Market Minute: Putting The Correction Into Perspective

We officially had a market correction, which is defined as a 10% decline from a market’s peak, but a period of market consolidation was inevitable after the straight-up rally from the March 2009 nadir.

As the market climbed higher, shares moved from being slightly cheap (using a cyclically-adjusted P/E ratio) to expensive. Meanwhile spreads on high-yield bonds (the extra yield investors demand to hold company debt rather than government securities) fell from more than 16 percentage points at the start of 2009 to less than six points.

So we were due for a correction, but that is no reason for investors to fall into the fetal position. Corrections are pretty normal. According to David Rosenberg of Gluskin Sheff, corrections historically have occurred about every 12 months and tend to occur more in the second year of a rebound than in year one.

Market contractions like the last 30 days feel severe, but it must be viewed in the context of an 80% surge from the March lows. It would have been surprising if the markets had not paused to catch its breath. I laid out a plethora of market risks in my April 22 blog post and made it abundantly clear that this recovery will be bumpy and market pullbacks should not come as a surprise.

Before markets turn bullish again, we need to see LIBOR (London Interbank Offered Rate) spreads begin to narrow. LIBOR is the interest rate one bank charges another for a loan and serves as the benchmark for $360 trillion of financial products worldwide, ranging from mortgages to small business loans to credit cards. This key benchmark of interbank lending continues to rise, suggesting that there is rising caution even among banks about lending to each other. Banks’ reluctance to lend to each other stems from concerns about (1) the deteriorating quality of each other’s collateral as a result of the Eurozone’s financial problems, and (2) the U.S. financial reform bill that could adversely affect the credit ratings and profitability of major U.S. banks.

Of course, LIBOR is nowhere near the levels reached at the worst of the financial crisis back in October of 2008 – 3-month LIBOR is currently 0.537% compared to 4.81% in October 2008. Still, I’d expect investors want to see LIBOR come down before they start plowing money back into riskier assets.

Peter Lazaroff, Investment Analyst
http://www.acrinv.com/

Market Minute: Tips For Market Volatility

The fact that market volatility has been elevated recently is no secret. Volatility can have a harmful effect on investor behavior. One of the most common mistakes is attempting to time the market, as investors generally react too late to be able to capitalize on gains or avoid major losses (not to mention the significant costs that come with market timing).

It’s no surprise that this behavior is more prevalent in volatile markets since it is our human nature to seek safety in times of trouble. The problem with selling in fear is that you also have to determine the appropriate time to re-enter the market. Unfortunately, most people that wait until “the coast is clear” miss out on the gains and end up buying at high prices. I don’t have to tell you that selling low and buying high is harmful.

Today I would like to present you with a few tips that you may find useful in volatile times. Follow these tips and you will never fall victim to market timing.

Stay the course. Maintaining your target asset mix of stocks, bonds, and cash is the most important part of a long-term investment plan. In fact, 90% of variation in portfolio performance can be attributed to your asset allocation. There is no one-size-fits-all allocation since everyone’s asset mix depends on individual objectives, time horizon, risk tolerance, and current financial situation. Once you (with the help of your financial advisor) determine the appropriate asset allocation for your circumstances, stick to it.

Continue automatic investment contributions. Making regular contributions to your 401(k), IRA, or taxable investment accounts is one of the best and most disciplined ways to grow your wealth. For most people, this means having a predetermined sum transferred directly from their paycheck into an investment account. Others will have automatic transfers from a checking or savings account. Regular contributions result in better average purchase prices – you buy more shares when prices are low and fewer shares when prices are high – and take emotions out of investment decisions.

Tune out the noise. These days there is an amazing amount of news outlets vying for your attention. Newspapers, magazines, and news reporters all try to identify the causes of every market gyration and predict the next move, but it’s impossible to explain market activities until long after the dust has settled. Try to ignore all this noise and keep focused on your long-term goals. As a close friend of mine so perfectly said to me, “I’m going to let you worry about all the nonsense.” Good idea.

Volatility is the norm, with market fluctuations cancelling each other out over the long term. There is never any guarantee in the financial markets, but staying on course over the long run increases the chances of meeting your financial goals.

Peter Lazaroff, Investment Analyst

www.acrinv.com

Reflecting On The Market Sell-Off

I was out of the office on the two trading days that followed last week’s “flash crash,” which allowed me some time to reflect on the events of that day.

In case you haven’t heard, market indexes dropped precipitously in a matter of minutes last Thursday on basically no fresh news (unless you count the reports that a new Pampers diaper made by Procter & Gamble is causing rashes).

The first conclusion I’ve come to is that last Thursday’s market action clearly demonstrates the inherent risks of our increasingly automated stock market.

High-frequency traders account for 50% to 70% of daily trading volume and, thus, these computerized trading systems provide gobs of liquidity in a normal market. But when the high-frequency crowd jumped ship last Thursday, they took their liquidity with them. I don’t think this right or wrong, fair or unfair. However, I will remember this event the next time I hear someone argue that the “constant” liquidity these computerized trading systems provide justifies their grab-every-fractional-cent-in-sight nature.

Another conclusion I have reached in the aftermath of the “flash crash” is that while human error and computer glitches are accused of being the primary culprits for the epic freefall, I think in some sense the market had been craving a sell-off.

In my April 22 post I suggested that the market would take a breather once earnings season slowed down. There is nothing wrong with sentiment growing bullish, but it’s a problem when markets are willing to shrug off just about any bad news. The bright side of a sharp market reversal like last week’s is that the jubilation dissipates and investors more soberly assess the potential risks at hand.

I’ve said this before and I’ll say it again: stocks rarely go up in a straight line. The S&P 500 has seen five pullbacks of at least 5% since March 2009, none of which ultimately prevented the market from continuing upward. This latest 8.7% drop from the April 23 peak may prove no different than the others.

