Christmas is coming, and that means two sets of flurries are on the horizon – snow and retail news. Now that the aftershocks of the 2008 financial collapse have had time to set in, this year will be a test to see how resilient consumers are in spending for the holidays. Retailers, for their part, have been preparing by slimming down; most are carrying record low levels of inventories to avoid the need for post-rush markdowns. But as the fundamentals are uncertain, retail stocks have been rallying with the rest of the market – the Retail HOLDRs ETF (RTH) is less than 13% off its all-time high in July 2007, led by large allocations to Wal-Mart (WMT), Home Depot (HD), Target (TGT), and Walgreen’s (WAG).

Large-cap, diversified retailers lack the appeal of a growing niche apparel company, for instance, but in many cases they look to be safer bets with decent upside in a market that’s looking increasingly overextended. Wal-Mart and Home Depot attract my attention with relatively stronger moats for the retail industry and a consistent history of posting ROEs in the double-digits, and although they trade at higher earnings multiples than a company like GameStop (GME), I believe the sustainability of earnings favors the stodgier retailers. Earlier this year, investment funds that I co-manage (BCIC) sold GameStop stock on a belief that it is a value trap with illusory single-digit forward earnings multiples, as competition for video game sales increases, and video game makers look to connect directly with consumers and disintermediate brick-and-mortar stores. That stock is down 15% in the last week and is close to its 52-week low, one of the exceptions in a market that is making new 52-week highs.

There will be plenty of news on short-term sales trends involving consumer spending in the month of December, but there might be limited comparability with past years because the paradigm may have shifted in this newly frugal economy. If you’re going to play with retail stocks, then, stay high quality and go with solidly entrenched middlemen. Bed Bath & Beyond (BBBY) is one retailer more off the beaten path that also fits that definition – a differentiated inventory strategy, improved pricing power after the Linens ‘n Things bankruptcy, and a modest valuation – and I’m happy BCIC owns it.
On the apparel front, Goldman Sachs (GS) analysts believe the sweater will be the go-to gift of 2009; while apparel is admittedly not my specialty, BCIC recently established a position in Ralph Lauren (RL).

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Originally posted here.

I have not posted in a long time, having been busy interviewing for post-graduation jobs, but I just received an email from Forbes asking a question that was eerily relevant to the situation many of my peers find themselves in – it read,

“Recently, the U.S. Bureau of Labor Statistics reported a jump in the unemployment rate to 10.2%. Some economists think we could be looking at 10.5% by early next year. Given these grim forecasts, how do you counsel recent college graduates and others entering the job market for the first time in this employment climate? Is there any advice or strategies you find particularly useful?”

After interviewing for a number of finance jobs, I wound up with several offers, including two doing equity research at large buy-side firms – exactly the position I wanted. Forgiving the somewhat cliched headings (I hope the descriptions make up for it), I found the following things beneficial, and hope they can be used in your personal situation:

Know what you want
It sounds trite, but the number of students who don’t have a good idea of what they’d like to do after college is surprisingly high. If you don’t know what you want to do, why should an employer hire you?

In my case, I identified investment management as a dynamic, intellectually challenging field that would hold my attention and challenge my analytical abilities early on. Do some introspection and examine what skills you have, then figure out where they’ll be put to good use in an enjoyable way. There’s no substitute for putting in the time to think.

Show your passion
Once you’ve identified what you want to do, capture it on your résumé by involving yourself in a relevant activity. If you actually want to be in a certain line of work, this won’t be a huge imposition. Should a readily apparent method of accomplishing this not be handy – there might not be a club at your school, or a field/service trip, a study program, etc. – then get on the internet. Find people doing what you want to do, and contact them. If everything comes up empty, start a website– it doesn’t have to be a grand production, just steady documentation that you’re trying to learn about something.

I started my website because I was bored during exam week freshman year. Through it, I’ve been read by tens of thousands of people, invited to write for much larger publications, and had opportunities to meet and talk with dozens of incredibly helpful people in the finance industry.

Put in the time
As the first point said, there’s no substitute for actually investing the time positioning yourself to get hired. The word choice is intentional; learning about what you want to do really is an investment in your future. A willingness to study countless hours for classes in tangential (at best) subject areas while spending no time planning a destination after college is simply short-sightedness and poor strategy. Whatever is fundamental to the job you want to be hired in, you should be actively learning right now.

I’ll often be talking to other students who want to enter finance, and they’ll ask what books I read to get to the level of knowledge they think I have. Though I don’t give this answer, I conservatively estimate that I’ve spent more than 6,000 hours reading anything and everything about investing, financial markets, etc. that I’ve come across. That translates to 3 full years of 40 hour weeks, and I think that is on the low side.

