At ZachStocks we have spoken several times about the possibility for a sharp drop in the value of the dollar.  In this article by Keith Fitz-Gerald we take a look at China’s potential to move the Yuan into a dominant place as a global world currency.  Keith is the editor of the Geiger Index and has recently been discussing his concept of the “Golden Age of Wealth Creation.” This article certainly got my attention as a shift in the way major governments create and maintain their reserves could have a huge effect on our economy and investments.  Please let me know what you think about this article.

China Seeks to Dethrone the Dollar, Transforming the Yuan Into the Dominant Global Currency

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

China has taken yet another step to transform the yuan into the dominant global currency, a long-term initiative that could ultimately dethrone the dollar as the world’s top unit of exchange.

In the last four months alone, China has signed currency swap agreements worth more than $95 billion (650 billion yuan) with an array of nations – including: Argentina, Brazil, South Korea, Indonesia, Malaysia, Belarus and Hong Kong – that are only too glad to move away from the increasingly shaky U.S. dollar.

For Westerners who are struggling to come to terms with the notion of a disarrayed dollar, the thought of oil, gold or other commodities being priced in yuan instead of dollars has to seem about as likely as having another country put a man on the moon.

But the Chinese yuan is already well on its way to becoming that globally accepted standard unit of exchange and the proverbial genie, as they say, is out of the bottle. In fact, I’d even go so far as to say the dollar’s days of dominance are numbered and with each new round of bailout chicanery, the clock is winding down ever faster.

Asia’s Long-Term View

In such Asian markets as Japan, Hong Kong and Mainland China, the long-term planning that’s an anathema to Corporate America is actually standard fare. During the height of Japan’s dominance in the 1980s, the Western business press – with a touch of derision – wrote about how some Japanese companies routinely formulated business plans with durations of 100 years or more (while working in Asia early in my career, I actually even contributed to several such plans … but that’s another story for another time).

That’s neither here nor there to most people who note smugly that Japan is getting its comeuppance. But what they don’t understand is that Japan is not alone. In fact, many people I talk with are shocked to learn that at a time when the West is still busy handing out Band-Aids in an attempt to deal with the greatest financial crisis on record, China has been quietly and shrewdly reinventing itself with the same kind of long-term vision.

Take commodities, for example. While companies in the United States, Great Britain and Europe are being forced to shed promising assets in order to compensate for massive losses or to pay down debt, cash-rich China has been able to operate as a buyer in a buyer’s market. While the rest of the world has interpreted this as a sign that China’s interested in buying the things it needs to grow, what they have not understood is that China’s also interested in using physical assets as a source of  “currency” that offsets an increasingly eviscerated U.S. dollar.

This is actually a double-whammy of sorts, for while the rest of the world has been grappling with the global slowdown, China has been locking up supplies of commodities that are only going to become more scarce (and more valuable) as global demand escalates.

In fact, as I’ve suggested for months, now, China isn’t just going to consume those assets; it’s going to use them as part of the same long-term vision it’s been staking out with regard to its own currency, the yuan, which it fully intends to boost in status to the point where it becomes an internationally accepted currency.

The Once-Dominant Dollar

That’s quite a turn of events.

Even now, despite the travails of the U.S. economy, the dollar remains the world’s most widely held reserve currency and, as such, is the standard unit of exchange in most international transactions. In fact, many non-U.S. firms (such as Airbus SAS) actually price their manufactured products in dollars. And the dollar is the de facto unit of pricing for such commodities as oil (hence the term “petrodollar“). Several countries even use it as their “official” currency. But the global financial crisis is threatening that dominance.

The United States has already “injected” into the world economy trillions of dollars that are collectively worth more than 60% of this country’s entire gross domestic product (GDP). And the prospect of still more injections for California, GMAC LLC and other “national” interests is extremely worrisome – and not just to millions of Americans, either. If Washington stays on this path, the result will be a currency crisis the likes of which few are capable of imagining and a near-complete devaluation of the once-almighty U.S. dollar.

Ironically, both events will only further embolden China, speeding up its efforts to boost the yuan’s international acceptance.

The “New” Yuan

While some experts may question Beijing’s motives, it’s hard to question China’s long-term strategic vision, since the country is actually being forced to take these steps that ensure its own survival. Unfortunately, our leaders in Washington don’t seem to understand this, so they’re only making matters worse – when they instead could be actively working with China and the world community on this instead of summarily ignoring the fact that the yuan may well be the world’s next reserve currency.

At the very least, China’s currency is likely to be granted a global status on par with the current major currency trading pairs for purposes of settling international transactions, whether the West wants that to happen or not.

I’ve outlined this scenario many times in recent years and, quite frankly, too often received blank stares in return.  Most folks here in the West just aren’t prepared to deal with the idea that the U.S. dollar could be finished and that another currency could replace it after more than 60 years of global dominance. But they better get used to the idea – and in a hurry.

China is acutely aware that not having international currency convertibility hampers both its development and – thanks to the ongoing financial crisis – its potential survival. Not only has China been forced to accept huge reserves built upon previous trade growth (its $2 trillion in reserves is an all-time record), but its own policies have contributed to its relative inability to flex its capital-market muscles. That’s especially true in transactions involving U.S. dollar/yuan exchange rates.

What for us sounds quite theoretical in nature represents a very real problem for businessmen such as Dong Xianbin, the chairman of theGuangxi Sanhuan Enterprise Group Holding Co. Ltd. He estimates that he’s lost more than 150 million yuan (about $22 million at current exchange rates) on international trade in the past three years alone because of exchange rate changes between the dollar and the yuan. So he’s keen to see yuan-based transactions that will reduce exchange-rate risks, or eliminate them entirely. And he’s not alone. Thousands of Chinese companies are chomping at the bit for the same reasons.

