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Three Industries for Building Short Positions

Three Industries for Building Short Positions

The SEC’s suit against Goldman Sachs on Friday brought an entirely different tone to equities markets.  In an environment where investment assets have become overly correlated, many investors have noted a “risk on – or risk off” approach to trading.  When news is positive – or even marginal – the “risk on” mantra applies and managers use available cash to load up on high-beta names.  However, if we are now entering a “risk off” period, it will not just be the investment banks which will suffer

At risk are many of the sectors which have seen the most speculative buying since the most recent January swing low.

Newsletter AdMarkets have continued to motor higher, and recently the crossing of major points of interest (11,000 on the Dow and 1200 on the S&P 500) has had a major psychological effect on short exposure.  For the most part, short-sellers have picked up stakes and gone home – leaving the market more vulnerable to a significant drop.

When there are enough short participants in a market, that can help to add support.  This is because profit taking occurs when markets fall – and shorts covering profitable positions can sometimes be the majority of buying interest in certain stocks or sectors.  With very little short interest, a significant drop in speculative sectors could go un-checked and lead to more volatility.

So due to high levels of speculation and risk – and with the next inclination likely to be a flight to safety, here are the three areas I think traders should be most interested in shorting.

Consumer Discretionary / Retail

The retail industry has logged some impressive gains since the pullback in January / February.  After hitting a low on February 5, the retail HOLDRS (RTH) made a new recovery high in just 20 days, and has continued to march steadily higher.

Retail Holders (RTH)

Individual retailers have been reporting a pickup in sales levels and with inventories largely low and overhead costs also reduced, the profitability increase has been tremendous in some cases.  For the most part, the profitability increases has been boosted by one time issues (it’s unlikely that companies will continue to cut overhead and inventories are already picking up in anticipation of stronger demand).

The same could be said about the consumer demand for goods.  Especially if you buy into the concept of strategic defaults boosting consumer spending.  Since I have written the article on strategic defaults, I have received what I would consider a bi-polar response with many outraged readers suggesting the concept is ludicrous, while the other half actually know at least one (if not more) friends or neighbors engaged in a strategic default situation.

The ability to spend more through living rent-free in one’s house (by simply not paying the mortgage) cannot continue indefinitely and when this practice is stopped, it is likely consumer spending will once again decline – especially since employment numbers have yet to show much in the way of recovery.  When consumer spending is called into question – or simply when managers start applying the “risk off” portfolio management, retail stocks could take the brunt of the selling.

Shorting the RTH vehicle is one broad way of capitalizing on this movement, but it may be more profitable to focus on some individual stocks which have experienced significant gains and could be due for a pullback.  Stocks that quickly come to mind (for more research later) include Abercrombie and Fitch (ANF), Ann Taylor (ANN) and potentially Lululemon Athletica (LULU).

Domestic China Companies

Strong economic growth in China has attracted significant foreign investment and led to strong price appreciation.  While speculative buying has supported strong price multiples, another issue has been reduced supply of available investment vehicles.  Since the Chinese government restricts the amount of financial assets available to foreigners, mutual fund managers and other institutional investors have found it difficult to secure their desired level of exposure to China.  By nature, a low supply of an asset coupled with strong demand will result in higher prices.

With current prices already reflecting strong long-term growth for the Chinese economy, it would only take some small disappointments for this sector to begin to fall.  The strong GDP reports are likely to cause the government to be more aggressive, tightening regulations on the banking sector which would reduce available capital to industry.  As these measures are enforced, the Chinese economy could continue to grow at a slower pace, but the stock prices could decline sharply to reflect the lower growth rate.

Two easy vehicles for investors to trade are the iShares MSCI Hong Kong (EWH) and the iShares FTSE/Xinhua China 25 (FXI).  The EWH includes a broader section of the Chinese economy, while the FXI has a larger financial concentration.

iShares FTSE/Xinhua China 25 (FXI)

For a bit more volatility (and potentially larger gains) traders  could consider short positions in individual China companies:

  • E-House China (EJ) – A real estate agency whose profitability is closely tied to property transactions in China’s overheated real estate market.
  • Baidu Inc. (BIDU) – The well-known Google competitor running online advertising and internet search capabilities.  The stock has a strong trend but investors are paying 63 times this year’s expected earnings.
  • Home Inns & Hotel Management (HMIN) – A Chinese hotel manager with a high multiple and declining revenue growth.  The hotel industry is closely tied to a vibrant economy and any hiccup could send the stock sharply lower.

US Regional Banks

During the last financial crisis, many of the largest banking institutions were deemed “too big to fail” and were subsequently bailed out or backstopped by the US government.  While it is certainly not fair, the majority of US regional banks are decidedly NOT too big to fail and face significant risks in today’s environment.

A rising stock market and improving confidence has led many investors to overlook balance sheets with excessive leverage, and the impending danger of write-downs.  Commercial mortgages still comprise a major risk to regional banks and many of these loan portfolios are still being carried at valuations which imply economic health and little risk of default.

If the Goldman news causes a new “risk off” dynamic with lower amounts of liquidity and a focus on what could go wrong instead of only what could go right, the multiple on many of these smaller and more vulnerable banks could decline sharply.

