The most reliable way for investors to lose money is to buy assets that have been inflated by a bubble. Considering the lofty prices investors are paying for highly cyclical trucking stocks, many must believe that they cannot lose — especially in today’s echo stock market bubble environment engineered by the Federal Reserve and Treasury Dept.

Many stocks exhibit bubble characteristics, having rallied far ahead of evidence that earnings have really recovered. In typical economic recoveries, rallies often occur on scant evidence that fundamentals have turned. But we are dealing with a hangover from a giant credit binge.

This hangover will return after the effects of the stimulus wear off, and it will correct many of the capital spending mistakes made during the credit bubble. Some of those mistakes are obvious, including supply gluts in residential and commercial real estate. But mistakes were also made in asset classes you might not expect, like building too much capacity in the trucking industry.

If businesses react to misleading price signals, they can easily make capital spending errors. Credit bubbles cause misleading price signals. These signals are unhealthy because they act to pull future demand into the present.

This artificially boosted demand sends the signal to businesses to add capacity. Then, once the growth in credit slows, or even reverses, demand can fall far below supply. The industries that were most aggressive during the boom are left with excess capacity. Even the best businesses within each industry suffer from the investment enthusiasm of their peers, which winds up suppressing prices and profits.

Governments, central banks, the banking system, and borrowers worked together to inflate the biggest credit bubble in history. The bubble was so large that most of its fallout cannot be stopped — only delayed. Governments are running huge stimulus programs, which eases and delays the adjustment process. This temporarily restores some of the earlier boom conditions. But sooner or later, prices adjust until supply and demand fall into balance.

Inventories Are Critical for the Trucking Business

As the global economy adjusts to post-credit bubble reality, it remains to be seen how much inventory of physical goods is sustainable. The desire to hold inventory is critical for the trucking industry. Lower demand for inventory and lower final consumer demand translate into less frequent deliveries from 18-wheeler trucks. Inventory is in a constant state of flux, and reflects businesses’ estimates of their customers’ demand.

Most mainstream economists expect inventory replenishment to boost GDP growth in the coming quarters as government stimulus spending wanes. But I have my doubts. Those expecting an inventory replenishment cycle are operating under the assumption that 2006–2007 inventory levels were sustainable.

How much inventory do businesses really need?

This is something that each business must decide for itself. But with hindsight, we know that retailers in particular held far too much inventory heading into the 2008 collapse in retail sales. Inventory planning has its tradeoffs: Too much inventory leads to weak profit margins and returns on capital, while too little inventory leads to missed sales opportunities. The recent buying behavior of many retailers reveals that most are willing to sacrifice sales in order to protect profit margins and are not expecting a quick recovery to peak sales levels.

This nasty recession has forced every business involved with physical trade — from manufacturers to distributors to retailers — to reassess how much inventory is appropriate to hold. The inventory-to-sales ratio provides a rule of thumb. This ratio has historically trended downward as more businesses adopt just-in-time inventory management. But during the 2008 crisis, this ratio spiked as sales dropped much faster than inventories.

According to the U.S. Census Bureau, the economywide inventory-to-sales ratio was 1.3 at the end of October 2009, down from an early 2009 peak of 1.45. This ratio is now back to the 2004–2007 average of 1.3, so unless final demand picks up dramatically, the widely anticipated inventory rebuilding cycle will be tame.

With many businesses still shell-shocked from the crisis, it’s unlikely that we’ll see a rush to preemptively build more speculative inventories. Yet the trucking stocks have already priced in a robust recovery in freight volumes and pricing.

While I think that trucking is the industry with the most downside right now, a similar situation is likely to continue for a number of other industries, including bulk shippers and companies that operate in similar transportation niches. Stay away from these issues until further notice.

[Ed. Note: Some small-cap trucking names worth watching for a downside play include Quality Distribution (NASDAQ: QLTY), YRC Worldwide (NASDAQ: YRC), and Arkansas Best (NASDAQ: ABFS).]

Regards,
Dan Amoss, CFA

December 22, 2009

Why Inventory Numbers Point to a Tame Recovery for Trucking Stocks was originally featured in the Penny Sleuth.

In short, people seem to have had enough of stocks. They’re moving into bonds. Oddly, and as strange as it sounds, this inflection point just might be the turning point for stocks. Put another way, investors as a group just got the last 10 years wrong. Thinking in contrary fashion, they may get the next 10 years wrong as well.

