Up And Away

We’re off to a grand start in the new year. The markets have been on a tear, taking most of our positions higher.

The malaise at the end of December was lifted by comments from the Federal Reserve’s minutes last week giving hope that the long campaign of interest rate increases may finally be coming to a close. There was nothing definitive, of course, but hope was enough to keep the mood cheerful. On Monday, the Dow cleared 11,000 for the first time since 2001.

Thursday and Friday saw lower volumes and narrow range markets as that cheer faded a bit ahead of earnings season, scheduled to begin in earnest next Tuesday after the Monday holiday to observe Martin Luther King Day. Earnings reports should be positive. The S&P; 500 overall earnings will be about 13% higher than they were in the same quarter a year ago.

However, growth will probably slow later this year, and investors will be looking for forward guidance to that effect. We’ve had double-digit increases for three years in a row. A fourth would be quite a feat, and most likely won’t happen.

The economy, though, is looking healthy. The holiday sales period was good. The Producer Price Index (PPI) measures the average change over time in the selling prices received by domestic producers for their output. Recently, you’ll recall, the Fed has been on a mission to keep inflation at bay. That means they want such prices to remain low, not to increase dramatically. We, too, want them to remain low because if they do then maybe the Fed will stop raising interest rates, which would be good for the stock market.

Guess what? The core PPI for December came out last week at an increase of just 0.1%. That’s the fifth month in a row of 0.1% or less. The year-over-year gain is just 1.7% and the annual rate over the past six months is just 0.8%. Inflationary pressures are nowhere to be found, giving stock investors reason to smile. This on the back of last week’s Fed minutes is making the end of rate increases look likely.

It’s also making my stop-loss orders on Decker’s Outdoor (DECK) and Maxtor (MXO) last month look premature. Both enjoyed amazing run-ups from November and had started settling back toward the end of December. Just in case, I set stop-loss orders at gains of 40% on DECK and 60% on MXO. Both filled. Since then, each stock has moved higher in this New Year’s rally.

To be sure, booking gains of 40% and 60% in three months is excellent work. I wish all of my problems could be so good as wishing to have made more than we made. Nonetheless, I’ll seek to capture a greater share of future strong performances from our holdings. If you rode these two investments to solid profits along with me, congratulations. If you passed them over or are a new subscriber, don’t worry, we’ll find new opportunities.

Then, too, in the spirit of “I made a fortune by selling too early” we can look at the Jan. 12 edition of The Economist for a dour take on the American economy. They believe that departing Federal Reserve Chairman Alan Greenspan’s low interest rate policies created first a stock bubble and then a housing bubble, and that Americans have overextended themselves by borrowing against the paper equity in their homes to keep shopping. That has boosted GDP growth, but at what risk?

When house-price rises flatten off, and therefore the room for further equity withdrawal dries up, consumer spending will stumble. Given that consumer spending and residential construction have accounted for 90% of GDP growth in recent years, it is hard to see how this can occur without a sharp slowdown in the economy.

Which would naturally bring a sharp downturn in the stock market. This risk is further exacerbated by the handing over of the Fed to incoming chairman Ben Bernanke. Handovers are always tricky. They have often been followed by financial trouble, like the 1987 stock market crash just two months after Mr. Greenspan took over. Nobody knows how Mr. Bernanke would respond to plummeting house prices and a screeching halt in the economy.

By nature, I tend to look on the bright side. It does seem prudent, though, to curb our enthusiasm for this great start to the new year by remembering that:

- Corporate profits are bound to slow.
- The Fed is entering a new leadership phase.
- High housing prices are destined to settle back.
- Lower housing prices could sputter the economy’s spending engine.

I prefer finding ourselves happy in the market when others are not. Looking around these days, I see a preponderance of happy people among us. Always a tad frightful, that.

Let’s take a look at some individual stock action.

Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. said its full-year earnings won’t meet previous forecasts, although its total sales rose 5% in the fourth quarter. The sales growth came through low-margin products, while high-margin sales declined. I was looking to double down on our position at $20, but the stock never fell below 20.55. It has now rebounded sharply from there to nearly $23, putting us down 8%. While the company is transitioning and exhibiting all the usual pains associated with doing so, revenue is still growing at 8.5% a year, quarterly earnings are growing 56% a year, the forward P/E is just 12.5, and insiders still own 10% of the company. I feel comfortable holding on, and will consider buying more on significant weakness.

Japan remains the hot place to be. So far, our overall market investment has outstripped our banking investment. The former is up 41%, the latter down 5%. The media have been calling for an end to the rising Nikkei average since October, but what’s hot has just gotten hotter. It bears watching closely, though. The beauty of
Arial” >The Kelly Letter
being entirely email-based is that I can notify you immediately of sudden changes.

However, I remain optimistic. Prime Minister Koizumi is in office for just nine more months. His success at reforming Japan’s politics and economy has made the idea of reform very popular. That has created two positive influences. First, there’s an urgency in the air to enact the final pieces of PM Koizumi’s agenda before he leaves. Second, there’s a litmus test in place to elect the next PM based on how compelling his own agenda appears. All reforms point to a faster growing, leaner Japan and that can only be good for both stocks and real estate. Also, the yen will most likely strengthen and that will further boost corporate profits in this export-driven economy.

