Jubak's Journal Recent articles: • 3 picks for the dog days of summer, 8/26/2005 • A hero for speculators: Davy Crockett, 8/16/2005 • Don't trust us with Social Security accounts, 8/9/2005 More... | Jubak's Journal Play the lottery with airline, tech stocks Technically, shares of Delta and Northwest are worthless -- but hope of a jackpot keeps some investors buying. That same mentality could fuel the next tech rallies. By Jim Jubak What do airline and technology stocks have in common? Shares in both sectors trade puzzlingly above their fundamental value. Understanding why they do will tell you how to profit -- and how to keep the profits -- from the traditional post-Labor Day rally (if it materializes) and from a stronger and longer-lasting end-of-the-year technology rally. The puzzle isn't exactly the same -- certainly not in degree -- for both sectors. Most airline stocks, considering the industry's history of red ink and the likelihood that those flows of red ink will continue as far as the eye can see, should sell on their fundamentals -- for something close to zero. That's according to Martin Fridson's calculations in the Aug. 11 issue of his Distressed Debt Investor newsletter. (Go to www.Fridsonvision.com to see a sample, sign up for a free trial, or to subscribe.)
With airlines such as Delta Air Lines Most technology stocks are worth something based on their fundamentals. Here the puzzle is the persistence of valuations -- five years plus after the technology-stock bubble burst in 2000 -- that are much higher than current rates of sales and earnings growth justify. It's one thing for a Cisco Systems Related news and commentary on MSN Money
Fridson, for my money the best analyst of high-yield bonds on or off Wall Street, offers a convincing explanation in his article for why airline stocks don't sell for $0. What puzzles Fridson is the persistent underperformance of airline bonds and stocks. Since 1996, airline high-yield bonds have returned an average annualized 1.45%. That's stunning, since the average high-yield bond, measured by the Merrill Lynch High Yield Distressed Index, returned 7.19% a year. In other words, despite everything that investors know about airlines and their history -- the industry accounts for 12% of the 50 largest bankruptcies since 1970, for example -- investors have consistently paid too much for the industry's bonds. A 20-year tailspin The record on the stock side isn't any better. An investor who bought Delta's shares 20 years ago is today looking at a 92% loss. Northwest? An 86% loss over 20 years. AMR The persistence of such underperformance is simply extraordinary, according to conventional financial theory. Investors certainly know these companies have earned and will earn below-average profits. The theory says they should adjust the price they're willing to pay for the industry's bonds and stocks. Rational investors, Fridson summarizes, would look at each company's very low future cash flows, discount those to a present value and then pay a low price for the shares. That price should reflect that dismal financial performance, giving the investor a chance to earn a decent return. Buying a stock at $12 a share results in a loss if it drops to $6. But buy that same stock at $4 and you've got a profit. So why hasn't this rational process driven down the price of airline securities? The lottery-ticket mentality Volatility is Fridson's answer. Conventional financial theory says that a rational investor will demand a risk premium before buying a bond or stock with greater-than-average price volatility. If the price of the bond or stock is more likely to go down than is the average stock, an investor would look to pay less to make up for the greater risk. But Fridson points out that some parts of the financial markets aren't dominated by rational investors and conventional financial theory. Instead they're dominated by traders and speculators who follow what Fridson calls the lottery-ticket mentality. In these parts of the market, traders buy shares with no expectation of holding for any length of time. Fundamental analysis and future cash flows are completely irrelevant. In these parts of the financial markets, volatility, rather than being a bad thing, is exactly what the investor is looking for. Everyone knows that playing one of the state-run lotteries is a losing proposition. A typical payout, Fridson calculates, puts the fundamental value of each $1 ticket at about 60 cents. From a fundamental perspective, buying a lottery ticket is a way to guarantee a loss. But fundamentals aren't important to lottery players. They buy a ticket despite the guarantee of a 40% loss -- fundamentally speaking -- because of the potential to turn $1 into $1 million. The size of the potential payout overwhelms the fundamental loss. The infinitely attractive, and worthless, stock The traders who bet on airline bonds and stocks find them attractive not as fundamental investments but as lottery tickets. Deltas shares have produced monthly returns of 9% or better in 56 of the past 300 months, according to Fridson. That positive monthly return annualizes out to a better than 180% total return. In one case, the monthly return exceeded 40%. For long-term investors, these numbers dont matter much: Over those 25 years, Deltas return is deeply negative. But to lottery players, they do matter. Nor is Delta a unique case. AMR's stock shows 42 monthly returns of 12.8% or better and two occasions when the one-month return exceed 38.8%. With that kind of lottery potential, who cares that these bonds and stocks are guaranteed fundamental losers over the long haul? And, perversely, since the potential for a lottery ticket paying off huge rises as the price of the stock falls, investor betting works to support the price of airline bonds or shares on the downside. The stock never falls to $0 because, at $0, the potential return from winning the monthly lottery is infinite. I find Fridson's logic attractive and I think it has application to sectors besides airlines, including sectors where the stocks have much greater long-term fundamental value than airline stocks do. Tech-sector lottery I'd point to the technology sector, for example. Everyone knows -- well, if you don't, you've got to have a really, really short memory -- that technology stocks are volatile. What else can you call shares that fell 60%, 