Stocks, as a group, have not done well now for 10 years. As of yesterday, if you had put $10,000 in the S&P 500 10 years ago, you would now have about $6,200 — a loss of 38%. And it’s worse than that considering the effects of inflation.

If you look at bonds, they’ve done much better. The Merrill Lynch U.S. Corporate Master index, a measure of high-grade debt, for instance, has gained 58% in the last 10 years.

You can hear the gears turning. Stocks have not done well, investors reason, and bonds have done much better. Therefore, buy bonds.

That’s what they are doing in large numbers. Here are some telling quotes from a recent Wall Street Journal article. From a manager of $185 million in individual accounts:

“I think a lot of investors have just had it with the equity markets… The baby boomers are saying, ‘I’m too old to make up these losses… I’m not going to risk it.”

Another, who has $414 million in assets under management:

“The credit markets are the market, and the stock market is a sideshow, period.”

One more, from a money manager of $900 million in assets:

“The debt markets seem pretty well understood, while the outlook for equities is still murky.”

Even the Journal itself waxes on about the simplicities of bonds. You only have to figure out if the company can meet the minimum payments of the bonds. You don’t have to worry about figuring out growth rates or what earnings per share may be. “With no end to the recession in sight,” the Journal sighs, “logic for buying equities is wavering.”

(If you’re like me, you’re probably suspicious of someone who repeatedly says “equities” when the plain-old word “stocks” suffices.)

So the stock market has been cut in half… and NOW these advisers are all cheerleaders for the bond market. Already this year, bond funds have added some $15 billion to their assets. Last year, investors took out nearly $200 billion from their stock mutual funds.

Going with what’s worked well in the past sounds reasonable, but investing is an odd thing. It’s not like many other areas of life.

If you get a bad haircut after going to the same barber for a few times, you stop going to that barber and find another. You don’t stick with bad barbers and you don’t go looking for bad barbers.

And if you get a good meal at a restaurant, you keep going back. You don’t worry about the restaurant getting too popular. You don’t look for a dive where hardly anyone goes, thinking you’ll get a better meal.

Investing is almost the exact opposite — which is one of the things that make it so hard. The best way to make a lot of money in stocks is to buy something good that few people seem to want. Then you sit on it, and when people get excited about buying it again, you gladly sell at a premium price and make some multiple on your initial investment.

All the greats made most of their hay in just this fashion — John Templeton buying up small-cap stocks in the Great Depression… Warren Buffett picking up The Washington Post and adding shares of GEICO in the depths after the 1973 market tank… and on and on…

The best deals become available during times like now. That much is a fact. I’m not saying it’s easy. I’m not saying all stocks will rise. Some of them are going to go to zero. Some of them are never going to come back. But some of them are great businesses and have great assets that will certainly come back at some point.

I know it can be tough when stocks you own are down so much. But looking ahead, I can’t help but be more optimistic…

Regards,
Chris Mayer

February 27, 2009

Why You Shouldn’t Move to Bonds was originally featured in the Penny Sleuth.

We all thought the age of easy credit killed layaway for good late last century. There simply wasn’t the need to put a new television on layaway for $15 a week when you could just buy now…and pay later. But with credit markets frozen and the average consumer swamped with leftover debt, retailers have grabbed back onto their old layaway strategies.

Kmart pushed a revamped layaway program during the Christmas shopping season. But America’s retail Goliath continues to hold out—Wal-Mart discontinued its layaway program several years ago… and its showing no signs of bringing it back.

In fact, we seriously doubt that layaway will ever again become as popular as it once was. Regardless, cheap, payment-oriented retail methods should flourish while the average and below-average income shopper retreats to survival mode.

What the consumer needs now more than ever are options—especially when it comes to the purchase of big-ticket items. That’s why we’re taking a close look at the rent-to-own industry.

Two small-cap names come to mind in this field. There’s industry leader Rent-A-Center Inc. (RCII: NASDAQ) and close competitor Aaron Rents Inc. (RNT: NYSE). Their business models are simple: both stores rent and sell furniture, appliances and electronics

This earnings season has been downright poor across the board. But these rent-to-own firms are one of the few bright spots in today’s market. Rent-A-Center posted a fourth quarter profit and finally seems to be benefiting from a recent restructuring plan that reduced its store count to 315 locations. Aaron Rents posted strong fourth quarter numbers and raised 2009 guidance.