Is that time commitment necessary for everyone? It’s just something that I did – and it does have its drawbacks beyond the obvious skipping of college bar happy hours. At least two jobs I interviewed for didn’t extend me offers because they felt my level of background knowledge would have made me a poor fit for their entry level program. I’m encouraged by that long-term, however, because it should help me at places which are more flexible and offer greater responsibility sooner.

Go deeper in certain areas
Knowing what you’re interviewing for is too broad a suggestion and should be a given. To stand out in an interview pool against similar students who have similar course work, dig deeper into a few specific niches in the field you’re interviewing in, so that you know them better than anyone else your interviewer will see that day. My areas were railroad business models and valuations (I was lucky that Mr. Buffett made his acquisition when he did, my thanks to him), as well as credit default swaps – esoteric, yes, but very effective because I know them well.

Having familiarized myself with countless companies over the past several years, it was also much easier to discuss General Electric (GE), Freeport McMoRan (FCX), supermarkets, agriculture, pharmaceuticals, and certain retailers, depending on the sector background of the person interviewing me. All of those made appearances, and I happen to have done research into each of them previously.

Create and sell a narrative
In the end, a résumé is piece of paper with data points. The goal of an interview is to turn those data points into a story that’s easy to remember because it’s so compelling. On paper, I’m a finance major with a good-but-not-great cumulative GPA who is also the vice president of my school’s investment club. In an interview, I can talk about major market events that occurred pre-housing bubble, display an odd fascination with poorly-performing small-cap railroads, and can relate my involvement with investment club to at least one stock in the universe of the person interviewing me. That turns the relatively boring data point of “extensive investing study” into something worth remembering – everything on your résumé should come with a catchy, memorable story mentally attached.

Since I’ve probably taken away valuable time that can be used to start with #1, I’ll conclude by saying that there’s no substitute for working hard, that the time invested is worth it, and that jobs are not impossible to come by if you’re willing to set yourself apart by prudently picking a direction and then following it with everything you have.

A final note – writing this made me reflect on the journey. Thanks, Mom and Dad, for humoring my odd interest from a young age, caring so damn much that I do well, and putting your wants behind an education that couldn’t have been easy to afford.

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Sulaman Chaudhry and Andy Cole send: Last week was very interesting for a number of reasons, the main one being that many of our trendlines remain intact:

The S&P 500 has been forming a rising wedge over the past six months now, and is eventually going to be forced to breakout to the upside or the downside within the coming months. There are two things we need to take note of here: the first being the negative divergence we are seeing in the MACD, the second being the increase in selling volume over the past few days. Looking at this objectively, this is definitely bearish for the markets.

As we mentioned a few days ago, we have seen gold (ETF: GLD) consolidate a bit over the past few days. On a daily chart, the GLD formed a double top, and proceeded to break out of an uptrending channel that had been in place since two weeks ago. We would look for a bit more selling in the GLD from here.

Similarly, the UUP dollar ETF has experienced a double bottom over the past week or so and looks to be headed higher from here. Again, we mentioned the heavy increase in volume on the UUP in the last post, and it looks as though that did prove to be a short-term bottom. Keep an eye for clues such as this to help determine future trends.

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After Buffett’s investments in a handful of major railroads – Union Pacific (UNP), Norfolk Southern (NSC), and most notably Burlington Northern Santa Fe (BNI) – the industry garnered plenty of attention. The attractive industry dynamics and a myopic focus on the major players makes me interested in the small number of publicly traded regional railroads – among them Kansas City Southern (KSU) and Genesee & Wyoming (GWR).

Why railroads? Foremost, it’s an industry with significant tangible barriers to entry, and it provides a vital economic service. Although fixed asset investment is substantial, I also believe that the general consensus underestimates the variability of the typical railroad’s cost structure – yes, there’s operating leverage there, but there is also room to reduce headcount as unit volumes decline. Below is a graph of quarter-over-quarter revenue growth compared to QoQ operating expense growth for two major carriers (Norfolk Southern and CSX), one larger regional (Kansas City Southern) and the short-line amalgamation G&W.

A fixed asset business is going to have scale, but there’s still a fair degree of correlation for those companies. For the quarterly dataset going back to the beginning of 2006, the slopes vary from 0.51 (NSC) to 0.87 (GWR), so some flexibility exists in aligning expenses with revenues.

Next is a list of several metrics used to compare the four railroads, focusing primarily on their track infrastructure. Although other equipment is needed to operate a railroad, the real economic asset I’d be buying is the network.

A few explanations: there’s a strong correlation between revenue per track mile to market value per track mile. I chose to use enterprise value in addition to market cap, since these rails all have some level of debt attached and the end results cluster around 2.5x revenue per track mile. Also, the capital spending necessary to maintain the track network is important, and for the larger and more continuous players, spending is substantially higher than for a fragmented short-line company like G&W.

One red flag that makes me tread with caution is that railroad stocks have generally seen a robust recovery since the March lows, though I’m wary of mentally anchoring to those prices. On the whole, the rail industry has several positives about it – so even if a cross-section of some stocks don’t show any great bargains, it’s an understandable industry with competitive advantages, and that means good returns can be obtained at the right price.