The final topic I’ve reflected upon is Greece. Before the big plunge, the S&P 500 was already down on concerns about Greek debt problems and the stability of the Euro zone.

I’ve avoided talking about Greece in past weeks simply because I was never that concerned about the situation to begin with. Greece’s economy is just 2.3% the size of the U.S. economy. A default on Greece’s debt would not be big enough to derail the global economy or topple any major financial institutions in the U.S. That said, if a Greek default causes a major bank in, say, Germany to fail then all bets are off.

Still, even if Euro zone economies stagnate for years, the global economy is not highly reliant on them. Only 13.6% of U.S. exports go to Euro zone countries and only 12.7% of our imports come from the Euro zone. Europe’s economy is also of little threat to Asian economies, which are leading the world’s economic recovery. This is not to say that there wouldn’t be any global economic consequences of a Greek default, but I don’t think pain and terror would spread across the globe the way it did following the Lehman Brothers bankruptcy in 2008.

That’s all for this week. Thanks for reading and keep those comments and questions coming!

Peter Lazaroff, Investment Analyst
www.acrinv.com

April 2010 Recap

Market volatility picked up in April as investors grew concerned about the indebtedness of several European countries, a major oil spill in the Gulf of Mexico, and Goldman Sachs’ legal mess. Despite the concerns, the S&P 500 managed to post a 1.58 percent gain for the month.

Corporate earnings reports helped offset some of the negative sentiment, with 77.9 percent of companies in the S&P 500 that have reported beating expectations. According to Bloomberg, earnings estimates for companies in the S&P 500 increased 10 percent on average in April, the largest monthly increase since at least 2006. Earnings have certainly benefited from low expectations and year-ago comparisons, but this era is rapidly coming to a close. On the bright side, positive earnings results and outlooks with little price movement allow the fundamentals underlying the market to catch up to the price action.

A bigger reason for domestic equities’ April performance was the Fed’s decision to keep its benchmark interest rate at a record low to help keep the economy from dipping back into a recession. The Fed continues to paint a “Goldilocks” scenario for the economy in which growth is not too hot and not too cold. Although there are signs of prices picking up in the production pipeline, consumer prices have been showing deflationary signs in recent months. In addition, it’s very unusual for the Fed to tighten until the unemployment rate goes down.

Small caps continued to outperform large caps during April. Smaller firms tend to thrive in low interest rate environments, which allow them to borrow cheaply to fuel their growth. Additionally, new net inflows into small cap funds may also be providing support to small cap stocks, with the four-week moving average inflows topping $701 million in April according to Lipper FMI data. Small caps began the year with outflows exceeding $144 million.

The best performing S&P 500 sector was Consumer Discretionary, which benefited from improving sales data and consumer confidence. Consumer Discretionary and Industrials, which has benefited from global economic improvement, are the top performing sectors year-to-date. Healthcare stocks were the worst performers in April as the sector’s earnings reports exposed the bottom-line effects of the new U.S. healthcare legislation.

Volatility, as measured by the VIX Index, perked up 25 percent. For a market that seemed overly complacent in recent months, the return of volatility can be interpreted as a healthy development. The uptick in volatility coincided with several negative events including fraud charges by the SEC against Goldman Sachs, continued Eurozone debt problems, financial regulation concerns, and tightening by numerous foreign central banks.

Problems in Greece, Spain, and Portugal sent investors fleeing to the safety of U.S. assets. As a result, Treasuries rallied and the dollar strengthened. Mortgages followed Treasury yields lower, with spreads more or less unchanged, as the market yawned in response to the Fed’s MBS-buying program coming to an end. Meanwhile, Commercial MBS gained despite widespread worries about rising commercial defaults and high-yield bonds add to a record run that began in late 2008.

Overall, investors continue to show desire to put cash that yields nothing to work, but they are hesitant to stick with riskier bets in the face of volatility. Investors have plenty of headwinds ahead including the removal of monetary and fiscal stimulus, interest rate uncertainty, weak housing market, national debt burdens, Chinese economic and policy questions, expiration of the Bush tax cuts, and the growth-restraining effects of the rapid rise in commodity prices.


Peter Lazaroff, Investment Analyst
Acropolis Investment Management
www.acrinv.com

Eli Lilly (LLY) Earnings and Measuring the Costs and Impat of Healthcare Reform

Eli Lilly (LLY) became the first Big Pharma firm to give some concrete numbers relating to the cost of reform.

LLY trimmed its 2010 earnings guidance to reflect a 35-cent (full-year) impact from U.S. healthcare reform. The company projected government rebates related to healthcare reform to reduce full-year revenues by $350 million to $400 million. The healthcare reform-related charges in the first quarter amounted to 12 cents, or 9% of EPS.

The charges were higher than analysts were expecting, but this will not necessarily be the case for all drugmakers. Roughly 20% of LLY’s total sales are to government programs Medicare and Medicaid, both of which received discounts from pharmaceutical firms in the healthcare bill. As more pharma firms report earnings, I think we will see that LLY’s high exposure Medicare and Medicaid creates a disproportionately large impact for the firm relative to its peers.

It will take several years for the volume created by newly insured patients to offset the costs associated with the healthcare legislation. At the same time, I expect LLY to be one of the harder hit firms in the industry.

Shares of LLY are basically flat on today’s earnings release, but they have trailed the broader market over the past year. The firm’s pipeline will not offset the revenue loss expected from looming patent expirations and it seems inevitable that LLY will need to acquire a late-stage drugs.

Without additional revenues, LLY will need to slash its attractive dividend. Of course, any M&A activity would likely lead to a reduction in the payout anyways. The bigger downside to M&A is that it has historically destroyed shareholder wealth for drugmakers.

