Looks Like February

February is seasonally a weak month, and last week showed all signs of continuing that tradition. We used weakness in Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. to double down on our positions. That lowered our average buy prices so that we’ll make higher profits when the stocks eventually recover. There’s no doubt that these two will recover, there’s just the question of when.

Let’s take a look back at last week.

Monday
Very little happened on Monday as investors sat still ahead of Tuesday’s Fed meeting, almost universally expected to produce another 1/4% interest rate hike. The attention would be paid to the language accompanying the hike. Would there be an indication that rates will stop rising soon?

Wal-Mart said that its January same-store sales clocked in at a preliminary 4.7% gain. Thanks to gift card redemptions, the gain topped estimates. It also gave hope that other stores would see a similar January boost over December.

Tuesday
The controversial Alan Greenspan retired after serving 18 years as chairman of the Federal Reserve. In his last major piece of business, Mr. Greenspan raised rates a 14th consecutive time by 1/4% to 4.5%.

The language everybody watched so carefully disappointed. It said that “some further policy firming may be needed” to keep economic growth and inflation balanced. May be needed or will be needed? As ever, it wasn’t clear. That mystery, along with the statement that, “Although recent economic data have been uneven, the expansion in economic activity appears solid,” leaned a little more toward further increases than investors had hoped for. There’s probably another rate hike in the cards for the March meeting.

Last week, I wrote:

Somewhat anecdotally, the “January Barometer” looks set to give a positive signal on the year. According to The Stock Trader’s Almanac, “as the S&P; goes in January, so goes the year. The indicator has registered only five major errors since 1950 for a 90.9% accuracy ratio.” It doesn’t speak to the size of gains or losses to be had, just whether the market will end the year up or down. As of last Friday, the S&P; 500 is up 2.8% so far this year, indicating a positive signal.

Indeed we got one. The S&P; enjoyed its best January since 2001. It ended the month at 1280, up 2.6%, making the January barometer positive on the rest of the year.

While our Dow and Midcap index investments rose 2.5% and 11.7% respectively in January, we’d have done even better in small caps. The Russell 2000, which measures stocks with market caps between $100 million and $2 billion, rose 8.9 percent. The S&P; Midcap 400, the index followed by our midcap investment, gained just 5.9%.

Just as they did this same time last year, analysts expect the performance to shift from small to big any day now. Historically, it should happen, but historically it should have happened last year. Whenever it does finally happen, Double The Dow will shine again.

Wednesday
The Tokyo Stock Exchange announced plans to adopt a new order-processing system under which a large transaction equivalent to 20-30% of a firm’s outstanding stock would be automatically rejected. This is to prevent another shutdown like the one that happened during Livedoor Shock two weeks ago. In retrospect, the incident was good for Japanese stocks. Not only have they already fully recovered and gone higher, the market has become more transparent and the exchange more stable. So far, we’re up 2% on our Japanese bank investment and 46% on our Japanese market.

Tech darling Google finally failed to meet expectations and dropped 12% for the week. That didn’t tank the overall market, though, and the relief turned into a mini rally.

Thursday
An ugly down day to follow Wednesday’s strong showing. The purported reasons were reflection on the Fed’s policy statement indicating more rate hikes, adjustment to lower earnings projections, and a terrorist threat.

There are always reasons given but you can generally just choose from the usual list of culprits on any given day. Oil is up, stocks are down. Terrorist threats are up, stocks are down. People believe that interest rates are going up, stocks go down. Then, on up days, the reasons are often just reversed. Oil is down, stocks are up. Terrorists are silent, stocks are up. People believe that interest rates are staying firm or going down, stocks go up.

This week’s down performance looks to me like the continued realization that profits are slowing this year, something I’ve been discussing for the better part of two months. Once all the reports are in, that adjustment should be taken care of without too much damage. Earnings are coming down a notch from their recent high levels, but they’re not dropping into the mud. They’re still healthy.

Friday
Another down day.

That old bugbear, inflation, came ’round again, this time in the form of a 0.4% increase in hourly wages for December. It was expected to be only 0.3%.

Why are higher wages bad? They’re not when you receive your paycheck. However, when everybody’s paycheck grows too quickly, sellers are quick to notice and prices can be quick to rise. That’s inflation. How does the Fed combat inflation? By raising rates. What happens when rates rise? Stocks fall.

