What’s $10 billion between friends?  That’s what the FDIC is asking a handful of large banks as the insurance operation attempts to rebuild its balance sheet.  Currently, the FDIC is reeling from the losses it has taken as nearly 100 banks have gone belly up this year.  As the black list of troubled banks continues to grow, the FDIC is running short on capital used to guarantee deposits.

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Now before you go and pull your money out of the bank and put it under a mattress, please understand that the FDIC is not insolvent.  Even under the worst case scenario where the coffers turn up completely empty, the US Treasury will extend a credit line to insure the deposits, so we are far from a place which warrants a run on the bank.  But since the FDIC wants to make sure that line of credit is never actually used, they are asking four of the largest banks to pre-pay a hefty chunk of fees in order to shore up the balance sheet.

The request comes at a time when banks are struggling to re-build their own balance sheets and instill confidence in their financial soundness.  While a fully functioning FDIC is in the best interest of all banks, prepayment is certainly not a pleasant scenario for these large banks.  The institutions in question are Bank of America (BAC), Wells Fargo & Co. (WFC), JPMorgan Chase & Co. (JPM) and Citigroup (C).  All four of these institutions appear to have pulled back from the brink of disaster, although Citi will still likely post a loss for 2009.

The FDIC is very much an insurance program where banks are charged premiums and in return their depositors are guaranteed against a loss (for deposits up to a maximum limit).  The premiums vary by bank and are calculated based on the financial soundness of each institution.  While the rates may seem too small to be significant (typically 0.12% to 0.45%), earnings on these deposits are extremely low due to the low interest rates, so the premiums certainly eat into profit.  If banks are required to pay 3 years worth of these premiums by the end of 2009, it would be a significant cash-flow issue.

As of the end of the second quarter, the FDIC reserve was down to 10.4 billion.  That represents just 0.22% of total deposits insured.  By law, the FDIC must rebuild the reserve ratio when it falls below 1.15% so there is obviously a lot of work to be done to beef up these levels.  At the same time, regional banks are likely to be hit by a serious wave of commercial mortgage defaults.  Many of these regional banks are significant in size and while the FDIC won’t disclose which of these banks are on its problem list, we can see that the list itself continues to grow.

So as investors, it is very important to determine the financial credibility of any financial institution you are invested in.  Remember, there is no mandate to be involved in any particular industry and it may be wisest to step back from this risky sector until the financial picture clears up.  Citigroup may offer the best chance for returns as investors appear to have a very negative perception of the company despite an improving condition.  Still, there is plenty of uncertainty around financial institutions and the best bet may be to step aside.

FD: Author does not have a position in C

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Investors in Shanda Interactive Entertainment (SNDA) have dealt with some significant disappointment over the last week.  The company completed it’s spin off transaction where it listed its gaming division – Shanda Games (GAME) as a separately trading ADR.  The new stock was listed at $12.50, netting the company more than $825 million as the parent company sold more than 70 million shares.  Shanda Games also sold roughly 13 million shares for net proceeds of about $152 million.

Leading up to the deal, it appeared that the spin off was going to be a positive catalyst for the company.  A separately trading gaming ADS would allow investors to concentrate their capital in the fast-growing portion of Shanda’s business, and since the parent company retained 71% ownership in Shanda Games (and 96.08% voting rights), investors in SNDA still retained the ability to participate in the long-term growth.

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Unfortunately, it looks like the underwriters botched the deal which is unusual for Goldman Sachs (GS) who was the lead.  The number of shares offered to t he public increased by 20 million as the deal neared completion, and the underwriting discount may have been a bit too much for the current environment.  Goldman and the other underwriters received roughly 78 cents for each share they placed with investors – a tidy sum when you consider more than 83 million shares were placed.  Underwriting has typically been a very strong business for investment banks, but in today’s market we may eventually see margins on these transactions come under pressure.

Shares of GAME were offered to the public at $12.50 per share, but at the end of the first day of trading they closed at a disappointing $10.75.  Monday the shares made up a small bit of the loss and the stock is flat to positive in early trading on Tuesday.  But the bottom line is that the transaction was relatively disappointing and with a lower stock price on GAME, it will be more difficult for SNDA to sell more shares if it so chooses in the future.

