The Tycoon Report

40% Profits in 7 Weeks

Wow, it sure was nice to get that extra hour of sleep this weekend – but I can’t say I really enjoy its being darker outside a whole hour earlier.  Something about coming home after work in the bright sunshine just makes me feel so much better about the day.

Today I’d like to share a little story with you about what happened here at Tech Stock Insider last Friday.

Better yet – I’m going to use a stock I currently have in the Tech Stock Insider Model Portfolio to show you exactly what it is we do over here.

Most people in my business would say I was crazy – how could I basically “give away” proprietary research that I normally charge thousands of dollars for?

Well, I believe in the principle of “you’ve gotta give to get”…

So here goes…

Let’s Take it From the Top

Ok, now this might seem a bit “unfair,” but before I even decide to delve into a company’s finances, strategy and competitors, I first identify the industry I’d like to look in.

It’s like going ice fishing – you have to decide where you’re going to drill your hole in the ice before you cast your line into the water.

The same applies to investing.  This is known as a “top down” approach, meaning, we start very broad and then narrow our search down.

Now, if you’ve been following my writing – as painful as it may be – I talk a lot about the wireless sector.  I even try to use clever titles from time to time like “The Wireless Wave.”  And I use “catchy” language like, “let’s ride the wireless wave to profits…”

I know I’m a bit of a ham, but I really do mean every word.  I feel like the wireless sector is the place to be for the next 5 – 10 years and I constantly find myself looking for opportunities there.

So that’s where I began my search when I found the stock I’m about to discuss.

Once I decided to look in the wireless sector I used a stock screener from a company called Value Line – this is a semi-expensive piece of software, and I wouldn’t recommend it for the casual investor.  But Value Line really does provide some of the most comprehensive and condensed research on publicly traded companies I’ve ever seen.

You can use some of the other stock screeners out there for your future searches, and if you check my article from a few weeks ago, you’ll see that I mentioned a couple in there.

But in any case, I narrowed my screen down to the wireless sector; then I set out the following criteria:

Return on Equity: 15%
Profit Margin: 10%
Debt: 0%
Earnings Yield: 8%

But Why’s That Important?

This is an important step – these may seem like simple numbers, but they can tell an investor A LOT about a company.

For instance, Return on Equity (ROE) not only tells you how much money the company is earning on its investments, but it’s also indicative as to how competent management is.  Good managers know how to invest the company’s money, and bad managers don’t – period!  So if a company’s ROE has been consistently high for a number of years (above 15%,) then chances are we’re dealing with solid management and a good business.

If a company has been increasing sales while increasing profit margins, it shows that the company is benefiting from economies of scale and is able to keep costs in line as it grows – another very important characteristic to look for.

I can’t tell you how many times you’ll see companies report “record earnings” and see their stocks soar during a bull market – but meanwhile the companies’ margins are shrinking which simply means they’re not effectively employing their capital.  At the first sign of a downturn, these stocks will get hit the worst, while those that are cost- conscious will weather the storm the best.

Having no debt is obviously a good thing for people and businesses alike.  During a market correction, companies with low debt will do far better than companies saddled with loans and unable to pay them.

Most of these filters I apply are less about finding spectacular companies very quickly, and more about making sure I don’t invest in any of the bad ones.

If I’ve had any success in this business, it’s not because of the trades I made – it’s because of the bad trades I didn’t make.

And in case you’re wondering, Earnings Yield is simply the inverse of the P/E ratio.  I like to think of it the same as how I would think of the yield on a bond.

Since, on average, you can get risk-free government bonds yielding around 6% (this is averaged over a long period of time,) if I’m even going to look at a stock, I want to make sure it’s “yielding” something higher than that.

OK, Makes Sense – What’s Next?

Value Line then comes back to me with a long list of stocks in this particular sector that match all the criteria listed above.  Pretty boring so far, but here’s where the “fun” begins (at least for an analyst/computer geek like me.)

Now we get to dig into every single company the screener spits back out!  Yay!

OK fine, it’s not all that fun; it’s kind of tedious actually, but, when you know you’re essentially “digging for gold,” it makes the process a bit more enjoyable.

That’s really one of the best things about investing:  you’re using your brain to generate wealth.  There’s really no other business in the world where you can simply “think” about an issue and make money at the same time.

So back to the list of stocks…

I comb through this list, and there are some decent companies in there – but some of them have only recently become profitable.  Or some of them are only the number 4 or 5 competitor in their respective industries which means there’s room for improvement, but it’s going to be an uphill battle.  I don’t want to find stocks that “might” make it, I want to find stocks that have already made it, and people just don’t know about it yet.

I’m not sure if I ever talked about this in my Tycoon Reports, but I really love consumer products companies (Apple, Hershey’s, etc.).

This is for a number of reasons:

1)  It allows the company to spread around its risk – companies in the B2B space (Business-to-Business) can see their revenue get cut in half if a big customer walks away.  But a company that sells to consumers has its risk spread around.
2)  I can easily observe emerging trends in the market – if everybody is still falling all over each other to get the latest iPod, then I’m fairly certain Apple will have a “decent” Holiday Shopping Season, to say the least.