70%, or more in the quarters after the technology bubble peaked in March 2000? That demonstrated volatility scared a lot of fundamentally inclined investors out of the sector as the correction wore on. And many of them still haven't returned to technology stocks. If you're like most investors, you certainly own fewer technology stocks today than you did in 1999. Not all investors who look to fundamentals to figure out what to pay for shares have deserted all the stocks in the sector. I know value investors and growth-at-a-reasonable-price investors who own shares of Microsoft But I believe there are fewer of these investors in the technology sector, proportionately, than in the market as a whole. That gives more influence in the sector to traders and lottery-ticket buyers. And the market for some of the most volatile stocks in the sector is, in my observation, dominated by investors for whom volatility means not increased risk but the increased potential for reward. The next tech rally: fast and furious I think the prevalence of lottery-ticket investors in the technology sector has three implications for investors. First, I think that technology-sector rallies -- for example, the traditional end of the year-rally that begins in late October -- are likely to be short and very sharp. Lottery-ticket investors jump in at the first sign of a rally in order to put themselves in a position to win a big jackpot while lottery tickets are cheap -- and they then jump out at the first sign that momentum is fading. Since these investors aren't paying any attention to fundamental valuations to begin with, they can't be kept in the market by analysts who try in the later stages of rallies to argue that valuations are still reasonable. There's no point to holding a lottery ticket once you have the opportunity to cash out. Second, I think any technology-sector rallies the rest of this year will be led by lower-priced, more speculative and more volatile stocks -- as was the case in 2004. The logic of lottery-ticket investing tells you to buy cheap tickets. They'll go up more on a percentage basis, if they do go up, and they'll cost you less on an absolute dollar basis if they crater. So lottery-ticket buying tends to concentrate on high-beta, small-capitalization stocks with easily understood and easily promoted stories. Sure, the technology stocks with reasonable fundamentals will go up in any rally, but don't expect to see Microsoft or Cisco lead the pack. And, third, I think it makes sticking to your discipline, whether it's fundamental or lottery, absolutely essential. In a normal market, value investors buy first and then sell to growth investors who sell to momentum investors. Forget about that pattern in a lottery-ticket market. Here, the momentum investors begin the rally and hope that growth investors will get sucked into the excitement before the upward momentum shifts. You don't want to be the fundamental investor who forgets those fundamentals just in time to be the last buyer. Nor do you want to be the lottery-ticket, momentum investor who forgets his discipline and convinces himself that the stocks that have been rising so fast and furiously must have solid fundamentals after all. Take a tip in any technology rally from all those temporary rallies in airline stocks that have punctuated the long downturn in the sector -- a 9% or a 13% or even a 40% monthly gain in a lottery stock isn't a sign that the fundamental story has changed for the better. Gains like that are more often a sign that it's time to sell. And now, of course, all we need is a thrilling, if temporary, post-Labor Day rally so that we can test all this theory. Updates Changes to Jubak's picks Sell Talisman Energy It's tempting to forget about costs and focus just on the rising price of oil, but I think that's dangerous for energy investors. Talisman Energy In its second-quarter results, which the company announced July 28, Talisman reported a rise in costs of 17% from the second quarter of 2004. That's not out of line for the oil industry, but you have to put that together with the $10.85 that it costs Talisman to discover and develop a barrel of oil equivalent. That's higher than the industry average. The price of a Talisman share is more leveraged to continuing climbs in the already high price of oil than I'd like. I can see Talisman rising another $4 or so a share, but the company's position as a high-cost exploration-and-development company exposes me to more risk than I'd like for that potential gain. I'm selling these shares with a 54% gain since I added them to Jubak's Picks on February 8, 2005. (Full disclosure: I will see my shares of Talisman Energy three days after this column is posted.) New developments on past columns When will oil run out of gas? I'm raising my target price on Marathon Oil First, on the production side, the company increased projected 2005 production estimates from 325,000-350,000 barrels a day to 340,000-355,000 barrels a day. Production in Russia and Equatorial Guinea is running ahead of schedule. Based only on projects that are close to completion, JP Morgan estimates that Marathon Oil can increase production by 6.5% by 2008. (This estimate doesn't include projects with post-2008 potential such as the recent find in the deep ocean off Angola in partnership with BP Second, soaring refining spreads and the huge premium earned by refiners that handle sour crude, as Marathon Oil does, drove company gross earnings in this segment to $823 million in the quarter. That was far ahead of Wall Street estimates of $500 million to $600 million. (About 63% of the oil refined by Marathon this quarter was sour crude, which is more plentiful but more difficult to refine than sweet crude.) In the last month, the Wall Street consensus earnings estimate for 2005 has moved up by more than a $1 a share to $6.37. So Marathon Oil shares are trading at just 9.3 times the consensus estimate for 2005 earnings. On July 27, the company also announced a 5 cent, 18% dividend increase, to an annual $1.32 a share -- a yield of 2.2%. (Full disclosure: I own shares of Marathon Oil.) 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, Marathon Oil, Microsoft, PepsiCo, and Talisman Energy. He does not own short positions in any stock mentioned in this column. | |||||||||||||||||||||||||||||
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