Sears, Urban Outfitters Smart to Consider Rival Bids for J. Crew

According to reports out of Bloomberg today, J. Crew Group (JCG), the upscale clothing retailer run by former Gap CEO Mickey Drexler, could receive competing buyout offers from the likes of Sears Holdings (SHLD) or Urban Outfitters (URBN). J. Crew has already agreed to a private equity buyout for $43.50 per share in cash, but the deal included a "go-shop" provision,which allows the company to solicit higher bids until January 15th. This Bloomberg report signals that other parties are indeed interested to some degree.

I have been following the situation closely because J. Crew is a current holding in a portfolio I manage for Peridot Capital on Wealthfront. Normally with the stock of an acquisition target trading less than 1% below the agreed upon buyout price I would have long sold the stock, but the price J. Crew accepted made me hold on with hopes of another offer. JCG agreed to sell out for less than 7.5 times trailing cash flow, which may be in line with their peer group, but JCG is not just an average run-of-the-mill retailer. The company's upscale apparel, coupled with the merchandising abilities of CEO Drexler, make the company a very hot commodity in retail. The original purchase price of $43.50 seemed low to me, given that one would expect a buyout to fetch a premium price for such a wonderful asset within the retailing arena.

As a result, the Bloomberg report that other retailers are poking around and weighing offers should not be overly surprising, but the two parties mentioned are very interesting. Sears, you may recall, was taken over by Eddie Lampert in a move widely expected to result in him diversifying away from their legacy Sears and Kmart stores. Investors (myself included) were excited about the potential for Lampert to siphon off cash flow from Sears' retail stores and expand into other areas with better growth prospects, but became disgusted and bailed on the stock after he did very little to move away from those two chains. Other than a bid for Restoration Hardware several years ago, Sears has squandered an opportunity so far but perhaps their interest in delving into J. Crew's books signals a much needed shift in strategy. Not only would J. Crew give Sears a new upscale brand with much more growth potential, but the company's lower end J. Crew factory outlet line could sell quite well in Sears and Kmart stores, which would boost J. Crew's reach almost immediately.

Interest from Urban Outfitters is also interesting because it would fit in with the company's Anthropologie stores as an upscale brand with a middle age target consumer. Rather than building new brands from scratch, which is what Urban has chosen to do in the past, buying an established company like J. Crew (and getting Mickey Drexler) would really mesh well with the company's image and overall direction in the industry.

While there are no assurances that a rival bid will actually emerge in the next 10 days or so, this story is certainly one to watch. Not only could a company easily justify a purchase price 10-20% above the $43.50 that J. Crew has already accepted, but in the case of the specific companies rumored to be sniffing around, the strategic fits are quite obvious, which cannot always be said in the world of M&A.

Full Disclosure: Long shares of J. Crew and Urban Outfitters with no position in Sears at the time of writing, but positions may change at any time.

Least Surprising Prediction for 2011: Wall Street Strategists See Market Rally of 10%

According to data compiled by Bloomberg from twelve of Wall Street's largest investment banks, strategists expect the S&P 500 index to rise by about 10% next year, which would mark the third straight year of double-digit gains for U.S. stocks. Their figures, based on operating earnings in the low 90's for the broad index, equate to a year-end P/E of about 15 times, in-line with the market's historical average.

Investors well-versed in market history may not feel like these predictions are all that interesting. After all, the market averages a 14-15 P/E ratio over the long term, and the mean return for the S&P 500 since it was created is about 10% per year. These Wall Streeters are clearly not going out on a limb with these estimates, which is hardly surprising given their nature to hedge their bets in an effort to protect their jobs (by rarely differing very much from the consensus view).

Since consensus viewpoints typically will not make us money, it is helpful to think about whether the odds are that the market does better or worse than these predictions. Personally, I would guess the odds are better that we see single digit returns in 2011, as opposed to a better-than-expected gain. I say that because P/E ratios are unlikely to rise given that interest rates are headed higher. Couple that with the fact that analysts consistently overestimate forward earnings growth (by a factor of nearly 2 times). A long term study by the consulting firm McKinsey has found that long-term earnings at public companies grow by about 6% per year on average, versus projections by industry analysts of 10-12% heading into any given year.

