Jeff Saut Presents: Investing on Noise
Be careful to listen through the noise.
In his book, Capital Ideas, Peter L. Bernstein discusses "Noise" and contrasts it with information:
"Noise arises as people buy and sell on what they believe is information but is really rumor, badly analyzed information, misinformation, or hunch. Confused by the noise, investors respond to their brokers' urgings to 'Hurry, hurry!' . . . suggesting that many people trade on noise simply because they enjoy fooling around and trading on hunches. Others are not even aware that they are trading on noise - they believe they are trading on reliable information.
. . . Noise traders who take their tips from stories told at cocktail parties, chase only what is hot and dump their stocks in a panic, lose out in the long run no matter how smart they may seem in the short run. They end up selling too cheaply to better-informed, and patient investors, or else they pay too dearly for stocks that more systemic investors are kind enough to sell them."
For the past few weeks we have characterized the current market as "noisy." While noise often pertains to cult-stocks like Taser International (TASR), which has gone from $6/share to $33/share and back to $6 over the past two years and with "the lightning round" passing as legitimate investment advice, "noise" has even crept into Raymond James' universe of stocks. For example, recently rumors swirled that Linens 'n Things (LIN) was putting itself up for sale, lifting those shares from $22 to $30, where the cocktail-crowd bought the shares, and are now sitting with losses. Or how about LaserCard (LCRD), which leapt from $5/share to $10 in two weeks on rumors of a large contract. Currently, the rumor du jour is that Google (GOOG) is considering a bid for InfoSpace (INSP). Ladies and gentlemen, investing on "noise" is a sure road to disaster, yet the difference between perception and reality is where our opportunities lie.
A case in point is Synagro Technologies (SYGR). Over the past few weeks Synagro has declined by roughly 15% on rumors that the amount of natural gas it uses to palletize wastewater sludge was "killing" the company given natural gas' parabolic rise. In speaking with our analyst, however, we learned that most of Synagro's contracts are written such that a rise in the company's energy costs is a pass-through item to its customers. Moreover, as the nation's largest recycler of biosolids, serving over 560 municipalities, Synagro has a competitive advantage when bidding on new contracts. To wit, the company is the only bidder for the upcoming Philadelphia contract. If Synagro wins said contract it will likely not be very accretive in the first year as the company builds the Philadelphia facilities. In 2007/2008, however, this contract should add $5 million to $6 million in EBITDA. Accordingly, the recent "flop" gives the patient investor the opportunity to buy shares from the noise-investors. Manifestly, if you were astute enough to buy Synagro at $4.50/share last week, a rise to our analyst's 12-month price target of $5.00/share produces an 11% capital gain and when combined with Synagro's 8.5% dividend yield provides a total return of nearly 20%. Indeed, the difference between perception and reality is where our opportunities lie!
More noise-induced opportunities presented themselves recently when 6.7%-yielding Enterprise Products Partners (EPD) sold-off on worries about Hurricane Rita. Likewise, Cognos (COGN), covered by our Canadian subsidiary Raymond James Ltd., has declined on worries that growth is slowing. However, growth has slowed because customers have curtailed the buying of Cognos' existing products, awaiting the rolling-out of the new state-of-the-art "Cognos 8" product. Recall that Cognos is the leading provider of business intelligent software that helps companies transform vast amounts of corporate data into information that improves business performance. Indeed, Gartner Group recently recognized Cognos as the dominant brand in business intelligence software. Also notable is that some of these business intelligence metrics are mandated by the Sarbanes-Oxley laws. Further, Cognos has a great management team with a strong record of value creation, as reflected in its 20%+ return on invested capital (ROIC). Moreover, without the drag from its excess idle cash ($5 per share) Cognos' ROIC rises to 50%. Yet, "stock noise" is not the only noise currently echoing down the canyons of Wall Street.
Last week we were on CNBC with two other strategists. One of these fellows knew all the statistical economic information, but had no sense of what is happening in the "real world" . . . that would be the world in which you and I live. This gentlemen espoused the belief that inflation was virtually non-existent and that the economy was doing just GREAT! As noted in these missives, we thought the economy was cooling even before "Katrita." Moreover, as repeatedly stated, our governmental bureaus have a HUGE measurement problem when it comes to indicators and consequently their statistics, are at best, suspect; begging the question, "if you think inflation is less than 2% why is the middle-class shrinking?"
The other fellow joining us on CNBC was from the astute investment management firm Cumberland Advisors. Speaking to the inflation question Cumberland's David Kotok posed the following conundrum (as paraphrased by us): The Fed says its preferred measure of inflation is the market-based core PCE (personal consumption expenditure deflator). Core PCE does not include energy. That suggests there is no inflation in the current data. . . So, why is the Fed worried about inflation if its preferred indicator says don't worry? Is the Fed telling us that their preferred indicator really isn't that preferred? (Since the PCE doesn't include energy) are they saying it is energy prices that are raising inflation expectations? If so, then the Fed should not raise rates since energy prices will not pass through to an inflationary spiral. Consequently, the Fed Funds rate at 3¾% is already way above PCE-measured inflation. If the Fed wants to use energy, it must look at the CPI, which includes energy and is approaching a 4% inflation rate. The Fed can help its search for transparency by clarifying this issue for the markets.
Clearly we agree with David Kotok given our recent statement that one of our worries is the lack of future visibility from the Fed. David concludes his comments by noting, "At Cumberland we are holding a cash reserve on the stock side. We are also keeping duration shorter than benchmark on the bond side. Risk premia in stocks and bonds are rising. We are not sure in which market they are rising faster. It could be both of them." Obviously those words "foot" with our "predominantly defensive" investment strategy of recent weeks.
The call for this week: With the end of the quarter now behind us maybe the noise-level subsides, yet we remain cautious. Consequently, we were surprised by last week's report in The Wall Street Journal of the Dow Jones Hedge Fund Benchmarks, which showed that the various hedge fund investment styles only produced YTD returns of between -5.3% and +5.6%. Why surprised? Because our conservative strategy has returned 16% (excludes dividends) for the Focus List YTD. We continue to invest accordingly.
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