An Exciting Week

Whew! We had an exciting week.

Markets around the world ended last week in the doldrums. Japan had tanked all week on the heels of Livedoor being indicted on allegations of securities fraud. The U.S. was concluding a massive sell-off on the heels of lower earnings guidance from tech titans Intel and Yahoo.

Markets around the world ended this week in a party mood. In last weekend’s week-in-review, our investments in Japan were down 7.1% and up 21.8% respectively. This weekend, they’re up 2.7% and 46.3%. That’s a dramatic turn of events.

In the thick of the struggle, we held firm and even started looking for bargains. I spent Monday in Tokyo, talking with investors and brokers at Nomura Securities, and concluded that Japan is still in a bullish mode and that we should hold tight. That was spot-on, as the Nikkei hit a five-year high on Friday. For the week, our aforementioned Japan investments gained 10.6% and 20.1%.

We doubled down on Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. at $22.50, giving us a new average buy price of $25.25. We have an order in place to double down on Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. at $21.50.

We were disappointed by the IPO of Chipotle Mexican Grill (CMG), which was priced at $22 but opened at $45. We did not buy shares at those prices because I sent a note shortly after the stock became tradable to place a limit order at $25.

Before I dive into the week’s day-by-day action, I want to take a moment to highlight the excellent long-term pace of our permanent portfolios. They generate little short-term exhilaration because I focus my energies on boosting our returns with smart stock trades.

However, the core of The Kelly Letter remains the permanent portfolios and the star of the group remains Maximum Midcap. The Dow just poked into positive territory for the year, but the midcap index has been positive all along. Double The Dow is up 3% so far and the Dow 1 is up 11%, both decent. The Dow 1 looks fantastic, until you realize that it lost 13% last year and is just finally getting the rebound it’s been due for a long time.

Maximum Midcap is up 10% so far this year, and that’s after rising 60% in 2003, 29% in 2004, and 19% in 2005. To put that in perspective, since Dec. 31, 2002 the Dow turned $10k into $13k, the Dow 1 turned it into $14k, Double The Dow turned it into $16k, but Maximum Midcap turned it into $27k. You can see the Maximum Midcap performance table here.

I’m very proud of all of these systems, particularly Maximum Midcap. It’s an excellent core holding for any long-term investor.

Now, to the daily recap.

While gains in the U.S. remained moderate Monday, equities rebounded from sharp selling action that sunk the previous Friday’s market. Buyers scooped up bargains left in the wake of the prior week’s average 2.6% drop in the indices.

In Japan, Livedoor executives including president Takafumi Horie were arrested for securities law violations. Economy and banking minister Kaoru Yosano called the arrests “very unfortunate”.

I spent that day in Tokyo and sent a report to subscribers saying to hold our positions. You can see the report below.

U.S. President George W. Bush said Monday the United States will work aggressively to reopen the Japanese beef market after Tokyo reimposed a ban on American beef last week, expressing hope that the trade problem will be resolved quickly.

Chipotle Mexican Grill announced plans to offer 7.9 million shares at a range of $18 to $20, with the timing set for a pricing on Wednesday night for trading on Thursday. I sent a note about this on Monday evening.

We had another case of lowered earnings guidance cratering one of our holdings. Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. plunged 15% after hours when the company predicted that quarterly results would fall short of both the company’s own prior outlook and the average of estimates on Wall Street. Excluding things like restructuring charges and stock-based compensation, the company forecast that it would earn 25 cents to 27 cents a share for the three-month period ended Dec. 31. The outlook was well below analysts’ estimates that the company would earn 38 cents a share on revenue of $274.5 million, according to a Thomson First Call survey. We would take advantage of these cheap prices to buy more shares on Friday.

While that company disappointed, our e-commerce holding delighted. It said that it shaved its first-quarter loss, even as revenue slid more than 12 percent, and its adjusted results handily beat Wall Street estimates. Shares have traded between $5.40 and $14 over the last year and rose 82 cents, or 10.7 percent in after-hours trading from Monday’s closing price of $7.69. Excluding one-time items, the company said it earned $10.2 million, or 14 cents per share, compared with adjusted earnings of $1.3 million, or 2 cents per share, a year earlier. Analysts polled by Thomson Financial expected the company to earn 7 cents per share for the quarter on $75.9 million in revenue. This has been a great holding for us from the very day we bought back in mid-September. It would finish this week up 57%.

Japanese economic activity rose 0.3% in November, the government said, suggesting that the economy remains in a recovery trend.

The Tokyo Stock Exchange said that it will shorten the trading hours of Livedoor to avoid turmoil on the bourse given a large number of sell orders on the issue.

Livedoor President Takafumi Horie stepped down, a day after he was arrested on suspicion of violating securities laws. The company named Kozo Hiramatsu, its senior vice president, as president.

Analysts weighed in on our computer security company’s bad report, as the stock dropped almost 18% in a day.

“[This company’s] fourth-quarter preannouncement had a bark that may ultimately prove to be worse than its bite,” wrote Bear Stearns analyst Sarah Friar, in a client note issued on Tuesday. “With some time to digest and the stock already trading at a significantly discounted valuation of just 8 times enterprise value-to-adjusted free cash flow, we see room for recovery.” She speculated that [the company], which did not provide details regarding the earnings shortfall, may have been unable to book sales for some larger deals due to the deferred structure of these contracts. “We are maintaining our ‘in-line’ rating on the stock, but our key message to investors would be not to panic given that the bookings number was not bad and should provide increased support to revenue estimates in 2006,” said Friar. I agree, of course, which is why we bought more shares.

