note: This post is a follow up the the New Year post: Four Stocks for the New Year as well as the first quarter review

We’re halfway through 2009 and the markets continue to be very dynamic.  After a full fledged rout in the first quarter, equity markets have rebounded sharply in the second quarter posting the best market return since the bullish days of the late 90’s.  Despite the strong performance off the March lows, equity markets still appear to have a significant amount of risk.  Unemployment numbers continue to be weak, consumer spending is contracting even with upticks in income levels, and governments around the world are piling on excessive debt.

A true dynamic investment program needs to be able to adapt to market changes in order to protect against new risks, and capitalize on evolving opportunities.  However, picking four stocks at the beginning of the year is a great exercise in long-term planning and evaluating what broad sustainable trends are in place.  This quarter our four stocks have increased sharply from the weak Q1 levels but still leave much to be desired.  By contrast, the ZachStocks Growth Model which is continually adjusted to account for risks and opportunities has outperformed the market by quite a large margin this year.

So here are the four positions we chose at the beginning of the year:

1. JA Solar Holdings (JASO)

Solar energy has rebounded in the past few months as stimulus dollars finally hit the market and are beginning to drive demand for solar power and the components necessary to produce that power.  JASO has traded higher and currently shows a slight profit for the year.  As traditional energy prices increase, the relative competitiveness of alternative energy is boosted.  JA Solar has had trouble keeping up with many of its peers as management has issued relatively weak revenue guidance.  By comparison, our position in Yingli Green Energy in the same sector has yielded triple digit gains.  JASO will likely continue to ride the solar trend higher but it now appears competitors int he sector make for better investments.

2. AECOM Technology Corporation (ACM)

AECOM has rebounded impressively as our second theme for 2009 (infrastructure) finally takes hold.  Over the past weekend, the stock was upgraded by Stearne Agee and the price target was increased to $40.  It appears that this target could prove conservative over the next 12 months as AECOM is quickly proving its ability to convert its backlog of potential projects in to real-for-sure revenue paying contracts.  Througout the recession, ACM has continued to post growth in both revenue and earnings on a quarterly basis.  Analysts are targeting $2.04 as expected earnings for 2010 (fiscal year ends Sept 30) but that estimate may be increased due to strong execution.  Aecom continues to be a strong component of the ZachStocks Growth Model.

3. TBS International (TBSI)

Shipping stocks have been an incredible disappointment this year.  The recessionary environment has cut down on international trade and the corresponding weakness in day rates has caused difficulty even for shipping companies with long-term contracts.  Shippers have also had to deal with the frustrating issue of customer defaults.  So while long-term contracts may have been in place, once the global crisis hit the customers were unable to keep up with their obligations and the contracts were no longer viable.  TBSI is now down more than 20% for the year and we have not held the stock for some time.  A rebounding economic climate could push these stocks higher, but currently there appears to be more risk than potential reward in shpping stocks generally and TBSI specifically.

4. China Medical Technologies (CMED)

ChinaMed is relatively flat on the year despite some difficult and proactive decisions made by management.  The company decided to divest its tumor therapy division and instead concentrate on its diagnosis business.  The strategic move should drive profitability in coming months as the diagnostic business has a recurring revenue stream which is very reliable and has strong margins.  The stock continues to sport a single digit multiple despite expected and historical growth trends.  It is unclear exactly what catalyst will propel the stock higher, but for the time being valuation is very compelling.

The second half will no doubt bring new issues to ponder, trends to follow, as well as risks and opportunities.  Inflation has the potential to eat away at savings and non-performing assets, the current administration appears to be somewhat hostile to free markets, and global economic weakness could spark civil unrest in unexpected places.  So continue to be flexible and alert with your trading and make sure you manage risk appropriately.

Below are links to the other participants in this contest (will be updated as more articles become available)

The Financial Blogger

The Wild Investor

My Traders Journal

Intelligent Speculator

Where Does All My Money Go?

Dividend Growth Investor

Million Dollar Journey

Four Pillars

FD: The ZachStocks Growth Model has positions in ACM, YGE and CMED

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Investors in for-profit education stocks are seeing gains this morning after Apollo Group earnings were released.  Revenue crossed the $1,000,000,000 mark this past quarter.  With revenue at a new record high, and growing by 27% over the past year, it truly looks like the company (and the sector in general) is sidestepping much of the economic weakness during this recession.  Student enrollment was 22.6% higher in the company’s fiscal third quarter which includes the final semester of the school year (fiscal year end is August 31).

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Profitability was strong so while revenue came in basically even with analyst expectations, Apollo Group earnings beat expectations by 14 cents and came in at $1.26.  Enrollment for the quarter was up 22.6% over last year which is a bit lighter than the 23.1% seen in the previous quarter but still very impressive.  In early trading, the stock is up more than 7% as buyers cheer the report.

Apollo Group (APOL) has an excellent balance sheet with nearly $800 million in cash and very little debt.  Over the past quarter the company used $444 million to repurchase shares at an average price of $61.62.  In June the board approved what appears to be a small increase in the cash available to repurchase shares.  The press release states that the amount increased to an aggregate of $500 million which seems a bit odd considering the majority of that has already been used.  It is likely that the statement was supposed to read “an additional $500 million” but that has yet to be confirmed.