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Sulaman Chaudhry and Andy Cole send: Hope you all had a great weekend. Let’s look at a few charts:

The S&P looks to be forming a rising wedge of sorts. A break to the downside would definitely be bearish, but until that happens, which it most likely will, the trend is up and continues to be for now.

After that high volume breakout on the Gold (ETF: GLD) chart a few weeks ago, we’ve seen a nice bit of consolidation around that 100$ level. For those traders banking on a move past 100$, this is definitely healthy in order to have a sustained move higher.

The head and shoulders that we have been on top of since February is still in play. A break above 100$ should lead us to a target price of 115$ on the GLD over the course of a few months.

There was a strong surge in volume on the U.S. dollar (ETF: UUP) last Friday. Whether this will form some sort of short term bottom remains to be seen, but it’s something to keep an eye on.

Finally, take a look at Hecla Mining (HL). This stock has seen a surge in buying volume over the past few weeks as it completed a cup and handle breakout, which was no doubt influenced by the pennant breakout in gold. We would look for a retest of $3.90 on the downside as nice entry position.

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In a note to file under the “Playing for Time” theme, the Curious Capitalist notes:

First American CoreLogic has taken a look at the effect of the government’s efforts to drive down mortgage interest rates, which, among other things, makes for easier refinancing. According to the loan analytics company, in the first half of 2009, refinancing homeowners set themselves up to save some $11.5 billion over the next five years. The typical person who refinanced was able to drop his monthly payment by $120 a month, a reduction of 10.5%… The value of mortgage originations hit $664 billion in the second quarter, and 69% of that was refinancing (by contrast, 37% of origination activity was made up of refis in the last quarter of 2o08). Fair or not, the government’s plan at least worked.

Reconcile this with one of the headlines on the site of Connecticut’s new candidate for U.S. Senate, Peter Schiff, which reads, “What America has succeeded in creating is not an economy impervious to shocks, but merely one which enables their consequences to be postponed to a later date.” I’ve spoken briefly with Peter before, and I’ve read his books, but I’m by no means in complete agreement with his views - yet in this instance, what he says is a perfect application to what the banking system is doing with the blessing of our government. Their strategy? Between the PPIP and mortgages, let’s sell as many options as we can now, book a benefit, and hope the adverse scenario that results in our option position(s) taking losses doesn’t occur.

I’ve wondered before whether or not we can carry trade the U.S. consumer back to health by attempting to force Treasury rates and other borrowing rates to converge; I’m not sure, but we’re certainly giving it the old college try.

If the typical person refinancing can save an extra $120/month, where does the money come from? It’s money that mortgage lenders aren’t making anymore in a lower interest rate environment. Now, the yield curve is steep, and short rates are near zero, so the relative change in rates is still helping banks. But at the same time, we’re more heavily leveraging banks to low rates; net interest margins might be getting fat at present, but they will compress and then some when rates inevitably rise. Zero, as James Grant has said, is the wrong rate for any economy, but more and more, I’m leaning toward believing that short rates stay extraordinarily low because of the idea that the economy depends on it - even when reality is that it aids speculators much more than the economy as a whole.

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Sulaman Chaudhry and Andy Cole send: Let’s watch this to see where it breaks out. We did make new monthly highs Thursday across the board. Keep in mind, however that it was on very light volume.

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Sulaman Chaudhry and Andy Cole send: Well after a somewhat extended and very much needed summer break, we getting down to business again. As you have probably noticed, we’ve seen some volume come back into an otherwise dry market, and we are beggining to see some very defined trends starting to form. Let’s take a look at a few charts and see what we can break down:

We have seen some volume come back into this market over the past few days. However, given yesterdays action, the signs do not look favorable heading into the remainder of the year. We’ve had a massive rally bottom to top, and it is safe to say that we are due for a correction sooner or later. Also, take not of that broadening formation on the S&P 500, as that could be a possible area of support in the coming weeks.

In our last market analysis, we mentioned the posibility of a bear flag formation on a monthly chart. As of right now, that observation still stands, especially given the general lack of volume on this rally.

Gold (ETF: GLD) broke out of a triangle formation that had been developing over the past few months. The volume across the Gold sector was tremendous today, and it looks at though $1000 could be within reach very soon.

Gold had a huge move today, breaking a number of technical resistance levels. Volume is flowing into anything Gold-related these days, and it is slightly foolish to not have at least some part of your portfolio dedicated to this sector.

The Gold Miners ETF (GDX) looks to be in the forming an ascending triangle over the past few months. There is signifigant resistance at $42.5 and it is likely we will see some consolidation before that level is broken. A break above it, though, should lead to some increased buying.