There are two primary ETFs which were designed to track the regional banks – the iShares DJ US Regional Banks (IAT) is comprised of some of the largest regional banks like US Bancorp (USB) and BB&T Corporation (BBT).  While these banks may be vulnerable, they may also still fit into the “too big to fail” bucket and be propped up by the government in some shape or fashion.

For this reason, I’m more interested in the SPDR KBW Regional Bank (KRE).  The ETF is made up of many smaller banks and even its largest holdings only represent a small portion of the total fund.  Shorting this vehicle will give traders more exposure to the general factors that affect the small traditional US bank, and looking through the top 25 holdings for this ETF (which can be found on could yield some individual picks that are even more powerful.

SPDR KBW Regional Bank (KRE)

Timing is Everything

Timing will be key when laying out shorts in the post Goldman lawsuit period.  My expectation is for bulls to step in early this week and prop up markets.  After such a stunning run for the last 6 weeks (and for the last 12 months for that matter), it is hard to imagine the market rolling over and heading directly south without at least a week or two of wrestling.

Other Articles of Interest
Why The Market Won’t Trade Straight Down From Here
Rampant Speculation in Restaurant Industry
Calculated Risk: Weekly Summary & Look Ahead
Prag Cap: China Learning Keynesianism the Hard Way

Using reflex rallies to lay out shorts may help to cut risk.  At the same time, small positions could be initiated right away so that if the bearish sentiment takes hold immediately, at least we have some exposure taking advantage of the new trend.

For long positions in these three sectors, I would urge caution.  True investors may want to hold these positions long-term for better tax treatments and for fundamental reasons.  If this is the case, it may make sense to sell calls against individual stocks to create some income and reduce the risk, or potentially buy inverse ETFs which can generate gains while the market falls.  This could help offset traditional exposure and lead to better long-term profitability for your portfolio.

The ZachStocks Newsletter will likely begin adding short positions later this week or early next week.  At this point we are waiting to get a better feel for the market reaction, but should be able to use a reflex rally to step into some profitable shorts at appropriate risk / reward ratios.  The important thing for traders to do at this point is to continue building a watch list of appropriate short candidates so that when the decline begins in earnest, we will have a robust list of short candidates.

FD: Author does not have a position in any stocks mentioned in this article.

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Posted in Featured, Markets, Short IdeasComments (13)

Apollo Cashes Out with Metals USA

Apollo Cashes Out with Metals USA

Metals USA Holdings Corp (MUSA)Late last week Metals USA Holdings Corp (MUSA) made it’s stock debut being offered to the public at $21.00 per share.  The deal was relatively small with just 11.4 million shares being offered and a broad assortment of underwriters took the lead in distributing the shares to the public.  Recently, new issues have performed well in the after-market but MUSA was an exception.  It may be that the underwriters reached too far on this one, setting the bar a bit too high with the $21 offer price.

Newsletter AdWhile at first blush the prospectus states that the shares are primary (with the shares being distributed to the company) further reading highlights the fact that private equity holders will actually retain the majority of funds from this transaction.  In no more than 60 days, the company is required to make an offer to purchase Payment In Kind (or PIK) notes which are held by the asset manager Apollo Group and some of its subsidiaries.  So while all the information is public, it appears this is a bit of a stealth deal to allow Apollo to cash out.

At this point there is still significant incentive for Apollo Group to support the stock and also provide MUSA with the necessary support to grow its business.  While 11.4 million shares were offered to the public, a full 37 million shares are outstanding with Apollo Group still owning a majority position.  I wouldn’t be surprised to see these additional shares hit the market later in the year – especially if equities markets continue to price in a recovery scenario.

Metals USA is an industrial company which is heavily dependent on sustained economic growth.  In the prospectus, management indicated that they expect demand for steel products to increase alongside improving general economic conditions.  The company believes that its customers are continuing to operate with low inventory levels which could bolster demand if these inventories are rebuilt.

To show how economic conditions affect this company, consider the wide swings of the last three years.  In 2007, the company collected $1.8 billion in revenues and produced 55 cents in earnings per share.  2008 was an even better year with revenues of $2.2 billion and earnings of $2.87 per share.  But 2009 was quite a challenge – revenues were cut in half to $1.1 billion and through cost cutting and managing expenses MUSA was able to generate just 14 cents per share.

Improving trends this year should push earnings higher but we are unlikely to see returns similar to 2008.  It is very difficult to forecast future growth because manufacturing and broad economic conditions are so unpredictable.  But lately the price of steel has been rising and competitors like US Steel (X) are expecting strength in 2010 and a much more profitable year in 2011.

MUSA operates three primary business segments

  • Plates and Shapes accounted for 47% of 2009 sales
  • Flat Rolled and Non-Ferrous commanded 45% of revenue
  • Building Products is much smaller with 8% of revenues.
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Ritholtz: Farewell to Most Widely Anticipated IPO

Looking through the prospectus materials, it is clear that the company has been slowly working both its inventory and its debt level lower.  This should provide a more stable fiscal foundation which is encouraging for shareholders.  But the failure of the IPO deal and the overhead resistance from Apollo’s shares which could eventually be dumped on the market will likely keep this stock lower.

As I write Thursday, the stock is trying to rally a bit and very well make a run back towards the IPO price.  If it reaches $20.50 or even $21, I will be interested in setting up a short position.  The position would not be entered until the stock began to fall again, but using a sell stop to get short and a tight stop above the IPO price, there is a good chance that traders could capture $2 to $3 in profits quickly, while only risking about $1.00.  Timing is critical and it might take more than one trade to get it right, but busted IPOs are some of my favorite short opportunities to pursue.