Other uses of cash include acquisitions as Apollo Group recently announced the purchase of BPP Holdings which is a UK company offering educational services for the legal and financial industries.  The purchase will cost $540 million (assuming conversion rate remains steady) and is expected to close in the current quarter.  The acquisition is likely to be profitable considering the ability of the company to leverage back office functions, and management’s strong track record of driving profitability.

The excitement over Apollo Group earnings is pushing other equities higher in the education sector.  It appears that while APOL is relatively fairly valued, some of the company’s peers may be trading at dangerous levels and be worthwhile short candidates.  Strayer Education, Inc. (STRA) and New Oriental Education (EDU) may be particularly vulnerable as the valuations are higher representing more investment optimism and higher expectations.  While neither of these companies have significant debt levels, the lack of liquidity for students may once again become a factor as we move into the fall semester both in the US (for Strayer) and in China (for EDU).

Education companies have typically been strong during recessionary periods as unemployed or underemployed make the decision to further their education order to build earnings power.  However, this time around we are experiencing a much deeper contraction which includes incredible destruction of wealth and corresponding cuts in the availability of capital.  Recent reports on bank loan charge offs and delinquency statistics point to further pain and will likely cause banks to cut back on lending.  This liquidity is necessary for most for-profit schools to maintain growth levels.  Up to now, the government (both US and internationally) has stepped in and filled this funding gap but now governments on the local and national level are finding themselves overextended and may pull back on lending programs.

The bottom line is that while investors are largely bullish on the for-profit education industry, and while Apollo Group earnings have helped to drive this optimism, there could be significant contraction over the coming months.  Investors in education stocks should watch valuation metrics closely and consider hedging against declines associated with lower growth rates.

FD: Author does not have a position in stocks mentioned

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It’s not easy being a banking institution in China.  Often the lines are unclear between national and private interests, and political regulation has a large degree of influence over what personal loans can and cannot be made.  Most recently, stimulus regulations have required China bank loans to be made to local governments in order to pay for bridges, roads, and other infrastructure projects.  To some extent these loans were backed by an implied guarantee from the national government.  After all, it was the national government who mandated that the loans be made in the first place.

But this weekend an article appeared in the People’s Daily warning that China bank loans made to local governments could face risk of default based on the municipality level rather than holding the full faith and credit of the China government.  According to the Wall Street Journal article, the weekend piece “calls into question the safety of billions of dollars of debt backed by local governments country-wide.”

The possibility of these China bank loans defaulting appears to have been overlooked by lenders for the most part.  Since railroads and highways are largely being sponsored by the central government.  But it now appears that as the projects are completed, the liability will be maintained by local authorities who inherently represent a much greater risk.

China as a whole continues to be a bright spot in the bleak global economic picture.  While growth levels have certainly contracted, China is still increasing its GDP quarter after quarter while most of the other superpowers are shrinking.  Much of the growth in the past two years has been a direct result of the China stimulus measures which have largely been funded by these China bank loans.  If banks are forced to re-price the risk on these loans it will likely mean higher interest rates and potentially less capital available for the projects which are currently helping to prop the country up.

The People’s Daily has historically been a mouthpiece for the central government, reflecting the views of China leadership and the future path policy will likely take.  While some say the paper has lost some of its relevance as China emerges as a free economy, the words are still sobering and worth considering.  From an investment standpoint, there is danger not just in the China financial sector, but also in infrastructure companies with projects financed by these banks.

Currently we have a very positive outlook on infrastructure stocks.  Stimulus measures around the world continue to keep the backlog of projects robust.  And doing business with governments has historically meant that collecting payment for these projects is reliable (if not filled with red tape).  But new concerns with China bank loans coupled with rumors that some G-8 members believe spending has gone too far makes it necessary to take a close look at these investments.

One of the traits of a good investor is the ability to re-evaluate a position or theme when new information becomes available.  It is tempting to be stubborn and stick with a theme that we have worked hard to research and establish positions in.  But at ZachStocks we don’t want to be married to a particular sector if new information proves that there is more risk than we originally accounted for.  So for the time being we are still bullish on infrastructure stocks, and growth in China.  But new information on China bank loans will certainly be worth watching closely and may eventually lead to a change of opinion.

FD: The ZachStocks Growth Model holds positions in China and Infrastructure stocks.

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As markets trade higher to start off the week, underwriters for the new LogMeIn IPO are likely drumming up interest in the latest offering to hit Wall Street.  The IPO market has been relatively slow over the past year as the bear market has reduced the amount of liquidity and made such offerings very difficult.  But the spring rally has made it possible for several new stock offerings to come to market helping companies raise much needed cash for their businesses.

On the block for a possible offering this week is LogMeIn, Inc. (LOGM) which is the primary provider of on-demand remote-connectivity solutions to small and medium sized businesses as well as individual consumers.  Essentially the technology allows users to log onto their home or office computers from any web browser, making sure that all data is easily accessable and yet still providing for secure connections in order to protect sensitive information.  There are several tiers of service offered including a basic free service all the way up to delux permium products.  As of March 31, the company boasted 188,000 premium accounts and continues to grow their subscriber base very quickly.