As a nation, not having a universally accepted currency is a huge issue. China’s record reserves are now at risk thanks to the U.S. government’s bailout boondoggle, because each new greenback printed debases the value of every other dollar out there, including the ones China holds.

Historically, Beijing sought to mitigate that risk by diversifying its holdings into other currencies most notably the European euro and the Swiss franc, for instance. But now China’s facing the kinds of problems that massive mutual funds closer to home must deal with when they hold a disproportionately large amount of money: China’s reserve fund is so massive that there’s literally no other single currency that can absorb all that liquidity. So even if China wanted to diversify more aggressively, it’s going to be hard pressed to do so.

Incidentally, this is precisely why China’s so-called “nuclear option” will never become more than a theory bandied about by conspiracy buffs. Under such a scenario, China will either “dump” its dollars, and/or stop buying them, causing the value of the greenback to plummet. China might start selling, but there literally is not another currency on the planet that could absorb a wholesale liquidation.

Therefore, the reality is that China needs to have the U.S. boost the value of the dollar – even as the United States needs to have China do all it can to maintain the dollar’s value.

Shopping for Commodities

At this point in time, China essentially has two alternatives:

• It can seek out other stores of value, such as natural resources, which are highly liquid and reasonably “deep” in global markets, but which can also be very volatile from a pricing standpoint.
• Or it can elevate the credibility of its own currency in the international financial markets and effectively remove the exchange rate risks associated with its own partially blocked yuan.

Never one to leave anything to chance, China is pursuing both strategies. For instance, China’s been buying gold like there’s no tomorrow – and is looking to add to its holdings. Since 2003, China has boosted its holdings of gold by 73% to an estimated 1,054 metric tons, with an approximate value of $31.3 billion. This makes China the fifth-largest holder of gold on the planet, followed by the United States, Greater Europe, and Switzerland.

China’s also gone global in its hunt for oil – which, of course, is the only other global “currency” truly in international demand.

While there’s a real benefit to having locked up supplies of commodities, they aren’t an ideal store of value. And that suggests that what China really needs to do is elevate the global prominence of its own currency at the same time, whether U.S. leaders aid the process or not.

History shows that strong economies tend to have strong currencies. And the actions that I’ve reported on recently from China – the cross-Straits agreements reached between China and Taiwan, the Hong Kong yuan-trade agreements and the “yuan carry trade,” to name a few – only reinforce the effort China is putting forth to achieve this goal.

Speaking of goals … there are obviously plenty of Doubting Thomases on this issue – but they were around years ago before China announced that it wants to put a man on the moon by 2020.

SolarWinds, Inc. (SWI) became just the 5th domestic IPO to be launched on the NYSE this year as the company sold 9 million shares raising more than $104 million.  The offering was well accepted by the street with shares closing their first day of trading up 10% from the $12.50 offering price.  After taking a week to consolidate gains, investors have gotten a bit more aggressive and Friday the stock closed at $15.00 as US indices closed in on their 2009 highs.

SolarWinds actually has nothing to do with the recently hot solar energy sector but is instead a network management company offering solutions to a wide assortment of business clients.  The company boasts of more than 80,000 customers worldwide and claims that its software is employed by more than 1 million network engineers within that client base.  Management must be doing something right as the company has seen their earnings grow sharply over the past three years.  According to the IPO prospectus, SolarWinds grew earnings from just $9.6 million in 2006 to $22.3 million in 2008.  The first quarter of 2009 also saw earnings growth which is impressive given how ugly the economic environment was during the three months ending March 31.

The IPO was underwritten by JPMorgan Chase & Co. (JPM), Goldman Sachs Group, Inc. (GS), and Morgan Stanley (MS).  All three of these underwriters have a history of turning out quality deals which should give investors a bit more confidence in the long-term success of this investment.  The deal wasn’t too bad for the underwriters either who received $0.875 for every share they sold (a grand total of more than $10.6 million).  For underwriting firms and IPO investors alike, it is good to see a bit more activity as issues are brought to market.  On a related note, Merrill Lynch / Bank of America Corporation (BAC) brought OpenTable Inc (OPEN) to market last week ans the IPO has also met with significant buying interest.

SolarWinds has stated that it will use the proceeds from the IPO to repay $50 million in debt, to pay primary shareholders $20 million, and use the rest of the proceeds for general purposes including the potential to acquire other companies.  While I am a bit disappointed to see proceeds paying existing shareholders (these are the private investors present before the IPO – not the buyers of this deal), the payments toward debt should result in a better capitalized company.  To take a look at issues I consider when buying IPOs, sign up for the ZachStocks free newsletter which includes your copy of my special report “Three Essential Issues for IPO Investing.”

Looking at earnings per share (the company reported EPS of $0.18 in 2008) the stock should actually be considered very expensive.  While no analysts have issued formal estimates for upcoming years, it is probably not unreasonable to expect this strong small cap company to grow earnings by 50 to 80% annually over the next few years.  Aggressive growth rates like this can attract momentum investors who care little about the fundamental value of a company and much more about the enticing growth rate.  For this reason I think SWI could be an excellent trading vehicle as there are few new investment ideas showing this kind of exponential growth.

