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Bubble lessons to learn -- and to forget
Too many investors are selling stocks they ought to hold out of fear they will blow up in their faces. Some lessons from 2000 still apply, but we're not facing the same sort of disaster.
By Jim Jubak
"Those who cannot remember the past are condemned to repeat it." Those words from writer George Santayana should be emblazoned above every investor's computer. Most of the investing mistakes we'll make tomorrow are the same ones we made yesterday.
Most, but not all. To Santayana's words, I'd add these: For investors, it's almost as expensive to draw the wrong lessons from history as it is to draw no lessons at all.
And that's exactly what I think many investors have been doing, to their portfolios' loss, over the last couple of weeks. Burned by the collapse of the bubble in 2000, investors have been selling exactly the stocks they ought to be holding onto for the long haul out of fear that the bubble of 2000 is about to play out again in 2005. Although I think theres a good chance were not done with the recent correction, Im not looking for anything worse than another 4% to 8% decline in stocks. I think the odds of a sell-off like that of 2000 are very low indeed.
Echoes of Amazon.com
For many investors, the thought that we might be about to replay the bubble of 2000 traces back about three weeks.
On March 31, Goldman Sachs analyst Arjun Murti predicted oil could climb to $105 a barrel. To many investors, the call was a sure sign of a market top. How did they know? Because it was eerily reminiscent of those Wall Street calls for Amazon.com (AMZN, news, msgs) to hit $1,000 a share that marked the final frenzy before the bubble broke in 2000. Goldman's forecast was a clear signal to sell oil, coal, railroad and metals stocks. It was time to get out of the shares that had led the market up for 2004 and 2005 before the bubble bursts.
Again.
I can understand the logic that fed that fear. (Although to be fair to Murti, he actually just raised the top band of his price range for oil from $80 a barrel to $105. A peak of $105 doesn't seem that wild if you remember that -- corrected for inflation -- oil peaked at $85 a barrel in 1980). Some of the lessons of the bubble market of 2000 are applicable to the current market. I can name three.- When supply can't meet demand and corporate profits soar, you can bet that the juicy returns will speed a rush of new competitors into the market. This happened in the lead-up to 2000 in sectors such as long-haul optical fiber, telecommunications gear, flash memory chips, Internet advertising and wireless phones.
Companies such as Corning (GLW, news, msgs), for example, are still working to dig themselves out from under the global surplus in optical fiber. Although demand for optical fiber is growing at about 30% a year, according to the last figures from Corning, that part of the company's business continues to struggle since prices are still falling. Too many companies rushed into the market, built too many factories and created the capacity to produce too much fiber. That crushes everyone's profit margins and the stocks of companies in the sector ultimately take a beating.
Companies in the commodity sector are notorious for overexpanding in good times only to be punished when supply outstrips demand. Want to see this happening right before your eyes? Read the latest annual report from Companhia Vale Do Rio Doce (RIO, news, msgs), the huge Brazilian iron-ore producer. Last year the company recorded its biggest profit ever. Adjusted EBIT (earnings before interest and taxes) profit was 38.7%. It's never been higher.
What has the company done with all that cash? A lot of it has been plowed into expanding production. In 2004, the company increased production of iron ore at its Carajas mine to 70 million tons annually. And it invested almost $1.25 billion on projects that will expand production in the future. So, of course, have competitors BHP Billiton (BHP, news, msgs) in iron ore and Phelps Dodge (PD, news, msgs) in copper.
- Don't underestimate the ability of customers to substitute alternative -- and cheaper -- products. Substitution of this sort is still biting companies in the technology sector five years after the bubble burst. You can see it in the otherwise great growth announced by EMC (EMC, news, msgs) on April 19. EMC's earnings for the first quarter of 2005 jumped 93% compared to the year-earlier quarter on a 20% increase in sales. But it would have been still stronger if the company's customers hadn't forced it to cannibalize the sales of its own most expensive, and most profitable, systems. Revenue from the company's Symmetrix storage systems fell 3% from the first quarter of 2004. Sales of its cheaper Clariion product, introduced to keep customers from defecting to cheaper products from competitors, jumped by 47%. EMC's net profit margin of 10.6% in 2004 marks a great rebound from the losses in 2001 and 2002, but it's a long way from the 20.1% recorded in 2000.