This cycle is as much a part of stock market investing as flour is a part of baking. Get used to reading about it. The tone of the market is set by interest rates. The Fed determines interest rates. The U.S. stock market has a huge influence on markets around the world. That’s why some people consider the chairman of the Federal Reserve to be the most powerful man in the world.

With the language from Tuesday’s Fed meeting already having investors on edge, the higher wages goosed fears of further rate hikes.

That was the week.

There’s nothing terribly disconcerting about any of it. It’s just the normal fluctuation of the market and, seasonally, the market often struggles through February before giving a strong performance in March and April. You should expect more volatility dead ahead, but nothing to sicken the stomach.

I’m happy to have picked up additional shares of Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free., and to see that prices on our target stocks are coming into range.

I’ve added two new names to the Watch List, both in the debt business. They are Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free.. Let’s take a look at each.

The first one buys bad debt from credit card companies, banks, telephone companies, and others. All companies have customers that do not pay. They follow some basic debt collection procedures to recoup what they can, but eventually the situation becomes too time-consuming to be worth the eventual outcome. That’s when companies bundle their uncollectible debt together and sell it as a package to bad-debt collectors like this one. The firm strives to pay as little as possible for the package, then focuses all its efforts on recovering the entire amount of debt owed. That’s its business, so it does not lose patience nor quickly run out of techniques.

For example, it might pay just $10,000 for $50,000 of debt owed to a credit card company. It knows that it’s very unlikely to collect the full $50k, but what if it can collect $20k or $30k? That would be a 100% or 200% return on investment (not counting expenses like collectors’ salaries, e
tc.). Consistent returns like that can add up to a pretty healthy business, and they have.

Management has achieved a 27% return on equity. It’s sitting on $52 million cash with just $227,000 debt, giving it a debt/equity ratio of essentially zero. Never forget, you can’t go bankrupt if you don’t owe any money. I find it fitting that this debt collector has no debt. Follow their example in your personal life and you’ll be happy. Never assume debt. The fact that so many people fail to follow that age old, widely-advised, and indisputably correct advice is what keeps this company profitable. Its profit margin is a fat 23% and its quarterly revenue growth is 15%. The financials are solid.

What puts a glimmer in my eye, however, is the insider picture. The company is 81% owned by insiders. I find that comforting. If they don’t do a good job, they’re going to lose a great deal of money. You learned in your first economics class, if it was anything like mine, that people act on incentives. When the people in charge of the company own the company’s stock, they have a powerful incentive to keep the company profitable and growing.

The stock closed last Friday at $18.22 with a forward P/E of just 10.5. A year ago, it traded right around $20 before rising to $32 in October. Then, the company started hinting that its experimental acquisition of cellphone debt was not proving to be as easily recoverable as it had initially thought. That led to a sharp sell-off at the end of October and into November, all the way down to below $20 again. The stock made a steady march up to $25 at the end of January, then had a preliminary conference call last Thursday confirming that the slowly-recoverable and unrecoverable cellphone debt would hurt earnings, to be reported at the end of this month. That bad-debt bad news sent shares plunging to a 52-week low of $17.51 on Thursday.

The company said that quarterly earnings would plunge as much as 55% year-over-year. Management put the blame squarely on those larger-than-expected write-offs for unpaid cellphone bills that it has given up on collecting.

From SmartMoney magazine:

Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. has been out buying this nontraditional paper away from its core asset base [of credit-card debt and student loans], and it’s had aggressive collection assumptions on that paper,” says Dan Fannon, an analyst at New York investment bank Jefferies & Co. “It’s a function of the asset pricing going up and the company’s outlook for this asset class being more optimistic than it is proving to be. The company is confident it will make money, but not at the pace originally expected.”

“The company suggests it’s not a trend, that they are taking care of it and we should not expect it in the coming quarters,” says Mark Hughes of Suntrust Robinson Humphrey, an Atlanta investment bank. “But the collection environment seems tougher now. The company has benefited from an improving job market, tax refunds and mortgage refinancing. But perhaps now the incremental benefits have been achieved and now you are looking at a more stable environment. And if you’re not getting the improvement that you had and business is flat to down on collections, that may contribute to more write-offs.”