These concerns are well-known and something I’ve covered before; I’d say the bigger takeaway from LLY’s results is that investors will now expect the same level of disclosure regarding the impact from healthcare reform. That’s better than nothing, right?

Peter Lazaroff, Investment Analyst
www.acrinv.com

March 2010 Recap

Equity markets finished the fourth quarter strong, as market participants celebrated the Federal Reserve’s commitment to keeping exceptionally low rates in place for “an extended period.”

Economic data was mixed throughout March. Investors were excited early in the month by February’s labor report, which showed payrolls dropped less-than-expected. The strength of the labor market is widely considered the key factor determining the pace of household spending. The jobs situation is lagging previous recoveries, though, and may be weighing on consumers, which was evident with the preliminary consumer sentiment index contracting.

Weak housing starts and softening home price indicators dampened sentiment a bit, but also provided additional reasons for the Fed to keep interest rates at emergency levels. Low inflationary indicators also supported accommodative policy, with consumer prices remaining flat month-over-month and capacity utilization well below its long-term average.

Inflation remains a concern in the future and the Fed is walking a tightrope with its exit plan, but equity markets appear content with the Fed’s direction for now.

All equity asset classes moved higher in March, led by domestic REITs. REITs continue to benefit from merger and acquisition activity, headlined by the bidding for General Growth Properties, which filed for the biggest real-estate bankruptcy in U.S. history.

Small cap stocks outperformed their larger counterparts. This is somewhat surprising given the fact that credit is still relatively tight for small caps. Smaller businesses are also more likely to be affected by the healthcare legislation passed by Congress in March.

Speaking of healthcare legislation, hospitals and drugmakers appear to be the biggest winners as they pick up a glut of new paying customers. Meanwhile the insurance industry is coming out of all this relatively unscathed. In the end, the most controversial proposals – a government-run insurance option and direct government negotiation on drug prices for Medicare – were eliminated from the bill.

In overseas markets, concerns about Greece eased as the bailout of the debt-ridden country gained clarity. Despite nice gains in March, international markets have underperformed the S&P 500 in 2010, with performance for U.S. investors in many developed markets hurt by the relative strength of the U.S. dollar.

Treasury yields rose to their highest levels since late last year as investor’s appetite for risk improved following last month’s volatility in the credit markets. After a bout of flattening at the beginning of the month, the curve steepened back up to finish where it started at 280 basis points spread between the 2-year and the 10-year, just 11 basis points shy of its all time high of 291 set on February 22. The Barclays Aggregate Bond Index was down 0.12 percent for the month, with corporate debt being the best performing sector in the index.

A lot was written this past month on the end of the “Greatest Bull Market in Bonds Ever,” with many analysts calling March 2010 the beginning of the next rate cycle. A rising rate environment will hurt longer-term bonds significantly more than shorter-term bonds; given our bias toward the shorter-end of the curve, we consider our portfolios well positioned to weather such an environment. The majority of bonds we hold will allow us to reinvest more quickly than if we were to buy longer-term debt and take advantage of higher yields.

Peter Lazaroff, Investment Analyst
Cliff Reynolds, Investment Anlayst

Plant some seeds in Monsanto (MON)

I’ve mentioned recently that it is difficult to find bargains in the market today, but it may be time to plant some seeds in Monsanto (MON).

The stock market rally has left behind the seed giant as falling grain prices sapped demand for seed and profits from selling herbicides were squeezed by generic competition. Not only has MON lagged the broader market, but it has trailed its peers in the fertilizer and agricultural industries.

But MON has two game-changing products about to hit the market that can drive margins and market share gains for years. The first is SmartStax corn, which has the broadest array of genes available for fighting pests both above and below ground and for tolerating pesticides. The second is Roundup Ready 2 Yield soybeans, which promise higher yields (more beans per pod).

Success of these products will further expand MON’s dominance over the food chain and help win back investors frightened by the shrinking herbicide unit and regulatory concerns. As the saying goes: be greedy when others are fearful.

“Wait, did he just say dominance over the food chain?” Yes, I did.

World population is growing and appetites are growing in developing countries with rising wealth (see related article). With only so much land and water for farming, seed technology that improves crop yield is essential to the planet’s food supply. And unlike fertilizer, the market for genetically tweaked seeds still is largely underpenetrated outside the U.S.

When it comes to the U.S. seed market, MON has at least one of its patented genes in 90% of soybeans and 80% of corn. And competitors can’t seem to catch up, choosing to partner with MON rather than compete. Pouring 10% of sales into research and development, MON has an unmatched product pipeline that Credit Suisse estimates is worth $11 to $17 per share alone. Add this to an intrinsic value between $85 and $88 for the core business and the shares appear to be a steal.

Of course, those who plant seeds in MON shares today must be patient as the upside is limited until we see positive yield performance on the company’s newest products from this fall’s harvest, these results will drive longer-term acreage targets. But, given the decent valuation, strong product pipeline, and solid fundamentals in the agricultural biotech industry, MON represents a compelling long-term investment.

Peter Lazaroff, Investment Analyst

Healthcare stocks may rally on reform bill

Bloomberg reports that U.S. health stocks are poised to rally if the overhang of uncertainty is removed by the passing of a healthcare reform. The argument in this article is extremely similar to a post of mine from January (see: Healthcare sector trending up).

The most visible positive catalyst for the industry is that the worst-case reform scenarios – a single-payer system or a public plan with a Medicare-linked fee schedule – are no longer a threat. Managed care companies like WellPoint (WLP) and UnitedHealth Group (UNH) stand to gain new customers as coverage expands to people who previously went without insurance.

A common concern for these insurers is that the government will restrict profitability by scrutinizing rate hikes as we’ve seen in recent months in California, but this concern is not justified. The fact that is important to consider is the cap Congress proposes to put on the medical-loss ratio – the percentage of premium revenue used to pay patient bills – is well above the industry’s historical average, which means that they will not be impinging on profitability as much as feared.

