fiscal year is less than the long-term debt to assets ratio for the fiscal year two years ago.

*The current ratio for the last fiscal year is greater than the current ratio for the fiscal year two years ago.

*The average shares outstanding for the last fiscal year is less than or equal to the average number of shares outstanding for the fiscal year two years ago.

*The gross margin for the last fiscal year is greater than the gross margin for the fiscal year two years ago.

*The asset turnover for the last fiscal year is greater than the asset turnover for the fiscal year two years ago.

According to Forbes, the system has worked very well.

A stock screen run by the AAII based on Piotroski’s approach has a 10-year return of 32.5%, compared to a return of 5.5% for the S&P 500 during that same period. The 5-year return is better, at 40%, compared to 5.9% for the S&P. Year-to-date through the end of July, the Piotroski screen is up an amazing 105.7% versus 18.2% for the S&P.

Morning News: January 21, 2014
Posted by Eddy Elfenbein on January 21st, 2014 at 6:37 am

‘Rich Kids of Beverly Hills’ Has a Message For Davos Leaders

German Economic Expectations Fall Slightly

Deutsche Loss Underlines European Economy’s Dependence on Banks

Korea’s Biggest Card-Data Theft Prompts Executives to Resign

China Workforce Slide Robs Xi of Growth Engine

Iran Viable Investment With 29% in Poll as Rouhani Visits Davos

CEO Profit Skepticism Backs Decade’s Weakest Stocks Estimate

China CNR Plans US $1.5 Billion HK IPO in 2nd Quarter

Overstock.com Sees New Market in Bitcoins

Unilever Beats Forecasts as Emerging Markets Rebound

SABMiller Third-Quarter Lager Sales Rise Less Than Estimated

SAP Delays Profitability Target Amid Cloud Push

Remy Cointreau’s China Woes Continue

Credit Writedowns: Bank Reserves and the Falling Loan to Deposit Ratio at US Banks

Jeff Carter: Milton Friedman Predicts Bitcoin

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The Mystery of 21 Points
Posted by Eddy Elfenbein on January 21st, 2014 at 12:42 am

Recently, I’ve been wrestling with a math/sports puzzle and I wanted to share my thoughts with you. The puzzle began when I saw two charts by Seth Kadish of Vizual Statistix. One is a “heat map” and the other a histogram of points scored in every single NFL football game going back to 1920.

The histogram shows pretty much what you’d expect—the more points a team scores, the more likely they are to win the game. But I noticed an exception. There was something odd about teams that scored exactly 21 points.

Since 1940, teams that have scored exactly 20 points have gone 831-753-36 for a winning percentage of 0.524. But for teams that have scored 21 points, that record falls to 557-765-28, which is a winning percentage of 0.423.

Why does one more point translate into worse performance? I couldn’t get this out of my head. Were teams that scored 21 points just unlucky? Couldn’t be…the sample is just too large.

This riddle brought out my best and worst qualities. I love a good puzzle and I’m stubborn as hell. After giving this a lot of thought, I’ve come up with an answer. Let me share that with you.

The reason why 21 is so unlucky is that teams scoring 21 on the nose most likely haven’t kicked any field goals.

Think about it. While field goals aren’t that valuable by themselves, they’re the preferred instrument teams use to win close games. The teams who’ve scored 21 most likely haven’t used one.

As a result, we have a bit of a statistical illusion. Kicking lots of field goals won’t give you lots of wins, but winning games, particularly close ones, means you’ve probably kicked some field goals. (By the way, overtime isn’t a factor. We see the same effect on 21-pointers before 1974 when the NFL didn’t have overtime.) Conversely, this field goal effect also gives a nice bump to the 20-pointers with their numerous 20-17 victories. That’s the most-common football score.

This brings up an important fact about football. The object isn’t to score as many points as possible. Rather, it’s to score more points than the other team. That’s a subtle but important distinction when looking at the data. If a team is trailing by one or two points, or the score is tied, and they have the ball within field goal range, they’ll forgo trying to score a touchdown. They’ll try to burn as much time as they can, and go for the game-winning field goal as time expires.

When we look at the histogram we can see that there are a large number of games settled by three points (17-14, 20-17, 27-24). We can confirm our FG hypothesis by looking at 28 pointers, which is another candidate for few field goals. Teams that have scored 28 points on the nose have gone 622-281-30. Not bad, but it’s still below the 23 pointers at 658-280-8.