The stock price in SNDA took a similar hit on Friday and we are likely seeing two forces at work here.  First, you have the lower market value for the gaming portion still owned by the parent company.  Fluctuations in GAME will have a very real affect on the value of SNDA because the parent company still owns 71% of the spin-off.  The second issue is that investors who want pure exposure to the gaming side of Shanda’s business are likely to be selling the parent company and buying GAME over the next several weeks.

Despite the negative initial action in GAME, I think that the stock will offer investors a great opportunity in the coming weeks and months.  Online role playing games are attracting a growing customer base and China is the epicenter of this movement.  Shanda Games has a strong pipeline of new features for existing games as well as completely new games which will likely drive future revenue.  The stock is not cheap based on historical earnings attributed to the spin-off, but the valuation is also not unreasonable.  Future growth even in a difficult economic environment should attract investor attention and lead to a higher multiple.

I think GAME is worth pursuing, but would wait for the stock to re-take the IPO price.  There is a chance that the stock could wash out a few more holders and if the selling gets extremely heavy, we may be able to pick up shares at a much better discount.  So for now it is a waiting game with the intention of buying when it breaks above the IPO price ($12.50) or starting a small position if the stock experiences heavy selling (likely down to $9.00 or so).  This is a risky name and will likely have plenty of volatility, but it is also an opportunity for very strong returns.

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

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A Moody’s report on Wednesday raised new concerns for the vulnerable economic recovery.  Credit card defaults for August rose to a new record at 11.49% underscoring the difficulty consumers are facing in today’s market.  Credit card defaults are typically highly correlated with unemployment which remains stubbornly high despite the recent strength in equity markets.  The credit card news is likely to weigh on retail stocks as investors had been counting on consumers to increase spending as we approach the holiday season.

The report showed current weakness (as seen in the August defaults) but also points to future concerns which could lead to even higher defaults in the coming months.  The number of loans delinquent at least 30 days also rose in August coming in at 5.80%.  The “early stage” delinquencies (delinquent for 30 to 59 days) was especially hard hit which indicates that individuals are facing new issues when trying to keep up with credit card bills.  The newly delinquent accounts have a good chance of working through the system and turning into realized defaults in the next 2 to 3 months.

As the unemployment rate continues to rise (estimates are for a peak near 10.5%), we should continue to see rises in credit card defaults.  Moody’s currently estimates this peak to be mid-year 2010 with a high of 12% to 13% default rate.  These defaults would be particularly challenging for the three largest US credit card lenders JPMorgan Chase (JPM), Citigroup (C), and Bank of America (BAC).  But although lenders will have to write off these bad loans, I fear investors in retail stocks will actually bear the brunt of the weakness.

Recently we discussed how shares of Under Armour Inc. (UA) may face disappointment as spending for football season will likely be constrained.  Additionally, our article on Tiffany & Co. (TIF) offered three reasons to avoid the luxury retailer.  Consumers are running out of options for funding spending habits and even those who remain employed and financially secure may find themselves unwilling or unable to spend at the same rates seen previously.

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When dealing with consumer spending, retailers are facing both fiscal and emotional challenges.  In response to the rising default rates, credit card lenders are cutting back available balances in order to shore up their risks.  Employed consumers no longer have a widespread ability to borrow against home equity as home prices have declined, and banks are less willing to offer additional lines of credit.  These are the fiscal issues which are having a very real effect on spending.

Emotional decisions also come into play as workers who remain employed are reluctant to spend on items viewed as unnecessary.  The savings rate has begun to climb as consumers realize the need for financial stability, and consumers who are not defaulting on their loans are usually using excess capital to pay down these balances in case their financial situation changes.  The net result is that retailers are finding it more and more difficult to move merchandise out the door.

It will be interesting to see how the retail industry survives the holiday period.  Last year consumers were certainly in shock after the collapse of many large financial institutions.  But the prevailing sentiment seemed to be that consumers would continue to spend for the holidays in order to “count our blessings” or try to retain some sense of normalcy.  This year consumers are much more entrenched in savings initiatives and I believe more likely to cut back on gifts.  Spending will still pick up relative to the summer months, but I doubt it will be at a level which justifies the massive increase in share price for many of these stocks.

