Bumpy Ride in the Stock Market

Whoops!
If you have kept up with Q2 earnings, you may have heard that Intel (Ticker: INTC) had a blow-out Q2 and earnings were awesome.  From that report, Intel raised outlook for Q3, lifting expected revenues to $11.6 billion, when estimates at the time were at most $11.3 billion.  But today, just a bit over 1 month after the earnings, Intel announced in a press release that they were going to miss the estimates, lowering revenue expectations to $10.8 to $11.2 billion.  Can you say, "whoops"?

What this tells us is that their sales had great momentum up to the point when they released their earnings in the middle of July, and quickly saw a reversal as Q3 progressed.  Intel is a big company and a large majority of computers use their processors.  If Intel says sales are slowing, it likely means the economy is slowing as well.

Double Dip - Here We Go Again?
Is this not contradictory to what I just wrote yesterday about the stock market not going to go into a double dip?  Well, not exactly.  I argued that the stock market was not going to see the levels that were reached in March of 2009.  I still believe in that.

From my conversations with my close friends, I have noted how the economy appears to be a system with a very slow or long time constant (here's the engineer in me starting to take over).  A what, you ask?  To put it simply, it's something that reacts very slowly to a stimulus, like an electric stove.  If you switch on your stove to its maximum setting, it probably eventually heats up to somewhere around 200°C, but it doesn't actually get there too quickly.  You can put on your finger on the coil for a few seconds before you need to remove it.  That's a long time constant.  And, say you wanted to fry an egg.  You know that if you leave the heat on "max" for too long, you're going to totally ruin your breakfast, but you still go ahead and turn the knob to "max" when you first start cooking.  Why is that?  Well, it's the same reason. It's because the time constant of the stove is too long. You want to get it up to the temperature quickly, so you don't set it to "medium" right off the bat.  You use the "max" setting for the first little bit, and when your cooking intuition tells you that the heat is now too high, you turn the knob back down to "medium".  If your cooking intuition is similar to mine, chances are you'd turn the knob down a little too late, and the temperature of the stove shot way above what you needed, and the egg white turns into "egg black".  This is typical of a system with a slow response.  It is hard to control and often overshoots where it needs to be.

Sorry...what were we talking about?  Yes, the economy having a slow time constant.  What is happening now, I guess, is that our economy was turned to the "max" setting in March 2009.  All of a sudden, everyone started to spend again and the economic numbers were awesome for a bit over a year.  Intel confirmed that when it came out with a great quarter and raised outlook.  Then, reality set in and people start to realize that they may have been a little too optimistic and turn the knob back to low, realizing how the economy had shot up too high.  We are now in that "low" setting.

What Happens Next?
As I said, the economy is slow reacting.  What will happen in the short term will probably not be too encouraging.  You will continue to see signs of a down turn.  The slow reacting economy has begun a downward motion, and it will take some time for it to reverse its course.  When that will be is anyone's guess.

Is it time to sell or a time to buy?  I'm no good at picking the right time to buy or sell.  So, I'm going to stick to accumulation of good quality companies if the prices are right.  And for many companies right now, I believe the prices are very right.  Do your homework and buy with a margin of safety/error.

Double Dip - Is it Likely?

These days, much of what you read is about the economy/stock market going into a double dip.  The fear is justified by recent economic data.  For example, US jobless claims are now at a 9-month high.  Existing home sales are at a 15-year low, and so on.  The main question is then, for investors, will the stock market dip to where it was in March 2009, when S&P 500 dropped to as low as 666 points?

The Economy Versus the Market

I want to highlight an important distinction between a double dip in the economy and a double dip in the stock market.  As much as some would like to believe that the stock market is an accurate reflection of the economy, it is not.  Studies have shown that GDP growth do not correlate to a stock market's performance.  That's strange, isn't it?  Am I saying that when the economy is doing badly, the stock market could rise, or vice versa?  Yes!  But how can that be, you ask?

It's actually quite simple.  The stock market prices are controlled by investor sentiment, and sentiment may not always align itself with reality.  For those of you who have owned stock, you would know what I am talking about.  You've found this amazing company, have studied on it, and made the conclusion that it was a good buy.  You put some money where your mouth is and buy the stock.  In a few weeks, the stock is down 20%.  What do you do?  You sell your shares and take a hit.  You just confirmed what the market thought, that the stock was worth 20% less than when you bought it.  But is it?  Was your decision based on an evaluation of how much the stock was currently worth, or was it affected by your aversion to further loss?