The U.S. Dollar (ETF: UUP) continues to see selling pressure. Volume has actually increased, though, over the past few weeks. Could it be a short-term bottom? Or just consolidation before another move lower? Time will tell, but odds are this move lower is far from over.

And that’s about it from here. We leave you with this:

Congress members hard at work debating the budget. So much for change.

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I haven’t said much about what I’ve been doing personally here of late. In sum, the general theme is that I’ve been scaling out of positions the entire summer, and am now 100% cash. Had I not sold anything, I would be up more on the year than I am at present – but that’s pretty much par for the course in a rally that has been as sharp and persistent as this one.

There’s still a strong undercurrent of disbelief at this rally, so in that sense not much has changed since March, when the world was bearish and nothing but pain existed for equity holders. The difference now (besides much higher prices) is that there’s a growing contingent with a belief that the recovery is at hand, or their more speculative counterparts who don’t believe in a recovery but are afraid of missing a higher move.

A growing number of financial stocks that are essentially worthless have seen their option values multiply several-fold; the well-documented list includes Fannie Mae (FNM), Freddie Mac (FRE), AIG, Citigroup (C), and Lehman (LEHMQ.PK), and August trading volume has been heavily concentrated in those names. I’m not discounting the option value of a stock; real-world outcomes are probabilistic and stock prices should reflect that. But it does speak to speculation returning to the market, and that’s a sign of caution in a time of great uncertainty – and make no mistake, the short-term bandages are only hiding long-term problems.

Good investing is not about having a myopic focus on maximizing returns, it’s also about managing risk. Winning is important, but so is not losing. With the feedback loop of the last six months, market conditions are such that it’s very easy to forget that losing is a distinct possibility in an era of debt deflation. Although inflation has been the headline worry of Fed watchers, I’m not convinced; the intermediate concern (2-5 years) that seems underestimated is deflation. Central banks are small in comparison to global capital flows, and although we might try to stimulate like crazy, it will be difficult to offset trillions of dollars in irresponsible lending being rationalized.

In light of this, I’m looking at convertible securities that offer yields of 6% or more (about 500 bps over 2-year Treasuries) in industries that will have above-average profitability in the case of an economic recovery. My assumption is that the yield alone will offer an attractive return, and with most at a discount to par, the total return potential approaches double-digits over a two-year time frame. If I’m wrong about the immediacy of a market recovery, the convertible option offers a hedge on rising stock prices – in sum, a better balance of risk and reward than either a straight stock or bond allocation.

A final closing note: I’m going to change up my policy about writing, since I often spend dozens of hours studying something only to determine it is a dead end. So, in the future, I’ll comment on those, instead of just the scarce opportunities I end up acting on.

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Mike Price sends: In the second part of the books series, I’ll go over my favorite history and intermediate economics books.

To find the first part, which focused on beginner economics and investing books go here.

Intermediate Economics Books

An Austrian Perspective on the History of Economic Thought (2 Vol. Set)
Murray Rothbard was the dean of the Austrian School of Economics in the second half of the twentieth century. He wrote books on economics , early American history , libertarian political philosophy , the federal reserve , fractional reserve banking and the ethics of liberty .

He was the center of the libertarian movement in the 70’s and 80’s (He was a founding member of the Cato Institute, the Mises Institute, the LP and probably any other libertarian think tank or organization you can think of). He essentially created the anarcho-capitalist philosophy and was critical to its expansion in the Austrian School.

This book is Rothbard’s history of Economic Thought. He starts with the Greeks and Lao Tsu and shows how economic history evolved from the Spanish Scholastics, to the first ‘real economist’ (Richard Cantillon), where it fell back a step with Adam Smith, then got better with the French-classical school (including JB Say), was perverted through Marx and finally where the laissez faire tradition started with Frederic Bastiat.

The book is a two volume set comprising over 1,000 pages total. In it Rothbard goes over the economists above and all others. He writes about their economic theories and their lives, showing how they were influenced.

I consider this book the best introduction to the many economists and their theories, unfortunately Rothbard died before he could get into the Marginalist Revolution and the huge onslaught of economics that followed.

PJ O’Rourke On The Wealth of Nations
I find the actual book by Adam Smith virtually unreadable (and for those who can read it, unnecessary as there are so many economists who have said it clearer and better), but this book by P.J. O’Rourke has the essence of the book and allows readers to understand the same theories while laughing and not creating migraines without compare.

The Price of Everything
This was the first book I read on the Hayekian spontaneous order theory. Basically, in a free market prices are the feedback mechanism which create order, sort of spontaneously since there is no one in charge. For example, if there was a hurricane those who needed to build a new house would bid the materials away from someone who had a lesser need for the materials. Without a market there is no way to calculate who is most needing of the materials.

Roberts goes over this in much greater detail in a novel setting. In the story the local grocery store doubles prices after an earth quake, and an economics professor must convince a student activist that this is not the end of the world.

