Tech Cheat Sheet: Find a Way to Weather the Volatility Storm

The Big Picture

Right now we are at one of those crucial macro inflection points in which everyone must focus on the bigger picture risks and understand the context within which this market is moving around.  With the talk about fiscal austerity in the Eurozone, contagion in the US and financial reform at home, there are considerable obstacles to short-term strength in equities.  This requires a multi-pronged approach.  In times like these, our first priority is to protect and preserve capital.

When markets go down aggressively, correlation tends to be very high.  This means that just about all assets (these days all assets across the globe) move in harmony in the same direction.  Diversity in a time of panic markets does not protect investors from losses.  That does not mean that investors should completely cut exposure to equities, but rather, it means buying some form of portfolio protection–whether that be a negatively correlated instrument, such an inverse ETF (such as FAZ), Gold (GLD), or US Treasuries (TLT)–or outright shorting a weak stock.

Panic markets also provide the opportunity to start SLOWLY accumulating fundamentally strong companies, companies with good relative strength and companies whose strengths or weaknesses are independent of the broader economy’s strengths or weaknesses.

Brief digression: I think inverse leveraged ETFs as investment tools are awful instruments.  Much has been written about this and there is nothing unique to add.  That being said, just because they are awful investment tools does not mean that they don’t have some form of utility.  We just have to view them in a different light.  Personally, I think due to the pervasive weakness and fragility in credit markets that the financials are more vulnerable than most sectors.  As a result, I like keeping a small percentage of my portfolio (between 0.5 and 1% depending on the level of macro risk) as insurance against a one-sided market move.  I view the risk as essentially absolute (i.e. I am ok with losing the full extent of my purchase in FAZ) but the insurance this provides in the event of a steamroller move in the market is well worth the cost.


The NASDAQ builds a wedge on the dailiy.

The NASDAQ (QQQQ) continues to exhibit far better relative strength than the rest of the market.  While the SPY continues to be dragged down by anything with housing and financial exposure, the NASDAQ benefits from the unstoppable one-way train we call Apple (AAPL), which now accounts for just over 20% of the entire index and just about every hedge fund in the world seemingly STILL wants in for more.

This Week’s Focus Stocks:

International Business Machines (NYSE: IBM)

A monthly chart of IBM shows the clear breakout level.

Let me start this one with an analogy that some fantasy baseball players and baseball fans alike might understand.  Mark Teixeira starts out every year slowly and consistently struggles through the early months.  Yet despite these persistent early season woes, he ends EVERY season batting somewhere between 280-300, with comfortably over 30 home runs, 100+ runs and 100+ RBI.  He does this every single season.  In fantasy baseball, many are reluctant to trade for slumping players, but Teixeira is a different story each and every year.  This year, he was drafted in the 1st or 2nd round and no one would trade him for anything less.  This is relative strength.

Many confuse past performance with certainty of future performance.  It’s not that Teixeira’s past performance alone justifies his lofty valuation–it’s more than that.  It comes down to the fact that Teixeira possesses a top tier, diverse skill set: he has great plate discipline, can hit for average, and can hit for power.  In essence, the guy has solid fundamentals.  This leads me to IBM.  The stock tends to get a little hurt when the broader market weakens, but it consistently outperforms the broader market.  Even in times of pervasive weakness, IBM holds up far better than the market.

Sure IBM will be hurt by the strengthening dollar–the company derives much of their revenues from abroad– but that does not take away from the fact that every year, the company delivers solid earnings, double-digit % EPS growth, an increasing dividend and top tier management (Microsoft (MSFT) could learn a thing or two from this tech giant which started purely as a computer hardware manufacturer and now is a diverse technological behemoth).  Year in and year out, IBM’s exceptionally solid fundamentals generates strong, reliable results.  We know that even if the economy weakens, at the end of the day, IBM will still be doing outstanding business around the globe.

The stock has a trailing p/e of 12 and has been averaging double-digit EPS growth over the past 5 years.  Furthermore, the company sits on a strong pile of cash ($10.90 per share to be exact), continues to increase its dividend year after year (now paying a nice $2.60/share, or 2%) and continues to buy back company stock (the company scooped up $4.02 billion in the 1st quarter alone).  For the last 8 months, IBM’s stock has been basing right under the all-time highs set back in the bubble days (the all-time high is $139.18 but monthly resistance sits at $135), only this time around the company’s earnings more than justify the present valuation.  I have included a monthly chart of IBM in order to provide a visual of the energy this stock has built up over the past decade for its next move higher.  Investors can look to buy right here with an out below the $119 area, or the $116 flash crash low, depending on your risk tolerance.

A123 Systems (NASDAQ: AONE)

A123 looks to break the downtrend.

