AlphaNinja 2010

8/14/2019 AlphaNinja 2010

1/10Contact: [email protected]

January 12, 2010

A week into the new year, I thought Id share my 2010 outlook, in addition to some investment picks and a summary o2009. My 12 month target for the DJIA of 12,690 (+20%) is explained in detail. Near the end of this piece I share theperformance of my picks from last year, which clearly justify the Alpha in AlphaNinja. As always, my 2010 goals are share profitable stock picks and point out positives and negatives that all equity investors should be aware of. Its goingbe a very good year!

Some broad 2010 Themes. Some will be discussed today, some to be addressed later

The cost of capital has nowhere to go but UP. This is a major headwind for most asset classes. The yield curve is VERY steep. Youre paid only .14% to park money in treasuries for 6months Stay away from IPOs in 2010. Most will be offered at unattractive prices as private equity investors try to retur

to the public companies that were purchased using cheap financing and nosebleed valuations. Focus on equities that offer good compensation in terms of Free Cash Flow, with downside support provided b

reasonable valuation and shareholder-friendly management. In terms of economic stewardship, trust the government about as far as you can throw it. Every announced

stimulus or jobs bill poaches the publics tax dollars & directs it towards public employees, as the governmcontinues to emulate the worst of private equitys practices, the dividend-recap.1

STOP overpaying for investment management! If your advisor isnt outperforming, then dont pay them 8-10times what a cheap fund would give you. The New York Times2 recently reported that 36 percent of wealthmanagers said they believed they were"not fully qualified to do their job." Is your broker one of them?

Death of the C.A.P.M. For too long, companies with zero debt have been penalized with a higher Cost ofCapital due to the Capital Asset Pricing Model, which assigns debt-free companies a riskier cost of capital.

Beware Price-Blind Arguments (PBAs) with Regard to Investing

By Price-Blind argument, I mean an argument that would not change regardless of the valuation of the underlying ass

I give you two examples: Cisco Systems and Gold.

Your stock broker or analyst could wax poetic about Cisco Systems for hours. Glorious charts will show the hugebandwidth demands that will inevitably choke communications networks, necessitating massive capital outlays to buynetworking gear from companies like Cisco. But the argument means nothing if it could be given with Cisco stock at $or Cisco stock at $24. Personally I think Ciscos 2010 estimated Free Cash Flow Yield of almost 9% is a fantastic deal, Id certainly not think the same if the stock was at $80 today with a Free Cash Flow Yield3of 2.2%, despite the argumenabout Ciscos prospects being just as bright. Thats a Price-Blind argument (PBA), and whoever is pitching it isprobably compensated in an asset-gathering manner that would be poorly served by adhering to valuation-based

arguments. Note I said based - valuation isnt everything, but it mustbe a large factor in investment decisions. [Whyou speak to your broker or financial advisor, do they prattle on about a certain stock or industry theme withogiving a valuation framework? If so, be skeptical, because it might be more of a selling pitch than aninvestment strategy.]

The biggest PBA of the moment is made by the gold bulls. Its easy to attack gold bears (those who say its overvaluedbecause one would seem to be crazy to make the anti-gold argument. Gold is looked at as the reserve asset to flee totimes of danger or inflation, much like the US dollar enjoys status of the reserve currency. In the case of both howevthats only true until its not; a new reserve currency or asset can come take their place. In the dollars case, its statusthe reserve currency has much better fundamental underpinnings than gold does. The US, for all our flaws, is the mostable economy on earth backed up by the strongest military on earth yes, both give foreign investors confidence inholding our debt. As hard as our government is working to destroy our reserve currency status, were holding onto itthanks to other governments behaving just as bad if not worse. But Gold only enjoys its status due to groupthink. The



is NOTHING to stop groupthink from changing its mind one day and deciding that oil reserves or silver or land are abetter reserve asset than gold.

Sticking with Gold for the moment, Ive looked at it from the long and short side, as a possible way to make some monI agree with the gold bulls that our government is spending its way to the poorhouse, necessitating the printing of evermore dollars. But that argument was made when gold was at $400 an ounce. And at $600 an ounce. And $800, $1,000

and then recently at $1,160 an ounce, at which point I wrote in response to extreme gold price projections:

Gold is loved for many reasons, including its malleability, extreme durability, and long-term proven success as a store of value. But in term

practical use, it's vulnerable, as you can see in the below data from the World Gold Council.Jewelry accounts for over half ofidentifiable gold demand, and it was down 30% in q309 versus q308.

