Market Curbs Enthusiasm for AMD

On March 8th I wrote that the disparity between Advanced Micro Devices (AMD) and Intel (INTC) shares (AMD significantly outperforming) is not a new phenomenon, but rarely prolongs for any meaningful amount of time. Oftentimes AMD gets a lead only to see Intel close the gap, usually via massive price cutting. Below is the historical chart I provided, comparing the two computer chip makers.

The majority of feedback I got from that post was from technically-focused investors who were bullish on AMD based on their superior technology. Given I don't have a computer background, I was basing my opinions on historical evidence, as well as valuation metrics, not product specifications. Over the last four months, the trade I recommended (short AMD, long Intel to play a closing of the gap) has proved very profitable. Intel has dropped less than 10% while AMD is down more than 40%, as this chart shows.

I would be tempted to close out the trade here. Once again steep price cuts from Intel are hurting AMD, as their profit warning late last week indicated. After a huge move in a short amount of time, booking the profit and moving on seems prudent. If the AMD bulls out there are right, and the company will continue to gain market share from Intel, perhaps AMD stock in the low $20's is a good buy, as it's much cheaper now than it was in the 40's earlier this year. I, however, think that call is much tougher than the paired arbitrage trade, so I am going to move to the sidelines.

Citigroup Shareholders Beware

If you own stocks, undoubtedly you want management teams to feel an obligation to work for the shareholders. This boils down to striving to maximize shareholder value. Of course, attaining customer and employee satisfaction is important too, but succeeding on those fronts will usually aid in boosting a company's public market value, so these factors go hand in hand.

If you own shares of Citigroup (Peridot does not) you might want to consider what CEO Chuck Prince said in response to a piece in Barron's over the weekend about the possibility of breaking up the financial services giant. The weekly paper suggested that if Citigroup's stock remains sluggish, there could be calls for the company to be broken up. The following is an excerpt from a Reuters story published Monday.

"In the article, however, Prince flatly rejected any discussion of splitting up the company into separate units. "Breaking up Citigroup is the dumbest idea I've ever heard of," Barron's quotes Prince as saying. "You would take a franchise that people have worked almost 200 years to build and break it up into two or three parts, only to see the parts acquired by others."

Now why should Citigroup investors be upset with this? Within the financial services sector, only insurance companies garner P/E ratios lower than the big, diversified banking giants. Citigroup, along with JPMorgan Chase and Bank of America trade at only 10 or 11 times earnings. Many investors see this as cheap, but if the multiples don't expand, share price appreciation will only come from earnings growth, which is hard to attain in any meaningful way since these firms are so huge.

The argument for breaking up a company like Citigroup is twofold; to achieve operational efficiencies, as well as a higher public market valuation. On the operations side, smaller firms are easier to manage and can move at a much faster pace in adapting to changing business environments. From the investor perspective, right now all of Citi's business units are getting the meager 10 or 11 multiple. Breaking up into several pieces, the logic goes, will allow some units to get higher valuations, and thus the entire Citigroup enterprise would be more valuable.

I have seen specific break up estimates on Citigroup that value the parts at between $60 and $70 per share, versus the current price in the high 40's. By splitting into 4 smaller companies (domestic retail banking, international retail banking, global asset management, and investment banking), Citigroup shareholders could make a hefty profit, perhaps 30% or more. Chuck Prince's blatant dismissal of the idea doesn't bode well for investors.

As Second Quarter Ends, IPO Market Heats Up

Investors had a tough second quarter as the S&P 500 closed June up a mere 1.8% for the year. Unlike prior periods, where the IPO calendar slows dramatically in dicey markets, we have actually seen a pickup in IPO activity in recent weeks. Why the sudden interest?

With the average stock not doing much of anything, investors seem to be looking anywhere for places to make money. New offerings, whether well-known consumer brands like J Crew or Mastercard, or much hyped ethanol plays like VeraSun and Aventine, offer the potential for a quick payoff, something that has been lacking for several months in the market.