So how does this relate to finance (you knew where I was going with this, didn’t you?) The issue I’m raising isn’t about football. Rather, it’s about how we interpret data. Sometimes the numbers can fool us and we have to be clear what we’re looking for.

The similarity between finance and football is that the numbers are aware of themselves. This is very different from an experiment in the physical sciences. Boron doesn’t know it’s boron but the participants in a football know exactly what the score is and that they’re trying to win. As a result, statistics like standard deviation and the normal distribution are hindered.

Likewise, market participants know what the market is doing and the score of that game impacts their decisions. That’s why we see daily changes in the Dow far, far outside what a normal distribution would predict (in other words, fat tails).

One of the constant dangers of finance is the desire to quantify things that are either resistant to it, or simply not needed. The numbers are a picture of reality, not reality itself.

MLK Quote
Posted by Eddy Elfenbein on January 20th, 2014 at 8:20 am

Dr. Martin Luther King Jr. was born 85 years ago last Wednesday. One of my favorite MLK quotes is:

If a man is called to be a street sweeper, he should sweep streets even as Michaelangelo painted, or Beethoven composed music or Shakespeare wrote poetry. He should sweep streets so well that all the hosts of heaven and earth will pause to say, ‘Here lived a great street sweeper who did his job well.

I think the quote may have been influenced by Ecclesiastes 9:10.

Morning News: January 20, 2014
Posted by Eddy Elfenbein on January 20th, 2014 at 6:38 am

The Five Most Important Questions For The Davos Elite

What Lies Beneath China’s Growth

China Rate Swaps Drop as PBOC Injects Cash Before Lunar New Year

Malaysia Relaxes Rules For Auto Makers, Opening Industry To Energy-Efficient Foreign Producers

Bitcoin Judged Commodity in Finland After Failing Money Test

Deutsche Bank Posts Surprise Net Loss

AB InBev to Regain Grip on S. Korean Brewer OB for $5.8 billion

Shell Announces Sale of Wheatstone LNG Stake in Australia

CNOOC Limited Announces its 2014 Business Strategy and Development Plan

Peugeot Board Said to Approve Capital Increase Plan

Wells Fargo, US Bank And Fifth Third Plan To Close Payday Loan Program

Amazon Wants to Send You Stuff Before You’ve Even Decided to Buy It

Building Toward the Home of Tomorrow

Jeff Miller: Weighing the Week Ahead: More “Experts” Predicting a Market Top

Howard Lindzon: Clicks over Bricks…Long Live E-Commerce and Death to Best Buy…Even Movie Theatres

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December Industrial Production = +0.3%
Posted by Eddy Elfenbein on January 17th, 2014 at 10:31 am

The Federal Reserve reported that Industrial Production rose 0.3% last month. In November, the index became the latest to eclipse its pre-recession peak.

In six years, IP has risen by 0.9%.

CWS Market Review – January 17, 2014
Posted by Eddy Elfenbein on January 17th, 2014 at 7:12 am

“It is not the crook in modern business that we fear, but the honest
man who doesn’t know what he is doing.” – Owen D. Young

Earnings season is finally here. We’ve already had one good earnings report from Wells Fargo ($WFC). The big bank beat earnings by two cents per share, and after a delayed reaction, the shares broke out to a new 52-week high. This week, I’m raising my buy below on WFC (more on that in a bit).

Things are about to get very busy for our Buy List. Next week, we’re due to have six earnings reports including heavyweights like IBM, McDonald’s and Microsoft. In this week’s CWS Market Review, I’ll preview our upcoming earnings, and I’ll break down the results from Wells Fargo.

Looking at this earnings season, the consensus on Wall Street is that earnings rose 4.9% last quarter. That’s kind of blah, but going into this earnings season, there were some serious concerns. Before earnings season even started, there were 95 earnings warnings in the S&P 500, compared with just 15 good-news surprises. But most of those warnings have been about rather minor adjustments. Actually, the market seems unusually sedate. A few times this week, the Volatility Index ($VIX) dropped below 12, which brought the “Fear Index” to some of its lowest levels in the past seven years. Fortunately, the stock market continues to hold up well, and the S&P 500 reached an all-time high close on Wednesday. We edged out the previous high close of December 31 by 0.00108%.

The economic news continues to be mostly positive, with a few bumps. This week, the Federal Reserve released its Beige Book report, which looks at regional economies across the country. The reports were mostly good, and I think we can expect more tapering when the Fed meets again at the end of this month. Janet Yellen officially becomes the new Fed Chairman on February 1.

