Breakout Stocks Weekly Summary
Larsen Kusick
Stocks were able to rally Friday afternoon following the announcement that Tim Geithner will be the new Treasury Secretary, but the major indices finished the week in the red.
Citigroup (C:NYSE) became a key focus in the equity markets, as the company's shares lost more than half of their value during the week. Despite the fact that Citi is one of the banks that received a major equity investment from the Treasury, shares are trading as if the company is about to fail. Although it's highly unlikely that the government will allow Citi to default on its obligations, this situation illustrates one of the major difficulties facing investors looking to buy stocks now.
With the economic crisis resulting in the potential failure of many companies across many sectors, stocks are taking a back seat to bonds and other debt securities that receive priority in a bankruptcy scenario. The equity markets are surprisingly small compared to the global debt markets, and it's exceedingly difficult for stocks to show significant gains so long as the debt markets are under duress.
As a result, it's understandable that institutional investors are showing little interest in owning stocks (or stepping up and buying on selloffs). Why buy a stock when the corporate bonds are trading at extremely low levels and offer attractive yields as treasuries continue to see strong demand despite offering almost no return? This situation is one of the major drivers behind the continuing slump in the major indices, and it's hard to imagine stock valuations being able to climb without improving conditions in the debt markets.
During the developing economic crisis, we've tried to focus on companies that have strong positions in their respective sectors and are on solid ground financially. However, the market is communicating extreme doubts regarding the potential for many companies to go bankrupt over the next year or more. Unfortunately, owning the best company in a weak sector (which most sectors qualify as, due to economic conditions) is no guarantee that investors won't lose money as multiples contract or earnings suffer due to price declines caused by failing companies dumping inventories into the market. In an economic crisis, bad companies disappear while good companies survive -- the only difference for shareholders is that one stock loses 100% while the other loses less than 100%. This is a very simplistic and extremely pessimistic scenario, but so far the current crisis has played out in a virtual worst-case scenario. If this truly is the environment that investors face in 2009, there's a strong argument to be made for using pairs trades -- in other words, buying the best stock in a given sector while shorting one that is likely to go bankrupt.
As we said in our Weekly Summary last week, it's extremely difficult to find a reason to get bullish in the current market. With investors showing little regard for fundamentals and valuations, we're cautious about bulking up in any position. In addition, it remains difficult to buy on extreme weakness, as the market's overall downtrend is keeping the rallies small.
We continue to believe that the record levels of fear are making stocks more attractive for investors looking for large profits; we simply need to see some increased confidence in the ability of governments around the world to enact policies that will stabilize the deteriorating economic conditions. The U.S. housing market remains in a downward spiral and needs significant action to reduce foreclosures, while the banking system remains under extreme stress and also requires a better plan than what has been offered so far. Unfortunately, the timing couldn't be worse in terms of having to rely on a lame-duck session of Congress to deal with the crisis.
We expect volatility to remain high over the next few months, but see potential upside for the overall market if a solution is found to keep thousands of U.S. autoworkers employed, conditions in the financial sector improve, or visibility improves regarding how deep the recession will be in 2009. We plan on continuing to pick away at our favorite names, but remain cautious given the ongoing turmoil that is making it so difficult to own stocks during this historic period.
Turning to the model portfolio, our sole trade this week was initiating a 250-share position in biopharmaceutical company Alnylam (ALNY:Nasdaq) on Tuesday. Our timing couldn't have been worse given that virtually all unprofitable biotech companies were crushed this week, as investors' increasing risk aversion hit the sector hard. We believe Alnylam's significant cash stake and valuable intellectual property make the shares an attractive play following their recent declines. However, it's becoming increasingly obvious that investors are willing to sell shares in companies beyond existing cash levels. We remain bullish on Alnylam and plan on continuing to add to this position through the end of the year.
We're leaving the Watch List unchanged this week, aside from removing Alnylam. Our List includes AeroVironment (AVAV:Nasdaq), American Ecology (ECOL:Nasdaq), American Science and Engineering (ASEI:Nasdaq), American Superconductor (AMSC:Nasdaq), Axsys Technologies (AXYS:Nasdaq), AZZ (AZZ:NYSE), Charles River Laboratories (CRL:NYSE), Fuel Systems Solutions (FSYS:Nasdaq), Genoptix (GXDX:Nasdaq), Gmarket (GMKT:Nasdaq), Greatbatch (GB:NYSE), II-VI (IIVI:Nasdaq), Luminex (LMNX:Nasdaq), Natus Medical (BABY:Nasdaq), Neutral Tandem (TNDM:Nasdaq), Phase Forward (PFWD:Nasdaq), Quidel (QDEL:Nasdaq), RiskMetrics Group (RMG:NYSE), Synovis Life Technologies (SYNO:Nasdaq), Techne (TECH:Nasdaq) and VNUS Medical Technologies (VNUS:Nasdaq).
