Game Over for Nintendo’s Risk-Reward Ratio

• Sell NTDOY around 71.15

Avid readers of SmartGuyStocks know that Nintendo (NTDOY.PK) has been one of our favorite stocks over the past year. NTDOY is the only stock I have recommended twice. The company has delivered two of the most exciting products in the world: Wii and DS. However, I believe price appreciation is limited for the following reasons: skyrocketing shipping costs, the weak dollar, and the current point in the console cycle.

First, let me preface my comments by saying NTDOY is still one of the best companies in one of the hottest sectors in the world. If the global economy was steamrolling, I would hang on to NTDOY through the coming holiday season. Unfortunately, my wish is not the economy’s command. Rather than fight reality and stubbornly hold my shares, I am willing to take my extraordinary gains and accept that my risk-reward ratio has diminished.

Although many shareholders will focus on the positives at Nintendo, headwinds are gaining strength. As oil costs levitate, shipping costs perform the same miracle. These costs eat into NTDOY margins for both manufacturing and distribution. Moreover, the dollar continues its celebrity makeover as toilet paper. This will continue to diminish the value of building in yen and selling in dollars.

Thus, the great irony of globalization (i.e., foreign production is cheaper) begins to mature. The forces in the global oil and currency markets are stronger than those in the growing video game space. And until something changes, these costs will limit upside in NTDOY.

Lastly, the easy money has been made in the current console cycle. Those who remain in shares are playing chicken with the inflection point of the cycle. Some time in the next 12-18 months I expect Microsoft (MSFT) and Sony (SNE) to start introducing exciting concepts for their next generation consoles. These glossy press releases will create signs that the current cycle is in the latter stages. Once that happens, analysts and investors will start to look ahead. And once that happens, doubt will arise as to whether NTDOY will repeat their success in the future. If you are still holding shares at that point, you will be very disappointed to see Nintendo the company still minting money while NTDOY the stock discounts for the great unknown of the next console cycle.

I do not aim to find the absolute high and low of a cycle. Rather, I seek to capture the easier money when companies are in stride during their climb or descent. That’s why I have not made many picks since the market has traded in a choppier manner. I prefer shorts and puts when things are falling hard, and buys and calls when they are rising in a healthy environment. Occasionally I will offer a short-term trade that contradicts the macro environment, but those who follow my picks will make most of their money in the sweet spot of each cycle. My one-year track record on SmartGuyStocks validates this strategy.

On a technical note, NTDOY peaked in the high 70’s and has not been able to push back. This is more evidence that the macro environment has great control over NTDOY shares. I held my shares during the decline from the peak because I believed the stock had a chance to bounce back and charge ahead for another leg up. Despite excellent growth and earnings, the stock has not made new highs. Therefore, I believe we may be witnessing the best price for NTDOY we will get as the hype for Mario Kart and Wii Fit bring optimistic buyers back to the trading floor.

Of course, the economy could improve later this year, but I do not take my economic analysis from the White House. From where I sit, it’s game over for Nintendo’s risk-reward ratio.

A small company with HURC-ulean profits

• Buy HURC around $41.54

One of my favorite companies is Hurco (Nasdaq: HURC), a small manufacturer of machine tools and the software that powers them. Hurco’s machines help manufacturers decrease labor costs and achieve increased production efficiency. I first wrote about Hurco last August when the stock was trading close to 50. In that article, I mentioned that Hurco had experienced solid and consistent growth over the past few years, but has been an extremely volatile stock. I suggested that as long as growth remained strong, I would be a buyer on any undeserved stock price dips.

Well, I believe that time has come. Last week, Hurco announced first quarter earnings that left analysts looking silly. The company earned $1.21/share on $61M in revenue, vs. expectations of $0.90 and $50M. Last year, Hurco earned $0.84 on sales of $47M. Despite slightly down U.S. sales, growth was fueled by insatiable European and Asian demand, helped by the weak dollar. CEO Michael Doar specifically called out new successes in fast-growing India and Eastern Europe.

In response to this news, the market sent shares of Hurc up 30%. Since then, the stock has given back almost 20% on no news and is trading at a trailing P/E of less than 12. With net cash representing more than 10% of its market cap, record new order bookings, and limited exposure to the U.S. economy, Hurco has all the makings of a success story. Look for this little guy to fly during any market rally.

Disclosure: SmartGuyStocks is long HURC

Deja vu, Akamai style

As I wrote in October, SmartGuyStocks selection Akamai (AKAM) seems to be falling into a pattern.