Overhaul or not, health insurers have always found ways to make money and preserve profitability despite government regulation. I don’t expect that to be any different this time around. Managed care, as well as pharmaceuticals, are still looking very cheap relative to the rest of the market, and removing the uncertainty surrounding reform will provide a catalyst to expand valuations throughout the healthcare sector.

Peter Lazaroff, Investment Analyst

General Electric (GE) to raise dividend in 2011

General Electric (GE) CFO Keith Sherin told investors the company would like to grow the dividend in 2011. Sherin said losses and delinquencies from GE Capital are going to peak sometime in 2010, which could allow for “a real earnings snapback,” going forward.

Substantial improvement to the leverage ratio and GE Capital, vastly improved capital market conditions, and projected earnings of $23 billion over the next two years support the idea of hiking the dividend. The company’s equipment and service and equipment backlog stands at $175 billion and is “slowly turning.”

In other news, financial reform proposals put GE under the Federal Reserve’s regulation, but do not force a break of the parent company and the finance unit. It appears GE will be able to keep its controversial industrial loan and thrift banks based in Utah.

The market seems to finally be warming up to GE and I feel vindicated.

Peter Lazaroff, Investment Analyst

Is the market fairly valued?

It’s the one year anniversary of the S&P 500 lows, and what a difference a year makes! The S&P 500 is up over 68% in the last 12 months, but clearly the tremendous opportunities that were in place a year ago are no longer there.

There are two market conditions, however, that will allow investors to take advantage of opportunities. The first is that volatility is dramatically lower. As measured by the VIX index, volatility is nearly 80% lower than it was at the time of the Lehman Brothers bankruptcy.

The second favorable condition is that correlations between assets and within markets have come down. When correlations were extremely high, and everything was going down at the same time, the only thing that mattered to investors was to have as little risk exposure as possible.

Lower volatility and lower correlations across different asset classes presents the opportunity for investors that do their homework to generate good returns. That means looking at fundamentals such as earnings, cash flow, and dividend payouts. It also means identifying long-term trends that will cause specific sectors to outperform. For example, the Technology and Industrial sectors are positioned to perform well in 2010.

But are stocks way ahead of the economy? Is the good news already baked into stock prices?

Clearly the stock market is a forward-looking mechanism that moves in advance of the economy, but it hasn’t necessarily moved too far at this point.

Economic data over the past few weeks makes the double-dip scenario seem less likely, with new orders for equipment, retail sales, and even things like hotel stays pointing to a brighter economic climate. The jobs numbers are still bad, but have shown improvement. More importantly, many individuals are feeling less uncertain about their job prospects.

Meanwhile, corporations are reporting strong cash flow and balance sheets look relatively healthy. We are starting to see businesses buy back stock, raise dividends, and increase investment for future growth – all of which are positive signs.

We always hear about historically high P/E ratios (here is a good story in today’s Wall Street Journal), but when the market is measured by cash flow (P/CF) the S&P 500’s valuation is 37% below the 12-year average and half of its valuation in 2007. P/CF has increased from roughly 4.5 in March 2009 to 8.2 today. With data going back 1998, the CF multiple has never fallen below 8.0 prior to 2008.

I believe the S&P 500 will finish 2010 somewhere between 1200 and 1250, 5% to 9% above today’s levels, but I would be concerned around 1300. Notice that I say “in 2010.” There are many uncertainties beyond 2010 that are keeping investors at bay. Because the market is forward-looking, it is affected by how far investors are willing to look into the future, which depends on their level of comfort and safety. One year ago, investors could barely look a week into the future. When a bull market is under way, investors are willing to look 18 to 24 months into the future to discount future earnings.

Some may argue that fair value is 20% below where the market stands today. I agree that buying stocks at prices 20% lower than today's would better compensate for the long-term risks facing the U.S. economy; however, I am not selling stocks because waiting for this event to occur could take several years. Markets are historically "overvalued" for extended periods of time. At the same time, ignoring the significant risks at hand is not prudent behavior either. Expectations must remain reasonable.

One year ago, investor sentiment and psyche was quite low among both individual and institutional investors. One year later, the easy money has been made, so it's important to remember that the recovery will be slow and bumpy as the economy moderates.

- Peter Lazaroff, Investment Analyst

Pfizer (PFE) bids for generics business

Oh, Pfizer. You just love acquisitions, don’t you?

Pfizer has reportedly bid $4 billion Euros (or roughly $5.4 billion U.S. dollars) for German generic drugmaker, Ratiopharm. This acquisition would thrust PFE into the big leagues of generic drugs with annual sales of roughly $11 billion compared to the biggest player, Teva Pharmaceuticals (TEVA), which had $13.9 billion in 2009 revenue.

I figured Pfizer would want to focus on integrating the massive Wyeth acquisition, which cost them more than $65 billion, before prowling for additional acquisitions to combat patent losses. The price tag doesn’t really concern me because Pfizer has plenty of cash and investing in a generics business makes some sense. In addition, global scale is critical to generics, so buying the top manufacturer in the EU’s largest market (Germany) is wise.

I suppose my main concern is the vastly different economic of generics compared to the Big Pharma model. Integrating a business with intense cost competition will be more complicated than just writing a big check and eliminating overlapping business costs.

Another concern is that annual generic sales totaled just $83 billion, according to IMS, while PFE alone generates more than $60 billion with much more attractive margins. Significant patent cliffs mean $150 billion in annual sales will go generic by 2014, but growth will then slow substantially.

I guess Pfizer is shrinking it research spending for a reason: they are going to purchase future revenues for the foreseeable future. Ok, so PFE is officially no longer a growth stock. That’s no big deal if they keep paying a fat dividend (current yield of 4.17%) and find ways to grow the dividend at a meaningful rate.