Metals USA Holdings Corp (MUSA)

FD: Author does not have a position in MUSA

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Posted in Featured, IPO, Short IdeasComments (4)

Rampant Speculation in Restaurant Industry

Rampant Speculation in Restaurant Industry

The retail sector has been particularly strong as it appears that strategic defaults are driving a significant amount of spending.  Optimism may also be increasing which is driving consumers to be more willing to spend – and consequently driving savings levels lower.

OpenTable Inc. (OPEN)While consumer cash flows may be increasing towards discretionary purchases, the value of many discretionary spending stocks appears to show not only the expectations that the consumer will remain strong, but also proves that Wall Street to a large degree buys deeply into the recovery theory.  Take, for instance, the speculative price on OpenTable Inc. (OPEN), a computerized reservation and table management system for restaurants.

ZachStocks NewsletterThe business model is sheer genius for strong economic times.  Restaurants are able to subscribe to Opentable’s software on a monthly basis and gain not only publicity and exposure, but also better manage their flow of guests during busy periods.  Diners also have an advantage as they are able to book reservations quickly and easily, view information about different restaurant choices in their area, and even view a menu before deciding where to eat.

Opentable relies on economies of scale to cover overhead expenses and generate attractive earnings.  At the end of the fourth quarter, there were 10,850 restaurants in North America using opentable’s program as well as an additional 1,501 restaurants internationally.  According to the fourth quarter press release, there were over 12 million diners seated during the period which was up more than 40% from the fourth quarter of 2008.  Tapping into today’s mobile handset market, the company recently announced that it had seated its 2 millionth diner through booking over a mobile device.

Analysts believe that the future is bright for the company as well.  The current estimate is for earnings growth of 45% in 2010 to 45 cents per share.  While it seems almost impossible to predict dining trends in 2011 (given the uncertainty of the current economic climate) analysts are handicapping another 44% increase to $0.69.  The commentary out of the company is positive – to be expected – and management expects a positive year ahead.

Jeff JordanWe’re energized by the opportunities in front of us and are focused on helping our restaurant partners grow and providing diners with the convenience of online, real-time restaurant reservations.”  Jeff Jordan, CEO

While I’m impressed with the way this business has been built – and will likely use the service myself in the future – from an investor’s standpoint I have some significant concerns.

The first potential issue is that there are basically no barriers to entry for competing firms.  Anyone with a few thousand dollars or some technical know-how could replicate the main components of OPEN’s software.  There doesn’t appear to be anything keeping a copycat entrepreneur from creating a similar business platform which would eat into the niche that Opentable has built.  And as OPEN becomes more successful and generates significant profits, the environment for competitors will become even more tempting.

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FMMF: 52 Stocks Returning 50% in 2010
Barron’s: OPEN Insiders sell $16 Million in Stock

Secondly, management currently owns 61% of the company.  While I typically like for management to have a significant stake in a growing business, the controlling ownership makes it very difficult for shareholders to implement any changes should they disagree with management over particular business issues.  At the same time, management appears to be slowly liquidating shares through exercising options and selling the stock.  It makes sense for officers to be able to capitalize on the company’s success, but if this trend increases it could become more concerning.

Finally, the stock is trading for an overwhelming 80 times 2010 earnings – much more than most investors should be willing to pay even for a great growth opportunity.  I definitely expect OPEN to trade at a fat premium due to its unique business and the success it has enjoyed so far.  But the market is essentially projecting 40% growth for several years and any disappointment could quickly send shares back down to the $25 area where it was trading in January and February (or potentially even lower).

Trading is a difficult and sometimes counter-intuitive game.  Over the weekend I wrote a piece on the difference between value-based investing and technical trading.  This piece might be helpful in analyzing the potential trend for OPEN over the coming weeks and months.  At this point, OPEN has strong momentum and may very well continue trading higher as investors brush aside risk concerns.  I’m not brave enough to step on this train – I believe the risk is too great at such lofty valuations.

But shorting this stock is a dangerous undertaking if timing is off.  I would keep OPEN on the watch list for now and look to short after a failed breakout attempt (which may be forming now at the $39.00 level) or possibly on a break below $35.  It will be important to confirm that the trend is in fact lower, and that there is an appropriate stop point to minimize risk.  OPEN will likely turn out to be an excellent short sometime this summer, but traders must first have the patience to wait for it to falter.

OpenTable Inc. (OPEN)

FD: Author does not have a position in OPEN

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Posted in Featured, Short IdeasComments (9)

Citigroup Taps a Liquid Market

Citigroup Taps a Liquid Market

Primerica Inc. (PRI)The current market is flush with liquidity as speculative traders search for opportunity.  Growth and speculative companies are especially attractive due to the potential high returns if the economy really is on track for a full recovery.  Faithful readers of ZachStocks know that I am hesitant to buy into the “full recovery” argument, but that doesn’t mean we can’t make money trading this speculative environment.

The ample liquidity has allowed new companies to raise capital to build their businesses, and has also allowed private equity investors to unload positions at a profit as the public market snaps up shares.  Last week Citigroup (C) took the position of a private equity player by selling a large portion of its position in Primerica Inc. (PRI).  The stock was issued to the public at a price of $15.00 and quickly began trading near $20.

