Tom A's Stock Picks

Convergys (CVG) outsourcing may beneift from economic slowdown

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Convergys Corp (CVG) does outsourcing in customer management, information (billing) management, and HR management, 64%, 28%, and 8% respectively. They have some customer concentration in communications and have experienced some customer loss due to consolidation. This may continue in the future. However, the stock is very attractive on its valuation metrics and 2008 guidance portrays adequate growth. Furthermore, outsourcing becomes attractive as economic conditions create cost pressures, and their CEO was optimistic on this basis during the last conference call. The company has increased its sales force and their pipeline is up. This type of concrete talk about how growth is going to be created is appealing to me.

At Friday's closing price of 14.40, this trades at a P/E of 11.7, well below its industry, the S&P 500, and its own 5 year average. EPS Guidance for 2008 is 1.31 to 1.36, so the forward P/E based on guidance is 10.9. Growth, based on EPS guidance, will be 8% next year. This is right around the 7% which John Neff notes, gets no respect, but adds up over time. The balance sheet is healthy.

By segment, the Customer Management (the largest) is on target, to judge by guidance. Information Management needs expense rationalization, which is in progress, and margins are ample. HR Management, the issue is implementation - from my own experience, this activity can be complex, and they have had some difficulties with implementation timeliness and cost. They have made it a good way up the learing curve and are selecting new business which falls within their capabilites. Guidance limits their loss from this activity to 15 million.

I recently added this stock to my SLO portfolio, a small position, and I intend to add to it as circumstances permit. From more or less 15, I see a price target of 22.50 within a year, based on a P/E of 17 X EPS of 1.33 = 22.50.

Tom

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Computer Sciences (CSC) Cost reductions and share buybacks

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Cost reductions and share buybacks should generate higher EPS.

Computer Sciences Corp (CSC) is a large IT service provider. At 43.45, it currently trades at a P/E of 12.6, well below both the industry average (20.5) and its own 5 year average (21.1). I have followed it for several years - it was in S&P's Platinum Portfolio and I decided to track it due to the indications of good quality. They have been restructuring over the past year or more, moving operations to lower cost areas. A large amount of their business is long term contracts, so if costs can be reduced profits should increase. This is another 7% a year growth story, it gets no respect but adds up over time. Share counts have decreased in recent years due to buyback activity.

Cash flow is interesting, CSC trades at 5 X Cash Flow, vs. an industry average of 13. I compute a statistic, Earnings as a % of Cash FLow, in this case it seems to run somewhere around 25-40% year after year - most companies its more like 70-80%. Always good to receive cash but not report earnings, as it reduces taxes and the cash can be put to good use.

Taking all of this together, and projecting based on historical average margins and growth, which may be conservative, I get EPS 3.80 x P/E 16 = 60 per share within one year. I recently added this to my SLO portfolio, a small position, which I can add to as circustances permit.

Tom

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Applied Materials (AMAT) as a solar play

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Applied Materials just announced a 1.9 billion sale of equipment for multiple solar factories to be constructed by the buyer. I bought AMAT early in SLO1, and still hold it, based in large part on its potential in solar.

The thinking was, that AMAT has huge resources in terms of capital and R&D to bring to bear on the solar field. An investment in AMAT is more attractive than multiple investments in IPOs or high priced popular Chinese Solar stocks which is kind of a guessing game who the winners will be.

It's like the California gold rush, the people who made money were those who sold to the miners, picks and shovels, blue jeans (Levis), etc. AMAT supplies the factories for the solar gold rush, very similar to what they have been doing in the semiconductor industry and the flat panel (TV) industry.

The 1.9 billion would be an additional 20% of their TTM sales. It will take a while to be delivered and accepted, but the stock price should increase as the market starts to price the growth in solar into the stock. The last earnings conference call featured quite a bit of enthusism about solar, assertions that it is "ramping." 1.9 billion sounds kind of rampant.

AMAT is up 4 or 5% on the news. There is no need to rush, given this will take years to play out, but I will hold my position and look to add to it. With the stock at 19.xx today, I think it has 35 in it somehwere in the next year to two years.

