The Price is Light: Market Weighing a Skinnier Load

There is a famous American game show, The Price is Right, during which contestants attempt to guess the correct price of a certain item. The winning contestant guesses closest to the true price. A somewhat similar game is occurring with the stock market’s financial companies. However, rather than observing a familiar item and guessing the price based on a few simple known variables, many complicated and obscured variables affect the true value of financial companies.

Let’s attempt to play a simulated version of this game with the headlining stock Lehman Brothers Holdings Inc. (LEH). A little over a year ago, LEH was trading near $80 a share. The company was coming off a multiyear bull run and was profiting from investments related to the strong real estate market, the roaring global boom, and tons of private equity deals and IPOs. The market looked at LEH’s financials and imagined every investment providing superior returns, the global boom spiking without fail, and the deal flow continuing ad infinitum. Although none of those projections were connected to reality, they were included in the stock price nonetheless.

So, in our simulation we are now staring at a share of LEH trading at $80 in 2007. We are bright-eyed and having idealistic fantasies like parents do while staring at their newborn babe. LEH is our little darling. LEH can do no wrong. LEH is genius! We are guessing that the price of LEH is “right” at $80 - for sure.

While we are staring at our simulated computer screen enjoying the beautiful ascension of our darling, simulated LEH employees are making trades, signing contracts and checks for more projects, and marketing their services to prospective clients. As all the aforementioned booms started losing momentum, the quality of the then current deals began to erode. Long trades in real estate related securities started to sour. Deal flow came to a screeching halt. But all the while, LEH bulls kept demanding shares because they were living in a deluded intellectual world where LEH was invincible.

Last summer a handful of people snapped out of their daydream. So, LEH shares started to slide. Despite the mounting evidence that the boom had peaked, LEH management and their well-paid PR machine told the public, “Although you can’t see behind our veil, trust us that things are just fine.” And since most analysts, fund managers, and individual investors are too far removed from the company’s reality, they drank the Kool-Aid and guessed that the price for LEH was “cheap.”

This is the point when most people are simply investing based on the inertia of the market (e.g., “buy the dips”). Although any reasonably discerning person could find plenty of data to support that major problems were manifesting in the economy (if you are lazy read Barry Ritholtz’s brilliant blog The Big Picture), the inertia bots piled back into shares and kept them stable until February of this year. At that point, reality was harder to conceal and the protectors of the veil (e.g., CEO, PR team, Federal Reserve, National Association of Realtors, etc.) were forced to concede a host of problems. Thus, the next wave of sellers dumped their LEH shares.

Despite the concessions and selling, the protectors of the veil followed all their negative revelations with positive rhetoric and spin. They are, after all, trying to prevent us from accurately repricing the market all at once - because that’s what we call a “crash.” So, once again plenty of inertia bots started buying shares. As a result, we had a little rally from the middle of March until the middle of May. At that point, more of reality was revealed, and the next wave of selling began.

At this point, we are in the present moment: Monday, July 14, 2008. LEH has taken a hard beating down to $12.40. The mainstream media is finally reporting that LEH owns ghost towns and has an enormous amount of possibly valueless illiquid assets on their books. However, despite all the negative data about LEH’s reality, there are still people who continue to buy. And, despite those who continue to buy, the reality behind LEH’s veil has still not been fully disclosed - not to mention the economy is getting worse.

This same issue is true for the market as a whole. Although companies have revealed some things about the cancers growing on balance sheets, they haven’t revealed everything. And we definitely don’t know how much worse that cancer will be as the economy continues to slow. But, like contestants who know results of a reality show that was filmed but not yet aired, those who can see behind the veil are very well aware that share prices are not yet based on reality.

Legendary investor Benjamin Graham said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.” So, we will continue this classic Bear Market game where insiders are forced to give us nuggets of reality and prices reduce another leg based on weight. Then protectors of the veil will find a statistic or two and claim things are bottoming, and we will have another bounce based on votes. Maybe LEH execs will even consider going public to end the slaughter? But until we know everything and get to stare at the naked skinny horror behind the veil, LEH and the market will continue to be inaccurately priced as a heftier load. Therefore, I recommend staying out of this volatile market unless you are an incredibly skilled trader. As the maxim goes, “When in doubt, stay out.”

Stay tuned for SmartGuyDH’s upcoming article about how to play this market …

Steal shares of Metalico, not church organs

• Buy MEA around 14.03

In the latest sign of the global commodity craze, churches in England are seeing increased thefts of metal from roofs, statues, and plaques. And last week, someone even stole the organ pipes from a 13th century church, presumably to cash it in for scrap.  Here in America, we have a little more respect for our religious institutions-so we limit our larceny to kegs and manhole covers.

The bottom line is that metal prices are soaring, especially in the scrap and secondary markets. And as iron ore prices increase (Rio Tinto recently announced it secured an 85% price increase for the current contract year), scrap metal becomes an even more appealing alternative. This is not likely a passing trend- Dan DiMicco, the CEO of Nucor, the largest metal recycler, stated last month of CNBC that he sees 15-30 years of a strong continued upward trend in metal demand and prices. He acknowledged that there may be some short-term blips, but the overall trend would be sharply positive.

