Lots
Of Movement Below A Calm Surface
(From BARRON'S) Like a satellite photo of the ocean, a flat stock market
gives an illusion of calm that's often belied by an up-close look. The market,
in aggregate, was static last week, with the headline indexes making a virtual
round trip. But underneath that apparent inaction were some dramatic moves in
several important sectors. The Dow Jones Industrial Average slipped a mere
10 points on the week, 0.1%, to settle at 10,785. The Standard & Poor's
500 index sagged nearly 4 points, or 0.3%, to hit 1201. And the Nasdaq Composite,
again underperforming, lost 18, or 0.9%, to finish at 2058. Pretty sleepy
action. Unless, of course, you had a big bet on the banks or brokerage stocks,
which lost more than 3% each on the week amid a nasty selling storm in the
bond market. Federal Reserve Chairman Alan Greenspan's suggestion that
short-term interest rates will continue their upward march -- and his avowed confusion
over still-low long rates -- helped send the 10-year Treasury note yield from
4.09% to 4.26%. The carnage was exacerbated Friday with a greater-than-expected
rise in core wholesale inflation. That qualifies as rather violent one-week move
for the government-bond market. So, the week was pretty deflating, then --
unless, of course, you had loaded up on oil or drug stocks, both of which sprinted
ahead. The major oil stocks as a group surged 3.9%, led by a big 6% climb in ExxonMobil
shares to a new high. In the process, Exxon vaulted ahead of General Electric
to become the largest stock in the market at $383 billion in equity capitalization.
The ebullience in the major oils suggests burgeoning institutional rotation
into a group that's generally under-owned by professional investors, and in which
there are a mere handful of very large stocks. Chart experts will tell you the
energy sector is overbought for the short term, but in the way that genuine bull
markets sometimes get a bit ahead of themselves. As for the drug stocks,
they popped Friday in a news-driven move that hinted at some relief from their
regulatory and legal challenges. An FDA panel cleared Merck to return its painkiller
Vioxx to the market in limited fashion, and allowed Pfizer's comparable Celebrex
to stay on pharmacy shelves. There's a seeming desire among investors to
hear that the drug stocks are safe again, and there have been a couple of "false
spring" rallies in the sector on its way to underperforming the S&P 500
by 15 percentage points over the last year. If, indeed, the news continues to
get "less bad" for Big Pharma, investors' thirst for stability and the
stocks' hefty dividend yields could well support them. If that happens, look
for other health-care shares to suffer the brunt of the shift. As the near-vertical
charts of Aetna and Wellpoint suggest, fund managers have been using the HMOs
to provide much of their health-care allocations, in effect hiding from the tricky
drug names. Of course, there's always more going on at the individual stock
and sector level than on the surface of the indexes. Still, the degree of rotational
activity last week stood out. The question is what, if anything, it means.
Without drawing too many grand inferences from a few days' ticks, the pullback in
financial stocks -- if it persists -- and the continued sluggishness of technology
could weigh on indexers. Those two sectors account for more than 35% of the S&P
500 market value. Energy, meanwhile, represents 8%. Other recently strong
groups -- such as materials and utilities (at least until Friday's bond selloff)
-- combine for just 6%. Those are some pretty small horses to expect to pull along
the whole market. That would be consistent with the idea that this is a maturing,
narrowing bull market that won't necessarily spread its rewards as broadly
as it did the past two years. That said, expect the bulls next week to
derive encouragement from the fact that the broad market has, so far, weathered
the backup in bond yields without much damage. A benign consumer price index report
Wednesday could also allay the direst Fed-related fears of stock traders.
After all, the market is only 2% from a new high, and it wouldn't be like bullish-leaning
traders not to give another run at it before long. -- Evaluating
the investment merits of Fannie Mae and Freddie Mac was tough enough when the
variables were generally financial. It was necessary to take a view on interest
rates, the yield curve, hedging strategies, not to mention the relative eagerness
of the mortgage-finance duo to shoulder risk. Now, though, the fate of Fannie
and Freddie shareholders is largely in the hands of politicians and regulators,
thickening an already soupy fog that shrouds the companies' future. By the evidence
of the stock action late last week, a number of its stalwart shareholders may
have sold into the dimness. Fannie shares dropped 7% from Wednesday through
Friday, to 58.90, after they had already slid from 71 at the start of the year.
