What the Cordray Appointment Means for Stocks

President Obama surprised many with an arcane political maneuver called a "recess appointment."  There is a political imbroglio over this decision, which helps to maintain full employment for pundits!

Here at "A Dash" we wonder whether this has any implications for stocks.  At the Wall Street All-Stars site where I have been contributing, one of our readers suggested that the Cordray appointment was good news for big banks.  The hypothesis is that there might be a global settlement that would lift a cloud from the banks and allow them to trade on their strong fundamentals.

Veteran investors know that this approach has been important in asbestos, financial reporting, and tobacco.  It is worth consideration.  Meanwhile, there was a competing alternative — the rumor of a secret Obama plan.

This is a great topic, but I did not have time to do the research and write it up (although I might have made a trade).  Fortunately, the University of Illinois is on break, so I am able to call upon the talents of one of their Poli Sci students — one who has helped us before.

Here is Derek Miller's  analysis, with a few comments from Dad in the conclusion.

Political Background

President Obama’s appointment of Richard Cordray to the top job at the Consumer Financial protection bureau has sparked significant controversy in Washington. While Republicans claim their pro-forma sessions technically keep the Senate ‘in session,’ White House lawyers (under President Bush) have determined that this does not prevent the president from making recess appointments. Based on this interpretation, it is likely that Richard Cordray will remain as the CFPB Director. Therefore, his history as Attorney General of Ohio and his probable agenda in the near future are of intense interest.

The Agenda

Cordray takes the helm of the CFPB with an aggressive agenda, seeking to target “nonbank” financial companies like money transfer agencies, credit bureaus and private mortgage lenders. In a January 5 article of the New York Times, Cordray was quoted to have said:

“Many subprime loans during the housing bubble were made by nonbank mortgage brokers. Since most of these businesses are not used to any federal oversight, our new supervision program may be a challenge for them.  But we must establish clear standards of conduct so that all financial providers play by the rules.

Clearly, mortgage companies are sure to be a target of intense focus for the CFPB under Richard Cordray. Indeed, the CFPB was explicitly designed by the Dodd-Frank legislation to “monitor mortgage originators and servicers, which were instrumental in the financial crisis by providing subprime mortgages to individuals and families who were not able to afford them.”

In a recent Residential Mortgage Litigation & Regulatory Enforcement Conference, Indiana Attorney General Greg Zoeller commended Richard Cordray as “an excellent person to run the CFPB.” In fact, thirty-seven attorneys general sent a letter to the Senate in October of 2011 to urge them to confirm Cordray. This suggests an environment conducive to a global settlement, as there is widespread demand for clear regulatory guidelines on a federal level.

Global Settlement Potential

As a matter of fact, when Cordray was first selected to run the CFPB by the Obama Administration, it was speculated that the bureau would “have a role in getting to a final settlement and particularly in enforcing the mortgage servicers, over which it has primary oversight.”

CNBC real estate reporter Diana Olick elaborates on this theme by citing Edward Mills, a policy analyst from FBR, who notes the advantage Cordray could have as a former Attorney General. “As a former AG, he could use that to his advantage in the ongoing negotiations with the AGs…Beyond a settlement, what we would be looking for are updated disclosure documents that are easier for consumers to understand and a definition of what is a ‘qualified mortgage’ – which sets in place new consumer protections on all mortgages.”

In the video below, Larry Kudlow speculates that the appointment of Cordray is the Obama Administration's first step towards an election year bailout of the mortgage market.

Regardless of what you make of Kudlow's prediction, it is clear that Cordray’s background as an Attorney General – in particular given his statements on the mortgage crisis and the manner in which he has gone about prosecuting cases – highly suggest that his appointment as the Director of the CFPB is a step closer to a global settlement to the mortgage crisis.

Investment Conclusion

[Thanks, Derek — back to Jeff]

I saw an interview on CNBC this afternoon where the interviewers started with the political angle and the opposition of the big banks.  When Cordray swatted away those challenges, citing recent conversations with Jamie Dimon and others, the questions quickly shifted to whether he was favoring big banks.

The exact causal path and reasons are still open to investigation, but the big mortgage-lending banks have shown relative strength this week.

Obvious candidates for this thesis include JP Morgan Chase (JPM), Bank of America (BAC), and Wells Fargo (WFC) for starters.

We have been very cautious, underweighting financials, but we own JPM.


Profit Margins: The right answer to the wrong question

Many intelligent people make mistakes not because they have the wrong answers, but because they have asked the wrong questions.  Smart investors are no different.  There is an antidote!  Readers of "A Dash" know that I strongly recommend the go-to guide on critical thinking written by my own favorite professor, Neil Browne.  The book title, Asking the Right Questions, tells an important part of the story.

Critical thinking is always important, but this may be a special time.  It is so easy to be confused.  Let me take a different tack.

Let us start with a positive, strong answer from James Altucher on tonight's CNBC Kudlow show.  Asked about the pressure on profit margins, Altucher said, "At the end of the day I don't care that much about profit margins, I care about profits….growing huge…."

This seems so obvious, yet is missed by so many.  Margins don't matter if overall earnings are great.