As a long-term investment, I have trouble rationalizing a purchase of SWI.  The stock is likely to make a strong run this summer due to its “hot IPO” status, but will likely then settle back to a more reasonable fundamental valuation.  Timing is everything in this type of market and with new issues specifically.  For aggressive traders I would suggest taking a small speculative long position with the potential to see some excessive gains in a very short time.  Once this stock has made a summer run, however, all bets are off.  Much like solar companies saw huge drops in their market cap over the last 12 months, this network management IPO could eventually trade back to the IPO level or below.  SolarWinds should be an excellent trading vehicle for today but as an investment it is a very difficult call.

FD: Author does not have a position in SWI

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Facebook recently sold a roughly 2% equity stake to a Russian firm for a cool $200 million.  If you do the math, it turns out that the investment valued the entire firm at $10 billion putting the market cap well above many blue chip names.

The transaction immediately raises my curiosity as valuations like that would likely lead to the company eventually issuing stock.  After all, these private owners have what could be a huge goldmine on their hands if they can recognize anything close to $10 billion in a public sale.

Now if an IPO were to occur, it is almost certain that only a small portion of the company would come to market.  Typically private investors or founders sell 10 to 25% of the company in the initial transaction to establish a market for the shares and develop confidence in the company’s ability to execute.  Then down the line when shareholders have bid up the stock, the private holders usually begin unloading which sometimes leads to significant drops in market valuation despite a strong underlying business.

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Facebook certainly has options besides going public.  Microsoft has made an investment in the firm and there is always speculation that the social networking leader will be gobbled up by Google Inc. (GOOG).  But some believe that the company should do something quickly and take advantage of their popularity.

Internet social media can be a very fickle thing.  In the early stages AOL appeared to be a sure winner as the leader in user friendly email and online information.  Time Warner bought the company for an extreme multiple but very quickly found out that it was difficult to monetize this investment.  Myspace has also had its day in the sun, but lately its popularity has waned.  Twitter may become one of the next rivalries although I have my doubts as to whether this medium will stay relevant long-term.  The bottom line is that it may be in the owners of Facebook to strike quickly while the iron is hot.

Hat tip – Intelligent Speculator – Facebook gets $10 Billion Valuation

Tiffany & Co. (TIF) reported earnings Friday before the market opened.  The results were not pretty which should not come as a surprise given the state of the US consumer (and to a large degree the global consumer).  Sales for the quarter ending April 30 were down 22% to $523.1 million and earnings cane in at $0.20 per share compared to $0.60 last year.  While the earnings were in line with expectations, sales came in a bit below the consensus figures.

Weakness was most pronounced in the Americas region where total sales were down 31% year over year, and comparable store sales were down 33%.  Europe on the other hand actually showed some relatively good performance.  Actual European sales were up 18% although currency issues caused some problems.  A stronger dollar caused European sales to come in with an 8% loss when converted to US currency.  The strength in Europe was largely due to new store openings.

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One issue that may be concerning to investors is the inventory balance.  Despite lower sales, inventory levels were 6% higher than last year.  Management stated that obviously a portion of this growth is due to new store openings, but a lower level of sales is likely more to blame for the increase.  With input costs rising, it will become more difficult for the company to hold high levels of inventories as they wait for the economic picture to turn.

Tiffany is sitting on a strong balance sheet primarily due to its recent offering of $400 million in debt.  While some of this capital was used to retire old debt, a good bit of it is left for “general corporate purposes.”  This capital will likely help finance new store openings as management continues to pursue a relatively aggressive growth strategy.  This strategy could pay off huge if the economic picture turns quickly and TIF has a much wider footprint of stores.  However, the gamble is pretty dangerous as a prolonged period of weak consumer spending will leave Tiffany with costly non-performing locations.

Another aggressive move (or non-move) by the company has been to stick with their upscale pricing and product offering.   While some competitors have begun offering lower cost items, Tiffany believes that this strategy would cheapen their brand and cause more pain in the long run.  Wealthy clients could potentially turn their nose up if the Tiffany brand is affordable to a larger portion of the population.

Earlier this month, Tiffany bought the handbag brand Lambertson Truex.  The move could potentially diversify revnue from the largely jewelry oriented offering.  The move could certainly be beneficial in adding incremental revenue, but it remains to be seen whether this could backfire as it deviates away from the company’s niche offerings.

Currently the stock is trading in the high 20’s and like many retail stocks it is up significantly from the March lows.  Compared to 2010 (January) expectations, the stock holds a multiple near 18 which is reasonable for a growing retail operation.  However, with the future growth of the company somewhat in question (I don’t think they will fail, but growth levels will likely be lower than some expectations), the stock seems to be a bit over-priced.

With the market trading in a relatively range-bound level after a sharp advance this spring, the potential for a quick decline could be dangerous for TIF shareholders.  If you are not involved in the stock right now, it could be a great short opportunity to offset long exposure in other areas.  Despite catering to some of the most wealthy customers around the world, Tiffany is not immune to the global recession.

FD: Author does not have a position in TIF
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Occasionally I come across some articles which are worth passing on to ZachStocks readers.  In an effort to provide quality content which complements our topics covered here at ZachStocks, I plan to begin passing along a few articles each week which I think will be helpful in your investment process.

Please enjoy this piece from Jason Simkins:

Is the Dark Cloud Over Solar Energy Beginning to Break?By Jason Simpkins
Managing Editor
Money Morning

By sucking the air out of energy prices and sapping private investment, the financial crisis submarined solar energy last fall. But a silver lining has emerged around the dark cloud that has blanketed the sector for so long.

Oil prices have recovered, climbing over $60 a barrel, the recent stock market rally has lured many investors back off the sidelines, and President Barack Obama’s clean energy agenda has breathed some life back into the browbeaten sector.

