The Homebuilders ETF (XHB) is up 35%, the Financial ETF (XLF) is up 25%, and the Retail ETF (RTH) is up 15%. But as Bespoke shows, the only things really pushing close to new highs are the countercyclicals – healthcare and staples. Utilities, oddly enough, aren’t included in that mix – perhaps high commodity prices have them down? Anyways, the few indicators of momentum I do watch have begun to roll over, suggesting that further buying is going to meet much more selling pressure in the coming weeks. What really bothers me is how low the indicators were when they started turning; the last time I looked at these I suggested the prudent thing to do was to be quick to lighten up long trading positions, and I’m worried now how far the next down wave could go. Can anyone say S&P 500 at or below 1150?

I don’t really like exercises like market forecasting, but from a conceptual standpoint I find it useful to ask what theme(s) will dominate the market over the next few quarters, and the impact those will have. Right now, I think there’s too much hopefulness on the equity side coupled with more forecasts that need to be cut to end the year materially higher from this point. Just a guess, though, because it all depends on just how sweeping the GSE rescue plan is.

2. If it’s structured correctly, a Fannie/Freddie bear hug by the government could do enough good in the near-term to offset the price (real and indirect) that citizens will be forced to pay.

Making the government take control of the GSEs is monumental – this is truly an extraordinary time to be following the markets. Lots of people will raise noise about moral hazard, the effect on the dollar of billions more in government liabilities, and similar, but the bottom line (this coming from someone whose generation will pay for the current recklessness and clean up, you’re welcome) is that if this sends a signal to financial players that mortgage paper backing is good, liquidity is present, and Fannie/Freddie spreads come down to the point where the companies have earnings potential, it will be worth it. Whatever the plan is, hopefully it will involve a complete wipe out of the common equity; the market is already pricing it as crap (Caa3 for Fannie, Ca for Freddie) according to Moody’s market implied ratings. Holding common now is pure speculation that shouldn’t be rewarded.

Hopefully the next President will stand behind whatever solution the Bush Administration comes up with, because all hell will break loose if political rhetoric adds to the uncertainty. While it would be preferable if liquidity/capital was provided on an as-needed basis until after the elections to allow for a coherent plan put in place by the people who will actually be carrying it out, preserving the ability for potential homeowners to get a classic conforming loan is crucial given how bad the housing and lending environments are. Just get it done, and please get it done right, so try to get ahead of the next crisis-in-the-making.

3. It is one thing for the government to backstop the mortgage market, but making $50 billion in loans to automakers would be an extreme example of overstepping.

Mortgages are important, they let people buy homes. And whether right or wrong, much of our financial system is structured around and levered to home price appreciation. Most markets are efficient most of the time and government intervention generally does not help, but when crucial markets cannot function, government needs to step in. I wouldn’t blink at $50 billion for Fannie/Freddie, but $50 billion for Ford (F), General Motors (GM), and Chrysler? You’ve got to be kidding me. This is almost like a temporary, backdoor bailout of the Pension Benefit Guaranty Corp., because – at least in the case of Ford and General Motors – those companies are owned not by the common stockholders, but by the pension recipients.

How about this for an alternative while we’re bailout happy? The government takes over three companies, assumes all the existing pension liabilities, and terminates all the remaining promises to the UAW about future benefits. The common of each gets zero – where it’s probably going anyways – with the government retaining all the equity, and then the companies are merged and consolidated down to the point where there is sanity in domestic auto supply.

The existing route I see is basically the American automakers saying they can’t compete for yet another reason – financing costs – that are really just a symptom of their underlying malaise. Nobody wants to finance these companies because they don’t believe they’ll get their money back.

4. The most overlooked part of growing as an investor is understanding risk management.

I’ve been reading Seth Klarman’s Margin of Safety lately, and one of his main points is that investors too often speculate in situations where safety of principle is far from assured. By placing the desire for capital gains ahead of capital preservation, investors take on far too much risk without adequate compensation.

When I think about this in the context of my own learning, I know that when I first started looking at the markets, I saw “opportunity” – the quotation marks are intentional – far more clearly than I understood risk. I think this is only natural in the sense of wanting to establish oneself through outsized returns, but it really is dangerous – especially for beginners who happen to have their first pick or two work out and develop a false sense of confidence.

It might seem odd or otherwise contradictory for me to talk about this when I’m solely invested in one company, but that position was not one taken on with the idea of showing large returns quickly. I simply liked the easy-to-model exposures, and (in a probabilistic sense, at least) the large odds in my favor. This was clash between the axioms of “diversify to stay in the game” and “play for large stakes against disadvantaged opponents,” and the latter won out. I still don’t know how the Primus common (PRS) or debt (PRD) will ultimately turn out, but if I get black-swanned out of that, hopefully this is the start of some small good that will emerge as a consequence.

One of my hopes is that, as I progress in my learning, readers come to see better discussions of risk management at this site, as well as other investing blogs. For those of you who don’t have a copy of Margin of Safety ($1,000 and up on Amazon), I suggest reading David Merkel. More than any other professional out there, his goal is to help investors grow their skill set through the lens of risk management.

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When I say risk, I don’t mean beta or simply how volatile the price swings up or down are. Is it riskier to own a stock that is more volatile? Well, that depends on what you buy it for and sell it for. If a stock is down 20% at one point during the time you own it but gains 200% over a few months it is not riskier. Risk, to me, is paying to much for a stock based on company fundamentals. There is simply and clearly less risk buying a stock cheap. There are good opportunities in net current asset stocks because you can essentially buy assets for less than what they are worth. When you buy a stock selling below its net current asset value for its cash and inventory, you get the plant property and equipment of the company for free. This kind of stock is not risky if and only if the company is bringing in money or there is some kind of special situation, such as a buy out or distribution of assets to shareholders.