Why the Market Shed More Than 55% of Its Value in 2008-2009

Until I followed my friend Matt's recommendation of reading a book called The Big Short, I really didn't have a good idea of what exactly happened during the great crash of 2008-2009.   I recommend any investor to borrow that book from his closest library and read it from cover to cover.  It opened my eyes to the whole subprime mortgage debacle.  What happened was that Wall Street created a whole bunch of junk bonds, which were backed by subprime mortgages, and sold them to unsuspecting investors, because they were able to get the rating agencies to rate them as AAA (the best rating possible).  When mortgage owners defaulted as housing prices fell, the value of these bonds went pretty much to zero.  This industry was worth a few hundred billion dollars, and you all witnessed what happened when it went bust.

Since many banks were involved and had huge losses, the ones that survived held on to cash and created a credit crisis.  The result was that many companies not affected directly by subprime mortgages now could not borrow money (to run its operations, for example) and everyday investors lost a significant sum of money.  This all contributed to the eventual recession as both groups tightened their belts severely.  If you recall September of 2008 when Lehman Brothers went belly up, all you could really think of was, "Wow, the world is ending before our eyes."  Not only was it Lehman Brothers, there was Merrill Lynch, Citigroup, Morgan Stanley, Fannie Mae, Freddie Mac, AIG, and the list goes on.  Eventually, the crisis spread beyond the financial sector and the first to be hit were inefficient companies like GM and Chrysler.  Seeing all of this, investors pulled all of their funds as quickly as possible.  As a result, stock prices free fell.  In March 2009, S&P 500 hit its bottom when it briefly touched 666 points.

Remember, It's All Sentiment

Maybe it's been a little too long now, but most people seem to have forgotten how apocalyptic things looked back in 2008-2009.  Now, let's see if this whole episode can be replicated.  Is it likely for the stock market to reach 666 points, again?

First, to answer that question, we need to answer the question of what 666 points in the S&P 500 index represented? That low level likely represented market sentiment that priced in a recession that would be similar to the 1930s Great Depression, where 30% of the population was unemployed, where men had to ride on freight trains from city to city to find work, where countless people called the streets their home.  666 points represented a time when all of the companies named above were expected to go out of business, when the American economy was expected to be even worse than Japan's lost decade.

Second, we turn to the latter half of 2009-2010.  We have seen one of the greatest V-shape recoveries of the stock market of all time.  In April and May of 2010, I recall pundits calling it a "bear market rally" or a "dead cat bounce".  What ultimately happened was that the S&P 500 rallied from 666 points all the way up to 1219 in a little over a year.  The US GDP actually expanded at an astonishing rate (see figure below) during that period.

The market may have gotten a little ahead of itself, jumping from depression to euphoria in a few quarters.  To be sure, there are many issues yet to be resolved in the US and global economy.  Unemployment is 10% in the US.  Many European countries have debt problems.  However, will it warrant a double dip of market sentiment to drive the S&P 500 index back down to 666?  As I see it, the market, even at its current levels (1055 pts versus 666 points), do not reflect a very optimistic or exuberant sentiment.  Excellent growth companies that I have frequently mentioned are at very low P/E ratios (e.g. FSLR: 17, TRLG: 11) relative to their expected growth.

In order for the market to dip down to 666 points again, an event of catastrophic proportions must occur.  Exactly how big that event has to be?  I would venture to guess that you would need to see a good number of major corporations on the brink of bankruptcy (recall Lehman Brothers, Citigroup, Fannie Mae, AIG, etc. etc.).  Yes, housing sales are dropping...yes, unemployment is still high...yes, the US population is growing older...yes, the US government has trillions of dollars in debt.  But will we see the same number of companies go belly up?  I do not think so.

What's Next?

I'm no economist (heck, I didn't even take ECO101 in university) and I may be totally off the mark, but history tells us a lot.  The 1970s were a grim period and yet, Warren Buffet was able to make a killing during that time.  Why?  It was not because the economy was doing great, but it was because he picked the right companies in which to invest.

So, even if I were utterly wrong in this post, there are still plenty of ways to be profitable.  In fact, this may be the best time to invest.  Remember Buffet's famous saying, "Be fearful when others are greedy, and greedy when others are fearful."  I'd say there's plenty of fear on the street right now, just like in March 2009.

Watch Out for "Contraceptive" Drugs!

Just saw a story about a French drug company called HRA Pharma getting FDA approval on its "contraceptive" drug, EllaOne.   Why do I put a quote around the word contraceptive?  Well, it's because the drug is not a contraceptive at all.  It is technically an abortifacient, a drug which causes an abortion, as well as a contraceptive.  I would even go to say that the company is grossly misleading (if not committing fraud against) the public in advertising it as a contraceptive, which, by definition, is a device in preventing pregnancy.