Investors are likely very happy with their 30% plus gain in a single day and it looks like Citi may have sold itself short, as it could easily have collected $17 or $18 for the stock and still made investors very happy.  Fortunately for the company, it still owns roughly 40% of the company so it should be able to write up the value of its holdings.

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The transaction has certainly benefited Citi as the company was able to raise roughly $300 million.  That number is actually very conservative because as part of the convoluted transaction, Citi issued warrants to Warburg Pincus LLC, and also was the lead underwriter for  the stock – meaning Citi was able to keep a large portion of the underwriting discount usually paid to brokers who place IPO stock.

Primerica could be considered a “low-tier” financial services company whose primary business is selling life insurance.  The target client includes middle income families with $30,000 to $100,000 in annual income.  The prospectus lists these client as:

  • Having inadequate or no life insurance coverage
  • Needing help saving for retirement
  • Needing to reduce consumer debt
  • Preferring face-to-face meetings for financial decisions.

While this target market covers a large percentage of households (Citi estimates the demographic at 50% of US households), the margins on this segment of customers is usually relatively low.  That is why Primerica was considered the perfect solution for Citi – allowing middle income households to be served by Primerica while the Citi financial professionals focused on the bigger and more profitable clients.

Why gold will not make new highs or lows this year

Why gold will not make new highs or lows this year

The problem that I have with the Primerica business model is that the representatives often take a multi-level marketing approach to building their client base.  In the prospectus, Primerica speaks of “independent entrepreneurs” who are responsible for building and operating their own businesses.  These representatives are classified as independent contractors and are not official employees of Primerica.  Many of these “financial representatives” are part-time workers and Primerica actually encourages this aspect in order to attract more representatives.

The end result is that many of these representatives have little experience, a deficient knowledge base, and may not be giving the best advice to clients who need financial information.  While there are of course exceptions, Primerica has become known as the “Amway” of financial services – a reputation Citi would like to distance itself from.

I must say that I am a bit surprised at how well the IPO has been accepted by the market.  Financials are still a bit sketchy as it is difficult to understand the pro-forma numbers presented in the prospectus and account for the adjustments.  Below is a flowchart of the organizational structure which shows the convoluted state of the offering.

Primerica Org Chart

With this much complexity, I would avoid buying the IPO at this point as the market hates uncertainty and once the hype of the IPO wears off the stock could drop quickly.  Farther down the road, I expect Citi to unload the rest of its  shares and Warburg will likely exercise its warrants and liquidate the shares as well.

Aggressive traders might consider shorting below $19.60 but don’t get too greedy.  Citi will defend this stock vigorously as they still have a vested interest in the deal working.  So the stock could drop to $17 or even $16, but the IPO price is important for Citi to defend so I would expect them to start buying aggressively at the $16 level.

Other Articles of Interest
Resurging IPO Market Adds Liquidity for Businesses and Owners
Explosive Growth Opportunity in Latin American
Primerica – A Multi-Level Marketing Scheme
WSJ: Citigroup’s Primerica IPO Soars 31%

Typically an IPO that trades well out of the gate is likely to continue its positive trend.  But Primerica is a different animal and I wouldn’t put too much confidence in the positive initial reaction.

Primerica Inc. (PRI)

FD: Author does not have a position in PRI

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Posted in Featured, IPO, Short IdeasComments (18)

Employment Issues Trigger “Backsourcing”

Employment Issues Trigger “Backsourcing”

ZachStocks NewsletterAs the US deals with stubbornly high unemployment and relatively low consumer confidence, some new trends are developing in the business of “outsourced services.”  For some time now, large companies have relied on offshore companies to supply services such as technology support, customer service, and even more business critical functions such as R&D and manufacturing.  Efficiencies gained from working with cheaper labor forces and relaxed regulations allowed businesses to post better margins.

But today, many of these trends are shifting as US companies are benefitting from stimulus incentives aimed at encouraging employers to hire the swelling ranks of unemployed.  Currently, employers who hire particular unemployed workers will be allowed to save their share of the Social Security tax (6.2%) for the remainder of 2010.  The monetary benefit along with the PR boost of hiring American workers is causing many reputable companies to consider closing down outsourced solutions and “backsource” these jobs back to the US.

While this is one of the smarter moves that the current administration has made (cutting taxes actually increases productivity and in time should lead to stronger, more stable tax revenue), the news is not exactly positive for outsourcing companies with operations in India, China, and other International centers.

Wipro Ltd. (WIT)Today, we are going to look at Wipro Ltd. (WIT) which is an Indian provider of outsourced consulting, technology and R&D.  The stock has become a favorite vehicle for swing traders and momentum players who have enjoyed a steady trend higher for the majority of 2009.  During the difficult days of the credit crisis, WIT continued to pull in strong revenues, averaging between $1.3 and $1.4 billion in revenues.  Fundamentally the business survived very well throughout the challenges.

In 2009 as US based companies were desperate to cut costs, WIT’s services became more attractive and investors quickly caught on to the idea that this would once more be a growth story.  By October of 2009 the stock had already hit a new all-time-high and the positive trend continued through the end of the year.

But 2010 looks to be a much more challenging year.  Companies are demanding price concessions and the competitive factor of backsourcing is likely to cut into margins – possibly more than analysts are currently modeling.  As technology solutions become cheaper domestically, Wipro is likely to face a more difficult environment, and engage in tough negotiations in order to land contracts.

