It was a trendless week for the market, but an eventful week for us. Stocks remain subdued now that earnings season is winding down and the Fed’s next move is unclear. This type of malaise is typical for February, and is often followed by strength in March and April.
The listlessness was clear in the up, down, up, down pattern of the averages. The S&P; 500 rose Monday, fell Tuesday, rose Wednesday, fell Thursday, and rose again Friday. Where does it want to go?
Whichever way interest rates don’t go, and since we can’t get a read on them, the market is scratching its head, glancing up and down.
We have to take one more step back and admit that we don’t even know whether inflation is picking up. Neither does the Fed. If more evidence comes to light showing that inflation is on the upswing, then new Fed Chairman Bernanke will move swiftly to keep it in check. That means further rate increases.
There’s wide agreement that the Fed will raise rates on March 28. The question is whether that will be the last time for a while. If inflation colors the data, then there could be another ratcheting up on May 10.
This coming Wednesday, Mr. Bernanke will address Congress on monetary policy. You can be sure that all market ears will be tuned in and eyes will be scanning the chairman for body language clues. We want to know how aggressively he intends to ward off inflation.
Think about the situation for a moment. If you were the new chairman of an organization whose primary role is fighting inflation, you would probably want to immediately establish your credibility by striking a strong inflation-killing pose. That’s most likely the way Mr. Bernanke will handle Wednesday, too. That means the odds favor the market interpreting the presentation as a harbinger of two more rate hikes ahead, rather than just one. If so, the markets are likely to continue treading water or sink a little.
I mentioned in the February issue that the out performance of small cap stocks over the past few years is probably due to end, with large caps taking the lead. Last week settled out that way. Disney gave a strong earnings report and that helped the Dow come out on top. It’s too soon to call it a trend, but if it is the beginning of a trend, it wouldn’t be surprising.
Let’s look back at the week.
MondayIt was a narrow range market with most talk on, naturally, the Fed.
One thread that’s still running through the discussion is earnings. Investors are adjusting to lowered guidance, but not quickly enough. The street is still predicting double-digit earnings in the second half, but companies are hinting at single-digit. If this over-optimism persists, it could set us up for disappointments in the seasonally-weak summer months, further bolstering my case for a buying opportunity later in the year.
TuesdayOr, maybe we won’t have to wait that long. Tuesday’s downward slope was almost entirely due to earnings concerns. I detected no whispers of inflation or rate increases.
For us, though, as holders of , it was a golden day. The company reported strong earnings and the stock rose 7%. We’re now up 78% since investing and I expect more upside from here.
In other news, our long-suffering electronics retailer, down 13.5% since we invested, is still trying to get back on its feet. Mostly in New York and Pennsylvania, 54 stores will start distributing Cellular One wireless products and services from Dobson Communications.
It’s easy to dismiss this firm as a dud, but it’s a good company striving to recover. Its profit margin is a solid 7%, impressive for a store. Management has achieved a 53% return on equity. It does carry more debt than I’d like to see, but that’s not unusual in a turnaround situation. Insiders own nearly 10% of the stock.
Finally, it’s cheap. I should add in a lower voice, even cheaper now than when we first bought. Earnings are growing at 56%, yet the forward P/E is just 13. That gives a P/E to growth ratio (known as the PEG ratio) of 1.1, pretty low.
By comparison, Circuit City (CC) has a PEG ratio of 2.2 and a forward P/E of 25. Its profit margin is a razor thin 0.8% and it has no meaningful earnings growth.
Yet, in the past year Circuit City has risen 72% while has fallen 33%. This will be corrected at some point. The stock closed last Friday at $21.63. A year ago, it was at $34. We bought at $25. I’m keeping an eye out for a potential chance to buy more shares before a rebound back above $30. Even if we don’t buy more, though, I expect to make at least 20% on this eventually.
WednesdayThe average daily balance of Japanese bank lending expanded 1.3% to 389 trillion yen in January from a year earlier for the sixth straight monthly increase, the Bank of Japan said Wednesday. One of these days, we’re going to see get going. So far, we’re down 1.3% as the stock has fluctuated around the flat line since we bought last fall.
In the U.S., the market took a break from inflation worries to cheer Cisco (CSCO) for strong earnings and our pharma holding for the potential divestiture of its low-margin consumer healthcare business. Also, we got a nice boost from an upgrade to our computer maker.
For some time now, I’ve been watching the fiasco at General Motors (GM), content to not even try to call the bottom. It’s disheartening to see an important American icon under such atrocious management. Does anybody remember how Japanese car makers trounced Detroit back in the 70’s with fuel-efficient cars that didn’t break? The U.S. automakers so thoroughly blew it that decade that they let in fierce competition that has never gone away. Prior to that colossal blunder, foreign cars were a fairly small part of the U.S. market. Now, they dominate.
