Readers,

I have started a new stock market and opinion site at TheMarketTone.com.

In the near future, TheMarketTone.com will grow to be a leading provider of investment opinion, analysis, and commentary on the internet.I am currently looking for contributors to the site, you have a blog or would like to help contribute please visit http://themarkettone.com/contributors/.

I will be exclusively publishing at the domain in the near future so make sure to visit TheMarketTone.com and subscribe to our RSS Feed located at:  http://feeds.feedburner.com/Themarkettonecom

Diageo’s stock has struggled along with the overall market this year. The concerns surrounding the stock (strong GBP, weak consumer, and rising input costs) should have been eased after last week’s conference call. If anything, Diageo’s H2 earnings reaffirmed the long case for investors.

The long case:

o Cost Control
o Demand Growth Continues
o Very Attractive Valuation

Cost Control
By far, the two most sensitive costs DEO faces are its input costs and transportation costs. While DEO is largely levered to these costs, the profit growth in H2 was directly achieved through cost cutting and cost control. This is substantial because other distillers and brewers have suffered from rising corn, wheat, hops, aluminum, and plastic costs. Furthering this point, Organic net sales increased 6.6% while profits increased 9%.

Demand Growth Continues
While Europe and North America have recently slowed, the overall industry appears stable.

For example, Brown-Forman’s recent quarter reported:

o Jack Daniels volumes were up +4% globally, single-digits in the U.S., and +8% internationally
o Southern Comfort down in the U.S.;
o Finlandia continued strong growth outside the U.S. +16% globally.

These results were echoed by Constellation Brands, Fortune Brands and Diageo.

DEO’s H2 sales growth was largely driven by international performance. International sales grew by 16%, North America by 5%, and Europe by 3%. The strong performance was lead by positive growth in all brands with the exception of Johnny Walker. This should relieve the fears investors have over slowing demand growth.

Valuation
After the release analyst estimate remain unchanged, leaving the shares on at a 2009E PE of 15.1x and 2010E PE of 13.7x with an expected yield of 3.7%. This is slightly ahead of the market average, but given their earnings constancy and strong results it is probably deserved.

DEO’s recent earnings show that management is executing flawlessly in a potentially difficult environment and its customers continue to purchase it spirits. DEO stands out in the consumer products space not only in performance but valuation.

MLP Defined

A MLP is a master limited partnership. MLPs are publicly traded limited partnerships and operate in the natural resource, financial services, and real estate industries. MLPs have a significant tax advantage over other public companies; MLPs are not subject to the double taxation of public corporations. Instead they pass through the income, meaning owners of MLPs are personally responsible for paying taxes on their individual unit of the MLP’s income, gains, losses, and deductions.

Evaluating an MLP

Since MLPs are required to pay out their income to unit holders the size and visibility of future cash distributions are the largest contributing factor in the value of MLP units. Consequently, it is particularly important for investors to evaluate whether an MLP is able to meet its current distribution obligations and whether it will be able to continue or raise its future distributions. To judge this the distributable cash flow coverage ratio of used.

Cash Flow Coverage Ratio = (Net Income + Depreciation, Amortization & Other non-cash expenses - maintenance Capital Expenditure) / Total Distributions

The ratio measures compares total distributable cash flow to the amount paid out to shareholders. If the ratio is below 1.0 the firm is not generating enough cash to cover its distributions.

The Screen

When searching for MLPs it is very difficult to screen for high cash flow coverage ratios directly. Each MLP will have different portions of their Capital Expenditures geared towards maintenance of continuing operations – you will need to examine the note in their 10k.

However, the ability of a MLP to maintain and grow their distributions will be factored into the MLP’s stock price via its standard deviation and dividend yield. In theory, more unsecured distributions will correlate with a higher standard deviation, and the dividend yield will likely be higher to compensate for this risk.

I have prepared a screen of the 10 lowest yield standard deviation MLPs and highlighted this with their dividend yield and past one year return (excluding the dividend yield).

The screened MLPs represent low risk and adequate yielding investment options within the MLP space.

Disclosure: Long EPD

Tags: features, MLP, Stocks, Yield

Ultimately the performance of a stock will follow the underlying fundamentals of a firm. Stocks that are rising quickly usually represent firms which are executing well and have strong profit growth. On the other hand, stocks that are falling usually represent firms that are failing to grow earnings or whose fundamentals are declining.