Beyond our current holdings, I’m watching a broad list of potential investments. For now, only three are near a price where I’d like to buy. They are Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free.. In addition, I’m interested in the upcoming initial public offering (IPO) of Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free.. Let’s look at all four.

The first one has been in my sights for a couple of months now, as longtime subscribers know. I’ve set various price points to watch between 18 and 20, waiting for a definitive break one way or the other. We have finally gotten it to the upside, which is good. The semiconductor industry is entering a retooling phase which will see large capital expenditures on new equipment. If the recent upsurge in the semiconductor sector — up some 10% so far this year — continues, that will help this company a lot. It closed last Friday just above
20, so there’s a good chance we’ll be able to buy it below 20 before it embarks on a solid uptrend to 30.

The next one looks to me like the best-priced of the niche clothing retailers. It competes with Abercrombie & Fitch, American Eagle Outfitters, and Urban Outfitters among others for the dollars of teenage fashion buyers. This store’s unique take is a focus on the sporting lifestyle, particularly the “rebel” sports of snowboarding, skateboarding, and surfing. There’s a trend in America toward longer childhoods with people staying single into their 30s and continuing youthful sports well into maturity. The company boasts some nice numbers including a 9% profit margin, 20% earnings growth, zero debt, and a forward P/E of 12. Shares have fluctuated between about 21 and 28 over the past year, and closed Friday at $23.58.

The third one is like Yahoo, but in Chinese. It’s the sixth-ranked site in the world by monthly page views. That’s despite less than 10% of China’s population being online.

The company takes a broad portal approach with many revenue streams rather than focusing on just advertising. For instance, it offers subscription services for news, dating, games, and mobile fortune-telling. (I’d sign up for the latter if it could tell me the future price of the stock.) Its portal network consists of four destination websites to users in Greater China, including mainland China, Taiwan, Hong Kong, and overseas Chinese in North America.

Now, this is a risky investment.

China is a communist country and the government can do whatever it wants to this company. So far, it’s left well enough alone, but there are no guarantees that it won’t decide down the road that this kind of broad information sharing is just not good for the people.

Beyond that, the company is young and exhibiting the same kind of lousy numbers that U.S. internet companies exhibited several years back. Its revenue and earnings growth are currently negative, and it has $100 million in debt.

So, why the interest? Because the company has a forward P/E of just 21 and has $289 million in cash. Top-ranked Chinese portal Baidu, by comparison, has a forward P/E of 142. While our pick is not squeaky clean, it looks like the most solid bet on a fast-growing sector in the fast-growing economy of the most populous country.

Shares pushed above 34 last March, but have steadily moved downward since then to Friday’s close at $22.44. When the stock moves up, it does so in dramatic fashion. The stock’s 52-week low of 20.18 came less than a month before the high of 34.25. That’s a quick 70% gain. The stock is heading downward recently, but I think we could be nearing such a dramatic turnaround point again. I will watch carefully and let you know.

Finally, there’s the upcoming IPO of one of the most delicious new restaurants to hit America in years. You may have seen its famous foil-wrapped logo by now. It pioneered back in 1993 the concept of fast-casual food. The segment didn’t even have a name then, but it does now as the restaurant’s success has attracted competitors. The menu is simple, the ingredients are fresh, the workers are cheerful, and the atmosphere is upscale.

You’ve probably heard of the company behind this restaurant. In fact, I know you have. It’s one of the most powerful restaurant companies on Earth, and that kind of backing will help a lot after the new company goes public. You are who you know, and the company behind this restaurant has opened a lot of doors for the startup and will continue to do so.

Several members of senior management served for years at the parent company. Others on the management team are no slouches, either. The founder and CEO holds a degree from the Culinary Institute of America. That never hurts in the food business.

I’m encouraged by the restaurant’s pre-IPO business success. It had revenue of $471 million in 2004, up 49% from 2003 and 130% from 2002. The increases came from new store openings and higher average store sales.

Net income has improved from a loss of $8 million in 2003 to income of $6 million in 2004 and $33 million (including a nonrecurring $20 million tax benefit) in the first nine months of 2005.

Earnings before interest, taxes, depreciation and amortization, or EBITDA, were $7 million in 2003, $28 million in 2004, and $44 million in the first nine months of 2005.

The restaurant says it intends to use money from the IPO to repay the balance left on its $30 million revolving line of credit with its parent company, as well as for long-term capital to support the growth of its business. And what growth it should be. There were 489 stores on December 31, 2005, 184 of which were opened since January 1, 2004, and 80 of which were opened in 2005. The company expects to open between 80 and 90 new stores in 2006 and continue significantly expanding in 2007 and 2008.

The IPO is not officially scheduled yet, but is expected sometime in the first quarter. It should be priced between $15.50 and $17.50. I’m looking to pick up shares immediately.

If you’d like to see some of the company’s advertisements and read one of the best-written, plain English prospectuses I’ve come across in a long time, stop by the IPO website at Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free..

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