Gold may keep flying, but it's only because of groupthink that this asset is chased. Andas for the extreme gold predictions, likgold at $5,000 or $8,000, stop to think about what that would say about the state of the USA and global

economy.If you own Gold and it hits $8,000, and IF you can find someone to buy it, take that money and invin a shotgun, some rural land, and cattle, because we would truly be in an apocalyptic situation.

With no cash flow or earnings stream with which to value Gold, the people best equipped to trade this commodity are

those who track investor sentiment. They follow long term trends, and can get a better handle on what inning Gold in its current bull run. As a fundamentals-based investor, I have no business getting involved here.

The DJIA divided by Gold ratio is near its long term average, hurting the extreme bullish and bearish arguments:

Equally as damaging as using PBAs to promote a bullish stance is using one to promote huge future declines in the

market. There are countless pundits who can talk your ear off about government spending run amok, our futureunfunded liabilities, unsustainable debt burdens, etc., until one is out of breath. What doomsdayers havent done (fothe most part) is turn that sentiment into actionable results for their clients, because theyre too busy pontificating on th

big picture while forgetting to look under the hood, if you will, at the stocks that make up the stock market. Take Maof 2009. I didnt call the exact bottom, but I did make good money by taking a step back and looking at individual stocThe doomsday argument still made perfect sense at that point in time, but people didnt take the time to sit back and saHmm. Yes, things are bad, but now IBM is trading at $90, which is a P/E of 10times trailing earnings and 9times thisyears expected earnings, versus historical averages in the upper teens. At those levels IBM had a Free Cash Flow Yielof 11% (12% if you netted out their $8 in cash per share). One didnt have to know if the market had hit bottom to knthat an 11-12% yield on IBMs cash flow stream was a very attractive place to put your capital.



The Market is fairly priced, and will likely finish 2010 up 20% from the current level, to finish at 12,690

Below is a chart of Where Weve Been, from 1977-2009, before I discuss where I think were headed. Theres nothtoo complex about the past 33(ish) years -- interest rates ballooned into a peak in 1981, with the 10 year treasury toppin

16%. With a yield like that, one would be crazy to put their money in risk assets like the stock market. From that poininterest rates began a long decline to the low single digits, enabling an explosion in debt and speculation of every sort.The cheaper the borrowing cost, the higher every other asset can fly, and the market took off along with the expansion borrowing:

(Source AlphaNinja, Federal Reserve)

So where are we now and where are we headed? First, Ill start with the scary concept that the doomsayers are peddlingthe comparison of last years massive V-shaped rally to the rally after the 1929 DJIA crash. The initial selloff this timearound might not have been as rapid, but the kneejerk 65% rally was MORE robust than what the market experiencedeighty years ago. Why is that a problem? After that initial rally from late 1929 to May 1930, the DJIA proceeded to los85% of its value before finally bottoming in the summer of 1932:



If we must compare this period to the great depression, my opinion is that were closer to mid 1932 than late early 1930If you look back, the DJIA actually shed 12 of 30 companies over a 24 month period4, something that is not going tohappen today. The 30 stocks of the Dow Jones Industrial Average include some fantastic deals.

If you bought the DJIA today (using the DIAMONDS Trust, ticker symbol DIA), the weighted dividend yield is 2.6%,nice annual gain BEFORE any capital appreciation from increased earnings or a higher earnings multiple. The highligharea in the following chart is the top 9 stocks in the Dow, whose weights account for just under 50% of the index.Among these are Johnson & Johnson and Procter & Gamble, two fabulously run firms at low teen PE multiples, versuaverage historical PEs in the upper teens to near 20. Also among this group is IBM with a Free Cash Flow Yield (FCFof 8.4% - closer to 9% if you net out their balance sheet cash. The highlighted groups average Free Cash Flow yield isabout 8%, which is far too high considering these firms can borrow money for 10years at rates in the 4% range.

Twenty-six of the 30 DJIA components earnings estimates are increasing, certainly not surprising given the economysjobless rebound. Skeptical of the quality of bank loan portfolios and the potential for further weakness and necessaryequity dilution? ME TOO, but you can have BAC and JPM fall to zero and cost the Dow a whopping 4.4%. I can

promise that will NOT be the case, as Fed actions have enabled banks to repair and increase capital levels by borrowingzero and lending higher.



