Many of the concerns that prompted the unexpectedly large Fed rate cut last August are still in play. The economy continues to decelerate; corporate profit growth is slowing; the housing/mortgage market is in disarray; the dollar is crumbling before our eyes; and the Great Debt Bubble is just beginning to deflate. Despite all these conditions, a surprisingly strong stock market rally continues. Why?
It's certainly not the market's fundamentals. As I observed, profits and economic activity are both deteriorating. And it's not a shrinking risk premium. One only needs to look at structured debt pricing to see that. It's not interest rates. While Treasury bond prices have firmed, yield spreads have widened on most other debt. And finally, it's not valuation, as stock valuations have returned to high-teen price/earnings ratios. Currently, the Value Line Arithmetic Index trades for 19 times 2007 estimated profits.
What's a rational investor to make of this? The conclusion is simple and obvious. If enough
guests scream loud enough, the Fed will bail out equity investors. And since stocks always decline in sync with some fundamental concern, there will always be some "crisis" to precipitate a rate cut, however overblown or manufactured. Did the Fed save Main Street with its actions? You tell me.
If the Fed is willing to positively surprise the stock market after a skimpy 8% correction, investors can lever up and go for it. A Fed bailout is always only a single-digit pullback away! Fed members will tell us that they don't exist to spare aggressive investors from poor decisions. They have to say that. But we know the real scoop. They will save us the next time as well. And investors will continue to ante up.
There's no telling how long the game will last, but I remain very concerned about the elevated valuation levels for shares in a deteriorating fundamental environment. And I am reluctant to chase the "average" stock at 19 times earnings. But I do have a few deep value stocks that might participate if investors continue to 'roll em':
. At $25, the shares trade for 11 times my 2008 forecasts. You would think that SKX was struggling like many other shoe companies, most of which trade for 15-18 times next year's profits. That's not so. The fashion shift away from white athletic shoes and toward fashion and color plays right into Skechers' strengths.
The company has excellent exposure to the family- and department-store channels that emphasize fashion-oriented shoes. The company has been racking up huge market share gains all year, with domestic scanner data revealing 20%+ wholesale shipment growth. And their international growth is exploding and large enough at 22% of sales to move the needle.
Skechers represents a value man's (these days, poor man's) Deckers, 20%+ revenue growth for an 11 P/E. If the company can expand its industry-low 8% operating marginsto 11% (peers are at 12% to 16%) over three years, and grow sales 12% to 15% per annum, earnings would double to $3 by 2010! And that kind of growth would expand the P/E ratio, perhaps to 17 to 20 times, generating a $50 to $60 stock.
trades for 10 times my fiscal-year 2008 (next 12 months) estimate. The company is a leading steel scrap processor and mini-mill. Of all of the domestic steel stocks, CMC has the largest exposure to strong domestic non-residential construction and international markets. The company is a net seller of scrap here as well. Due to insatiable foreign demand for iron ore and steel scrap, the scrap market has been on fire here in the States.
Commercial Metals should be able to squeeze more margin from its vertically integrated domestic steel mills, as well as exploit a strong merchant scrap business. Finally, the company has a few major start-ups/acquisitions to drive continued revenue and earnings growth in 2008 and 2009. A 13.5 P/E target, not bad in a 19 P/E market, would boost the shares to $47.
trades for nine times my aggressive 2008 calendar-year earnings and only 7.6 times my 2009 forecasts of $1.29 and $1.55. My earnings are considerably higher than Wall Street consensus because I believe the recently closed
acquisition will result in significant synergies, as well as dramatic improvements in the competitive dynamics of the EMS sector. As other players forcibly merge, industry pricing and returns should advance significantly, generating a striking secular improvement in the business.
I realize that the EMS space is ground zero for bad managements, irresponsible corporate directors, aggressive pricing and profitless prosperity for shareholders. If EMS corporate officers and directors would only realize the value of their logistical and manufacturing capabilities and price it to make only acceptable returns, profit margins and shareholder returns would soar. A 14 P/E on my $1.55 estimate for calendar 2009 would generate a stock at $22 in the next 12 to 18 months. That is conservative for a company with a few years of 20%+ revenue and profit growth.
, a leading but under-owned and under-followed toy company, is exceptionally cheap, with a powerful new-product portfolio. Long known for its wrestling action figures, the company has morphed into a toy brand conglomerate, with products such as Care Bears, Pokémon, Disney, Cabbage Patch, Hannah Montana, Neopets, and SpongeBob SquarePants. This holiday season, Jakks has three of the top toy brands in Hannah, Pokémon and Eyeclops, a 200-power microscope that plugs into one's television.
Because of the Street's lack of coverage, investors are unaware of the growth opportunities afforded this mid-sized company. After a strong September quarter, I expect another earnings surprise in December. I also expect double-digit revenue growth next year and earnings approaching $3 per share, numbers significantly higher than the sell side. At 4.7 times 2008 EBITDA with a strong balance sheet, the shares are simply too cheap not to own. A 13 P/E generates a 50% trade.
trades for 8.75 times my calendar 2008 estimated profits. As the world's leading hard-disk-drive company, Seagate stands to benefit from the explosion in digital content storage in both the business and consumer space. Also, developing market computer growth should accelerate as Internet access stimulates strong emerging-market PC demand.
The hard-drive industry continues to consolidate, as drive assemblers and component suppliers merge. Were it not for the socialist morons running a couple of Asian drive companies, the sector would be a rapidly growing, very profitable high-tech oligopoly. Rumors exist that
, the incompetent, billion-dollar drive loser, is willing to partner or sell its miserably performing hard-drive division. That would be a huge victory for owners of Seagate and
were it to happen.
For now, Seagate is still very cheap with large positive revisions and a tradition of powerful rallies in the typical seasonally strong fourth quarter. A 12 P/E valuation target on Wall Street's positive revisions to $3 after the September quarter would price the shares at $36. Not bad upside for the world leader in a high-unit-growth, improving-pricing-environment industry that generates strong free cash flow in a difficult environment. Imagine Seagate's profits if Hitachi priced drives to simply break even.
"Don't fight the Fed" is an old Wall Street saw. That saw hadn't really worked the prior four initial rate-cut cycles in the last 18 years. But it's working big-time since this last rate cut. It's not because stocks are cheap. That 19 P/E ratio proves it. It's not because earnings are soaring either. Profit growth in mid-single-digits is the slowest in years. It's not because of unnaturally low interest rates. The foolish Greenspan 1% deflation hoax is now flushing through the system. Treasury bonds are up to 5%, and yield spreads are back to normal.
No, stocks are soaring because the Chairman announced to the world that the "Fed put" still exists for stock holders. And that the strike price is only down a few percent. Major concerns still exist, and the Fed rescue rally has run hard. So I believe selectivity is important in an expensive market. But buying cheap stocks might generate high enough returns to satisfy all but the most expensive tastes.
At the time of publication, Marcin had positions in Skechers, Commercial Metals, Flextronics, Jakk's Pacific and Seagate Technology, although positions may change at any time.
Robert Marcin is the founder of Defiance Asset Management, a private investment management firm. Client accounts managed by Defiance Asset Management often buy and sell securities that are the subject of commentary by Marcin, both before and after it is posted. Under no circumstances does this column represent a recommendation to buy or sell stocks. This column is intended to provide insight into the financial services industry and is not a solicitation of any kind. Neither Marcin nor Defiance Asset Management can provide investment advice or respond to individual requests for recommendations. However, Marcin appreciates your feedback;
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