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Sunday, January 30, 2011

FASCINATING SLIDE: The Power of Compounding - P&G's 54 Consecutive Years of Dividend Increases

Per our December post, 1-800-Flowers.com (FLWS): Is "Moat" Shallow, Shrinking, or Nonexistent?, we still owe readers follow-up commentary on the company's Fannie May Confections business. We hope to share something soon. Please stay tuned.

About one week ago, we shared a "fascinating slide" from Compania Cervecerias Unidas S.A. (CCU). Here, we share a striking slide related to our stocks versus bonds stance. The fact remains that numerous large, high quality, dividend-paying companies are offered at reasonable multiples of earnings. Moreover, rather than a static coupon payment from a bond, many companies consistently increase dividends to equity shareholders year in and year out.

Take Procter & Gamble (PG) for instance. Per the below slide from P&G's December Analyst Meeting, the company compounded dividends at an average growth rate of 9.5% for 54 consecutive fiscal years:

Not too shabby and evidence of a very durable franchise. SO, in addition to potential capital appreciation derived from a growing stream of earnings (assume constant P/E multiple but higher "P" and "E" over time; "E" grows through levers such as new product launches, market expansion, and pricing power), investors benefit handsomely from a growing stream of dividend income.

While we've no position in P&G, the company's incredible dividend track record neatly illustrates why we prefer equities to bonds for those investors with a long-term time horizon.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long FLWS, CCU.

© 2011 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, January 22, 2011

FASCINATING SLIDE: Per Capita Beverage Consumption in Chile, Argentina, Spain, USA and Australia, plus Chilean Trend

Every now and then, we may share what we think is a "Fascinating Slide." The below comes from a recent management deck of our Compania Cervecerias Unidas S.A. (CCU), which we briefly mentioned in our happy new year post. Here, we see beverage consumption per capita (in liters) for Chile versus a handful of other countries, including the United States (click to enlarge):

The difference among the countries is striking and worth pondering. The next obvious question is how fast is the gap closing? How fast are the countries/regions moving toward parity?

We can surmise that consumption in developed markets is relatively stable and answer the Chilean component of this question below by sharing one more relevant slide (click to enlarge):

Part of the company's organic growth plan is to ride the gradual increase in per capita beverage consumption in Chile and Argentina over time. Nothing is guaranteed, but the historical record suggests the favorable per capita trend may continue, assuming economic growth in Latin America remains on track. Of course, the macroeconomic and political environment, as well as currency fluctuations, are primary risk factors.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long CCU.

© 2011 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, January 19, 2011

Reconciling Epoch's Sensible Investment Approach with Sir John Templeton's Advice

We previously shared content from Epoch Investment Partners (EPHC) in our 9/1/10 post, Epoch Investment Partners: "Ratio of equity free cash flow yields to bonds near 50 year highs" = More Value in Stocks than Bonds.

We mentioned then that Epoch's investment approach is fairly consistent with our primary investment approach: in a nutshell, focus on growing, franchise-type companies that generate meaningful excess cash flow and use the cash in shareholder friendly ways.

Below, we share a 12/31/10 video from Consuelo Mack WealthTrack featuring the CEO, Co-CIO & PM of Epoch, William Priest.
  • On this week's Consuelo Mack WealthTrack, Epoch Investment Partners William Priest has created a new paradigm for picking stocks, enabling him to beat markets and competitors with less risk. He'll explain how and where he is doing it (link to video).

His sensible key message: keep a global perspective and seek companies that generate consistent, significant excess cash flow with capable managers who allocate capital to the benefit of shareholders. Plus, while you're at it, emphasize less volatile holdings that maximize excess return per unit of risk across the portfolio.

We concur that his investment strategy makes common stock sense and works over time. Examples of our holdings that fit the billing include eBay (EBAY), Weight Watchers (WTW), j2 Global Communications (JCOM), and PriceSmart (PSMT). However, our investment strategy also includes caveats (detailed in CS$ Approach).