Smart investors should continue to remain vigilant and look for less traditional investment opportunities.  Commodities, precious metals, alternative energy, and a few other niche areas offer investors true value with good growth opportunities.  But traditional buy and hold investors should consider hedging positions in order to protect against losses coming into the end of the year.

FD: Author does not have a position in any of the mentioned stocks.

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In today’s volatile business environment, sometimes its more important to determine who your customer is, than figuring out exactly what you are offering.  Stanley Inc. (SXE) has built a strong business by offering services primarily to the US government which gives them a bit more revenue stability than contractors offering services to the private sector.

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Stanley is involved in a number of different service categories:

• Systems Engineering
• Enterprise Integration
• Operational Logistics
• Business Process Outsourcing
• Advanced Engineering and Technology

A diversified approach to the services offered helps to spread contract risk across a number of different areas of government spending so that no one project can make or break the firm’s budget.  Despite having their hands in so many different government projects, Stanley is still basically a small-cap company with an innovative spirit.  It’s very easy to imagine an environment where the company could continue to grow revenue and earnings at an attractive rate for several years to come.

Since Stanley operates with a fiscal year which ends in March, their most recent reporting period was the first quarter of fiscal year 2010.  The company reported record earnings of $0.45 which exceeded prior guidance.  The strength was due in part to progress on a major contract with the US Marine Corp for the Joint Strike Fighter Program.  Revenue was up 21% over last year at 208.7 million.  SXE has strung together quarter after quarter of revenue and earnings growth and management appears to be very skilled in successfully engineering a healthy growth trajectory.

While the first quarter numbers were very attractive, investors were a bit spooked by comments from management indicating that there were some delays in contract awards.  As a result of these delays, management lowered revenue and earnings guidance for the second quarter and fiscal year.  The firm should still grow earnings by more than 10% in 2010, but this is below the trend line of 20% or higher growth investors have become used to dealing with.

Stanley continues to post record operating margins and net income as we see more favorable contract mix and realize greater operational efficiencies. ~Phil Nolan, President and CEO

Still, the backlog of awarded contracts remains robust at roughly $2 billion.  This means that the company could work for roughly 30 months without winning a single contract before it would run out of jobs.  So while the guidance was a bit of a disappointment, the company is still very healthy and it looks like the initial selling was a bit too dramatic considering the fundamental strength.  Over the past couple of weeks, the stock has begun moving higher as investors once again view the company’s value in a positive light.

Currently the stock is trading at roughly 17 times this year’s expected earnings.  While it is difficult to know exactly how much the company will grow over the next two years, I think analysts 10% and 11% earnings growth expectations are a bit too conservative.  If the 2011 estimates are eventually raised to be closer to $2.15 per share (still a conservative number) and investors place a more confident multiple of 23 to 25 on the stock, we could easily see the stock trade 60% from this level.

Stanley has proven itself to be a strong competitor in a stable industry.  The company will likely offer positive surprises in the coming months and I expect investors to be rewarded in the next 6 to 12 months.

FD: Author does not have a position in SXE

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HealthSpring Inc. (HS) is fighting the battle of rising health care costs.  The company operates affordable healthcare plans for individuals on Medicare in Alabama, Florida, Illinois, Mississippi, Tennessee and Texas.  As the nation’s attention turns to healthcare reform measures, HealthSpring is building its market share and is likely to emerge as a strong competitor in the regions where it has established a presence.

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Analysts were expecting a rough second quarter for HS due to the rising costs of medical coverage.  Despite positive demographics and an aggressive cost cutting program, HS did in fact see earnings drop 19% compared to the levels it saw last year.  But looking at a larger picture, the firm actually should see earnings growth this year with the consensus expecting earnings of $2.17 per share.  A growing customer base has led to a predictable stream of increasing revenue, and management expects margins to stabilize over the next year.

Currently it appears that investors have a much more negative impression of the company.  The stock is currently trading below $15 which represents a multiple of less than 7.  The stock is significantly higher than the $4.27 logged during the market panic in March, but a multiple of 7 is still extremely conservative for this growing company.

