Monday, July 12, 2010

I'm Cheap

By now, if you've seen any of our comments on Twitter, you probably know that we're cheap. Paying up for anything, a car, a home, a movie, and especially stocks/bonds is against our personal religion and something we try to avoid at all costs. As investors, everyone should avoid buying expensive stocks/bonds.

Specifically regarding bonds, we really only like to pay below par for a bond, being that the bond will be redeemed for par...we just find it too difficult to figure out when you get out of a bond if you already bought it for more than par. Obviously, if you hold a bond that you bought for more than par to're going to lose money when the bond principle is paid out since all bonds end up at par by maturity. So, a quick lesson on bonds for you individual investors out there is to try and only by bonds when you can get them below par...or you may fall into a yield trap (which you can do when you buy them too far below par as well). We'll save the bond less for another day.

Today, since we were asked about valuation, and how we use it, we're going to talk about stocks. P/E and recently PEG, are the two things we use before we even look at a stock further. Often, if a stock has a P/E over 18...we just don't even take a look at it. BUT, there are a couple metrics that we use that will let us buy a stock with a P/E north of 18 and stick to our discipline.

One of the things we'll use to buy a stock with a P/E north of 18 is forward P/E. So, trailing P/E is valuation based on earnings already in the nothing really to figure out there because everything you're looking at (P, E, and M (the multiple)) is real time and you can trust it. Forward P/E, that's the P/E based on either guidance from the company OR from analysts when the company doesn't give forward guidance. When we see a stock with a current P/E that's HUGE, but a forward P/E that's in our range...we get very interested. It's a simple math problem from there. For more on P/E, check out the video from our YouTube Channel on how to do the math (it's easier to watch then to write it out).

EMC is a perfect example of a stock that has a P/E of 32.04, but a forward P/E of 14.2. That's EXACTLY what we want to see. If those forward earnings come to fruition, then we could see the stock trade BACK UP to something close to 32 (since it trades there now and people still own it). So we'll say, forward earnings are $1.36 ($19.45 current price divided by 14.2 forward P/E (19.45/14.2) = 1.36 in earnings). Then, we apply a discounted multiple back on the earnings. If it trades at 32 now...what if it trades with a P/E of 20, you get a stock price of $27.39. That's about $8 higher than the stock trades at right now...we double check the PEG (that's P/E dividend by long term growth rate) and we see that EMC trades with a 0.99 the future earnings SHOULD be higher than current earnings and the stock is actually "cheap" and can be bought here safely.

PEG is like taking the temperature for us. A stock may look healthy based on the P/E, but may actually be overheated if the PEG is too high. A PEG over 2 usually signals to us that the growth really isn't there (or there are not enough analysts out there that think it's there and so no one's model includes high growth in it) and we have to believe everyone else that values the company is wrong and we're right. We usually don't like to make that bet, so we avoid stocks with a PEG over 2.

Walking away from stocks with high P/E multiples and a PEG over 2 means that we'll often miss some of the market's hottest stocks. That's OK, those that follow us have to know that we're value managers, not growth managers over here. Every now and then we get up the guts to buy something like VMWare (which we caught for 22 points) or Amazon (which we flagged as a buy at $70/share)...but then we get off before most people do when we catch a move like that because we're value investors over here...not growth. Something like a is a PERFECT example of something that we'd normally stay away from because P/E is 140, forward P/E is 60 and the PEG is 2.83. BUT, if we believe that analysts have estimates that are too low, and that the "G" in PEG could be higher, or that E will come in better than expected...that will bring down P/E (momentarily) to something more reasonable. If you believe in a strong, secular trend, like cloud computing, then owning (CRM) might not be as reckless as valuation indicates (but you MUST be right about the growth and earnings). If you're wrong, and you own a stock like Google, when they pulled out of China, the decline will be breathtaking ($150 was erased off Google's stock price in a matter of weeks). Those kinds of losses can be devastating.