While on the topic of PFE, I should acknowledge that earlier this week an experimental Alzheimer’s treatment, Dimebon, failed to show effectiveness in a large late-stage study. This is one of the drugs I mentioned in this post as a catalyst for 2010 performance. In short, the results were very disappointing to investors.

Peter Lazaroff, Investment Analyst

February 2010 Recap

After enduring an 8.03% drop from Jan. 19 to Feb. 8, the S&P 500 posted a solid monthly gain despite concerns about sovereign debt and lackluster economic data.

January retail sales data showed that U.S. consumers are starting to pull more of their weight, but a surprising increase in initial jobless claims and disappointing durable goods report near the end of the month kept investors expectations for the economy tempered. Housing data didn’t help either, with sales of previously owned U.S. homes falling 7.2% in January to a seven month low.

More important to the markets was the Federal Reserve raising the interest rate it charges banks for emergency loans and reaffirming that broad tightening of credit was not imminent. In addition, core consumer prices fell for the first time since 1982, leaving room for the Fed to keep rates relatively low if necessary.

The MSCI EAFE index posted a small loss of 0.65% on weaker-than-expected European Union GDP data and concerns surrounding Greece’s debt problem. The MSCI Emerging Markets Index squeaked out a 0.34% gain in the face of China removing economic stimulus. The bright spot among international areas was the MSCI Pacific Ex-Japan Index, which posted a 3.12% gain on strength in Australia.

Domestic REITs outperformed all other asset classes amid merger and acquisition activity. Multiple bids were made public for General Growth Properties, which filed for the biggest real-estate bankruptcy in U.S. history after amassing $27 billion in debt during an acquisition spree. Simon Property Group offered $10 billion and Brookfield Asset Management, which owns roughly $1 billion in General Growth debt, offered $2.63 billion for a 30% stake. General Growth is holding out for a higher bid, which led REITs to advance further.

Rates were barely lower for the month, falling just a few basis points across the curve, while news in bond land was dominated by sovereign credit issues overseas. Corporate spreads domestically were tighter by a few beeps compared to the end of January, despite widening out mid-month to levels not seen since November.

Weekly Roundup: ESRX, MON, RIG

Express Scripts (ESRX) +5.89%
Investors bid up ESRX shares following 2010 guidance that suggested the integration of WellPoint’s NextRx unit is ahead of schedule.

The acquisition of NextRx gave ESRX the scale to compete with its biggest competitors in the pharmacy benefit manager (PBM) industry. PBMs negotiate drug prices with manufacturers and retailers on behalf of clients.

ESRX’s proven track record of successfully integrating acquisitions and the firm’s outlook that suggesting synergies associated with the transaction are likely to come earlier have lifted investor confidence in the firm’s ability to achieve above normal earnings growth over the next few years.

ESRX and other PBMs are positioned to benefit from positive trends such as the aging population, healthcare cost containment efforts, and increasing customer acceptance of mail-order pharmacies. More important, though, is the looming patent cliff in 2011 and 2012 since ESRX earns profit margins when customers use generics over brand-name pharmaceuticals.

ESRX’s fourth quarter income rose 8%, including one-time charges from the NextRx acquisition, helped by an increase in the use of generic drugs to 69.1% from 67.3% helped push margins higher.

Monsanto (MON) -7.10%
MON lowered its second quarter profit outlook as the late 2009 harvest is shifting purchases to the second half of the year.

MON also said the two new products they are counting on to drive earnings this decade may be planted on 20% fewer acres in 2010 than previously forecast. Farmers are trying the new products in the numbers expected, but on fewer acres. MON said the shortfall may reduce earnings by less than 5 cents a share.

The two products of topic are Roundup Ready Yield soybeans, which increase yields 7% to 11% from the original product introduced in 1996, and SmartStax corn seed, which has eight genetic changes (traits) that resist bugs and tolerate herbicides.

MON shares have been crushed this year, but I think sell-off is not justified. The SmartStax corn seed is a true game-changer that can drive margins as well as market share gains for the firm’s corn business in coming years. As for the soybean product, China recently gave import approval to Roundup Ready 2 Yield soybeans, which paves the way for large-scale commercial introduction of the product.

Longer-term, MON’s success comes down to its powerful research and development efforts – the firm plows 10% of sales into R&D – and their elite production and distribution capabilities.

Transocean (RIG) -5.30%
RIG’s earnings trailed consensus amid decreasing demand for rigs. Only 69% of RIG’s fleet was working during the fourth quarter, down from 90% a year earlier.

Utilization declined in six of seven rig categories, more than offsetting the 18% increase in the fleet’s average daily lease rate. Idling rigs, even for a few days, directly hits the bottom line since the day rates (or rental rates) are so substantial.

The market is down on RIG shares after this report, but the company’s superior free-cash-flow generation and above average earnings visibility versus its peers should not be ignored. RIG management has made it clear they plan to return significant cash to shareholders through dividends and buybacks over the next two to three years.

Last week, RIG announced a $3.2 billion share-buyback program as well as the issuance of a $1 billion special dividend. Instituting a buyback program rather than paying out a larger dividend at this juncture gives the company financial flexibility for opportunistic acquisitions.

The potential for a jackup spin-off could also help support shares in the near-term.

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Peter J. Lazaroff, Investment Analyst

Weekly Roundup: LLL, WLP, CERN, WMT, WAG

L-3 Communications Holdings Inc. (LLL) +3.33%
LLL agreed to buy Insight Technology Inc. to add night-vision goggles and thermal-imaging systems to its already diverse defense portfolio. The acquisition will be completed in the second quarter and will immediately add to operating results. Insight, which also makes laser aiming devices and laser rangefinders, is expected to have about $290 million in sales in 2010.