Azim Premji, Chairman, Wipro Ltd. (WIT)In 2010, we expect IT budgets to be flat to marginally positive.  For the quarter ending march 31, 2010, we expect revenues from our IT Services business to be in the range of $1,161 million to $1,183 million. ~Azim Premji, Chairman

When the company reports fourth quarter earnings in the coming weeks, it will be extremely important to determine what demand trends are shifting as a result of global competition both from similar corporations as well as from the “insource” factor.

Why gold will not make new highs or lows this year

Why gold will not make new highs or lows this year

Currently, WIT is trading at about 35 times this year’s expected earnings (the company’s fiscal year end is March 31) and earnings are expected to grow by 9% in fiscal 2011.  The multiple is not too excessive for a company with stellar growth, but as earnings trends flatten out the market is more likely to place a lower multiple on the stock – leading to a reduced stock price.

On March 17, WIT broke to a new high after a healthy looking two month base building process.  However, the stock immediately came under distribution and the breakout failed.  This is a dangerous pattern – especially for a stock that appears over-valued relative to its earnings and growth.  Volume has yet to confirm the negative pattern, but if WIT begins to break, it may be a good candidate to short, and long positions should definitely be hedged or trimmed.

Other stocks that may also face challenges from the backsourcing issue include Cognizant Tech Solutions (CTSH) and Infosys Technologies (INFY).  All of these stocks are currently trading with strong positive momentum, but they are worth putting on a radar list for potential breakdowns in the future.

Wipro Ltd. (WIT)

FD: Author does not have a position in WIT

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Posted in Featured, Short IdeasComments (2)

Blue Nile Diamonds Losing Luster

Blue Nile Diamonds Losing Luster

For the last few months, the market has continued to push to new recovery highs, and the Retail HOLDRS (RTH) have actually been exhibiting leadership and outperformance.  Now a day does not a trend make, but Wednesday’s action was interesting as the RTH declined by 0.92% while the S&P 500 was only down 0.55%.  I understand this is only one data point and may turn out to be insignificant, but today could turn out to be the day the retail sector turned.

Blue Nile Inc. (NILE)While I don’t have extreme confidence in calling a top for retail, I am developing a healthy dislike for the way Blue Nile Inc. (NILE) has been trading.  In early November, ZachStocks covered Blue Nile’s earnings report, noting that international sales were growing more quickly than domestic revenue (although international revenue only represented about 13% of total sales).  Despite the relatively healthy earnings report, we noted that the stock could easily be trading at double its reasonable value – and laid out the case for initiating a short position.

Newsletter AdAs of the close Wednesday, the stock has dropped about 14%, but the negative outlook is still just as dire as ever.  Analysts are expecting the company’s earnings to grow by 21% this year to reach $1.02 per share, and then in 2011 the expectation is for $1.23 in earnings.  I’m not sure that we can place much confidence in these numbers given the uncertainty due to unemployment and the potential “re-destruction” of wealth as adjustable mortgages reset and US taxpayers foot the bill for the new healthcare plan.

But assuming these analysts are accurate in their assessment, please explain why the stock is trading at roughly 53 times next year’s earnings!  This is a very aggressive price even for a company growing rapidly like Crocs Inc. (CROX) back in 2007.  But for a company like NILE with 20% growth expected over the next two years, the multiple seems absurd.

Over the past week, NILE’s chart has featured a pattern which many technicians call the “death cross.”  This pattern occurs when the 50 day moving average crosses below the 200 day average.  Now I don’t think there is any magic in these moving averages, but they do offer an excellent way to graphically illustrate the pattern that is evolving.  After spending a significant amount of time in a positive trend, the stock has finally begun to falter and at this point the short-term average of its daily closing price is below the long-term average – that simply means the tide is turning and the prevailing trend is negative.

Is The US Dollar Reversing Again?

Is The US Dollar Reversing Again?

Now while I said I don’t place too much credence in the actual pattern (I’m looking more carefully at the concept), there are traders who will swear by the patterns and make their trades like clockwork based on special indicators like the “death cross.”  As traders we have to respect this action and understand that a significant amount of selling pressure could quickly hit the stock.  At this point with a series of lower highs and lower lows, we could quickly see momentum pick up and NILE could be in the 30’s or even 20’s by mid-summer.

One thing to be careful of is that Blue Nile has been a big target for other short-sellers.  Currently the published amount of short exposure is 14% of the float.  It would take 15.5 days of trading (using the average daily volume) for these short sellers to exit their position.  The danger in this statistic is that if something positive is announced and the stock begins to move higher, the shorts could quickly hit the exits all at once, driving the price higher in a short period of time.

Other Articles of Interest

Mastercard Concerns for a Potential Market Turn

Consumer Confidence Pressures Rebound
New Home Sales, Modifications, and Other News
24/7WallSt: Will Financial Reform Be Legitimate?

So fundamentally and technically, this looks like a good short opportunity with the potential for 40% to 50% profits.  However, the risk is certainly present so position sizing should be appropriate and traders should always use a stop-loss when holding short positions.