For example, recall the advice from the late Sir John Templeton (click for prior post) that we included in our 11/2/10 post, Parlux Fragrances (PARL): One Dollar of Value for Only 58 Cents - No Catch!:
  • "Never adopt permanently any type of asset or any selection method. Try to stay flexible, open-minded and skeptical. Long-term top results are achieved only by changing from popular to unpopular the types of securities you favor and your methods of selection." (Source: The Book of Investing Wisdom)
In the Parlux post, we continued, "So, while it's great to seek out consistent, high margin, high ROE, high-barrier-to-entry companies, sometimes other types of companies or investments offer equally favorable -- or better -- investment returns over time."

Keeping an open mind and considering different sources of value brought us to our off-the-run holdings such as Sonic Foundry (SOFO), Parlux Fragrances (PARL), and Market Leader (LEDR). All of these companies have yet to generate consistent excess cash flow, but met our investment requirements by offering tangible margins of safety through other measures.

Indeed, like William Priest at Epoch Investment Partners, we prefer all of our companies to generate sizable, growing, and consistent excess cash flow that is prudently allocated by capable management teams. But, in the vein of the late Sir John Templeton, sometimes deviations from this strategy can uncover diamonds in the rough.

While volatility may be higher for these types of holdings, risk-adjusted returns may be quite favorable over time and disciplined exposure can also increase portfolio diversification.

We believe both approaches make common stock sense.

Happy investing,

Jeffrey Walkenhorst

Disclosure: no investments in Epoch funds or EPHC shares; long EBAY, WTW, JCOM, PSMT, SOFO, PARL, LEDR.

© 2011 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, January 13, 2011

PS: Parlux Fragrances (PARL) Moves Higher as Perfumania (PERF) Credit Overhang Eliminated; Still Offered at Discount

As a brief follow-up to our Tuesday post, What's Moving Parlux Fragrances (PARL) and Market Leader (LEDR) Higher?, we wanted to point out one more important reason behind Parlux's recent upward move that we didn't see until Wednesday (our excuse: busy week, including some travel).

