The Tycoon Report

Who's Coming to Dinner?

Monday, October 15, 2007 | Wayne Mulligan

Let me just say that this was one of the toughest and yet, most rewarding weeks of my life.

Want to know why?

Because Dylan and I had to sit down and go over ALL of the answers from our “bet” two weeks ago.  And after hours of reading, debating, arguing and fist fighting (just kidding), we finally chose three winners.

However, this isn’t to say that only three people deserved to win this bet – the truth of the matter is, the vast majority of the answers we read were AMAZING and could’ve all reasonably won.  But since we limited the bet by deciding to choose only the best answer for each question, we could only choose three winners.  But you all really deserve a round of applause for the job you did – you all made me look very smart for making this bet with Dylan in the first place.  And for that, I thank everyone who participated.

Also, if you’re one of the winners and have yet to receive an e-mail from us, then sit tight.  We’ll be contacting you individually throughout the day to try to set up a good day and time for you to join us for dinner. 

So here were the winners of Tycoon’s “Dinner on Us” bet:

Question Number 1:

What are the strongest investments in a down market?

Winning Answer:

Tycoon reader Myung said:

The best companies in which to invest in a down market are those with excellent business fundamental performance.  There is no reliable connection between current market sentiment that shows in their stock prices to that of the business performance of any company.  It doesn't matter whether or not they are small to large cap companies.  Take Want Want Holdings in China, for example; their stock prices plummeted when they announced an investment in a hospital and into charity. Their primary business is processed snacks, especially rice crackers.  Investors thought they were going downhill, especially when they reported a decrease in their profit margin.  From the details I have written above, you would probably conclude that the company is indeed going down.  However, if you really look closely into the news, it turns out that the decrease in their profit margins was a result of their management strategy to squeeze out their competitors.  It is just a matter of time before they get back to their original profit margin levels.  As for the hospital investment far away from their core business, it turns out that the investment was far less than their yearly income.

This means that there is absolutely no perceivable risk to their healthy business operation.  By the way, the hospital is turning up a healthy profit margin, too.

This information can only be gleaned from reading their financial statements.  That is what I meant - to seek those with strong business fundamentals.  Market sentiment is simply very short-sighted.

Question Number 2:

How do you know when management of a company is good if they are not Warren Buffet or someone well-known?  What is it you look for to tell you?

Winning Answer:

Tycoon reader jester112358 said:

Insider ownership.  If insiders are buying their own stock or initiating buybacks at the market price, not just exercising options, they feel their capital will get the best returns invested in their own stock.  And who knows more about a company's prospects than insiders, which explains the large profits in insider trading?  Increasing insider buying and large amounts of insider buying are bullish.  Recent examples include Mylan Labs and Texas Instruments.

Question Number 3:

Why are a company’s P/E ratio and Return on Capital important factors to look at when making an investment?

Winning Answer:

Tycoon reader Michael O said:

When a new investor is first told about the concept of P/E ratio, it is well received.  It's a simple, straightforward measurement of money (earnings) that a company is receiving as compared to how much it will cost a potential investor to own a piece of that company's earnings.  This cost is expressed in the price per share.

I view P/E as a starting place filter, but it isn't the be-all and end-all of stock selection.  Also, it is subject to accounting variables.

You could find strong supporters of other types of company financial health measurements, but I will tell you that P/E is included in my watch list spreadsheet of fundamental information.

Kicking P/E ratio up a notch, I would use it as a relative indicator with which to view all stocks in a sector.  For instance, if all grocery companies have a P/E ratio in the 4 to 7 range and a company is showing an 18 P/E, it's reasonable to ask, "What's with that company?"  Why would some companies have an exceptionally small or large P/E ratio?  Is it a long or short opportunity deserving further investigation?

You should also know that all market sectors and indexes have historical P/E norms:  that group P/E number is expressed by adding each individual stock's P/Es together and dividing by the number or stocks in the group.  What if you could see P/E ratios expressed on a chart in a historical context?  You would have an immediate reaction to seeing that the historical norm for the S&P 500 P/E is 19, but what if that number happened to be at 38 P/E at this moment?  Wow!  Twice the historical norm means way overbought.  Dangerous?  Maybe, even highly likely.  What would cause such a huge number?  Time for some due diligence.

Here is something else about P/Es that I have discovered recently.  I have been studying high performance stocks in every aspect that I can think of because I want to know what makes them tick.  What's a 10-bagger look like in the beginning and as it rises?  As for the P/Es of these companies, they can fall (get more conservative) even as the stock price is climbing handsomely!  How can that be?  It means that the earnings are outperforming the price rise of the stock, and therefore the P/E falls.  How exciting is that!!!?  As the price increases, the fundamentals are getting better and better!  That's the best P/E ratio situation that a stock owner can have!  Unless you're short the stock!

And speaking of SHORTS, one final comment regarding P/Es.  What if you are looking at a stock whose price is way up, and the P/E shows very little earnings?  Look at the SHORTs for the stock.  You may find a lot of people increasing the short interest ratio, because they believe that this stock without earnings is heading for a fall.  Again, time for research.