Where To From Here? Based on my targets for each DJIA component, I arrive at an estimate of 12,690, up 20% frohere. This figure is based on my estimates for what each Dow component should yield in either free cash flow or earni

(for the financials). This estimate could easily turn out to be conservative, at it would represent 12/31/2010 trailing

twelve month PE ratios for the thirty components at an average 16.3. At that is on earnings estimates that will likely harisen as job cuts turn into job growth, and investors look beyond to 2011 earnings to value the index. In times of

economic stress, companies often overshoot when cutting costs, which could create a spring-loaded factor, whereearnings could rocket on slight revenue upside. The 16 PE cited above will also decline as companies use cash flow ovthe next four quarters to reduce shares outstanding through stock buybacks.

Banks borrow here...

...and lend he



Another way to look at the market is how it compares to real-world data such as annual auto sales and rail traffic. Inboth cases those metrics plummeted from peak numbers, but the DJIA if anything overshot to the downside, which ispart of why I was bullish back in March, writing on the 18th:

The DJIA has bounced just 12% from the recent lows. The five highest-weighted stocks (totaling about 40% of the entire index) trade nehalf their average historical PE multiples and are poised to rebound. The bottom five could fall to zero (a possibility more remote by the day

and cost the index a mere 2.8%. These are very bullish signs

(Source AlphaNinja, Railfax)

In 2010 Ill continue with a theme of buying great companies at good prices + good companies at great prices.By that I mean Ill buy IBM (a great company) at a Free Cash Flow Yield in the 8-12% range and hope to sell when thstock has risen and the yield drops to the 6-8% range. And for a good company like Dell, Ill buy near 20% Free CaFlow Yields and sell as that yield falls to the mid to low teens.

I will continue to use Free Cash Flow Yield (FCFY%) as a barometer. It is the clearest way to evaluate what you wouldget in return for buying a company (or a piece of a company, in stock). What may change is what I compare FCFY% tThis past year, extremely low debt yields have driven the cost of debt financing to miniscule levels for great companiesand still tiny levels for good companies. So when I look at Dell 2012 debt5yielding less than 2%, its not proper to sathat they deserve a FCFY% as low as 5% just because their debt is cheap. Their debt is cheap for two main reasons:

1. A fed funds rate near zero2. Irrational exuberance in the corporate debt markets, pushing prices up too far and yields down too low.



Too be clear, Ive never argued for such a low FCFY% for troubled companies like Dell, preferring to buy them above20% and sell in the teens. Just as people occasionally value stocks using a normalized (higher) earnings number whenevaluating long term prospects while numbers are recession-depressed, its important to use a normalized cost ofcapital when financing is irrationally cheap.

Using Free Cash Flow Yield as a valuation framework worked well in 2009, mostly because instead of talking yourself ina PE multiple for a given company you wait for the yield to come into your comfort range. Below are the pound thetable stock picks I made last year. Not included are my market calls. I made a bullish DJIA argument in March and msome good money, but later (about 20% higher) hedged with an S&P500 short position to negate about half the remainupside.

Also not included above are my comments about other stocks I own, including CSCO, CMCO, and WDC, because Istarted recommending them before I began AlphaNinja. Worth sharing though, both the good and bad:

CMCO > Maybe my worst pick. Off 38% while the S&P is off only 11%http://seekingalpha.com/article/63134-columbus-mckinnon-expanding-operating-margins-should-provide-50-upside

CSCO and WDC > + 41% and +184% versus +23% for the S&P500.

http://seekingalpha.com/article/104069-capital-structure-and-some-cheap-stocks

Bullish on DIA near the March09 bottom, up 48%:http://seekingalpha.com/article/122302-value-still-exists-in-the-dow

I still own all the stocks mentioned above, as their earnings and cash flow estimates have increased enough to keep theiFree Cash Flow Yields at attractive levels. I added Qwest Communications (Q) to my portfolio last week, and shared twith AlphaNinja readers. This would be an example of a good company at a great price. Among my reasons forowning the name, as I wrote on January 7 th:
http://seekingalpha.com/article/63134-columbus-mckinnon-expanding-operating-margins-should-provide-50-upsidehttp://seekingalpha.com/article/104069-capital-structure-and-some-cheap-stockshttp://seekingalpha.com/article/122302-value-still-exists-in-the-dowhttp://seekingalpha.com/article/122302-value-still-exists-in-the-dowhttp://seekingalpha.com/article/104069-capital-structure-and-some-cheap-stockshttp://seekingalpha.com/article/63134-columbus-mckinnon-expanding-operating-margins-should-provide-50-upside