The retail investor seems to be jumping in with both feet to the IPO market, which I would use as an indication that it's time to tread carefully. Despite lackluster financials, small investors jumped all over the J Crew deal, causing a huge spike. On a valuation basis though, the stock does not appear cheap. The ethanol plays are also expensive, with the Aventine deal actually dropping more than 10% on its first day of trading last week.

History has shown that IPOs are some of the worst investments around. Just think about why this is likely the case. Companies don't sell shares to the public unless they think they can get a great price. Why are ethanol companies going public now, even though oil prices have been high for a fairly long time? Perhaps they are sensing that speculative interest in the industry is at elevated levels and they want to take advantage of that.

The fact that many deals, including J Crew, are being brought to market by private equity firms is another red flag. These buyout firms bought companies years ago when prices were depressed. Now the so-called "smart money" is selling their stakes to the retail investor via IPOs. Which side of that trade do you think is going to come out on top?

Of course there will be exceptions, but I would caution investors to be careful when venturing into the IPO market. There is a reason why someone has decided this is the right time to sell. With initial public offerings having been relatively poor investments over time, make sure you pay attention to the stock's valuation, not just what company you are dealing with.

The Great Independent Research Debate

There is a very simple reason why Peridot Capital does its own research; there are very few people I trust more than myself to implement my investment philosophy. As much as so-called "independent" research claims to be such, experienced investment professionals know that research is often far from independent. All you have to do is ask yourself, is there reason to believe that this research is independent?

In the case of a buy-side firm like Peridot, there is every reason to believe that our research is independent because it is solely used internally to make investments on the behalf of clients. If clients do well, the company will prosper, and if they do poorly, clients will leave.

But what if a company doesn't manage money? What if they are solely in the business of selling research? Do they have to be independent? What is keeping them from doing whatever it takes to sell the product? After all, selling research is their only line of business. It's the same reasoning that some journalists print things that might not be completely accurate. They are in the business of selling papers, or magazines, or whatever their product is. How do tabloids stay in business? Is it because their stories are always accurate? No, it's because people buy them.

I decided to write this piece after reading a transcript of testimony given by Kim Blickenstaff, CEO of Biosite (BSTE), a small medical diagnostics company based in San Diego. Her testimony was part of a Senate Hearing this week entitled "Hedge Funds and Analysts: How Independent is their Relationship?" Below is an excerpt:

"In the ten months from February to December 2002, the number of shares [of Biosite] controlled by short sellers increased from 690,000 to 7.1 million shares, which represented nearly 50% of our outstanding stock.

During this same period, Sterling Financial Investment Group, a Florida-based research firm, issued at least seven negative research reports on Biosite, each carrying a Sell/Sell Short recommendation, and an $11 target price. We believe that these reports contained numerous inaccuracies or false and misleading statements, which ultimately lent volatility to the stock's performance, thereby harming many of our long-term, fundamentally-based investors."

There are many issues I have with this testimony from Biosite's CEO.

First, short sellers do not "control" shares of stock. They borrow shares from other investors and immediately sell them in order to raise cash proceeds. The investors who have sold the stock short no longer control the stock, they simply owe it to someone, and will have to buy it back at some point in the future to repay the loan.

Second, Blickenstaff claims that negative research reports issued by Sterling between February 2002 and December 2002 were successful in "harming many of our long-term, fundamentally-based investors." This is interesting given that Biosite stock was $18.37 on February 1, 2002 and closed December 31, 2002 at $34.02 per share. So, even as the number of shares sold short increased more than 10-fold, the stock price soared by 85 percent. How exactly long-term investors in Biosite were hurt by this I'm not exactly sure. Sounds like these types of investors should beg short sellers to target their stocks!

What can we take away from all of this?

One, short sellers do not cause stock prices to go down. If a stock can rise 85% as half the outstanding shares are being borrowed and immediately sold, such as argument is easily discounted as silly.

Two, independent research is not always independent. Merely listening to Sterling's negative view on Biosite stock (which did prove to be inaccurate) would have lost you a lot of money if you were in fact a long term investor who wanted to "invest" (versus "trade") in BSTE shares.