This past Tuesday, the Census Bureau released the December retail-sales report, which showed an increase of 0.2%. December is obviously a huge month for retail. While the report wasn’t outstanding, economists were expecting a gain of 0.1%. Also, the big increase for November was revised downward from 0.7% growth to 0.4%.

These are important numbers because consumers drive most of the economy. Also, retail stocks have been hit hard this year. I still like our Buy List retailers, Ross Stores ($ROST) and Bed Bath & Beyond ($BBBY). However, their most recent quarterly reports included sales through November, and not the holiday season. Once the dust settles in the retail sector, I expect our stocks to flourish.

Of course, it’s still very early, but our Buy List is already slightly ahead of the S&P 500 this year. We’ve done that despite a horrible start for Bed Bath & Beyond, which is now down over 16% for the year. Ouch! The lesson here is that diversification works. I should also note that you’ll often see the worst stock in your portfolio dropping more than the gain from your best stock. Stock performance tends to be asymmetrical. In plain English, the bad ones are worse than the best are good. That’s a key insight, and ultimately, it’s what makes value investing so effective. Now let’s look at Wells Fargo.

Wells Fargo Is a Buy up to $50 per Share

On Tuesday, Wells Fargo ($WFC) reported fourth-quarter earnings of $1 per share. That beat Wall Street’s consensus by two cents per share. Strangely, the shares initially dropped after the earnings report (yep, we know how melodramatic traders can be). Then on Wednesday, it was as if rationality and math suddenly dawned on everyone, and the nervous traders got squeezed out. Before the closing bell, WFC had rallied to a new 52-week high.

Lesson: Don’t trust the market’s first reaction. Actually, keep a wary eye on the second and third ones as well.

Now that I’ve had a chance to look at the earnings from Wells, I can say that I’m impressed. Net income for Q4 rose 10% over last year’s Q4. For the entire year, Wells’s net income rose 16% to $21.9 billion. This was their fifth-straight record year. Last year, Wells made more money than JPMorgan Chase (sorry, Jamie).

I was particularly impressed with the efforts of CEO John Stumpf and his team to trim overhead. (Notice how good companies don’t wait to cut costs; they’re always looking for excess fat they can cut.) Quarterly revenue dropped 6% to $20.7 billion. For banks, you want to see where their “efficiency ratio” is. That’s a good measure of how well they’re managing their operations. For Wells, their efficiency ratio actually ticked up a bit last quarter. That’s not bad, coming in the wake of lower revenue.

Wells’s mortgage-originations business got shellacked last quarter, but there wasn’t much they could do about that. In that sector, you’re at the mercy of the Mortgage Rate Gods. On the plus side, Wells’s wealth and brokerage business did very well. One big benefit for Wells is that they don’t have the legal bills that many of the other big banks have.

I like Wells Fargo a lot. The bank is going for less than 11 times this year’s earnings estimate. I expect another dividend increase this spring. This week, I’m raising my Buy Below on WFC to $50 per share.

Next Week’s Buy List Earnings Reports

Next Tuesday, two of our big tech stocks, IBM and CA Technologies, report earnings. I want to warn you ahead of time that IBM ($IBM) may fall below expectations. The Street expects $5.99 per share, which could be just a bit too high. I’ll tell you ahead of time not to worry about a slight earnings miss. New additions to our Buy List are often dented merchandise, and Wall Street bears have been out to get IBM. They may not be done just yet. Either way, IBM is a solid value at this price. My take: IBM is a good buy anytime you see it below $195 per share.

Three months ago, CA Technologies ($CA), the shy kid, blew the doors off its earnings report. CA netted 86 cents per share for Q3, which was 13 cents more than estimates. Wall Street expects 71 cents for Q4, which is probably a wee bit too low. There’s also a chance that CA might sweeten its quarterly dividend. CA Technologies remains a solid buy up to $35 per share. I have much love for CA.

Wednesday: Earnings from Stryker and eBay

On Wednesday, we get earnings reports from Stryker and eBay. If you recall, Stryker ($SYK) raised its dividend by 15% last month. The company missed earnings by two cents in its last report. That was mostly due to currency effects, and I said not to worry about SYK. Indeed, the stock just hit another 52-week high. This time around, Wall Street expects $1.22 per share in earnings, but I’m more interested in what they’ll have to say about 2014. Wall Street currently expects full-year earnings of $4.56 per share for 2014. Stryker remains a very good buy up to $79 per share.

eBay ($EBAY)’s earnings tend to be very consistent. So far this year, their earnings are up 14%. If we apply a 14% increase over the Q4 earnings from 2012 (70 cents per share), that gives us 80 cents per share, which is, not surprisingly, exactly what Wall Street expects. eBay is a very good buy up to $58 per share.