All in all, U.S. stocks are far from overvalued, but with strong earnings growth in 2011 already expected and a ceiling on multiples seemingly close by, returns in the year ahead should be decent but not fantastic, especially given that we are coming off two above-average years in a row for the U.S. stock market.

Deficit? What's Another $1 Trillion Among Friends?

So much for having any optimism on the budget front after a bipartisan majority voted for a sweeping plan that would cut the deficit to 3% of GDP by 2015 and balance the federal government's books by 2025. Democrats and Republicans are gearing up to vote early next week on a nearly $1 trillion tax cut package. What's worse is that not a dime of it is paid for, so the entire cost (initially estimated by the Congressional Budget Office to be more than $850 billion over 10 years).

Given these developments it is not hard to understand why treasury bond rates are surging, despite the Fed's massive $600 billion asset purchase plan. Even with the drop in bond prices, U.S. government debt continues to be the most overvalued asset class out there (maybe with the exception of cloud computing stocks). Selecting solid corporate bonds and holding them until maturity appears to be the far better investment today, even after the strong performance we have seen from them over the last couple of years. Bond buyers better tread carefully.

After Missing The Latest Quarter, Cisco Shares Are Dirt Cheap

There is no doubt that earnings season is my favorite time of year from an investing perspective. Every quarter Wall Street overreacts to dozens of seemingly disappointing profit reports and punishes stocks in the process. For a deep value, contrarian investor like myself, it's Christmas, Hanukkah, and Kwanzaa all wrapped into one. One of this month's best holiday doorbusters has to be networking giant Cisco Systems (CSCO), whose shares have fallen 20%, from $24 to $19, after the company guided down for the current quarter.

Now, I understand that investors hate quarterly misses, especially for larger companies like Cisco whose businesses typically have far more visibility than smaller upstarts. That said, Cisco's current valuation (12x trailing earnings, 7x trailing cash flow, and 11x 2011 profit estimates) makes it seem like this company is barely growing at the rate of GDP. That does characterize some mature tech forms such as IBM (IBM), which only grows sales at 3%-4% and also fetches about 11 times earnings.

Despite recent softening in some of their businesses (especially sales to governments), Cisco is still growing sales and earnings at double digit rates and should continue to do so. This is a classic case of getting to buy a company that is growing faster than the S&P 500 at a discount to the market's overall valuation. Not to mention that Cisco is a leading company in an excellent and highly profitable industry. I would be quite surprised if Cisco shares didn't reclaim all of the recent losses sometime over the next 12-18 months.

Full Disclosure: Peridot Capital was long shares of both Cisco and IBM at the time of writing, though positions may change at any time.

Finally, A Concrete Income Tax Simplification & Reform Plan That Makes Sense!

Continuing the post from yesterday about the ideas put forth by the co-chairmen of the Obama Administration's deficit reduction commission, I skimmed through the 50-page presentation (you can do the same here if you would like to) and there is a lot to like in it. One of my favorites is a real, well thought out plan to simplify the U.S. income tax code. I mentioned in my last post why I think the mortgage interest deduction is ridiculous, but the whole code is too complicated with so many brackets, schedules, and deductions.

One of the things that bothers me the most is that income is taxed differently depending on how you earn it. Shouldn't a dollar of income be considered a dollar of income, regardless of whether you are an employee earning a fixed salary, a CEO who cashes out stock options, a retiree who lives off of dividend payments, or a hedge fund manager who trades stocks for a living? Our current tax code essentially tells us that certain ways of earning a living are better than others by rewarding them with lower tax rates. It doesn't make sense that George Soros or Warren Buffett should ever be in a lower tax bracket than their secretaries, but today they are.

But maybe there is hope. The co-chairs of the commission put forth three options for fundamental simplification of the tax code and one of them really stands out to me. They propose eliminating all tax deductions, treating all income as ordinary income (rather than having dividend income and capital gains income be taxed at lower rates), reducing the total number of tax brackets from six to three, and best of all, dramatically reducing income tax rates for everyone to make up for the loss of deductions.