Atlas Shrugged
I read Atlas Shrugged and The Fountainhead in the summer after my senior year of high school. I had planned on only reading The Fountainhead, and it took me basically the whole summer to struggle through it.

Then with a couple days before school started I decided to read a chapter of Atlas Shrugged, and ended up not putting it down for the next two days and finishing the 1,200 page novel with a whole new perspective. Thankfully the arrogance and selfishness subsided, but the main economic theories remained.

In the book Rand follows two different parties - the good businessmen and the government leaders. She shows how government meddling has a bad affect on the economy. In fact one of the characters of the book is so tired of government meddling that he convinces every great business leader or likewise minded person to quit and move into the mountains of Colorado where a kind of paradise is made and everyone trades with gold.

The non-stop sexual references and “selfishness-is-the-only-way,” are annoying, but the book is the best I’ve read at showing all the incentives in an economy and how people are affected by them.

The Failure of the New Economics
I took a macro-economics class last year at college. In the class we basically went over all the Keynesian models, and talked about the Monetarist models for a week and that was it. Thankfully I had this book to use to refute the stupidity I was learning in the class.

Keynes’ General Theory came out in the mid-thirties, just in time for the government to use it to justify more and more government spending. Unfortunately the book is an unreadable blob which seemingly contradicts itself every other sentence.

Thankfully, Henry Hazlitt wrote this chapter-by-chapter (and sometimes line-by-line) refutation of the General Theory. Hazlitt destroys Keynes, and for those who like that kind of thing uses pretty funny writing to do it.

The Austrian Theory of the Trade Cycle and Other Essays
This book contains essays by Ludwig von Mises, Murray Rothbard and F.A. Hayek (probably the three foremost macroeconomist of all time) and has a forward and afterword by Roger Garrison, who is probably the foremost macroeconomist today. Note: none of these labels are accepted by the mainstream economists, who probably haven’t heard of any Austrians except for Hayek.

The essays go over the Austrian Theory of the Business Cycle (wherein a surplus of fake money unnaturally reduces the interest rate and discoordinates investment with consumption, causing malinvetsment and an eventual, but necessary, recession or depression to realign investment with consumption).

Meltdown
Thomas Woods is a historian, and a great one at that, but late last year he took up the task of being the first one to explain the current crisis, and do it from the Austrian point of view.

In this amazing book (the first ever that focused on the ABCT and ended up on the New York Times best seller list), Woods goes over how Greenspan reduced the interest rate to a negative rate and then legislation pushed all the easy money into the housing industry. He also goes over why bailouts won’t work and a recession is the necessary cleaning of malinvestment.

Plus, he backs it up with a history of the priors panics, depressions and recession in the US.

Antitrust: The Case for Repeal
This book is a more focused one.

In it the author, Dominick Armentano, shows how the history of anti-trust is that of lesser competitors trying to find a way to compete without being more efficient or better satisfying their consumers than their better competitors. Armentano also uses monopoly theory to show why Anti-trust is not needed.

Great Austrian Economists
Most of the good advances in Economics have come from Austrian Economists. This book goes over the 15 most prominent, from a Spanish Scholastics in the 1500’s to Murray Rothbard, and shows their additions to economic theory.

The Case Against the Fed
In this booklet Rothbard not only goes over the history of the Fed and shows how it was created frivolously, but also why it is unnecessary and a negative for free societies.

Economic Science and the Austrian Method
In this book Hans Herman Hoppe (the current foremost Austrian) destroys positivism and shows why economics must absolutely be deduced from the action axiom, or praxeology.

History
The Politically Incorrect Guide to the Great Depression and the New Deal

The current crisis is very comparable to the Great Depression, realizing this Bob Murphy (of the PIG to Capitalism) wrote a great guide to it and destroyed all the myths surrounding it.

Unfortunately, his book centers more on destroying myths then the ABCT. But, it is full of great stats and facts and arguments to use to destroy the myths (apparently that’s what it does seeing as I’ve said it three times in two sentences). The book also has a chapter on the current crisis and what the government should do.

America’s Great Depression
Rothbard’s book was the first great one on the Great Depression.

Rothbard goes over the ABCT, kills the arguments against it, then shows how the money supply and easy credit rose in the late 20’s. He also goes over how interventionist Hoover was and how Hoover turned a 2-3 year correction into the Great Depression.

Mobs, Messiahs, and Markets
I just finished this book last night. In it Bill Bonner (of the Daily Reckoning)and Lila Rajiva take readers on a gallop through history to show how mobs are usually wrong and why one should take this into consideration when investing.

Final Thoughts
Most of the books here are more specialized than in the prior list, I believe this allows readers to pick and choose which subjects are most interesting to them at the time and read about that. Again, you do not need to read all of these books right away, though it would do one well to read them all eventually.

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Stephen Frankola sends: As I begin this, Vonage (VG) is trading at over $2.40 in the aftermarket.