In Japan, a Liberal Democratic Party committee met Wednesday and agreed to call for stricter monitoring of the securities markets by the Securities and Exchange Surveillance Commission (SESC) in response to the recent turmoil instigated by Livedoor. This is the silver lining in the Livedoor cloud. The short-term pain of sudden losses last week should be replaced by the long-term gain of a steadier, more fully-disclosed market.

The U.S. markets rose all day to their best performance in weeks. Suddenly, last week’s high-profile earnings
slowdowns have been forgotten in the face of bargains and overall improvement in reports.

Shares of Chipotle Mexican Grill, the stock I wanted to buy at the start of its initial public offering, debuted. We missed out because the stock opened at twice its expected price. The mainstream media breathlessly reported that shares in the IPO were priced at $22 Wednesday evening, but that they doubled that to close at $44 on the NYSE. Ahead of the pricing, the company had increased the expected range by $2.50 to $18 to $20.

This is an absurd take on the IPO. The stock may have been “priced” at $22, but it opened to individual investors at $45 and never dropped below $39.51. With a close at $44, the very best the individual investor could have done was an 11.4% gain from $39.51 to $44. With a market order at the first available prices, most investors got in between $43 and $45, making the first day breakeven money. That’s not terrible, but it’s a far cry from the media shriek of a one-day 100% gain.

On Friday, shares of CMG would fall 4%.

Stocks opened sharply higher on the Tokyo Stock Exchange on Friday, with the Nikkei recovering the 16,000 line. The Nikkei closed at 16,461.

Regarding Japan’s Livedoor Shock, I wrote in a note sent to subscribers on Jan. 18:

The end of Japan? Not at all. . . .Livedoor is popular but not very important. Ask yourself how much the company has changed the world in the last fifty years. Then, ask yourself how much Nissan, Toyota, and Sony have changed the world in the last fifty years. The contrast is striking, and the important companies are in no trouble whatsoever. . . .the factors that I outlined in the January edition of The Kelly Letter pointing to a positive Japan in the near future are still in place. . . .If you were waiting for a nice dip to get into the Japanese stock market, now’s your chance. I suggest buying into [our market investment] at this discount. If you invested along with The Kelly Letter last fall, then just sit tight.

Evidence supporting that note came to light on Friday.

First, Sony’s shares soared in heavy trade after the company sharply lifted its full-year forecasts and posted a record net profit and sales in the quarter ended Dec. 31.

Second, Japan’s core nationwide consumer price index grew 0.1 percent in December from a year earlier for the second straight monthly rise, the government reported. This is a compelling sign that deflation is finally coming to an end.

In the U.S., a solid round of earnings reports maintained a bullish mood Friday. The lower than expected read on fourth quarter GDP growth didn’t interrupt the upward trend.

Earnings have been strong so far, the blow-ups I highlighted last week and this week notwithstanding.

Of the 241 members of the S&P; 500 that reported earnings as of Friday morning, 155 companies, or 64 percent, surpassed Wall Street analysts’ forecasts. Another 42 companies, or 17 percent of those reporting, matched estimates, while 44 companies, or 18 percent, had lower-than-expected earnings. According to Thomson Financial, that’s well above than the S&P; 500’s long-term average of 59 percent better-than-expected earnings. Profit growth remained strong, with the average company posting 13.2 percent year-over-year gains, Thomson said.

Despite that, I still remain cautious about this year. I’ve been warning of an earnings slowdown since December. Now we’re seeing it in the form of lower guidance that hit investors hard two weeks ago. Part of that is that the economy is widely expected to slow down this year.

In fact, we received evidence to that effect on Friday. The gross domestic product grew 1.1% in Q4, less than half of the projected 2.8% increase.

Now, this is a mixed bag. In the short-term, it’s probably good news because it might signal the Fed that it’s time to stop raising interest rates after one more increase at next week’s meeting. An end to interest rate increases would be good for stocks. However, a slowing economy is ultimately not good for business (by definition) and therefore not good for stocks.

My December forecast for the 2006 market was for single-digit gains, mildly bullish. 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.

Whatever gains 2006 produces won’t happen in a gentle upward-sloping line, though. I anticipate that we’re going to see a valley pattern with a strong beginning to the year, a weak middle, and a strong end. That would make midyear a ripe hunting ground for bargains.

It’s not midyear yet, though, and we’re enjoying the good times.

Our big pharma holding continues recovering well. Diabetics are getting an alternative to the regular needle jabs of insulin they’ve endured since the discovery in the 1920s of the hormone that controls blood sugar levels. This company hopes to begin selling Exubera, the first inhalable version of insulin to win federal approval, by summer. The FDA approved Exubera on Friday, a day after the multinational European Commission did so. Our investment in the company has had a rough go of it, but we’re now just 2% below our average buy price. The stock is also this year’s Dow 1 holding.

Long-time holding Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. climbed $1.29 to $27.79 after seeing its profits grow 5 percent for the quarter. The company said new server products helped boost sales. Contrary to the recent trend, the company increased its full-year earnings outlook because it has high hopes for the new software coming later this year. Our position is now up 23.5%.

That’ll do it for this weekend. A lot of hard work has paid off for us and I’m confident that it will continue to do so. The market is a turbulent place, but when approached with a steady hand and an eye on value, it can be rewarding.

Just as rewarding for me is the pleasure of continuing to navigate it with you.

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