So at a more (maybe unreasonably) conservative $1.3billion in 2010 Free Cash Flow, that's a Free Cash Flow Yield(FCFY) of 16% on the company's market cap. With cost of capital at 7%, the stock probably does not need such a hi

FCFY%, and should trade higher. What's more, one could technically buy the company for $8billion and pocket the

company's $2billion in cash -->> now we're talking about a $6billion purchase with Free Cash Flow of $1.3billion...aFCFY% of 22%. Why net out cash when I don't add in debt? Because they cover quarterly interest payments 6 times ova very healthy margin in this sector. And again, I'm being VERY conservative in my Free Cash Flow estimate.

This is one of those situations where the company has issues, but the yield is simply too great for me to ignore. Justbought shares, as I expect Qwest to rise significantly.

Another recently initiated position is America Online (AOL), which was spun out from Time Warner last month. Thisstock would be a new category that Id call marginal companies at ridiculous valuations. From December 10th:

Dating Advice for America Online = STAY SINGLE AWHILE (AOL, TWX)AOL shares are being spun out of Time Warner. For every 11shares of TWX stock owned, 1 share of AOL will be given. This

equates to about 106million shares of AOL outstanding, for a market value of $2.5billion. With Free Cash Flow of about$1billion expected this year and next, the shares are a BARGAIN.AOL shares are off today, and Wall Street is pretty bearish this morning, with several analysts initiating coverage with a SELLrating.

Don't get me wrong - AOL/TWX was likely the biggest merger failure in HISTORY, and AOL's business is a wreck, in adownward spiral that will be difficult to correct. That said, I compare this situation to one I saw withWestern Digital (W Dlast fall. People were absolutely FREAKED about the threat to WDC from solid state drives, or flash drives. It was a decentargument, but my point was that WDC was trading at a level where you would literally make your money back in Free Cash Flbefore that argument over competitive products was even completed.

Could be a similar case here, with a potential Free Cash Flow Yield of 40%. You could buy the company outright and make yocash back completely, while people still argue about AOL's viability.

STOP Overpaying for Underwhelming Investment Performance

Before closing, I have one recommendation for people in 2010 a checkup with your financial advisor or broker. Istarted AlphaNinja for three main reasons. Number one, to share actionable, profitable stock picks. That has beensuccess so far. Number two was to take companies to task when they do not act in the best interest of commonstockholders. In that respect I think Ive also been successful. The third reason I started AlphaNinja is due to the leveTERRIBLE financial advice being peddled by Wall Street and its extended network. While I believe superior investmeadvice or performance should be rewarded handsomely, the vast majority of people are paying big fees for very littleadded value with regards to their investments.

The following is from a piece I wrote in November,in which investment planners were reassuring nervous clients byincluding cash contributionsto their equity portfolios performance:

"If you were Rip Van Winkle and had fallen asleep for a year, you wouldn't have known we had a crisisand you woulhave saved a lot of sleepless nights," says a Washington, D.C., financial planner.

That's from a recent WSJ piece called "Surprise! That 401(k) Account Is Looking Good."

I'll give the author the benefit of the doubt and assume she's calming investor jitters over their nest eggs. It's a great point to remininvestors that their position might not be all that bad considering the market recovery and added benefit from regular contribution
http://alphaninja.blogspot.com/2009/07/free-cash-flow-yield-better-way-to.htmlhttp://alphaninja.blogspot.com/2009/07/free-cash-flow-yield-better-way-to.htmlhttp://alphaninja.blogspot.com/2009/12/dating-advice-for-america-online-stay.htmlhttp://seekingalpha.com/article/104069-capital-structure-and-some-cheap-stockshttp://seekingalpha.com/article/104069-capital-structure-and-some-cheap-stockshttp://finance.yahoo.com/news/Surprise-That-401k-Account-Is-wallstreet-1400162598.html?x=0&.v=2http://finance.yahoo.com/news/Surprise-That-401k-Account-Is-wallstreet-1400162598.html?x=0&.v=2http://seekingalpha.com/article/104069-capital-structure-and-some-cheap-stockshttp://seekingalpha.com/article/104069-capital-structure-and-some-cheap-stockshttp://alphaninja.blogspot.com/2009/12/dating-advice-for-america-online-stay.htmlhttp://alphaninja.blogspot.com/2009/07/free-cash-flow-yield-better-way-to.htmlhttp://alphaninja.blogspot.com/2009/07/free-cash-flow-yield-better-way-to.html



he worrisome aspect is the quote above from the financial planner. OF COURSE the portfolio is doing better thanks toTcontributions. Below is an example of a $100,000 portfolio over two years, in a fund that mimics the S&P500. The red line shows account value without any monthly contributions, and the blue line includes contributions of $1,000 per month. With contributionthe account is positive over the period. Without them, it is down almost 20%, just like the index.