Vonage was trading below $.40 just five days ago.

The (investment) world is looking for an explanation. Barron’s tech writers have been blogging frequently over the past few days, marveling at the huge move. The Yahoo! message boards are abuzz.

To me, this looks like a euphorically-driven chain reaction.

A short squeeze might have triggered this rally, but it isn’t responsible for the majority of today’s move. According to Yahoo! Finance, around the end of July, there were 4 million shares sold short. 41 million VG shares traded today, so short covering can’t be credited with this move.

There also hasn’t been any significant news within the past few days. Vonage reported optimistic results in the recent past, and they also announced a new international phone service last week. Vonage’s comment on the situation seems to imply that the entire world just realized these couple tidbits and all tried to enter at once. I’m not buying that. I think that’s the equivalent of saying “we have no idea why our stock is up 500% in a week, but we’re just as estatic about it as you are!”

So my conclusion is that this is a euphoric rally driven by people going long. Owners at $.40 (who may have been underwater from previous purchases) probably aren’t selling into strength, driving price even higher. Coverage in the media likely attracts new investors to this hot stock.

VG has been prone to such explosive moves; I was lucky enough to own it in the past prior to a positive announcement; shares jumped 100%.

Buying (or shorting) VG today or tomorrow is simply gambling. Without a clear driver of this extreme movement, there’s no concrete reason why shares are worth so much more today than they were last week. At the same time, shorting against such powerful upward movement is insane. Three times during the day today, VG moved up over $.20 (representing 20+% moves) in mere minutes. That’s not the kind of momentum I’d want to be shorting into.

This is certainly an interesting story, and it’ll be interesting to see how and where things settle down. Stay tuned.

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I go to school just outside Boston, and my family lives near Philadelphia, so I do a fair amount of travel between the two cities. Lately, I’ve noticed one bothersome change – the amount of traffic created by construction projects has greatly increased the length of the drive. Given the poor shape most state budgets are in, and the emphasis on infrastructure spending in spending stimulus funds, my intuition says that the stimulus funds are financing this construction, which is in turn causing traffic.

Now, my trips are done later at night – I usually work during the day, have dinner, and pack before getting on the road. I’m usually traveling between 8 p.m. and midnight, since it fits my schedule and will theoretically minimize rush hour traffic issues. The favored time to do this roadwork, however, is overnight, when it impacts fewer people than during the day. As much as I don’t like that, at least there’s some forethought there.

One of the dangers of the government allocating funds as it will is that the need for economic value to be created might not be considered. We will spend in the name of taking action, even though taking action is more costly than not doing so, in terms of opportunity costs – the money must come from somewhere, after all.

It’s a fact of life that roadways need to be maintained, and I’m not arguing that. But if less-than-necessary work is being done in the name of “creating jobs” or “investing in America,” all the costs need to be included. There’s little good that can be said about traffic jams, but they do offer plenty of time to think, and this thought experiment occupied me during a recent construction-induced backup on I-84 in eastern Connecticut one evening.

The total time I sat in traffic, which I’m defining as a speed below 10 m.p.h., was 40 minutes – this excludes, for example, when the road was closed down to one lane, but traffic flow was moving along around 40-45 mph. During that time, I traveled about 2.5 miles of road that was bumper-to-bumper across three lanes of traffic, and a half mile that was two lanes of traffic of similar density.

According to this from Edmunds.com, the average mid-size sedan in 190 inches (15.83 ft.) long, and the average length of a trailer truck is 80 feet (various sources). I’d say about 15% of the traffic on the road with me at that point was trailers, giving an average length of 25.45 feet for vehicles on the road. Assuming 10 feet between vehicle in either direction, and each vehicle takes up 35.45 feet – meaning 149 vehicles would fit in one lane one mile long. Approximating that for the number of “lane-miles” (8.5) yields 1266.5 vehicles in the traffic jam with me at that point in time (about 10 p.m., for the record). If there are 1.2 adults per car, then 1520 adults had their time wasted by sitting in traffic caused by road renovations; with Connecticut’s minimum wage of $8.00/hr. (being conservative), I calculate that it costs $12,150 in lost time per hour wasted, or $8,000 for the 40 minutes I sat in traffic.

These assumptions were meant to be conservative (i.e. not counting wasted gas), and it makes me wonder whether or not we’d actually be better off just dropping money from helicopters as stimulus, rather than making busy work that creates negative externalities. Since we’ve clearly committed to trying to carry trade the economy back to profitability, we might as well take the next step in forming the Hedge Fund of the United States and find the best relative value opportunities.

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I recently finished reading Stephen McClellan’s revised and updated book Full of Bull: Unscramble Wall Street Doubletalk to Protect and Build Your Portfolio. McClellan spent over 30 years as an analyst of technology stocks, and had a front row seat to the evolution of the modern sell-side analyst.

