What to Cheer About?

Watching market reaction sometimes is like watching an emotional woman, swinging between fear and relief without much patience or long-term view. I find it amusing when the market roared in a best day in a year after soothing words from Mr. Bernanke promised a more flexible and nimble FED, hinting further rate cut. I just don't know what to cheer about for any average investor.

Rate cuts, since used by Greenspan, has been welcomed by the wall street (note it's the street) as a bail-out and pain-killer in times of problems. This is because of their short-term interest (keeping the job, getting bonus) is directly linked to that. Having such an semi-insurance policy, the stock market also takes more risks than it normally should.

The rate cuts, unfortunately, isn't a medicine without side effects. Seriously speaking, the current housing market has its roots back to days when Greenspan cutting rates aggressively to alleviate the market melt-down by the Internet Bubble in early 2000s.

The current rate cuts underway may provide some essential liquidity to the banking industry, so in a sense, it will help financial industry to stabilize. But it can't change the fact of a slowing economy that has a possibility of recession. They are like pain killers, can't really kill the germs and can't really cure the disease. And isn't the fact we need more and more pain killers means we are really in a bad situation?

So far the ARM resetting rate is at 45 billions per month or so. That has already caused couple big investment banks to write down tens of billions of bad debt and oust their CEOs (what a shame they got away with millions of compensations still). Towards year-end, the ARM resetting rate will double to about 90 billions per month, assuming the percentage of going-default-subprime-mortgage is the same (which is a quite reasonable assumption), much more write-downs will happen on the horizon. We are just at the beginning of an avalanche.

No matter how FED trying to save it by cutting rates, the credit crunch will continue and impact the rest of the economy in a more pervasive way. Besides FED, those SIVs are also jokes. Buffet said "not only you cannot turn a toad into a prince by kissing it; you also cannot turn a toad into a prince by re-packaging it..." It's a shame financial industry again uses cryptic derivative product names. Investors should be aware that the emperor wear no cloth after all, no matter how beautiful words he describes it.

Human nature has little changes since day one. That's also the blessing for smart investors who can override and resist spontaneous feelings like fear, greed, euphoria, and relief. In the next 12 month or so we'll see more market reactions like that, and we should not be surprised.

Sit Tight

It's no secret the credit-market crisis starting with sub-prime mortgage is getting into a real problem for the whole economy and the market. To say it's only contained in the housing sector is like an ostrich hiding its head underneath the sand, it's wishful thinking at best. Bill Miller at the Legg Mason Capital Management pointed this out precisely:

"Credit markets are different. They are the source of liquidity to fund operations. If they are not
functioning, the economy is threatened. That is why the problems that began in US subprime but which have spread to encompass a wide swath of the mortgage market, as well as the commercial paper market, are so serious and have galvanized central banks and government financial authorities to move swiftly to try to restore those markets to normalcy."

There are two kinds of ostriches: the first kind would think what's happening in credit market doesn't impact the overall economy; the second kind would think the worst is already over or almost over. Both are somewhat based their belief from all kinds of economics report like inflation within range, jobless claim is ok, other part of economy seems strong, etc. Yet all these are data, i.e., old data, i.e., rear-view mirror.

To admit the credit crisis to be a big problem requires some high-level reasoning. What Xie has posted in his blog reminds me something I read about two years ago, someone said that the next financial crisis will come from the derivatives because so few people understand them and so huge the market for it. Xie puts out a simple but powerful fact: the total value of derivative market is 400 trillion dollars, roughly three times as the value of the original securities. That's equivalent to say, each dollar worth of securities has been traded three times as much. This is a pyramid up-side-down. This is exactly why if someone bought a house using a sub-prime mortgage for, say paying $1000 per month, and find himself/herself cannot pay the monthly mortgage on time, the down-stream impact is much more than the just $1000 becoming default.

Anyway, back to what I originally want to write. What we should do right now is probably sit tight till the storm is over. This inevitably would present both risks and opportunities. The bargains could come from banks and housing stocks. After all, people should have belief we still need banks and we still need houses.

BAC may present itself as a great opportunity in this crisis. Compared to other banks and investment banks, BAC may prove itself more stable on a more traditional model and less aggressive investing.

LEH is a well deversified company and may position better in the investment bank industry.

I feel lucky to have chosen AAPL half year ago as my primary holding. AAPL has no debt (matter of fact it has too much cash) and thus expose no risk of financing when borrowing cost inevitably rise. The stock will be impacted by general market for sure, but that only gives more opportunities to increase positions.