What is different about EllaOne is the increased duration of up to 5 days after intercourse (from 3) that the drug could be effective.  The drug has several functions.  First, if ovulation has not occurred, it prevents ovulation from occurring.  Second, if ovulation has already occurred, it could prevent fertilization.  These two effects can be considered as contraceptive, because fertilization has not occurred.  A third effect can also occur, which is the prevention of implantation of the fertilized embryo to the uterus.  This third effect is effectively an abortion.  This is because life, as Catholics understand, begin at fertilization.

So, what does this have to do with investing?  Lots!  First, we know we should definitely not invest in HRA Pharma.  Second, as I have mentioned before, since drug companies make so many drugs, it is difficult to keep track of every single product that they have.  Therefore, it would be difficult for us to be confident that the drug company in which we have invested is completely ethically sound.  Even if they were ethically sound, the drugs that they make could have side effects that no one has discovered yet, and it happens all the time.  You hear about drug recalls or stories about new drugs causing deaths in patients.  I know I wouldn't be able to sleep well at night if I knew my money could be funding a company that has questionable ethics and products.

As a result, I do not recommend owning shares in any drug company.  There is just too much at stake.

Your Investment's Time Horizon

I was recently asked by my friend, Mario (hi, Mario), how my True Religion stock was doing.  I told him that it was down to $22 ($20.94 now, at time of writing).  He knew that I started buying when the stock was $29.  He did not say much, but I can guess what he was thinking.  He was probably saying in his head, "So, Felix, you have your own investing blog and claim to know a few things about stocks, why has your stock dropped more than 24% since you started buying?  Why should I listen to you?"

Patience: Gift of the Holy Spirit

My answer to Mario is that God was gracious enough to grant me one of the twelve gifts of the Holy Spirit: patience...well, at least when I'm investing.  The reason why the title of this blog is "The Catholic Investor" and not "The Catholic Trader" is the fact that I have a long time horizon.  Define long?  It is difficult to say, but it would be in the order of magnitude of years and definitely not weeks or months.  Of course, this gives me a nice excuse of telling you, just wait...and by the time a few years have gone by, you would likely have forgotten about what we talked about!  Hopefully, you would not hold this cynical view!  This is also a reason why I have published my trades starting this year.

A long time horizon is the foundation of fundamental analysis.  The jist of fundamental analysis is that the stock of a company has an intrinsic value, that is sometimes independent of the price of its stock.  Even though True Religion may be priced at $20.94 per share right now, we posit that the value of stock is much higher than that.  The market is driven by emotion and stock prices can fluctuate immensely for an extended period of time.  We need to exercise the strategy that is so well known and obvious, but seldom executed well, "Buy low, sell high."

A Good Guess

Despite how some claim that stock price movement is entirely random (hint: this is absolutely false), stock prices exhibit many identifiable characteristics.  Amongst these is the rate of ascend and descend.  What I mean is that a stock rises and drops roughly at the same rate that it has always done so, within a certain range. If we look at Google's (Ticker: GOOG) stock chart for the past 5 years, we can see that during an uptrend, the stock doubles roughly every 1-2 years.  Even during the cataclysmic market meltdown in 2008, the descend is just slightly faster (on a logarithmic scale), at about 50% decrease in a bit less than a year.

Right now, GOOG is at about $490.  I happen to think that the intrinsic value of the company is around $1000-1100 (using my Rule #1 spreadsheet).  Let's just say it's roughly double from where we are today.  So, looking at the previous behaviour of the stock, we can guess it would take no less than a year to reach that point, if today was the start of an uptrend.  We are currently in a correction and frankly, I don't know when this correction will be over (there are some hints of it though).  Let's give the market another year to bounce up and down without going anywhere.  That brings us to at least 2 years out.  And since we've seen a spectacular rise in the stock since December of 2008, we can guess that the next leg up would not be as dramatic.  In conclusion, I would expect my time horizon for my Google stock to be 2-5 years.

A Moving Horizon

Let's look at our crystal ball: we are now 4 years into the future.  Google has found a way to massively monetize Android, which now has 50% of the mobile phone market share.  Youtube has turned into a money printing press.  People are starting to adopt cloud computing and Chrome OS has 20% market share.  Google TV turns out to be revolutionary in the way we watch TV.  The stock is now at $1100 as we had calculated.  What now?  At this point, we re-run our initial analysis to see what the intrinsic value of the company is.  If  the stock is fair or overvalued, find a good opportunity to sell it.  If it is still undervalued, it would be wise to hold the stock and buy more when the stock price dips.  