Just last week, LLL’s CEO Michael Strianese said the company had “plenty of dry powder” for acquisitions with about $1 billion in cash as well as access to credit. The purchase will be an all cash transaction, but the terms are yet to be disclosed.

LLL has a strong history of acquiring cutting-edge technology and his built a stable position in the defense industry thanks to its diversified product portfolio – LLL has about 2,000 contracts with no single contract accounting for more than 3% of total revenue.

The Pentagon’s budget is slated to increase by 3.4%, not including money for the wars in Iraq and Afghanistan. In particular, the Pentagon’s procurement budget is set for a 7.6% increase with command, control, and communications systems expected to see a boost. This will directly benefit firms like LLL and Harris Corporation (HRS).

WellPoint Inc. (WLP) -0.86%
WLP shares fell this week amid the company’s Congressional testimony over proposed premium increases in California. WLP said in a statement the pervious earnings forecast for 2010 is now subject to the “ability to secure and maintain sufficient premium rates.”

The health insurer has postponed premium increases of as much as 39% for two months so that California’s insurance commissioner could review the plan after it was heavily criticized by state officials and the Obama administration.

The recession and difficult labor market is leading younger, healthier individuals to forgo insurance, skewing the mix of policy holders toward the elderly. This dynamic and rising medical costs are the basis for WLP’s premium increases. Insurers were banking on federal legislation to help contain rising healthcare costs, but there is little choice but to raise rates since the healthcare bill has stalled.

Cerner (CERN) +3.00%
After a rough start to 2010, CERN has rebounded a bit in the past few weeks. Some of the bounce may be attributable to investors taking positions after the sell-off in January – the stock fell 8.22% for the month. CERN also reported earnings late last week that should a strong rebound in systems sales during the fourth quarter, which suggest the healthcare IT environment is improving.

Also lifting sentiment was various analyst upgrades for both CERN and fellow healthcare IT firm Quality Systems Inc. (QSII).

Additional content from this week:

• Wal-Mart Stores (WMT) hurt by deflation and lower traffic
• Walgreen Co. (WAG) buys New York drugstore chain

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Peter J. Lazaroff, Investment Analyst

Wal-Mart Stores (WMT) hurt by deflation and lower traffic

Wal-Mart Stores (WMT) dropped 1.09% today as fourth-quarter revenues missed expectations and soft guidance left investors unenthused.

The impact of deflation on operations is becoming increasingly obvious for a company that has traditionally been a back-door dollar play – WMT buys goods from foreign countries where the dollar is strong and sells them in the U.S. The company spent a good part of last year downplaying the impact of deflation in food and in other areas such as consumer electronics, but deflation cannot be ignored. Still, WMT has not publicly addressed with how it is dealing with this issue.

A decrease in traffic during the quarter was also responsible for disappointing results. I can’t help but assume some of the traffic decline is due to consumers trading. WMT’s low price advantage has been crucial in attracting recession-stricken consumers, but increasing signs of stabilization threaten to reverse this trend. Comparing WMT’s results to those from high-end grocer Whole Foods (WFMI) earlier this week makes the trade-up case even more compelling. WFMI raised its full-year forecast amid more store traffic and increased number of items per sales ticket.

Consumer sentiment won’t be going gangbusters until the unemployment rate moves significantly lower, but still investors should be less focused on WMT’s low-cost position and pay more attention to the company’s international sales.

Much of the company’s future leans on their international success. International operations have grown to roughly $100 billion in annual sales from nothing 20 years ago, but much of that growth came from directly acquisitions. And while international sales are growing faster than those in the U.S., profitability is lower – international operating margins are 5% and 7% in the U.S. An even bigger concern is that WMT has not been able to show the economies of scale or explicit synergies that were always the rationale for such expansion.

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Peter J. Lazaroff, Investment Analyst

Walgreen Co. (WAG) Buys New York Drugstore Chain

Walgreen Company (WAG) announced that it will acquire New York-based Duane Reade, giving WAG a leading position in the nation’s biggest pharmacy market. At a price of $1.075 billion, including the assumption of Duane Reade’s debt, WAG will acquire Duane Reade’s 257 stores, which generate the highest sales per square foot in the retail drugstore industry nationwide.

WAG expects the transaction to be dilutive to earnings in the first 12 months after closing before becoming accretive going forward. WAG anticipates meaningful distribution and purchasing efficiencies as well as back-office synergies that could amount to $120 million and $130 million in the third year after closing.

The true value of Duane Reade is their presence around the lucrative New York City market – no doubt about it. From what I have read, everyone seems to hate Duane Reade’s staff and customer experience, but the chain also seems to carry to unambiguous title of most convenient drug store in the market place. This makes the company a perfect fit for WAG’s strategy.

WAG has used its free-standing stores in prime locations as the backbone of their growth strategy for over the past decade – WAG has a store within five miles of 70% of U.S. households – benefiting from the fact that people fill their prescriptions where it is most convenient. Because New York real estate is difficult (expensive) to obtain, an acquisition like this is the only way to build a powerful position in New York.

It’s also worth noting that the acquisition represents another step away from its historical focus on organic growth. After years of rapid expansion, WAG has significantly slowed new store openings to focus on remodeling and scrutinizing its merchandise to enhance consumer experience and convenience. Management’s goal is to increase their customers’ average basket size by one item.

I think this is a nice move by WAG, but it doesn’t dramatically change my opinion of the company. If they ever consider purchasing or signing a long-term deal with a pharmacy benefit manager (PBM), then that would be a different story.

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Peter J. Lazaroff, Investment Analyst

The Fed's Exit Plan

Today, Fed Chairman Ben Bernanke released the central bank’s exit strategy. His statement didn’t shed much light on the timing of the exit, but it provided some more specific details on policy tools. It is clear, though, that meaningful tightening won’t be happening anytime soon as the Fed Chairman explained the economy still needs “highly accommodative policy.”