Yet Another Amazing Quarter

Quote:
"
Apple has announced their financial results for their 4th quarter 2007 (July - September 2007). Apple posted revenue of $6.22 billion and net quarterly profit of $904 million, or $1.01 per diluted share. These results compare to revenue of $4.84 billion and net quarterly profit of $542 million, or $.62 per diluted share, in the year-ago quarter.

Apple shipped 2,164,000 Macintosh(R) computers, representing 34 percent growth over the year-ago quarter and exceeding the previous quarterly record for Mac shipments by 400,000. Apple sold 10,200,000 iPods during the quarter, representing 17 percent growth over the year-ago quarter. Quarterly iPhone sales were 1,119,000, bringing cumulative fiscal 2007 sales to 1,389,000.

"We are very pleased to have generated over $24 billion in revenue and $3.5 billion in net income in fiscal 2007," said Steve Jobs, Apple's CEO. "We're looking forward to a strong December quarter as we enter the holiday season with Apple's best products ever."

"Apple ended the fiscal year with $15.4 billion in cash and no debt," said Peter Oppenheimer, Apple's CFO. "Looking ahead to the first quarter of fiscal 2008, we expect revenue of about $9.2 billion and earnings per diluted share of about $1.42."

"

What an amazing quarter. I couldn't be happier. Yet we shouldn't be surprised at all. Jobs once said "we are not investing in a company, we are investing in people.". I can't agree more. If there is one company that innovate relentlessly, that'll be Apple. I started to have the confidence after following the iPod product line for several years. No one, I mean, no other company in the industry, going in a pace as fast as Apple, when its product is already the hottest in the market. I should attribute this to Jobs. He is a perfectionist, yes, and what a great perfectionist.

I love to analyze Apple's products and its strategies because they are so focused! Laser focus to be exact. (remember what Jobs did when he returned to Apple? He slashed most of the unimportant products and focus just on the Mac)

Mac: The turning point, as I pointed out earlier, starts with the Intel conversion. At that time most regarded the move to be bold and somewhat viewed as a "forced" decision. It's partially true since PowerPC just can't give Apple the thermal (or performance per watt) requirement for its modern thin and light design. The root cause, however, lies in the fact that Apple gradually realized the importance of compatibility to PC world. The logic is that in order to pursuade someone to switch, you have to give them a non-exclusive choice. (interestingly this is not true for the iPhone case, in which Apple sacrificed a lot by asking a lot). This logic couldn't be demonstrated better than moving to Intel platform. Suddenly Apple can let Windows and Mac co-exist on the same sleek Mac hardware. I felt the urge to buy one, but I'm not sure if I can represent the market. Now it seems it's true. People want Mac. The market share stood at 3.2% world wide as of now. I see huge potential in the next decade, even though "Computer" has been dropped off from its name.

iPod: Nothing more to say. It's a legendary story and should be written as a legend MBA case. For now, however, it's one leg out of three that has least expanding space. Apple could further differentiate and innovate but the focus would no longer be gaining market share.

iPhone: Good as the number it looks, I believe it's not up to the bar Jobs wanted it to be. One demonstration of this is the $200 price drop. Investors were scared to death when the price drop is announced. Yet people forget one thing, Steve Jobs has higher standard than anyone else, including you and me and all other investors. The only reasonable explanation is that Steve is not satisfied with the sales number of iPhone, albeit it's actually already quite good. Last night I saw the new iPhone ads. It's targeted at small-business. Evidently Apple see that as a big profitable market segment for iPhone to enter.

Software: This is not one of the "legs" Jobs mentioned. Yet it's actually THE secret receipe. People buy Apple products due to its top-notch user experience. If hardware design by Ive gives people the sleek satisfaction while sitting on the desk or in your hand, the software gives you the "feeling".

The sales/profit number is abstract when looking at a summary level. It's more meaningful if we look at geographically divided data. 40% of Apple's profit comes from overseas. I'm quite happy at that. Japan excluded, everywhere on the earth loves Apple's product.

The final question is, with current price as high as $186 a share, is AAPL still a good buy? My thoughts is that if the general market doesn't go south, it's a fair price. One thing investors might not realize is the profiting power of iPhone. The monthly pay-cut from carriers can be almost twice as the manufacturing cost of an iPhone. What that means is that when Apple sells you an iPhone for $399. They actually can get roughly $400 (price) + $400 (pay from carrier in two years) - $200 (manufacturing cost) = $600 pure gross profit per iPhone. 10 million iPhone to be sold in 2008 equals 6 billion gross income (although the number will be spreaded out gradually). This leg does seems will hold to itself quite well.