Here is the slide in the presentation that summaries this option:

As you can see, we are left with three individual income tax brackets (8%, 14%, and 23%) along with a reduction in the corporate rate (which will serve to boost stock prices and declared dividends).

Does anyone else think that treating all income the same and taxing it at 8, 14 or 23% makes a lot of sense? I know people will have to give up their standard deduction or several itemized deductions (such as mortgage interest and charitable donations) but look at those rates! Not only would it be hard to argue that the government was taxing us too aggressively, but without deductions you can bet that your tax return will be confined to a single page and take a lot less time to prepare. And most importantly, this recommendation is included in a comprehensive plan that reduces the deficit to 2.2% of GDP by 2015 and eventually balances the budget.

I know it will never fly with the politicians but I am going to hold out hope anyway as it is exactly the kind of plan that I would create if given the power to do so.

Bipartisan Deficit Reduction Commission Brings Some Sanity to Budget Debate

According to a story from the Associated Press, it appears that President Obama's bipartisan deficit reduction commission is ready to bring some realism and logic to Washington on ways to reduce the federal budget deficit. Of course, the odds that politicians will support these ideas are low since they have proven lately that they believe in magic (on one hand calling for deficit reduction while on the other refusing to support entitlement spending cuts or tax increases -- both of which are needed to balance the budget).

Not all is lost though, according to this AP story. I say that because the recommendations being put forth by the two leaders of the commission (one from each party) are exactly the kinds of budget cuts that we should be talking about. Social security and defense spending together account for about 40% of government spending, making it imperative not to deem those areas "untouchable." I was also happy to see that they mentioned farm subsidies and the mortgage interest deduction as other areas of focus.

While the mortgage interest deduction is a tough sell politically (if eliminated it would hit the middle class), it costs the United States about $100 billion per year and makes little sense from a policy perspective. In a day and age when many Americans believe that Washington, DC is spending money unnecessarily, why should the federal government help us out with our mortgage payments? Really, that is all the mortgage interest deduction is, the federal government reimbursing you for a portion of your mortgage. There is no reason whatsoever for a government running annual deficits of over $1 trillion to be paying some of people's mortgages.

Let's cross our fingers that the new Congress, filled with people who got elected by campaigning on deficit reduction, actually deliver on their promises and support some of the commission's recommendations, because if they don't real cuts will be impossible.

Earnings Growth Does Not Predict Stock Market Returns

Lots of readers are writing in to question my assertion that the stock market does not track corporate profits or GDP. They seem upset to learn that if you can correctly predict GDP growth or earnings growth in the short term that you can't also predict the direction and magnitude of the market's moves. The key here is that the market prices in certain expectations about the future ahead of time and then readjusts prices based on how the future plays out relative to those expectations. We cannot simply infer that, say, over the next year GDP will grow 3%, leading to earnings growth of 8%, and therefore the market will rise 8%. Markets are more complicated than that!

Here is an illustration I came up with to back up these claims (raw data compiled by NYU from Standard and Poor's and Bloomberg). As you can see, correctly predicting S&P 500 earnings growth (grouped along the x-axis) for any given year does not help predict the market's return (plotted along the y-axis) during that same year. In fact, the market does better when earnings are declining, relative to how it fares when earnings are growing by double digits. In the near future I will try and compile data that shows which figures actually have predictive value.

Political Gridlock Good for Markets? Another Common Theory Debunked

Stock markets love gridlock. This is what one would think after listening to investment pundits in the media. The thinking goes that markets hate uncertainty and with gridlock in Washington very little actually gets done, eliminating fears of new, unexpected legislation. However, a quick look at the numbers show that this theory is completely wrong.

Sam Stovall of Standard and Poor's looked at historical U.S. stock market returns under three political scenarios, "unity" (one party controlling the presidency and both houses of Congress), "partial gridlock" (one party holding the presidency and another controlling Congress), and "total gridlock" (a split Congress). The results since 1900 show that the stock market actually hates gridlock. How this stuff gets repeated so often in the financial and political media is beyond me.

