Streetwise for Sunday July 26, 2009

Streetwise

Lauren Rudd

Sunday, July 26, 2009

Be Careful Of What You Listen For

Last week I mentioned a parable, attributed to Kermit Long, about two men who were walking along a crowded sidewalk and one mentioned he had just heard a cricket. The other commented he had heard nothing and asked his companion how was it possible to hear a cricket amid the din of the city?

The first man simply took a coin from his pocket and dropped it on the sidewalk, whereupon a dozen people began looking around. “We hear,” he said, “what we listen for.”

Well, we certainly put that supposition to the test when Neil Barofsky, the special inspector general for the Treasury’s Troubled Asset Relief Program, was asked for the largest possible cost number for TARP.

Barofsky stated that, “The total potential federal government support could reach up to $23.7 trillion.”

It did not take long for every talking head on the planet to pick-up on that figure with a cry of “The sky is falling.” Yes, everyone heard the falling coins, but unfortunately no one heard the cricket.

Specifically, Mr. Barofsky qualified the $23.7 number, stating that it was vastly overblown. For example, it included estimates for the maximum cost of programs that have already been canceled or that never got under way.

It also assumed that every home mortgage backed by Fannie Mae or Freddie Mac goes into default, and that all the homes turn out to be absolutely worthless. It assumes that every bank in America fails, with not a single asset worth even a penny.

And it assumes that all of the assets held by money market mutual funds, including Treasury bills, turn out to be worthless. It would also require the Treasury itself to default on securities purchased by the Fed.

Trust me; if that scenario ever played out the cost of the TARP program will be the least of your worries. Nonetheless, Darrell Issa, the ranking Republican on the House Committee on Oversight and Government Reform, rushed out a briefing memo highlighting the $23.7 trillion number. Yet, he somehow forgot to mention the assumptions.

Let me give you another example, one that could directly impact your portfolio. A highly touted stock these days is Green Mountain Coffee Roasters (GMCR). If you bought this stock at the beginning of the year, you have a 68 percent return; a purchase a year ago yielded a 165 percent return. However, the trailing 12 month earnings were only $1.05 per share with a price to earnings (P/E) ratio of 62.

In other words, if the company paid out all their earnings to shareholders, it would take over 60 years to recoup your purchase price of the stock. And there is no dividend. The intrinsic value of the shares is $47 using a discounted earnings model and $46 per share using a free cash flow to the firm model. The shares recently closed at $65.

Investors also appear to be ignoring factors such as Green Mountain’s 67 percent debt to equity ratio and that institutional investors hold less than one percent of the shares outstanding. You see, people hear what they listen for.

Meanwhile, Gilead Sciences (GILD) has an intrinsic value of $67 per share, using the discounted earnings model, and $79 with the free cash flow model. The shares recently closed at $48 with a P/E of 21. The debt to equity ratio is 24 percent.

Although your return was a negative 2 percent over the past 6 months, the past three months netted you a 10 percent capital gain. Furthermore, 1,179 institutional investors hold 95 percent of the outstanding shares. Keep in mind that institutional investors generally carry out considerable due diligence prior to taking a position.