Disclosure: Holding AAPL, and 2009/2010 call options.

SHLD/AAPL

SHLD $188.63

I eventually sold SHLD on $186, making a tiny gain.

Regardless of how I once was enthusiastic about SHLD and trying to tie it back to Buffet's original invention. Lampard is drastically different.

One thing for sure, SHLD now bears much more risk than a typical retailer due to the fact that Lampard is trying to utilizing its extra cash for various unknown investments.

When news comes out about Lampard played a trick on Sears' brands, my initial response was also a "whao". But then after a while, I asked myself, did he created any value from this? The answer is no. While Buffet sees a business behind a stock, Lampard sees investment just as investment.

SHLD might see more upside, but I'm not crazy about it.

-- Update 08/26 --

SHLD has since dropped to $140 range.

AAPL $100

Bought Apple when it was $75. I bought this "hot" stock not because it's hot, but because I believe Apple has something in its sleeve that'll keep surprise the street. The success of transitioning to Intel processor is the key to its computer success. iPod has dominated the market and iPhone will continue the story in the phone industry.

The biggest competitor is not Dell or Microsoft, it's actually HP, who has the resource and ability to pull together hardware and software to make a big punch. Its revival in laptop demonstrated the superior positioning it has.

Dell is out of favor not because of its operation, it's because the time has changed. One sentence says it very well for Apple: "Apple never changed, it's the flavor comes to Apple, not vice versa".

In the new century, user interface and user experience is the key features of a successful product. Apple can do it best, no one can compete.

One other factor, Apple is learning from its previous failures. Jobs is more realistic about the market than before (when NeXT failed). While Gates is the master of bringing the best out of a technical geek; Jobs is the master of bringing the best out of all people around him.

It's a matter of time to watch Apple grow, grow, grow.

Unlike Microsoft and Intel, Apple has big room to grow. When iPod was the center of everyone's focus, I once predicted the killer also comes quietly in its computer line after they moved to Intel platform. The recent quarterly report (April 2007) demonstrated the strong demand for its Mac computers (even though leopard is delayed).

I was shocked to see an article in Forbes that states Apple has the highest sales per square foot in retail industry, almost double the number that Tiffeny can make. When I bought Apple, I was doubt about its retail strategy. I was wrong. Jobs uses the retail stores to demonstrate Apple's product. It's called Apple University.

About Apple's fundamentals, I don't need to repeat too much. It's almost as perfect as an Apple can be.

With limited capital, I have to use call option to maximize my potential gain on this stock. I bought Jan 2008 option strike $100 for prices between $8 to $13. I predict 2007 will have two big upside point. On the day iPhone launch, and on the day year end quarterly report. I should sell the options (not the stock) on the same day or the day after since it typically take 1-2 days for the market to consume any good news from Apple.

I don't know the ceiling of Apple. It depends on how quickly it introduce iPhone series and what's interesting in its pipeline. I have enough confidence though, to see the success of iPhone. The 1% market share prediction is conservative even from Apple's perspective. If people are familiar with Apple's (always) conservative earnings guide, they will know when Apple says 1%, it probably really mean 2-3%. Apple just love to give a surprise party.

Threats to Apple includes Jobs to be the single point of failure. He's working harder than ever. I hope he can do well to see the Apple domination beyond iPod.

Another threat comes from HP. The new HP has already seen its revival in its PC division. It'll be the most respectable competitor Apple will face in the computer line in the years to come.

Another threat comes from Sony. Sony has the stylish element in its product. And Sony has most experience in home electronics. And thanks god Sony's play station 3 is not a success.

Microsoft is getting less and less of my favorite. It'll still earning a lot of cash from its software. But Apple beats Microsoft relentlessly, almost make it humiliated. The Zune launch to be caught off guard by the iPod reduced price is just another way to tell everyone (if you know how to listen and read into behind the story) that Apple's operation is top notch, at least two steps ahead of Microsoft, and everyone else.

Let me make a prediction for 2008. AAPL will hit $140.

--- Update on 05/24 ---

Given limited fund, I decided to use options.

I have bought three dates options

Jan 2008 strike at $100.

This is the first option I bought. Initially bought 2 options for $10 to "taste" it. It subsequently fell to $8, at which point I bought 2 more. It turns out option can be an excellent instrument to "exaggerate" capital gain and loss and thus gives you leverage. My 4 options give me about equal dollar gain/loss with 200 shares of Apple stock. I subsequently sold all these options and change to Jan 2009 strike $120 to avoid iPhone launch risk.

Jan 2009 strike at $120.