McClellan covers a diverse set of topics, and although there are occasions when the book doesn’t flow right – he frequently jumps back and forth between advice and sometimes tenuously-connected anecdotes – that’s a minor problem at worst. More glaring - and perhaps a consequence of when it went to press (February 2009) or his personal investment outlook - is the negative undertones and myopic focus on the current bear market. I wonder if recent market events have changed his disposition…

The best lesson this book offers is for the individual investor who believes they can benefit by listening to headline recommendations of upgrades and downgrades – i.e. new “buy” (or equivalent) calls. Wall Street analysts, as McClellan says, aren’t judged by the accuracy of their stockpicking, but instead by client relations and related business they generate. Helping individual investors is at the bottom of their priority list.

By now, that overwhelming urge to be optimistic (at least in public) about stocks should be well-known, even if the situation doesn’t warrant it. Most research disclosures still show that a “sell” rating is used less than 20% of the time, and that’s part of the game played by analysts with the company’s they cover – many of whom McClellan says take petty actions against analysts who aren’t favorable on their shares.

Another important takeaway for emphasis: the short-term is overanalyzed, and individual investors don’t really have a chance of gaming those movements. Particularly in the large-cap space, dozens of analysts will be following a company, and there’s no edge to be had from ratings changes or earnings estimate revisions. Stick to the small-cap space where more inefficiencies can be found, and take a longer-term view of a company’s competitive positioning.

One prominent part of the book that won’t directly help you as an investor, but I nonetheless found to be great reading, was the description of how the analyst’s role has evolved. Research has become entwined with other functions at an investment bank, and most research today is paid for indirectly. McClellan bemoans this, and how it compromises the ideal purpose of research, but no solution to this problem is offered. That’s one idea I’d like to see more thoroughly developed should another edition of Full of Bull ever be published.

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Disclosure: The book publisher provided me with a free copy to review. If you purchase the book using a link from this page, I earn a small commission, but that does not result in you being charged anything extra.

One phrase I keep coming back to is “playing for time” – I see it as a good description of the strategy (or lackthereof) underlying most of the economic policy decisions that emanate from Washington.

What areas are being targeted, and how is it being accomplished?

Real Estate

Autos

Banks and Other “Financials”

The entire point of playing for time is to increase optionality. More information becomes available, and perhaps the economic situation will change for the better. But keeping businesses alive comes with indirect costs – more competition reduces the ability of healthier firms to pick up profitable customers – and with an implicit backstop from the government, borderline financial companies are incentivized to take more risks than usual.

The immediate result of those actions is to accelerate consumption, defer pain (losses), or interfere in allowing the market to set the prices it would otherwise set. To loosely quote a recent note from David Rosenberg, only in America are policies that encourage excessive consumption celebrated as a success. Yet that’s exactly what’s being done through a program like Cash for Clunkers, and the public reception has been very enthusiastic – a dangerous turning point in the series of bailouts.

I’m wary of data (and interpretations) suggesting that recovery is at hand, because uneconomic activity can only be encouraged for so long. That’s a lesson the Fed should have learned from previous heroic rescues during downturns, but chooses not to, because the expedient solution is to shovel money into any area of the economy that will take it.

Home prices, which undoubtedly went through an enormous bubble, are now the subject of a great experiment in controlled deflation. “Affordability” products sprung up earlier in the decade, when buyers had no savings for a down payment. Those turned out to have disastrous consequences, and yet policy now is directed toward offering what amounts to down payment assistance via a tax credit, and artificially low mortgage rates through the Fed’s market operations. We’ve been down this road before…

Boosting GDP for one or two quarters with the $3 billion (at present) Cash for Clunkers will quickly be revealed as wasted money; there are only so many new cars that people need. Most shrewd observers have realized by now that the program will skew statistics favorably for a time, without doing any real good. Of course, if the point is to save the “American” automakers, the program has been a failure on that front too.

The silent bailout of the financial system through zero interest rates and guaranteed debt is more pernicious – the TLGP, for instance, is estimated to be a $24 billion gift to those using it. And yet, little will be said about that as long as the impact on the Treasury’s borrowing costs remain marginal. Can we carry-trade weak financial institutions to profitability by leveraging the U.S. government’s borrowing ability? Likewise, can we store the health of balance sheets by stealing from savers through interest rates effectively at zero? We’re certainly trying.

Across sectors, there are many companies awaiting a turn in the cycle – and the only reason they’re still around is due to the good graces of the government. But cycles don’t truly turn until fewer people are around to looking at them, and it’s doubtful policymakers are willing to adopt this position and let liquidations occur. Playing for time comes at a cost – on a personal level, it means delaying decisive action that stands a chance of accomplishing something. I can only imagine what it will mean for the country as a whole.