My take is different from Mr. Hughes’. The company has clearly mastered its traditional asset base of credit cards and student loans. It needed to find new ways of making more money and that entailed expanding its range of collection targets. It has discovered the new, juicy realm of unpaid cellphone bills and moved aggressively into it. However, cellphone debt is not the same as credit card debt and student loan debt, so the company got its forecasts wrong. The president said in Thursday’s conference call that he is very disappointed and that management is working hard to see that this doesn’t happen again. Perhaps they’ll pay less for cellphone debt in the future, build in a longer collection time frame, or scrap it entirely in favor of something else.

In any event, the bad news is out and it’s recovery time. Given this company’s successful history, its solid finances, its 81% insider ownership, and the technical support around $18, I am placing a buy target of $18 or lower. If the stock can merely regain its previous high of $32, we’ll see a 78% gain.

The second company I added to the Watch List is a student loan outsourcing service. It offers a suite of program design and marketing, borrower inquiry and application, loan origination and disbursement, and loan securitization services for student loan programs tailored to meet the needs of the respective customers. Those are usually universities and colleges themselves as well as financial institutions that work with the education market. The company primarily focuses on loan programs for undergraduate, graduate, and professional education, but also offers programs for the primary and secondary school markets. Since 1991, it has completed 28 private student loan securitizations totaling $7.5 billion.

There are three reasons that the private sector student loan market is poised for growth.

The first is that tuition is rising. Over the past ten years, it’s more than doubled the rate of inflation. If you or your children are or were in school recently, this is no news to you.

The second is that the number of students is rising. Children of baby boomers are reaching college age and the need for a college degree is widely known. It’s not just for the elite anymore.

The third is that the government has not raised federal student loan borrowing limits. Students quickly hit the federal ceiling, but don’t have enough funding to finish their education. That’s when they turn to the private sector, where this company plies its trade.

And plies it well, I should add. The numbers are swell.

Management has achieved a 47% return on equity. The company has $156 million cash and $16 million debt for a debt/equity of 10%. Its quarterly revenue growth is 57%, it’s profit margin is 37%. These figures are the equivalent of straight A’s, with perhaps a B+ in the debt department.

As with the first company, we’re looking at a heavily insider-owned company. A full 61% of the stock lies in the hands of insiders. Last quarter, the company repurchased 4% of its outstanding stock, a positive sign.

The stock hit $73 on Mar. 4, 2005. It then steadily deteriorated to $21 on Oct. 7, mostly due to being overvalued. It had more than doubled in 2004 and was primed to disappoint. When it did, the downgrades came pouring in. As recently as August, it reported earnings below expectations.

The crowning gem of bad news came in September when the former chairman and CEO resigned over allegations that he gave $32,000 in gifts to a former employee of a major client of the firm. That’s a big no no. The company derives 80% of its work from only three clients, so the prospect of losing one of them in a bribery scandal was pretty grim. However, like so many scandals that sell newspapers and sell-off stocks, this one proved unimportant to the company. The relationship with the client remained intact.

The sun shines a bit brighter around the company these days. From its Jan. 26 fiscal 2006 Q2 report:

Total service revenues for the second quarter of fiscal 2006 increased to $230.5 million, up 48% from $155.8 million in the second quarter of fiscal 2005. During the second quarter of fiscal 2006, the Company securitized approximately $1.3 billion of private student loans in its largest securitization transaction ever, which generated $189 million in service revenues. During the same fiscal quarter last year, the Company securitized $807 million of private student loans, which generated $132 million of service revenues.

Insiders, ever confident,
have been buying. On Dec. 15, the CEO bought 10,000 shares at $28.69. On Aug. 30, the vice chairman bought 10,000 shares at $29.54. On May 2, the president bought 1,290 shares at $38.60 and the CIO bought 500 shares at $39. On April 29, the executive vice president bought 2,000 shares at $39.

The stock closed last Friday at $32.25 with a forward P/E of 9. I’d like to buy at or below $31.50. If the stock recovers to $73, we’ll gain 132%.

As always, I’ll let Kelly Letter subscribers know if and when these two new stocks-to-watch reach my price targets, and if and when I place live orders.

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