Thursday: Earnings from McDonald’s and Microsoft

On Thursday, we get two more blue-chip earnings reports: McDonald’s and Microsoft.

Three months ago, Microsoft ($MSFT) surprised a lot of folks on Wall Street with an outstanding earnings report. The software giant earned 62 cents per share, which was eight cents more than estimates. Sales rose 16% to $18.5 billion. Microsoft generated sales that were $700 million more than expectations. I think people forget that MSFT is a very profitable company, especially with its business clientele. For the December quarter, the expectation is for MSFT to earn 68 cents per share, which is down from 76 cents the year before. That sounds about right. We should remember that in September, MSFT raised its dividend by 22%. Microsoft is very attractive below $40 per share.

Like IBM, McDonald’s ($MCD) has been rather sluggish lately. This one may take some time before we see solid results. The consensus on the Street is for earnings of $1.39, which is only one penny more than last year’s Q4. The burger giant is coming off a lackluster year, but you should never count Ronald and his friends out. McDonald’s is a good buy up to $102 per share.

That’s all for now. The stock market will be closed on Monday in honor of Dr. Martin Luther King’s 85th Birthday. Next week will be all about earnings. In fact, there’s not much in the way of economic reports. An important note: With these earnings reports, we want to pay attention to forward guidance as much as to the actual results. I think a lot of traders are nervous about this year, especially with the Fed’s tapering plans, so any optimism from companies will go a long way. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

Morning News: January 17, 2014
Posted by Eddy Elfenbein on January 17th, 2014 at 6:30 am

U.K. Retail Sales Exceed Forecasts With 2.6% Christmas Surge

RBS to Face Review of Business Lending by External Consultants

Advocates for Workers Raise the Ire of Business

Bernanke Likens 2008 Financial Crisis to Car Crash

Numerous Retailers Said Hit by Data Hacking Attacks

Best Buy Reports Disappointing Holidays; Stock Dives

Shell Warns of “Significant” Profit Miss

AmEx Posts Higher 4Q Profit, Revenue

Taiwanese PC maker Acer Q4 Loss Worse than Expected at $245 Million

IBM Commits $1.2 Billion to Cloud Stack

Goldman Sachs Shares Decline as Trading Revenue Drops

Why People Love Working at Goldman Sachs—It’s Not Just the Money

Nu Skin’s Big Strategic Mistake

Joshua Brown: Tonight’s Must-Read: Howard Marks’ Memo on Luck

Cullen Roche: The Most Interesting Aspect of Bitcoin as Money…

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Spotting a Turnaround
Posted by Eddy Elfenbein on January 16th, 2014 at 2:25 pm

When you’re a value investor, you often look at stocks that are far off their highs. The problem is that a stock that’s down only means it’s down from where it was, and not necessarily where it ought to be.

The thing with business is that turnarounds are very, very hard. Yes, they happen, but it ain’t easy. Business isn’t like sports where a team that’s leading will play very conservatively, and a trailing team has a shot of getting back in it. In business, success often breeds success (though it can breed complacency as well). Imagine a basketball game where the team that makes a basket gets to take the ball out again. That’s the business world.

J.C. Penney ($JCP) has gotten crushed lately and the company is in a world of hurt. So does that means it’s a value? Possibly, but I’m staying away. Target ($TGT), on the other hand, is down as well, but I like Target a lot more (though I’m not willing to call it a buy just yet).

Here’s the important lesson: There are some key differences between a stock that’s down (like JCP), and a stock that’s down and could be a good buy (like TGT). For me, the first sign is looking at the dividend. JCP doesn’t pay one but TGT does. That’s a major distinction. The second is cash flow. JCP is hemorrhaging money. They’ve been losing money, are losing money and will most likely continue to lose money for some time.

Target, meanwhile, is in rough shape but it’s making money — more dollars are coming in than are going out. Their earnings this fiscal year will be down from a year ago. What happens next year, however, is a question mark. If the company resumes its growth rate, it’s very likely that Target is a very good buy here.

So remember that just because a stock is down doesn’t mean it’s a good buy. You need to look for key anchors like cash flow and dividends to tell you if the decline is (probably) transitory.