Blue Nile Inc. (NILE)

FD: Author does not have a position in NILE

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Posted in Featured, Short IdeasComments (6)

A Retail Powerhouse Falls Behind

A Retail Powerhouse Falls Behind

What happens when the leader can’t keep pace with the competition?  Well the obvious answer is that he no longer remains the leader… Inc. (AMZN)For some time, Inc. (AMZN) has been in the good graces of a number of different economic participants.  Investors have been pleased with the exceptional rally which began well before the broad equity market bottomed in March of 2009.  At the same time, consumers have obviously been taken with the firm as revenue growth has continued throughout the financial crisis and has accelerated in recent months.  In fact, the fourth quarter reflected a 42% increase in revenue for the global internet retailer.

ZachStocks Free Newsletter

One additional group that has been very content with the firm is the number of affiliates who drive traffic and encourage sales on Amazon’s platform.  These affiliates (many of whom actually receive their primary income through this business line) are paid a commission for sales driven by their leads – a process which has been instrumental in the company’s strong growth.

But questions are surfacing in regards to the manner in which these affiliates and the sales that they generate are taxed.  Recently, Amazon actually cut off all affiliates in the state of Colorado after a dispute with how taxation matters will be handled.  This “nuclear option” will certainly be a negative for the company as far as sales growth is considered, but AMZN is willing to make this very public statement in order to pressure Colorado and other states to drop rules which will cause a financial or operational burden on the firm.

It will take some time for the logistics and regulatory issues to work their way through the system, but during an economic time where employment is under pressure, the US does not need additional red tape discouraging individuals from operating home businesses to generate income and promote economic activity.

Relative Weakness

From a trading perspective, AMZN is throwing up a number of red flags that will likely foreshadow weakness in the stock.  To start with, the stock has begun significantly trailing other retail names.  Now I understand that AMZN has some different dynamics than a typical brick and mortar retailer, but at the same time, the company is in the consumer area and has not been keeping pace.  While AMZN peaked in December of ’09, the retail index has continued to make new highs and is in a strongly trending pattern.


The underperformance of Amazon points to decreasing investor confidence and will likely lead to significantly lower prices once the retail sector begins to back off.  It probably makes sense to wait for RTH to break below the 20 day average or even the 50 day average before committing any serious capital to shorting AMZN.

Amazon is currently trading with a premium multiple.  Analysts expect the company to grow earnings by 43% in 2010 – which leaves us with an estimate of $2.91 per share.  Based on today’s price, investors are paying $44 for every dollar that the company earns which is a bit excessive.  I question what will happen if the estimates for 2010 are decreased.

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If Amazon issues guidance that fails to support analyst expectations, the numbers could easily be adjusted down to $2.50 per share which still represents a healthy 22% increase over last year.  But the surprise could cause investors to place a lower multiple on the stock – and a PE of 33 along with estimates of $2.50 per share would lead to a stock price of $82.50.  That’s quite a decline from the current level near $130.

Shorting individual equities is a tricky business.  It takes proper risk control and appropriate timing on both entry and exits.  The newly revised ZachStocks Newsletter is designed to help traders identify timely long and short opportunities and also monitors open trades with risk stop points and levels for taking profits.  For Amazon, the risk is still high that the stock will be carried by bullish retail investors who continue to add exposure.  So while the opportunity is exceptional, we are waiting for the retail sector to show weakness before initiating a short position.

Once the trade has been entered, it makes sense to use a stop point a bit above the most recent swing high (currently $134.20) and then to use a trailing stop as the trade shows a profit.  Along the way, aggressive traders can use days of exceptional weakness to take profits off the table, and retracements higher to add exposure back into the trade.  But I would use moving averages and a picture of the retail sector as tools for determining when the downtrend is in trouble.

Other Articles of Interest
Mastercard Concerns for a Potential Market Turn
Homebuilders Face Challenges
FT: Consumers Fear EU Curbs on Sales
Barron’s: AMZN Playing Hardball

In short, Amazon is over-priced and likely to disappoint.  The chart pattern is exhibiting weakness.  Retail should pull back at some point as unemployment continues.  And the combination of these forces will favor a nimble trader willing to sell short. Inc. (AMZN)

FD: Author does not have a position in AMZN

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Mastercard Concerns for a Potential Market Turn

Mastercard Concerns for a Potential Market Turn

Mastercard Inc. (MA)Mastercard Inc. (MA) has had a bumpy ride so far in 2010.  After posting a new recovery high near $270 in early January, the stock lost roughly 20% of its value after the company issued a disappointing fourth quarter report.  While the card issuer’s revenue was up 6% and earnings actually increased by 31%, investors were less than pleased.  Nearly all of the growth in earnings came as a result of cost cutting within the firm and even the 6% increase in revenue was primarily a function of currency fluctuations and not a real growth in business.

Back in 2008, MA became extremely weak as traders (myself included) expected the consumer to rein in spending and transaction volume to decrease.  Not only were we working against a general panic among both professionals and individuals, but spending was also to be affected by tighter credit limits, decreased card issuance, and higher fees charged by banking institutions.  Many consumers had to scramble and find alternate sources of funding such as a direct payday lender or other non-traditional measures.

ZachStocks Free NewsletterBut as investors regained confidence in 2009, the stock made back a good portion of its losses as Mastercard reported a continually growing chain of quarterly earnings.  The last four quarters featured EPS growth of 9%, 27%, 41% and finally 31% in the fourth quarter.  But a lack of revenue growth points to the fact that Mastercard manufactured the majority of its earnings growth through controlling expenses and not as a result of a material increase in the business.  In fact, the last four quarters of revenue growth have been (2%), 3%, 2%, and 6%.  Not exactly what you would expect out of a stock priced for growth.