1. Akamai reports strong (40%+) YoY revenue and profit growth, in line with or ahead of expectations

2. Analysts predict the end of the company’s growth at the hands of growing competition

3. Akamai reports strong (40%+) YoY revenue and profit growth, in line with or ahead of expectations

Given that this has been going on for a few quarters now, I think we can guess what the investment community’s reaction will be tomorrow.

But I’m still holding out hope that some analysts will finally re-consider their doom and gloom mantra, as Akamai’s results for the fourth quarter certainly appeared to snuff out any competition fears. Not only did revenue increase 14% and profit 22% over last quarter(!), but gross margin even increased by 20 basis points. CEO Paul Sagan certainly had every right to brag that “the value of Akamai’s differentiated services is stronger than ever.”

Sagan also reassured investors in this uneasy market climate, insisting that an economic slowdown may even help Akamai. Since companies save money by moving operations to the Internet, Akamai would benefit if the migration process picked up as businesses seek to cut costs in a tougher economic climate, he said.

A large driver of Akamai’s growth is the downloading of video content. The company provides technology that allows companies and government agencies to deliver digital internet content, such as commercials and videos. Between the announcement by Apple of a movie download service, the internet-only NBC soap opera “Coastal Dreams”, and the proliferation of forwarded video clips in my inbox, the growth of video is one trend you can count on. And given Akamai’s track record and position at the forefront of content delivery technology, this is one company I’m willing to bet on.

Disclosure: SmartGuyStocks is long AKAM

AMSWA’s SGS swan song

• Sell AMSWA around 9.29

We are selling American Software (AMSWA) on the recent price spike as we seek to take profits on our marginal positions, solidify our strong long-term convictions, and wait for the next big opportunities. While AMSWA is a solid, growing company that has beat the market during our holding period, it has been somewhat of a disappointment.

We based our recommendation in part on the under-appreciated 88% interest that AMSWA has in Logility (LGTY), a fast-growing provider of supply chain management software. Or should I say “was” fast-growing. While Logility had routinely been seeing 20% quarterly sales growth, the second quarter brought only an 11% bump. More discouraging were the comments from the conference call, where the CEO underwhelmed investors by predicting that “the third quarter has an opportunity to be better than last year’s third quarter.” Not exactly the kind of words that give one confidence in what is supposed to be a high-growth company. Perhaps for these reasons, Logility’s stock has dropped nearly 40% since we recommended AMSWA, thus significantly diminishing the value of AMSWA’s “hidden” asset.

AMSWA still has a sparkling balance sheet and a tempting dividend. But we are taking a cautious approach to this market, and believe that we will find better opportunities in the near future.

Disclosure: SmartGuyStocks is no longer long AMSWA

Nasdaq on track

It’s been tough to jump into this market. Nearly every day, the pundits seem to change course on whether we’ve already hit bottom or are only at the tip of the recessionary iceberg. At SmartGuyStocks, we have decided to generally sit on the sidelines for now with our favorite long-term plays and wait for things to shake out a bit before taking any new positions.

So while we’re waiting to jump back in, I wanted to take this opportunity to catch up with one of our favorite companies, Nasdaq Stock Market (NDAQ). Despite a market slump, the stock is up nearly 30% from where we recommended it in July, and we believe it will continue to be a winner for years to come.

Last week, Nasdaq followed the huge swings of the market, temporarily nose-diving on fears of a recession. Ironically, Nasdaq is minting cash out of those fears in the form of transaction fees from record share volume. Last week, Nasdaq CEO Bob Greifield announced “At the moment, our business is doing better than it ever has because the volumes have been incredibly high,” he said. “So, it’s (the recent period of high volatility) been very good for us.”

And don’t be distracted by the hubub over the potential reduction in IPOs that has caused some to worry; initial listing fees accounted for less than 1.5% of Nasdaq’s record 1.7B in 2006 revenue. The success and growth of Nasdaq comes down to three simple words: volume, volume, and volume.

And the long-term growth of trading volume is one trend that we can count on. The World Federation of Exchanges has some great data showing the incredible growth of exchanges since 1990. Just for illustration, the value of shares traded on the Lima Stock Exchange (Peru) has increased 55-fold, while the Tokyo Stock Exchange has increased 600% despite a lackluster economy. Even own own mature financial market grew overall volume by 25% in 2007 alone. And if that’s not enough to juice growth, new exchanges in emerging markets like Vietnam, Colombia, and even some African countries are beginning to take hold.

The opportunity for the largest exchanges like Nasdaq and NYSE Euronext to consolidate this fast-growing and fragmented space is obvious. Economies of scale are especially valuable in the exchange business, where trading is done by computer networks that require large fixed costs. Consolidation can lower trading costs, which attract more traders and listing companies. Larger exchanges also create increased liquidity, helping share prices move more quickly and efficiently.