Now, let's look at the model portfolio. As a reminder, Ones are stocks that we would buy at their current quotes, and Twos are stocks that should not be purchased at their current share prices.
ONES
Akamai Technologies (AKAM:Nasdaq, $10.52, 500 shares, 3.81% of the model portfolio): The company is the world's leading provider of Internet content delivery services, with a broad range of offerings and a leading market position in the content delivery (CDN) space. Akamai provides services for organizations ranging from News Corp.'s (NWS:NYSE) social networking Web site MySpace to the Pentagon. Shares traded sharply lower this week on concerns over the deteriorating health of the company's end markets. On Wednesday, the company announced a restructuring aimed at cutting operating costs in order to support growth investments in the current economic climate. The move will result in the elimination of about 7% of the company's workforce, and it will take a $4 million restructuring charge during the fourth quarter. On Thursday, the company hosted an analyst day that was well-received by researchers, who had a favorable reaction to the detailed data that were provided by management about each of the company's segments. While Akamai is vulnerable to the current economic weakness, its management team is still in place from the difficult 2001-02 period and the company has more than $3 in cash per share on its balance sheet. With high free cash flow and a leading position in its core markets, we believe shares continue to offer significant upside from the current price.
Alnylam Pharmaceuticals (ALNY:Nasdaq, $17.97, 250 shares, 3.25%): Alnylam is a biopharmaceutical company focused on developing therapeutics based on RNA interference (RNAi), which is regarded as one of the most significant breakthroughs in modern medicine because it allows scientists to target diseases on a genetic level. Although there are significant doubts as to whether RNA-based drugs can be used in humans without triggering a defensive response by the body, we believe that any progress in overcoming the issues at the delivery stage would result in huge upside for investors. Shares declined throughout the week as much of the biotech/pharma sector sold off on weakening sentiment. On Tuesday, we initiated a 250-share position in Alnylam given the company's solid financial position and significant doubts in the analyst community, despite ongoing interest from large pharmaceutical companies that are struggling to find potential new sources for drug development. The company has more than $12 in cash per share and almost no debt, making us confident in its ability to weather the current economic crisis that has impacted many smaller biotech companies. Alnylam boasts partnerships with market heavyweights including Novartis (NVS:NYSE), Roche, Medtronic (MDT:NYSE) and Takeda, and has used its attractive intellectual property to drive significant growth in licensing revenue. The company's lead candidate is ALN-RSV01, which is in phase II clinical trials for the treatment of respiratory syncytial virus (RSV), a common virus that is estimated to cause 125,000 infant hospitalizations per year in the U.S. Our thesis for this position is focused on the company's significant intellectual property (valued around $5 by the most bearish analysts) and the huge potential upside if progress is made in solving the problems associated with delivering RNAi- based treatments into the body.
A-Power Energy Generation Systems (APWR:Nasdaq, $3.45, 1,400 shares, 3.50%) A-Power is an under-the-radar name in the alternative energy space. The company designs, builds and installs distributed energy facilities in China and Southeast Asia, providing power generation capabilities separate from national power grids. A-Power is also preparing to enter the wind energy business, with one turbine production facility recently completed and plans under way to begin construction on a second plant soon. On Wednesday after the market closed, A-Power reported third- quarter results that were below consensus estimates but relatively in line with the more conservative estimates from analysts at Roth Capital. Shares sold off Thursday along with other energy-related names, as panic over the deteriorating global economy took center stage. Management reiterated its goal of selling 10 of its largest 2.7 MW wind turbines during the fourth quarter, along with 30 of the smaller 750 kW turbines. Although it's difficult to remain patient with this name considering the massive and ongoing declines in the share price, our thesis remains intact for A-Power, especially given the potential for additional economic stimulus from the Chinese government. For the moment, the biggest catalysts for A-Power will be the company's ability to turn its $300 million distributed generation project in Thailand into a solid contract and the start of turbine production.