Looking for stocks selling around these levels is beneficial because it is an accurate metric of value. They are great to look for because most net-nets, so to speak, are smaller stocks with market capitalizations typically below $2 billion. The best performing small stocks will always outperform large stocks as they simply have more room to grow. True, most net-nets will not be five-baggers (see their stock price rise 5x) the best are good for a small pop or more. They are also often under followed by analysts meaning individuals can beat the institutions to the shares and feel comfortable knowing 20 analysts are not pouring over the stock and making overly optimistic forecasts. I personally don’t believe the market is efficient, so a cheap stock that is over-looked is likely a really, really cheap stock. Consider Alliance Semi (ALSC.PK)…

$1.08 share price
$.23 net cash and cash equivalents per share
$2.08 net cash and short-term inv.
$2.51 NCAV per share

on 33,047,882 shares of Common shares outstanding.

Alliance Semi has a long story so I’m going to make it brief so we can get to today. They have sold their entire operating business and are no longer a semi-conductor company. In 2007 they received a gain of $6.2 mil on the sale of the semi biz and a $108 mil gain selling Alliance Ventures and Solar Venture Partners. On July 17, 2007, they paid $124 mil in a special one-time cash dividend of $3.75 per share and have made some smaller payouts to shareholders. They are still sitting on a bunch of cash and don’t have any definitive plans for it yet.

There is $.23 per share in net cash. There is $2.08 per share in net cash and short-term investments. These figures are after netting out total debt, which is only $4.08 million.

They had $1.7 mil worth of Tower Semiconductor (TSEM) stock in their short-term investments. They say as of June 30th they sold off the remaining shares. In the short-term investments they have asset-backed securities with primary holdings consisting of short-term investment grade commercial paper. “We do not have any investments in securities that are collateralized by assets that include mortgages or sub prime debt. Our investments in auction-rate securities are AA-rated as of March 31, 2008, and collateralized by commercial paper, 80% of which must be rated A-1+/Prime-1 or better, and no more than 20% rated A-1/Prime-1.”

So what’s the problem? The credit markets are horrible and about all of their short-term investments which ideally would be safe are illiquid and inaccessible.
“At March 31, 2008 we held asset-backed auction-rate securities issued by sub-trusts of two master trusts, Anchorage Finance Master Trust and Dutch Harbor Finance Master Trust (the “sub-trusts”).”

“All of our auction-rate securities portfolio has been subject to failed auctions… we cannot provide assurance as to when liquidity in the regularly scheduled auctions will be restored.”
-10K

In a press release on September 3rd, the company said they had decided to continue dissolving the company and giving cash back to shareholders. This net-net has potential as the auction rate market looses and allows them to liquidate.

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For examples of past successful net-net situations, Mark points to Ashworth (ASHW) and Tandy Brands (TBAC).

TTWO raised guidance for the year, and released their pipeline, which should provide strong sales during the next quarter and through the Christmas season.

Investors were unimpressed, however, and shares are flat.

The withdrawn-bid of $26 continues to cap the stock price. Hopefully analyst upgrades or commentary (which I expect to be forthcoming) will inspire investor interest; otherwise, Electronic Arts (ERTS) needs to bid reasonably ($35+, now that TTWO is set to make $2/share this year), or admit that TTWO is too expensive for them so that the stock price can rise organically.

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There was no news released (though Barron’s later said that the price decline was due to rumors about Electronic Arts (ERTS) walking way from merger talks), though ERTS had an executive speak at a conference right around noon.

Below is a graph of TTWO’s trades between about 11:15 and 12:05, when shares declined sharply, rebounded sharply, and then settled roughly 5% lower than where they opened.

As the stock crossed $24 about 8 minutes into the graph, the first pickup in volume can be seen, possibly by stop-limit orders being triggered. The price continued to slide on light volume until shares broke through $23, when volume accelerated to over 50,000 shares per minute.

As the shares dropped below $22, volume topped 150,000 shares per minute, which is impressive, considering only 500,000 shares traded during all of Friday and only 1.3 million exchanged hands yesterday.

Frantic selling and buying took place over the following ten minutes, as about 1.3 million shares were traded. It seems as though stop-limit orders first were triggered, panic selling insued, and finally, as the stock sat at $22, buyers came in to snap up shares.

Normally I wouldn’t analyze the intraday trading of a stock so deeply, but the trading pattern certainly seemed odd. TTWO consolidated at $25 during the previous week, with Thursday’s trading featuring a $.15 range.

If there was a news leak, or some sort of manipulation, I’d expect to see it in the options, as premiums are still low enough that a trader with information could make a killing. However, volume and pricing on the options seemed normal. The options with the greatest volume were the $25 and $27.5 September calls; premiums did decline, but the $25 call, which went from being nearly at-the-money to almost 10% out of it, only lost about 25% of its value, and ended the day with a trade at $1.10. Volume was a little high (relative to open interest) in some deep OTM Sept, Oct, and Dec puts (with trades at the $15 strike), but I can’t see the shares falling that low.

So I backed up the truck a little further and bought a few more $27.5 calls at a cheaper price, adding to my unwisely-large position going into tomorrow. (Thankfully recent good trades with FSLR puts, AIG, AEO, and DDM calls have helped to offset any potential losses from TTWO.)

Once again, in my humble, bullish opinion, all signs (besides today’s trading) point to good events tomorrow. I don’t know why TTWO would have bothered setting up these secret meetings with ERTS if they weren’t showing them something good, and I don’t know why ERTS wouldn’t have walked away already if they were wholly unimpressed. TTWO has historically beaten earnings, and they are still riding the success of GTA IV, with a decent slate of titles that will be released for the holidays this year.