The LogMeIn IPO is expected to raise about $67 million for the company assuming the stock prices in the middle of the $14 to $16 expected range.  In addition to the 5 million shares being sold by the company, an additional 1,666,667 shares will be sold by existing shareholders which largely include private venture capital firms as well as company executives.  At this point it looks like the executives are selling a reasonably small portion of their holdings which helps investors maintain confidence that the executives have an incentive to continue to grow the business.

While the remote-connectivity concept is very useful and popular (especially for road warriors and those of us with dual home / business offices), only recently has LogMeIn been able to capitalize on its success and post a profit.  Looking into the financial statements it is amazing to see how much money the company spends on sales and marketing.  In 2006, the company spent 88 cents in marketing expenses for every dollar received in revenue.  But the efforts appear to have paid off with revenue growing by 139% in 2007, 91% in 2008, and 73% in the first quarter of 2009.  As revenues have caught up with high fixed costs, the company is inching closer to profitability with the first quarter actually posting pro-forma EPS of 0.10.

Although the growth is impressive, the price tag on the LogMeIn IPO may be a bit excessive.  Analyst expectations are still hard to come by, but annualizing the first quarter numbers, it is likely the company will earn 40 to 60 cents in 2009.  With the stock price likely to start near $15, the PE will be roughly 30.  When the market is healthy, multiples of 30 on growth stocks are commonplace and often expand to much higher levels.  But in an environment where consumer and business spending is constrained, it is likely that this multiple could prove a bit dangerous.

The company has relatively little debt, so the threat of default is not an issue for investors.  However, the expanded advertising budget could quickly burn through new cash if corresponding revenue does not continue to flow.  The technology sector is highly competitive and LogMeIn believes that it will face threats from similar services in the coming quarters.  There is no guarantee that the company will be able to maintain its leadership in this niche business, especially with companies like Citrix Systems, Inc. (CTXS) and and Cisco Systems, Inc. (CSCO) using deep pockets to develop and promote similar products.

The lead underwriters who handle the LogMeIn IPO are set to be JP Morgan and Barclays Capital which are relatively well respected firms.  Thomas Weisel Partners, Piper Jaffray, and RBC Capital Markets are also on the deal ensuring that there will be a relatively wide distribution for the new stock offering.  With the market starting out higher this week, I wouldn’t be surprised to see the deal come at or above the high end of the range ($16 or above) and possibly trade up from that level on the initial deal hype.  These underwriters often do a good job of creating a perceived shortage of stock on the deal which can lead to more buying pressure on the day the IPO is launched.  But once the hype wears off in the following few days, LOGM will likely be vulnerable to a quick negative move.  At that point, any additional weakness in consumer spending or in the broad markets could push the stock down to the low teens or even single digits.

So while the LogMeIn IPO may generate some near-term buzz and help to develop confidence in market liquidity, the deal appears a bit dangerous and I would not recommend holding deal stock beyond the first few days of trading.

FD Author does not have any positions in LOGM and does not have immediate plans to participate in the deal.

The political and financial message boards lit up late Friday after the House passed the controversial cap and trade bill.  The bloggers have done an excellent job explaining why this bill could be extremely damaging to the economy and despite the rhetoric about creating “green collar” jobs, it will likely put more Americans out of work in the long-run.

While the bill was passed late in the day Friday in what appeared to be an effort to slide it under the radar relatively un-noticed, no one should be extremely surprised by the measure.  The Obama administration has made it exceedingly clear that this would be an important part of his agenda and however misguided the bill may be, it has been expected for some time.  Today I’ll abstain from too many judgments as to the bill’s merits and instead focus on the investment opportunities that will surface as a result of cap and trade initiatives.

Energy is the Obvious First Beneficiary

At ZachStocks, we have been carefully watching the alternative energy sector as stocks have begun to rebound from early 2009 lows.  After achieving rock star status in late 2007 and early 2008, solar energy stocks experienced particular weakness due to overcapacity, falling prices on traditional energy sources like oil and natural gas, and a liquidity crisis which put many expansion projects on ice.  Today, many of those concerns are alleved with prices of oil and natural gas back on the rise and global stimulus dollars pouring into projects to build factories, solar farms, and transmission grids.

Some of the stocks that show the most promise include LDK Solar (LDK), First Solar Inc. (FSLR) and Renesola Ltd. (SOL).  While overcapacity may be the primary remaining concern for the industry, prices are dropping quickly and government subsidies are paving the way for demand to pick up the slack.  The cap and trade bill could go a long way to filling that gap and encouraging (read: forcing) much more demand for clean renewable energy.

Ironically, the cap and trade bill is unpopular with both the left and the right spectrums of politics.  The left has argued that the bill offers too many perks to businesses which takes the teeth out of what is perceived to be a purpose of “punishing business.”  From our standpoint as investors, it is important that legislators realize that in order to create jobs and promote the economy during this difficult time, there needs to be some olive branches extended to business in order to help with employment levels.