Aspect Medical Systems (ASPM:Nasdaq, $3.00, 2,100 shares, 4.56%): Aspect Medical is a medical equipment maker that operates in the niche market of preventing incidences of anesthesia awareness. The company's primary product is a Bispectral index (BIS) monitoring system, which employs a sensor applied to a patient's forehead in order to measure brain activity and ensure that he or she has reached an appropriate depth of unconsciousness for invasive procedures. We continue to like Aspect as an under-the- radar play with a limited connection to the current economic crisis. The company does not announce new developments very often, but we're positive on management's plan to focus on driving growth in sales of its BIS systems and monitors. Expectations for the company are extremely low, which we believe sets the stage for significant gains if it's able to follow through and gain wider acceptance of its BIS technology. For now, shares are not faring much better than the broad market, which we believe is a result of the ongoing issues that are forcing institutional investors to shy away from stocks in general. Nevertheless, we believe a modest position in Aspect is attractive considering the significant upside potential.
Central European Distribution (CEDC:Nasdaq, $19.26, 350 shares, 4.88%): The company produces, distributes and imports alcoholic beverages, mainly in Poland. We see upside potential in this company based on its strong position in distributing alcoholic beverages in Poland, Russia and throughout Europe. Synergies between the company's recent acquisitions should help drive strong earnings growth over the next 12 months, with potential market share gains coming from the demise of some of its smaller competitors. Stocks with connections to Russia remain under pressure as the country has had to halt trading on an almost daily basis due to the steep declines in its Micex Index. With a stable business in Poland and an attractive position in Russia, we believe that Central European remains a solid pick for investors willing to accept the risks associated with the high volatility in both the Russian ruble and Polish zloty. Shares continue to trade at extremely low valuations due to the ongoing stresses in the global financial system that have forced institutional investors to flee from risky equities and into the safety of U.S. treasuries. Shares traded well above the $30 level after announcing strong quarterly results earlier this month, and we believe the current quote represents an attractive entry point for investors willing to accept the currency risk.
Dolby Laboratories (DLB:NYSE, $25.85, 400 shares, 7.48%): Dolby is a global leader in audio technologies used in consumer electronics and professional content productions, such as films and TV programs. Shares of Dolby traded lower this week along with the rest of the market. We've highlighted Dolby as one of the best growth stocks investors can pick up during the current economic crisis based on the company's solid financial position, high visibility into revenue streams, and lack of major competition. Nevertheless, the crisis is leaving no stock untouched, and shares remain tied to the broad market's panic-driven moves. Earnings announced earlier this month showed that the company remains in good shape despite the weakening demand for consumer electronics. We believe management has done a nice job of keeping expectations at levels it can surpass, and remain confident that shares will outperform the broader market as macroeconomic conditions stabilize. With almost $400 million in cash on its balance sheet and minimal debt, Dolby is well- positioned to weather the storm and drive sales growth even in a tough environment for consumer spending.
Energy Conversion Devices (ENER:Nasdaq, $21.00, 275 shares, 4.18%): The company has made strides throughout 2008 in ramping its solar business and is now a major provider of rooftop and BIPV (building integrated photovoltaic) systems in Europe, North America and Asia. Shares fell sharply this week as oil prices continued to drop and investors remained extremely concerned about the potential for huge declines in solar module pricing. In addition, the stalled credit markets pose problems for virtually all solar companies as their customers will have trouble financing new projects. For now, the near-term picture is extremely cloudy for the solar sector, but analysts have sharply cut their estimates and views on the sector, and negative sentiment is at a multiyear high. We added to our position in Energy Conversion last week after shares tumbled more than 40% from their early-November highs. We believe the company represents the best play in this sector, but it's been difficult for the stock to stage a rally as it's becoming increasingly obvious that many of the smaller solar firms in the market are likely to go under. Although the economic crisis is increasing the risk profile of virtually every stock connected to energy prices, we believe shares offer huge upside if conditions stabilize.
Perfect World (PWRD:Nasdaq, $15.73, 500 shares, 5.69%): The company is a leading Chinese video-game developer. Recent data have shown that trends in Chinese online gaming remain strong. Perfect World's stable of successful existing games, such as "Zhu Xian," "Perfect World II" and "Hot Dance Party," should continue to provide solid revenue results as the company develops and launches new titles. Shares traded lower this week despite a lack of any major news for investors, as concerns over the global economy remained the focus for all major stock markets. Perfect World is one of the best-positioned companies in the Chinese gaming space, thanks to its stable of popular games and valuable game-generation platform. In addition, near- term results are likely to remain robust, as the company has two new games ("Pocketpet Journey West" and "Battle of the Immortals") that are likely to be launched in the next few months. Its development of simpler 2D (two-dimensional) games could also increase sales outside of major Chinese cities that have been the traditional drivers of sales growth for Chinese gaming companies. Although we've been cautious on this name due to the grim outlook for the Chinese economy, we've become more bullish since shares fell below the $20 level. In our view, investors can pick up shares at current levels and be confident about the long- term outlook.