Three, if you are an "investor" then you should, by definition, have a long-term view. Traders focusing on the short term probably were hurt by these negative research reports because they likely caused a quick drop in the stock price upon being published. In the short term, any kind of report can influence stock prices, accurate or not.

Over the long term, however, company fundamentals will matter above all else. Since the research Sterling published turned out to be incorrect, the stock price went up, not down. That is why someone who bought the stock in February before all the short sellers and negative reports came out of the woodwork, and held it throughout all of this sketchy behavior, would have made 85% on their investment in less than a year.

Hopefully you can see why people should do their own research and invest for the long term. If your analysis proves accurate, you will make money, no matter whatever anyone else out there is doing. That is the philosophy I use when managing my clients' money, but it is valuable for anyone who doesn't want to be adversely affected by the inherent conflicts of interest on Wall Street, whether you are a Peridot client or not.

Will Bernanke Throw Investors a Bone?

We know that interest rates hikes work with a lag, so it takes 6-12 months for the effects to ripple through the economy. We know that we've had 16 straight rate hikes that has taken the Fed Funds rate from 1% to 5%. Shouldn't Chairman Bernanke and the FOMC take a break, and see how the two-year long rate-raising campaign affects everything?

That's the case for the Fed to quit. I'm in that camp, personally. It's not like the Fed can't raise rates whenever they want to anyway. If they pause for a month or two and regret it, you can always go back and raise some more. Would such a plan have any drastic repercussions? I doubt it. And let's not forget, even though the market gets on a regular timeline with the FOMC meetings, Bernanke and Co. can move between meetings if they need to.

The way I see it, the stock market has stabilized after getting down to S&P 1,225, 8% below the highs. It has a little room to rebound, given the chance. If we get more of the same later this week from the Fed, and by that I mean a 25 bp hike and a similar statement to recent ones, equities will have a tough time to hold current levels. Uncertainty is always bad for stocks. If we get a signal that this hike is the last one for a while, I think can get a brief rally that might get us to back close to 1,300 on the S&P 500. At that point, I'd probably do some selling.

Another less likely option, but a good one nonetheless, would be to move 50 bp this week and signal a pause. This would satisfy both those looking for a hawkish stance on inflation, as well as a pause to observe the ultimate effects of all of these hikes. I think the market would rise in this scenario as well. I hope Bernanke decides to take a wait and see approach, but we'll just have to, well, wait and see.

My Take on Mark Cuban's Latest Venture

In case you haven't heard, billionaire entrepreneur and owner of the Dallas Mavericks, Mark Cuban, has caused quite the commotion by announcing his latest venture, ShareSleuth.com. The site, which will debut next month, will be a blog-style investigative reporting site that will focus on exposing corporate fraud. The site will be edited by Christopher Carey, a long time business reporter who recently quit his job at my hometown paper, the St. Louis Post-Dispatch.

Sounds pretty cool, right? Well, all was well and good until Cuban disclosed that not only does he plan on investing in the site, but he also will be taking investment positions based on what the investigations uncover. He plans on disclosing all of his investments, but will make the trades after the research has been done and before the site publishes its findings.

Given the controversial nature of most of what Cuban says and does, it's not that surprising that many are outraged at this idea. However, let's calm down and analyze exactly what is going on here. Then we can decide if what Cuban plans to do is illegal (it's not) or perhaps unethical.

This company is going to investigate individual companies and the people behind them. If something fishy is uncovered, Cuban might make trades based on this information (presumably by shorting common stocks). Then the research will be published on ShareSleuth.com and any positions Cuban has will be fully and properly disclosed.

Now some might be up in arms that Cuban will be in a position to short a company's shares prior to his editor publishing the negative research to the public. Let's think about this for a second. How is what Cuban plans to do any different than a hedge fund, pension fund, or mutual fund manager coming on CNBC and talking about what stocks he or she likes. The manager has previously conducted in-depth research, come to a conclusion, traded the stock, and come on the air to explain and disclose the position.

I really don't see how ShareSleuth.com will be any different than someone from Goldman Sachs recommending a stock on CNBC. In fact, investors should be happy that there will be a new place to find negative research on public companies. Most of the time everybody is telling you what investments to buy because they are in the business of selling investments.