The Fed will “before long” modestly increase the discount rate – the rate at which the Fed charges banks for emergency loans – but explained that this “should not be interpreted as signaling any change” in monetary policy. As expected, Bernanke also discussed paying a higher interest rate on excess bank reserves and reverse purchase agreements as the first tools for tightening credit.

The media seemed to emphasize the Fed’s plan to pay interest on excess reserves, which provides banks with some incentives to not lend all of their capital. In addition, if a bank can earn a reasonable return from the Fed, which poses no credit risk, other banks loans will be priced higher and credit will contract. Until reserve levels are much lower – and they are at unusually high levels – this tool along with targets for reserve quantities may play a bigger role in the Fed’s exit strategy than the fed funds rate.

Bernanke also explained that the Fed could sell securities to drain reserves from the banking system, but he did not anticipate doing so in the near term. The Fed is allowing agencies and MBS to run off and would sell them only if “the economy is clearly in a sustainable recovery;” however, the Fed is still rolling over Treasuries into new securities.

The obvious risk to the Fed’s exit plan is the error in execution. The amount of credit expansion that could be caused by the enormous stockpile of reserves at the Fed is largely unknown, as is the rate at which banks will be content keeping these reserves with the Fed. The timing of the exit is also a very delicate balance that we can’t expect will be perfect.

Any progress towards an exit, however, should be viewed as a positive at this juncture since the “emergency” rates in place are simply unnecessary.

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Peter J. Lazaroff, Investment Analyst

January 2010 Recap

January was a difficult month for stocks as market participants weighed the impact of U.S. bank regulation, Chinese monetary policy, and Greece’s financial health.

Economic data for the labor market as well as housing demand was underwhelming, while fourth-quarter GDP – showing the U.S. economy grew at a 5.7% annual rate – lacked evidence of sustainable growth. Corporate earnings largely exceeded expectations, but investors seemed to "sell the news" and take profits rather than bidding up shares further.

Domestic equities fared better than their overseas counterparts. The hottest international asset classes of 2009 felt the most pain in January, with ETFs covering emerging markets and the MSCI Pacific Ex-Japan losing roughly 7-8% in January. This can be attributed to the pre-emptive removal of stimulus in China that included increased rates for short-term bills and higher reserve requirements for banks. There have also been rumors that the central banks ordered banks to stop lending.

The Technology and Materials sectors, which were also red-hot in 2009, posted the biggest monthly losses of the S&P 500 sectors. The next weakest sector was Telecom, where mounting price competition in wireless services is creating significant threats to profitability. Verizon cuts the price of calling plans with unlimited talk, which is likely to force AT&T to cut rates as well. The competition between wireless carriers was previously built around what handsets were available and for what price, but the competition between services costs is a definite negative.

The only S&P 500 sector to post a gain was the Healthcare sector. The stunning Republican victory for the Massachusetts Senate seat squashed the likelihood of the healthcare reform bill passing in its current form, sending Healthcare stocks soaring.

Yields pulled back in January from the end of the year selloff, and the curve set an all time record for steepness at 288 basis points on Jan 11 as expectations for a Fed rate hike in the first half of 2010 chilled out. The Barclays Aggregate Bond Index was up 1.53% after losing 1.56% in December, with no help from credit spreads, which actually had their worst month since Feb 2009.

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Peter J. Lazaroff, Investment Analyst
Cliff J. Reynolds, Jr., Investment Analyst

Pharmaceuticals in 2010: JNJ, PFE, LLY

Last week I spoke of the general attractiveness of the healthcare sector, and today I want to focus particularly on pharmaceuticals. The most visible positive catalyst for the industry is that the worst-case reform scenarios – a single-payer system or a public plan with a Medicare-linked fee schedule – are no longer a threat.

Another boon to the industry could be the significant number of late stage product results are due in 2010 and 2011. In 2008 and 2009, there were very few Phase III drugs completing clinical trials that were viewed as significant improvements in the standard of care. Consequently, the news surrounding the industry had low emphasis on sources of future revenue growth and high emphasis on generic erosion. The game-changing clinical data on tap for 2010 and 2011 could help reverse investor skepticism on the industry’s pipelines – a very substantial factor in the group’s deeply discounted valuations.

Also working in favor of pharmaceuticals is that mega deals have improved the patent cliffs, and thus the industry has a better outlook to longer-term earnings than a year ago. There is also reason to believe that some additional upside could surface over the next few years for deals involving emerging markets and biologic capabilities.

As the above dynamics generate investor interest, I expect to see the valuation gap between the S&P 500 and Pharmaceuticals contract.

Here are a few of the pharmaceuticals currently on our Approved List.

Johnson & Johnson (JNJ)
It’s hard to find a higher-quality healthcare firm than JNJ. The firm’s AAA credit rating is rare among its pharmaceutical competitors. With nearly $15 billion in annual cash flow from operations, JNJ has plenty of financial flexibility to continue making strategic acquisitions, increasing their dividend, and buying back stock.

One of the more expensive healthcare companies (as measured by P/E ratio) on our Approved List, JNJ still trades at a 25% discount to the S&P 500 and about a 37% discount to its 10-year average valuation.

The firm trades at a premium to the healthcare sector because investors value its diverse revenue base (in which JNJ controls the #1 or #2 leadership spot in 70% of its products), robust drug pipeline (with 10 potential blockbusters in Phase III development), strong brand names (Tylenol, Band-Aid, Listerine, Splenda, Neutrogena, Acuvue, Audafed, Rolaids, just to name a few), and exceptional free cash flow generation. Furthermore, JNJ’s patent exposure was more prominent in the last two years than it will be in coming years.