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Mike Price sends: This is part two of the series on special situation investing. View part one here. The special situations written about here will be:

Closed-End Fund Arbitrage
Closed-end funds are mutual funds that have a limited amount of shares and trade on a public exchange (NYSE, NASDAQ) like stocks. Because of the nature of the funds trading on an open exchange they frequently trade above, at a premium, or below, at a discount, to their NAV - Net Asset Value or the value of the mutual fund at the time. Thus a smart arbitrager can find a closed-end fund trading at a discount and buy it until the gap closes, or do vice versa and short a closed-end fund trading at a premium.

However it is not that simple - if it was these situations would not exist. Some closed-end funds trade at a steep discount to their NAV, but the discount is probably deserved, as closed-end funds that underperform or have always traded for a discount should not be bought without a foreseeable catalyst - like activists - that will propel the fund back to it’s NAV.

Currently my favorite in this category is the Gabelli Dividend & Income Trust (GDV). The fund “invests at least 80% of its assets in dividend paying or other income producing securities. In addition, under normal market conditions, at least 50% of the Fund’s assets will consist of dividend paying equity securities.” according to its website. Currently it trades for about a 15.5% discount to its NAV. Returns have been satisfactory and the dividend yield is 6.6%, so while you wait for reversion to mean, which is about 18%, you own a fund with satisfactory performance and a good yield.

Activism
A method rising in popularity among hedge fund managers is activism. In this method the manager buys >5% of a company he believes is not returning value to shareholders and becomes active in the business until value is returned to shareholders. When selecting companies to buy the manager usually looks for undervalued companies based low cash flow multiples, or companies with a lot of FCF and cash, he then buys 5 or more percent of the company which requires him to file with the SEC, when he files he not only discloses his holdings in the company but he also writes a letter to the board of directors about why he has bought the shares, what he thinks is wrong with the company and how he believes value can be released. This filing is available for everyone to see on the SEC website. Sometimes the company will immediately comply with the manager, but other times the fight can get pretty scary between a manager and a company.

Obviously regular investors cannot become activists, but ‘piggybacking’ activists is easily possible. When trying to find good activist investments one can use the sec website to follow each filing daily from activists, follow all 13Ds filed, when one is found it must be scrutinized to be reassured that the company will comply with the activist and value will be returned to shareholders, but when an opportunity is found great returns will most likely follow.

Deep, Deep Value
Deep value has been discussed on this site before, I interviewed deep value focused investor Henry Lu and I purchased Lazare Kaplan (LKI) which is trading below its Net Net Current Assets. Deep value is basically buying companies trading deeply below assets, at a very low price to earnings multiple or a very high cash flow yield. Companies trading at a fraction of their book or for 1x earnings is what Benjamin Graham originally championed buying.

This type of investing is usually called “cigar-butt” investing, you buy the stock, or pick up the cigar butt, for one last puff then quickly sell it. When investing in deep value the quality of the company is ignored and the investor is focused just on finding companiess so ignored by Wall Street they can be bought for as low as $.25 on the dollar. Because business quality is ignored value traps may be purchased, value traps are companies which appeared to be undervalued but are discounted for a reason, and they will stay discounted, or fall and become more discounted.

To avoid value traps one must look for companies not only deeply undervalued but also with quality, or at least profitable and have an expectation of earnings which will not fall. Also you must make sure management wants to return value to shareholders, if a company is trading below its cash, you must determine how management is going to use the cash, if they will just let it sit then a discount must be applied to cash to adjust for ignorant management.

LEAPS
I won’t go over the basics of options here, go here for that. LEAPS are options with a longer period of time attached to them, usually about two years.

As an example lets say I have resarched DirecTV (DTV) and have decided they are a good business which is discounted when compared to its peers, has good financials and good management, but the only thing holding them back is the fact that GM holds a large portion of the common stock and investors fear this. I also believe in the near future GM will sell all of these shares, whether it be because they are forced into bankruptcy or if DTV buys back these shares, as they have already started doing.

Because I believe in the company, and think investors will realize this once GM sells the shares and DirecTV is no longer connected to them, I can buy LEAPS for JAN 08 with a strike price of $17, the current price is $17.50 and the options are priced at $2.75. If I buy one contract my investment is $275 (one contract is 100 shares), as opposed to $1,750 if I had bought 100 shares of the common stock.

Lets say in the next year and a half the stock appreciates to $26 per share because GM sells their shares and investors realize it’s a good company, my investment in the LEAPS has appreciated about 330% (I bought them for $2.75 the price of the options is now $9, $26-$17) and my investment in the common stock is up only 49%.

Also if DirecTV were to fall because GM refused to sell it shares or something else happened to force DTV’s shares down you would only lose you initial investment of $275 with the LEAPS, but you could possibly lose a much higher amount.

Conclusion
I believe that even great investors can only find 6-8 really good investment per year, to insure good investment returns when markets are volatile and good investments are hard to find special situations are needed to propel returns to an exceptional level. Afterall special situations are just ‘value with a catalyst’.

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