Related news and commentary on MSN Money
Energy consumers now have the same ability -- and incentive -- to switch fuels. Oil and natural gas are vastly more expensive than coal. The fuels can't be readily substituted for some uses -- you can't pull up to your corner gas station and pump coal into your Hummer. But for other uses, such as generating electricity, the fuels can readily be switched. Right now, using coal to generate electricity is much cheaper than natural gas or oil. But building a natural gas-fired generating plant is much cheaper and quicker. As utility companies -- and their big corporate customers -- become convinced that $50-a-barrel oil, or higher, is here to stay, investment in coal-fired electricity will become more attractive. And that will put a damper on demand for oil and natural gas that will certainly slow the march to $100-a-barrel oil.
- Don't confuse growth in the market as a whole with growth in earnings at individual companies. I've already mentioned that Corning is experiencing falling prices for optical fiber even as the market for fiber grew at 30% in 2004. You can think of lots of other examples yourself where sales are booming but, thanks to ever-growing competition and falling prices, companies are struggling to make any money at all: wireless phones, digital cameras and flat-panel displays are three that come to mind.
In the same way, you cant project a one-to-one relationship between growing global oil demand and higher prices with increased revenue and profits at all of the world's oil companies for the long term. Or, especially at the world's biggest oil companies, with stock price increases for the next five years that match those of the last five years. The difficulty of finding new oil fields big enough to make a difference to the top line of companies as huge as Exxon Mobil (XOM, news, msgs) or BP (BP, news, msgs) has kept the world's super-major companies from increasing their budgets for exploration.
Most of these companies aren't replacing the reserves they're pumping with new finds. Sometime in the not-too-distant future, these companies are going to have to decide to either spend big on adding new reserves -- in which case, kiss current high profit margins and return on invested capital goodbye -- or to become trusts, in name or in practice, that are liquidating their only assets.
Look at the differences
Those lessons from 2000 need to be updated to safely be applied to todays market. I can think of three differences between 2000 and 2005 that explain why we're not looking at anything like a 2000-style meltdown.- First, it's extremely difficult to add capacity in some of the sectors that have led the stock market up in 2004 and 2005. Nobody is likely to build a new transcontinental railroad. Ever. The amount of capital, the difficulty of assembling the land and the time to complete a system means that the existing transcontinental systems neednt worry about new competitors. As a beneficiary of the boom in commodity shipments, railroads don't follow the logic of the 2000 bubble.
In other sectors, adding capacity is just immensely slow. Yes, a new pipeline eventually will be built from the oil fields of northern Canada and Alaska, but not for another decade. Yes, a new electrical transmission line will be built from the coal fields of Wyoming and Utah to the consumers of California and Nevada, but that will take more than a decade, too. So when a coal company like Peabody Energy (BTU, news, msgs) projects that demand for coal will grow by 50% over the next 25 years, it's worth taking the projection seriously. But keep in mind many of the plants that will fuel the additional demand for coal are still 10 years away.
- Second, new technologies dont disrupt and replace existing products overnight. Since its a long process, commodity prices and stocks remain fairly stable during the transition. Yes, coal will substitute for natural gas in the generation of electricity, but not at a rate that will cause the price of gas to fall by 20% in a year. The U.S. passenger car fleet now averages just 24 miles to the gallon -- about half of that achieved by Japan and Europe. As gas prices rise here, U.S. consumers will oh-so-gradually shift to more fuel-efficient cars. But the move is likely to be so incremental that it has no noticeable impact on commodity prices, given the runaway trends in demand growth elsewhere in the world.