Who knows, maybe TTWO will report a loss, and these talks were about some firesale price at $14/share, and some speculator (or inside-information-haver) will be chuckling as they rake in the bucks. However, TTWO’s management has insisted on the strength of TTWO’s business, and empirical evidence doesn’t contradict their statements.

Considering that ERTS lost over $400 million last year while TTWO is expected to profit about $140 million in profit this year, barring a disaster, I don’t get how TTWO shares would move lower. An independant TTWO (without this takeover hangover) would be trading much higher than it is today, and TTWO should demand a price somewhere in the $30’s if they are to be bought.

Prior to the after-the-bell announcement tomorrow, I’d expect that TTWO trades around $22.5 or $25, as those option strikes have been heavily traded. When they report at the close, a beat-and-raise (without any mention of a takeover) should send shares skyward; ultimately, there could be some announcement concerning the deal during the call tomorrow. Though there is the non-disclosure agreement, I can’t believe that TTWO will be completely silent about a deal during the call tomorrow.

If I had a reputation, I’d be putting it on the line. Thankfully, if I’m wrong, I’m young enough to lose some money. If I’m right, the profits, and vindication, shall be lovely.

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At some point, commodities accelerated from a slow melt-up to a sharp gallop. And, because the self-evident difficulties of earning consistent market-beating returns in commodities, this is almost a Macroeconomics 101 lesson in supply and demand… unless.

Unless the Peak Oil/Scarce Everything crowd is right, and there simply isn’t the supply to be brought on line at a cost anywhere near existing prices. How correct could they be? I won’t begin to speculate, as that is an entirely different subject that I’m probably not fully qualified to write about. The best I can offer is that a weakening global economy is going to decrease demand for commodity inputs, and the amount of hot money in those assets could create even more in the way of volatility. Looking several years out, there will be demand for these commodities, and prices will rise. What role, then (if any) should commodities play in a portfolio?

As part of the process of analyzing the existing portfolio for the Boston College Investment Club, one thing I’m trying to be more aware of is the risk management side of things – it’s much more important to not lose money, after all, but that tends to get overlooked. The argument is out there that an allocation to commodities can reduce risk, since they are an asset class unto themselves uncorrelated with equities. This has proven to be true only to an extent, because it really depends on the other allocations and hedging actions that are being taken. If you’re short (or underweight for those seeking relative performance) financials, long commodities – specifically oil – has been a highly correlated trade, so it hasn’t really added much in terms of diversification benefits.

The BCIC portfolio owns several financials – Goldman Sachs (GS), JPMorgan (JPM), Bank of America (BAC) - and plenty of companies with related financial exposures, like Interactive Brokers (IBKR), General Electric (GE), and Harley Davidson (HOG). Because the first set tend to be the best-of-breed names, hedging in a non-direct way (i.e. through a long commodities position) seems unreasonable, in that such a correlation could break down because the existing relationship is due more to technical trading than business fundamentals… not to mention that the point of owning the best businesses is to allow for greater returns with less risk over a long time period.

Commodities have certainly offered great returns over the majority of this decade in an otherwise tough equity market, and became very popular because of this. I’d also argue that the lower-visibility of commodities allowed financial firms to charge more in the way of fees, and thus accelerated the democratization of commodities, but the net result is that commodities have become overcrowded, at least at present. It’s tough to find values on the equity side of commodity-producing companies, and thus in terms of opening up the BCIC portfolio to alternate investment methods, I’m going to be pushing much more for short selling (either directly or via put options) because I think that offers a more direct and effective way to hedge long equity exposures at the retail investor level. And, as a final sidenote, I will also be pushing for a larger allocation to some high-quality financial firms with easily understandable businesses. They do exist, and the distressed market surrounding their shares offers value.

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I’d be absolutely shocked if oil and natural gas prices don’t rocket upward by at least 5% during Asian trading tonight. Gustav has shut down the majority of energy production in the Gulf and a significant portion of refining capability on land.

Refining capability had been underutilized during the previous weeks leading up to the storm, so refineries not affected by the storm should be able to maximize production (if they want to) to compensate for shut-downs. The US Department of Energy plans to release oil from reserves if it is deemed necessary; so there should be no lines at the pumps next week.

My instincts say that futures will jump and oil company equity will drop Monday, so long both USO and DUG would have been a good trade. Higher prices don’t help companies who are shutting down production and are enduring damage to their rigs, while the Saudis will reap higher prices for the oil they are pumping.

Thankfully I don’t do much driving while here at school, but gas prices should surely be higher in the coming weeks and months, even if only due to the fear factor. The extent of Gustav’s disruption and damage waits to be seen. I sympathize for lives and property in the path of the storm, and hope that the early evacuations minimize damage.

A Crucial Side Note: Multiple Democratic pundits, from position-holders to the fat, shameless Michael Moore, have called Hurricane Gustav a “blessing from God.” Below are two links. Please note that these are thoughts produced by the intellectual kin of Barack Obama when you don’t vote for him this November. How heartless must a person be to claim that the destruction of homes and property and loss of life can be a positive event?

Fowler Fouls: Hurricane is God’s Favor to Democrats
Michael Moore: Hurricane During GOP Convention ‘Proof There is a God in Heaven’

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There was little spike in the stock price or options premium, so I decided to load up on more calls. TTWO has now set September 4th as the date of their earnings report and conference call for the quarter ended July 31st.