A Little Background

When the economy and stocks started to recover, skeptics predicted the worst for corporate earnings.  It would be easy to find specific quotes, but why pick on anyone?  Most people will remember the general perma-bear litany from last year:

  1. There will be a double-dip recession, crushing corporate earnings.
  2. Corporate earnings are only up through cost-cutting.  This cannot continue.  We need revenues!
  3. Increased corporate revenues are not enough.  Earnings growth is only due to peak profit margins.  These margins must fall.

By contrast, I predicted that companies (Caterpillar was my prime example) cut costs to maintain profits during hard times.  These companies had great earnings leverage as the economy got better.  We are now entering a time when companies are increasing work forces to match growing demand.

This is smart corporate management, and a very natural progression.  Instead of understanding this process, many stock pundits are on a mission, trying to find any false note in the story.

The Miller Rule (Good Idea, Bad Name?)

There is an important principle called Occam's razor, which emphasizes simple explanations.  My "rule" takes the opposite side.

The more variables, the more spin potential.

I proposed this last year.  It is a good concept, perhaps in need of a cooler name (My dad was not called "Occam" so I have a disadvantage!  What is the opposite of "razor"?).  Here is my list of ways (from last July) that skeptics could distort earnings reports:

Since we are investing in interesting times, we are challenged with complex stories.  A few weeks ago I wrote that earnings would be strong, but that the market response might not be as expected.  Now we see why — there is always something to criticize.

As you consider this list, please keep in mind the example of what strong management might have done.

No longer is there a single bar.  Were earnings strong?  Or even a second bar.  How was revenue?

Instead, there is a long laundry list of tests:

  • Earnings — comps from last year.
  • Earnings — meeting expectations.
  • Earnings — meeting the "whisper number."
  • Revenues — should meet all of the above.  The market is very skeptical of earnings from cost-cutting, even though that shows smart management and can easily be reversed.  It is a clear-cut bias.
  • Gross margins falling — another thing that can be wrong.  Even though it might be correct to compete by cutting margins, the pundits will pounce.
  • Gross margins rising –  evidence of unsustainable earnings on a long-term basis.
  • Foreign sales — another no-win area for management.  If you suggest that sales were lower, then pundits will infer Europe weakness.  If you try to cite currency changes, you get the opposite spin.
  • Ignore current earnings.  Look backward.
  • Ignore forward earnings.  Look backward.
  • Ignore strong earnings.  Look at multiple year growth estimates.
  • Ignore long-term growth estimates.  Those are too bullish.

 The current earnings growth is proving strong enough to defy the entire list.

The Margin Question is Wrong!

The pre-eminent figure on profit margin reversion is Vitaliy N. Katsenelson, whose book I reviewed favorably in January.  He regularly updates his work, including the compelling chart here, which has been republished by everyone of the bearish persuasion.

I agree about profit margins.  In my own article from January, I listed profit margin reversion as #1 out of ten things that will be more normal in 2011.

The problem is that Vitaliy's analysis is too limited.  Many other factors are at work.  As margins narrow, employment will rise, revenue will rise, housing will stabilize, skepticism will decrease, P/E multiples will improve and stocks will rise.  Why not look at the big picture, not just one variable?

Vitaliy's book, as I wrote, is quite valuable as a guide to stock selection, but I predict he will be wrong about the sideways market thesis.

Compare his approach to the Altucher answer — earnings growth, whatever the reason,  huge…..

Earnings Season Shopping

I'm looking at stocks with good reports and a poor reaction.  Stryker (SYK) fits my themes (health, graying of the population) and is also a pick of my respected colleague and source, Eddy Elfenbein.  I own this in some client accounts and have been looking to add in others.

[long CAT, SYK, and other cyclical and health names]

ETF Forecast for 2011: Seeking Alpha Interviews Jeff Miller

This article is based upon a recent interview I did with Seeking Alpha.  SA has graciously included me in their annual preview series for three years.  This year's focus was on ETFs, so I revealed something about our Dynamic Asset Allocation (DAA) method.  I have not written about this system before, so it should be of interest to readers at "A Dash."

There were many good questions, drawing out ideas about the market as well as specific stock recommendations.  It does a good job of explaining my bullish posture for 2011.

A Little Background

I am sometimes asked why I use both "A Dash" and Seeking Alpha, as well as other republishing outlets.  The answer is simple:  The audiences are very different.  I can tell this from the comments and the email that I get.

Seeking Alpha has a wonderful editor who works with me and makes suggestions.  They carry most of my work, but not everything.  While I applaud their new program to compensate authors, I am not joining in.  That is not why I write.


Each year I write two or three pieces that are published first at a different source and later republished here.  Since the original interview ran there have been two important changes in the model output.  Readers should note that I warned that the recommendations might be different in two weeks!

Our DAA model asks about the best ETFs for the next twelve months, but we ask the quesiton every day!  This means that we can adapt to changing circumstances.  The DAA is great for situations like 2008, where the model shifted to bonds, gold, and eventually to inverse ETFs.

For those reading the article today it is only fair to update the forecast to the most current recommendations.  Once again readers should understand that the actual positions change many times during the year.  With that in mind, GDX and KOL have dropped from the list, replaced by IYR and XLY.