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Bond insurance update - ABK & MBI

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Last week, Ambac raised additional capital by offering common stock and equity units. Dilution was severe, and in recomputing adusted book value/share that number went from 55.20 to about 20 after the offering. The stock traded at 8.xx most of the day Friday. I was disappointed as I thought that the recapitalization could be done by less dilutieve means, such as a soft capital arrangement initially funded by the bank counterparties. Guess again. S&P and Moody's reaffirmed ABK at triple A with negative outlooks, and Fitch announced that their review was continuing but that they did not believe either ABK or its competitors could enjoy stable ratings until they capped their CDO exposures.

Fitch is continuing its role as the aggressive enforcer of capital requirements for triple A rating.

MBI asked Fitch to withdraw its ratings, which were under review. The reasons initially stated publicly were bland. However, MBI wrote privately to Fitch and explained quite clearly that Fitch's rating methods did not produce stable ratings and that FItch's capital requirements for SF were roughly twice those of S&P or Moody's. In addition, MBI questioned the benefit of Fitch's rating because Fitch is not a major presence in the Structured Finance rating business. Fitch responded by publishing MBI's letter and writing back in a tone that can only be described as catty, for instance, implying that MBI didn't have the funds to pay FItch's fees and questioning MBI's good faith. The exchange is available on Fitch's website, and is getting some press attention.

My take on it is that Fitch's model responds excessively to certain unspecified inputs, and that the inputs, and specifically the worst case scenario, just keep getting bigger, so that it is not possible to make a capital plan based on FItch's requirements, because they keep escalating. Fitch's views make implementation of a split between structured finance and public finance difficult, because they are so very different from what S&P and Moody's requrie. In the split, according to Fitch, much more capital needs to be allocated to the structured finance. Fitch is in the process of making themselves irrelevent. I support MBI's action.

What to do with my holdings? I continue to believe that the stock of both companies is undervalued. However, the prices at this point are totally news driven, and have been up and down 20 to 30% over very short periods of time. Coming months will see a continuation of this process as the FOMC meeting, earnings, mortgage default news, and various rating and regulatory pronouncements will contribute to volatility. Full recovery of share prices may be painfully slow. Under the circumstances, I will start reducing my positions if and when good news causes them to rally. The funds can either be invested in other opportunities or reinvested in ABK and MBI the next time they tank.

Those few of you who read my blog know of my concerns about the moral hazard created by credit default swaps that are not supported by an insurable interest. I wrote a letter to the editor of Barron's, along the lines of what I have put in my blog, and it was published March 3. I was pleased that I was able to get my views in front of a larger audience. I have been on a letter writing campaign, presenting my opinion to industry participants, legislators, financial publications, and regulators. I wrote to Governor Spitzer a couple of weeks ago, words of wisdom on moral hazard, of course judging from today's news it wasn't somthing he wanted to hear about...

Tom

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Unwelcome Guests - Risk, Volatility, Margin Calls, and Loss

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Here we are, guests at a Stockpicker's party. At a country estate, on the carefully landscaped grounds of a newly built mansion, we are enjoying a pleasant gathering, chatting with old friends, sipping a drink, munching on various delicacies, strolling through the spacious formal gardens. I forget who our host is, it doesn't really matter, there's plenty of good food and a truly wonderful spirit of companionship and camaraderie among all concerned. Day Traders, Active Traders, Swing Traders, Investors, Speculators, Brokers, Analysts, Gurus and Guru wannabees - everybody is having a good time.

Suddenly a cloud comes over the sun, the day grows noticeably darker, and we hear a whispered rumor: "unwelcome guests, uninvited, they are crashing the party." The first to appear is Risk, perhaps you have seen him on TV lately, bleary-eyed and with a sallow complexion, he keeps sneaking around, insinuating himself into the conversation, slyly sabotaging all the arrangements. He saunters over to the punchbowl and surreptitiously spikes it from a small flask he carries in his pocket. Soon his cousin Volatility arrives, built and dressed like a professional wrestler, he drains the bowl in one long swallow and then starts picking fights and tipping over the tables, smashing glassware, hurling plates and saucers at everyone.

Then comes Call, not the pleasant fellow who always hangs around with Put, but Dr. Margin Call. When Margin calls, people listen - they have no choice. With a rueful grimace he informs his victims of the precarious state of their financial health, and prescribes his remedies - purging and bleeding. The last unwelcome guest is Loss, mournful and lugubrious, like an undertaker come to lay to rest our fondest hopes of quick profit, not to mention our legitimate aspirations to financial security.