Freddie also fell 7% in from Wednesday on, to 61.73. The latest trigger was
Greenspan's comments to a Congressional committee, in which he recommended
sharply curtailing the size of the companies' mortgage portfolios, perhaps
to a small fraction of their current size. This would mean shrinking their
balance sheets and likely eliminating the prospect of profit growth for some time
to come. Congress is considering various restrictions on Fannie and Freddie,
meant to reduce the concentrated financial risk of their huge portfolios.
There is a small but passionate short-selling community that continues to gun
for much lower prices in these stocks, based in part on the prospect of a potential
derivatives blowup. Numerous smart and patient value investors have stood
in opposition -- so far wrongly -- sticking by Fannie and Freddie amid loud
attacks on the companies, bond-market tumult and the departure of Fannie CEO
Franklin Raines. The stocks' valuations long ago lost their growth premium,
indicating that the market didn't believe the stated earnings were either fully
real or sustainable. Otherwise the shares wouldn't trade at multiples of official
2005 profit forecasts as low as the current eight and nine. Fannie is already
shrinking itself, buying back billions of its debt, allowing mortgage holdings
to run off its books and bidding less aggressively for new paper. This has helped
agency-bond investors. And a voluntary reduction in the companies' targeted profit-growth
rates could in fact work to shareholders' advantage, too. But for shareholders
now, the burning question is what the real and future earnings base of the company
will be. Is the stock dirt cheap, or are the companies about to have their capacity
to grow permanently taken away? That's something that won't be answerable
until the interplay of Congressional horse trading, lobbyist maneuvering and
regulatory rhetoric plays out. -- Apparently, having a former chief
executive defending himself in court isn't always a bad thing for a company.
MCI, of course, is being courted by both Verizon Communications and Qwest Communications,
even as its former CEO Bernard Ebbers is on trial for federal fraud charges.
And Tyco International has regained its one-time status as a Wall Street
darling, while former CEO Dennis Kozlowski faces state larceny and securities
fraud charges in New York. The stock is up 25% in the past year and has tripled
since its panic low in early 2003. At this point, apparently, to know Tyco
is to love it. The affection is evident in the 16 of 18 sell-side analysts who
recommend buying the shares, with the other two urging investors to hold it.
Tyco has also won over the professional value-investing fraternity, with the shareholders'
list top-heavy with some of the most accomplished value seekers (Capital Research
& Management, Legg Mason Funds, Davis Selected Advisers and Wellington
Management among them). Does this imply, then, that all the good news is
out and all the big money already in? Perhaps, although it may just mean
that any further upside in the stock will come more grudgingly and will require
the company to deftly transition from a restructuring posture to growth mode.
The company's annual investor meeting Tuesday will indicate whether the company
can make the case that it's doing just that. The impressive ascent of
Tyco shares -- to 33.61, down from a high above 36 late last month -- have
come as CEO Ed Breen has sold some weaker businesses, dramatically cut the
debt load and won the confidence of the Street. Last week's announcement
that chief financial officer David FitzPatrick would retire and be replaced by
Christopher Coughlin was taken in stride by Wall Street, a sign of how far investors
have come in trusting Tyco, the former perpetrator of aggressive accounting.
With a market capitalization of $67 billion, Tyco is now valued just over 17 times
forecast earnings of $1.97 for the fiscal year ending Sept. 30. (Tyco last week
affirmed its own projected earnings range of $1.88 to $1.98 for the year). In
fiscal 2006, profits are forecast by analysts to grow by 16%. That places Tyco's
valuation a bit below the elite industrial conglomerates such as General Electric,
3M and Honeywell International, but it is in line with the broader group.
John Snider, co-portfolio manager of Tyco holder TCW Galileo Large Cap Value Fund,
says Tyco's free cash flow generation is a big reason to stick with the stock.