In addition to more details last week around the imminent launch of Rihanna's new perfume -- please see prior post or Rihanna to Launch Her First Fragrance, Reb’l Fleur (People StyleWatch), very favorable news was released Monday evening by Perfumania (PERF):
First, although same store sales for the month of December were down 7% Y/Y, Perfumania is surviving and -- this is the big news -- was able to secure a new credit facility:
  • Perfumania Holdings, Inc. announced today that the Company has entered into a new $225 million senior secured revolving credit facility with a syndicate of banks for whom Wells Fargo Bank, National Association acts as Administrative Agent, Collateral Agent and Swing Line Lender. The initial proceeds of the new facility were used to refinance the Company's existing senior credit facility, which was due to expire in August 2011. The new facility will be used for working capital and other general corporate purposes. It has a four year term, does not require amortization of principal and may be paid before maturity in whole or in part at the Company's option without penalty or premium. Bank of America, N.A. serves as Syndication Agent; Regions Bank and RBS Business Capital, a division of RBS Asset Finance, Inc., a subsidiary of RBS Citizens, NA, serve as Co-Documentation Agents; and Wells Fargo Capital Finance, LLC and Merrill Lynch, Pierce, Fenner & Smith Incorporated serve as Joint Lead Arrangers and Joint Bookrunners.
  • Michael W. Katz, President and Chief Executive Officer, said, "the Senior Credit Facility will provide Perfumania with improved financial terms and greater flexibility. Most of the financial institutions in our bank group have been supporting us for many years, and we are very pleased to retain the continuity. We look forward to working with Wells Fargo and the entire bank group."
Why do we care? Perfumania is a significant customer of, and related party to, Parlux. We don't have time to share all details, but plenty of information can be found in Parlux's SEC filings. We will relay this from the latest Annual Report Form 10-K:
  • In the United States, we have our own fragrance sales and marketing staff, and utilize independent commissioned sales representatives for sales to domestic U.S. military bases and mail order distribution. We sell directly to retailers, primarily national and regional department stores, whom we believe will maintain the image of our products as prestige fragrances. Our products are sold in over 2,500 retail outlets in the United States.
  • Additionally, we sell a number of our products to Perfumania, Inc. (“Perfumania”), which is a specialty retailer of fragrances with approximately 370 retail outlets principally located in manufacturers’ outlet malls and regional malls in the U.S. and in Puerto Rico, and to Quality King Distributors, Inc. (“Quality King”). Perfumania is a wholly-owned subsidiary of Perfumania Holdings, Inc.
  • The majority shareholders of Perfumania Holdings, Inc. are also the owners of Quality King, a privately-held, wholesale distributor of pharmaceuticals and beauty care products. Perfumania is one of our Company’s largest customers, and transactions with Perfumania are closely monitored by management. Any unusual trends or issues with Perfumania are brought to the attention of our Company’s Audit Committee and Board of Directors. During fiscal year 2007, Perfumania Holdings, Inc.’s majority shareholders acquired an approximate 12.2% ownership interest in our Company at that time (10.1% at March 31, 2010), and accordingly, transactions with Perfumania and Quality King are included as related party sales in the accompanying Consolidated Statements of Operations.
  • Perfumania offers us the opportunity to sell our products in approximately 370 retail outlets and our terms with Perfumania take into consideration the relationship existing between the companies for almost 20 years. Pricing and terms with Perfumania reflect (a) the volume of Perfumania’s purchases, (b) a policy of no returns from Perfumania, (c) minimal spending for advertising and promotion, (d) exposure of our products provided in Perfumania’s store windows, and (e) minimal distribution costs to fulfill Perfumania orders shipped directly to their distribution center. During the three years ended March 31, 2010, our sales to Perfumania accounted for more than 10% of our sales. Our sales to Perfumania were as follows (click to enlarge):
  • While our invoice terms to Perfumania are stated as net ninety (90) days, for over fifteen years, management has granted longer payment terms taking into consideration the factors discussed above. We evaluate the credit risk involved, which is determined based on Perfumania’s reported results and comparable store sales performance. Management monitors the account activity to ensure compliance with their limits.
  • Net trade accounts receivable owed by Perfumania to us amounted to $10.5 million and $12.4 million at March 31, 2010, and 2009, respectively. Between April 1, 2010, and June 25, 2010, we received $6.7 million from Perfumania in payment of its outstanding balance. Trade accounts receivable from Perfumania are non-interest bearing, and are paid in accordance with the terms established by management. See “Liquidity and Capital Resources” for further discussion of this receivable.
  • We continue to evaluate our credit risk and assess the collectability of the Perfumania receivables. Perfumania’s reported financial information, as well as our payment history with Perfumania, indicates that, historically, their first quarter ending approximately April 30, is Perfumania’s most difficult operating quarter as is the case with most U.S. based retailers. We have, in the past, received significant payments from Perfumania during the last three months of the calendar year, and have no reason to believe that this will not continue. Based on our evaluation, no allowances have been recorded as of March 31, 2010, and 2009. We will continue to evaluate Perfumania’s financial condition on an ongoing basis and consider the possible alternatives and effects, if any, on our business.
SO, we do care about the performance and viability of Perfumania for the sake of Parlux. Some investors have avoided Parlux entirely and correctly highlighted risk to the company because of Perfumania's weak liquidity profile (debt burdens coupled with tough operating environment and already thin margins) and Parlux's customer concentration (Paris Hilton products represented 42% of fiscal 2010 sales). Indeed, these are risk factors that must be considered. However, per our initial Parlux post, celebrity brands such as Paris Hilton proved strikingly resilient over the last several years (through the downturn).

While Perfumania's new four-year credit facility doesn't change the company's operating fundamentals, it does mitigate concerns around liquidity. HENCE -- as the Market conveyed on Tuesday by moving Parlux 5% higher on above average trading volume -- we can happily report that the Perfumania credit overhang is now eliminated.

As shareholders, we are pleased to see renewed Market interest in the stock and stand by our original view for Parlux Fragrances:
  • [Rather than a broken, potentially bankrupt business], recent results and cash generation tell a different story, which implies that shares should trade at or above net tangible book value of just under $5.00 per share. Moreover, we can envision at least another $1-2 dollars of upside beyond the $5 for Parlux's going-concern value (celebrity relationships, licenses, etc.). Finally, if management executes and delivers margin expansion toward the company's former 10% target operating margin, we could see a fair value range meaningfully higher than current levels. But, this would be gravy. For now, we're focused on $5 as a starting point. This simply makes common stock sense.
Happy investing,

Jeffrey Walkenhorst

Disclosure: long PARL, LEDR.