TTWO made $1.52 per share in during the quarter ended in April; much of that money was made during the few days that Grand Theft Auto IV was sold during the end of that quarter. However, sales continued to be strong during this quarter and TTWO’s results should reflect this. The consensus estimate for this quarter is only $.55/share, which could easily be beaten; in fact, TTWO has beaten estimates handily each of the past four quarters. Full-year predicictions (currently $1.85) also may be revised upward; so far this year, TTWO has tallied -$.41 and $1.52, for a total of +$1.11. The estimes for the next two quarters, $.55 and $.19 could be easily crushed. TTWO is releasing GTA IV in Japan in early October and on the PC in November (which falls under the next fiscal year), so sales should continue to trickle down to TTWO’s bottom line.

As long as TTWO comes in at least in-line this quarter, ERTS will have to re-bid at a much higher price or admit that TTWO is too expensive for them. If ERTS does make the $1.52/share that they’re expecting to tally this year, the stock trades at about a 32 P/E. ERTS’s asking price of $26/share for TTWO assigns a 14 P/E. Activision-Blizzard trades at a P/E in the high 20’s. ERTS cannot expect TTWO to sell out at such a discount to itself and the industry.

So I am indeed speculating as this tango proceeds. If TTWO’s management has presented its material to ERTS’s board already, they could forseeably make an offer before earnings to minimize the influence of the investor community’s reaction on a takeover price. If TTWO reports in-line or surprises positively, shares should jump for many reasons - TTWO’s shares are deeply undervalued compared to its competitors, and investors like me may think that ERTS will pony up more for the company.

Shares currently seem to be hugging the $25 level, but I’d be surprised if they stayed there for long. It’s time for ERTS to sack up and make a reasonable bid, or leave TTWO alone. The lead-lined takeover cloud capped TTWO’s share price as it released the best-selling media release of all time and subsequently reported unbelievable earnings. It’s time for the sun to shine on TTWO.

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Disclosure: Long TTWO Sept. $27.5 and $30 calls.

This is the latest development in a soap-opera-like courtship that has disappointed TTWO investors as the share price has been stagnant since ERTS’s first offer of $26 this spring. ERTS extended the offer multiple times throughout the summer. ERTS withdrew the offer earlier this month, but agreed to view a presentation of non-public material by TTWO’s executives.

This disclosure of privacy should stoke investor speculation that a new offer may be in the works. Whether an offer is publicly made, however, remains to be seen. Electronic Arts seemed set on acquiring TTWO at $26, but many investors thought that the bid was a shrewed tactic to cap TTWO’s share price as it released Grand Theft Auto IV, the biggest game release ever. But Electronic Arts shareholders may be disappointed by a higher bid, as each dollar increases the takeover price by about $75 million. A price in the $30s, which would represent a reasonable premium in light of GTA’s success and TTWO’s earnings potential, would represent a bid increase of hundreds of millions of dollars.

I may sell some of the options, likely the 30s, if TTWO share prices (or options premiums) pop tomorrow at the open. After speculating twice on this merger, I’m willing to take profits when I can (hopefully) get them. TTWO didn’t move much after hours, so maybe longs aren’t enthused by this hype anymore. However, TTWO and ERTS will probably clear the air with a new bid or a conclusive “not-interested” statement fairly soon.

I held TTWO calls that expired (worthless) at the end of August, and did buy September calls at both the 27.5 and 30 strike.

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Last Friday, Warren Buffett was on CNBC for several hours in the morning answering questions on all sorts of topics with his usual reserved wisdom. If only I could get Warren to speak with me for three hours…

One of the big revelations was that Buffett has been adding to either Wells Fargo (WFC) or American Express (AXP) – both extremely large positions in the Berkshire Hathaway (BRK) portfolio. Earlier in the program, Buffett noted the macro slowdown had spread across demographics to impact even high-end consumers, as evidenced by the things American Express has been saying:

Well, it – obviously, I pay a lot of attention to what’s happening. And we’ll say at American Express – and Ken Chenault talked about that here a month ago – but they are experiencing credit deterioration and they’re experiencing it sort of in all segments. So they’re seeing the rich customers slow down in payments, slow down in purchases. And American Express can describe that rather than I, but I pay a lot of attention to that sort of thing. And incidentally, it will get cured at some time in the future, but right now the situation is getting worse and I would say that I don’t see any early end to that.

Overall, Buffett’s comments on the macro environment were quite negative, and on the whole he suggested that growth prospects would likely remain weak into 2009. The thesis of a weak consumer has led many people to bet against companies tied to consumer spending – particularly those like American Express which also carry credit exposure – and it even reached a point where recent debt issuances by the company were being priced at more than 400 basis points over Treasuries. According to Moody’s, the implied ratings put the company at close to junk status. But this is a company that BusinessWeek said was the 14th most valuable brand in the world, with a value of nearly $20 billion. With a market cap of $45 billion as of market close Friday and net tangible assets at the end of last quarter of $12 billion, American Express looks very inexpensive; but ignore the exact details for a moment. Even if you erase the tangible equity on the books, you’re still left with an immensely valuable company because of the network and customer base American Express has. The replication cost test – Buffett applied this to Coca-Cola (KO), saying that he couldn’t take the company’s dominance of soft drinks with $100 billion in capital – seems to apply to American Express as well. With $50 billion in capital, could you replicate the merchant relationships that American Express has, much less gain acceptance by such a large number of wealthy consumers? I think not.

American Express has a fantastic business model because it requires next to nothing in the way of capital expenditures to grow the business, allowing for a combination of high returns to shareholders through dividends and buybacks, as well as continued organic growth of the business. This isn’t to detract from Wells Fargo, but banking is a much more competitive sphere than credit card processing, and given the relative values of the two firms, I believe Buffett is more likely to be taking a long-term view that the American consumer will remain strong (a belief he reiterated numerous times) and purchasing one of the most beaten-down names that will – eventually – be due for a recovery.