Free cash flow -- or cash generated beyond required interest and capital-spending
needs -- should hit $4.5 billion in the current year, the company said. Snider
thinks that can grow to $5.4 billion next year and $6 billion in fiscal 2006.
He notes that well-run industrial conglomerates with leading brands (such as Tyco's)
tend to be capable of 12% to 14% earnings growth during economic expansions.
Though free cash flow was a bit below expectations in the latest period, Snider
says that frequently occurs at Tyco in its first quarter, related to working-capital
needs.
The business mix at today's Tyco is concentrated in electronics, health-care and
fire/security products, in roughly equal proportions, with smaller units in engineered
products (tubes and valves and such) and plastics. The betting among shareholders
is that Breen is satisfied with the current portfolio of businesses, even if the
divisions bear no intuitive connection to one another. Though it continues to
pare debt, the company has $3.4 billion in cash and is entering a phase in which
it will start to scout for add-on acquisitions. Big, ambitious deals, though not
very likely, would probably spook the market. As for Tuesday's meeting, the
Street is looking for Breen to emphatically state that he's staying at the helm,
given recent talk that he might be a fit for the vacant top job at Hewlett-Packard.
The new CFO, Coughlin, will be introduced and his background at Interpublic, Pharmacia
and Nabisco extolled. Beyond that, there's little suspense on financial guidance
now that the company reiterated its projections last week. But Breen's statements
and body language on acquisitions, further divestitures and other strategic matters
will be in focus. Given the upbeat sentiment surrounding Tyco, it stands
to be a friendly audience -- but one that arrives with already-high expectations.
-- Once more back to the theme of the corporate breakup, an underrated
way to create value often lost amid the excitement over lavish mergers.
When empire builders start to liberate distant provinces, all parties often benefit.
The researchers at Spinoff Advisors in Chicago attempt to value the parts of pending
corporate breakups, while trying to handicap future spinoff candidates. The
idea is to identify big companies that have an underperforming division that could
be profitably set free via a stock offering or spinoff to shareholders. The firm
recently came up with a half-dozen prospects, none of which has stated an intention
to unload any businesses. The companies and the lagging divisions are: Abbott
Laboratories and its diagnostics group; Cendant and the vehicle-services business;
Fortune Brands' office-products unit; General Dynamics and the marine-systems
division; Honeywell and its specialty-materials business; and Textron and the
fastener unit. -- The homebuilding stocks might be responsible for more
broken keyboards and shouted curses in short sellers' offices than any other
group of stocks. For more than two years the term "housing bubble"
has been the two-word bearish thesis on these stocks, which tend to feature fat
short-interest levels and just as many momentum investors happy to take the other
side. Over those two years, the Philadelphia Housing Index has risen about 125%.
The stocks have recently suffered a minor setback. And an influential bullish
analyst, Stephen Kim of Smith Barney, downgraded the group to a neutral stance this
month. The verdict is hardly in, and the skeptics can't declare victory until
new-home demand enters a deteriorating trend, or Treasury yields continue last
week's steep ascent. But a popular arbitrage idea -- one that so far hasn't
been profitable -- could act as a sort of stealth, safer short position in the
housing group. The trade involves playing the spread in the two share classes
of homebuilder Lennar. Lennar's share classes are identical except that the
A shares have no voting rights, which are only available in the B shares. Yet
the A trades at about a $5 per share premium despite their non-voting status,
or close to a 10% premium at recent prices. In theory, voting shares should be
worth a bit more, but the A shares are much more liquid and are a component in
the S&P 400 Mid Cap index. Since it was described here in late 2003 (The
Trader, Nov. 3, 2003), the spread has stayed static, meaning it's been dead money
for arbs. Yet Jonathan Blumberg of Ronin Capital thinks the trade is now
worthwhile. He notes that the spread tends to widen when the stock rises, and
contracts in downturns. This way, shorting the A and owning the B to capture
the spread would likely be profitable if the stock were to collapse with the
homebuilder group. The other way the spread could narrow, or be eliminated,
would be if the company elected to eliminate the separate classes. Insiders
generally own the lower-priced B shares. Any braver housing bears, of
course, could always short just a bit more B shares than the A they own. At
the risk of broken keyboards, of course. --- |
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