Trading Exchanges Overlooked but Full of Potential

I’ve read very little press about the actual “trade” portion of cap and trade, but opportunity to benefit from the businesses that enable the trading of emissions credits could be significant.  ZachStocks readers should be keenly aware of IntercontinentalExchange, Inc. (ICE) which was actually the first stock we discussed when the site was launched back in mid 2007 (hard to believe it has been 2 years now).

ICE had its beginning as an energy trading exchange and has methodically built its reputation as an Over The Counter (OTC) exchange, a futures trading platform, and most recently as a clearinghouse for many regulated and unregulated financial contracts.  The company is one of the front-runners to participate in the trading of these carbon credits and could quickly begin to realize increases in revenue as the trade picks up.  ICE has expertise in launching new trading vehicles so it would be a natural beneficiary of this new trend.

The New York Stock Exchange may be a dying icon of the past, but the parent company NYSE Euronext (NYX) continues to innovate and add new products to trade and new methods of trading.  It would be very unlikely that a new exchange would be developed without NYX having at least some part in the formation or upkeep of the platform or contracts traded on that platform.  As carbon credits gain popularity on an international level, NYSE Euronext’s expertise in Europe, Asia and developing markets could prove very useful.

Engineering and Infrastructure May Play a Key Role

The final area of opportunity I see with cap and trade involves companies who are active in helping retrofit plants factories and engines which are the prime producers of the capped emissions.  We’ve looked at infrastructure in the past as another initiative by this administration has been to support this industry through building of bridges and roads, revamping the national electricity grid, and restoring federal buildings.

As power plants, chemical factories, paper mills and dozens of other industries scramble to cut down on emissions (and  thereby cut down on the tax of buying carbon credits), companies like Fluor Corp (FLR), and Jacobs Engineering Group (JEC) will likely land some substantial contracts.  These big conglomerate businesses may see their stocks increase a bit due to this new business, but smaller contractors like Hill International Inc. (HIL) and to some degree Aecom Technology Corporation (ACM) will have a better chance of yielding strong stock returns due to their smaller, more nimble approach.

So while the cap and trade bill will likely have significant and possibly very negative unintended consequences, there are opportunities for investors who are willing to overweight sectors who stand to benefit from this political move.  I’m interested to hear what action you are taking to protect your wealth and grow investments despite changing political and economical trends.  Please leave your comments and take some time this weekend developing a game plan to pro-actively approach markets based on the information we have today.

FD: the ZachStocks Growth Model holds positions in several of the stocks mentioned.

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When looking for successful growth stocks, China companies have shown up in my screens quite often in the last few months.  One of these success stories is Ctrip.com International (CTRP).  The company operates the largest China based travel portal, offering flight ticketing, hotel reservations, packaged tours and more.  During the market crash in the fourth quarter 2008 and the first quarter this year, the stock dropped to a very attractive valuation in the mid to high teens.  When considering the company is expected to earn $1.13 this year and the growth prospects are relatively good, this was most definitely a buying opportunity.

Investors who took a chance on the company when the economic picture looked the bleakest were well rewarded with a 140% current gain from the 2009 lows.  The company itself has continued to grow revenue and earnings as it captures market share in the difficult consumer environment.  However, despite the company (and the stock’s) recent success, the much higher stock price raises concerns of a potential pullback which could cause investors to give up much of the gains from the past few months.

Investors Current Optimistic Attitude

In general, equity markets move ahead of economic trends.  This is because stock market participants buy and sell based on future expectations.  If I think that the economy will turn higher in 2010, then I will likely begin buying today so that I have my capital in place when that actual turn takes place.  The buying pressure usually pushes markets higher before any rebound in the fundamental picture is recorded.  This is why many economists are not worried about the continued growth in unemployment and lack of economic growth.  They simply believe that this recovery will come in time and that the market has already signaled the change is underway.

But my concern is that the market has fully priced in a recovery and at the end of June we are going to get hard data on just how that recovery has been progressing in the second quarter.  Not all of the market buying pressure has been built around second quarter expectations, but there certainly is some hope that Q2 earnings numbers will show a bit of a stall in the economic decline, or even the “green shoots” of growth.  If the fundamental reported data fails to deliver this improving picture, we could see investors become disenchanted with their holdings and a quick selloff in the market.  Growth stocks with high multiples will be the most vulnerable because they are the companies with the most optimism and therefore the most risk for investor disappointment.

Ctrip’s Potential Disappointment

Ctrip.com fits the “optimistic” category as the stock is currently nearly 40 times the estimates for this year.  The high valuation is largely justified by the expected growth as CTRP continues to capture market share and is expected to grow earnings by 28% next year.  The company also recently made a stock purchase of Home Inns & Hotels Management Inc. (HMIN) to increase its stake in the company from 9.52% to 18.25%.  The purchase was made at a price of $13.31 (Total value of $50 million) which has quickly produced a 24% unrealized gain.  As long as HMIN continues to trade higher, that investment appears to be a wise move.  However, HMIN has some of the same dangers as CTRP and could simply leverage the risks already associated with the company.