Now, solar energy stocks – some that lost more than two-thirds of their value last year – have come roaring back.

After topping $300 a share last spring, shares of First Solar Inc. (Nasdaq: FSLR) plummeted to just $85.28 a share in November. But since then the company has bounced back, soaring 125% to Friday’s close of $191.72 a share.  Shares of Trina Solar Ltd. (NYSE: TSL) hit $52 last summer before bottoming out at $5.61 in November. That stock is up more than 260% since Nov. 21.

Global economic growth is far from guaranteed at this early stage, but there’s good reason to believe that when a recovery does get underway, solar stocks will be shooting for the moon.

California’s Gold Standard

While many other solar energy companies have collapsed under the weight of the economic downturn, a small upstart out of California has managed to greatly expand its business.

That company is BrightSource Energy, which last week agreed to what the company’s Chief Executive Officer, John Woolard, called the “the largest solar deal in the world.”

Pacific Gas and Electric Co. agreed to purchase 1,310 megawatts (MW) of solar thermal power from BrightSource Energy for a sum that analysts’ believe tops $3 billion.

BrightSource had already agreed to transmit 900 MW of solar power to PG&E in a deal that analysts valued at $2 billion to $3 billion. The terms of the new deal, which expands upon the original 900MW agreement, will build on top of that figure.

BrightSource plans to build seven solar power plants in the Mojave desert of California that will use mirrors to direct sunlight onto a group of centralized water towers to create steam that will, in turn, power turbines. PG&E estimates that the amount of energy produced by the plants will be sufficient enough to power 530,000 homes.

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Earlier this year, BrightSource signed a similar 1,300 MW agreement with Southern California Edison Co. – an indication that, despite economic hardship, the solar energy business is still hot.

But a lot of BrightSource’s recent activity has to do with California’s newly adopted state energy policy. In 2006, California passed a law that required electrical utilities to get 20% of their power from renewable sources by 2010.

However, on November 17, 2008, California Gov. Arnold Schwarzenegger took the state’s green energy mandate further by signing Executive Order S-14-08, which requires that utilities generate 33% of their power through renewable sources by 2020.

Indeed, the state of California has led the country in adopting renewable sources of energy, particularly solar.

Renewable energy accounts for 13.5% of the state’s energy consumption, and for the past three years, the California Energy Commission has been managing $400 million targeted for solar on new residential building construction. That includes an ambitious “Million Solar Roof” initiative that will create 3,000 megawatts of installed photovoltaic capacity by 2018.

But California is more than an energy pioneer. It’s an early indication of where U.S. energy policy is headed.

If President Barack Obama’s administration has its way, mandates similar to those issued in California will be employed across the country over the next 10 years. In fact, they already are.

Solar Shift

Obama announced Tuesday that he is making California’s standard for vehicle fuel efficiency and greenhouse gas emissions the new national standard.

Under Obama’s new proposals, vehicles would be 30% cleaner and more fuel efficient by 2016. And that’s just the beginning.

The President’s budget incorporated $646 billion in revenue from capping global-warming pollution, while allocating $150 billion to renewable energy investment over the next 10 years, making his green-funding initiative the largest such effort in U.S. history.

Among other things, Obama’s recent stimulus package provides a tax credit of up to 30% for home solar installations.

The Obama administration also advocates a policy that would require 25% of U.S. electricity demand be met by renewable energy by 2025. The President has the support of the Democrat-led Congress. U.S. Sen. Jeff Bingaman, (D – N.M.), Chair of the Senate Energy and Natural Resources Committee, is working on legislation that aims to make 20% of U.S. energy demand renewable by 2021.

While a renewable energy policy was largely neglected by the administration of George W. Bush, Obama’s effort can hardly be described as partisan. It is more representative of a shift in political ideology that arose when gas prices soared above $4 per gallon last summer.

A recent Gallup Poll showed that the majority of Americans support higher fuel efficiency standards such as those Obama announced Tuesday. In March, 80% of Americans said they favored higher fuel efficiency standards for automobiles.

Currently, just 28 states have renewable energy goals, but with the Obama administration’s effort and a shift in public opinion, it won’t be long before all 50 are enacting their alternative energy mandates.

According to a study by Allianz Global Investors, 78% of investors think green technology could be the “next great American industry,” and 97% of investors believe the development of alternative fuel sources will remain important even if oil prices remain relatively low.

And statistics bear that out. Venture capitalists invested $4.1 billion in alternative energy projects in 2008 – a 54% increase from the year prior, according to a report by PricewaterhousCoopers. What’s more, 45% of that money went to solar projects, compared to 23% in 2007.

“Alternative energy’s rise isn’t going to be smooth, but it’s going to be one of the great new growth industries,” Steven Berexa, managing director of research for RCM Informed, an Allianz subsidiary, told Kiplinger’s Personal Finance magazine.

A Global Industry

In addition to the United States, solar energy is gaining traction around the world.

After subsidizing 2,400 MW of solar projects last year, the Spanish government will subsidize an additional 500 MW this year. Japan aims to create more than 100,000 new jobs in its solar industry as part of an effort to jumpstart its flailing economy. Proposals for solar energy plants are also being considered in the Middle East and northern Africa.

Even BrightSource’s Woolard has attributed some of his company’s success to its overseas operations.

“PG&E looked hard at what we’d done,” Woolard told The San Francisco Chronicle. “They looked at the results from our plant in Israel, and that built a lot of confidence that we were meeting milestones and delivering.”

