Thursday, December 13, 2007


Enduring this long drawn out mid cycle correction has been no fun. I am thankful that it is finally coming to the end. I believe it was more than a year ago that I wrote about how the word recession would come up often when the turn was upon us. At the time, I had no idea it would take so long.

In the past several days, "big houses" such as Merrill Lynch and Morgan Stanley have called for a recession just ahead. Whether there is or is not is not the important point. I do not believe there will be an official recession as the definition has historically been two consecutive quarters of negative GDP. In the most recent quarter, we saw growth of 4.9%. Growth in the current quarter will probably fall to about 2% but again, even if it goes negative investors should remember that stocks typically go up before recessions are known to have been. In my humble opinion, the current political game being played by the congress and the president is the fly in the ointment. The congress simply refuses to pass the budget without several tax increases and Bush has refused to accept a budget that includes tax increases. The congress is likely to pass a one week continuing resolution but even so the budget needs to be passed this week.

Here again, the exact compromise reached is not so important to the markets as is just moving forward. The one thing markets hate the worst is uncertainty. As always, it is the waiting that is worse than the problem. I believe the 5+1 nations are purposely playing a game of "good cop--bad cop" with Iran. The Chinese and the Russians have alternated in the role of good cop and the US, France, England and Germany have taken turns being the worst of the bad cops. While the 5+1 take forever to decide what the next round of sanctions will be, Iran is left to stew but then is given a bone by Russia or China. The methods being used are nothing more than the "carrot and stick" approach.

I have followed the actions of the "big boy investment banks" long enough to know that they tend to make out like bandits during the toughest of times. Indeed, Merrill Lynch does a lot of advertising during the tough times because accounts move when they are down in price. Of course, I am not accusing Merrill Lynch, Morgan Stanley or any others of doing illegal acts. It is simply an observation that Goldman in particular is good at buying big when the markets are low. When ever the "big boys" are talking about recession, you can bet your boots that their trading desks are buying a lot of stocks.

8,000,000 SHARE OF CAL

Yesterday, more than 8 million shares of CAL were purchased. This volume was about double the norm. While I do not believe that anyone can pick exact bottoms well, the action yesterday looked an awful lot like a "blow off" or "capitulation". Wouldn't you know that Merrill raised its 2008 price target for oil to $90 per barrel yesterday. This $10 increase is to come in the first year of significant new supplies coming on line and the first year of significant conservation. The number of rigs drilling for oil went up dramatically from 2002 until recent months. Now that a number of large reserves have been discovered, the drilling activity to decline. Development wells will still be drilled, one right after the other, but these wells are in know oil fields. These wells are not looking for a needle in a hay stack. The drillers already know the oil is there. My memory tells me that there are only about 340 active rigs in Saudi Arabia. There are about 1,400 in the USA. Here again, the Saudis are not searching far and wide for oil but steadily drilling in known fields.


CAL is a very cheap stock. The analyst who now assume that the economy will be slow next year and that the price of oil will stay at extreme levels have typically reduced CAL's projected earnings to around $3.75 during 2008. The stock is selling for less than 7 times earnings. It is selling at only .2 times sales, 2 times book, and 2 times cash flow. Cheap, cheap, cheap.

The contrast to a stock like Apple makes one almost dizzy. Apple trades at 49 times earnings, 7 times sales, 12 times book, and 42 times cash flow. Google has interesting numbers as well. It trades at 56 times earnings, 15 times sales, 11 times book and also at 42 times cash flow.

Some 25 or 30 years ago, I got a good chuckle when Peter Lynch said that a stock with a PE of 40 would be worth something by the time Cher became a grand mother. I bet Warren Buffet would not buy a stock trading at 49 times projected earnings even if you held a gun to his head.

The key numbers that bring some rationality to the prices of these stocks are the profit margins and sales growth. CAL has a profit margin of 3.35% and a sales growth rate of about 8%. Apple enjoys a profit margin of 14.5% and sales growth of 24%. Google is the prize of the bunch. It enjoys at profit margin of 26% and it is growing sales at the rate of 60% compounded or better year after year!

The key question in regard to these companies is, "do they enjoy a moat" in Morningstar terms or in Warren Buffet terms, "do they have a sustainable competitive advantage"? A tricky question but if I had to choose one of the three for having the most powerful competition, I would choose Apple. Companies like Texas Instruments, Nokia, Samsung and Motorola are constantly bringing out new and better phones. Staying on the top of the phone heap is going to require constant innovation.

Google faces lots of complex challenges on lots of fronts. For example, Google only has about 28% market share in Russia. One of the reasons it has struggled in Russia is because credit cards are not very common. Google has lots of "little" issues to tackle. Still, I believe mobile search will be more than half of Google business in just a few years. Google is going to more than double its revenues on desk top computers while it brings on phone revenues of several times the size.

CAL has built a substantial "moat". Forty seven percent of its flights are international flights. Many of these flights are the only direct flight available. The flights are on the newest fleet among its competitors with planes that get 15 to 40% better mileage. The company has the most sophisticated reservation system in the business. Customers at 227 airlines buy one ticket that includes the CAL leg or legs of their flights. CAL has the reputation among the high dollar business travelers as the best in the business. The moat CAL has built around its Liberty New Jersey Hub is most impressive of all. CAL operates the only true international hub in the New York area.


I have always been up front about my long term approach. I started buying CAL when it was around $6 a share in 2002 and it has been a good investment. I still project it as a $150 stock before this cycle is over. I certainly wish I had know it was going to trade dramatically lower during 2007 but the exact path the stock takes on the way to $150 per share is not so important. Yesterday, the FOMC, which has been dragging its feet, waiting on congress, announced new measures to provide liquidity to the banking system. In someways the new measures do not amount to much but are a way for the Bush administration to be able to say, "we did our part". The pressure is still on the congress to act. On the other hand, the new program will pump $20 Billion of reserves into a banking system that only has $44 Billion of free reserves. Free reserves are powerful dollars.

Still, the FOMC must eventually take the brakes off and let the Fed Funds rate float down to the 90 day t-bill rate. Of course, the t-bill rate is not a static number but right now the FOMC could cut fed funds by 100 points and still be well above this market rate.


In prior letters I told you that company insiders have been buying heavily. This is one of the strongest indications that stocks will be a lot higher in 6 to 18 months. Today, Goldman Sachs announced a new $30 Billion Fund. Goldman and partners have raised a lot of money so that Goldman can work its magic. I am sure that Goldman will earn fees as the manager but that a chunk of the money belongs to Goldman. THINK ABOUT WHAT JUST HAPPENED! Goldman was busy doing IPO's a few months ago. It was earning big fees by bringing selected companies to market. Now it is focusing on the "buy side". It will use the $30 Billion to do leveraged buyouts. The total value of the companies it will buy will be huge. If we assume that the company will put up an average of 10% in cash, (probably less than 5%), the $30 Billion would buy $300 Billion dollars worth of stocks.

BUY LOW SELL HIGH. You many not have money available to add to your account right now, so it may seem difficult to buy low. The truth is that stocks go up and up and up over time. A few years from now, the "correction of 2007" will look like a dimple on stock charts. The compounding effect will take over and boost all accounts that hang-in through the tough times.