With the latter case, your time horizon may continue to grow.  You bought the stock in 2010.  Now, in 2014, your stock is still undervalued and you expect it to reach fair value in, say, 2017.  Your time horizon has just increased to 7 years.  I suggest re-running your analysis every quarter to fine tune your portfolio.

What Have You Done About Your Loses?

So, I'm in the red in True Religion, because I bought at the wrong time.  However, the perfect timing of the market is almost impossible.  I do not know of any investor that can accurately predict a stock's bottom over an extended amount of time.  However, a lot of good investors are out there.  What do they do?  A fund manager, who controls billions of dollars in assets, cannot enter into a position all at once without pushing up the stock price.  What he/she does is buy shares over weeks or even months.  This is what I try to do as well.  Since I can never figure out when the real bottom of a stock is, I determine an entry price for the stock I want to own.  For True Religion, it was in the $30s.  Therefore, I started buying when it was $29.  As it dropped, I did not panic, I did not dump the stock, I did not have a stop-loss order in place...I simply bought more!  It was because I knew the stock was worth way more than $29.  The lower it is, the better for it is for me.  After I have exhausted my capital (which I have not), I just sit and watch the stock rise back to its fair value and cash out.

As I said, that may be years into the future, but if my analysis is correct, I will reap great rewards!  You, too, can benefit in this way...so, pray, and pray hard for the gift of patience!

True Religion 2010 Q2 Results - More Detailed Analysis

So, did you read the True Religion Q2 press release and call transcript like I suggested?  No?  That's ok.  I'm going to give you some highlights in this post.

First off, TRLG missed analysts' estimates for quarterly earnings.  They came in at $0.30/share compared to analysts' estimate of $0.46/share.  This is how the market gauges the stock, and as you can see, the stock dropped an easy 6% the day after earnings were reported.  That's ok.  We don't need to sweat it yet.  So, let's look at  the relevant details.

Earnings Per Share

In Q2 of 2009, TRLG earned $0.45/share.  In 2010, it earned $0.30/share.  What happened?  At the top of the press release, a separation cost of $0.12/share was stated.  What the heck is that?  Well, the former president of the company, Michael Buckley, decided to quit to "pursue other interests".  Lucky guy, 'cause he negotiated a $4.5 million deal if he were to quit the company!  What?  I'd quit too if I were him.  That is simply ridiculous.  You get paid because you decide to quit??  Unfortunately, these deals are ubiquitous for many company executives.  It is a way to attract talent, if you will.  I absolutely do not agree with it though.  It's like me going to my boss and saying, "OK, I quit...now give me $100K for it."

Anyway, taking out this "one-time item", the EPS was $0.42.  Therefore, there was a decline of $0.03/share.  We typically want to see an increase in EPS.  This is a cause for concern.  Let's dig deeper.

Revenue / Top Line Growth

If you read the press release, you can't actually find the word, "revenue", as it is more commonly used.  What you do find a lot is the term, "net sales".  It is essentially the same thing.  Net sales is simply revenue minus any discounts or returns.  For Q2, net sales increased 14% over the same quarter last year, from $72.1 million to $82.2 million.  More importantly, we want to note that net sales for the U.S. Consumer Direct segment saw increased sales of 47.2%.  This is very significant.  True Religion splits its sales into 4 segments.  First, there is the US consumer direct segment, where it sells its products through its own True Religion branded stores and its website.  Second, there is the wholesale route, where the company sells its products to department stores, boutiques, etc.  Third, all sales outside the US are labeled as "International" where the sales may come from a True Religion branded store or through other venues.  Lastly, there is the "Other" segment, which is the money it makes through licensing its products.

The US Consumer Direct segment is performing the best out of all 4 segments.  If you scroll down to the "Q2 2010 Segment Results", you will see a table that shows the net sales of the 4 segments.  US Wholesale saw a decrease of 16.7% and the International and Other segments saw an increase of 14.1% and 16.6%, respectively.  So, the US Consumer Direct segment absolutely blew away all of the other segments.  Why is this important, you ask?  For one, US Consumer Direct makes up about 50% of total sales.  Second, this is reflective of the success of True Religion's expansion plan, that is, opening up stores all around the US.  Third, the efficiency of their sales has increased.  In the call transcript, Jeff Lubell (CEO) tells us that in Q2, there were 82 stores compared to 59 stores last year.  That is a 39% increase in number of stores, and yet, the net sales grew by 47%.  This was helped by increased same store sales of 6.7%.  This means that wherever True Religion opened up stores, they were able to generate increased revenues.  The market has not been saturated yet.