Nucor is putting its money where its mouth is, gobbling up scrap metal operators. In February, it bought scrap broker and processor David J. Joseph (”DJJ”) for $1.4B. In April, its newly acquired DJJ platform acquired two smaller scrap processors for an undisclosed price. According to the company, it plans to use the DJJ platform as a “a platform for continued growth in the scrap processing industry.”  It also sees an opportunity for more consolidation in the industry as prices rise. And Nucor’s acquisition strategy appears to be on the fast track, as the company raised $2.05B through a recent stock offering and plans to raise an additional $1B by selling bonds for acquisitions, capital expenditures, and general corporate purposes.

So who might be a beneficiary of high scrap metal prices and a dominant industry player hungry for M&A? My bet is on Metalico (AMEX: MEA). The ~$500M New Jersey-based company operates a number of ferrous and non-ferrous scrap processing facilities as well as a lead-fabrication business. The company has been acquisitive in its own right, and its blowout 2008 first quarter was a result of successful acquisitions and high demand for scrap.

The street has begun to take notice: in the past few weeks, analysts have upped their price targets on the stock to $20 and $21, citing increased worldwide demand for scrap. And although the stock has risen over 40% this year, it is currently more than 20% off its high. Analysts currently expect revenue to increase by 135% this year and at least 13% the next. Given MEA’s recent track record, this latter number seems potentially very light.

Shares of steel-related companies, including MEA, tanked last week on worries over GM’s production cutbacks.  This despite an earnings announcement from Schnitzer Steel a few days earlier, whose CEO stated that “Global demand for recycled metals remains robust, driven by economic growth in developing countries.” Dan Dienst, CEO of Sims Group (another large metal recycler), appeared on Cramer’s show Tuesday night to dismiss any worries. He cited the “voracious” demand for metal, both ferrous and non-ferrous, that his company continues to see. He specifically addressed the GM issue, noting that “a couple million tons in diminished production” from automakers is not going to come close to offsetting the huge infrastructure demands from BRIC countries.

An analyst from UBS was out yesterday with a note to buy steel companies on last week’s overdone drop.  I agree, and believe that this is one of those aforementioned negative blips in a company with a clear positive trajectory. Between the strong demand for scrap metal and the possibility of a buyout, Metalico is a buy.

Disclosure: SmartGuyStocks is long MEA

SGS Five Investing Pitfalls: #3 The One-Dimensional Thesis

Savvy investing is tough. Success requires solid due diligence and constant observation of the economy. However, many investors like to oversimplify a thesis and then buy-and-hold with total confidence.

Since last fall I have received many emails from readers who challenged my assertion that the bull market was finished. On December 31, 2007, I wrote an article Banking Crisis: No End in Sight. Some Seeking Alpha readers passionately argued that banks were in as little trouble as their CEO’s alleged - despite the troubling mortgage and commercial loan data I provided.

The constant theme I noticed was that some people bought into stocks like Wachovia Bank (WB) on the general thesis that finance is the engine of capitalism and therefore will be fine in the “long term.” This is the same bullish rhetoric I quoted in my article as stated by Rich Pzena of Pzena Investment Management (PZN): “Citigroup is everywhere. It is a massive global franchise that will grow in line with global financial growth …” Try to explain that to the poor investors and employees who have seen WB and C shares erase all gains from the past 16 and 10 years, respectively. That, my friends, is as “long term” as long term gets.

The lesson here proves that developing a general thesis is not enough. In fact, a general thesis is merely a starting point for the savvy investor. The next action step is due diligence, and the following step is constant monitoring of the situation. When investors execute step one and ignore steps two and three, multiyear gains can evaporate quicker than Lake Lanier during a drought.

I can tell investors are ignoring steps two and three when they tell me broad-based statements like, “WB is a steal at 40 because it’s already down over 20% from its highs,” or, “With WB’s dividend, you can just load up the truck and get paid to wait.” Wait for what? The stock to go to 15 and the dividend to get slashed or suspended? If you find yourself ignoring important reports displaying a company’s exposure to a major problem (e.g., WB’s exposure to toxic debt), you are deluding yourself into the land of hope and dreams. And once you start using hope as support for your thesis, your investing days are limited.

Another perfect example of the one-dimensional thesis is Whole Foods Market (WFMI). A very oversimplified thesis states that organics are a growing trend. True. WFMI was the first-mover in the space and delivered an excellent retail experience. WFMI also had nearly zero competition. With those supporting data points plus the awesome financial metrics, WFMI was a screaming buy.

However, over the past several years many world-class companies have entered the still growing market for organic products. Traditional grocers such as Kroger (KR), Walmart (WMT), and Target (TGT) created isles dedicated to organic foods, while other organic retailers such as Wild Oats and Trader Joe’s simply attacked the niche - and companies such as Safeway (SWY) and Publix (PUSH) did both. Thus, WFMI lost its first-mover advantage as well as its pseudo-monopoly (i.e., pricing power). Once you add food inflation, rising shipping costs, merger costs (Wild Oats), and decreasing consumer spending, WFMI looks like a very ripe target for multiple contraction and decreasing earnings. But the one-dimensional thesis (i.e., increasing demand for organics) is still intact. If you relied on this sound thesis without due diligence and constant observation, you probably watched 6 years of gains disappear like organic double-chocolate brownie samples on the bakery counter.

So, next time you find yourself conceding to cognitive dissonance and ignoring new data points, take a step back and make sure you’re not succumbing to the pitfalls of the one-dimensional thesis. If you are the preventative type (which I highly recommend), then apply your trusty three-dimensional framework - sound thesis, due diligence, and constant observation - during all your prospective and current investments and trades. The added dimensions will blow your mind when you preserve and grow your hard-earned cash.