The average price I bought is between $18-$20. I don't think $140 ($120+20) is that of a "good" deal. But $20 gives enough "leverage" for speculators/investors. My major holding as of today is 8 options.

Jan 2009 strike at $100.

When I noticed this option, it's at $30 which I think is quite good deal. It, however, turns out to be lightly traded. Evidently investors don't regard this option to provide enough leverage. I bought 2 options of these.

--- Update 06/25 ---

Sold put strike $130 for $24 for Jan 09. Another word, buyers of this option is protecting against $130-24 = $106 on Jan 09. I thought that's unbelievably expensive. I'm quite comfortable to sell this insurance out. I only sold one option though.

--- Update 07/04 ---

Apple's execution of iPhone launch is flawless. I'm glad my predictions about it are mostly right. Barron's had a very cautious article about Apple during the week iPhone is launched. I believe Apple will surprise the market, this is more based on my faith in Steve Jobs. Such a perfectionist wouldn't allow it to fail. The marketing of iPhone can defnitly goes into an MBA case. It's a great splash when Jobs announced it, remained silent for a while, then when close to launch, Apple used a series of actions to build the momentum. First is the ads on Oscar event, then little by little Apple releases more information and surprise for the market. It's a climax build-up. In the market's view, it's a build-up of "hype". Those analysts don't know, though, the reason Apple builds up a great "hype" is because they have a great product. So few people realized that. I was amused by market's reaction when Apple announced improved battery life and its scratch-resistance surface just one week before its launch. Mind you, at that point, probably all the first batch of iPhone are already in shipping carriage to US. Apple waited and waited for the precise moment to announce this.

-- Update 08/23 --

There was a test to my tolerance during the market sub-prime mortgage melt-down. AAPL at one point tanked to $106. The once profitable options are now biting back hard on me. To a point where the total returns from options is negative (granted I already take profit once before). Now I don't think AAPL sells mortgage or buys mortgage backed derivatives, yet AAPL get hit harder than the market. As one online post put it, it very well be because of those hedge funds selling AAPL to cover losses. I think that makes sense. AAPL has since recovered to $131 today.

The motivations for AAPL's share price for the rest of the year comes from its three major business. I think iPhone sales figure will be slightly above guidance but won't have much surprise here, its time is yet to come but on the way. Mac business will, however, surprise the street. My prediction about Mac is paying off, in the next two years Mac will remain the core income source for AAPL. New iPod version will come out for year-end shopping season in time.

There is nothing wrong I can see about the company. I think I'm pretty satisfied with the company's product line. Apple knows better than anybody about what customers want. I still remember last year iPod's refresh. Most investors wasn't satisfied with what's new with the product, yet it's good enough to spur sales. The share price go up and down more because of the rational/irrational investors. Most time people let their imagination go up into sky.

The general market may still hurt AAPL in the months to come. AAPL's upside could comes from iPhone European deal news and new iPod announcement. And, of course, wait till the quarterly report.

-- Update 09/17 --

Everything about Apple has been pushed to extreme by Steve Jobs, the perfectionist. Yet I somehow feel a little worry on its pressure to its partners. Apple evidently has great leverage on negotiation table. The iPhone carriage thing is a perfect example. One carrier after another, they'll all kneel down in front of Apple, agreeing on some unprecedented subscription-profit-sharing. Maybe I'm wrong, maybe I underestimated how this is just business reality, maybe I didn't understand the cruelty of the business world, yet I still feel a little worried. Apple sometimes is too greedy. I wonder if it may backfire sometimes. When people condemn Microsoft for its dominance and its relentless assault on Netscape and took it out using some unfair competition, I feel under same circumstances Apple would do the same, if not worse. If there is only one enemy that can destroy Apple, it's itself. The giant has grown to be so proud and it better not been blind-sighted that integrated as it is now, it still need partners for a wild wide success.

-- Update 10/14 --

AAPL has since reached all time high of $170, after which settled at $167, which still rises much faster than I expected.

GS/LEH/FDX/UPS/COH/XTO/COP

GS $211.89 and LEH $73.50

These two are financial icons on wall street. GS is the gold standard while LEH is a growing competitor. Both highly leveraged. Yet GS remains the crown.

LEH has lower price to book and price to sales, however GS has higher price to cash flow and slightly better P/E, indicating GS's higher profit margin (14% vs 8%) and earning power. Not surprisingly, GS has an excellent ROE of 32% vs LEH's 23%.

GS has more than double income per employee than LEH which is industry normal. LEH do have a higher revenue per employee than industry average.