© 2011 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, January 11, 2011

What's Moving Parlux Fragrances (PARL) and Market Leader (LEDR) Higher? Hidden Value Now Coming into Plain Sight

Shares of Parlux and Market Leader are now garnering more attention from the "Market." Five-day view from Google Finance shows PARL up 14% and LEDR up 34% versus the NASDAQ up 1%:

For Parlux, product details, marketing messages, and images of Rihanna -- all of which have been in the works for some time and really should be no surprise -- are giving the Market assurance that Parlux is a viable business, a business which -- per our original view -- arguably should trade at least at net tangible book value of near $5 per share. Of course, seeing is believing for the Market and, now, it can almost smell Rihanna's new perfume.

We first mentioned Market Leader in our 1/1/11 Happy New Year post and hoped to share a bit more color before too long. Our brief thesis, previously shared with a handful of friends in 2010:
  • Illiquid microcap company trading below net cash value that happens to have a growing, subscription-based $15+ million run-rate (MRQ +40% Y/Y) real estate software-as-a-service (SaaS) solution business inside the company. All of this was/is certainly worth something, even with slight cash burn to build the business.
Consider this: venture capitalists strive to find and fund great, new business models and often award rich valuations early in a young company's life (even prior to the development of proven revenue models). YET, in Market Leader, here was an existing, growing operating business delivering a necessary service to real customers. Moreover, the company has a committed management team and excellent board sponsorship (insiders own ~20% of the company per latest proxy statement). To us, the valuation simply didn't make sense given the underlying business trends and franchise value. Thus, we were actively building our position in December by purchasing shares seemingly offered by an abundance of tax loss sellers.

Alas, before we found time to share more details here on CS$, a large deal announced on Monday made the Market realize that, HEY, maybe this company is worth something. We agree.

Although we believe predicting short-term share price direction is impossible and akin to gambling, sometimes "the trend can be your friend" once the Market "wakes up to a story."

Importantly, we continue to see margins of safety in both names.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long PARL, LEDR.

© 2011 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, January 8, 2011

Just Like Clockwork: Seaspan (SSW), Casella Waste Systems (CWST), and Weight Watchers (WTW) Again Back in Favor; What's Next?

Over a number of years, the same thing seems to have over and over: certain companies first lose favor -- either for macro or micro reasons -- and then later, perhaps after years, regain favor. Human psychology, which we've touched on before, plays a large role through various market cycles.

Recall the familiar Market cycle that we shared in Jobs Lead or Lag Recovery? CNN vs. Historical Evidence (courtesy of Schwab's Liz Ann Sonders) and also in slide four of our Which Way from Here presentation in January 2010. It's always important to keep this in perspective (click to enlarge):

Several of our holdings initiated during the out-of-favor period are now benefiting from positive shifts in sentiment:
  • Yes, it's true that Seaspan was actively purchasing ships at elevated, boom-time prices (and simultaneously contracting them under long-term leases to major ocean liners). However, we expect average invested capital across the company's fleet will balance out over the long-haul, across shipping cycles. Assuming the global economy keeps growing, we expect shares will once again achieve the $20s-30s even with dilution related to capital raised during the downturn to fund new builds. As "built-in" growth materializes through 2011 and 2012, we expect brokerage "price targets" will consistently bump higher.
  • Next, Casella Waste Management (CWST) was upgraded by at least two firms last month on improved operating results and potential for near-term asset sales. Management has been talking on the latter point for the past two years and, in our view, is executing to plan. For more information, please see Casella's latest results and fiscal 2010 annual letter to shareholders (*not currently on Web site for some reason - perhaps soon; we received via U.S. mail last fall). Here's Casella's long-term chart from Yahoo Finance:
  • For what it's worth, shares used to trade consistently between $10 and $15 per share. The company operates a stable business and owns irreplaceable disposal assets in the Northeast. Per our original Casella Waste Systems thesis, we own the company as a levered asset play that should benefit from management's strategy to selectively reduce the asset base to repay debt incurred to expand capacity to support long-term waste fundamentals. We see incremental upside.
  • While the margin of safety and potential returns are narrowing for new buyers of the stock, we continue to believe reasonable fair values are in the $40+ range and could extend into the $50s IF historical multiples are awarded to the company.
  • To help tell the story, Weight Watchers' CEO David Kirchhoff made the media rounds last week. We share two videos below. Both include slightly different questions/commentary and worth watching:
  • Weight Watchers is leading provider of weight management services, with David Kirchhoff CEO. Airtime: Mon. Jan. 3 2011.