What is one instance when we will ignore a high PEG? When we don't need/want growth. Take for instance, an MLP (Master Limited Partnership) that we really don't care if they grow that much...we just want the dividend paid consistently. We're not that concerned about the PEG as these companies rarely grow at the rate of an Apple, Google, Amazon, VMWare,, etc. Take one of our favorite, Calumet Specialty Products Partners (CLMT), it trades with a forward P/E of 11.42 (that's great for us), but the PEG is 9.41. That's a terrible PEG, but we don't expect big growth out of a company like CLMT. Look at KMP, a P/E of 34.41 and a PEG of 11.75. That is TERRIBLE if you compare it to other companies...but we own KMP for the dividend (although, KMP is now getting expensive compared to other MLPs and you may want to consider swapping out of KMP and into another MLP before everyone else figures that out as well and does it before you do, leaving you with a lower stock price). The same is true of Kilroy Realty...and many other big dividend paying stocks that don't have big can ignore PEG (except you probably want to use it to compare it to other stocks in the same category).

There are reasons to use P/E and PEG, and some reasons not to (in certain circumstances)...but, as a general rule for us...cheaper is always better.

Saturday, July 10, 2010

The Blue Box

Best Buy is toast. The other week at the office, we had a conversation about Best Buy...and it's hard not to think that they're in trouble. Their most recent quarter, although not the horror show that some analysts say it was...was something to be concerned about.

Circuit City is gone, and for several quarters, it was clear Best Buy grabbed all their customers. The stock rocketed. But then, after the most recent quarter, we starting thinking about what might go wrong with Best Buy. Losing money is always the bigger risk when managing money than not making enough. People are generally happy, as long as they don't see red. Black is the new green these days.

So, after seeing the stock decline, selling the stock, then cashing out of the puts...we're left wondering what the future holds for Best Buy. Their biggest risk: pre-packaged media. That's the HUGE section of the store right in the center for movies, music, and games. That's right...going the the store and buying the ACTUAL CD or DVD will soon disappear. And with it, go great margins, revenue, and ultimately profit dollars. Granted, Best Buy announced on the call that they will be beating up GameStop and stealing their lunch money (they're going to start buying, selling, and trading of used games). This new strategy will help offset some of the revenue lost from other media sales...but it will only delay the inevitable: people shop online more an more these days. We visited the local Best Buy to see what computers they had in stock when it was time to get a new laptop at the office. It was clear that we could get far more from a or a than we could by going into the store...and we're willing to bet we're not alone in what we have found.

iTunes has revolutionized content distribution along with NetFlix. If other companies don't catch up, they will be eliminated...Circuit City style. These two companies are taking a huge bite out of Best Buy's pre-packaged media sales with their direct download to consumer programs. So, what is the solution you say, for Best Buy?

Best Buy needs to buy BlockBuster Video. BLOKA.PK (because it now trades on Pink Sheets after it was delisted) is in a world of hurt. Holleywood Video has already been eliminated (Movie Gallery) and BlockBuster is next. Why? Thanks to CoinStar...the creator of the Red Box, brick and mortar movie rental places are getting burned to the ground by these little red boxes with little overhead, no healthcare costs, and loads of profits. BlockBuster has already countered with the Blue Box...but it's too little too late. The ENTIRE MARKET CAP of BlockBuster's stock is now only $36 Million. Heck, for that price Best Buy could take a stab at it and be wrong and still come out OK...but I think that they'd come out better than OK.

First of all, the color schemes are almost identical, so very little in terms of branding would need to be done. They could change the name or leave it, and I don't think people would notice.

Second, all that space they now have in their stores can be converted from pre-packaged media into a BlockBuster. They keep only the hottest selling music in stock (same thing with DVDs, which BlockBuster already sells) and then throw in the buy/sell/trade for music, movies, and games (since they're getting into the act with video reason to stop there). This should be a much better use of the space in stores and they need more revenue/sq foot in the stores because media sales are down so much.

Third, BlockBuster already competes with NetFlix via it's in-the-mail-style rental package. Jumping with both feet into the content distribution for Best Buy should help margins and bring a serious competitor to NetFlix. You can easily see sales reps cross selling the down loadable content to those ready to walk out of Best Buy with a new television. Best Buy can work with the makers of the products it sells to add capability to the televisions, pick a video game partner...the sky would be endless. Deals like buy a television and get access to our downloadable content free for 3 months (after which the billing starts) would help subscriptions skyrocket for the BlockBuster division of the company who already has the service...they just need Best Buy's distribution.