As the chart below shows, Wells jumped substantially after a positively received earnings report, whereas American Express is still down somewhat and has more or less stayed in that range since July 1st, the earliest Buffett could have begun buying since a transaction like this was not reported in the last 13F.

On a related note, I found this table of US banks and their OTC derivative exposures to be revealing; the “spread vs. RBC (bps)” column on the far-right shows the percentage change in the marks on the derivatives needed to wipe out risk-based capital.

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The other day I read Joe Ponzio’s commentary on retailer American Eagle (AEO), and where it stands as one of his portfolio holdings. I owned the stock for a short time earlier in the year – ultimately selling in order to take advantage of the opportunities in the credit default swap market – so the thoughts of a more disciplined holder offer a good contrast in perspectives.

As part of Joe’s analysis into buying the stock, he noted the fantastic growth rate American Eagle has posted over the last decade, and the resulting strong balance sheet – plenty of cash, and no long-term debt. The American Eagle brand is very well-received, and comparable with Nike (NKE) and Apple (AAPL) in terms of its popularity among the younger demographic. All in all, it looks like a good company – though it is a relative newcomer to the apparel retail space, which is known for its constant upheaval and lack of enduring competitive advantages.

American Eagle, like most companies, benefitted from the lending-driven boom that gave consumers much more flexibility with their discretionary purchases. Quantifying such effects are difficult, but with recent same-store comparable sales declines of around 10%, I wouldn’t be surprised to find out that the company slightly overbuilt in some areas, and will need to cut back store count accordingly. While I don’t believe this will be severe, the combination of declining comps and a contraction (or adjustment) in store base is not a good combination for investors. Declining comps force fixed expenses to deleverage and eat up a higher portion of profits, and the flagship line (AE) store base reaching a saturation point is going to pressure return on marginal invested capital, which historically has been excellent as the first-year ROI of a new store was in excess of 65%.

In my original analysis of American Eagle, I was guilty of misjudging the severity of the drop-off in consumer spending, as well as where the spending shifts would take place. As it turns out, the mid-tier consumer quickly moved down-market to Aeropostale (ARO), and the higher-spending consumer is not shifting away from Abercrombie (ANF) to American Eagle quickly enough and with enough purchasing volume to offset the market share losses. This has led American Eagle to heavily increase promotional activity via markdowns and sales incentives, as my email inbox with such offers can attest. While this will undoubtedly pressure near-term earnings, the bigger issue is whether these actions are necessitated by a lack of demand stemming from a shift in how the company’s product is perceived by consumers.

A further source of potential stress for the company is the shake-up taking place on the operational side, with the departure of Chief Merchandiser Susan McGalla. Seeing how McGalla was effectively running the show during a time when American Eagle’s sales were growing at an extraordinary rate, the uncertainty here over the effectiveness of a successor is generating a lack of enthusiasm from the sell-side analyst coverage I’ve read. In all likelihood, this does not prove to be a long-term issue that significantly impacts shareholder value, but it highlights the risks inherent in apparel retail where the brand name is not in the exclusive realm of established designer brands.

This is not to say that there are no bright spots for American Eagle and its investors; the company is very well-capitalized, has a capable executive management team, and plenty of goodwill among customers. The stock is trading at 2.1x book value, and at the end of the last bear market the stock bottomed just under 2.0x – and with the company remaining profitable even in tough times, the stock could breach that mark after one or two more quarters of earnings. While such a valuation doesn’t guarantee a bottom, it does help highlight the fact that AEO in the low teens is a compelling value with minimal improvement in the macro environment priced in. I was early on this stock, as was Joe, but that doesn’t change the fact that apparel retail can be very profitable and American Eagle is one of the better operators in the space. Ultimately, I think Joe’s sticking by the company versus my selling out is a reflection of the differences in our situations; he runs a concentrated portfolio but it is impractical, if not unreasonable, for him to make the kind of bet I made. If I had funds consistent with the need to own 5-10 names, I would likely be buying the stock at or near this level.

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Most people who have read this site during the summer have seen my coverage of Primus Guaranty, a credit derivative products company (CDPC) that sells credit protection via credit default swaps (CDS). On July 22nd, I placed my entire portfolio into Primus, via a combination of its common stock (PRS) and senior debt (PRD). I saw (and see) Primus as a company with very clear risk exposures thanks to the finite and short-lived duration of its swap portfolio, and the fact that a stress-tested loss estimate nets an equity value in the mid-single digits (i.e. about $5/share), which holds even if the company were to enter a run-off.

I’ve tried to clear a number of misconceptions about Primus, the most important being that the company does not face the liquidity risk that took down Bear Stearns, et al. This is not an accident of chance, but due to the capital structure of Primus – because their AAA/Aaa-rated subsidiary that sells CDS protection is a CDPC, they do not post collateral regardless of how bad the mark-to-market losses on their portfolio become. Even a ratings downgrade could not result in counterparties demanding collateral; it simply isn’t how Primus does business. This “continuation” structure is the huge advantage of the CDPC model; not needing to post collateral makes writing business more economical and can make the system safer as a whole by preventing liquidity-driven runs on sellers of CDS. But that only holds true if the CDS sellers don’t take advantage of the collateral exemption and write too much business that goes bad, ultimately leading to insufficient capital to fund their obligations. Because Primus – the first CDPC – received its rating in 2002, there isn’t any historical data on how the model performs in periods of market stress.