As expected, we are seeing a lot of acquisitions, with NYSE buying Euronext and AMEX, and Nasdaq buying OMX (Nordic exchanges) and the Philadelphia and Boston exchanges. It looks like we are indeed moving towards the vision presented last year in The Wall Street Journal: “The accounting world has the Big Four. The auto sector had the Big Three. And stock exchanges, once a fragmented industry with dozens of players, may be headed toward a Big Five or Six.” Nasdaq has announced that it will spend 2008 integrating its three acquisitions, but will again be on the prowl for new buys in 2009.

Nasdaq’s recent deal with Borse Dubai perhaps foreshadows things to come. As part the OMX acquisition, Nasdaq and Borse Dubai traded stakes in their respective companies. The Dubai Exchange will be re-branded as the “Nasdaq DIFX” and will leverage Nasdaq’s software platform for expansion. It’s a promising development that the world’s next great financial center places immense value on Nasdaq’s platform, brand, and expertise. As the global economy continues to grow, more emerging markets will no doubt see value in partnering with the market leader.

Not only is the size of the pie growing, but Nasdaq appears to also be doing a good job taking a bigger slice from competitors. Last year, Nasdaq became the largest U.S. exchange, processing 29% of all equity trades in December, up from 27% in 2006.

Nasdaq reports earnings before the market opens this Thursday. I would use any negative market reaction or near-term weakness to pick up more shares, as this is a long-term story that is just starting to play out…

Disclosure: SmartGuyStocks is long NDAQ

Is the Fed Pandering or Too Late?

In case you were brilliant and went on vacation last week after raising 100% cash before Christmas, you may have missed the emergency Fed rate cut and the Britney Spears like attention on a rogue trader who nearly crashed the global markets. An interesting debate has emerged as to whether the Fed pandered to the equities markets and cut to stop the bleeding caused by the rogue trader, or whether the Fed applied “too little, too late” after the US equities markets already lost all gains made in 2007 and housing persists in free fall.

A few respected market commentators opined the following:

John Mauldin: Fed had to cut pre-meeting to break up the abnormally large reduction in rates.

Barry Ritholtz: Fed pandered to the markets.

Joseph Stiglitz: Too little, way too late.

I tend to believe that all three perspectives played a role. Nothing is black and white, and managing global market action is one of the more complicated pseudo-sciences in existence. I say the Fed offered too little too late because they should have used legislation and regulation to stop the mortgage market from expanding into an unsustainable ether (i.e., issuing debt to those who could not service it). I say the Fed pandered to the markets because they may have stopped what could have been a major market crash. I say the Fed broke up their cuts because one huge cut is too extreme for our analytical brains to digest (and, therefore, subject to harsh reactions).

I also add that Monday morning quarterbacking of the Fed is near worthless banter. First, the Fed can do no right because the media needs to dramatize everything. Thus, if the Fed did not cut, the market may have crashed and the Fed would have been blamed (note today’s WSJ front page article about Bank of England Chief King and the criticism he faces for letting markets unwind freely).

Second, what the Fed should and should not do is a philosophical issue (and largely depends on your personal asset allocation, job, etc.). The more valuable approach is to accept that the Fed exists, the Fed affects the markets, and we must determine how to plan our investment action steps as the Fed alters the landscape.

In the coming weeks SmartGuyStocks will discuss how the Fed action and other events signal what we can expect for markets in the midterm. But for now, we are still recommending bearish trades, raising cash into rallies, and nibbling at rare exceptions such as Pet Med Express (PETS).

Until then, we also recommend entertaining yourself with a fun Hollywood version of this week’s rogue trader debacle. The movie, Rogue Trader, stars Ewan McGregor (Trainspotting, Moulin Rouge) and is based on a similar true story from the late 90’s. (I guess that means rogue traders no longer qualify for the trendy label “black swan.”) Enjoy!

PETS a bright spot during market downturn

Despite the market taking yet another hit, SmartGuyStocks selection Pet Med Express (PETS) gave us something to smile about, shooting up over 20% yesterday. PETS beat analyst expectations for its third quarter as earnings rose 60% on the strength of a 19% jump in sales. The company also continued to deploy its strong cash position towards buybacks, purchasing 1% of the float in the quarter.

While the company has yet to release detailed financials, we can guess that overall margins improved due to the strength of re-orders and internet sales, which both outpaced overall sales growth. These are extremely positive trends for the company. Re-orders indicate that customers are happy and the company may be able to rely less on Betty White and more on word-of-mouth advertising. Online growth means that customers are moving away from the more overhead-intensive phone ordering.