Annual Stock Market Returns Under Three Political Scenarios (Source: S&P)

Since 1900: Unity +7.6% | Partial Gridlock +6.8% | Total Gridlock +2.0%

Since 1945: Unity +10.7% | Partial Gridlock +7.6% | Total Gridlock +3.5%

Record Corporate Earnings Continue to Fuel Stocks, Analysts Optimistic for 2011

According to financial data collected by Thomson Reuters, 70% of S&P 500 index companies have reported third quarter profits so far and earnings are up 30% year-over-year. This compares to estimates of just 24% growth and explains why the U.S. equity market is knocking on the door of the 2010 highs made back in April. For all of the pundits complaining that Washington DC politicians have been bashing Corporate America too much, aggregate corporate profits are actually making new record highs (second quarter earnings were an all-time record) so we have to wonder exactly how tough companies really have it these days.

As we head into 2011 analysts are expecting corporate profits to keep surging, by about 13% next year. With P/E multiples about average historically, the strength of earnings will likely dictate much of market's movement in 2011. Analysts notoriously overestimate profit growth (by a factor of nearly 2x over the long term according to studies done by McKinsey), so once again they are very optimistic about the coming year (corporate profits grow about 6% per year over long periods of time). As is usually the case, the numbers are telling a better story of reality than political and private sector commentators, which is why the market is doing pretty well despite 9.6% unemployment.

To gauge market prospects for next year, investors should continue to look at the numbers and ignore the posturing in the media and on the campaign trail. As things stand now, I would expect another gain for the U.S. equity market in 2011, but the magnitude will depend on whether the analysts are right or once again overly optimistic. That could be the difference between single digit and double digit returns over the next 12-15 months for stocks.

And on a somewhat related note, don't forget to get out and vote tomorrow.

Hiring of Todd Combs at Berkshire Hathaway Does Little to Solidify Warren Buffett Succession Plan

Maybe I am way off base on this, but given that Warren Buffett is the greatest investor we have ever seen (or even if you disagree with me, he has to be in the top few, right?) I would have expected more when Berkshire Hathaway decided to start hiring outside investment managers to eventually replace him. Given Buffett's knowledge and connections in the industry, coupled with the fact that this job opening has to be one of the most intriguing ones for a value investor anywhere on the planet, it seems as though they should have been willing (and able) to hire someone who we have at least heard of before. The addition of Todd Combs, an unknown 39-year old hedge fund manager who graduated business school just eight years ago, is not only baffling but I doubt that it instills all that much confidence for Berkshire shareholders.

Let's review some facts about Combs and the hiring process, according to an article recently published in the Wall Street Journal:

1) Combs graduated from Columbia Business School in 2002, and worked as an equity analyst for 3 years before being seeded with $35 million in 2005 to start a new hedge fund, Castle Point Management, focused exclusively on financial services companies.

2) While assets have grown to about $400 million during the five years Combs has been an investment manager, his cumulative returns over that span are 34%, less than 7% per year. Depending on the risk profile of the fund, which is unclear, this may or may not be very impressive, but it is interesting that Castle Point returned 6% in 2009 (when the S&P 500 rose by more than 26%), and in 2010 has actually lost 4% of its value (despite the S&P 500 rising by 6% during that time). Combs' five-year track record is not only extremely short, but it also doesn't scream "Berkshire Hathaway."

3) It is also interesting that Combs sent Buffett a letter in 2007 to apply for the job as Berkshire's next investment manager but Buffett was unimpressed (his resume "didn't distinguish itself" according to the WSJ article). Only recently did Combs send a second letter to Charlie Munger, which impressed Munger enough to advance the process and resulted in him being hired shortly thereafter.

To me, none of this information taken on its own can prove whether or not Combs is ready for the prime time or not. I have no doubt he is a very smart guy and his personality seems to fit with Buffett, Munger, and Berkshire well. His focus on financial services is important as Berkshire has a large insurance operation and invests in a lot of banks and other financial companies. That said, if I were a Berkshire shareholder I would be asking why this is the best they could do. Hiring an young, unknown fund manager with a five-year track record seems risky given how many more well known, established, and proven people are out there and would likely have been honored to join the Buffett team. In the case of Combs, it will be years before we find out exactly how good he is at picking stocks and managing tens of billions of dollars.

Full Disclosure: No position in Berkshire Hathaway at the time of writing, but positions may change at any time.