During the first quarter, Ctrip realized a healthy if not expected growth in both revenue and earnings.  However, it appears the company is having to work harder and harder in order to manufacture these attractive numbers.  Revenues from hotel bookings account for 43% of total revenues for the company.  While the category saw sales increase by 9%, the total increase in volume was 17%.  This means that margins on hotel bookings were significantly lower as a weak economy resulted in low pricing power.

Similarly air ticketing revenue (which also accounts for 43% of total revenues) increased by 16%.  But in order to outpace the weak pricing, the company actually had to sell 40% more tickets.  The obvious question (although I haven’t hear too many people asking it) is what happens when the company is only able to sell 10 to 15% more tickets and the price continues to drop.  The result could quickly become lower sales which would set off alarms for institutional and retail investors alike.

Options for Dealing with CTRP

Depending on your situation and risk profile, there are several ways to protect against, or even take advantage of a decline in the stock.  Each of these strategies offers different advantages while including certain drawbacks as well.  When investing there is rarely ever a “free lunch” (chance for return without some corresponding risk), but many of the financial tools at our disposal can shift those risks and returns to be more favorable for your individual situation.  If you would like a second opinion on how YOU should approach investing in this or other investment opportunities, my direct line is always open.  So let’s take a look at some of the CTRP options:

1. Short Stock – The first and most obvious opportunity if CTRP were to decline would be to short the stock.  This means that you profit directly in line with how far CTRP drops.  However, if investors continue to be optimistic and the stock climbs, a short position has unlimited potential for losses.  For this reason many IRA accounts are not allowed to short stocks.
2. Buy Puts – A put contract is simply an options contract which gives you the right but not the obligation to sell the stock at a particular price.  You can buy this contract (most IRA’s and qualified accounts allow for this trade) and the contract will increase in value as CTRP declines.  The benefit is that if our analysis is wrong, you are only out the amount you paid for the put contract.  However, the drawback is that prices on puts include extra premiums for volatility and for the duration (time remaining on the contract).  The stock would have to drop significantly or quickly in order to make up for the premium you pay for the put.
3. Covered Call – If you own the stock and like the company long-term, but are worried about the potential for a short-term drop, then selling calls against your stock position could be an option.  For instance, you could sell the September 45 calls for roughly $4.40 per share which is yours to keep.  If the stock drops between now and September, the premium you accepted for these calls will help offset your losses.  However, you give up the potential for a strong run as shorting the calls gives you the obligation to sell the stock at $45 if the buyer of the contract so desires.  Essentially when you include the $4.40 for the option your selling price would be $49.40 which is better than the current market price.
4. Sell Naked Calls – Another aggressive (and potentially dangerous) way to take advantage of the call premium would be to sell the calls naked (meaning without owning the stock).  The danger is that for every dollar CTRP trades above $45, you would be on the hook for when and if the owner of the call exercises his right.  Until the stock trades above $49.40 you will likely end up with a profit.  But above that price your risk is the same as being short the stock.

So you can see that there are several ways to profit from or protect against a decline in this stock.  Difficult markets don’t always mean losses for smart investors.  I would be interested in hearing your success stories from the last six to 12 months.  What moves did  you make against conventional wisdom which allowed you to profit while many others were losing?  Leave a comment on this post or send me an email (growth@zachstocks.com).  Hopefully we can all learn from the aggregate experiences and put more profits into our investment accounts.

FD: Author does not have a position in CTRP

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UBS AG (UBS) issued a press release today with results for trading so far in the second quarter.  It appears that even with the majority of equity markets rising, and liquidity seeping back into the economy, the company will still report a net loss for the second quarter.

The majority of this loss will be due to write downs and restructurings which have already been made public.  As far as the operating business is concerned, the company will actually post an improvement compared to the first quarter (not exactly a high hurdle to overcome).

Probably most concerning is the difficulty the company is having in attracting new capital.  Since UBS was one of the hardest hit banks during the liquidity crisis of late 2008 and early 2009, clients have largely lost confidence in the firm.  That confidence is incredibly important for a company built on trust and client loyalty.  Without net new assets brought in by the company’s advisors, there is little hope for a sustainable rebound in long-term profits or in the stock price.

UBS is working hard to get its capital base to a stronger place which should help with confidence and in turn increase marketability and new assets under management.  Along with the second quarter pre-announcement, the company also said it would sell 293.3 million shares to “a small number of institutional investors.”  If the company is able to privately place these shares instead of selling to the broader market that will probably have less of an immediate effect on the stock price.  However, the new shares certainly dilute existing shareholders who have too accept the fact that they own a smaller piece of a (hopefully) stronger bank.

Ironically, while UBS is still in poor shape financially and having a difficult time gaining traction in growing earnings, it may be a great speculative buy at this point.  Now please hear me – this is not a safe investment that you can put a significant portion of your capital into and sock it away.  The UBS trade is fairly risky as the company still has to deal with some very difficult issues.  However, the market may already be pricing these risks into the stock price which means that if any positive surprises occur the stock could jump substantially.

Currently analysts are projecting anemic earnings of $0.36 per share for 2009.  But in the following year if the Swiss bank gets its act together, it could earn $1.50 (or even more if the expectations prove conservative).  Currently, the stock is just below $13 which means the stock is just 8.6 times next year’s earnings.