HealthSpring currently has a debt balance of $251.3 million, but also has a hefty cash balance of $295 million.  The debt does not appear to be an issue for the company, and investors will likely begin to pressure management to do something productive with the large cash balance.  It would likely make sense for the company to initiate a stock buyback program in order to reduce the number of shares, which would boost earnings per share.  Alternatively, the company could use the cash to open or purchase additional offices and expand its geographical footprint.

Looking to the quarters ahead, management is increasing its guidance for revenue, earnings, and enrollment.  The guidance for earnings has been revised higher to a range of $2.10 to $2.25.  Revenue is expected to come in at $2.6 to $2.65 billion and enrollment for the Medicare Advantage membership is estimated to be 186,000 to 188,000 at year end.  The prescription drug plan is the only area that was revised lower with expectation of 310,000 to 320,000.

Wachovia has the stock listed at outperform with a price target of $16 to $18.  The research report noted that HealthSpring’s focus on HMO products and their strong relationships with doctors and hospitals should give the company a competitive edge over others in the field.

The company has submitted its bids to Medicare for 2010 and expects that profitability margins will be relatively stable over the coming year.  Assuming flat physician fees over the next 12 months, and relatively conservative enrollment levels, the company should maintain stable profitability in 2010.  It seems that the expectations are a bit overly conservative and any pleasant surprises could quickly lead to margin expansion.  I think that at some point over the next 12 months, we should see the stock reach a multiple of 12 which would represent a price of $26.  This would be a significant increase from the current stock price and offer great returns for investors.

So currently HS appears to be pricing in the most conservative outcome possible.  Healthcare reform has met enough resistance that it is unlikely congress will destroy the free market approach to medical care.  This is good news for HS and I expect patient investors to be rewarded.

FD: Author does not have a position in HS

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Shorting stocks can be a risky business.  Especially in a runaway market like we have seen over the past six months.  While fundamental analysis and valuation techniques are helpful over a long period of time, short term market movements can turn the plans of even the most well respected analyst into dust.  But despite the challenges, it still makes sense to understand fundamental concepts behind price movements.  I can guarantee you that at some point, the pendulum will swing and prices will once again be affected by prospective earnings and less by investor psychology.

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CH Robinson Worldwide (CHRW) is one of the stocks that I want to be holding short when that transition takes place.  Sure, the $9.8 billion dollar company has a 1.6% dividend yield and no debt.  But the current stock price simply cannot be justified by the fundamentals of the company.

For starters, the company is simply too big to grow by leaps and bounds.  I find plenty of companies with a strong business model who can grow annual revenue from $150 million to $500 million in a relatively short period.  The market cap for these turbo-charged growth names can increase five-fold or even ten-fold in a year or two due to the leverage built into the financial structure of the company.  But at some point, successful companies will get to a size where the potential for growth on a percentage basis is much more subdued.

Over the last four quarters, CHRW pulled in nearly $7.8 billion dollars in revenue.  I simply can’t imagine that this level will double in the next two or three years.  (quite possibly not in the next decade) Earnings are stable, but rapid growth is simply not a way to describe the earnings power of this giant.  And yet investors are paying nearly 25 times next year’s expected earnings in order to own the stock.  This seems like an outrageous multiple for a large cap freight company growing by maybe 10%.

One reason investors may prefer this stock is that the company offers a relatively healthy amount of safety.  While revenue and earnings are certainly affected by economic activity, the company can usually forecast these fluctuations as contracts are often predictable.  Prices can be adjusted to help with lack of demand, and the company can also simply take trains off the track in order to preserve costs during a slow period.  There is certainly something to be said for stability, but I have a hard time paying 25 times earnings for this peace of mind.

A second positive behind this company is that a recovery in the economy would certainly mean more freight movement throughout international markets.  Since most investors appear to believe the economy is on it’s way to happy days again (just look at the movement in the S&P), I guess it makes sense that CHRW would be a popular pick.  But despite the sunny forecast that has become so widespread, significant dangers still remain.  Issues like unemployment, consumer credit, destruction of wealth, regional bank charge-offs, and government debt could easily send us back into a double dip recession and punish investors who jumped back into risky positions at the wrong time.