Both RCII and RNT have been solid post-crash performers. Aaron Rents is hovering near break-even since the beginning of November, while Rent-A-Center is up nearly 50%. These two firms have actually benefited from the growing ranks of unemployed workers.  The connection is clear: If you have no job, you’ll be hard pressed to get store credit. But you’ll still need to replace a broken appliance…

According to Cowen and Co. analysts, Aaron Rents in particular is helping customers who have not been able to get credit at Best Buy or Sears but still have to replace a broken fridge or other large appliance.

Will major retailers like Best Buy and Sears try new layaway or rent-to-own plans in an attempt to boost slumping sales? In our opinion, the economy will have to get much worse for this scenario to unfold…

Best,
Greg Guenthner

February 13, 2009

Cash In on Our Rediscovered Layaway Culture was originally featured in the Penny Sleuth.

Many of them have been expanding gas production too quickly until recently, because they were accessing outside capital in the form of debt. But ever since natural gas prices tanked, most have announced that they will “spend within cash flow,” or limit drilling activity to reinvesting the cash flow that they generate.

I’ve spent a lot of time in recent weeks reviewing E&P capital spending plans, and I think the market is underestimating just how quickly U.S. natural gas inventories could contract, given the recent collapse in drilling activity.

The Jan. 23 natural gas inventory report from the EIA revealed a 176 billion cubic foot inventory draw despite severely depressed industrial demand.

E&P companies were financing new drilling projects with debt in 2007 and early 2008, but it did not lead to an inventory glut. This reflects just how intensely the industry needs to drill to meet demand. Now that debt-financed projects are a thing of the past, we can expect to see a significant negative supply response.

For the most part, the E&P industry in the U.S. is very disciplined — perhaps more so than OPEC. E&P companies are responding to the lower natural gas price by slashing drilling and well completion activity in this depressed gas price environment. At $4.50 per thousand cubic feet, the spot price of gas is below marginal cost for most producing fields.

At today’s low prices, it makes economic sense for E&P companies to defer new projects. The U.S. natural gas supply originates from thousands of wells scattered all over the country.

Decline rates of these wells are very steep. Consider that most new production comes from shale plays — where production can decline 70% in the first year after well completion.

So low natural gas production should balance the market later in 2009 — prompting a rebound in natural gas prices. E&P stocks should rebound even faster than gas prices, since they are already discounting years of unattractive prices.

Regards,
Dan Amoss

January 30, 2009

Natural Gas E&P Stocks Should Rebound Quickly was originally featured in the Penny Sleuth.

When our portfolios are headed higher, we usually go out and spend like the dickens.  After all, with nice fat investments we feel like we have a lot more money to spend.  And, as well all know, spending drives the economy.  Result:  Stock prices and the economy get a boost.

In addition, the wealth effect is a brand of self-fulfilling prophecy, which makes it even more powerful…

By investing in stocks that go up, we have more wealth.  Having more wealth causes us to go out and spend.  That spending, in turn, causes the economy to grow.  Economic growth then leads to better times for companies which, in turn, lead to higher stock prices.

Unfortunately, the power of the wealth effect works in reverse as well…

When we see our stock portfolios getting hammered, we feel a lot less wealthy.  That loss of wealth causes us to pull back on spending.  Less spending means slower economic growth, which is lousy for companies.  Poor outlooks for companies mean lower stock prices.

And declining wealth isn’t limited to stocks.  Take a look at this chart of real estate prices…

As you can see from this graph, the year-over-year change in home values — indicated by the dark solid line — began to slow around the beginning of 2006.  But economic growth — indicated by the red dashed line — didn’t begin to slow until the middle of 2008.

In other words, the wealth effect in real estate wore off long before the economy began to sputter.  In this case, the declining value in real estate was a huge leading indicator of poor economic activity to come.

In fact, changes in just about any asset — from stocks to houses to commodities — can cause their owners to adjust their spending habits.  And those spending adjustments are going to happen after the owners’ assets take a hit.  And that makes them a great predictor of where things are headed.

I’ve told my readers time and time again that a recovery in real estate prices — and stability in the real estate market — is likely going to be one of the biggest pluses for a stabilized economy and higher stock market values.  Real estate got us into this mess and it’s going to get us out.

Using These Leading Indicators for Profit

So, how can you make money off the predictive abilities of the stock market and other asset classes?

Simple.  While others are waiting for the big economic indicators — such as solid growth, the labor market, and the credit crisis — to get back on their feet, you can slip into key investments long before anybody else gets wind. The markets are telling us loud and clear patience will be rewarded.

Best wishes,
Wayne Burritt

January 7, 2009

Profiting from the Wealth Effect was originally featured in the Penny Sleuth.