If the investor received a $50,000 inheritance windfall, would the adviser claim that the investor's account is performing fabulously

thanks to this? "Hey Frank, wow your account's up $50,000 in a day!" It's not much different than the above points.

It's reasons like these that the NYTimes recently reported that 36 percent of wealth managers said they believed they were"not fully qualified to do their job."

Pulling the wool over investors' eyes intentionallyconfusing performance with account value confirms that this industrybypeddles awful advice.

This chart below demonstrates what the financial planners were doing. They were citing the higher blue line as clie

ris

performance, which included monthly cash additions to holdings. [Call your broker and ask how your equity

portfolio did last year. If they cant answer because its confusing due to contributions, just ask how it

would have done had you not made any cash contributions. If they still cant accurately give you a compa

of your equity performance to the S&P500, then why are you paying them to manage your money? Its akin

giving your mechanic access to your checking account, and him being unable to tell you what you were charg

for a new transmission.]

The reason I included the above attack on Wall Street is due to the major effect that fees can have on ones quality of li

alater on. If you find that your broker or fund is not generating outsized returns, then you MUST put that moneyelsewhere. Depending on your horizon (in this case below for a 25 year old), the 1% you save by switching fromhigh cost to low-cost equity fund would result in a 20% increase in monthly retirement income. Thats just frocutting fees. (This example ignores the shift toward fixed income that would be appropriate for a portfolio as one ages


10/10Contact: alphaninjainfo@gmail com

In conclusion, I expect this year to be incredibly interesting for investors. While I established a firm DJIA target price December 31st 2010, I expect volatile swings in the market to afford us opportunities to purchase shares with juicy (highFree Cash Flow Yields. I have a better record of being right on individual stock picks rather than broad market calls, sothat will be where I focus my energy in the coming months. The biggest variable on my mind is interest rates, whichdirectly affect the cost of capital I use to decide what level of Free Cash Flow Yield is acceptable. I expect the 10yeartreasury yield to climb at least 1%, but I also recognize the amazing ability of the Federal Reserve to throw its weightaround to keep rates artificially low. Whether rates rise or fall, I try to invest with a margin of safety by buying Free CaFlow Yields that are still very attractive even if rates were to jump several percent.

Thanks for your patronage in 2009 and I wish you the best of luck in 2010! Feel free to contact me with questions,comments, or requests for specific portfolio advice.

1http://blogs.wsj.com/deals/2008/04/01/the-return-of-the-dividend-recap/2http://www.nytimes.com/2009/08/01/your-money/financial-planners/01wealth.html3http://alphaninja.blogspot.com/2009/07/free-cash-flow-yield-better-way-to.html4http://www.djindexes.com/mdsidx/downloads/DJIA_Hist_Comp.pdf

5http://www.investinginbonds.com/corporatebonds/(cvt4c5enxyxmhefrrsd4muyg)/cusip.aspx?action=all&cusip=24702RAH4
http://blogs.wsj.com/deals/2008/04/01/the-return-of-the-dividend-recap/http://www.nytimes.com/2009/08/01/your-money/financial-planners/01wealth.htmlhttp://alphaninja.blogspot.com/2009/07/free-cash-flow-yield-better-way-to.htmlhttp://www.djindexes.com/mdsidx/downloads/DJIA_Hist_Comp.pdfhttp://www.investinginbonds.com/corporatebonds/(cvt4c5enxyxmhefrrsd4muyg)/cusip.aspx?action=all&cusip=24702RAH4http://www.investinginbonds.com/corporatebonds/(cvt4c5enxyxmhefrrsd4muyg)/cusip.aspx?action=all&cusip=24702RAH4http://www.djindexes.com/mdsidx/downloads/DJIA_Hist_Comp.pdfhttp://alphaninja.blogspot.com/2009/07/free-cash-flow-yield-better-way-to.htmlhttp://www.nytimes.com/2009/08/01/your-money/financial-planners/01wealth.htmlhttp://blogs.wsj.com/deals/2008/04/01/the-return-of-the-dividend-recap/

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