Most recently, Australia announced plans to build a solar power station that will rival BrightSource’s Southern California operation. The network is expected to produce about 1,000 MW of energy, but won’t be operational until at least 2015.

“We don’t want to be clean energy followers worldwide, we want to be clean energy leaders worldwide,” Prime Minister Kevin Rudd told theFinancial Times.

The Australian government hopes renewable energy will account for 20% of the country’s power grid by 2020. Rudd said the government intends to spend about $1 billion (A$1.4 billion) of the $3.6 billion (A$4.7 billion) it has pledged to clean energy initiatives over the next decade.

Like in the United States, the Australian government hopes its alternative energy initiative will be a catalyst for private investment. John Connor, head of the Sydney-based Climate Institute, told the FT that Australia’s clean energy plan will drive an estimated $15.5 billion (A$20 billion) in private investment.

Another country with an ambitious solar agenda is China. A country with notoriously high greenhouse gas emissions, China installed about 50MW of solar capacity last year, more than double the 20 MW in 2007, Renewable Energy World reported.

Beijing plans to expand the installed capacity to 1,800 MW by 2020, as the demand for new solar modules in China could be as high as 232 MW each year from now until 2012.

China is also a good place to find promising solar companies. LDK Solar Co. Ltd. (NYSE ADR: LDK), Yingli Green Energy Holding Co. Ltd. (NYSE ADR:YGE), and JA Solar Holdings Co. Ltd. (NYSE ADR: JASO) have all been beaten down by the market, but could post a strong rebound when China’s solar initiative takes full flight.

Many analysts also like the aforementioned First Solar and Trina Solar Ltd., which stand a better shot of withstanding the recession because of their size and experience.

[Editor’s Note: Money Morning Investment Director Keith Fitz-Gerald is the editor of the new Geiger Index trading service. As the whipsaw trading patterns investors have endured this year have shown, the ongoing global financial crisis has changed the investment game forever.

Uncertainty is now the norm and that new reality alone has created a whole set of new rules that will help determine who profits and who loses. Investors who ignore this “New Reality”will struggle, and will find their financial forays to be frustrating and unrewarding. But investors who embrace this change will not only survive – they will thrive. With the Geiger Index, Fitz-Gerald has already isolated these new rules and has unlocked the key to what he refers to as “Golden Age of Wealth Creation” The Geiger Index system allows Fitz-Gerald to predict the price movements of broad indexes, or of individual stocks, with a high degree of certainty. And it’s particularly well suited to the kind of market we’re all facing right now. Check out our latest report on these new rules, and on this new market environment.

DreamWorks Animation SKG, Inc. (DWA) has recently put up some impressive numbers.  On April 28, the company announced earnings for the first quarter and the stock rallied 25% immediately. The stock has held the gains firmly and it’s perhaps even more impressive that DWA has rallied an additional 15% since the first day of trading following the announcement.

The first quarter was the best Q1 in company history with revenues coming in at $263.5 million and net income of $62.3 million.  Earnings per share was $0.68 after adjustments compared to just 26 cents last year.  The performance was largely due to the blockbuster hit Madagascar: Escape 2 Africa.  As of the date of the announcement, the feature had raked in $595 million in box office sales worldwide.  This is truly an impressive feat considering trends in consumer spending.

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Box office and video sales could turn out to be an a-typical retail segment this year as the entertainment medium could be considered a “trade down” play for troubled consumers.  Instead of taking a trip to the beach, sending the kids to summer camp, or other large-scale summer plans, more families are opting to stay home and make the most of the time in their home town.

As parents go crazy and kids get cabin fever (I speak from experience here) the need to get out of the house could cause traffic at the box office to pick up.  At the same time, video sales should also be strong as kids seem to want to watch their favorite movies ad nauseum.  I can’t tell you how many reruns of Finding Nemo have gotten at our house.

The business of animation – or movie production of any kind – can be very much like the biotechnology business.  Typically companies will expend significant development costs in order to produce a product that will hopefully realize blockbuster returns.  The business can obviously be risky, but returns are enormous when a product is successful.

But unlike the biotech field, there is no competition with generic products which can dog medical drug companies.  Imagine spending 5 years developing and 3 years testing a new treatment.  After putting $50 million into the project, the company could only have 12 years remaining to realize profits on this treatment.  After that, the competition can come in and reproduce the same drug without any significant development or testing expenses.

Animators like DWA, however can often develop a franchise that lasts for generations and continues to pay dividends to shareholders long after the idea was generated.  Imagine what the “mickey mouse” franchise is worth today!

DreamWorks has spent a significant amount of time developing some very successful franchises.  It should be noted that the Bee Movie and Flushed Away which were developed in 2006 and 2007 actually provided meaningful revenue for the company in the first quarter 2009.  So as these franchises become well known and loved by children and adults, the long-term payoffs can be enormous.  Factor in sales of action figures, stuffed toys, royalties from theme parks and more and pretty soon you have a perpetual line of strong revenue.

Looking at the financial stability of the company, it’s impressive to see DWA with $260 million in cash and just $70 million in “borrowings and other debt.”  Now there are additional liabilities which come through the normal course of business, but the cash on hand gives DWA plenty of strength and flexibility.  The company is actively repurchasing shares which is an indirect way of returning capital to shareholders.  Year to date, DWA has repurchased 2.3 million shares at an average price of $20.20.

The stock is currently trading in the upper $20’s with expected earnings of $1.52 for this year and $1.99 for 2010.  While the multiple may be high compared to many retail names, I think it is better to compare DWA to successful biotech companies with similar cash-flow opportunities.  A multiple of 25 would not be unreasonable given the potential for another blockbuster release coupled with the stability of current earnings off its established business lines.  With this multiple, it would seem reasonable to expect a price as high as $50 in the next 12 months.