And now, the actual interview — thanks again to Seeking Alpha for selecting me as a participant and allowing the republication.

The Seeking Alpha Interview

Jeffrey A. Miller, PhD, is CEO and President of New Arc Investments. Also a fund manager at the firm, he has guided the Sector Rotation Fund throughout its exceptional history. Before beginning his financial career in October 1987, Jeff was a college professor who worked extensively with quantitative modeling of sophisticated state and local tax issues. He is the author of the A Dash of Insight blog.

Seeking Alpha's Jonathan Liss recently spoke with Miller to find out how he planned to position clients in 2011 in light of his understanding of how a range of macro-economic trends were likely to unfold in the coming year:

Seeking Alpha (SA): How do you arrive at your investment decisions? Do you have specific recommendations for our readers as we begin a new year?

Jeff Miller (JM): Thanks for inviting me to participate. My company has a variety of programs. We start with the client, not with our specific program offerings. Once we determine the client needs, we match up a blend of programs.

Some of our methods are driven by a scientific approach — models developed by experts, models that I personally test in ways the developer could not have imagined. Other methods reflect my personal analysis of the investment horizon. The answers in this interview reflect my own analysis, stock picks, and sector picks. These have done very well over our company's history.

Meanwhile, I would like to share some current output from our Dynamic Asset Allocation model. Each day we ask the question: Which five ETFs are the best choices for the coming twelve months?

We include a carefully selected universe of 56 ETFs. We chose this fund universe to avoid a situation where our "top five" were all from the chip sector, all Latin America, or the like. We picked a top representative for each sector group, based on liquidity and a narrow bid/ask spread.

I want to be clear. We ask the question each day. We are not "buy-and-hold" so we do not hold the positions for a year. This is active management. If you ask the "one year" question every day, you get about thirty changes in the portfolio. The portfolio also includes fixed income ETFs and three inverse ETFs. We can get very conservative, and even go short if that is indicated.

As long as readers understand that our recommendations might be somewhat different in two weeks, I would like to share our current best recommendations for 2011 with a line on the logic behind them.

  • KOL — Energy demand, global economy, a cheap source.
  • XME — Metals and mining — economic strength, the dollar.
  • PXQ — Networking — an emerging global trend.
  • XRT — Retail — the consumer has been stronger than expected.
  • GDX — Gold — a store of value and a hedge against inflation.

As you will see in the rest of the discussion, my own choices differ from some of the model recommendations, but that is just fine. It is good to have the discipline of a model, and also to have programs with different philosophies.

If you look at a chart of these ETFs you will see plenty of strength. This is a winning long-term strategy that deserves respect. It may miss smaller trades, but it keeps you on the right side of major moves. An easy way to get a feel for this is to compare the stock price to the 50 and 200-day moving averages over the last year. GDX has started the year poorly, but is still among the leaders in our ETF universe.

click to enlarge

SA: Despite predictions of a dip in equities amid slow global growth in 2010, stocks were clearly the better choice than bonds in 2010, especially in Q4 where bonds sold off almost across the board whereas stock returns remained robust. How are you planning to position clients with a longer-term horizon in 2011 in terms of an equities/bond mix?

JM: I like the distinction about the "longer-term" horizon. Each client is different. The first question to ask is whether the client needs wealth preservation or wealth creation. Next you need to know about risk — and I mean a very specific discussion. Even investors who enjoyed nice returns in the last two years still needed to deal with some corrections.

With that in mind, I am recommending an adjustment of at least 10% more stocks to one's normal stock/bond allocation. Many stocks and sectors are attractive in terms of earnings and earnings growth. With interest rates so low, there is a lot of risk in long-dated bonds. I am keeping bond portfolios in shorter maturities — seven years max.

SA: Name one ETF investment that worked out particularly well in 2010 and one that was a bust.

JM: This is a little tricky for me. We have two ETF trading programs with differing time horizons. Both were profitable in 2010. As is the case with every trading system there were winners and losers.

Playing along with the question, we had one of our biggest trading losses in XLY in July. The consumer discretionary concept was not working in July, although it did well as the year wore on. We sold the position and moved on.

One of our best trades was picking up the move in GDX during September. We locked this one in for a nice gain.

In a trading system you need to consider both your batting average and the amount of the win.

SA: Are we likely to see a continued sell-off in fixed income ETFs into 2011? Where can income investors turn for safety while still getting a reasonable yield?

JM: I have written about various income opportunities in my "Quest for Yield" series. I am looking outside the ETF universe to solve this problem: building bond ladders, writing covered calls, and finding great dividend stocks with the potential for appreciation. There are some ETFs that attempt these same goals, but I expect to continue better performance with my own picks.

SA: Which bond sector are you angling towards – Treasurys, Corporates (and if so Investment Grade or Junk?), Munis, Sovereign Debt?

JM: My bond program emphasizes investment grade corporates. Some investors are reaching for yield in risky places. My bond program is very conservative. For those who need more yield we use strong dividend stocks and covered writes.

SA: In which sectors do you expect strength in 2011 and beyond? Where do you expect particular weakness?