CH Robinson is a healthy company with a strong track record.  Given their stability I would love to own the stock at 12 to 15 times this year’s earnings.  At that price, I could collect my dividends (which would be at least a 3% yield) and wait for long-term gains.  Unfortunately, that price is $25.80 to $32.25 – a far cry from the current price in the upper $50’s.

I am not short CHRW…  yet…  The momentum in this name is too strong and if optimism continues to be the theme for another month, we could see the stock break through $60.  But I am watching the trend very carefully and will be looking to pick up short exposure as soon as it appears that the bulls have run their course.  CHRW is yet another strong company which has the potential to disappoint bullish investors.

FD: Author does not have a position in CHRW

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Thursday, the SEC unanimously voted to take the next step towards banning the controversial practice of “flash trading” which has been in place for the last three years.  Up until September 1, there were three primary exchanges involved in the practice in which clients were given a fraction of a second advantage for large blocks of stock traded on the specific exchanges.  Beginning this month, Nasdaq (NDAQ) as well as Bats Global Markets have decided to step away from the practice.  That leaves Direct Edge which is owned by Knight Capital Group (NITE) as the lone holdout.

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The SEC is seeking to ban the practice because it believes that some investors are disadvantaged because orders are often filled before they are ever displayed to the general public.  A client of BATS may have a block of 100,000 shares of a particular stock he wishes to sell at a particular price.  The limit order could be shown to other BATS clients for a fraction of a second to see if any computers are willing to buy at the specified limit.  If the bid is out there the transaction will be completed.  If not, the order will be displayed to the public where anyone else could bid to take the stock at the specified limit.

There is certainly some merit to the discussion over the public not having access to the order.  But at the same time, these exchanges are still bound by the “National Best Bid and Offer” or NBBO regulation which requires brokers to guarantee their clients the best available price on a trade.  So if this large block of stock was offered to be sold at $80.55 and a buyer existed on the public exchange for $80.56, the exchanges would be required to fill that public bid because it represents the best available price.

Currently, flash trading represents about 2.8% of the US stock volume.  So it is difficult to see how this practice creates a significant issue for most public investors.  Moreover, this practice actually appears to be a way by which some individual exchanges can use technology to benefit their customers.  In a world where stock execution has become a commodity and best execution techniques are required by the SEC and other governing bodies, it actually seems refreshing to see technology rising to meet the liquidity needs of large clients.  Keep in mind that many of these flash trading programs may be operated by mutual funds which are owned in IRAs and 401(k)s across the country, or by brokerages and trading operations which are often public companies and owned by individuals by way of stock ownership.

It strikes me as odd in an environment where industry is constrained and unemployment is high, that the regulatory bodies that be would be so intent on cracking down on profitable businesses.  These profitable concerns are required in a broad assortment of industries in order to promote employment and pull our economy out of recession.  Chemists who develop a cure for diseases should be able to profit from their hard work, and this profit will encourage even more discovery.  Physicists who develop fuel efficient technologies should be able to sell their patented technique to manufacturers at a profit.  And exchanges who use technology to benefit their clients should be able to operate in this manner and receive revenue from offering better execution.

Rather than seeking to heavily regulate the equity exchanges, I would propose approaching the subject from a disclosure standpoint.  Customers who wish to use “dark pools” where orders are shown to a limited number of traders should understand the benefits and detriments to these approaches.  Orders which are completed between clients of one exchange should still be reported to the public in a timely manner.  But the SEC should not ban the willing agreement of two traders at a certain price simply because the public was not privy to this arrangement.

FD: Author ownes NITE in the ZachStocks Growth Model

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It’s do or die time for Under Armour Inc. (UA).  As football season kicks into high gear, the specialty sports apparel company must prove to investors that growth is still on track.  At stake is not only the company’s reputation, but also the plight of thousands of shareholders who have bid up the stock in hopes of an improving second half.  The company is a well-oiled machine with a product line unmatched by rivals.  But it remains to be seen whether the brand is strong enough to beat an economic recession fueled by a consumer under pressure.

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The third quarter is by far the most important period for this niche retailer.  As football season kicks off, and athletes begin to fill out their fall wardrobe, Under Armour’s sleek high performance apparel typically begins to fly off retailers shelves.  Management has been very successful in promoting the quality of their wares and developing a robust distribution plan.  In years past some retailers have had extreme difficulty keeping enough product in stock to meet demand.