DWA is certainly a candidate for the ZachStocks Growth Model which is currently realizing returns significantly above the market.  DreamWorks has a market cap a bit above our typical investments, but with the growth potential over the next several years, the potential for a strong return rivals any small-cap growth company.

FD: Author does not have a position in DWA
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OK, I’ll admit that when it comes to fashion and shoes, I am completely lost.  In my closet sits a pair of running shoes, a pair of dress shoes, some casual walk around shoes, and a couple of flip flops.  To me, shoes are simply functional items and in no way express my personality.  (or maybe my lack of shoes shows my lack of personality…  hmmm)

However, I’m smart enough to realize that not everyone shares my view on footwear, and in fact there are some extremely profitable businesses who cater to this specialty retail niche.  One such company is Steven Madden, Ltd. (SHOO).  The company also wins a medal for one of the more creative ticker symbols.

In late April the stock traded sharply higher as the company issued guidance for fiscal 2009.  The company expects sales to come in flat to down 2% for the year and earnings are expected to be in the range of $1.85 to $1.95.  This obviously helped to assuage some investor fear regarding weak sales with the difficult economy.  Within a few days the stock hit a high of $30.40 which is 127% above the low from March and 28% above the closing price prior to the announcement.

While I certainly understand the relief that investors must feel when hearing that the company will maintain its sales levels, the higher stock price appears a bit over done compared to the expected earnings for the company.  At this point analysts are pegging their expectations at $1.89 for 2009 which means that the stock enjoys a multiple of 15 (which is fairly robust for the retail sector).

It is likely that investors are encouraged by the ability of the company to increase earnings despite flat sales volumes.  The company was largely able to accomplish this feat by increasing their operating margins from 2.8% last year to a level of 9.6% in the first quarter.  While this is an impressive feat, SHOO should have trouble increasing these margins any further due to the weak consumer spending environment.

There was a time when the company could sell shoes at inflated price points and count on fashionable customers to pay the premium.  But as global consumers move farther towards a mentality of saving over spending, specialty retail names will have difficulty keeping their margins high.  Of course there will be a portion of the population still willing to pay the higher prices, but this section of consumers is becoming a smaller percentage of the population.  This will force SHOO to either cut prices to appeal to a broader demographic, or keep prices high (supporting their margin gains) but sacrifice sales levels.

The bottom line is that while earnings levels may be stable, they will likely experience very little growth in the coming years.  Investors who own the stock and have paid 15 times earnings for the growth potential are likely to get frustrated and sell as the recession wears on.  While I don’t think we will see the stock trade as low as $13.42 again, a decline to a sub-$20 level could be in the cards.

Traders could profit from shorting the stock, or possibly by buying puts.  One strategy for aggressive traders may be to buy the September $25 puts which can be purchased at roughly $2.40.  At the same time, one could sell the September $30 calls for $2.90 pocketing $0.50 per share net between the two contracts.  If SHOO remains between $25 and $30 investors get to keep $50 per option contract free and clear.  If the stock declines below $25, traders will participate as if they were short at $25.  The risk is for the stock to trade above $30 which would leave the trader with the same risk as being short the stock outright.  At this point, the break even point would be $30.50 (less commissions).

Consumer spending is difficult to predict, but could be very weak for years to come as the US (and other countries as well) transition towards a more fiscal conservative mentality.  Beneficiaries could include discount retailers but all stock purchases should be made at attractive  valuations as growth is not guaranteed to anyone at this time.

FD: Author does not have a position in SHOO
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Neutral Tandem Inc. (TNDM) has been kind to investors over the last 6 months.  The stock is currently up 126% above its low from November as the company continues to post extremely competitive returns on a quarterly basis.  The company provides the switches which rout voice traffic between carriers.  The beauty of this business is the fact that all three of the major voice mediums (wire-line, wireless, and cable) all use the company’s services.

The last quarter’s earnings release was particularly exciting as TNDM posted revenues of $38.2 million which was 45.8% above the first quarter of 2008.  Net income was $9 million (or 27 cents per share) up a full 125% over last year’s profits.  The strength was largely attributed to an increase in minutes carried over the network which came in at 19.7 billion minutes.  At least part of this increase was due to the 9 new markets opened in the first quarter.  TNDM now operates in 109 markets and continues to increase that number.

Growth is particularly impressive given the economic weakness faced over the last few quarters.  Tandem offers investors a chance to participate in a growth story which has very little correlation to the broader economy.  After all, unless pricing methods change it is unlikely that consumers will cut back on the number of minutes they spend on the phone regardless of the economic condition.  In fact, one could make an argument that higher levels of unemployment may actually increase the number of minutes used for certain demographics.

Tandem is actively growing their number of markets served.  At the end of the first quarter 2008 the company served 71 markets.  The report for Q1 2008 showed 109 markets served with guidance for a full 30 additional markets during fiscal 2009.  Expanding to new markets certainly takes a fair amount of capital and TNDM is guiding for $18 to 20 billion in capital expenditures this year.

Many technology companies are struggling to find the capital to actually spend as credit and liquidity issues make it difficult to find expansion dollars.  But TNDM shouldn’t need to rely on any outside capital as the company finished the quarter with $128.6 million in cash and no long-term debt.  It’s certainly nice to have the financial flexibility during a time where opportunity is prevalent but competitors are facing capital challenges.