Stocks which outperform the broad market have a few things in common:

• Strong earnings growth
• Affordable valuations
• Improving industry fundamentals
• A healthy balance sheets
• Sound management

Most investors target these qualities and hope their stocks will do better than most, but I would suggest also doing the reverse. Look for stocks outperforming because their outperformance more often than not is due to the traits above. Stocks with strong earnings growth, affordable valuations, and healthy balance sheets can outperform for years.

If you are a value investor you may find a firm with all of the above and at some point Wall Street will realize the fundamentals and reward the shares. But who knows when this will be. Finding shares where investors are already realizing the firm’s excellence can accelerate the process. This brings me to Relative Strength.

Relative Strength (RS) is an indexed based number which ranks how your stock is performing relative to the overall market over a given period of time. For example, if a stock has a relative strength of 80 it has outperformed 80% of the stocks over a specified period.

Combining RS with individual fundamentals can be an excellent beginning point for a stock screen.

The Screen

For this screen I took:

12-month return > 99% of all stocks
QoQ EPS Growth > 0
5 Yr. Avg. ROE > 0

For this screen I received the following results:

Clearly this screen produced stocks which have significantly outperformed the broader markets and it may represent an excellent starting point for further research. I will follow this post up in the next 30, 60, and 90 days with updates to see how they faired.

In a perfect world the value of standardized futures on deliverable assets is determined via arbitrage argument, or FP = SP*(1+RF)^t.

But a unique opportunity arises in the pricing of futures that can not be arbitraged. In this scenario there is only one force setting the price: unbiased expectation of the future price of the asset. This is the case in VIX futures (CBOE Volatility Index Futures).

Looking at the VIX Futures, it is clear that market participants are anticipating a VIX rally starting in the next few weeks and continuing through 2008.

Source: CBOE

It is important to note, the VIX moves inversely to the S&P 500 and even more so when the S&P 500 declines. According to the CBOE:

“From 1990 to 2004, daily returns of VIX and the S&P 500 had a correlation of .56 for down S&P 500 moves and .40 for up moves. Over the same period, a 1% decrease of the S&P 500 was accompanied by a 4.26% average increase in VIX while a 1% increase of the S&P 500 was accompanied by a 2.30% decrease in VIX. “

So clearly VIX Futures traders are anticipating a sharp rally in the VIX, which would likely be correlated with a 5%+ decline in the S&P. Add this to why I am not buying the market’s recent rally.

In the early part of this decade we learned, ironically enough, earnings don’t represent real money. When a company says it earned a dollar per share last quarter, it doesn’t always mean it has that dollar to spend on dividends, share repurchases, debt repayment, or re-invest in firm’s operations.

As we all know that a dollar of earnings is comprised of assumed non-cash earnings called “accruals.” These accruals are not bad or negative for a firm, but they can be red flags in identifying a changing operational environment or potential management manipulation. I will give a few red flags that you should be aware of:

Red flags:

Sharp rise in inventories: This may suggest difficulties in generating sales, over costing instead of expensing items, or overproduction; all of which are not good.

Sharp rise in payables: This may imply problems with paying suppliers, which be due to insufficient sales or credit difficulties.

Sharp increase in accounts receivable: This may signal rising competitive pressures forcing the firm to extend better credit terms; this is sacrificing future sales for today. Also, inconsistent percentages representing reserves against receivables can be a sign that management is using these reserves and a “cookie jar” to produce earnings.

Disclaimer: Keep in mind, a rise in inventories may also indicate that a manager feels sales will rise in coming quarters. In many cases inventories, payables, and receivables may be seasonal; therefore, they need to be taken into the context of the firm’s history and industry.

I am not going to make the assertion that all firms with these red flags are the next “Enrons,” but in the last year of Enron’s operations all of these red flags were present. For example, Accounts receivable increased over 300% from 1999-2000. Inventories doubled, and Accounts Payable increased 400%.

There are ways to screen and compare firms with low or negative accruals, which is indicative of a firm generating large amounts of cash. The most common is the Accrual Ratio.

