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October for me brings up harvest themes as we head toward Thanksgiving. Investing to me is more like farming than hunting or fishing. Over the course of the year, I plough through analyst reports, financial statements, press releases, Excel spreadsheets and the like, tending to my investments and looking forward to harvesting a profit as the seasons pass. I start reviewing my portfolio to see how the year is turning out. Am I beating the indexes? Do I have winners or losers that need to be cashed in? Should I put the crop in the barn, before some economic storm destroys it, or leave it in the field?
Over the next two weeks, I see two important questions that will be partially answered - 1) sustainability of margins and 2) sub-prime/credit crunch consequences. October has been a crossroads month in the past and will be again this year.
Earnings will take center stage, with particular emphasis on margins. Because the economy has slowed, revenue increases will be modest, so that if EPS are to grow at all, margins need to hold steady or increase. If most companies are able to maintain margins, I look for a steady increase in the market up to the end of the year. On the other hand, if margins in the aggregate seem to be thinning out, I expect a short, sharp correction. I use 17% for planning and hedging purposes, and I expect that steady growth, dividend type stocks will outperform in a flight to security and predictability. Following the correction, if any, I look for fairly rapid recovery.
Also, the big question - who's holding the bag on the sub-prime/credit crunch debacle - will be further clarified. Today I read an article in the WSJ about Citigroup and the coalition that is being developed to rescue the SIVs. SIVs are off balance sheet entities that have been borrowing short term and using the proceeds to invest long term in CDOs, MBS, ABS etc., the whole caldron of toxic alphabet soup. If they are forced to liquidate at fire sale prices, serious consequences could follow: such as the requirement that the SIVs appear their sponsor's balance sheet. Citigroup's exposure was as high as 100 billion and has been reduced to 80 billion.
Financial guaranty insurer Ambac (ABK) pre-announced a loss of 3.50/share because of mark to market losses on CDS and their shares went up on the news. The similar MBIA (MBI) went up in sympathy. Citigroup's (C) shares went up when they pre-announced their earnings shortfall, caused in part by sub-prime exposures. Based on this market action, I suspect that in the aggregate Financials have been discounted more than their sub-prime exposures would require. As this is clarified, Financials could stage a relief rally, pushing the market higher. Again, if anything too scary comes out of the woodwork, it could precipitate or contribute to a correction.
To bring in Duff Beer's question on the 2008 Election, some of my optimism that the correction, if any, will be followed by a quick recovery is based on the Presidential Election year cycle. Basically, the market normally makes a large gain during the election year, fueled by the incumbent party and their competitors doing everything possible to make the economy run smoothly and curry favor with the electorate. Politically popular solutions to current economic problems will probably leave future generations or the prudent, industrious and thrifty to foot the bill: but, for now, we will muddle through.
The FOMC meeting later this month will shed light on the election cycle theory. Another reduction would argue strongly that is going to apply this time around.
In my SLO portfolio, I am holding 15% or more in cash, as a reserve for buying opportunities. In August there was a lot of over-reaction as the market declined, and October's earnings reports will provide more of the same. As an example, consider Sheldon Feinstein's blog on the 10% punishment in Fastenal (FAST) for a one cent miss. Some of these opportunities may not last that long, which will place a premium on being able to absorb and interpret new information quickly.
On my existing portfolio, as earnings come in, I will be looking for confirmation that my opinions are correct. I am not very demanding in looking for earnings to meet expectations to the penny, but I do look for financial results that are consistent with my impression of the long term potential of the company. I have two stocks in my SLO portfolio where I have above average expectations - BJ Services and Olin, both of which will report 10/30.
BJS is an oil & gas service provider, operating in 4 segments. After listening to management's presentation at the Lehman Brothers CEO Energy/Power Conference in September, and reviewing their segment information, I think they have room to increase margins in International Pressure Pumping and that they will be able to limit the decrease in US/Mexico Pressure Pumping margins by more careful pricing. I will be checking their earnings report to see if results support this thesis and adding to my position if they do.
OLN operates in three segments, Olin Metals, Winchester & Chlor-Alkali. I think their recent acquisition of Pioneer (PONR) will increase the profitability of their Chlor Alkali operation due to cost savings and synergies. Also, I think that production capacity in Chlor Alkali is pretty well matched with demand for the next few years, so that they will not suffer the normal loss of pricing power in a slowing economy. Again, I will be watching earnings and listening to the conference call to see if results are in line with my expectations.
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