Hopefully, yesterday definitively proved to investors that PETS is not a consumer discretionary stock. Note the contrast with leading pet retailer PetSmart (PETM), who last night slashed its forecasts on weak consumer spending. As I have been saying repeatedly, consumers increasingly think of pets as members of their families, and medications for family members are necessary purchases. PETS will continue to profit from this whether or not there is a recession, and we will continue to hold our shares.

Disclosure: SmartGuyStocks is long PETS

SGS Five Investing Pitfalls: #2 Buying “cheap” stocks

I wish I had a dime for every time in the last month I’ve heard a market commentator argue that a beaten-down stock is a buy solely because it is “cheap.” Maybe with all that money, I could pay investors back for all the money they’ve lost buying these supposedly bargain stocks.

At a recent visit to a bookstore, one of the financial publications was touting Wachovia (WB) as a buy at 40. The logic was basically “the stock has gone down a lot already, the PE is only 9, and it pays a 6% dividend while you wait for it to go up.” This might make sense if:
1) The stock hadn’t gone down for a good reason (write-offs, and an uncertain credit and banking market) and
2) Future earnings and dividends are guaranteed (many on Wall Street worry that WB may cut its dividend and earnings forecasts like other banks)

But the magazine didn’t mention these caveats, nor even attempt to give any catalyst for upside to the stock aside from the fact that it was “cheap.” Well apparently the market didn’t think so, and the stock is down another 20% in a matter of weeks.

While WB may yet end up being a long-term buy at 40, the reason is not because it was “cheap”. Rather, its business or the overall economy will have improved. With financial stocks in the toilet and nearly everyone jumping on the recession bandwagon, this is not the time to buy something without strong conviction. Investing 101 dictates that no matter how bad things may seem, they can always get worse.

Why try to guess the bottom instead of waiting for at least a modicum of evidence that things are turning around? Ask the Caylon Securities analyst who kept a “Buy” rating on Capital One (COF) despite its recent earnings warning (he’s had a buy rating on the stock since $80!). “I think it’s dead money for a while. I think that if you bought this stock at $40, in two years, you’d be happy if you did.” And yet he still recommends buying it now? Personally, “dead money” didn’t make my list of top investments for 2008.

Similarly, shorting a stock simply because it appears expensive can be a similar exercise in futility. Just look at the run of Salesforce.com (CRM), which looks pricey by almost any metric. And it’s been practically a daily ritual for someone on Seeking Alpha or another investing site to call the top on white-hot solar stocks like First Solar (FSLR). As you can see by the chart, it’s a dangerous exercise trying to get in front of the hype train.

As evidenced by our success in shorting Build-A-Bear Workshops (BBW), sometimes shorting “cheap” stocks can be the most lucrative. Wall Street is no different from any other market- too often you get exactly what you pay for.

At SmartGuyStocks we hate leaving money on the table. Too often, popular beliefs about investing lead to that result. We have identified five common mistakes that investors make. Stay tuned for the next three installments of “SGS Five Investment Pitfalls.”

Taking the squeeze off of Build-A-Bear

• Buy (cover short position) BBW around 12.10

We are closing our trade on Build-A-Bear Workshop (BBW) after a 20% gain in one month. The stock quickly fell from our sell point at over 15 to the low-12s, where it has been holding steady for the past couple weeks.

Despite the barrage of negative retail news this year, BBW has shown some recent strength. While I am not ready to definitely call a bottom on this dying retail concept, the company’s valuation is now well below other specialty retail shops (as it should be), and BBW is still sitting on $17M in cash and a large stake in the promising Ridemakerz concept. Given these factors, we think it is prudent to take our gains.

Disclosure: SmartGuyStocks is no longer short BBW

Locking up gains on Martha Stewart Living

• Sell MSO March ‘08 $15 puts around 9.20

Our sell order for Martha Stewart Living Omnimedia (MSO) puts filled today at 9.20 for an 84% gain in 6 weeks. Although we still believe that the future outlook for the company is dour, the margin of safety on this trade has diminished due to the stock’s fast and furious decline. The company’s P/S is finally now below other media companies, and let’s not forget that Martha is still sitting on a nice nest of cash.

There’s even a slight chance that this quarter’s earnings might be ok, as there will be a big (and final) payment from K-Mart combined with the initial returns from the full Macy’s roll-out. But the bottom line is that Martha’s popularity is waning and her company will have to diversify or sell itself to succeed. If MSO pops on a fed cut or general market rally, we will be right there again to buy puts.

Disclosure: SmartGuyStocks no longer holds MSO puts