To calculate the accrual ratio, simply subtract FCF from Net Income and divide the result by Total Assets. When FCF is greater than Net Income, the Accrual Ratio is negative, which is good because cash earnings are greater than accounting earnings. When Net Income is greater than FCF, it indicates that part of the income was the result of non-cash items (accruals). Earnings spiked by accruals are considered to be of a lower quality and can be indicative of manager manipulation or a changing operational environment.

I have created a starting point for investment ideas using the following screen:

Accrual Ratio > .5 (or <.5, depending on long or short)
Net Income > 0
Not in the financial sector
Market Cap > $1 Billion 

Twelve years ago Richard Sloan, from the University of Michigan, made a groundbreaking discovery; shares of companies with small or negative accruals vastly outperform (+10%) those of companies with large ones. He suggest that investors focus too heavily on earnings and not on cash generation, and this can lead to earning surprises and multiple expansion in the future. For this reason, the Accrual Ratio is a great starting point for any stock screening strategy.

Since the market “bottomed” on July 15th, we have seen a tremendous rally in all major sectors outside of materials and energy. But is this the end of a bear market or just a big short squeeze?

To answer this question we can look at historical bear market duration and price declines, and a technical picture of the market.

Historical Statistics

Historically, the average bear market has been about 305 days and a price decline of 35 percent; currently have not reached either of these levels. The historical information would suggest we have at least seen the majority of the price decline and duration.

If the market continues to rally this bear market would be the third shortest since 1900. Is anyone willing to take that bet?

Technical Snapshot

I am going to use two of the more popular and accurate technical metrics to interpret market price data, support/resistance and moving averages.

Our lows in January and March produced a line of support, at the 11,750 level. After breaking this level in late June, the market is attempting to test this new resistance level. Currently, the market is still 6% below its 200 day moving average and the average is sloping down, a signal of long term trend.

The technical picture is illustrates that we are still in a bear market. For this market to true be considered “buyable”, many technicians would want to see at least 12,500 on the Dow30.

Conclusion

History is telling us that we probably have another month or two and 8-10 percent on the downside. While we have probably have seen most of the decline, the charts are not looking too bullish. My opinion is not to get carried away. We have seen substantial moves in market indices since July 15th and it would be very difficult to continue this rate of change.

In a previous post I spelled out, why I am buying healthcare stocks for an Obama presidency . In that post I promised to provide three stocks that would benefit from this fact. The first stock was AET and now I will discus the second stock in this series, Schering-Plough Corporation.

Schering-Plough (SGP)

Schering-Plough discovers, develops, manufactures, and sells pharmaceuticals worldwide. The company has a joint venture with Merck & Co., Inc. for the development and management of two cholesterol-lowering drugs and an allergy/asthma drug.

Political concerns over government price negotiations with pharma companies have pressured the industry’s stock prices over the past year. I feel that this impact will not be as large due to its slowing momentum in Washington and the patent expirations coming in the next 3-7 years. These patent expirations will lower drug costs for consumers and insurance companies devoid of any government plan.

It is apparent that many big pharmaceutical companies are facing numerous blockbuster patent expirations in the next 3-7 years. In my opinion, Schering Plough has the best portfolio and pipeline position within the big-pharma group. Although SGP stock has faced headwinds from a recent ENHANCE panel, which I will discuss, I feel because of their above average portfolio/pipeline SGP will out perform its competitors in the next 12-18 months.

Product Portfolio and Pipeline

Almost every U.S. pharma company will experience sharp blockbuster patent expirations starting in 2011. Add this to a large pipeline shortfall along with the fact that drug development takes a decade and the future becomes very foggy for these firms.

In this fog, one pharma firm stand out, Schering Plough. SGP has the lowest patent exposure in the industry, with only 15% of current revenues exposed to patent expirations in the next 7 years. This relatively low exposure will allow SGP to remain the industry’s top growth firm well into 2012.

Source: Credit Suisse Estimates

SGP has its fair share of patent expiration in the next 7 years, these include Zemuron, Puregon(Follistim), Livial, Temodar, Implanon, Noxafil, Depot, Avelox, and Asenapine. But if you look at the expected revenue of SGP’s pipeline compared to the loss of patent exposed revenues, SGP is an industry leader. Its 2015E pipeline revenues exceed its patent exposed revenues by 11.6%.