Can't we do anything about this? Where is our host, surely he can have this riffraff evicted - he can call the authorities and restore order. We will send them back to where they came from and continue with our party, none the worse for the temporary interruption. Alas, our host is the renowned architect of financial disaster, Professor Leverage. A gifted man, incredibly inventive, but he sometimes overreaches himself. Some even question his sanity. Our unwelcome guests are his offspring, and he is powerless to make them leave. As we look on in horror, his mansion, in reality nothing more than an elaborate house of cards, collapses in a cloud of smoke, which billows upward and eclipses the sun...a flock of financial vultures circles overhead...

But wait! Isn't that a helicoptor I hear? Perhaps Ben will come to the rescue.

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Bear raiding - an old Wall Street game

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Looking at the recent demise of Bear Stears, it looks like several billion dollars of value was extinguished overnight. The share price plummeted from 80 (the approximate book value per share) to 2 in a matter of weeks. But what really happened was a rapid transfer of wealth, from the shareholders of BSC to other market participants, JP Morgan for one. The other beneficiaries are harder to define - the stock was not heavily shorted, at least at the last available report.

Rumors became self-fulfilling and Bear Stearns was gone. With all markets linked by electronic quotes, and everybody connected by cell phone, email, etc., it doesn't take long for word to spread. Lehman was luckier, they fought rumors of their own demise in hand to hand combat yesterday and they survived. The fact that the Fed was standing ready to hand out loans on all sorts of collateral was instrumental in stopping the run on the bank.

I think a lot of the wealth was transferred to those who planted the rumors. Bear Stearns was leveraged, as all financial companies are, but they had a reserve of cash that would have been more than adequate under normal conditions. It's like a card castle, you have to pull a card out. Presumably some group figured out where to push or pull to bring down the structure. That's right, I have a conspiracy theory. When things are so sudden, when the crisis just has to be resolved over the weekend, when the survival of the world as we know it is at stake - watch your wallet.

The implications for the ordinary investor like you and me are simple. It is very important to diversify because other targets will be found and you don't want to be holding too much of any one target. Companies that have a vulnerable capital structure should be avoided. Companies that may need capital infusions are to be avoided: that prey is reserved for others.

Too bad Elliot Spitzer isn't around to do an investigation. Maybe Wall Street wanted to stage a fitting celebration of his downfall.

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Goldman Sachs, Bear Stearns and Black Swans

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I want to talk about Black Swans first. "Black Swan" is a phrase popularized by Nassim Nicholas Tasseb in his book "The Black Swan (The Impact of the Highly Improbable)." It's a fascinating book, somewhat uneven, but worthwhile reading for investors or others concerned with potential catastrophes. His point is that life is characterized by occasional high impact events that are highly unlikely and almost impossible to predict. He notes that many of the outcomes in life just don't fit neatly into a bell shaped curve. Examples of black swan events would include the market crash of 1987 and the 9/11 terrorist attacks.

The implication for investors is that certain financial activities or transactions characterized by a very low probability of occurrence together with a very large size of loss/gain create a vulnerability to black swan events. As an example from the crash of 1987, options trader Tony Saliba had hedged himself, months in advance, with out-of-the-money-puts on the S&P index. When the totally unexpected occurred, he was protected. For those who sold him the puts, the outcome was less fortunate. In today's market, with massive amounts of derivatives outstanding, many of which are not fully understood, as well as other examples of excessive leverage, outcomes well outside the range of normal expectations are possible.

The demise of Bear Stearns is a small scale example of this type of occurrence. (For those who had their life savings in the stock, maybe it is not so small scale.) I habitually, and wrongly it would seem, regard a stock's range of potential prices as a lognormal distribution. The options market implicitly relies on this assumption. But the sudden plunge of Bear Stearns from 30 per share to 2 is simply outside the realm of this type of probability thinking. Those who bought and sold puts in the days and hours before the plunge were enriched or impoverished accordingly and disproportionately.

With that for a preface, on to a discussion of Goldman Sachs.

This large investment bank has done well during the sub-prime meltdown, having sold mortgage backed securities to their customers while at the same time betting against them by means of credit default swaps. Not beautiful ethically but it is effective economically. Their reputation as I perceive it is that they are very, very clever.