LEH has a gross profit of 75% (vs. GS's 65%), yet it's final profit margin is only 8.18% (vs. GS's 14% which is industry average). This indicates LEH has something go sideway during the profit chain. Investigating the income statements found that "interest and related expense" is the cause. LEH has roughly the same expense as GS in this item while revenue is about 35% less. With this industry where net profit margin is relatively thin, such thing can make a big difference. It may be due to the fact GS can borrow money on a lower cost.. Both rated AAA but somehow GS can borrow cheap money it seems… Not sure how much LEH can do better here.

Conclusion: GS is still the king of wall street and should buy more after 20 share of $200. Expect more than 5-7% better than index return for 2007. LEH has room to improve. If it improves its operation efficiency, the stock can do much better.

-- Update 08/23 --

During the sub-prime mortgage crisis, all financial stocks are hit hard. GS and LEH are no exception. That has created excellent buying opportunity. Yet I didn't because I don't have enough cash and when I have, I'll buy AAPL calls.

FDX $112.71 and UPS $71.47

Just opened overnight shipping in China. This seems like a good opportunity to me. Unlike US where business may still locate in rural area, in China almost every business located within major cities. I see delivery inside cities more challenging than between cities.

FDX has a price to sales of 1 and price to book of 2.82. It's amazing. Considering intangible assets only counts as $3B and Fedex's brand should worth a lot more, the price to book should be much lower. FDX is a buy from valuation perspective. UPS has price to sales of 1.6 and price to book of 4.64, also great, but not as good as FDX.

UPS, however, has better earning power. With a lower gross profit (17.75% vs 26%), UPS can achieve a higher profit margin of near 9% vs FDX's near 5%. This has helped its ROE to be 25%+ compared to FDX's 13% to 16%. UPS thus can achieve higher income per employee than FDX with lower revenue per employee.

FDX may be a good long term investment. So does UPS.

COH $50.96

Coach is an "affordable luxury" brand and has done extremely well. I feel so bad that discover it so late. The fundamental is outstanding. With virtually no debt (1% D/E ratio) and a high profit margin of 24.1%, COH posts an astonishing 40% ROE. However its valuation has been quite high. With PE of 33.4, investors are looking for 33% year-over-year growth which is somewhat unrealistic within the market segment at this moment. Other valuation metrics like price to book is not that important since COH is a fast growing company and it's the ROE and PE should be focused on.

Need to back check back. Expect slightly better than index return in 2007.

XTO $54.14

What stands out is its amazing profitability. With almost 80% gross margin and 35% net margin, the operating efficiency is evident. ROE is on par with the whole industry for about 35%. XTO is more leveraged than the industry average. I'm not worried about this given the fact it's still fast growing.

This industry's profit relies heavily on the energy price. So hedging such risk using derivatives is typical. That also limits the profitability unfortunately. So for XTO to beat expectation, the figure needs to come from volume. One thing better for XTO is it only operates inside US, a much less risky place than Middle East.

Projected from previous 5 year record, XTO should have more up side. Expect 5% or so more than index return in 2007.

COP $90

Attractive valuation. Buffet bought in 2006.

BUD/DEO/COST/XOM/PTR

BUD and DEO

Surprised at their D/E ratio. Although Buffet holds on 4.7% of BUD. The company doesn't seem to have a good balance sheet. Especially the D/E ratio is > 3 for BUD and >2 for DEO. Even though there might be some hidden value in equity, it's still a little too high. Yet, need to do further research see if such high D/E is typical for this industry.

BUD $50.35

DEO $81.40

COST

Read Barrons article about Costo. Impressed by the management and its consistency in terms of building a great business. It bought back some shares in 2006 for a total of 20 million shares. The only thing kept me from buying it right now is the P/E. It's hovering about 24. Costco will be a good long term investment if entry at a low PE.

COST $58.10

02/22/07

PTR and XOM

Buffet bought PTR in 2003. It was a very wise purchase decision. The stock has since five fold.

PTR in short-term won't have too much upside for two reasons: increase capital expenditure in 2007 and its already appreciated share price. Compare PTR to XOM has some similarities. XOM has a higher P/E for some reasons:

Its ROE has been steadily improving in the past four years to 34%, an impressive number. PTR is also improving. But at a 27.83% behind.

PTR do have a much lower D/E ratio. <0.5>

PTR has a 70+ days to empty inventories vs XOM's 15- days. This could be attributed to better transportation system in US. Both can clear receivable for within a month.

XOM has been gradually and consistently buying back shares in the past five years.

PTR $120.52 PE 11.26

XOM $75.22 PE 11.36