From what Primus has been saying about business recently and what I’ve gleaned from the helpful notes by the financial guarantor research team at William Blair, the major concern is that CDS buyers become wary of the CDPC model, and are no longer willing to transact business with sellers who don’t post collateral. Ultimately, it’s a question the market is going to answer – is there a significant difference in the value of CDS protection from a CDPC, and does the counterparty rating count for anything? Monoline-guaranteed bonds have traded at a discount to those backed by Berkshire Hathaway (BRK) Assurance Corp., so it’s conceivable that on the other side of the credit derivatives market mess, some sellers might get slightly better rates than others (we’re talking in basis points, but that counts at 30x leverage), because their balance sheets are perceived to be more solid.

Of the CDPCs listed to date that have been rated by Moody’s, only one has been placed on review for possible downgrade - Athilon (the second Aaa-rated CDPC, behind Primus) – on July 9th. Moody’s has essentially stood behind the CDPC model so far, but that is no guarantee they’ll continue to do so in the future, especially if one or more has a spectacular and highly-visible meltdown. Most of their concerns are limited to the CDPCs that were launched later, because they lack the existing book of business that generates consistent and recurring premium cash flow streams; this is not a problem for Primus, because they already have an adequately leveraged swap book generated good premium income along with an existing healthy cash position.

The most interesting point I gleaned from Moody’s note on CDPCs (keep in mind, this was published in March) is that their estimate of the one-year rate of defaults on investment grade corporate debt is 0.0466%; my stress test model has Primus’ realized credit losses roughly 30x higher at 1.32%, though that isn’t entirely comparable because the actual losses net out recovery, whereas the straight default rate merely shows what percentage of issuers default. This is significant because the recovery rate on some defaulted senior corporate debt can be very high – one person told me they aren’t highly concerned about the concentration of Primus’ swap portfolio in financials because they expect the senior debt to remain intact, I imagine through a combination of white knight guarantees or government backing. On an apples-to-apples basis using a 24% recovery (the lowest recovery rate on senior debt ever in a single year), the 1.32% rate I establish that Primus can survive between now and the middle of 2010 is 120x higher than the loss rate Moody’s estimates translate to. The DCF value of Primus common stock, should no credit losses take place and no new business be written, is $15/share – a triple from the current price. There will likely be some losses, but the probability is that Primus is sufficiently capitalized to weather a spike in defaults and still retain value down through the common stock, which is why I’m invested the way I am.

If you would like a copy of the Excel model I use to value Primus, send me an email at jcullen – at – collegeanalysts.com and I’ll reply as soon as possible.

Read the Primus Guaranty Stock Report for more.

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My latest reading project was Roger Lowenstein’s “While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Loom as the Next Financial Crisis. As involved as the subject of pension and retiree benefits are, Lowenstein presents the challenges through the lens of three narratives, and concludes with an overview of possible solutions. I imagine the presentation of the material is going to divide reader support, or lack thereof. While the narrative approach is certainly easier reading than a numerically heavy analysis of funding shortfall ratios, I don’t think the parts were tied together well enough – it’s just sort of given that General Motors, New York City, and San Diego are representative enough for all pension plan sponsors, which seems like an overgeneralization.

For the drawbacks, the narrative approach does make for the presentation of some compelling characters – which I’d say is a strength of Lowenstein, especially in a biographical work like Buffett: The Making of an American Capitalist. Of course, “compelling” does allow room for a very broad interpretation – some of the major players seemed genuinely concerned about the common good that could be brought about through pensions, though far too many more were motivated by greed and what essentially amounts to intergenerational theft. Of special note is how rife with conflicts of interest the entire pension system is, from the level of corporations or municipalities and their assistants, all the way up to federal regulatory agencies. Any pension mess, it seems, is truly the result of failures of courage by dozens (or more) individuals over a time span of several decades, and I wish Lowenstein emphasized this more – for once, I almost wanted a sermon on doing what’s intrinsically right, perhaps because my generation is going to be stuck paying for past misdeeds. Hopefully, enough people in the right places read this book that it creates some minimal level of awareness; pension reform isn’t sexy and thus has a slim chance of ever becoming a major talking point in Congressional or Presidential elections, but the magnitude – underfunding is counted in the “hundreds of billions” category – is nothing to sneeze at… simply more hidden liabilities buried on the American balance sheet.

At the end of the book, Lowenstein offers very rough sketches of the way to solve the pension crisis, though it comes off as hollow because there really is no “fix” for it. A substantial amount of taxpayer revenue needs to be raised and/or diverted to these trusts to catch them up, and a larger and larger percentage of existing tax revenues needs to be allocated to these kinds of expenses. To that end, Lowenstein’s solution is to bite the bullet and socialize retiree benefit programs, bringing everything under the watch of the federal government. Doing so, he argues, will help level the competitive playing field in industries where American businesses are saddled with legacy cost burdens their foreign (or newer domestic) counterparts don’t have. While I want to say I’m opposed to expanding federal entitlement programs, pension promises simply aren’t fair to break. That doesn’t mean that should be taken as is – in the case of San Diego, widespread fraud created a case for undoing a number of benefit hikes – but if unions want the security offered by a federally-backed pension plan (above and beyond the Pension Benefit Guaranty), it’s fair that they should accept some combination of modest reduction in pension benefits or later retirement/vesting ages.

Will any of this happen? Your guess is as good as mine. It’s going to require the scarcest of commodities these days – political courage – and raising tax revenues or cutting government services isn’t likely to go over well in most voting districts, much less during an economic downturn. Still, a state like New Jersey (my home away from school) is $25 billion behind on their pension plan, in addition to $58 billion in promised retiree healthcare benefits for which it has no reserves. How much longer this can continue is anyone’s guess, but at the rate the cash outflows increase annually, I find it hard to imagine we won’t have a reckoning on this one decade out. Lowenstein’s “While America Aged” is a good primer for understanding a huge potential landmine all levels of the country face.