So I come across a company in the wireless networking space that caters to both corporations and consumers.  It’s actually a company I’d seen years ago but held off on investing in – it just wasn’t at the right place in its business cycle…yet.

The company I’m referring to is Netgear (Nasdaq: NTGR).

You might even own one of this company’s products considering it’s the Number 2 manufacturer of home and commercial wireless networking equipment (right behind Linksys which is owned by Cisco.)

To be clear, going for a “Number 2” company is also risky.  Sometimes these companies are destined to remain Number 2 – but that doesn’t mean that they won’t perform well, especially when they’re as undervalued as Netgear was.

I watched this stock fall 25% off of its 52-week high for no reason whatsoever – it simply came down with the market.  However, the stock fell twice as much as the market did which indicated there might be a big price discrepancy here.

When I looked at this stock at the beginning of September it was trading at a P/E of 18 and a forward P/E of 14 – the stock usually trades at a P/E upwards of 20.

What was even better was that at $19.00 per share, the company had $4.75 in cold, hard cash – that means the enterprise value of the company (market capitalization, minus cash, plus debt) was only$14.25.  This made the stock look really cheap (and I mean that in a good way).

Not to mention the company’s earnings were up 20% per year for the last 5 years.  In fact, revenues and earnings were up 20% from the year before, but the stock was down 25%.

So, based on my reasoning, we had a “quantitative” price discrepancy – this is a “value” play in the tech sector.

Well, What About Cisco?

But now I had to ask myself if this company had the “qualitative” value to keep growing sales and profits while it competed against the likes of Cisco.

This is where the “tech geek” in me had to step in.

These companies both made wireless routers.  Now, since I am not a corporate IT buyer, I had no personal experience with their commercial products, so I had to base my judgment on their consumer line.

So I started doing some digging – reading customer surveys, reports from retailers such as Circuit City, and then simply asking around and seeing what my friends had been buying lately.

Now, two years ago, if you asked anybody what type of router they owned, they most likely said “Linksys.”

I mean, these routers were just too easy to set up.  It took minutes, and before you knew it every computer in your home was wired up to the internet.

But now, quite a few people told me that they had a Netgear router at home.  The setup was easier, the product was sleeker and the customer service reps at some of the electronics and office supply stores actually recommended the product to them.

The reports and retailer surveys I found actually said the same things.  Netgear was providing more sales support, thus better educating retailers on how to sell its products.  And the products themselves were getting better.

Several benchmarking studies showed that Netgear’s products were beginning to outperform comparable devices from Linksys.

By the way, you can find all of these things if you use Google long enough.  This isn’t some “secret” source of information I have access to.  It just takes some leg work.

Sometimes Being Number 2 is a Good Thing

Now that Linksys had some real competition, it was only a matter of time before it started to give up market share. 

And that’s exactly what I was betting on when I decided to take a position in Netgear.

I was betting that as the company continued to gain traction with the big retailers and develop a better brand amongst consumers, it would slowly eat away at Linksys’ position in the market and cause it to grow at a higher rate than Linksys could.

Let me elaborate on my logic a bit…

This is the same logic that investors use when they decide to enter emerging markets like China or India.  Even though these are still developing countries, and the U.S. certainly has a much more stable and larger economy, the U.S. also lacks the growth potential of these emerging markets.

Let’s say the U.S. has $100 billion in GDP in Year 1 – and hits $110 billion in GDP in Year 2 – The U.S. has increased GDP by 10%.

But if China only has $10 billion in GDP in Year 1, and moves up the same amount as the U.S. in Year 2 (another $10 billion), its percentage increase (growth rate) is dramatically higher – 100%.

That’s the same logic I used when looking at Netgear.

If this company could incrementally take market share from the market leader, its growth rate would be that much higher and the potential for some serious profits in its stock would be that much more likely.

The Research Pays Off

Well, it looks like my research, assumptions and logic all paid off.

Since I took a position in Netgear on August 31st, the stock is up over 35%.  It was up 20% alone last Friday when the company reported earnings and gave higher guidance for 2007.

The stock shot up on monster volume (5 million shares, while it usually only trades around 600,000 shares a day) too.

This is also where a little bit of technical analysis comes in handy.  The stock broke through a major resistance level at $25 per share.

Considering it broke through on such high volume, I decided to hold onto the stock because I think Netgear still has more upside in it.  The stock could definitely pull back in the short term as traders take profits (a 40% run in seven weeks means there’s a lot of people who wouldn’t mind a quick return on their investment.)

But I think over the longer term, this company could show Tech Stock Insider members even more profits so I’ve kept it in the portfolio.

So I hope I’ve finally given everybody what they’ve been asking for – a real look behind the scenes here at Tech Stock Insider.

I would’ve gone into more detail about breaking down the ratios and filtering out other stocks, but the editorial staff at the Tycoon Report would’ve beaten me senseless.

I hope you enjoyed it!

Until next time…