Finally, having a Blue Box outside EVERY Best Buy all over the world means that they have instant revenue Red Box style. I think Blue Box even has a deal with Sheetz, the gas station extravaganza that draws all sorts of people with it's selection and variety of things inside. Adding a Blue Box to the outside of every Best Buy should ADD to the foot traffic inside the stores as some will ultimately venture into the store to shop after they grab a movie. Or, you can see them buying a new BlueRay or Home Theatre and grabbing a movie on the way out.

BlockBuster may have $1 Billion in debt...but it looks like their free cash flow is $650 Million...plenty of cash coming in to refinance the debt with the financial backing of Best Buy behind it. The issue for BLOCKA.PK is that on their own...they face extinction and they just don't have the balance sheet to make it. At 16.5 cents/share for BlockBuster we think Best Buy is missing out on a great opportunity grab a perfect, complimentary a block buster price (and it's a move that might just save both companies).

Saturday, July 3, 2010

Financial Television is Like a Comic Book Series

People don't watch enough television. Seriously, I hear people all the time who say that so and so recommended a stock on television and all of a sudden it's down and they've lost money and they want to know what to do.

They're getting it all wrong. Television isn't one long buy/sell list for investors to watch, execute the trade, and then get rich. That's now how television works. If you read our article earlier "They Are Idiots", then you know that when you buy a stock from someone, you have to make the bet that they are an idiot...otherwise you are the idiot; as they convinced you to buy something they didn't want anymore. Guess how many other people are watching EXACTLY THE SAME THING you are watching right then; and you now have to trade with AND against these people to make money.

Say Steve Grasso comes on television and says he's buying BP, which he did. And then you go on vacation, forget about the real world for a week, come back and check on your BP position. You see that it's down from $34 to $27 and think: "What the heck happened to BP? That Grasso guy is an idiot, I'll never listen to him again." This is where people go wrong. A few days later, after getting long BP, Steve Grasso, Patty Edwards, and many others on the Fast Money Desk stated very clearly that BP had gotten too difficult to measure and that there was too much risk in the trade and that they had sold their position and were not going back in.

Watching television, at least financial television, is like reading a comic book. If you don't read every single issue that comes out, you are GOING TO MISS SOMETHING. That detail that you miss, could cost you hundreds or thousands of dollars. Like reading a comic book, it's important to read a few issues before you form an opinion. The biggest mistake (one of them) retail investors make is in thinking that a stock is going to run away from them, so they jump in when they hear a convincing story on say Jim Cramer's Executive Decision Segment, where he has a CEO from a company come on and tell you what's new and exciting about their company. Then, Cramer says he likes the company, the person is so excited, they go and buy it the next morning at the open (often the time that people pay too much and get crushed by the end of the day).

What they have forgotten, or not witnessed, is that on ANOTHER episode of Mad Money, Jim Cramer vehemently warned viewers to always wait 5 days before buying a stock, never buy your whole position at once (in case the stock goes down and you can get it for cheaper), and always use limit orders so you get the price you want. But, the person who buys this stock after the Executive Decision segment missed the other shows about disciplined investing and ignored all of Cramer's rules for buying a stock. They exclaim that Steve Grasso and Jim Cramer are idiots and they never buy another stock again (or they repeat their mistake after listening to someone else on TV).

The bottom line, you MUST watch EVERYTHING before you buy ANYTHING. Shows like Fast Money, Mad Money, Strategy Session, and Stop Trading are terrific; but they are often just one piece of a much bigger puzzle that needs to be pieced together before you buy or sell a position. There will never be any substitution for doing your own homework. When you watch someone on television they will ASSUME that YOU, the viewer, has heard everything else they have said or written. They have to do that, otherwise, they would say the same thing every single time that you watched them. This wouldn't help anyone...and it certainly wouldn't be entertaining. So, next time, before you make a decision that costs you thousands of dollars, "read up" and watch a week's worth of whatever program it is you're watching until you understand how each person trades so that when they change their mind on BP, Research in Motion (RIMM), or Goldman Sachs (GS) you'll be there to see it and then you can change yours too...after you do your homework of course.