Looking towards the rest of the year, management is guiding for revenue of $158-165 million (which is an increase from previous guidance of $151-158 million).  Management also increased the guidance for total minutes in 2009 and is now expecting to handle 83 to 87 billion minutes over its network.

Analysts are expecting a 72% increase in earnings for the second quarter which would put EPS at $0.29.  For the full year the company is expected to earn $1.17 and then in 2010 we should see growth of 22% to $1.43.  At this point most analysts appear to be filtering earnings expectations through conservative filters across their list of covered stocks.  If TNDM continues its pattern of surprising to the upside, we could see the stock continue its strong run.

Investors definitely have to pay extra for the growth and stability of TNDM.  Currently the stock price is roughly 23 times expected earnings for 2009 which is higher than many peers.  But on the other hand, there aren’t many peers who are posting the same kind of solid gains seen with TNDM.

In a more constructive market it is not abnormal for growth companies like this to trade for 30 to 35 times forward earnings.  If this market eventually begins to revert to historical trends, we could see TNDM trade at 30 times 2010 expectations.  This trend would have the ability to cause the stock to trade above $42 even with no adjustment to 2010 expectations.  At this point it appears that despite the premium multiple, TNDM can be a strong component of a growth stock portfolio.

FD: Author does not have a position in TNDM
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The last 18 months have turned many well respected and time tested portfolio management approaches on their head.  Professional investors with decade-long enviable track records saw their models reduced to rubble, and “conservative” investors who believed they had protected themselves from drastic losses quickly found that they were much more at risk than originally believed.

At ZachStocks, we certainly had our share of investment opportunities which quickly turned to disappointments as markets took out stocks of all shapes and sizes.  Aggressive growth opportunities quickly saw multiples contract as investors realized the new growth prospects no longer supported the generous stock multiples.  But conservative investments also took it on the chin.  Investors who expected stable rates of profitability also fell victim to declining margins, lower sales volumes, and anemic asset valuations which reduced equity levels on their company’s balance sheets.

Even fixed income investors were not spared.  Bonds which used to be considered suitable for “widows and orphans” folded quickly as the worlds financial system faced the very real possibility of melt down.  Even mortgage backed securities which had the implied full faith and credit of the US government behind them faced the possibility of failing to pay their coupons, principle, or eventually returning real returns to bondholders.

Opportunities for safe returns became harder to find as investors flocked to T-bills pushing rates on government backed treasuries to negative rates in some cases.  There’s nothing worse than putting your money in a vehicle which is guaranteed not to give you a positive return and has the possibility of significant volatility during the holding period.

So What Do We Take Away?

So why did many of the tried and true conservative approaches fail this time around?  Why did investors turn a blind eye to excesses which now seem so obvious in hind sight?  And what can we learn from this period in order to avoid the devastating results the next time we face a bear market?

While we may not totally be out of the woods yet, I think we are far enough removed from the October and March panic periods to begin to answer some of these questions from a rational point of view.  There are certainly well accepted rules of investing which need to be challenged and reviewed.  Human nature, on the other hand, continues to be relatively predictable which ensures that we will continue to see cycles of fear and greed in our markets for years to come.

So let’s look at a few of the accepted portfolio management tools.  I want to look at how well they stacked up to the bear market, and how we as investors can properly apply (or discredit) these approaches for use in future market environments.

Asset Allocation

Many investors were told that their accounts were safe from drastic returns due to proper asset allocation.  After all, investors with exposure to domestic equities, international equities, fixed income, commodities, foreign exchange, and alternative investments must see some of their investments rise even during a bear market.  Right?

Unfortunately, in many cases the answer was “Wrong!”  The argument that markets were increasingly decoupled from each other turned out to be quite inaccurate.  Emerging markets were expected to perform very differently from the markets of established global leading countries.  But it turned out that these emerging markets truly needed economically sound economies in order to promote their own growth and consume the goods these emerging markets were exporting.

Alternative investments were quite possibly the biggest disappointment as many ivy league managers turned out to simply be using leverage to accentuate returns which altered their risk profile to levels which were totally unacceptable.  Once the markets began to unravel, these funds were exposed and quickly turned out to have much higher correlation to established markets than many investors were led to believe.  As Warren Buffet says, once the tide goes out, you get to see who is swimming naked.

Investments in commodities did little to offset risk, as these positions turned out to be dependent on established markets to support prices.  Commodities are often tied to industrial production so when the majority of industrial economies began to decline, the diversification provided by this asset class did little to protect investors.

The bottom line is that during periods of significant market stress, all asset classes tend to increase their correlation to each other which provides less diversification.  One of the few exceptions would be foreign currency markets.  But this asset class truly represents a zero-sum game where for every dollar gained by one investor, there is a loser on the other side of the table.  This does not mean that foreign exchange does not offer utility to investors, but it is important for any foreign exchange investor to understand the risks, operate with skill, and to realize that there is certainly the possibility that forex positions could decline at the same time other positions are showing losses.

Diversification Can Be Over-Rated

In addition to asset allocation, many retail portfolio managers explain to clients how diversification can save them from losses should the market decline.  The argument is that if you spread your eggs into many different baskets, then at least some of your assets will be safe even when certain sectors turn lower.

The principal behind this move is certainly valid.  One need only to look at employees at Enron who had the majority of their retirement accounts in company stock.  One should never have their entire financial future pegged to a few carefully selected stocks.  No matter how much research you perform, there is always the potential for an unseen event to crush an individual position.  No one should ever put themselves in the place where the failure of one position brings irreparable damage to their financial goals.