TO SUMMARIZE: Normal human psychology makes the mental decisions to purchase out-of-favor companies inherently difficult. At these times -- as in late 2008 and early 2009 (or whenever a sector or company is shunned) -- doomsday pundits will be most vocal, and, even professional investors are afraid to stick their necks out to recommend companies where/when fundamentals are hazy. Most analysts feel more comfortable recommending companies when visibility is 20/20. Yet, history indicates that the greatest returns are generated by swimming against the tide and accumulating ownership stakes when everyone else is running scared.

Of course, risk always exists and company-specific risk factors can't be ignored. Confidence to move against the crowd can come from several sources, including whether or not the business in question provides a necessary product or service that people can't live without (e.g. garbage collection). Also, balance sheet strength, management capabilities, and valuation are critical considerations. For all three of the above businesses, we gained comfort that risk factors were mitigated and that the companies would likely be bigger, better, stronger over the course of time, at some point garnering upward revaluations from the Market.

We continue to see different degrees of upside potential for Seaspan, Casella Waste Systems, and Weight Watchers. Now that the Market is in a more favorable place, where can we look to find a still forlorn company begging for more attention?

Among the overlooked ideas we've highlighted here on CS$, one leading candidate is 1-800-Flowers.com (FLWS), where we see a strengthening "moat" for an increasingly diversified business. We can again relay that, by the time fundamentals turn positive and we see broker upgrades along with funds clamoring for a piece of the company, the stock will probably already be back at $3-4 on the way to $5-6.

Somehow the economy and the "Market" are almost always more resilient than most participants expect. As a result, the "Market" tends to work like clockwork: so long as we're talking about well-positioned, viable businesses, valuations and sentiment almost always come back around.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SSW, YHOO, CWST, WTW, FLWS.
© 2011 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Saturday, January 1, 2011

Happy 2011! Celebrating "401K" Recovery, Plus 2010 Portfolio Recap and What's in Store for 2011? As Always...

As we enter 2011, everyone should feel better about where household net worth and the retirement picture now sits versus, say, two years ago, when most Americans were looking at "201Ks" and the forward outlook was admittedly uncertain.

Remember this April 2009 60 Minutes segment, which we previously referenced:
  • The 401k Fallout - April 19, 2009 8:47 PM
  • Checked your 401k lately? The recent financial collapse has devastated this retirement resource. Older workers are hardest hit, as their financial futures may now be at risk. Steve Kroft reports.

Yet, we can now say that most 401Ks should be significantly higher than "201K" or "301K" levels, something we actually noted more than one year ago in our 11/28/09 post, Giving Thanks - Legacy 401K now Back to "401K" + Lessons Learned + Dubai. If participants continued to contribute through the downturn to present (dollar cost averaging), account levels may even exceed earlier levels (depending upon account vintage). For now, let's ignore the federal/state pension and entitlement dilemma resulting largely from aging demographics and earlier, but now untenable, promises.

Although market indices have not reached pre-crash levels, the recovery in equity values was swift, meaningful, and skeptic-defying. Here's a five-year view of the S&P 500 from Google Finance:

Thus, people who thought they would "never make back" paper losses should find themselves pleasantly surprised. Here, we can again share advice from one of our favorite reads, Peter Lynch's One Up on Wall Street (first published 1989):
  • "The basic story remains the same and never-ending. Stocks aren't lottery tickets. There's a company attached to every share. Companies do better or they do worse. If a company does worse than before, its stock will fall. If a company does better, its stock will rise. If you own good companies that continue to increase their earnings, you'll do well. Corporate profits are up fifty-five fold since World War II, and the stock market is up sixtyfold. Four wars, nine recessions, eight presidents, and one impeachment didn't change that."
Likewise, now that more time has passed, some stocks overlooked by the initial 2009 recovery -- such as our j2 Global Communications (JCOM, $28.95) and Sonic Foundry (SOFO, $14.09) -- garnered more "Market" interest during 2010 and were up nearly 40% and 190%, respectively, versus the broader market up low teens Y/Y.

