Contrarian Chronicles
Juggle the numbers and drop a bundle
Though many might not believe it, I’m looking forward to being bullish. But it’s easier to be bullish on a good stock bought at a reasonable price rather than one whose upside depends on a fanciful set of assumptions.
By Bill Fleckenstein
These days, it's not hard to find stories in the financial press about how stocks are "reasonably valued," so let's go out and buy them. The so-called experts get so busy juggling the numbers that they overlook the worsening prospects for those businesses. Of course, lots of investors then mistake what they read for sound analysis and potentially go on to make poor decisions based on that. To help readers of the Contrarian Chronicles avoid this pitfall, I've included a back-of-the-envelope analysis of a technology company in this week's edition.
Plaintiffs dance dough-si-dough
Recently, it was announced that an Ohio jury had ordered Prudential Securities (PRU, news, msgs) to pay $261.7 million in damages, as one of its brokers had sold people out of their stocks without permission in 1998. (That's $250 million in punitive and $11.7 million in compensatory damages.) So, the apparent horrific thing that he did was to keep them out of the mania.
Now, I don't know the further details of this case, but when I saw the news hit the tape, I thought, what are they going to do to all these brokerage firms when and if juries get cases in which people actually lost tons of money, as opposed to missed out on some upside? This bears watching, for that reason. Meantime, I would hope that common sense prevails, and that the award is overturned in the interests of fairness. But then again, maybe I am being a little too naive.
Moving to another jaw-dropping news item: On the heels of affirming its strong financial position just days earlier, TXU Corp. (TXU, news, msgs) did a bit of backpedaling this past week that was worthy of a Tour de France in reverse. To review, the stock had been halted on Oct. 9, down about 30%, and the Dow Jones Utility Index was under a huge amount of pressure. At that time, the company said it knew of "no fundamental reason for the way that TXU common stock traded this morning."
Well, last Monday, we found out a likely fundamental reason: TXU said it would slash its dividend, do some restructuring, and try to set up some more credit facilities. On the back of that news, TXU was again smashed for over 30%. I am not very close to this situation, but obviously, it's a giant mess. Given its present troubles, I find the discrepancy in its remarks stunning, and I would think that the class-action lawyers will have a field day.
Perma-anti-mania
Now I'd like to spend some time talking about being bearish. I find that often these days, those of us who are bearish are labeled as "permabears." Almost anyone who is bearish now was bearish in 2000 (and in all likelihood, was bearish some years before that) for one simple reason -- we were having a mania. Once one concludes that a mania is taking place, the only safe thing to do is to head for the exits, in my opinion. So, you can miss out on a lot of fun and games.
However, once one acknowledges that there's a mania, and still chooses to stick around, one is also saying that it's knowable when to leave the party, which is often a tricky thing to do. In any case, that is why those of us who are bearish now have been bearish for a long time. But that doesn't make us permabears.
I, myself, am looking forward to being bullish. It's much more fun making money on the upside. It's less stressful. In fact, it's quite a bit easier. However, just because being bullish happens to be easier does not mean that it's something I personally want to do, just to do it. Sometimes it takes a long time before it's safe to be bullish.
I was bearish on Japan in 1988. I started shorting that market when the Nikkei was about 29,000. It subsequently ran to 38,000. At that time, I stated publicly that before the bear market was over, it would trade at somewhere between 8,000 and 10,000. Well, here it is. It has taken a long time. Now, I was not necessarily bearish the whole way down in Japan. In fact, I covered my shorts at 20,000, and left that market alone.
I have been looking for reasons to turn bullish for years, but have not done so. Being "not bullish" has been the correct thing to be. Often, there are markets where it may not pay to be either a bull or a bear, unless you are a sophisticated operator. However, that doesn't always have to be the case. In some markets that are neither bull markets nor bear markets, some people can do extraordinarily well, also.
Pre-bull bouillabaisse
That brings us back to our market. I look forward to the opportunity to become bullish at some point, when I think the risks have been properly discounted, and the price of admission to owning securities properly compensates you for taking those risks. I do not feel that way today. (An example of this to follow, in a minute.) I am hoping that by some time in 2003, the bulk of the damage to the stock market and the economy will have been done. So, sometime next year, I hope to be bullish.
If history is any guide, I will be early in being bullish. That's what has happened to me in most markets that I have been either bullish or bearish on. I could miss the turn. I sincerely doubt that. There is tremendous pressure in this business, if one has been bearish, to turn bullish, and that tends to weigh on people. But, just because some people, myself included, are still bearish does not mean that we're permabears, and it does not mean that we expect to stay bearish forever.