It would appear that the future of Mastercard’s success (and the returns its investors will receive) hinges as always on consumer spending levels.  Since MA provides only the credit card transaction portion of the business, it is not on the hook for losses when consumers become unable to make payments on the loans.  But if consumers cut back on the amount of spending due to high unemployment, increases in the savings rate, or as a result of the destruction of household wealth, the fees MA charges will likely be affected.

ZachStocks AdvertisementWhile consumer spending is difficult to predict on a month-to-month basis, logic tells us that the long-term trend is going to be flat to down.  The US has consumer has been notorious for spending beyond his means, and while Mastercard has a strong international presence, the figures still show that over half of the company’s $28 billion purchase transactions occur within the US.  Bulls will tell you that the expanding international scene will more than make up for the declines in US transactions, but that may turn out to be untrue – especially if we face another global economic recession.

The competition appears to be weathering the environment a bit better than Mastercard with Visa Inc. (V) logging stronger revenue growth even thought the company is already much larger than MA.  Other card companies such as American Express (AXP) and Discover Financial (DFS) are more difficult to compare because these firms actually take on credit risk, collect interest payments, and are subject to write downs for bad loans to consumers and businesses.

Fundamentally, I am worried that Mastercard’s stock price has outpaced the company’s growth.  At the end of the year there were 966 million cards issued which is actually a decline of 1.3% from the number of cards that were issued at the end of 2008.  On top of that, the financial sector is likely not as healthy as many  believe with both commercial and residential mortgage issues hanging over banks.  Sheila Bair, Chairman of the FDIC states that there will be more bank failures this year than we saw during the crisis or as a result in 2009.  These are the banks that issue additional cards to consumers and they are under significant pressure.

Other Articles of Interest
Homebuilders Face Challenges
Consumer Confidence Pressures Rebound
Santoli: Pullback or Crash?
Congress Demands Explanation from Bernanke

Technically speaking, Mastercard has rallied in March but with less vigor than the overall market.  This relative under performance can lead to sharp declines whenever the broad market or specifically the financial sector begins to weaken.  Traders should probably use the 50 day moving average as a good spot to initiate shorts when the stock closes below this level.  Additional exposure could be added when MA crosses below the swing low of $216 logged in late February.  I don’t think it’s unreasonable to expect the stock to trade down to $160 (roughly 12 time 2010 estimates) with the potential for much lower prices if investors become fearful.

The US stock market has been surprisingly strong for the past six weeks, and despite Friday’s breather, it is certainly possible for this trend to continue.  Short positions should be placed carefully with proper risk controls, but in many cases adding short trades to a growth stock portfolio can increase returns while cutting down on the overall risk.  For more information about building a balanced long/short approach to investing subscribe to the newly re-designed ZachStocks Newsletter and take advantage of the free trading and portfolio management tips.

Mastercard Inc. (MA)

FD: Author does not have a position in any stocks mentioned in this article.

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Homebuilders Face Challenges

Homebuilders Face Challenges

MDC Holdings, Inc. (MDC)During any market advance, there are stocks that trade higher because they have significant merit, and of course there are those which are just along for the ride.  The axiom “a rising tide floats all boats” certainly applies for at least a time as professional and personal investors alike grasp for exposure to a rising market.  But it has also been said that “a bear market returns capital to its rightful owners.”  This usually applies to markets where speculative buyers have bid up prices to unsustainable levels, and then when the irrefutable laws of fundamental valuation come back into play, the capital invested quickly disappears.  I fear we will soon enter another period where capital is taken away from speculative investors.

ZachStocks Free NewsletterOne of the areas that seems most prone to a swift decline is the homebuilding industry.  From a business standpoint, the environment is definitely getting better.  After all, it’s not exactly hard to beat the devastating period builders have endured for the last 18 to 24 months.  But while business is beginning to show the signs of a recovery in infancy, the market is pricing in a full-fledged mature recovery and bidding stock prices higher as if they were fully functioning healthy businesses.

Take MDC Holdings Inc. (MDC) for instance.  The stock has no official PE because the “E” part is nonexistant – the company hasn’t earned a dime since sometime in 2006.  And this year analysts expect the company to lose another 44 cents per share.  But of course losing 44 cents is good news considering the fact that the company lost $10.44 per share in 2007, and lost $8.25 per share in 2008.  MDC is trading at roughly 40% of its high logged in 2005, and the value of its stock still appears to be very high.

A Quick Peek at Crude Oil

A Quick Peek at Crude Oil

If you read the company’s fourth quarter earnings report, you will immediately see that the company reported impressive earnings.  But it quickly becomes apparent that the earnings are entirely due to a tax code revision that allows the company to carry forward losses more than 2 years.  This is definitely a positive announcement for the company, but not one that will cause the long-term health of their business to improve.

The revenue picture is one that investors should look at carefully.  Quarter after quarter, the company has seen sales decline when compared to last year.  However the fourth quarter actually saw a pick up in sales – which is good news right?  Well it’s actually not all that impressive considering the fourth quarter of 2008 featured a decline of 62%.  So one would hope that MDC could at least match this dismal performance and even exceed it to a small degree.