Well, if you missed the drama of the 70’s, don’t fret, because it’s being re-run right now. At the Detroit auto show, it was almost comical to see among headlines of declining oil reserves the new fleet of gas guzzlers from Detroit. On the other side of the show, Toyota was proud to show its latest hybrids and promising results from all-electric and solar platforms. One had to wonder, is there a problem with newspaper delivery in Detroit?
There must be, because it seems impossible for a car company to keep making last decade’s trucks in the face of rising oil prices, increased political instability in the oil-producing regions of the world, and declining reserves worldwide.
Back to the 70’s for a moment. Chrysler almost went bankrupt. Its shares dropped to $2 and that’s where Warren Buffett invested, riding it back to $70 per share. Will we see a similar lifetime opportunity with GM? As incredible as it seems, the company is still the largest car maker in the world. It could still get itself back on track, however embarrassingly late. If it ever looks like that’s imminent, we’ll take a closer look.
For now, though, it’s mismanagement as usual. Profit margins are negative, return on equity is negative, revenue is shrinking, and debt is 17 times equity. I’ve seen lemonade stands with better numbers. A year ago, the stock traded above $37. Now, it’s below $22.
On Wednesday, Deutsche Bank downgraded the stock to Sell from Hold and cut their target to $17 from $22, citing continued disappointment in the limited cash savi
ngs targeted by the company’s current restructuring efforts. The stock got down to $18.33 in December. A bottom of $17 might be generous. There’s a chance that we could follow in the great Buffett’s footsteps and buy into the world’s largest auto maker at single-digit prices. In the meantime, the only opportunity regarding GM is to shake our heads and wonder when it will occur to the geniuses in charge that making cars people want to buy would be a marvelous first step for a car maker.
ThursdayThe markets stood still, but beat its previously reduced profit forecast. That would send shares up 18% on Friday. Great!
I sent a note to buy at $18 and at $34.
FridayIt was another go-nowhere market that ended with modest gains.
The December trade deficit climbed to $65.7 billion from a revised $64.7 billion in November. That was just about what most people expected (isn’t that what your family discusses at dinner every night?), and therefore made little difference.
guided EPS lower, continuing that recent trend.
I changed Thursday’s limit orders to buy at $18 and at $34 to market orders, meaning we would buy at current prices. Thanks to all of you who emailed me your execution prices. The average buy price on the former was below $18.40, but I’m tracking $18.45 as The Kelly Letter’s buy price. The average buy price on the latter was below $35, but I’m tracking $36.75 as The Kelly Letter’s buy price. I lean conservatively when we have a range like this, meaning that most if not all subscribers will actually perform better than the letter.
We can feel good owning both of these companies. Their statistics are excellent with low valuations, good margins, high insider ownership, and healthy growth.
I made the right call to change the debt collection company’s limit order to a market order as it looked like it had already bottomed out and was in a firm up-channel. It closed the day at $18.66, giving us a small 1.1% gain.
I made the wrong call to change the student loan company’s limit order to a market order. It broke above its resistance on Thursday and looked poised to break out higher. I wanted to capture that, hence the quick buy. It then proceeded to reverse course almost immediately, giving Yours Truly another chance to practice humility. The stock came down to below $34, where we would have bought had I simply left the limit order in place. That was a technical error on my part.
I feel in both cases, though, that I got the fundamentals right and that we own two good companies. As with almost all of the eventual profits achieved by Kelly Letter stocks, these two may see more downside before getting to the upside. We might even have a chance to buy more shares at lower prices. As with Maxtor and Decker’s recently, and others before them, I’m confident that we have the right companies if not the perfect entry prices.
In fact, we don’t have to look back farther than Friday to see this very technique at work. We paid $28 for on Nov. 28, then watched it drop. We doubled down at $22.50 on Jan. 27, nearly 20% below our initial entry price. That gave us an average buy price of $25.25. The stock closed Friday at $25.90, up some 18% that day alone, putting us up 2.6% so far.
More often than not, getting the right stock is more important than getting the right price. If the company story is correct, the price should eventually match. Of course I wish I’d bought the student loan company at $34, but if my target of recovering to the 52-week high of $73 is hit, we’ll still make 99% and probably won’t be too upset at having missed it at $34.
That’ll do it for this week. Good work, everybody. Congrats to those of you who bought at lower prices than those tracked here. For those of you who haven’t bought yet, you still have a chance to get on the cheap.
Now, take a break and watch the athletes in Torino. Best of luck to all of them.
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