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Differentiating Sow's Ears From Lemons

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Two old proverbs: 1) When life give you lemons, make lemonade. 2) You can't make a silk purse out of a sow's ear. In the first case, we learn to make the best of a bad situation. In the second, we learn we cannot make the best of a bad situation. So which is it?

Hmmm. . .a proverbial dilemma! What got me thinking about this was our faithful readers' desires to make money in light of the drubbing the market has given our 401K accounts over the last three years. I know - some probably don't need to be reminded. My apologies. But the fact remains that despite the bear market, some stocks are going to do incredibly well over the next few years by experiencing huge price moves, even in the carnage experienced by most other stocks.

Many of you know that I am a fan of dividend-paying, blue-chip stocks of great business on sale with a margin of safety. A guy named Warren Buffet says the same thing about stocks he likes to own - except the part about dividends since he's a bigger fan of retained earnings.

Anyway, much as technicals play the biggest part of my trading, I'm still Fundamentals Guy at heart. To that end today, I want to walk us through the methods I use to uncover potential values. I can't make a silk purse out of a sow's ear. I can't cobble money from the scrap heap of dead companies either. That's alchemy, a physical impossibility.

But in the case of stocks, there are invariably some fundamental bargains that are priced reasonably compared to the over-hyped (yes, it still happens) darlings of Wall Street. Already within the apparent sour lemon are the makings of lemonade. That's chemistry, a manageable science.

So where do we look for bargains? Glad you asked. It's really pretty simple. The first two things in which I zero in are 1) does the company make money? 2) does it have any cash? If it doesn't have any cash, it better be paying a hefty dividend by making money. Real Estate Investment Trusts (REITS) and Master Limited Partnerships (MLP's), both of which are traded in abundance on the NYSE and, to some degree, on the NASDAQ and AMEX, are great examples of hefty dividend-paying issues.

But since MLP's produce not only a return on equity, but also a return OF equity, they eventually shut down or burn out. With REIT's, all the eggs are in one real estate basket, which I consider to be greatly over-valued (despite attractive dividends) given the current state of the economy. The good news is that there are old stodgy companies out there that make money. One of my favorites is a sin stock - Philip Morris (MO). Let's take a peek. From Yahoo Finance, I pull up the Company Profile and see the following:

Yahoo Profile of MO:

First of all, while we don't see it here, a company description of MO would read something like, "Huge and efficient organization that sells stuff with broad appeal - mostly necessity or addiction (food, booze, cigarettes) - which command huge margins and make money for the company". Everybody ought to want a piece of that kind business, moral issues aside [we're talking about making money here, not saving the world].

Here's a dirty little secret too, which plays to investors' advantage. I almost hate pointing this out. But. . . the government will NEVER let MO's revenue stream slip, let alone allow MO to go out of business. Why? They want the money too - the tobacco taxes on every pack of cigarettes, not to mention the 20-yrs of protection money to be paid in the name of healthcare expenses caused by overly-sick smokers. Correction - the government NEEDS that money.

Did I mention MO pays a 5.44% dividend, which has steadily risen throughout the years?

But here's what jumps out me. Remember, "First I look at the purse" to quote the Jay Giles Band. Look at that cash - $1.38 bln worth, which although amounts to only $0.65 per share, MO clearly can pay their expenses with no danger of people all of a sudden ceasing to buy their products (Did I mention the steady revenues?). Thus, it doesn't need to keep a Microsoft-like $38 bln lying around. MO doesn't need to keep it around thanks to its steady revenue and earnings stream.

Another thing - $90 bln in sales and nearly $9.5 bln available for distribution to owners AFTER Earnings Before I Trick Dumb Auditors (EBITDA)! Note the valuation ratios too: slightly greater than 10 times a steady stream of earnings; slightly greater than 1 X sales. Nearly 5 X book value isn't so hot, but considering that as depreciation is taken on assets until they are ultimately reduced to zero, which would cause book value to drop - and MO has some old assets that have been reduced to $0 through depreciation - the denominator in "price to book" ratio is decreasing. As such, I can live with price to book a bit out of whack.

That's the lemon-aide Now let's look at a sow's ear, Lucent (LU)

Yahoo Profile of LU:

Same analysis: A company description might read, "Former giant in a beaten up industry trying to sell products that very few currently want in an already narrow market. LU recently warned of their 9th straight loss." Yes, it's much harder to sell an optical telecom switch to a bankrupt CLEC than to sell a truckload of beer, cigarettes, ketchup, or pretzels at Wal-Mart. LU does not have a business that anyone should aspire to be in right now.

But to be fair, let's look at the numbers. Whoa! A juicy $5.4 bln in cash! That's a bucket more than MO and the equivalent of $1.58 a share in cash. Their cash holding could buy back ALL of their own outstanding stock. But wait - the share price is only $1.05 and LU doesn't pay any dividend. Man that's cheap! A bargain?

The market is valuing the company at less than the amount of cash on hand. Why? Take a look at that debt load - 3.71 debt to equity ratio in a wrecked industry

Anybody have in any confidence in their revenue stream? Me either. But again, to be fair, let's look. Hmmm. . .sales of $15 bln. But what's this? $11.9 bln loss before they tricked dumb auditors with an actual $16.5 bln loss to shareholders. That's $31.5 bln in expenses vs. $15 bln in revenues. Looks like that $5.4 bln in cash will be burned up in four months. Is it any wonder investors have dumped this stock and reduced its price to just over $1 through lack of demand? Yeah, it's cheap, but it's cheap for a reason.

I'll make this point here before I go. Just because a stock is cheap does not make it a good value. Any stock can go to zero, including LU. To change their business picture would take an act of alchemy. Conversely, an "expensive" stock may be the relative bargain. If we want to make money in this market, we have to find the lemons and let the market make the lemonade. Sows' ears will never be a silk purse. Learn to distinguish the difference and reap the financial rewards.

Make a great weekend for yourselves!

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