2010 will bring clinical trial data from two of JNJ’s Phase III drugs. In the hepatitis C market, JNJ and Vertex (VRTX) are expected to report strong pivotal Phase III data on protease inhibitor telaprevir. The firm’s cardiovascular drug Xarelto is also expected to post solid data, demonstrating its ability to prevent strokes in patients with atrial fibrillation.


Pfizer (PFE)
PFE completed its acquisition of Wyeth last quarter, dramatically altering the trajectory of PFE’s patent cliff, while expanding PFE’s geographic reach (particularly in emerging markets) and other strategic (e.g. biosimilar) possibilities. Revenue will still be substantially lower in 2015 than it is in 2010, but PFE plans to use large amounts of cost-cutting to EPS basically flat across this period. If EPS is, in fact, roughly flat through 2015, then the PFE looks inexpensive compared to its peers (32% discount) and the broader market (55% discount).

PFE trades at a nearly 60% discount to its 10-year average, which is reflective of the fact that PFE is no longer the growth story it was in the past. Still, the company generates significant amounts of free cash flow and will continue to do so. PFE’s long trend of paying a growing dividend will also continue as well as their robust cash flows quickly work down debt during the next few years.

Whether or not PFE returns to their growth-glory-days will depend on their management of a massive pipeline that is heavily-weighted towards early-phase drugs. In the arthritis market, we will likely see data this year from JAK inhibitor, currently in a Phase III program – the drug has already established strong efficacy so safety will be the focus. Based on Phase II data, analysts expect the drug to make a significant dent in the rheumatoid arthritis market. Investors should also watch for data on dimebon, PFE’s Alzheimer’s treatment.

My longer-term concern with PFE is their tendency to use big acquisitions as a platform for growth. The company’s reliance on big takeovers rather than strong in-house research and smart licensing has destroyed an enormous amount of shareholder wealth.

Nevertheless, PFE is a great way to get exposure to the undervalued pharmaceutical sector and seemingly provides more sustainable dividend income than the next company of topic.


Eli Lilly (LLY)
LLY is set for decent EPS growth through 2011, but then will begin to fall sharply for what could be a multi-year period due to the loss of several major, high-margin products to generic competition. There are some regulatory and commercial concerns about several pipeline drugs in the latest stages of development, but the pipeline may still be incapable of replacing revenue from drugs losing patent protection.

While LLY looks inexpensive on a P/E basis when using 2009 or 2010 estimates, it looks expensive when evaluating the longer-term earnings trend that is substantially lower. The patent cliff loss is similar in magnitude to Pfizer’s before their Wyeth acquisition.

Thus, LLY may be forced to do a sizeable acquisition. The immediate question then becomes whether such an acquisition would lead LLY to cut the dividend, to which management persistently denies would happen. LLY management did provide a worst-case-scenario for long-term earnings in December, but the outlook remains cloudy.

So LLY is the wild card here, but contrarians may piece together an intermediate-term investment case. The company is the cheapest among its peers, sports the highest dividend yield, and has the most negative analyst sentiment, yet there is no easily identifiable sources of downside risk in the near-term.
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Peter J. Lazaroff, Investment Analyst

Weekly Roundup: IBM, GE, UNH, JCI, RJF

Tough week for equities, which are now on a 4.9% skid. Regulatory overhaul of U.S. financial institutions and speculation that China will rein in bank lending were in the spotlight this week. Several companies reported earnings that beat expectations, yet investors wouldn’t bid up prices – it’s fair to say many of those release quarterly results were priced for perfection. Here are some of the Approved List companies that reported earnings this week and their weekly gain/loss performance.

International Business Machines (IBM) -5.81%

• IBM reported solid fourth quarter results, but the fact the stock traded lower is testament to the view that all the good news is priced in.
• Although IT spending appears to be improving, customers’ appetite for expensive IT equipment remains weak.
• IBM’s largely counter- cyclical portfolio and more limited services margin expansion should be partially countered by improving revenue growth in 2010.
  

General Electric (GE) -0.21%

• Fourth quarter results continued the stabilizing process with better-than-expected cash flow, improved orders, and declining nonperforming assets.
• There are two ways to look at GE earnings. Optimists are quick to acknowledge the earnings beat and $16.6 billion in cash from operating activities in a difficult year. Pessimists would describe the results as tax-driven and of low-quality.
  

UnitedHealth Group (UNH) -0.48%

• Better-than-expected fourth quarter capped a solid year. Quarterly and full-year revenues increased by 7%, while operating margins declined on business mix changes and lower investment income.
• Prescription Solutions, the firm’s pharmacy benefit manager, was the star performer with full-year operating income increasing 90%. UnitedHealth is the least likely of the managed-care organizations to consider divesting its PBM.
• 2009 medical cost ratio was slightly higher than a year ago, but the firm had lower administrative costs as a percentage of operating revenue. Medical cost ratio was better than most peers, which is telling of UnitedHealth’s strong competitive position and sound understanding of underlying cost trends.
  

Johnson Controls (JCI) +0.38%

• Auto parts and building-systems specialist, JCI, reported record fiscal first quarter earnings thanks to spending on improving education and government buildings.
• School building projects had been stalled while waiting for government money, but projects are now being funded through bond issuance – a more traditional approach.
• The company raised its full-year profit guidance to reflect “cautiously optimistic” view on the auto sector and continued improvement in the building-systems division.
  

Raymond James Financial (RJF) +1.65%

• Fiscal first quarter profit fell 20% despite higher revenue and lower provisions for loan losses. Still, earnings beat analysts’ estimates.
  
• Nonperforming assets fell to 1.82% of total assets from 2.10%. With decent credit metrics and reserve levels, it seems like RJF will avoid the dilution that has plagued other banks that expanded aggressively over the past several years.
  

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Peter J. Lazaroff, Investment Analyst