- And, third, it's not just growth in demand that sets the price of stocks in this sector but shifts in supply as well. So growth in demand could actually slow, but prices of a commodity still rise, if supply turns out to be unexpectedly tight. It's that very real, and repeated, worry over a sudden constriction of supply that makes the behavior of shares of oil, iron, soybean and other commodity companies in 2005 so very different from the behavior of technology stocks in 2000.
The near-term and long-term trends for one key commodity, oil, suggest that we're headed into a period of even tighter supply than we've faced in the last year or two. The odds of another supply squeeze -- short term and long term -- in oil will be the subject of my next two columns.
Changes to Jubak's Picks
Sell MBNA
Nothing like a huge earnings miss to rub my nose in a mistake. When I added shares of MBNA (KRB, news, msgs) to Jubak's Picks on Feb. 4, 2005, I believed that the market was overreacting to fears that the Federal Reserve would raise rates in big jumps. Well, I was wrong, at least as far as this stock goes. On April 21, MBNA announced earnings of 40 cents a share for the first quarter (excluding restructuring charges). Wall Street analysts had projected earnings of 45 cents a share. Much worse, the quarter wasn't the result of some one-time event but of a rapid acceleration of trends in the credit card marketplace. As interest rates have edged up, MBNA card holders have begun paying back more of their balances and that reduces the size of the company's loan book and its stream of interest payments. This trend isn't likely to get any better this year, management said, and the company will very likely miss its target of 10% earnings growth for 2005. I'm dropping these shares from Jubak's Picks with a 28% loss since I added them on Feb. 4, 2005.
Buy Occidental Petroleum
I'm going to take advantage of the recent pullback in the oil sector that has taken shares of Occidental Petroleum (OXY, news, msgs) back to the stock's 50-day moving average. I think that's a solid base for future appreciation. Occidental Petroleum was the big winner when Libya, now that sanctions have been lifted, re-entered the global oil market. Occidental Petroleum, which had produced oil in the country for decades before sanctions were imposed, won the right to explore and produce oil on five of the 15 blocks let out for bid.
Libya has proven resources of 40 billion barrels of oil, which puts it eighth in the list of global oil producers right after Russia. Even better, Libya produces light, low-sulfur oil, a very precious commodity right now when just about all the extra production promised by Saudi Arabia will be harder-to-refine heavy oil. In 2005 Occidental should be able to increase production by about 3% over 2004 -- and that's before the company sees any oil from the Libyan concessions. In 2004 Occidental replaced 114% of worldwide gas and oil production (that's excluding acquisitions) at an average finding and development cost of $7.17 per barrel of oil equivalent. Wall Street analysts are calling for the company to earn $6.96 a share in 2005. I think that will turn out to be low by almost a dollar a share. Add that surprise to the growing value of the future production coming from Libya and you have a recipe for a safely appreciating stock. The shares carry a 1.8% dividend yield. I'm adding Occidental Petroleum to Jubak's Picks with a December 2005 target price of $84 a share.
New developments on past columns
5 stocks that could soar if rates stay low
The stock hasn't done much of anything lately. (Well, the shares did split 3/2 on April 15.) But Engineered Support Systems (EASI, news, msgs), the company, keeps picking up small acquisitions that should result in substantial gains in new business down the road. In the latest deal announced April 14, the company will acquire Mobilized Systems, a maker of specialized trailers and other kinds of shelters for the defense industry. Engineered Support Systems expects the all-cash deal to immediately add to earnings. At the end of 2004, the company acquired Spacelink International for $152 million in cash. That company designs, operates and maintains satellite and wireless networks for the Department of Defense. The deal should add about $90 million in revenues and about 10 cents a share in earnings in 2005. Engineered Support Systems finished 2004 with a backlog of $938 million in entered orders, a 43% jump from the end of 2003. Engineered Support Systems next reports earnings on May 24. As of April 22, I'm keeping my target price at $45 a share, but moving the timeline to September 2005 from December 2004. (Full disclosure: I own shares of Engineered Support Systems.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: EMC and Engineered Support Systems. He does not own short positions in any stock mentioned in this column.
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