But diversification has an ugly side to it as well.  As investors we rely on our ability to identify and select superior investment opportunities, and realize attractive returns on those picks.  No matter how much time I spend looking through opportunities, I will never be able to thoroughly analyze and track 150 different attractive investments.  It just isn’t humanly possible to have an edge on each of these names.

The danger with over diversification is that spreading yourself too thin can keep you from realizing above market returns.  The closer your portfolio mimics the entire market, the closer your returns will come to being exactly correlated to those market returns.  At this point it would be a heck of a lot easier to just buy a S&P ETF and spend the rest of your time pursuing other business opportunities.

There have been plenty of academic studies which prove that diversifying into 25 or 30 stocks gives a portfolio adequate diversification while still allowing an investor to realize outsized gains if his stock picking skills are sharp.  For this reason the ZachStocks Growth Model typically holds 15 to 30 core positions allowing us to capitalize on our strong analysis while at the same time protecting investors from any one position blowing up.

Many investors seek diversification by buying a handful of different mutual funds.  While this can be an excellent way of spreading risk, too often investors will buy similar funds who all have exposure to the same equity or fixed income trends.  If diversifying between different mutual funds, it is important to pick managers with different styles and expertise.  Five different large cap growth funds will simply have you owning exposure to the same companies five different times.

Timing the Market

In recent months, the idea of market timing has become more popular as investors who were out of the market free falls during October 2008 and March 2009 would have been significantly ahead of the game at this point.  It certainly makes sense to bypass these painful periods but the concept is much easier to explain than to put into practice.

We should note that even many of the most seasoned investment professionals had a difficult time determining the timing or validity of the market decline.  Several well known strategists warned us of a coming collapse in markets but were often discredited as their timing was off.  It does little good to have the foresight of impending doom if you are a year early and lose all your clients before the downturn occurs.

There is something personally satisfying about being right, but if you fail to make money or protect your client’s assets in the process, the victory is somewhat meaningless.  While I do believe it is possible to add value by adjusting exposure during times of exceptional risk (or greater than average opportunity), timing can certainly be tricky and it can be nieve to assume the ability to pick tops and bottoms of markets.

Investors are well served to pick a time frame for their investments which mesh well with their personality.  For years I tried to figure out how to profit from short-term trading in order to make consistent returns on a day to day basis.  I loved the idea of starting each day with a clean book and realizing gains or losses depending on my trading for that particular day.

What I realized, however is that my analytical personality did little to help me in my investment style, (or more accurately, this investment style didn’t cater to my strengths).  If I researched a company and realized they would have above average growth and the stock price should rise as a result, that did very little to predict what a stock would do on one particular day.  As it turns out, my strengths play towards identifying trends which last for a period of several weeks to a few monhts.  It wasn’t until I realized this and adjusted my investment approach that I began to make any substantial money in the market.

Long – Short approaches Can Offer Opportunity

One tool that I have found particularly helpful in negotiating a downturn is to have some short exposure to help offset losses if my long investments take on water.  While this approach is often seen as adding more risk (because short positions have theoretical unlimited losses), the combination of long and short exposure can sharply reduce the risk for an entire portfolio.

Now in order to be successful with this strategy, it is important to pair short exposure against long positions in a logical fashion.  For instance, being long consumer discretionary stocks with strong correlations to the domestic economy, and then being short conservative investments such as precious metals could be devastating.

If you are correct in your assumption that economic activity will pick up during a time of global growth, you will likely benefit from both the long exposure and the short side of your book.  But conversely if the economy begins to slump, you will likely realize losses on your long positions as consumers rein in spending, and also take on water from prices of precious metals rising.

Recently, mutual fund managers have had more opportunity to try their hands at shorting stocks with the advent of 130/30 funds (mutual funds who invest 130% of their assets long, and then 30% of their assets short).  Some of these funds have realized devastating results as managers simply used the short exposure as leverage to make even more concentrated bets on their expectations.

But when used properly, short exposure can be added to a long portfolio in order to not only cut back on risk, but also to enhance returns.  Successful short positions often drop much more quickly than long positions rise as panic can send investors fleeing from disappointing situations.  At the same time, confidence as a result of holding short positions can allow investors to be more aggressive on long positions taking more risk and consequently realizing larger returns on growth plays.

The key in this situation is to set up short positions that will actually trade down at the same time long positions would be hit with negative news.  A strong correlation between short positions and long positions enables managers to survive based on their skill level instead of simply making money during bull markets.

The ZachStocks Growth Model attempts to manage exposure through the use of inverse ETFs which essentially give us the ability to short markets or sectors.  The reason we use these vehicles instead of outright short positions is so that the model can be applied in retirement accounts which typically do not allow short sales.  This ETF approach has some drawbacks as we have discussed in previous articles, but can certainly be effective in hedging against short-term declines in the market.

Fear is Not An Investment Strategy

One thing to keep in mind after surviving one of the most vicious bear markets (which may or may not be complete at this point) is that fear rarely leads us to make wise investment decisions.  The natural reaction for many investors at this point is to shy away from the markets in order to protect against the visible risk.  However, investing from an overly conservative manner might actually carry more risk than expected.

The coming months will likely feature a sharp ramp in inflation which decreases the purchasing power of paper currency.  Investors who tread too conservatively will find their savings accounts hold a stable amount of dollars, but unfortunately decline in terms of what these dollars can buy.

It will be important to require your capital to grow in order to preserve value and so the important approach will be to foster safe, but purposeful growth in your portfolio.  Be aware of all of the tools available to you as an investor and if necessary, track down a responsible, seasoned veteran to help you review, rebalance, and maintain your risk level in order to recognize superior returns over time.

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