After successfully launching the company with a product line centered around form fitting shirts pants and fleeces, the company has branched out into other areas and has been working hard to take market share in the footwear category.  Given their popularity with football and baseball athletes, the cleat category was a logical choice.  This expansion has not been without its challenges, but strides have been made to the point where UA now is a respectable challenger to Nike Inc. (NKE) and Reebok.

Kevin Plank is the mastermind behind the cutting edge product line, and at the same time serves as the company’s Chairman and CEO.  A confident leader, Plank appears to fill the leadership role well and has built a solid team of aggressive players who have built an impressive retail giant out of what used to be a single product shop.

We have a powerful brand that resonates with consumers, a growth platform with enormous long-term opportunity, and a strengthening balance sheet. In 2009, we will continue to make key investments in our growth drivers, increase the level of expertise of our team, and become better operators. ~Kevin Plank, Chairman & CEO

Unfortunately, while I have the utmost respect for the company (and wish I was enough of an athlete to merit wearing their gear), I believe the challenges of a weak consumer will catch investors off-guard and likely send the stock significantly lower.  Despite a rise in the broad stock market, and improving investor sentiment, the mood on main street is still relatively cautious. Unemployment and underemployment continue to weigh on the American public, and the trends in retail are for consumers to shift to lower quality, lower price brands – certainly not a UA friendly move.

Despite a cautious tone on the US consumer, management issued guidance for 2009 and expects to see earnings come in between $0.80 and  $0.82 for this year.  Analysts who are brave enough to venture a guess for next year see the company earning 94 cents per share which theoretically represents a 16% increase over the prior yearr.  But despite the cautious outlook by management and analysts, shareholders seem to be much more speculative, paying more than $25 per share as of the close Wednesday.  This multiple of roughly 31 times forward earnings appears irresponsible even considering the company’s strong balance sheet and growth trajectory.

My advice to investors would be to use UA’s slogan and “protect this house” by avoiding the stock.  There is no need to invest capital in risky opportunities, and it certainly appears that UA could be setting investors up for disappointment.  Based on the growth rate and management’s strong history, I think a multiple of 15 (well above the industry average) would be warranted.  But unfortunately, this would mean a stock price close to $12 which would mean significant losses for current investors.    Aggressive traders could consider the October $25 puts which carry a significant premium but could yield a strong return if the stock begins falling sharply.

FD: Author does not have a position in UA

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We’re entering a new era of disclosure which will likely change the landscape for derivative investments for years to come.  Tuesday, a group of 15 different Swap dealers including JPMorgan Chase & Co. (JPM) and Goldman Sachs Group, Inc. (GS) agreed to increase the amount of trades they send to clearinghouses.  A clearinghouse is simply an intermediary which acts as a guarantor for both parties involved so that the risk of counterparty default is minimized.

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For the last decade, the number of unregulated “Over The Counter” contracts between financial institutions has grown and eventually these extensive derivative positions threatened to bring down the nations financial infrastructure.  To a large degree, the calamity came as a result of counterparty failure where large players like American International Group, Inc. (AIG) were unable to meet their obligations relating to these complicated agreements.

The news of increased participation by clearinghouses will likely be a strong benefit to companies like IntercontinentalExchange, Inc. (ICE) and CME Group Inc. (CME).  Both firms are leaders in facilitating both trade execution and clearing services.  The clearing portion of the business represents substantial risk, but also leads to the largest profits.  For clearing firms with robust and well monitored risk-management systems, the long-term reward can be substantial and investors can see substantial profits.

Clearance arrangements require both parties to put up a particular amount of capital which is held in order to meet the obligation should one party default.  As these positions are held and the value of the gain or loss shifts, the clearinghouse has the right to require additional capital be posted by either party in order to continue to satisfy the potential loss.  If a trader is unable to come up with the additional capital needed, the clearinghouse will close out the trade at the market price in order to protect against loss.

Traders pay clearinghouses fees and at the same time, a clearinghouse can often collect interest (only a very modest benefit with today’s rates) on the balances held as collateral.  New regulations are requiring a significant increase in cleared trades as agreements that were formally able to bypass the clearance process are now required to be guaranteed by a third party.  This new oversight will promote more stability in markets that used to fly under the radar and will instill trust in the system without the government over-regulating or becoming too involved in the actual process of monitoring trades.