In any event, I prepared my workbooks on GS and find that it is trading very low in its normal range when compared to either 5 year average earnings or book value. GS has traded in a range of 1.3 to 3.1 x tangible book over the past seven years, and currently trades at a multiple of 1.5. You could have made money any year during the past 7 by buying the stock at less than 2 x book and selling it for more. So, in my happy world of normal distributions, this qualifies as a buy. Of course the question comes up, what if GS suffered a fate similar to Bear Stearns?

I went over the financial statements and in particular the balance sheets, looking at liquidity and so on and so forth. Liquidity should be less of a worry now that the Fed is standing by to lend money on less than first class collateral. What I did see was that their balance sheets carry a large amount of more or less offsetting derivative liabilities and assets or short and long positions. Presumably there is a lot of hedging going on. If some of the hedges are not fully thought out, problems could ensue. The whole thing is kind of a black box, earnings come out, but it's not fully transparent. I experienced the same reaction when I tried to analyze Citigroup (C). Buying any of these type shares is something of an act of faith.

On balance, I would tend to bet in favor of these clever people, but I would keep position size modest in case they outsmart themselves. Because most market participants have been thoroughly scared by recent events, it is likely that a lot of the excessive leverage and derivatives will be unwound over time, and that risk management will be tightened up. That plus an economic recovery would make GS very attractive over the long term.

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Homebuilder Review

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I have a small position in homebuilders in my SLOport, and have been watching in wonder as they have rallied. Ryland (RYL) shows a gain of 35% since I opened it; Toll Brothers (TOL) is up 21%. I took some profits in early February, and now today's WSJ has an article suggesting that the rally in Homebuilders is fueled by short-covering, and probably won't last long. Short interest on RYL is 29.43% of the float; for TOL, it's 16.55%.

I have been using Price/Tangible Book as my value metric. When I opened the positions in August last year, I paid well less than 1 x Tangible book, but with write-downs and share price appreciation P/B is 1.25 for RYL and 1.11 for TOL. I blogged a while ago about what I call phantom book value - the idea being that assets that have been written down can be sold at a profit, essentially reversing the write-downs and making earnings look better than they would otherwise. After a big bath quarter, which we have seen for homebuilders, things could look up from there forward.

Initially I had shares of PHM, CTX, RYL, TOL and KBH, but I elected to concentrate on RYL and TOL because I think their balance sheets are stronger. Guesstimates about future earnings, if and when the housing market improves, are inconclusive. Various commentators suggest homebuilders rally 6 months or so before a recovery becomes evident.

I live in Wallingford, CT and a mile or so from my home a developer is putting up 65 new houses. Shopping for houses, north of Boston, my wife and I have not seen any big bargains. From my own experience, things don't look that bad. I asked Dave Bigos (Duff Beer), who is in real estate in the Midwest, and he says it's slow and he doesn't think it's going to get better any time soon. Recent news reports are not particularly encouraging, although the latest report on sales of existing homes showed an increase month over month, fueled by a reduction in average price. The market reacted favorably to even that glimmer of hope.

Today's new home sales report was inconclusive at a seasonally adjusted annual rate of 590,000, down 1.8% from the upwardly revised January rate of 601,000 (was 588,000) and down 29.8% from February 2007. Median price was 244,100; average was 296,400. Supply of 471,000 is 9.8 months at the current rate. The HGX index was off 2% shortly after the news.

In my personal portfolio, I have been selling straddles against my homebuilder positions. At a recent low point on 3/14, I sold out of the money puts, and over the past few days, following a decent rally, I sold out of the money calls. With volatility high, premiums are good, and the stocks can't go both directions at once. Over the long term homebuilders have increased book value 15 to 20% per year, trading at modest P/Es, and I believe that trend will resume, but can't say when. Under these conditions, I think it makes sense to harvest volatility premium while adding to my positions at low points, which the straddles should achieve.

In SLO, options are not permitted. The equivalent tactics would be to sell on the rallies and attempt to buy the shares back on the dips, with a long term goal of accumulating a decent size position before the housing market goes into a definite recovery. Eyeballing a 3 month chart on either TOL or RYL I see a succession of lower lows, followed by highs more or less the same or slightly higher. Because my positions are relatively small, I will hold and look to start adding if I see a 15% or better decline from recent highs, or to sell if they make new highs.

My guess is that Homebuilders will trade in a range with high volatility until August/September. By then, the long term prognosis for housing should be clearer; I believe it will be favorable, and hope to get my positions up to full size before the 4th quarter.

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