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Because discussing my personal holdings has become quite simplified in the last month, I’m going to be leaning more on two other things I’m involved with – one being the Marketocracy.com virtual portfolio, and the other being the Boston College Investment Club portfolio.

Because Marketocracy has diversification rules (for the weak, I know), I have to maintain a number of holdings – but I’m pretty close to the minimum with 11, as I run an aggressive portfolio. Year-to-date, I’m up 9.5% against a 10.4% decline for the S&P 500. Essentially all of that comes from this quarter, where I’m up 22% after buying up Primus common (PRS) and senior notes (PRD) close to the concentration limits. Read more in the Primus Guaranty Stock Report.

My next largest position in Accenture (ACN), a consulting company that has seen increased demand in a soft economy thanks to its ability to cut costs. They have $5.60/share in cash with a $41 stock, and will probably generate another $3.75/share in cash flow this year, giving them an FCF multiple below 10x. With a countercyclical growth story and an inexpensive valuation relative to earnings estimates that continue to rise, Accenture has the chance to catch a wave of institutional support.

I lump my next two holdings together as small-cap biotechs, even though the rationale is quite different. Exelixis (EXEL) is a gamble on the company’s deep, though early-stage, pipeline; my concern now is that in an environment where capital raising is difficult and costly, the stock isn’t worth owning. Another big selling point for Exelixis was its partnership approach with major pharmaceutical companies, though at least one company looks set to end that arrangement. I’m thinking of cutting this out of the portfolio as a lesson about not all risk-taking being equal.
The other biotech name is PDL Biopharma (PDLI), which was the subject of an intense activist battle by Third Point hedge fund manager Dan Loeb back in the day. Although Loeb eventually gave up his battle, I believe his underlying thesis was correct – on a sum-of-parts basis, the company looks undervalued. Seth Klarman’s Baupost Group added substantially to their stake in this name during the last quarter.

Another holding that I talk about here frequently is Ingersoll-Rand (IR), in which Berkshire Hathaway (BRK) increased their stake materially during the last quarter. As I’ve said for several months, Ingersoll has transformed their business into a diversified mini-conglomerate with steady and profitable revenue streams. Even so, I’ll admit that I didn’t fully appreciate the great collection of business lines until I read a recent note from KeyBanc. Consider:

Trane: #1 US, #2 Worldwide in Commercial HVAC Equipment
Thermo King: #1 Worldwide in Transport Refrigeration
Hussman: #1 in North America, Display Case Provider
Schlage: #1 in North America, Lock and Door Hardware
Club Car: #1 Worldwide in Golf Carts
Ingersoll-Rand: #1 in North America, Air Compressors and Tools

Now, there is near-term uncertainty with some risk related to merger integration, related synergy and tax issues, and the potential drag of dampened commercial construction, but I think that’s the reason the stock is trading just over 1.1x book value. This looks to be the kind of uncertainty you buy, because the underlying businesses are just so good.

The next holding is an ugly name – Avatar Holdings (AVTR) – a stock that I initially got involved with because it looked so cheap around .65x book. Avatar owns 17,000 acres of developable land in Florida and Arizona, as well as another 15,000 acres of land that is currently non-developable. Avatar has ample liquidity, and even excluding all of the non-developable property, are valued at a around $13,500/acre.

I own a pair of contract research organizations (CROs) because the requirements state I need to be at least 65% invested at all times; I was non-compliant and needed to make a quick buy. I plan on rotating out of these and into something I’m more comfortable with – maybe more IR or ACN, or perhaps add some insurance stocks at multiples of book of less than 1.1x. While that might not sound like something befitting an “aggressive” portfolio, I’m more inclined now to move away from an outwardly risky posture (i.e., biotech) to more concentrated positions that I feel more comfortable about. Hopefully this marks a sign of my investing maturation…

Rounding out my holdings is Headwaters (HW), which – one of these days – I really will get around to doing a full write-up on. I put it on the backburner for a couple days, they reported earnings, and the stock has been up about 50% since then. Headwaters did amend the covenants on a loan facility, ostensibly to enhance their capital position in a weak climate. With substantial exposure to buildings products, not to mention the regulatory and political hurdles the company has faced in the last 18-24 months due to an incoherent national energy policy, the debt they’ve carried has always been a concern for me. Overall, though, I’m impressed with their execution and like the business model. I consider it a building products company on the cheap, with a call option on some interesting alternative energy exposure via coal and heavy oil upgrading.

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I read an interesting call today from Toro about shorting the Euro off the top he believes the currency has set against the dollar, and – if he’s correct – there are plenty of side effects with important applications to the equity markets. He notes estimates that the purchasing power parity value of the dollar is $1.10-$1.20 against the Euro, and that the large differential on the short end of the yield curves between the US and Europe should converge as the ECB loosens.

Given how everyone and their mother has been short the dollar, a reversal in that trade would create a dramatic shift in the markets not only because of all the other trades that are associated with it (i.e. long commodities), but because currency changes have actual macroeconomic impacts. The dollar strengthening against the Euro would put even more pressure on commodity bulls to keep prices elevated, especially if the dollar rally isn’t caused so much by an economic resurgence stateside as it is by economic weakness across the pond. Depending upon how other sectors are acting, this could set off a crucial leadership shift away from basic materials, which would suddenly be on the wrong side of the macro trade. Where this money would flow is another question – tech tends to be a combination play on an early-cycle economic recovery, as well as a weak dollar – so I might have to revise my view of that should the Euro continue to decline. Utilities look reasonably priced from a yield perspective, and could look downright cheap if a combination of cost side-benefits from falling commodities combines with stickiness on the (lagging) rate increases that they’ve had to lobby to push through stick. Still, utilities aren’t the kind of leadership of a healthy market…