The US Wholesale segment was disappointing in that it actually decreased.  Lubell blamed this on the major department stores.  While it is not an excuse, it is easy to understand why large department stores would buy less of True Religion's products.  In a relatively weak consumer market, the more expensive and luxurious items would be the first to go.  This is not because people do not want True Religion products (the US Consumer Direct segment performance disproves this), it is simply the decision of the department stores to buy less.

All in all, the top line growth was not bad.  The strength of the US Consumer Direct segment shows the strength of True Religion's brand moat.

Why Did Profits Go Down Then?
Since EPS did decrease by $0.03, the money must have gone somewhere.  Was it because True Religion had to sell their jeans and products at a discount to attract consumers?  Let's take a look.  The best way is to look at the gross profit.  It came in at $52.7 million, or 64.1% of net sales (this is the gross margin).  Gross margin actually increased from last year's 62.1%.  Gross profit is simply the revenue generated minus the cost to produce the goods.  Therefore, True Religion actually made more money per pair of jeans.

What happened was that the operating margin had decreased, and it was significant.  Operating costs includes the cost to Sell the product, other General and Administrative costs (SG&A), and other operating expenses such as capital expense and costs to open up new stores.  Operating margins fell from 24.9% in 2009 to 20.1% in 2010 (if we include the separation cost, the operating margin would have been 14.6%).


So, in the end, is this a cause for concern?  I would say, yes, it is, but only slightly.  Management should have done a better job in controlling costs.  However, as a young company in its fast growth phase, I would say it is acceptable.  I would keep my eyes on their margins in the future quarters to see how well management deals with the company's growing pains.

The Future
I believe True Religion will have no problem expanding in the US.  The brand has reached the point of critical mass where it is no longer a fad.  The company plans to open up 12 more stores in the US in 2010, which is 15% more stores in 6 months.  That is an encouraging number.

The more important development is over in Europe (see Michael Egeck's comments in the call transcript).  True Religion, together with UNIFA Premium, has started a joint venture in Germany.  This is a great move.  As we saw above, much of the operating margin decrease resulted from increased operating costs, i.e. expansion costs.  UNIFA Premium is True Religion's international distributor, and therefore, is well entrenched in Europe.  They would be able to expand in Europe much more efficiently than if True Religion did it all by themselves.  There are plans to open a few more retail stores in the Germany region.

The stores in London and Japan are both performing above expectations.  This is another good sign.  These are the frontiers in the international market, and if the products are well received here, it is likely that expansion into these areas will be successful.  The Toronto store will open later this year, and I hope to be able to check it out personally.  For those of you living in Toronto, it's opening up in Yorkdale mall in the Fall.

The Technicals

Is there concern over the short term of where the stock is going?  Yes.  TRLG is forming what is called a descending triangle.  In general, this is a bearish sign, and if the stock breaks through the support of $21.50, the stock will likely head lower.

The Stock is Down...Buy More!
So, is this a concern for us?  NO!  After my long-winded post, I hope I have shown you that True Religion's fundamentals are still intact and it is a great growth story.  We don't know if the price will break through the support, but if it does, we want to buy more!  This is the strategy that Phil Town outlined in his second book, Payback Time.  Because we know the company has solid fundamentals, we know the value of the stock is higher than its current price.  The lower the stock goes, the happier we are.  Who would not buy a $10 bill at $5, right?

Will it happen?  I'm not so sure.  At $22, the P/E ratio is less than 12.  Analysts estimate that the company will grow at 22.5% per year in the next 5 years.  Do the math and you will figure out that the earnings will accumulate to the market capitalization of the company in less than 6 years (this is Phil Town's "payback time").  It is literally screaming, "BUY!!"  And so, I leave you with that!

True Religion 2010 Q2 Results - Quick Comments

True Religion (Ticker: TRLG) reported Q2 earnings today after market close.  The results weren't as stellar as I had hoped, but were still respectable nonetheless.  I will go over some key points with you in an upcoming post.  For now, here's what you need to read: i) True Religion's press release, and ii) Q2 earnings call transcript.  The former is what the company wants you to get out of their results.  It is a condensed version and often the description details what they want to tell you.  If management is hiding something or purely unethical, they would present only the bright side of the story.  So, take it with a grain of salt.  However, the numbers are there in the press release and they don't lie (usually).  That is probably the more important part.  The latter link is a transcript of what was said during the conference call.  The actual audio file can be found on the company's investor relations website and is usually more telling, because you can hear the tone of voice of each of the speaker, but reading a transcript is quicker and usually sufficient.  You will be able to pick up a lot of the nuances that are not readily available in a press release or a financial statement.

So, enjoy these for now...and also the above picture of my wife, Renee, and me at a True Religion outlet store at the Woodbury outlet mall in New York.