This was a much-hyped IPO that priced at $13.50 (after an expected range of $8.50 to $9 per share) and traded up to $29 in its first day.  Few, if any, thought that in a matter of months this stock would be in the single digits.  With IPOs, it’s often beneficial to wait until after the initial 6 month lockup period ends, following which time the insiders who helped build and take the company public have their first chance to cash in on their success.  Many view ALL insider selling as a sign of weak conviction in a company’s prospects, but when it comes to IPOs, such selling should be viewed in a different light.  With new companies, many of these individuals have their entire net worths tied up in the company and sell purely for the sake of cashing something in for diversity.

I often like looking to buy such stocks after allowing for this selling to transpire.  The company pursued an IPO in order to help expand their manufacturing capacity of cutting edge cleantech lithium batteries used in many lines of hybrid automobiles and in electric grid and consumer markets, in which A123’s batteries are one of the keys between capturing energy from alternative sources and storing that energy for distribution.  The electric grid market is one in which the build-out of utility scale alternative energy projects like solar and wind will necessitate energy storage devices like A123’s batteries.

Although the stock has taken a beating this year, share prices have held up exceptionally well during the market’s bloodbath and volatility storm that started in May.  This past week in particular, the stock exhibited outstanding relative strength in trading higher on significant volume despite pervasive weakness in the market.  To me, this indicates that not only have sellers been washed out, but also, buyers have taken interest.  With a short interest amounting to 12% of the companies float, it would take nearly 5 days of average volume for the short interest alone to cover.  With the Gulf oil spill having no end in site, investor attention is quickly focusing on fossil fuel alternatives and ways to integrate cleaner energy solutions into our existing infrastructure.

AONE is a well capitalized company, with $3.93 in cash per share and a book value of $4.89.  It’s very rare to find new growth companies trading at barely more than two times their cash value and less than two times their book.  The stock built a solid base in the $8.50-$9 area against which we can initiate a position.  Starting a position will depend largely on which way the market breaks in the coming weeks.  I would look for a pullback to the $9.25 area before initiating a position, while looking to add on a break and hold above $10.


IMAX building a higher base.

As I look around the Tech space, I am increasingly intrigued by the number of companies exhibiting impressive growth, while trading at fairly modest valuations.  Market-wide, multiples (i.e. the p/e ratio of stocks) at this time are fairly modest and not necessarily pricing in much economic growth.  That is not necessarily all that surprising considering the extent of the macro risk.  Yet when it comes to IMAX, I am somewhat shocked as to how modestly priced this rapidly expanding company with name-brand recognition in the 3d space actually is.  Some of the recent weakness can be attributed to the  combination of a sluggish market and profit-taking by those who bought this stock in the low single digits.

Just this past week, Disney signed a 3 movie deal with IMAX.  This is a trend that should continue.  Following the success of Avatar in 3d, studios realized that 3d is far more than a trend.  The combination of rising theater ticket prices and improved home theater systems with HD video and digital surround sound left many theatergoers with much to be desired.  People clearly wanted more.  Why go to the movies when you can just wait for the DVD and watch it in a movie-like setup while planting on your comfortable couch at home?  Well 3d is the answer to that question.  It is more than just seeing a movie, it’s a total experience and it is far more than just a fad.  As studios continue to benefit from successful 3d up-selling, they will increasingly gear both their production and script selection to better suit the 3d format.  After all, it should come as no surprise that a fantasy-based movie like Avatar struck 3d success rather than a biopic.

Presently, IMAX trades with a p/e of 27 and a forward p/e of 15.  While typically I shy away from companies that have as much debt as IMAX, this company is unique in that it has a catalyst.  This past year, IMAX’s earnings grew by 120%, as the company continued to build out its theater presence in the US and internationally.  Since the success of Avatar, the company went from a total of $161.2 million in net debt at the end of 1Q 2009 to a mere $16.5 million at the end of 1Q 2010.  This greatly enhances the company’s profit margins, cheapens their cost of capital, and provides a catalyst in and of itself for an increased stock price.

Over the past month, the stock has built a solid base in the $15.50 to $16.50 zone in which longer term buyers could begin accumulating positions.  On the monthly chart, the real breakout occurred when IMAX took out the $12.50 level, and I see little reason (well I guess other than pervasive market weakness) that this company should revert to those levels.  Typically on significant long-term breakouts, the back-test gets near, but not to that level and the stock is free to run to much higher prices.  With nearly double the theaters in 2010 as there were in 2009 the earnings momentum should continue to grow with this company whose name alone is synonymous with 3d to many generations.

Disclosure: Long IMAX and AONE and have no position in IBM

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