JM: The economic recovery has been sluggish so far, but there are many signs of improvement in the data. The Goldman Sachs economic team just upped their forecast for 2011, citing the start of a "real recovery."

This is bullish for cyclical stocks, the technology sector, and financials.

SA: Any specific ETFs or stocks (beyond XRT) you’ll be recommending clients add to the equity portion of their portfolios?

JM: Caterpillar (CAT) benefits from worldwide earnings growth. Apple (AAPL) is still cheap on an earnings or cash flow basis. Many investors get stuck on the absolute price of the stock instead of thinking in terms of earnings. XLK picks up the technology theme for those who do not want to analyze specific stocks.

Financial stocks are still cheap and are benefitting from the yield curve. JP Morgan (JPM) is a good example, and I also hold Goldman Sachs (GS).

I have re-established some energy positions, after avoiding the BP-related problems last year.

Health care has lagged. Eventually the market will quote focusing on the political debate and see the demographic forces. XLV is one way to play this.

SA: What are your expectations for commodities, the dollar and precious metals in 2011 and beyond? Will we finally start to see some real inflation in the coming year?

JM: As long as we have a current account deficit (let's call it a negative trade balance for the average reader) there will be pressure on the dollar. It seems like a lot of that has already been felt, but no one really knows. We need a change in China's exchange rate policy, but that has been true for years.

The emergence of real inflation in an era of high unemployment is very unlikely. This interview is not the place for detailed arguments, so I'll merely note that past times of stagflation share little with current times.

To summarize, I like stocks better than commodities for the coming year, although my long-term model has GDX in the top five.

SA: But no actual commodities exposure? GDX is made up of gold miner stocks.

JM: That is right. We invest in gold via the miners. We do not have direct commodity holdings.

SA: Let's move on to some specific issues that will affect equity returns in 2011 and beyond. In November the Fed implemented another round of QE. Will we get a third round of fiscal stimulus in 2011?

JM: No one knows whether there will be another round of QE, including the Fed! This entire discussion has been a sideshow — fun to debate, but missing the message for investors. I'll state that message quite simply: The Fed is going to maintain low interest rates and QE until there is greater confidence of economic recovery, including some improvement in employment. If the economy recovers as briskly as the Goldman team believes, there will be no more QE. It will not be needed.

SA: How does the incoming Republican House majority affect the economic outlook for the next two years? Is gridlock ultimately good or bad for equity returns?

JM: I do not expect gridlock. There will be action on issues requiring it.

The GOP success will change the nature of compromise. The deals will lead to more moderate policies. We have already seen this in the lame duck session, even before the new members were seated. Those deals would not have been achieved without a recognition of the new reality.

There is a perception that gridlock is good, but I do not think it is very relevant for the market at this juncture. The key economic policies are already in place.

SA: How about the situation in the EU. Have you lightened up on European stock/bond exposure in client portfolios as a result of continuing contagion there? Are there any bright spots you'd focus on in terms of European equity allocation?

JM: Like everyone else, I carefully monitor developments in the EU. So far the policies seem to have been reasonably effective. The EU and the IMF stand ready to do more.

Unlike those who merely point and worry, I like to monitor actual data. My weekly update features the St. Louis Fed's Financial Stress Index. I recommend monitoring this compilation of eighteen financial indicators (including many interest rates and spreads). This lets you enjoy market gains when stress is low, and reconsider if things actually get worse.

SA: Do your clients currently have any Europe exposure? In stocks, bonds, both?

JM: Europe does not figure in my own themes right now, and it is not near the top of our model lists. It is an important story, and I am more optimistic than most about a solution, but it is important enough already without taking on direct exposure.

SA: Same question but for U.S. states like California and Illinois. Will a government bailout ultimately
be necessary to backstop state debt as defaults pile up? Are muni bond funds something you're avoiding going into 2011, or do their significant tax benefits still outweigh the possible downside of one or more states defaulting?

JM: I do not expect state defaults. The defaults will come in specific sub-municipal bond programs. I also do not expect a magical solution, and certainly no federal bailout. Each state will need to find a combination of tax increases and spending cuts. It is not easy.

I follow this closely as an investment manager. I am also a former professor who taught public finance and a member of a financial advisory board for one of the largest school districts in Illinois. I have a front-row seat on this one.

This is a problem that defied solution during an election campaign and a deep recession. We will now take a closer look at the alternatives.

And by the way, there is once again a choice for investors. You can get obsessive about the anecdotes, or you can follow a real market indicator, the credit default swaps on state debt. The numbers have been rising, but they are nowhere close to panic level.

I do not currently hold any muni funds, but I find current yields much more attractive. Like Bill Gross, I see the risk/reward as pretty good for clients who benefit from the tax break.

SA: Are you likely to recommend munis to appropriate clients in the near term?

JM: Yes. The muni yields are very attractive for clients who want the tax advantage. Some care is required in making these choices, of course.

SA: The U.S. housing market seems to be in the midst of another prolonged leg down. How are you playing this via ETFs? Is the commercial real estate market a better bet going forward? How much weight are you giving to REIT funds in client portfolios?