Well, let’s just take one last peek at 2008, since the final score card is in. As bad as 2008 was, it was not the worst year on record. The Dow fell 33.8%, securing the third worst spot, behind the 52.7% drop in 1931 and the 37.7% drop of 1907 vintage. As for the S&P 500, which dates only to 1923, it too recorded its third worst year, with a 38.5% drop, just ahead of 1937’s 38.6%. The worst year for the S&P 500 was also 1931 — a 47.1% drop.

But there is always a sunny side…

That’s the way Phil Carret looked at things. Born in 1896, Carret (rhymes with “hurray”) was one of the more inspiring and successful investors of the 20th century. In the pit of the Great Depression — 1932 — Carret decided to start his own mutual fund. Yes, a quarter of the work force was out of work. But that left three-quarters working. And the Dow did lose 52.7% of its value in the prior year, but that meant that 47.3% remained.

Carret’s Pioneer Fund went on to compound shareholder capital at a rate of 13% annually for 50 years, despite slogging through losses in the early going. After he sold it, Carret managed his own money and private accounts. He was the great endurance man of the investing world, its Lou Gehrig or Cal Ripken.

John Rothchild discusses Carret’s exploits in The Bear Book: Survive and Profit in Ferocious Markets. Even at the age of 100, he put in a normal work week. He was a Wall Street marvel. He was 70 before cable TV or personal computers even came along. He was 85 before Microsoft was a public company. He remembered the triumph of Harvard’s undefeated and untied season in 1913, because he was there.

Carret played through all the great booms and busts of the 20th century. He remembered 1929. He remembered how no one saw the Great Depression coming.

He was giving a speech in Rome on the day of the 1987 crash. “They all wanted to know what was going on,” he remembered many years later. “I didn’t know myself. I still don’t know.”

Old Carret was a cool hand to the end, always looking for the bright side. He turned very bearish on stocks in 1997. The Dow was 7,000. Asked if he was selling stocks, Carret said: “I’m not going to do anything about it in my own portfolio. If stocks go down, they go down. I’m 100 years old and due to conk out any minute. If I conk out at the bottom of a bear market, it would save a lot of estate taxes.”

Always looking for the bright side, indeed…

Until next time,
Chris Mayer

January 6, 2009

Phil Carret: The Pioneering Investor Who Always Looked on the Bright Side was originally featured in the Penny Sleuth.

So in that kind of context, it’s not hard to understand why we see so many compelling valuations in the market. For the moment, I want to explore this idea of investors seemingly selling anything to raise cash or its near-equivalent, Treasury bills.

(All of this is great for the government, by the way, which can’t sell enough of ’em. The U.S. government basically locked in 0% financing for the first time ever. And the buyers of T-bills, dolts that they are, provided the financing.)

It’s still a breathtaking liquidation in the making. Essentially, people are looking to turn just about anything they can into cash. Once again, you have to go back to the 1930s to find anything comparable. I found some good nuggets in an old book about a great forgotten investor.

I was rummaging around some old books in my office the other day, cleaning some stuff out, and came across The Davis Dynasty by John Rothchild. I started to flip through it and remembered the tales of the world’s great investors. Much of the information below about the Great Depression comes from Rothchild’s book.

By 1931, the economy was shrinking like fresh spinach in a hot pot. Commodity prices fell to levels not seen since the 1870s. As today, companies cut back. Profits fell. Layoffs were common. Consumers cut back. Debts went into default. And the market tanked.

The Best Investor You’ve Never Heard Of

Art Loom was the creation of the Wasserman family. It sold rugs. The Wasserman family was one of the lucky ones to avoid the Crash of 1929. It kept its fortune in bonds. Joseph Wasserman once said, “The rug business is risky enough. I want to be conservative in savings.”

Fortunately, that capital would seed the start of one of history’s great — if largely forgotten — investors. His name was Shelby Cullom Davis.

The numbers, according to Rothchild, are amazing. Shelby Davis started investing in 1947, and was 38-year-old former freelance writer. Luckily, he married well. His initial stake of $50,000 came from his wife Kathryn Wasserman, daughter of a carpet mogul. Davis did well by them. By the time of his death in 1994, he multiplied that stake 18,000-fold. He turned $50,000 into $900 million.

Davis made the Forbes 400 list in 1988. He was the only one other than Warren Buffett who made the list by picking stocks for a living. Shelby Davis followed the old way of getting rich investing in stocks. He kept a long-term perspective through bull and bear markets and followed the basic tenets we talk about all the time here. He stuck with what he knew — in his case, mostly insurance stocks. He had a passion for investing and stuck with it even when times got tough.