Up to this point we have seen very clearly that the world governments have a vested interest in keeping the banks in business.  Now there is no guarantee that UBS won’t stumble and fall into receivership.  But if that were going to happen it most likely would have occurred in the past year.  At this point UBS is taking the difficult but necessary steps to repair its balance sheet and build a sustainable business model.  If they are successful, the $1.50 in expected earnings will likely be understated.

It appears the two forces of increasing earnings expectations and a rise in the stock multiple could both come into effect over the next 6 to 12 months.  If expectations were increased to $1.75 and the multiple rose to a still conservative 12 times earnings, the stock would hit $21 which is more than a 60% gain from current levels.  Investors may be able to use the additional supply of stock coming to market as a chance to buy this stock on the cheap and hold as the recovery story becomes common knowledge.

Now I don’t believe the banking industry will return to its former glory and UBS will probably not see the $4.56 in earnings we saw in 2006 for a decade or more.  But at this point with expectations so low, a small fundamental improvement could go a long way towards pushing the stock higher.

FD: Author does not have a position in UBS

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Markets closed mixed on Wednesday after economic issues gave both bears and bulls food for thought.

Early in the session stocks rallied broadly after a positive durable goods report.  While analysts were expecting a 0.8% decline, the numbers actually came in with a gain of 1.8%.  Now there are many different ways to examine the numbers, ex-transportation the report was up 1.1%, and ex-defense orders grew by 1.4%.  Lower inventories was also an encouraging sign as it means that when the economy turns stronger, there will be an immediate need for new orders instead of companies working through levels of inventory already built up.

The Organization for Economic Co-operation and Development (or OECD) did its best to offset the negative World Bank report which sent stocks spiraling on Monday.  The OECD raised its estimate for global economic growth from 0% to 0.8% growth.  An expectation for the US economy to bottom this year was certainly a contrast to the World Bank’s dour expectation of continued recession for the US and the global economy.

But the FOMC statement at 2:15 threw cold water on the rally as Bernanke and company stated that they are making no change to current policy.  According to the statement released, the FOMC sees the rate of contraction slowing which is relatively small comfort especially when the Fed later stated that they believe the economy will stay weak for a time.  It appears that the target rate for fed funds will remain near zero “for an extended period.”

Probably the most important part of the statement was the Fed’s continued commitment to buying treasuries and mortgage backed securities to add liquidity to the market and keep rates lower.  This is a less traditional policy method which was instituted in December and has been a key avenue for pumping cash into the economy.

While the official statement on inflation showed little concern, some of the governors have begun to express their concern about the long-term danger of loose policy.  Thomas Hoenig, the Kansas City Federal Reserve Bank President has been outspoken regarding the possibility of inflation and the historical tendency to leave monetary policy too loose when coming out of recessions.  We have begun to see rising commodity and fuel prices which are more volatile but certainly could be the precursor to a more widespread inflationary environment.

At the end of the day, the Dow was down 0.28%, the S&P 500 was up 0.65% and the ZachStocks Growth Model actually gained 1.80%.  Strength was relatively broad, but strong moves in our China Gaming positions Netease.com, Inc. (NTES) and Shanda Interactive Entertainment Ltd (SNDA) were of particular help.  Precious metals were higher as inflationary fears began to creep back into investors minds.  It will be interesting to see if the recent pullback in gold and silver will find support and regain its positive trend.  For our part, we are protecting client accounts against inflationary pressures and holding cash levels larger than normal in order to protect against market declines and broad volatility.

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The Blackstone Group, LP (BX) received an important endorsement on Friday which could go a long way towards building confidence with investors and partners.  According to Reuters, the China sovereign wealth fund China Investment Corp (CIC) plans to invest $500 million in one of Blackstone’s hedge fund units.  China has been watching the decline in global markets and is now anxious to put some of their capital to work at historically low prices.  The ZachStocks Growth Model currently holds a 3% position in BX and has unrealized gains north of 50%.

While $500 million is a small investment compared to a potential $80 billion which is estimated to be earmarked for hedge fund investments, any investment at all from China is significant for Blackstone.  Back in 2007 when Blackstone was preparing its Initial Public Offering, China committed billions in buying a pre-IPO position in the company.  The timing couldn’t have been worse and as Blackstone traded off sharply due to the global economic slump, China saw its billions evaporate.  So a new $500 million investment in one of Blackstone’s funds is a meaningful gesture.

Throughout the recession, Blackstone has been relatively successful in attracting new capital for its private equity funds, real estate funds, and other alternative opportunities.  However, the challenges have mounted as debt financing has been difficult to find in any significant size.  The company will typically raise capital from investors for its funds (for example $5 billion).  The business strategy is to then leverage that capital by borrowing another $10 billion and investing the entire amount.  Leverage can increase returns for investors and for the company as long as investment decisions are profitable.  But if $15 billion is invested in a losing venture, a 10% loss would actually cause the initial investors to lose 30% (and more due to interest on the loan).