Vocus (VOCS:Nasdaq, $14.55, 550 shares, 5.79%): Vocus is a small-cap company in the software as a service (SaaS) industry, focusing on providing public relations (PR) management to companies across a wide range of industries. Shares have traded in line with many other software- and technology-related stocks despite Vocus offering a less expensive set of services that are likely to see continuing strength in sales even in a tough economic environment. We like Vocus for its dominant position in a niche market, diverse customer base and reputation as a low-cost solution that companies are unlikely to cut when trimming budgets in 2009. Considering the carnage in the software sector, we believe the company will remain in excellent position regardless of how long the current recessionary environment lasts. Growth opportunities in Europe and Asia remain attractive, but will be more significant once conditions improve. With no debt and more than $80 million in cash on its balance sheet, we believe Vocus is a great example of the type of company that investors can buy and hold despite the terrible economic conditions.
TWOS
GameStop (GME:NYSE, $17.98, 200 shares, 2.60%): The company is one of the world's largest retailers of video-game hardware and software, with more than 5,000 stores worldwide. On Thursday, GameStop announced third-quarter results that included in-line earnings, slightly weak revenue and lower earnings guidance. Although shares held up well (considering the weak guidance) at the beginning of the day, the market-wide selloff sent them sharply lower by the end of the day. We viewed the quarterly results as positive considering the tremendous decline in consumer confidence that is hurting results at virtually all retailers. Highlights from the quarter included better-than- expected gross margins, lower-than-expected expenses and positive management commentary about the start of the fourth quarter. Nevertheless, the selloff shows just how difficult it is to own any stock in the retail sector. We sold 100 shares last week after positive video-game sales data from industry researcher NPD, and may look to add to our position if we see signs that the environment for retail-related stocks is improving.
Guess? (GES:NYSE, $10.88, 300 shares, 2.36%): Guess? is an international retailer and wholesaler of apparel aimed at young men and women. Although the retail sector has been beaten down over the past year, we like this name based on its attractive growth profile, international exposure and consumer base. Shares are down almost 75% in less than three months, owing primarily to the virtual stoppage in consumer spending at most apparel stores. We sold some of our position around $38 due to the potential for increased investor concerns over the holiday season. While we never imagined shares could sell off so much, it's obvious that the retail sector will be one of the casualties of the economic crisis as consumer spending has gone from bad to worse. We've stuck with Guess? based on the company's solid execution in an already-tough environment. A recent article in "Business Week" highlighted Guess? as one of the few retailers that will survive the current recession and be poised to thrive as competitors disappear. Nevertheless, it's obvious that survival does not guarantee shares will avoid the horrendous weakness in retail-related stocks. The upcoming fourth-quarter results will give us a better idea of whether expectations have come down enough that shares can offer upside for investors. In the meantime, this position has become progressively smaller as shares have slumped, and we're content with maintaining our existing stake.
Shaw Group (SGR:NYSE, $13.88, 375 shares, 3.77%): The company offers an array of services, including engineering, design, and construction, for projects ranging from power plants to environmental cleanup. Shaw's 20% stake in nuclear plant designer Westinghouse Electric provides significant upside opportunity based on potential future nuclear projects, as Shaw receives exclusive access to engineering work on any Westinghouse-designed AP1000 reactors. The infrastructure sector remained under pressure this week, due to ongoing concerns regarding declining oil prices and worries about the long-term health of the global economy. We've highlighted Shaw as a quality name that could see its shares put up significant gains as governments around the globe look to invest in nuclear power, but the economic crisis has taken center stage and left the entire infrastructure sector in tatters. Although the action in the stock has been brutal, Shaw's quarterly results from earlier this month showed that the company is doing well despite concerns over the potential for project cancelations resulting from tight credit markets and a deteriorating economic environment. While we're not adding to this name given on our preference for debt-free companies, it's difficult to not see significant gains for this position when the economy stabilizes.