Now for the second half of the question, "What is the value of knowing a company's 'return on capital'?"  This speaks to the question, "Considering all the assets that this company has involved in the process of running its business, how efficient is management at turning assets into profit?  A dollar of assets generates what percentage of return?"

As in my first answer about the value of P/Es, return on capital value is relative to specific sectors and industries.  For instance, the multinational oil companies make an astounding amount of money, but the capital that it takes to establish such an organization and keep it running every day is also astounding.  Airlines and department stores would be examples of capital-intensive businesses.  These businesses must have a huge cash flow every day in their accounts just to exist before anything is left over for net profit.

At the other extreme are the businesses which require very little capital to exist, and therefore their return on their capital is large.  No overhead.  The danger with these companies is that a competitor can spring up without much capital outlay and easily start taking market share from the first corporation.

Looking at P/E as your return on investment (like a company owner), the P/E is just the return you may expect that year.  So, a P/E of 20 has a stock yield of 5% which can then be compared to other investments like bonds, real estate, gold.  However, the future P/E (forward value) is even more important since the known P/E is likely already factored into the current stock price.  If you know that the future P/E will be lower than the present (trailing) one or that the Earnings will be particularly large next year, that justifies a higher P and thus stock appreciation.  An example where the market did not recognize this reality was shippers, where the shortage of dry ships will lead to large increases in earnings in the future (above market assumptions).  The results of this bad assumption by Mr. Market can be seen in the oversized stock appreciation of this sector this year.

Return on Capital is a good measure of management effectiveness.  In other words, how is management using both equity and debt instruments to enhance profits both now and, even more importantly, in the future?  By using capital to acquire key technology or competitors, or reward key employees (human capital) through stock options, management will enhance shareholder value (i.e. stock price), thus making current stock undervalued relative to its less effective peers who may have used their capital to buy company jets or squandered it on bad acquisitions which may not produce cash flow (e.g. Google's latest acquisitions).

Investors Educating Investors

As you can see, all of these answers were different – some were longer than others, some gave real world examples while others talked about investing in a more abstract sense – so there wasn’t some “winning formula” we were looking for.

We were mainly looking for “the best” answer for that particular question – and when I say “best” I mean the ones we found to be the most educational for an investor that legitimately asked those questions.

And that’s what we’re looking to do more of here at Tycoon – we’ve been educating you and other Tycoon members for quite some time now.  Three months ago, we launched a major initiative to get members to start educating other members.

In the coming months, we’ll be taking more steps to realize our vision of educating and empowering individual investors in new and innovative ways.  So sit tight and enjoy the ride – because we’re planning to give you a financial education that will help you live the life you’ve been dreaming of.

Have a great week!




Wayne Mulligan
Contributing Editor
The Tycoon Report


Mark Your Economic Calendar: What's ahead for the week of October 15, 2007

Tuesday, October 16

9:15 - Industrial Production (for September): Consensus 0.1%, Capacity Utilization (for September): Consensus 82.2%

Big Picture: Industrial production is showing a significant lift after the weakening in late 2006.  Annualized 6-month growth is twice the 12-month gain.  Factory orders are back on the rise and drive production.  The stall from autos, construction and business investment is past, but risk is that it returns, given the less glowing outlook for the economy.  Capacity use stands at 82.2% -- still below the level historically consistent with inflationary pressures -- as manufacturing reflects some excess capacity at 80.7%.

Implications: The index of Industrial Production is a fixed-weight measure of the physical output of the nation's factories, mines, and utilities.  Manufacturing production, the largest component of the total, can be accurately predicted using total manufacturing hours worked from the employment report.  One of the bigger wildcards in this report is utility production, which can be quite volatile due to swings in the weather.  Severe hot or cold spells can boost production as increased heating/cooling needs drive utility production up.  In addition to production, this monthly report also provides a measure of capacity utilization.  Though the rate of capacity utilization is seen as a critical gauge of the slack available in the economy, the market does not completely trust this measure.  Capacity is very difficult to measure, and the Fed essentially assumes that growth in capacity in any given year follows a straight line.


Wednesday, October 17

8:30 - CPI (for September): Consensus 0.2%, Core CPI (for September): Consensus 0.2

Big Picture: The core rate of consumer inflation reached a decade high of 2.9% yoy in September 2006, and has eased off to 2.1% yoy.  The stickier prices for shelter and medical care and tuition will continue to hold firm as yoy core commodity prices have fallen from a year ago.  Energy prices provide the swing, and are now lower than a year ago.  In the big picture, its aggregate demand which provides the price direction as sub-potential growth (below 3%) is easing the core inflation pressures over time.  The Fed more closely watches core PCE prices as an inflation guide which stands at 1.9% yoy -- in the Fed's 'comfort zone'.  Overall CPI reached a 14-year high of 4.7% yoy in Sept '05 given the push from energy prices and now stands at 2.0% yoy.