We specifically mentioned j2 Global and Sonic Foundry in our post one year ago, Opportunity Costs Hard to Predict in Short-Term, Watch Over Full Market Cycle. While j2 Global's valuation is now more full, the company's high margin, high ROIC business model is an amazing free cash flow machine. For prior commentary on Sonic Foundry/Mediasite, we point to Passing the Torch, Plus Key Investment Musings and our earlier posts. We also relay the fact that Director Mark Burish recently added 15,000 shares at $13.73 to bring is position to 115,000 shares. There were some recent option exercises by members of management, yet these were options issued ten years ago and set to expire in February 2011.
  • Slight digression: we always like seeing corporate insiders use cold, hard cash to purchase shares in our companies, particularly when such insiders already have meaningful positions. Insiders usually buy for one reason: they believe in the company and the outlook. More advice from Peter Lynch: "There's no better tip-off to the probable success of a stock than that people in the company are putting their own money into it."
Other ideas also performed well during 2010, including our container shippers Seaspan (SSW +30% Y/Y) and Global Ship Lease (GSL +241% Y/Y), our aircraft company FLY Leasing (FLY +49% Y/Y), mortgage portfolio owner and service company Walter Investment Management Corp. (WAC +22% Y/Y), and perfume company Parlux Fragrances (PARL +42% Y/Y). Our online flowers/gift company 1-800-Flowers.com (FLWS +3% Y/Y, but +30-50% from summer levels) finally bumped higher, too, thanks in part to mention on CNBC's Fast Money program the other week. For all of these companies, shares are offered at a discount to our estimates of fair value and thus, in some cases, we have been purchasing more shares.

Further, Wall Street embraced our waste resource management company Casella Waste Systems (CWST +63% Y/Y) and weight loss management company Weight Watchers (WTW +28% Y/Y), where we also see more upside. In addition, online merchant and payment giant eBay (EBAY +16% Y/Y) pushed higher as the company continues to generate mountains of excess cash flow.

Churchill Downs (CHDN +13% Y/Y), where we gained exposure via the company's acquisition of Youbet.com, nudged higher and currently implies an equity value of around $3.55 for former Youbet.com shareholders. We have been gradually reducing our exposure to Churchill Downs, but note that fundamentals now appear to be improving for the company. This bodes well for 2011.

Meanwhile, our Latin America exposure via Compania Cervecerias Unidas S.A. (CCU +54%) and PriceSmart Inc. (PSMT +71%) also performed very well, although like j2 Global, valuations are now more full. We're still holding these well-positioned, growing companies as part of our diversified portfolio.

All that said, we have experienced some disappointments such as Chinese medicine /pharmaceutical company American Oriental Bioengineering (AOB down 50% Y/Y) and online jewelry/fashion retailer Bidz.com (BIDZ down 45% Y/Y). We may come back with more commentary on these names, but we'll say now that we've been adding to our Bidz position in recent weeks. While our original Bidz thesis didn't pan out and retailing is a tough business, we still see value from several different angles. Separately, our sum-of-the-parts story Yahoo (YHOO down 3%) has yet to pan out, although shares are above our cost basis and we believe hidden value remains.

Other shortcomings were what some investors call mistakes of omission - e.g. not purchasing companies in 2009 or early 2010 that we've long followed and liked such as Netflix (NFLX +229% Y/Y), coffee behemoth Starbucks (SBUX +39% Y/Y), or auction house Sotheby's (BID +117% Y/Y).