JM: I do not know if we are in the midst of another prolonged leg down in housing. Many sources indicate that we may have a bottom in 2011, at least in some areas. I currently have no long-term position in these markets or in REITs, but I would not be surprised at a change. Our short-term model has signaled a buy on homebuilders in recent weeks.

SA: If you decide to go that route, are you more likely to play homebuilders with individual names, or via ETFs like XHB or ITB?

JM: This is another sector where it seems early to call a turn. Typically we play via the ETFs. If housing starts to look interesting, I will take a closer look at individual names.

SA: Finally, one of the great economic stories of our time is the emergence of China and to a lesser extent, India as global economic powerhouses. How much weight do you recommend for emerging market ETFs in both stock and bond ETF allocations?

I would expand the question to include Russia and Latin America. It is wise to take a step back and see the broad global trends.

All of my investment programs reflect global demand. In my stock selection I make sure to include companies with significant revenue from abroad. Think Caterpillar (CAT). Our ETF programs are model driven, but have frequently participated in the emerging market rally. I have often written about this in my periodic ETF Updates.

Having said this, I think that the foreign ETFs and commodities had a very good run, while the US market lagged. I expect to see some "mean reversion" here this year, as the relationships return to normal.

SA: How do you plan on getting most of your U.S. equity exposure? Any broad funds, or do you generally prefer sector and single stock exposure?

JM: We have never advocated a buy-and-hold approach. Many broad funds are closet indexers, so you are just buying the market. We find investment themes, and then choose ETFs and stocks to fit. While we do not beat the market every year, we do over time. We did not have a “lost decade.”

There are many companies that are developing new technology, introducing new products, and breaking into new markets. Productivity is better. The opportunities are there, and the prices are quite reasonable.

Disclosure: I own CAT, AAPL, JPM and GS personally and in client accounts, as well as the ETF names as model choices.

ETF Update 7/22/10

Jeff is on vacation for a while, but we will continue to update A Dash of Insight periodically over the next few days. Our short list ETF rankings for Oscar and Felix as of Wednesday's close are posted below.

Felix 072210 

Oscar 072210

Remember: we send out a TCA-ETF newsletter every week on Thursday, and you can receive our expanded 277 ETF report upon request.

What Apple Should Learn from Intel

As a top business story, the problems with Apple's iPhone 4 has almost all of the key ingredients:

  • It features a top company and a leading personality, Steve Jobs;
  • It is easy to understand;
  • There is a clear problem including an identifiable mistake; and
  • There are loyal defenders and vigorous attackers.

(If only the antenna problem were the result of a sex scandal of some sort, the issue would be perfect). 

These ingredients open the field to everyone.  In our office we watched the CNBC "box of six" where all participants were describing what Apple had done wrong, how Steve Jobs was mis-handling the situation, and what he should do now.  No matter that none of the critics has any of his experience, imagination, entrepreneurship, leadership, or communication skills.  On this day, and on this particular subject, the door to Monday morning quarterbacking is wide open for us all.

Intel and the Floating Point Processor Problem

When I recounted the Intel story today at lunch I did not have the exact year in mind, although I remembered the facts, where I was, and what I did.  Intel had a regular and very profitable cycle introducing new chips — the original PC processor, the 286, the 386, the 486, and by 1994, the Pentium.  Each cycle moved Intel a step ahead of competition and enabled new and more powerful software.  The Pentium had been released and was shipping in new computers.

In late November of 1994 there was a story about a "bug" in the new floating point processor.  The problem had been identified weeks before.  It was known in some scientific circles, but the story was not widespread. It appeared on some Internet "newsgroups" which were relatively small, specialized forums for discussion. (These days the story would have moved much more quickly).  The "bug" only affected a small minority of users who had software where the floating point processor was invoked and needed accuracy to many decimal places.  For those of us doing routine work, we would never know the difference.

Intel's initial response was to downplay the problem, explaining that it was not important and they would do a fix for anyone who could demonstrate they needed a replacement.  They held this position for weeks.

Can you guess the reaction?  The stock tanked to the tune of billions of dollars in market cap.  I found a nice reference for the entire story at Vince Emery's site.  Here are some jokes demonstrating how a great company can be an easy target:

  • At Intel, quality is job 0.999999998.
  • Q: Know how the Republicans can cut taxes and pay the deficit at the same time? A: Their spreadsheet runs on a Pentium computer.
  • We are Pentium of Borg. Resistance is futile. You will be approximated.
  • The Intel version of Casablanca: "Round off the usual suspects."
  • Q: How many Pentium designers does it take to screw in a light bulb? A: .99995827903, but that's close enough for nontechnical people.

Investment Reaction – 1994

When the story broke on TV I was at the health club.  I grabbed something from the sign-in desk and did an actual back-of-the-envelope calculation.  Knowing a few relevant facts, I determined that Intel could completely replace all of the suspect processors for less than 40 cents/share.  I guessed that they would figure this out.  I made some calls to my clients and we all did some buying.