Implications: The Consumer Price Index is a measure of the price level of a fixed market basket of goods and services purchased by consumers.  CPI is the most widely cited inflation indicator, and it is used to calculate cost of living adjustments for government programs and it is the basis of COLAs for many private labor agreements, as well.  It has been criticized for overstating inflation, because it does not adjust for substitution effects and because the fixed basket does not reflect price changes in new technology goods which are often declining in price.  Despite these criticisms, it remains the benchmark inflation index.  CPI can be greatly influenced in any given month by a movement in volatile food and energy prices.  Therefore, it is important to look at CPI excluding food and energy, commonly called the "core rate" of inflation.  Within the core rate, some of the more volatile and closely watched components are apparel, tobacco, airfares, and new cars.  In addition to tracking the month/month changes in core CPI, the year/year change in core CPI is seen by most economists as the best measure of the underlying inflation rate.

8:30 - Housing Starts (for September): Consensus 1285K, Building Permits (for September): Consensus 1300K

Big Picture: Housing starts reached a 12-year low in August with no sign of the fundamentals (housing demand) needed to provide the turn in direction higher the intermediate term.  The plunge has been a large drag on economic growth, as further risk surrounds the defaults coming from sub-prime and other mortgage borrowers.  Q2 starts were slightly stronger than Q1, but the downward trend seems to be accelerating in Q3.  The upturn could be a long way off, mid 2008 may even be optimistic.  The correction for the inflated housing market was expected (and needed) but with a more moderate decline.  Stability will have to wait for new home sales to begin to tick higher and a smaller supply of unsold inventory.

Implications: Housing Starts are a measure of the number of residential units on which construction is begun each month.  A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing.  Building permits are permits taken out in order to allow excavation.  An increase in building permits and starts usually occurs a few months after a reduction in mortgage rates.  Permits lead starts, but permits are not required in all regions of the country, and the level of permits therefore tends to be less than the level of starts over time.


Thursday, October 18

8:30 - Initial Claims (for 10/13): Consensus NA

Big Picture: Weekly initial claims can be volatile, as the trends reflect some easing in the tight labor market.  Layoffs (seen in initial claims) remain subdued given the lean supply of available workers as hiring (seen in continued claims) has cooled as reflected in the 20-month high in the early September 4-week average and the slower growth in payrolls.  Claims provide a nearly real time read on layoffs and the labor market as the low 4.7% unemployment reflects the broader combined read of layoffs and hiring.

Implications: Initial jobless claims measure the number of filings for state jobless benefits.  This report provides a timely, but often misleading, indicator of the direction of the economy, with increases (decreases) in claims potential signaling slowing (accelerating) job growth.  On a week-to-week basis, claims are quite volatile, and many analysts therefore track a four-week moving average to get a better sense of the underlying trend.  It typically takes a sustained move of at least 30K in claims to signal a meaningful change in job growth.

10:00 - Leading Indicators (for September): Consensus 0.4%

Big Picture: Six monthly declines in 2006 reflect the weaker economy in late 2006, as declines were shown in 5 of the first 8 months of 2007.  But the 6-month growth is back in the black as we are yet to see a 3-month string of declines.  Over the last 17 years, the index correctly signaled the 1990 and 2001 recessions while providing a false signal during the 1995 soft-landing.  The recession alarms go off when the cumulative 6-month decline exceeds -1% amid a string of three or more consecutive monthly declines.  No recession warning bells yet and none expected.

Implications: The Leading Indicators report is, for the most part, a compendium of previously announced economic indicators: new orders, jobless claims, money supply, average workweek, building permits, and stock prices.  Therefore, the report is extremely predictable and of very little interest to the market.  Though this series does have some predictive qualities, it is a common criticism that it has predicted "nine of the last six" recessions.

12:00 - Philadelphia Fed (for October): Consensus 8.0

Big Picture: The regional manufacturing index is volatile but tracks the direction of national orders and production.  The gains in orders and shipments follow the late 2006 stall tied to autos, housing and business investment.  Late 2007 risk is tied to another potential stall in business investment given economic growth concerns and financing rates.  The Philly index is independent of its components so can provide a misleading read and is especially volatile given the small region covered (mid and east PA, southern NJ and Delaware).  The manufacturing sector moves in mini-cycles compared to the overall economy and the regional measures move in even shorter cycles with far more month-to-month volatility.

Implications: There are many regional manufacturing surveys, and they tend to be ranked in order of timeliness and the importance of the region.  The Philadelphia Fed's survey is first each month, actually coming out during the third week of the month for which it is reporting.  Several smaller surveys are then released before the Chicago purchasing managers' report on the last day of each month.  A few, such as the Atlanta and Richmond Fed surveys, are released after the NAPM and are of little value.  The purchasing managers' reports are measured like the national NAPM -- 50% marks the break-even line between an expanding and contracting manufacturing sector.  For the Philadelphia and Atlanta Fed indexes, 0 is the break-even mark.


Source:  www.Briefing.com