Back of the envelope, front of the problem
Now, I would like to give a back-of-the envelope demonstration of why I think stocks are too expensive. I happened to catch a recent article in Barron's in which a portfolio manager was talking bullishly about a company called Cognex (CGNX, news, msgs). I think it's an interesting business, and I like the management. The stock sells for about $15. It has $7 in cash. This year, the consensus estimates are for it to lose about 6 cents, and next year, to make 34 cents. The portfolio manager opined that it's not unreasonable to assume it would make $1 down the road, and if it sells at 20 times that dollar, and you add back in the $7 a share in cash, it should trade for $27, which is quite a ways up from $15.
I pick this example because that kind of analysis, I think, seduces lots of people. Well, I'd like to own the stock one day. But I think that perhaps $10 (at most) is a better price to try than $15. Cognex is in the semiconductor capital-equipment business, so in essence, it's a capital-goods supplier to a capital-intensive and cyclical industry that just experienced a tremendously speculative orgy of overcapacity. This should have an impact on the multiple that people are willing to pay for peak earnings.
Now, at the height of the mania in 2000, the company did earn just under $1.50. I don't think that those earnings will be seen again in the next decade, because I don't think the environment will be quite like that. But let's say that it can do as well as it did in 1998 or 1999 and make 50 to 60 cents a share (which is a big "if"). If the market paid 20 times earnings for that, it would obviously be less than where the stock trades today. If the company were lucky enough to make almost a dollar, which was what it made in 1997, and the market paid 20 times earnings, you would clearly have made money from where you are today. Obviously, a bigger multiple would lend a bigger stock price.
However, it seems to me that from $15, the stock could easily trade at $10 (and I wouldn't be surprised if it saw $7 to $8), because if the economy (or the semiconductor capital-equipment business) is as poor as I think it might be, Cognex's recovery could be pushed out, and it could use up cash.
Sale-priced price-to-sales ratio
I think the 34 cents estimate for next year could turn out to be total pie in the sky, and the company could be faced with not making much money at all, for a while. If you were to buy it at $10, and you took out the $7 in cash, then you'd be paying about one times sales for the business, as opposed to the six times sales it actually sells at. At $10, if you looked at the upside analysis that I just did briefly, you can see your way to where the stock could trade in the mid-teens or possibly the high-teens, or you could get lucky and something wild could happen on the upside. Plus, your downside would have been dramatically reduced.
To me, the risk/reward in the stock is barely even: up a third or down a third, based on my back-of-the-envelope analysis. At $10, in a bad environment, you could probably have the same 30% downside risk. But you could easily have a much higher upside. So, while the story seems compelling at first blush, as initially articulated in Barron's, upon just a little more analysis, one can see how critical it is to get the right entry price in your security, in case your assumptions about the future don't quite come true, or are delayed. This small example is what I find, in the main, is wrong with lots and lots of securities. So, for whatever it's worth, I pass it along to readers.
Stratos fears
Finally, in view of the explosive stock market bounce that we are witnessing, I would like to emphasize once again that people at home not try to short stocks. When one is short, it's difficult to know how high a stock can go, and the epic moves we are now seeing makes this all the more difficult. Therefore, the position requires lots of maintenance, as I specifically talked about a few weeks ago in my column on short-selling. So, I want to emphasize that people who are not full-time investors stay away from the short side.
This bounce caught me a little flatfooted, as opposed to the last couple of bounces, which I was more prepared for. That said, this is starting out a lot like the July rally, and in many ways is a replay of it, in that two weeks ago, tech stocks kind of dug in and didn't go down when the rest of the tape did. I continue to feel that this is just a bounce. It's not possible to know, though, how high it will go, or from where the first pullback will come (though we will, of course, learn more about the rally when that pullback arrives). I'm sure that people are all geared up to say, we made it through earnings season, and we made it through October, and the world didn't end, and here comes the "seasonally good November-to-May period." Let's see if Mr. Market lets them.
VP for chaff-from-wheat separation
The psychological arm-waving variables might favor the bulls, even if the fundamentals and prices do not. We may be in for another period, as we've seen many times since this bear market began, in which people focus on touchy-feely stuff, as well as try to guess what all the other guessers are going to guess, before they do. (In that regard, I'll turn the floor over to one Ed Snyder, a dead fish with J.P. Morgan, who told a Wall Street Journal reporter, in a recent story titled "Motorola's Profit: 'Special Again’," "My job is not to be right on the fundamentals of the company. It's to be right on the stock.") However, none of this nonsense changes the fact that the economy is on the verge of serious trouble, and people who chase stocks do so at their own risk.
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