Clearance firms should be allowed to set their own limits and trading requirements in order to manage their own risk.  If several competitors are involved in the business, it will foster competition where clearance fees and margin requirements are fair, but clearance firms are still able to keep enough capital to offset potential losses and keep stability in trading markets.  Regulators should be aware of capital balances and make sure that these balances are sufficient to cover losses, but if the clearance firms are able to set free-market regulations in order to manage risk and create profits, the system will likely be much more healthy than if government agencies set arbitrary rules.

IntercontinentalExchange is currently trading at roughly 17 times expected earnings for 2009.  CME Group has a similar multiple closer to 18 times forward earnings.  Both stocks look relatively attractive given the potential for significantly higher earnings when swap dealers begin sending more volume through the clearing process.  The overall trend of more trades funneled through clearing houses will increase revenue, and both companies have shown an ability to convert new revenue into profitable earnings growth.

There is potential for both stocks to trade lower initially if we see the broad market decline.  Investors will likely make the assumption that a declining market means more risk for both companies.  However, the potential for more volume in a volatile market should actually increase the value of the stocks, so I would use any weakness as a buying opportunity.  Clearing firms are likely the beneficiaries of increased regulatory scrutiny and while OTC trading is here to stay, CME and ICE can play a vital role in ensuring that our financial infrastructure remains sound.

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

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Traditional culture in China places heavy emphasis on education – even as resources are limited for prospective students.  One of the detriments of the socialist economy is that higher education programs are limited to a few lucky students who earn the right to further study.  One of the primary means for deciding who is eligible for advanced studies is the Gaokao test which is required for college admission.  Chinese parents will usually make many sacrifices in order to help their children do well on this test.

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New Oriental Education and Tech. Group Inc. (EDU) is a leading test prep company which helps students prepare for and pass the Gaokao test.  It has also branched out to include language training courses and other online educational programs.  The company has done a good job of developing a number of different education services which are in high demand by Chinese parents.

In May of 2008, ZachStocks published a cautionary note on EDU stating that while the business was healthy, the stock price represented too much optimism and was vulnerable to a decline.  Since that time, the stock dropped more than 40% of its value, leading investors on a wild ride despite relatively stable earnings growth.  But today we once again find ourselves with a price that appears to have too much optimism built in, and the potential for a significant drop.

Lately any stock with the word “China” in the company name or description has been bid much higher.  The last two weeks may have killed a bit of the speculation, but growth expectations still appear to be overblown.  Equity multiples carry significant danger in many sectors, while future growth rates now appear to be below trends which have been in place for the last several years.  The resulting investor disappointment could lead to some sharp declines – especially for stocks where investors have been programmed to expect management to beat guidance.

Currently EDU is trading at 31 times expected earnings for this year.  This is a bit excessive considering earnings are only expected to grow by 10% this year compared to fiscal 2009 (the fiscal year end is at the end of May).  Analysts are pegging 2011 at $2.89 but that estimate is very hard to place much confidence in given the quickly shifting economic dynamics.  If the stock were trading at 15 or even 20 times earnings it might be worth considering, but a multiple of 30 is just too expensive considering the contraction in the growth rate.

A major concern that investors don’t appear to be worried about is competition.  Currently New Oriental Education has a well-known brand that is regarded as the industry leader.  But as the company reports quarter after quarter of strong profits, the market is bound to pay attention and competitors will quickly flock to take part in the profitable business.  It would be difficult for a competitor to take market share away from EDU very quickly, but several offerings could begin to erode the major’s market position and slowly lead to a more efficient (read: lower profit margins) marketplace.

I would recommend Shorting EDU now that it has broken the positive trend, as long as the stock stays below $75 per share.  Shorts could look towards $55 as a logical place to take partial profits as there is some support in this area.  Long-term, we could see prices in the 40’s, should the company begin to issue lower earnings projections or the overall China stock market continue to show weakness.  In short, there is significant risk of this stock breaking down and investors would do well to hedge or close long positions.

FD: Author does not have a position in EDU

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