Source: Credit Suisse Estimates

Given the above information, you can see why I feel SGP has the best pipeline/portfolio mix to weather the coming patent expiration storm.

Concerns over ENHANCE Cholesterol Findings

The study found that Vytorin, a combination of Merck’s Zocor and Schering’s Zetia, worked no better than Zocor alone at removing plaque from arteries. This has had the effect of reducing the market share of Vytorin from ~12% to about ~9.0%, where it has stabilized since April. The ENHANCE panel results should not effect the stock price further as Vytorin’s market share is stabilizing.

Valuation

Given SGP’s low exposure to patent expiration and promising pipeline revenue, investors would expect to see SGP have a premium multiple. This is not the case.

Looking at the industry’s P/S and P/E multiples we see SGP trading inline with its more patent exposed and less pipeline plentiful competitors. I feel SGP is deserving of conservative industry leading forward multiple of 15x giving me price target of 26.00, representing 20% increase from yesterday’s close.

Tags: Equities, Healthcare

In a previous post I spelled out, why I am buying healthcare stocks for an Obama presidency. In that post I promised to provide three stocks that would benefit from this fact. The first is Aetna Inc.

Aetna (AET)

Aetna, Inc. operates as a diversified health care benefits company primarily in the United States and Canada. The company provides health insurance products and related services, including medical, pharmacy, dental, behavioral health, group life, and disability plans, as well as medical management capabilities and health care management services for Medicaid plans.

Aetna has been making a strong recovery from its annual loss in 2001, showing consistent EPS growth in the following 7 years.

Source: Aetna Inc. SEC Filings

Many of its competitors have gone through troubling acquisitions, while Aetna has built consistent organic operational growth. Much of this has come through the addition of new product offerings and integration among its segments to optimize cross selling.

I am promoting a buy on AET because of its strong operational success and affordable valuation.

Operational Success

In Q2 we learned that AET has already achieved 72% of their full year membership guidance. This should put the wind at their back to meet their full year membership goal of growing medical membership by 50,000 “lives” in 2008.

In 2007, 5.7% of Aetna’s pre-tax income was generated by Medicaid and Medicare healthcare programs. AET is diversifying is revenue streams and seeking to gain greater access to Medicaid and Medicare markets and many analysts estimate that AET could generate over 10% of EBT from these programs in 2008.

Additionally, AET reaffirmed its guidance for full-year 2008 EPS, while other healthcare companies such as Coventry Health Care have had to reduce full year guidance due to cost pressures. AET’s new product offerings, scale, and growth have allowed it to better handle cost pressures.

In my past post, I spoke of the most likely scenario for universal coverage would be for an expansion of the Medicare and Medicaid programs. With AET’s diversification into these growing markets, it will stand to benefit from an Obama presidency.

Valuation

AET trades at 8.9x forward earnings estimates with a PEG of .6 which compares to its industry F P/E multiple of 9.3x. This is the same level in which AET’s valuation bottomed out at in late 2003. I feel that the entire industry will experience a multiple expansion over the next 12-18 months as investors realize that cost pressure will subside and government spending on healthcare will increase. AET should receive the greatest benefit from this multiple expansion due to its strong operational success and growth.

Tags: Healthcare, Obama

Yes, it looks like option traders are betting on a jump in EMC shares during the next two weeks. Aggressive call-buyers traded over 113,000 of the $15-stirke calls, three times the open interest, pushing the contract up 72 cents or up 380%.

The contracts closed at 89 cents, meaning the EMC shares would need to surpass $15.89 for the call buyers to be profitable. One can only hypothesize the motivation, but the WSJ’s Tennile Tracy quoted rumors that Cisco Systems might make an offer for EMC, or that EMC possibly will divests its 85% stake in VMWare.

EMC’s Chairman and CEO Joe Tucci did not deny this proposition in EMC’s Q2 earnings call saying “I kind of know a lot more of what’s going on than anybody else and we will do the right thing for the shareholder when and if the time is right.”

Additionally, the opportunity to announce this divestiture may come at be Pacific Crest Securities technology conference on August 4.

Tags: buyout, EMC, Equities, Spin-off