MDC is not without signs of improvement.  The company’s new orders for the fourth quarter totaled 637 homes which is much better than the 350 homes ordered during the fourth quarter last year.  Separately, the backlog of homes under contract has risen to 826 compared to 533 homes to end 2008.  Hopefully the majority of these contracts are honored and buyers are able to secure financing (although mortgage standards continue to be relatively stringent).

Other Articles of Interest
A Rolling China Short Candidate
Chimera Swoon Offers REIT Investors Opportunity
Home Builders $2.3 Billion Gift from Taxpayers
Forbes: Homebuilders Stand Pat with Quality

Investors who decide to buy the company based on the book value of the company’s assets need to realize that property values fluctuate wildly because of the illiquidity in the market.  MDC holds more than a half billion in “housing completed or under construction” and “land  and land under development.”  The value of these properties has been revised lower in the past due to market conditions and if another wave of foreclosures hits the market, this valuation will likely be hit again.  The stock price requires investors to pay 150% of book value to own the company and book value still seems suspect in my opinion.

I wouldn’t be surprised to see MDC trade down to parity with book value (near $22.75) or even lower if management takes another write down on inventory levels.  Sure, the market for real estate may be improving, but with a shadow inventory of foreclosed properties being sold by banks, and many consumers stuck in homes they can’t afford, I believe the environment will be challenging for homebuilders for years to come.

MDC Holdings, Inc. (MDC)

FD: Author does not have a position in MDC

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A Rolling China Short Candidate

A Rolling China Short Candidate

Home Inns and Hotels Management Inc. (HMIN)It’s no secret that the Chinese economy has experienced tremendous growth – even during the global financial crisis.  A demographic shift towards the middle class has bolstered demand for goods and services, and we are seeing a wide portion of the population moving towards China’s rapidly growing cities.  However, as with any rapid economic expansion, economists are beginning to wonder just how fast is too fast.   It seems that there is serious potential for China to stumble and lead the globe back into an extended economic slump.

ZachStocks Free NewsletterThe Chinese equivalent of the Federal Reserve appears to have concern with the situation as they have begun tightening reserve requirements for banks which essentially reduces the amount of capital available for lending purposes.  The moves have been minor in nominal terms, but the banks are getting the message… “Cut back on lending and get your books in order.”  No one wants to see a repeat of the US banking crisis from 2008.

Tightening in China could certainly slow the economic expansion.  Instead of having ready access to capital, business would have to compete for limited financial resources which in turn could drive the price of these resources higher.  When chasing limited opportunities for loans, the interest rate can become the “price” and it seems logical that the cost of financing will rise for businesses.

With this backdrop in mind, I am building my list of China short candidates which will likely trade sharply lower once investment managers begin to trim their exposure to the sector.  One name that has caught my interest and is potentially actionable immediately is Home Inns & Hotels Management Inc. (HMIN).  The Hotel operator currently manages 616 hotels, 390 of which are leased and operated and 226 of which are franchised and managed.  The company has a wide geographic footprint with hotels in 120 cities across China.

ZachStocks AdvertisementOver the past four quarters, the company has continued to grow revenue and earnings although I’m becoming concerned that the rate of revenue growth has begun to decline.  When HMIN was a young company with just a few hotels under management, it was easy to double or triple revenue just by adding a dozen more hotels to the mix.  But now that HMIN has reached critical mass, it will be difficult to maintain the growth trajectory simply because of the law of large numbers.  The last four quarters have seen revenue grow by 53%, 43%, 38%, and finally 29% in the fourth quarter.  That’s still impressive growth but not nearly as exciting as the triple digit revenue gains the company used to put up.

The earnings picture, however, is much better.  Management has been able to manage costs associated with its existing hotels as well as the expenses for opening new locations.  As a result, earnings growth has been 130%, 107%, and 225% over the last three quarters.  That’s an impressive feat – but also one that will be difficult to follow in 2010.  Despite the positive earnings momentum and the hefty multiple, I fear expectations could be tough to live up to in the coming months.

David Sun, CEOIn addition to our improved overall performance, due largely to the reduced impact of new hotel openings, the key metrics of our mature hotels strengthened in the fourth quarter compared to this time last year indicating an improved economic and operational environment. This has allowed us to renew our focus on our core expansion plan, as we remain excited and encouraged regarding the vast opportunity which we believe remains within China’s economy hotel sector. ~David Sun, CEO

Looking at the HMIN chart pattern, there is certainly reason for concern.  The stock peaked in early 2010 and began to lose ground in sync with broad China indices.  After putting in a swing low in early February (just above the 200 day average), the stock has traded higher but on very weak volume.  It appears mutual fund managers are more motivated to dump the stock when the environment is risky than to accumulate shares when we hit the “risk on” periods.

Friday (3/5) the stock traded down sharply on strong volume.  It’s definitely concerning to see a growth stock catching significant volume on negative days – especially when trading below the 50 day average which has been a key support level for the stock.  Today (Tuesday) in early trading, the stock is back below that level as markets are opening mildly negative.  It will be interesting to see if volume comes in with the selling which would be a strong indicator that it is time to begin building a short position.  As always, manage risk carefully and know your stop level.  But in the weeks and months ahead we may find that short opportunities offer the best chance for profits.

Home Inns and Hotels Management Inc. (HMIN)

FD: Author has a short position in the Sound Counsel Absolute Return Model

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