It took a few days, but the company finally announced the program.  They set aside about $400 million to cover a complete replacement program.  As I recall, very few people actually took them up on the offer, since part of the program was a careful explanation of the problem.  Most did not want to take the trouble, but were reassured that they could do the exchange if they wanted to.  I think they only used a small fraction of the reserve, so my estimate was actually too high!

It was a very profitable trade and carried a good lesson.  Most investors, and even most analysts, do not really try to estimate losses.  When there is "headline risk" they simply sell.  Readers can easily think of a few other companies in the current news where there has been massive selling because the risks were difficult to quantify.

The Lesson for Apple

Let us assume that the Apple executives are confident of their position — they really believe that they are right.  Here is the lesson Vince Emery derives (emphasis added):

…when you see hundreds of email messages and newsgroup postings which all say you have a problem, and you don't think you have a problem, think twice: you really do have a problem. You might not have a technical problem, but you have a PR problem. Intel said, "Pentium chips have a flaw, but it doesn't matter." Intel's customers said, "It does too matter." Intel responded "No, it doesn't," and even though Intel meant well, thousands of its customers on the Internet swore they saw Intel stick its virtual tongue out at them. In retrospect, it seems like a no-brainer, but Intel had the facts on its side and thought that the facts mattered. They didn't. When you are absolutely sure you are right, you increase your likelihood of making a mistake. Ask any prosecuting attorney. The facts have very little to do with the outcome of a case–it's how the facts are couched and presented that sways your jury.

Investment Reaction — 2010

I do not know how long it will take Apple to reach the same conclusion as Intel, but they will get there eventually.  There is an inexpensive fix (free "bumper" cases for all customers) that would only cost a few million dollars.

Disclosure:  Long Apple (AAPL) and adding to positions.  Also long Intel (INTC).

Finding Stock Ideas

When there has been a nice market rebound, we should expect to hear the familiar refrain:  It is a stock picker's market.

This wise-sounding expression means that it is no longer good enough to "buy the market" whether through index funds or market stocks.  It is time for some actual analysis.

There is some truth to the claim.  Last autumn nearly everything went down.  Even the hedge funds with inside information, with managers going to jail, lost on their long positions!  At times this year, everything has gone up, no matter how weak the company.

This is not the "new normal" and it is certainly not the old normal.

The ability to find outstanding stocks is important.

The New Weekly Series

As I noted in yesterday's piece about my blog agenda, I am going to write something each week about how the individual investor can find attractive stocks.  This is not directed to traders, although they may find a few interesting ideas.  Each article will be a building block for my work in progress, a book for people who are not currently reading investment blogs.  Since I have investment advisors and individual investors in my readership, I am hoping for plenty of suggestions and comments to keep me on the right track.

Each week I plan to do an article that considers one part of the stock-picking process.  I hope that it keeps up with reality, generates ideas and selections, and helps us all make money.  I might be too slow in the writing, but you can all join in the criticism.

Passive Approaches

There are many sources of stock ideas, but passive approaches are not the focus of this article,  Maybe I will revisit this topic, but there is a big hurdle for most investors.  I spend many hours each week reading opinions, analysis, and data about stocks.  The individual investor cannot match this.

Those favoring this approach might consider the following:

  • Jim Cramer's work, both on his website TheStreet.com and his CNBC program is a source of stock opinion and investor education.  I like it better as education, since the many recommendations may be difficult to track.  Anyone regularly watching Cramer should have learned the need to do homework — an hour a week on each stock position.  This is the minimum.

There are many other sources of ideas from reading — the subject for another article.  Here is the most important piece of advice about passive approaches:

Beware of Stock Tips

The problem is twofold.  The tipster is almost always swinging for the fences — high reward, but high risk.  More importantly, you will not know when to exit.  Buying on a tip puts you at the mercy of the continued advice of the tipster.

This is a big mistake of the individual investor, and a common one.

Active Approaches

Stock screening is a great way to find new ideas, if you have a sound approach.  The emergence of various screening tools have put dangerous instruments into the hands of the inexperienced.

Let us suppose, for example, that you are worried about the market and decide that a great dividend yield will provide protection.  If you screen for the highest-yielding stocks, you might simply generate a list of companies that are about to cut their dividends!  It is not so easy.

If you want to explore stock screening you can do no better than paying the modest membership fee and joining The Kirk Report.  Charles Kirk is an expert at this technique and he highlights screens that have a proven record. This is a continuing source of great ideas.

Thematic screening is another approach, the basis of my own Great Stocks program.  In my first article in this series, I suggested some interesting current themes.  If you have not read that article, I suggest that you review it before proceeding.

Pursuing a Theme

I start with the assumption of a theme.  For the purpose of this example, the theme is a continuing economic rebound.  I realize that many reject this assumption, and that is fine.  It actually helps in finding good opportunities.

I am looking for companies that could have explosive earnings growth potential if the economy continues to improve.  That is the first screen.  I then try to analyze the company in more detail. Most importantly, how much downside might there be if the thesis does not play out?

The point of this article is to find candidates.  In future articles I will examine how the investor should be skeptical and challenge the potential stock price increase.

One of the very best sources for this type of screening come from the companies themselves.  What is the business model?  How are they developing a strong position?  And most importantly, can there be explosive stock price appreciation.

Today's key concept is earnings leverage.  A company that has costs under control and a business model prepared to deliver should be talking about earnings leverage.

The key resource is the Seeking Alpha transcripts of conference calls.  The Seeking Alpha team covers many calls and it is a searchable database.  If you search the transcripts for "earnings leverage" you get 128 hits, and you can sort by date.  This means that you can look at companies that claimed leverage earlier this year and see how they are doing.

This is a powerful and valuable resource.  A couple of years ago conference calls were a high-priced subscription service, available only to the pros.  It is now free, available to us all, if you only know how to use it.

Finding a Case Study

The first step from a screen is putting the stock on your "watch list."  You follow the company news, the chart, and the economic backdrop to see if the story is playing out.  We are not trying to pick bottoms.  It is completely acceptable to buy a stock at a higher price when the reward/risk ratio has improved.

Here are some ideas from the search.  I invite reader nominations for our more detailed analysis.

Zebra Technologies Corp. (ZBRA)

Lennox International, Inc. (LII)

Manhattan Associates, Inc. (MANH)

Zep, Inc. (ZEP)

Applied Materials, Inc. (AMAT)

Varian Semiconductor Equipment Associates, Inc. (VSEA)

Teradyne, Inc. (TER)

Other suggestions are most welcome.  To be continued.

[No current positions in mentioned stocks, but I am watching.]

How I Pick Stocks

Valued commenter Mike C. asks for a change of pace from my regular topics and a focus on more specific stock picking.  He notes that I have said several times that there are plenty of opportunities.  So what are they?

This is a thoughtful question, so let me start down the path to a complete answer.  I cannot get there in one article, but this will be a start.

Mission and Audience

Anyone who is a regular reader knows that I have not catered to the existing Internet audience.  If you follow blog statistics, it is pretty obvious how you should get a big audience, and I do not do it!  Here is a list of things that I am doing wrong in a marketing campaign:

  • I do not think the world is coming to an end;
  • I do not  see the immediate application of Austrian economics (but I watch the debate carefully);
  • I do not hate Obama (nor did I hate George Bush);
  • I do not hate the Fed, nor do I see them as responsible for everything that has gone wrong;
  • I do not see a conspiracy around every corner;
  • I do not think that government is a unilateral force organized to lie to us, manipulating data.

Putting this into a positive statement, I think that government leaders, whatever their party, are attempting to avert a deeper recession and to create employment.  Presidents Bush and Obama both did their best, given the circumstances, the existing law, their teams, and their ideology.

The government is on a mission.  You may not like the policies, but as an investor, you fight it at your peril.

This is an unpopular viewpoint in the Internet audience.  This audience has had an undue influence on mainstream media, where writers are under pressure to get readers, comments, and page views.

It reminds me of the Truman versus Dewey polls, where newspapers all predicted the Dewey victory based upon their letters to the editor.  People need to realize that Internet blog ratings, Seeking Alpha popularity, and CNBC viewer polls, are all culled from a special audience.  If I were to take this seriously, I would quit writing!

My real audience consists of people who are not even following the Internet debates.  My ideal client is an expert in what she does in her work and is looking for an expert to help with her investments.  I use the feminine gender advisedly, since guys (including me) do not like to ask for directions.  People who want to read a few Internet articles, ask about last year's performance, and think they have a "feel for the market" are not my best potential clients.

Briefly put, I am writing a book for people who are not currently reading my blog, but who need help.  Having said this, I am delighted that some current readers find my material useful, and I value their comments and contributions.  I know from my email that many readers are other investment advisors who share the challenges I face.

Also, I write at night, after my day's work is done.  My list of blog agenda items grows more rapidly than I can work.  It is a labor of love, and one that I will never complete.

My Approach

The approach that I use is not a secret.  Anyone writing to me gets a nice description and a performance update.  I am not allowed to advertise this (so say my lawyers), but the excellent results are available upon request.  I talk to every potential investor.  If someone wants overall advice on asset allocation, I provide that.  If they want a good long-only approach as part of the portfolio, I screen them for risk tolerance and suitability.  That is part of being a Registered Investment Advisor.

With this "disclaimer" in mind, here is an overview of my stock-picking approach.

Find a Theme.  I look for themes where there is excessive skepticism.  I use my extensive background in economics (where I have real training, used to follow actual data and opinions), in politics (where I have built a sister site to track everything relevant), and in valuation (where I relate forward stock potential to alternative investments).  I use daily analysis of data to challenge and review these viewpoints.

My current themes include the following:

  • Recognition that public policy initiatives, from all government sources, are focused upon economic growth and recession concerns.  You can worry about inflation and excessive government, but the concern is too early for practical investment purposes.  There is plenty of stimulus in the pipeline, and more is about to be enacted.
  • Health care companies.  The uncertainty about the final shape of a bill, and whether something will be passed, have cast a pall over the entire sector.  It will not end badly for all of these stocks, despite the day-to-day market reaction.
  • Growth stocks.  There are always growth opportunities, if one looks at data and trends.  I always have some growth in the portfolio.
  • Energy stocks.  When economic growth was more promising, we were near a tipping point in energy prices.  There are many forces providing a bottom in these sectors, and the upside is significant.

There are other themes, but let us stick with those for the moment.  I am always adding or adjusting themes.

Find a stock.  I look for stocks with the themes in mind.  At the moment, here are some considerations I have in mind:

  • International exposure.  Many US companies have a  balance between US and foreign sales.  They are less exposed to a weaker dollar, and may even benefit.
  • Cost cutting.  Companies that have reduced costs are well-placed to enjoy a revenue rebound and extra earnings.
  • Analyst disfavor.  I like stocks that are unloved by the analyst community.  Unlike others, I think that analysts do a reasonable job on earnings forecasts.  They are too slow in changing official ratings.  I often buy when the consensus ratings are low, and sell when they are high.
  • Resistance to risk.  Some companies have a business model that can dodge the apparent pitfalls.
  • Stocks that have lagged the market in the rebound from the pre-Lehman levels, a point that I am using as an initial target.

Specific Ideas

I have revealed and recommended some of our holdings in past articles, especially in my 2009 preview piece.  I still like Transocean Energy (RIG), Apple Computers, Inc.  (AAPL), ResMed (RMD), and Caterpillar, (CAT), for reasons that should be obvious from the above analysis — energy, growth, health (with resistance to skepticism) and global economic growth.  I also own Intel (INTC) which I may not have mentioned before.

While the stocks have all rallied, they are all still buyable right now.  I own them for myself and for clients.

I take a fresh look each day.  Is this a stock that I want to own for the next month, next six months, or the next year?

I recently recommended Research in Motion (RIMM) as a good post-earnings candidate, when the stock sold off sharply.  The thesis is growth in the mobile Internet space, but I like holding it along with Apple to avoid changes in market share.

A Final Thought

I mention these stocks as examples.  Obviously, my actual analysis involves much more detail.  In a future article, I will take a single example and show how it fits the criteria.

Thanks again to Mike C. for the suggestion.  Tomorrow night I have a fine birthday celebration planned in Chicago for my wife and my son (birthdays two days apart).  That means no article tomorrow.  While I love to write about stocks, it is not something I can do every day.

Reacting to News: The RIMM Lesson

How the market reacts to news can be very revealing.  Twenty years ago, when a stock halted trading I was often asked by our trading team where it would reopen.  The problem is understanding the framework of the analysts following the stock and the overall market environment.  The same news can have a widely differing impact based upon the market circumstances.  I have occasionally worked as an expert witness on matters relating to news.  The key is to look at comparable companies and determine the market background.

The modern era is different.  Every commentary reflects knowledge of where the stock is trading after hours.

The Research in Motion Example

Research in Motion (RIMM) announced earnings that beat the official Street expectations by 3 cents (3%).  The revenues were about $90 million light (2% or so).  Gross margins were solid at 44.1%.  New handset growth was 5% short of expectations.  The outlook was in line with expectations.

In a neutral market environment the stock might be down 3-4%, but the current market is not neutral.  In after-hours trading the stock is down 12%, and tomorrow's reports and commentary will reflect this market reaction.

The Investment Lesson

The macro view.  The market is "teed up" for a focus on revenue.  The bearish argument has been that corporations achieved good earnings last quarter through cost cutting.  Here at "A Dash" we understand and accept this behavior.  Companies cut back on costs and employment.  They will hire slowly and reluctantly.  They are lean and mean.  If the economy continues to improve, revenues will grow and earnings will grow faster.  Slow hiring, wise for an individual company, undermines the need for the economy to add employment.  It will be a mixed picture for many months.

In addition, many are looking for a reason to sell after a big rally.  Dow 10,000, while meaningless to professionals, has a psychological impact.  Technicians see S&P 1050, which will be challenged tomorrow, as a key support point.

Briefly put, the market will be unforgiving when companies miss on revenues.  It will be doubly so when the company does not provide a bullish outlook.  Few can be expected to do so in a time of economic uncertainty.  Many companies are not even providing guidance.

It is a clear choice for investors in this stock and others:

If you see a depression as "off the table" and a period of reasonable growth, revenues and great earnings will follow.

Those who hate government data and prefer specific company reports and anecdotal information (the Power Lunch economic index comes to mind) will find plenty to worry about.  We highlighted this in April in our article, Jim Abbott and the Wall of Worry.  Our viewpoint, now proven to be correct, was met with plenty of skepticism.  The worries continue.

It would be naive to expect the market to move in a straight line.  That is too easy.

The RIMM viewpoint.  We own RIMM in our own account and those of many clients.  We have been looking to add a good growth stock for more recent clients, and will add RIMM in the coming days.  Despite today's report, the prospects are very good.  Jordan Kahn at RealMoney (subscription required) sees earnings of $5 next year and a target of $100 in a year or so.  Every portfolio should have a growth component, and this is a great candidate.

Since we are aware of possible market share loss to Apple (APPL), our clients also own that stock.  We expect both companies to benefit from the growing mobile Internet market.

Final Take

We expect to see this story repeated many times during the earnings season.  There have been few negative pre-announcements, but companies use earnings as the trigger for those statements.  There will be revenue misses.