Debt financing is a great tool for Blackstone when working well.  That is because the company usually gets to keep a portion of the gains on hedge fund assets.  So not only is the company collecting a management fee, but for every $1 billion investors make in gains, $200 million is siphoned off the top as Blackstone’s incentive allocation.  Gains have been hard to come by in recent quarters, which has hurt profits.  In some quarters the company has actually reported negative revenue as incentive allocations booked in previous quarters were wiped out by losses.  However, the picture appears to be improving for hedge fund returns which should result in profits for Blackstone in the form of investment management fees as well as incentive payments.

In a separate piece of news Friday, the supreme court ruled in favor of Blackstone, upholding a lower court’s dismissal of a lawsuit brought by ADS.  ADS had taken action against Blackstone after Blackstone backed off an agreement to buy out ADS.  As the economy turned lower, ADS’ prospects diminished, and Blackstone ran into funding issues, the deal could no longer complete the transaction.  ADS wanted Blackstone to pay a breakup fee, but obviously the dynamics changed materially which was cause for termination of the deal.  With this court case in the rear-view mirror, hopefully management will be able to spend more resources towards driving profitability for investors instead of playing defense against the lawsuit.

Analysts are calling for earnings of 31 cents this year and 81 cents in 2010.  These expectations are very fluid and dependant on both market conditions as well as the skill of managers running the investment programs for Blackstone.  I believe after the difficulty during the last year, analysts are overly cautious with their expectations.  Blackstone is obviously able to attract capital as alternative investments become more attractive to pension funds and other large institutional investors.  Managers are more aware of the risks of the markets and will likely handle investments more conservatively.  This means that incentive allocations per $1 billion of investment capital may be lower, but with significantly higher balances in their various funds, the total amount of fees should be attractive with any positive investment performance.

Despite the strong run from the panic-driven lows in March, the stock still appears to be an attractive investment which could be strong regardless of the market direction.  The company’s real-estate portfolios may still be subject to write downs, but the hedge fund businesses should help offset that weakness.  Bottom line, if China is making investments with Blackstone, this is a ringing endorsement and should go a long way towards helping the funds raise more capital, and creating confidence for BX shareholders.

FD: Author has a long position in the ZachStocks Growth Model

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Another insigtful article from my friend and Colleague Justice Litle – Editorial Director for Taipan Publishing Group.

A Raging Bull Market in Organized Crime

The most profitable business in the world isn’t big oil. It’s organized crime. And the global financial crisis has unleashed more opportunity for the kings of crime than ever before…

“The Mafia isn’t part of the past, it’s part of the future.”
– Roberto Scarpinato, Sicilian prosecutor

Just how heavy is a million dollars cash?

If you’re trying to smuggle that kind of dough in old-school $100 bills, you’ll be lugging a little over 22 pounds. But if you’re rolling with banded, manicured bundles of the highest denomination euro notes (a cool €500), then the same amount only weighs you down by 3.5 pounds – and takes up a lot less space.

This is the kind of thing it’s good to know when you’re in the most profitable business in the world.

Ask a Wall Streeter to name a line of business that produces endless gushers of cash, and big oil probably comes to mind. The oil majors have certainly been known for record-busting profits these past few years. But the mafia’s profits are far bigger.

The mighty Exxon Mobil, for example, booked a profit of a little over $45 billion last year. That’s a whopping $10 billion per quarter or more. And yet, in comparison, the top three organized crime outfits in Italy – just the top three, mind you – more than doubled Exxon’s profit for the same calendar year.

And of course, where Exxon has to pay taxes, the mafia mostly avoids such hassles. So when you take the tax-free aspect into account, the mafia leaves big oil in the dust. And of course, the “big three” in Italy are just the tip of the iceberg. The powerful tentacles of organized crime extend all over the world…

Meet the Octopus

During my time at Oxford University in the mid-1990s, one of the best things about the experience was the speakers who came and talked to us. The Oxford Student Union (which has nothing to do with unions as Americans know them) would regularly bring in fascinating people to come and speak.

One of the speakers who made a real impression on me was a man named Brian Freemantle. An organized crime expert who has worked in more than 30 countries, Freemantle is the author of a book called The Octopus: Europe in the Grip of Organized Crime.

The book is nearly 15 years old now, and so many of the statistics are way out of date. But the basic outlines of the organized crime “octopus” Freemantle describes still hold true. And if Freemantle were to update his book with numbers for the new millennium, they would no doubt be mind-boggling.

As Freemantle writes in the opening pages of The Octopus,

Crime pays. It always has done. Not, of course, for the street people or the amateurs. They are swept up, like the disposable dross they are, as much victims as those upon whom they prey. The people for whom crime pays are the professionals, the men and women who operate it as a business, conducted through structures closely resembling legitimate multi-national corporations and conglomerates, their boardroom-like hierarchies serviced by accountants and financial advisors.

Freemantle then goes on to describe the eight tentacles (i.e. money-making activities) of the octopus: “the illegal arms trade, the illegal drugs trade, money-laundering, computer crime, prostitution and pornography, illegal immigration, terrorism, and fine art.”

One might think the octopus, too, has been hit hard by the global financial crisis (just like everyone else). One would be wrong though… instead, the crash of 2008 may turn out to be the biggest coup in decades for organized crime.