I found his story inspirational. Stay with investing and don’t give up on stocks — especially now, when so many are so cheap.

Until Next Time,
Chris Mayer

December 23, 2008

Shelby Davis: The Best Stock Investor You’ve Never Heard Of was originally featured in the Penny Sleuth.

A single company – one you’re probably familiar with – sold all three seemingly unrelated products. A few years ago, Sara Lee Corp (SLE:NYSE ) – maker of frozen (yet tasty) pies and cakes – owned hundreds of brands, many of which made no sense.

For instance, the frozen cheesecake manufacturer was the sole owner of Coach handbags and Hanes underwear. These two subsidiaries obviously didn’t make much sense to the company. That’s why – during two separate transactions – Sara Lee’s management and board of directors divested them through a process known as a spinoff.

Spinoffs are common in the business world. They can present smart investors with huge opportunities and sometimes, less fortunate investors with even larger losses. Spinoffs are usually as simple as they sound – a parent company decides it can do without one of its business. So, the subsidiary is spun off onto its own.

There are four basic reasons for a parent to spinoff one of its “children”:

• Unrelated Businesses – many times, companies like Sara Lee own certain subsidiaries – like Coach and Hanes – they have no business owning. This happens often in conglomerates when a certain product takes off and is held back by the organization of the parent company.

• Tax Benefits – taxes can be burdensome and confusing. But every once in a while, the mathematicians and financial wizards find a loophole to save on taxes and preserve shareholder value. Occasionally, it takes a spinoff to do it.

• Refocusing – oftentimes, a large company will take a look at its operations and find one of its businesses lagging behind, which inevitably puts a strain on management to fix the problem. The best solution is to spinoff this business so management of the parent company can get back to growing profitable businesses. This often benefits both the parent and “child” company.

• Pinching Off Debt – some spinoffs are created to unload debt and other burdensome liabilities. This is where many unfortunate investors take enormous losses. As you can imagine, a company created out of a need to unload debt is doomed from the start.

It’s important to decipher between the four reasons because if you find the right one, you stand to make colossal gains. Let’s look back at our top example…

As we noted, Sara Lee’s situation fits the first mold – unrelated businesses. Spinning off a perfectly capable business creates earning potential neither the parent nor the “child” even realized.

Sara Lee first spun off Coach in 2000. Almost immediately, the newly formed Coach Inc (COH:NYSE ) began its own marketing program. This turned into an enormous success and unrealized profit potential came to light, which shot shares straight up over the next six years. As you can see in the chart below, Coach outperformed its former parent by more than 2,000% to negative 15%.

The same thing happen in round two, when Sara Lee spun off Hanesbrand Inc (HBI:NYSE ) in 2006. Although the gains were not as fantastic, Hanes shareholders watch their shares double as Sara Lee shares stayed flat:

Of course, not all spinoffs work this way. It takes serious studying and an ear to the ground to find out exactly what’s going on.

Many times, when parents spinoff businesses, they keep it quiet. If the media gets a hold of it, shares can crash artificially, or spike prematurely. And, as we mentioned, many spinoffs negatively affect shareholders.

One recent example is InterActiveCorp’s (IACI:NASDAQ ) spinoff of Ticketmaster Entertainment Inc (TKTM:NASDAQ ) . When Ticketmaster was sent on its way, InterActiveCorp left it with a parting gift of about $750 million in debt, just as the credit crisis began to peak this summer. Shares of Ticketmaster, inevitably collapsed under this weight, falling more than 80 %:

Of course, you have to use your best judgment when you discover a spinoff. You’ll have to make the decision on why you think the parent company spun it off.

More than not, however, buying spinoffs when they’re fresh is a pretty good idea. According to Chris Mayer of Mayer’s Special Situations – a newsletter focused on spinoffs and other unique investments – “spinoffs beat their industry peers and outperformed the S&P 500 Index by about 10% per year in their first three years of existence.”

Those numbers account for both spin offs that lead to gains and those that lead to losses. Obviously, this is something to look into.

If you are lucky enough, and have the right inside knowledge, you can easily take advantage of the next Coach spinoff and leave the next Ticketmaster alone.

Sincerely,
Jim Nelson

December 18, 2008

Spinoff Stocks: Quick, Proven Way to Grab Easy Gains was originally featured in the Penny Sleuth.