An alternative would be the light cyclical industrial stocks begin to catch a bid, though this might be dependent on the benefits of the deflation of the commodities run-up outweighing the downsides of a stronger dollar making their product more expensive overseas. The one stock I continue to like in this area is Ingersoll-Rand (IR), whom I think made a series of vastly underappreciated acquisitions, in the process becoming the best company in the profitable climate control business. Apparently someone in Omaha agrees with that sentiment, as Berkshire Hathaway’s (BRK) latest 13F showing they bought nearly five million shares of Ingersoll during the last quarter. Regardless of the economic cycle, climate control is an organic growth market throughout the developing world, and even in saturated countries the recurring revenue stream from maintenance contracts provides sustainable high returns. And don’t think the Buffett news is fully priced in, either – at the risk of sounding arrogant, I seem to be the only person writing about it.
Other stocks that could fit this bill are chemical companies like DuPont (DD) or Todd Sullivan fave Dow Chemical (DOW), as well as a more diversified company like 3M (MMM).

So if a stronger dollar brings commodity prices down and creates the perfect set-up for a new leader to emerge from sector rotation, but that isn’t something defensive like staples or utilities, nor is it something slightly more aggressive like some of the light industrials, what’s the next alternative?

One could make the ultra-contrarian argument in favor of financials, but I think that’s just too much of a stretch. Likewise, consumer discretionary deserves consideration, but the reality is that Americans are likely to continue facing relatively high energy costs as well as weak prospects for near-term economic growth. Thus, I don’t think that’s the place to look either. A very real possibility here would be that a stronger dollar would materially weaken the equity markets because the value proposition for foreign investors would change for the negative. This might take place through some combination of diminished acquisition activity (still too late for Budweiser) and a reduced willingness for sovereign wealth funds, et al., to recapitalize the decimated balance sheets of financial institutions, but regardless, it would be a cause for concern if foreign investors started to see America as “expensive,” given the huge need for debt-funded capital investment over the next several years.

Of course, one can always look to purchase stocks which are largely immune to macro cycles and instead are much more dependent on industry-specific conditions. Be careful with this however – something like aerospace might be thought of as uncorrelated, but a stronger dollar relative to the Euro is going to make Boeing’s (BA) jets more expensive relative to those of Airbus. Here, I’m thinking something like insurance, which has enough of a financial stigma that plenty of historically good underwriters have gotten knocked down to levels near 1x book value. White Mountains (WTM) is trading within a few dollars of that mark, and even Berkshire has come down substantially off its $150,000/A-Share high. For what it’s worth, my investment continues to be an effective short position in credit default swaps on investment grade corporate debt. In my Marketocracy model portfolio, where I have to be diversified, I maintain a large allocation to that position, as well as owning Ingersoll and Accenture (ACN), a smattering of contract research organizations (CROs), some small-cap biotech, a small building materials/energy company, and a land bank selling below book value that I’m actually considering getting rid of should I find something better, or want to cut my 85% long exposure…

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In a rising market, the Bullish Percentage normally tops out above 70%. As you can see from the chart, successively lower peaks have coincided with intermediate market peaks – the reason you should shorten up long trading positions in bear markets. In itself, this still looks to be too low to justify calling a top.

The percentage of stocks trading above their 50-day moving average typically rises above 75% before the market reverses course. With less than half of stocks above that mark presently, there are still many stocks that are beaten down.

The percentage of stocks above their 200-day moving average tends to peak above 70%, though it too has topped out at lower and lower ranges as the bear market has unfolded. Still, the overall low score suggests more upside.

Likewise, the McClellan Summation is still negative, but rising. This is supportive of further rallying.

Supporting these readings, the VIX is moderating in the low 20s, though its effectiveness as an indicator might be impaired in markets like this, as I’ve discussed before.

With the indicators implying that the trend remains higher for the time being, what are the likely causes that could bring an end to the rally party?

A very simple way to end the party would be if financial institutions took advantage of their newly higher equity prices and did additional dilutive equity offerings. For example, I can’t focus enough on how Wachovia (WB) continues to drag out the bad news – this time of an extra $500 million loss provision – and I continue to be puzzled by how they can provision for less than their existing nonperforming assets. Again, US Bancorp (USB) has allowances for 270% of existing nonperforming assets, Wells Fargo (WFC) has 184%, Bank of America (BAC) has 187%, and Wachovia has 90%. Um hm. I noted previously that it would take another $1.25 billion for Wachovia to true up and match their allowance to their existing nonperforming asset base, but it’s apparent that the truly well-capitalized banks suggest about twice Wachovia’s existing provision is appropriate. That would require just short of $11 billion, and with $36.2 billion in tangible equity on the balance sheet at quarter’s end, and that could spell trouble.
Alot of this rallying depends on how well the market can bounce back from JPMorgan’s (JPM) announcement of $1.5 billion in mortgage security losses; perhaps it’s the optimist in me that sees that amount as not enormously significant, and views the sell-off in the investment banks today as sign some healthy fear remains in place.

Another point of note is that as oil and gas prices have come down substantially, the retail ETF (RTH) has finally caught a bid; most of the up move has happened in the last few days. My main concern here is that consumers won’t have an immediate reaction to falling pump prices, and thus same-store comps next time around still won’t be anything worth celebrating, and cause the strength of the consumer to fall further into the realm of questionability. Coincidentally, retail sales are reported… tomorrow.

While I don’t believe the underpinnings of this rally are exceptionally strong – the leadership of poorly performing financials who are likely to turn around and use the rally to issue equity is less than ideal – I also believe that enough other people are still negative that the market could push higher another 4-5% before things get overly extended. At that point, you’ll likely hear more people come out of the woodworks with surprisingly optimistic view of the economy…

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