Cash in Hand

So why is the mafia set to wax, even as the whole world wanes? In a word, cash. We have all heard many times by now, in various guises and forms, that when times get hard, cash is king. And nobody keeps more cash on hand than the kings of crime…

Banks everywhere are afraid to lend their precious reserves. Fears of a fresh downturn, combined with the heightened credit risk of battered borrowers and toxic assets still weighing down bank balance sheets, have all but turned off the credit taps.

Many businesses, including well-run, profitable businesses that simply need access to capital in the normal course of operations, are suffering. At the same time, the most sophisticated players in the criminal underworld are sitting on tens of billions – no, make that hundreds of billions – and have a pressing need to launder those funds.

One of the most important tasks for any self-respecting crime boss is white washing the ill-gotten gains… turning “dirty” money into “clean.” This money laundering process is often handled by channeling funds through legitimate businesses. (I experienced this firsthand during my time in Olomouc, a charming little town in the Czech Republic, where the puzzling proliferation of clubs, restaurants and jewelry stores served mostly as mafia fronts.)

So now, with banks more or less out of the lending picture and businesses facing a dire need, the mafia has a once-in-a-generation opportunity to go “legit” on a bigger scale than ever.

As Giorgio Napolitano, the president of Italy – not to be confused with flashy Prime Minister Silvio Berlusconi – observed in May: “There’s a risk that Mafia organizations can profit from the current crisis by buying control of struggling businesses, infiltrating all regions of the country.”

A “risk?” More like a guarantee…

“The Mafia is ramping up its investing,” prosecutor Antonino Di Matteo tells Bloomberg. “The Mafia’s financial managers are trying to invest now, while the time is right, so that they can launder their fortunes once and for all.”

The Tony Soprano Full Employment Act

It isn’t just Europe where crime pays. In the United States, scores of less than savory characters are salivating at the new opportunities created by Washington.

We already know that the alphabet soup of acronyms dreamed up by Turbo Timmy Geithner and Helicopter Ben Bernanke are borderline criminal – TARP, TALF, PPIP and so on – but I’m talking straight-up Goodfellas type stuff here. For instance…

Two weeks or so ago, I sat next to a paving contractor in a local poker tournament. (Just as in Las Vegas, in Reno/Tahoe you can find a tourney on any given weekend.)

“Business is very good,” my fellow poker player reported. “Amazingly good actually. That stimulus cash is really starting to flow.” Apparently he was doing some heavy construction work on a nearby Indian reservation. Big road upgrades, courtesy of a check from Uncle Sam – and the backlog of work was piling up.

Now, I imagine this paving contractor’s business is probably 100% aboveboard and legit (even though he wears enough heavy gold to fall somewhere between Liberace and Mr. T). But if he wanted to cut a few corners, how hard could it be?

Or, heck, maybe he’s the victim in all this. Plenty of aboveboard businessmen in the construction trade wind up greasing a palm or two on their way to a finished project… sometimes it’s just what you gotta do…

The scale of opportunity, er, corruption, is bigger than one might think.

According to fraud consultant David Williams of the Deloitte Financial Services advisory, a whopping $50 billion worth of stimulus cash could be siphoned off the top for fraud (above and beyond the legally fraudulent activities of a venal and corrupt Congress).

“The rule of thumb typically,” Williams reports, “is that of the about $500 billion worth of money that’s going to run through the procurement process, somewhere between 5% and 10% of that usually finds it way into potential problems.”

The FBI is aware of the danger. As FBI Director Robert Mueller recently warned, “These [economic stimulus] funds are inherently vulnerable to bribery, fraud, conflicts of interest, and collusion. There is an old adage, that where there is money to be made, fraud is not far behind, like bees to honey.”

Of course, being aware of the danger and being able to do something about it are two different things…

Call it the Tony Soprano full employment act. With the government anxious to throw bales of taxpayer cash at “shovel ready” projects, the organized crime element will be standing by with a “shovel” too… “ready” to haul away veritable garbage trucks of loot.

Eyes Wide Open

So what can you and I do about this? Realistically, not very much. (Okay, let’s be honest… not a damn thing.)

But at the same time, I would rather go about my business with eyes wide open than eyes wide shut. The strong and growing presence of organized crime is something that ordinary citizens don’t have much day to day contact with (most of us anyway). But it is a reality we all pay for… like an extra form of goods and sales tax, paid to a de facto shadow government operating behind (and sometimes in direct cahoots with) the official one.

Think about the difference between undertaking a new business or investment venture in a low-corruption Western country, like the United States, versus a high-corruption “frontier market” country, where the rule of law is still only vaguely formed.

In the more advanced Western country, you can rest in peace knowing that the laws will be upheld and everything is completely above board. Right?

Not quite. That bit about the United States being “low-corruption” was a touch of sarcasm. As the global financial crisis continues to unfold, one of the side effects could be the gradual disappearance of the brightly drawn dividing line between high-corruption and low-corruption nation states.

This reality will make following conventional, business as usual, “eyes wide shut” investment advice all the more dangerous in the years ahead… just as it would be dangerous to open an import-export business in some far-flung outpost without having a clear handle on the risks present.

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