For the big picture in 2010, the WSJ offered this summary article: A few points from the opening section:
  • Stocks turned in another solid year, the Dow Jones Industrial Average gaining nearly 11% and the Nasdaq doing better still. Yet for much of 2010, it didn't feel like a winning year.
  • Amid stumbles and scares, U.S. stocks clambered to a second straight year of gains, in which the Dow reached levels not seen since the fall of Lehman Brothers in September 2008.
  • "It was a pretty hard-earned 11%," said Jeffrey Palma, global equity strategist for UBS Investment Research. "It was like a roller coaster—certainly nothing like a straight line."
  • With one day of trading left in the year, the Dow Jones Industrial Average has gained 1,141.66 points, or 10.9%, and stands at 11569.71.
  • The Standard & Poor's 500-stock index has added 142.78 points, or 12.8%, to 1257.88. The Nasdaq Composite index has risen 393.83 points, or 17.4%, to 2662.98.
  • There was hopeful economic news Thursday, as initial claims for unemployment fell to the lowest level in over two years. An index of pending home sales rose 3.5% for November.
What will happen in 2011? It's really anyone's guess. Market sentiment is certainly more bullish than last summer when we shared, Psychology Remains Fickle as The Big Bad Wolf Ignores Fundamentals, which is a potential contrarian indicator (negative). That said, fundamentals across most sectors appear favorable and the particularly troubled sectors of the recession -- financial services and real estate -- have been digging themselves out and/or otherwise retrenching for the past two years, which should mitigate some risk. So, we can see reasons for a more positive consensus view.

For example, this 12/30 FT article covers positive economic data released this week: US data point to surge in recovery. And, a worthwhile read from tongue-in-cheek Stanley Bing's blog (and Fortune column), Is it time to invest again? But, note one of his key points:
  • Companies attain and lose favor based on whiffs and vapors and rumors and crazy fears and hopes and dreams. The Street lunges at short-term gain and flees anything that smells of patient strategy that will pay off over time.
True, true. Indeed, the short-term is whimsical and patient strategies are seemingly being tossed aside in favor of "bots," as in robots -- please see NYTs 12/22 piece, Computers that Trade on News. OF COURSE -- psst, tiny secret -- the patient, old-fashioned approach still works! The new style simply isn't our cup of tea.

Back to what will happen this year. Per our prior warnings, we shy from most forecasts and recommend reading this article from Fortune:
  • Don't believe the rosy forecasts - Most economists and pundits predict a continued upward trend for most assets next year, but they will eventually be proven wrong.
One key lesson from the late Milton Friedman in the article:
  • ... the anecdote amounted to a parable on the pitfalls of economic forecasting. Friedman also liked to use the aphorism, "Predictions are extremely difficult, especially when they're about the future."
  • Friedman's lesson isn't that forecasting is impossible, but that the best prediction is usually the basic assumption that prices and growth rates will go back to their historic averages, or in economic parlance, "revert to the mean." What's difficult is guessing when that will happen. Indeed, the timing is truly unpredictable. But it invariably does happen.
So, forecasting is incredibly difficult and fraught with risk. However, from an owner's perspective, we continue to see stable to better fundamentals at our companies, coupled with still attractive valuations (in most cases). Fundamentals (earnings) drive share prices and we agree that reversion to the mean tends to occur so long as a company's underlying business model is intact.

Likewise, we continue to find unrecognized values, including some off-the-run franchise type companies such as Market Leader (LEDR) trading for less than a song (in this case, less than net cash value, although burning some cash). Large, high quality, dividend-paying companies are also offered at attractive multiples of earnings. We stand behind our stocks versus bonds stance and see more value in equities.

As always, "it's all about what you pay and what you get" (Fairholme Fund's Bruce Berkowitz, variation of Ben Graham and Warren Buffett). By assembling a portfolio of companies that are likely to be bigger, better, stronger in three to five years' time at the right price (e.g. discount to intrinsic value), risk is mitigated and performance is usually favorable over a full market cycle. With this strategy, short-term price fluctuations and broader "Market" palpitations can mostly be ignored. Of course, short-term, manic Market volatility is what creates incredible opportunities and is, therefore, the friend of the patient investor.

Thank you for reading CS$. Wishing you a happy, healthy, and prosperous New Year!

Jeffrey Walkenhorst

© 2011 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer