As the House passes its version of the $819 billion dollar “stimulus package” and the Senate readies their nearly $900 billion dollar response, investors are going to have their hands full deciding exactly how to navigate the ramifications.

Let me start by saying that I am optimistic for America, the global economy, and our investment approach.  Dynamic markets always provide opportunity that can be exploited by savvy traders.  Government investment in renewable energy programs, infrastructure repair and expansion, and healthcare initiatives will certainly benefit some growth companies that operate in these sectors.  It is my job to uncover these opportunities for investment returns.

However, I would be less than honest if I didn’t voice concerns over the power we are giving the federal government over what I would consider to be the “private sector economy.”  My mother used to tell me “there is no such thing as a free lunch” and that is certainly true in politics and economics.  So with all this government spending on a tossed salad assortment of projects comes strings.  I fear that you and I and our children will be paying off these initiatives for years to come.

Capital and Control

Whenever the government contributes taxpayers dollars to a particular project, it has a responsibility to see that those dollars are used wisely.   I understand that it would be unfair for the federal government to place several billion dollars into a failing investment bank and then see that same capital be used to pay for private jets, extravagant salaries, or executive perks.  This point has been more than adequately covered.

However, the other side to this coin is that too much government control can stifle creativity, growth, and the potential for exponential investment returns.  I remember a publicized event where successful traders of an investment company were rewarded with a lavish company sponsored trip.  This was essentially a perk for bringing significant revenue to the firm.  Now the firm as a whole did poorly for the year and so there was a public outcry that this perk would have been offered.  But if it were not for perks like these, successful traders would leave the firm for the competition leaving the company weaker and less likely to rebound.

Now when government funds are introduced, the entire capitalist structure begins to lean towards socialism.  The government was not made to participate in commerce, but instead to provide a safe and hospitable environment for private citizens to be able to engage in commerce.  Those private citizens are then responsible for securing their economic future, and free to pursue the many creative, and even ingenious endeavors that have given the United States a strong economic foundation.

But when the government controls how business practices take place, and how employees and investors can and cannot be compensated, it disincentive’s the creativity, work ethic, and resolve needed to maintain a healthy and growing economy.

Paying for the Package

The biggest question that investors and citizens should be asking right now is “at what cost” these spending measures are enacted.  The Senate bill is expected to be nearly $900 billion dollars, and many economists expect the actual spending to exceed $1 trillion before all is said and done.  According to the Wall Street Journal, this package will cost more than the entire Iraq war!  The pricetag will likely leave our government with the biggest budget deficit since World War II.The logical question to ask is exactly where this money is coming from?  In essence, our budget deficit is largely capitalized by international funds who invest in US Treasuries.  Since the United States and the US Dollar is still viewed as the primary vehicle to store wealth, demand for these securities remains relatively robust.

However, over the long run if our economy continues to experience weakness, the feds will have to print more dollars to meet our obligations.  Currently our printing presses are running full steam as billions have already been committed in the TARP program and other initiatives.  While there is very little cost to producing more dollars, the long-term inflation danger is mounting.  Foreign parties who own our securities may eventually see their wealth diminished as the dollar looses value.  These entities would be much less likely to purchase debt securities in the future leaving us with fewer options on the table.

So while aid to the economy may certainly be necessary, it is important to note that the capital is spent at a cost, and that cost could actually depress the economy for years to come.

The Personal Side of a Recession

Now I want to be clear that I am not insensitive when it comes to the plight of individuals within this economic crisis.  I am personally not immune to the effects of the recession and members of my family have suffered through unemployment, underemployment, and financial difficulty.

I do not believe that the government should sit idly by and watch its citizens suffer.  There should be programs to ensure basic life necessities are met.  But these programs should be structured to encourage innovation, hard work, and with the purpose of sending each recipient back into the private sector to adequately provide for themselves.   Too much government control stifles this ambition and eventually leads to the depression of the entire economic system.

So while we seek out the most profitable investment ideas over the coming months, and work with the environment we are given, I hope that the country will escape the perils of an increasingly socialized economy.  In the end, it will be our creativity, work ethic, and private sector growth that will restore our thriving economy.

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Additional Reading:
WSJ: House Passes Stimulus Package
The Big Picture: Treasury Plan Lifts Hope

“Sully” Sullenberger is my hero!  The now famous pilot of US Airways flight 1549 kept his head and saved the lives of 155 people on a cold NYC afternoon.  His calculated and controlled response to a true emergency is admirable and the scenario is an important reminder to all of us as to how important life is.

The situation is also an important reminder of the importance of aircraft maintenance.  Whether mechanical issues had anything to do with the crash or not, the fact remains that more attention than ever will be given to the importance of keeping aircraft well serviced and in top shape.

TransDigm Group Incorporated (TDG) makes parts for aircraft and turns a healthy profit on these products.  The company typically sells original equipment for a wash or even a small loss.  But once the company’s systems are installed on a plane, TDG makes good margins on the replacement parts.  Since TransDigm owns patent rights to most of its products, the competition is locked out and the company has a captive audience when it comes to clients.

So without further adieu,  here are my three reasons to own TransDigm Group:

1. Fundamental – The company produces strong cashflow and stable earnings.  Even with declining air travel, there is still plenty of business as airlines will continue to keep their planes maintained, and delivery flights continue at regularly scheduled intervals.  The company has significant debt but the stable business model provides enough cushion to manage that debt level.
2. Current Events – The recent airline crash will not only increase the public’s awareness of aircraft safety, but it could encourage regulatory bodies to take a closer look at the standards in place. Additionally, investors will likely migrate to TDG which has been a relatively unknown name just because of the business it is in.
3. Technical – The stock is trading in a much more attractive pattern than we saw a few months ago.  The stock has rebounded off its low with strong volume and is now creating a well-shaped base from which it could mount a significant rally.  Technical analysis may not be as important in the long-run, but it could help to drive trader interest in the coming weeks.

Transdigm announces earnings next week which should set the tone for several weeks if not months.  By the time the quarterly numbers are out, the stock could easily run higher making for a more risky entry point.  I would suggest starting a position before the announcement and then possibly adding to that position once the earnings picture is clear for the most recent quarter.

FD: Author does not have a position in TDG
TDG Notes

Additional Reading:
Minyanville: Citi’s Jet Gets Grounded
Top Stocks: Stock Ideas from an Expert Advisor

Interactive Brokers Group, Inc. (IBKR) reported earnings this past week and the stock sold off nearly 12%.  It appears that even though the company reported record fourth quarter profits, investors were still concerned about the risk in financial stocks.  This risk is certainly nothing to take lightly as evidenced by the demise of many “blue chip” competitors such as Bear Stearns, Lehman Brothers and Merrill Lynch.  However, Interactive Brokers may be facing an unfair stereotype.

Looking at the past year, the company reported earnings of $2.24 per share, an increase of 41% over 2007 earnings.  The number of cleared “DARTS” (a measure for average revenue trades) was up by 46%.  According to Thomas Peterffy the CEO, IBKR’s “focus on long-term growth, controlling risk, and building technology continues to pay dividends.”  I would have to agree that the performance of this company appears to stand heads and shoulders above the competition.

Skeptics can certainly point to some mistakes over the past year.  In one particular instance, IBKR lost $10 million because of a customer who somehow slipped through security measures and was able to take on too much risk.  When the customer’s account was wiped out, IBKR was responsible for additional losses unable to be covered by the diminished equity in the customer account.  Mistakes like this can be very costly and have the potential to pull down an entire brokerage.But this event probably did more good than harm in that it allowed for a careful inspection of the technology, and probably left the systems in a much more stable place.  Margin requirements will be much more closely monitored so the chances of another event like this happening are probably very low.

One other issue that should ease investor concerns is the type of securities traded by IBKR and its customers.  The company has decided to only be involved in exchange listed securities which cuts down on the amount of illiquid and risky assets.  It also gives the company a chance to more quickly sell customer assets if margin levels are not met.  It may be that IBKR is bypassing some potential profits by only trading listed securities, but the lower risk profile is certainly a positive factor for investors.

IBKR has a strong balance sheet that will allow for stability and growth in the coming year.  Of particular note is the planned expansion of its market making business in Asia.  The company will leverage its current position in India to add more products covered, and the addition of some Japanese markets will also add to revenue.  Currently the company operates in 70 market centers which represent 27 countries and 16 different currencies.

With the stock trading in the mid teens, and earnings expected at $2.15 this coming year, it appears the value is solid.  Interactive Brokers has proven its ability to navigate turbulent markets by growing profits even during the past difficult year.  Since the stock is  near the lowest level in its history, investors likely have the chance to own a quality company at a significant discount.  Even if the company began trading at a multiple of 10 by the end of the year, investors would see a 35% gain.  IBKR is one of the positions in the ZachStocks Growth Model and should perform well during the coming quarters.

IBKR Notes
FD: Author does not have a position in IBKR

Additional Reading:
The Big Picture: Reverting to the TARP
FMMF: State Street Crumbles

Investors in Open Text Corporation (OTEX) have been on a wild ride the past few months.  After topping out at $39 in late September, the vicious market sell off took the shares to a low of $22.  That’s a 43% drop which took place in the course of just 5 weeks!  The stock has since recovered and is hovering just above the $30 level as I write.

Open Text is one of the few remaining successful growth stories that is trading at a reasonable multiple.  The company has seen its growth rate decline from the 30-40% level to what will likely be 16% in the fiscal year ending June 30, 2009.  But in this environment, any growth should be seen as extremely positive.

The company develops content management software which helps customers keep track of the growing mountains of data.  One of the primary growth drivers for OTEX is a growing regulatory burden that requires firms to store, manage, and be able to retrieve a vast amount of information.  With a new administration taking office and relegating more power to the government, you can expect this trend to continue.

During the quarter ended September, 2008, the company reported earnings of 53 cents per share which was up 28% over the same quarter last year.  Revenue growth was only 11% coming in at $182.6 million.  These metrics show that the company is able  to leverage their fixed costs and efficiently drive new revenue straight to the profit line.  With an impressive gross margin of 68%, the company appears to be operating very efficiently.

Management is committed to maintaining strong profit margins which is why the company will cut their headcount by 10%.  This move is to take place after a new acquisition is completed and will eliminate redundant positions within the company.  As a result of this move, the company has taken a restructuring charge of $20 million, but with that charge behind us, it should be smooth sailing for the next quarterly report.

OTEX reports earnings next week (January 28) and investors will be listening carefully to management’s perspective on the current market.  The customer base is certainly diversified by geography and by industry, but this may not be enough since the economic slowdown is so broad.  Still, a healthy balance sheet with plenty of cash should help to buffer any industry weakness.  The company is also in the middle of a large share repurchase program which could help the “per share” numbers look a little better.

Given the low multiple on the stock, the strong balance sheet, and management’s commitment to profitable growth, I would expect the stock to trade higher over the next few months.  In order to see profits, we will need the broader market to show some resiliency.  But with all the stimulus capital being put to work, I believe the overall environment will take a turn for the better in the remainder of this quarter.  Please use caution with this name as it has a volatile pattern.  But if timed correctly, it could yield superior returns.

FD: Author does not have a position in OTEX
OTEX Notes
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Additional Reading
Barrons: IBM Layoffs Underway
Jefferies Ups Rating on Checkpoint Software

Shanda Interactive Entertainment Ltd ADR (SNDA) must have missed the recessionary memo.  The Chinese gaming company continues to grow earnings and sales despite weakness in the global economy.  Last quarter Shanda cleared $136.7 million in revenues and handily beat consensus expectations with EPS reported at $0.68 per share.  In fact, this was the 10th consecutive time the company has beat consensus expectations.

A few years back, investors were a bit skeptical about the revenue model for many of the firms in the industry.  Typically, online games are available for free or for a very small charge.  This yields a large number of “non-paying” customers who use the game but do not add to the revenue base.  But premium products within the game are sold to a handful of subscribers and this revenue is enough to drive margins to extravagant levels.  For the last quarter, SNDA posted a gross margin of 73%.

Another profitable source of revenue has turned out to be in-game advertising.  With 77 million total users, it would make sense for an advertiser to pay premium dollars to feature their product within a particular game.  Currently Shanda has more than 20 games in operation.  This provides a significant amount of non-traditional advertising space.

Shanda has worked hard to build the largest online game revenue base in China.  Currently, the company receives roughly 70% of revenue from its two most popular games: “World of Legend,” and “Legend of Mir 2.”  Initial reactions may be that the company is not well diversified, but it is interesting to note that these two games have been in existence for more than 7 years.  So obviously the company is talented at managing the progression of these games to keep players interested for so long.

But Shanda is not sitting back and enjoying its success.  There are actually more than 50 games currently in the pipeline and  the company has an aggressive schedule to put these games in front of users.  Over the next 12 to 18 months, Shanda will launch 10 multi-player role playing games and 6 casual games.  If any one of these turns out to be a blockbuster, the company could realize significant profit growth.  At worst, the new games should still bring in a moderate number of new users and give current gamers a new reason to stick with Shanda.

The company owes much of its success to a healthy financial position.  With no debt and roughly $587 million in cash and alternatives, Shanda is in an excellent spot to be able to buy out struggling competitors, or purchase new content for future games.  Much of the cash is also being used to retire shares as an aggressive buyback program is in place.  This will increase the value of each remaining SNDA share.

With the stock trading at just 12 times earnings and the potential for significant growth, SNDA appears to be a strong investment candidate.  In fact, the stock is currently the best performing member of the ZachStocks Growth Model.  If the stock were to trade at just 15 times the consensus expectations for 2009 (which appear to be conservative), we would see a price of $42.75.  There is certainly risk that expectations could turn out to be too optimistic, but at this time it appears the potential reward far outweighs the risk.

FD: Author does not have a position in SNDA
SNDA Notes
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Additional Reading:
Forbes: One Boom Market Remains In China
Barrons: Shanda Boosts Share Repurchase

The stock price for Emergent BioSolutions Inc. (EBS) took a sharp hit earlier this month when the company announced a delay in shipping Anthrax Vaccines in the fourth quarter.  While the company has been growing revenues and earnings at a steady clip for the last three quarters, the shipment delay will disrupt the pattern of revenue growth and cause sales to be a bit below management’s range of guidance.

The stock dropped more than 20% intra-day after the announcement was made, but paired losses to less than 10% by the end of the day.  Part of the recovery was likely due to the fact that the company will make up the majority of this shortfall in the first quarter of 2009 when the shipments come back online.

Emergent BioSolutions is a relatively small company with a very important role.  The company has the sole US approved vaccine for Anthrax and provides the government with doses on a continual basis.  It’s pretty nice to have a business model where the government buys as much inventory as you can manage to produce.  Most recently, EBS has signed a contract to supply an additional 14.5 million doses to the Strategic National Stockpile (SNS) and the contract runs through the third quarter of 2011.  Sales for this agreement should come in at about $404 million.

EBS should enjoy a long and prosperous relationship with the US government – and possibly other governments as well.  That is because the vaccines have a typical shelf life of just three years.  While technology may improve to extend this shelf life to four years, the fact remains that the company will have to continue to replenish aging doses and thus maintain a recurring revenue stream.

While the company has made its name (and the majority of its profit) from the Anthrax vaccine, EBS is working hard to diversify its product base.  Currently it has three products in stage II trials to treat Typhoid, Hepatitis B, and Tuberculosis.  Even though its primary business offers a stable source of cash flow, there is always a chance that a competitor could develop a better vaccine which would compete with EBS’ product.  So diversifying the product line is certainly important to investors.

At a current price near $23, the stock appears a bit risky.  While the business is certainly one I would want to own, the current investment environment requires caution and a healthy margin for error.  In order to justify an investment in EBS, I would much rather try to pick up the shares under $20.  But if that price were reached, it would certainly be a good candidate for the ZachStocks Growth Model.

About 47% of the stock is controlled by the CEO, Fuad El-Hibri.  While heavy insider ownership is usually a positive for small-cap stocks, investors should be aware of a shelf filing which allows Mr. El-Hibri to liquidate about 1.1 million shares.  This would likely be a short-term burden for the stock considering the fact that it is relatively thinly traded and there are only about 13.5 million shares in float.  Still, this pending sale could be the catalyst to allow us to purchase at a discount to the current price.

EBS Notes
FD: Author does not have a position in EBS
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Additional Reading:
TopStocks – Stocks with an Exceptional 2008
Trader Mark – Emergent BioSolutions hits IBD

Amedisys, Inc. (AMED) has been knocked around by news quite a bit.  In November, the company re-affirmed guidance for 2008 and received a 16% haircut in just one day.  Conversely, when the company released guidance for 2009 in January, the stock rebounded 16% as investors cheered the expected growth.  Still, with all of the theatrics, the stock remains in a wide range that has held the stock for the last 12 months.  I’m going to explain why I think this stock will show investors significant gains in 2009, and why it is a strong candidate for the ZachStocks Growth Model.  But first a bit about the company:

Amedisys owns 325 nursing offices and 29 hospice offices across the United States.  The company has strong internal growth, but is best known for its acquisition strategies.   In March of 2008, the company paid $395 million for TLC Healthcare Services.  The acquisition was the largest for the company in the past several quarters, but certainly not the only one.

Management has proved adept at targeting competing companies that may be run less efficiently and then rolling them into better operating procedures.  It looks like the TLC acquisition is coming along nicely as operating margins for the acquired locations are quickly moving from an average of 22% towards standard 33% margins for AMED.  According to Raymond James, this should equate to an additional $40 million in operating profit.  The analyst says that this acquisition should add $1.50 per share to 2010 earnings compared to initial figures of $0.40 when the deal was first announced.

Looking to the year ahead, management has stated that they have a robust pipeline of future acquisitions in place.  With the industry concerned about the future of medicare expense reimbursements, there may be some deals that are done at very attractive prices as current owners want to get out quickly.  For what its worth, company guidance of $4.10 to $4.30 in earnings this year do not include the benefit from any un-announced acquisitions.  So these figures could turn out to be quite conservative.Amedisys owes some of its success to strong relationships with local physicians.  It turns out that the company receives a much higher percentage of its patients from individual physician referrals as opposed to hospital referrals.  Typically physician referrals are more acute patients that generate higher revenue.  Now it sounds a bit callous to refer to patients in terms of revenue, but it is comforting to know that Amedisys is providing quality care to the individuals who need it most.

One of the reasons the stock is trading at such a low multiple (roughly 11 times 2009 expectations) is due to concern with the company’s uncollected bills (as measured by Days Sales Outstanding or DSOs).  It is certainly a concern if the company is not able to collect on services performed, but it appears that progress is being made.  The company most recently reported that DSO’s were declining, and pointed to the fact that they have been able to collect 98% of billings over the past several years, and 99.5% of all medicare revenue.

So with the possibility (or more accurately the probability) of the company completing accretive acquisitions, and the low price for which this company is trading, I expect investors to experience healthy returns for 2009.  Nursing care is a needed service and Amedisys is in the position of providing valuable care.  The growth rate could slow from hefty 45% earnings growth seen over the last 2 quarters, but even with a modest 20% growth rate, the stock appears under-valued.

AMED Notes
FD: Author does not have a position in AMED
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Additional Reading:
Minyanville:  A Hospital in Your Home
FMMF: States Continue to Spend

The markets were greeted today with an economic report that disappointed even negative expectations.  Retail sales for the month of December dropped 2.7% which was basically double the consensus expectations.  Although the report is being heralded as “the worst holiday spending in decades,” it is helpful to put some of the figures into perspective.

Retail sales make up a very broad category and most headline readers probably missed the fact that the majority of the sales drop was due to lower gasoline prices.  Without factoring in gasoline and the automobile category, retail sales only dropped 1.5% for December.   This is still quite a large drop, but it helps to put the numbers into perspective.

Unfortunately, these numbers aren’t set in stone, as the statistics from November and October were adjusted lower as well.  It now looks like November retail sales declined by 2.1% instead of the previously reported 1.8%, and October saw a slide of 3.4% compared to the previous 2.9% level.

There are those out there who believe in conspiracies to make things look better than they are initially.  Then once the sting of the headline has passed, the figures are revised lower and hopefully slid under the radar.  I’m not one to see a shadowy figure behind every tree, but it is interesting to see that the information has a trend of getting worse.  For whatever it is worth, December marks the sixth consecutive month that we have seen weaker sales.

According to the Wall Street Journal, much of the weakness in consumer spending is due to three factors:

1. A high level of debt.   Consumers are essentially maxed out on much of their available credit.  Since the financial institutions are unwilling to lend much additional capital, and home equity loans are not nearly as available, this level of debt reduces the amount of flexibility consumers had for holiday shopping.
2. Weak Asset Prices.  Most households have a large portion of their wealth tied up in their personal residence.  As home prices decline, consumers “feel” poorer and are unwilling to spend as lavishly.  Also as mentioned under the debt category, a lower asset value means home equity loans are unavailable because many consumers simply no longer have equity in their homes.
3. Fears of Layoffs.  I’ve seen plenty of my friends or neighbors either experience layoffs, or see cuts in compensation.  Whether this happens to you or not, you likely see the same issues in your neighborhood.  While unemployment is still much lower than depression status, the fear of loss of income has a very negative effect on spending.

So what do we as investors do with this data?  You’re probably guessing that I’m not going to tell you to hit the “panic” button.  It simply doesn’t make sense to completely bail out of the market at these levels.  But I do think you have to be very strategic in your tactical approach.

• Cash is an investment.  While long-term, inflation will eat away at a large cash balance, it makes sense to have some dry powder until we get a better indication that growth is coming back
• Selective Short Positions.  Many of my short ideas are already trading to levels where the risk of a rebound prevents shorting.  However, a few categories (For-Profit Education, Transaction Processing, and certain Niche Retailers) still have attractive short attributes.  This portion of your investment account can have the goal of trading profits (aggressive) or simply to offset risk from long positions (a more conservative approach).
• Careful Investment in Strategic Sectors.  While late 2008 saw nearly every sector getting pounded, we are seeing pockets of strength in particular industries.  Shipping, Alternative Energy, and Infrastructure come to mind as beginning positive trends.  There will be other categories emerging in the coming months as well.  But success requires careful study, proper timing, and a healthy dose of patience.

So in short, yes the economy is difficult.  Headlines make for hand-wringing and fear.  But fear does not help in sound investment decisions.  As always, have a plan that is tested, implementable and one that you can be comfortable sticking with for the long-term.  Exercise patience and risk management.  And in the end, fundamentals will eventually be reflected in the prices of your investments.  If you do your homework right – the returns will work themselves out.

Best of success to you in this turbulent market,
Zach

Consistent readers should be aware of the fact that I see many for-profit education companies as short candidates.  Conventional wisdom states that during tough economic times, workers will pursue education programs in order to improve their wage potential, or to develop skill in an area likely to provide them a job.

From a personal standpoint, this is an excellent approach.  Early in my career, I put in the time and effort to get through an MBA program while at the same time earning the CFA designation.  The hours were long, the coursework was rigorous, and the mental strain was at times a bit overwhelming.  But completing these programs opened doors for me that would otherwise have been unattainable.  Furthering ones education is certainly a good thing.

But from an investment standpoint, many of these education companies bear too much risk at current prices.  Last month I recommended investors avoid or short Capella Education.   These concerns are still in place, and I continue to watch for the stock to fall.  Today I want to introduce readers to Devry Inc. (DV) and recommend investors avoid this name as well.  The stock currently trades at a published PE of 31 and the chart shows that the stock has significant overhead resistance.

Last week, many of the education companies rallied (Devry included) when Apollo Group (APOL) reported a strong quarter.  The company has been sinking investments into systems to help increase enrollment and it appears those investments are paying off.  Stocks in the sector ramped sharply as investors believed Apollo’s success would translate to the entire group.  However, Capella Education and Devry did not come close to making new 52 week highs.  In fact, both stocks simply made up some of the previous months losses.Devry boasts of a healthy balance sheet, strategic acquisitions, and an impressive number of graduates landing applicable employment.  Management states that only 5% of revenue comes from private loans which should help to offset negative credit markets.  Enrollment was up 12.6% according to the latest quarterly announcement, so it appears the company is growing at a healthy clip.

But liabilities to investors include a stock price that is high compared to reported earnings, account receivable balances that indicate difficulty in collecting tuition, and a difficult consumer environment that will make it difficult for willing students to be able to afford further education.  In the past, consumers have been able to charge tuition to credit cards – running up balances while increasing potential earnings power.  But the personal credit available to most consumers now has been diminished.  This will not show up on private loan stats, but could very well affect enrollment in the coming year.

With the stock priced for robust growth, and the sector being one of the last “safe” groups that has not been hit by a turbulent market, you can bet many managers have a significant amount of assets parked in these stocks.  Any disappointing news could easily send these stocks lower, and we have already experienced movement from Apollo’s positive news.

So I continue to expect losses in the for-profit education market and would avoid (and potentially short) Devry.  In fact, you may want to sell the stock, and use the proceeds to pursue a better education!

FD: Author does not have a position in DV
DV Notes
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Additional Reading:
ZachStocks: Capella Education Concerns
Trader Mark: Playbook for the Week (including APOL note)

With the conflict in Gaza escalating, the world has once again turned its attention to military action.  As investors, it is normal to look for opportunity in the midst of chaos and defense stocks are beginning to once again grab the eyes of traders.  It’s not just the middle east that should be turning heads, but also conflicts between Russia and the Balkans, (natural gas is actually one of the tools of warfare).  My friend Justice Litle, Editorial Director for the Taipan Publishing Group also noted that things have been unusually quiet in North Korea as well.  Is it out of the question that we could face a serious, multi-county conflict in 2009?

While I certainly do not relish the thought of armed conflict and civilians in danger, it’s important to protect ourselves both physically and fiscally if such an event were to arise.  And so investors should certainly keep an eye on stocks that will do well if conflict intensifies.  The natural tendency is to flock to stocks like Northrop Grumman (NOC)  Lockheed Martin (LMT) and General Dynamics (GD).  These large-cap players have actually held up fairly well during the fist week of trading this year.

As usual, my focus is on the smaller growth stocks in the area which have more potential for doubling or tripling my investment.  One of the most exciting names that I have come across is AeroVironment Inc. (AVAV).  The company has many innovative solutions for civilians as well as military, but they are especially well known for their unmanned aircraft which can be launched by hand.  The airplanes are small enough to be carried onto the battlefield and yet still carry sophisticated camera and data capture equipment.  If a convoy needs to see what is behind the next ridge or in the next valley, they just launch the plane and take a look.

The stock is a bit expensive at this level (trading at roughly 30 times earnings) and so it appears a bit dangerous to buy at the current level.  But with so much innovation and a strong list of prototypes, it could be that analyst estimates for future earnings are too conservative.  Keep your eye on this name for opportunities to pick up stock on a dip.

Its no wonder governments are turning to technology to fulfill their military needs.  Since recruiting has become difficult for some countries, defense departments are finding themselves with the need to do more with less.  The US military contracts with thousands of small companies to provide the innovative solutions to compete in this ever changing environment.  Despite advantages that large companies have in this sector (capital to hire lobbyists, inside contacts in the Pentagon) the military actually has a vested interest in keeping small companies in business.  This is because the niche manufacturers will be able to continue to service their products and hopefully continue to innovate in order to improve performance.

Since most military contracts rely more on quality of work than on price, the margins can be quite good in this business.  Also, the US military is often viewed as a primary outlet for new technology, while other countries can be a secondary source of income, buying proven products and services for years afterwards.  So with such strong profitability and a few large stable customers, it makes sense for investors to be aware of defense stocks in 2009.

AVAV Notes
FD Author does not have a position in any stocks mentioned
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