Cover Story: Healing Aetna By Lawrence C. Strauss
Highlighted companies: Aetna (AET), Merck (MRK), Humana (HUM)
Summary: Following an unprecedented 350% return over the past five years, health-insurance giant Aetna's shares sold off in early August due to a surprisingly high commercial risk medical-cost ratio [MCR]. Higher-than-forecasted medical costs (8.5% vs. 4%) for the first half of 2006 caught Aetna off guard; investors now fear that medical costs may be rising faster than the company can raise insurance rates to compensate. A third straight year of industry-wide decelerating premium increases is cause for further concern. However, with a still-reasonable P/E ratio of 13, the self-correcting nature of MCRs, and healthy profits in Aetna's other arenas, many analysts remain bullish on the stock. Since the stock blow up, Aetna has trimmed its full-year membership-growth estimate from 900,000-1 million to 700,000-750,000, reflecting a need to raise premiums. Aetna has thus far shied away from Medicare-based accounts, confining itself to the commercial sector which is mature but somewhat saturated. Now seen as a high-growth area, Aetna executive Ronald A. Williams says Aetna "may do more with Medicare over time."
Quick comment: Aetna's currently carries a cash-balance of $23/share, while its stock is trading just above $36. This has caused Phillip Frank to speculate that it may soon become the subject of a leveraged buyout offer [LBO] by a private equity consortium, who could use Aetna's cash to fund the buyout. Jim Cramer, though, sees Aetna's latest woes as a sign of inept management.
Big on Bill and Warren by Sandra Ward
Highlighted companies: Microsoft (MSFT), Berkshire Hathaway (BRKA), Google (GOOG), Apple (AAPL), ExxonMobil (XOM), Royal Dutch (RDSA), Chevron (CVX)
Summary: David Richards, private investor and former money manager at Capital Research & Management and PrimeCap, takes issue with the Fed's recent halt in interest-rate increases. Core CPI numbers, which fail to account for price-increases in key areas such as food and energy, have understated true inflation, and will lead to large price increases and ultimately interest-rate hikes. Higher interest rates will bring on a housing-market crash, and a subsequent loss of confidence in the dollar. He suggests avoiding companies whose customers depend on credit, such as retailers, finance companies, credit-card companies, and banks. He is bullish on companies that have a degree of protection against inflation, such as gold and oil-based stocks. Microsoft and Berkshire Hathaway both remain good buys, due to a large cash surplus, and the ability to sell their products at increased prices despite inflation. Rising interest rates, combined with unsustainably high hedge-fund fees and unreasonably optimistic expectations, could lead to disillusioned investors and a flight from the equity markets. Luxury spending thus far has been financed largely by "people [who] have used their houses like an ATM machine," which could lead to a sudden drop in consumer spending. Oil prices should continue to rise; the huge cash surplus of many major oil producers acts as a disincentive to new exploration. A volatile and largely anti-U.S. geopolitical scene could lead to a lack of interest in the dollar.
Quick comment: Despite his pessimism towards the stock markets, Richards actively pursues what he sees as 'investment safe-havens' to park his money, due to his equally pessimistic dollar stance. "I don't want to hold cash because the dollar is going to go down." At the same time, he remains bullish on Microsoft and Berkshire, citing that, "they have cash." In a related article in Barron's this week, Marc Chandler dispels some of the common misconceptions about what causes the dollar to rise and fall (trade deficit, interest rates), and makes the case for a strong dollar, at least short term. For their part, Hathaway has been and continues to be short the dollar, and has been actively exploring foreign investment, such as its recent $4 billion purchase of Israeli manufacturer Ischar. Also in Barron's this week, Lon Witter furthers the case for a burst of the housing bubble: people buying houses they can't afford, or using home-equity loans to live beyond their means, funded by adjustable-rate financing, means that inevitable mortgage-rate hikes will eventually flood the market with houses their owners can no longer afford. Finally, in a related article, Thomas G. Donlan, while not completely discounting the possibility of further rises in oil prices, argues that "what goes up must come down," and that in the not-so-distant future the cyclical nature of oil prices will drive it back to the $20-or-so per barrel plateau that has prevailed for decades.
Meet Mr. Generosity by Jim McTague
Highlighted companies: Fannie Mae (FNM), Gannett (GCI), Goldman Sachs (GS), Temple Inland (TIN), UnitedHealth Group (UNH), KB Home (KBH), Target (TGT)
Summary: James Johnson sits on the board-of-directors of six corporations, and chairs the compensation committees of five of them. Analysts question whether he's spreading himself too thin. Almost all of the companies he's associated with have been flagged by industry watchdogs as having executive compensation packages that bear little connection to performance and lead to 'runaway compensation.' ( The sole Johnson company that has escaped criticism thus far is Target, which Johnson has directed since 1997, and chairs its compensation committee.) Worldwide, only 2% of all companies are accused of such irregularities. Although Johnson was instrumental in the expansion of Fannie Mae, federal regulators recently criticized him for creating a culture of arrogance that eventually led to the company's overstating income to the tune of $11 billion. Earlier this year, his image took a hit with the disclosure of possible backdating of stock options at UnitedHealth Group.
Quick comment: As noted by Barron's, researchers at the University of Texas have found that directors who were themselves highly paid tend to approve compensation packages for their peers that far exceed industry standards. Spreading the wealth? Compensating for the guilt of gluttony by indulging others? In an environment of increasingly lean bottom-lines, it would be short-sighted for companies to ignore the lack-of-confidence that such one-hand-washes-the-other mentality generates.
Hunting Season in Japan by Leslie P. Norton
Highlighted companies: Hartford Financial (HIG), Millea Holdings (MLEA)
Summary: Over the past five years, Hartford Financial has held the No. 1 slot among sellers of variable annuities [VA] in Japan. Last year, its Japan sales outstripped those in the U.S., and accounted for 3/4's of Hartford's earnings gain of $159 million. In the second quarter of 2006, however, Hartford's Japan sales slid 47%, and its market share is slipping. Hartford now forecasts $5-$6 billion in Japanese VA sales this year, vs. over $10 billion in 2005. This, coupled with a vaguely-disclosed capital infusion of $423 million in 2004, has caused some analysts to question the underlying profitability of Hartford's Japan operations. To combat recent competition, Hartford plans to introduce new products in September, and to increase advertising in regional Japan where the market is less saturated. Other analysts remain bullish, citing a healthy 9.2 P/E ratio, well below its five-year average of 12.9.
Quick comment: After a rough 2003, in which Hartford posted a net loss of $91 million, it has come back with strong earnings of over $2 billion in both 2004 and 2005. Its inroads in the Japanese market have played a strong role in its comeback, and it's safe to assume Hartford will not sit back and allow its dominance to erode without a fight. Even so, as the article notes, current volatility has investors worried, and will likely keep the stock's valuation lower than its fans may have hoped for.
In Defense, Small Stocks Rule by Tiernan Ray
Highlighted companies: United Industrial (UIC), Armor Holdings (AH), Boeing (BA), Lockheed Martin (LMT), Northrop Grumman (NOC), BE Aerospace (BEAV), Precision Castparts (PCP)
Summary: The U.S. defense budget, which has increased by an average of 6.5% over the past five years, is not likely to keep up its pace. Midterm elections this year could spell the end of some defense projects, especially if the Democrats take more seats in Congress. Cutbacks are likely to hurt the largest defense conglomerates, such as Boeing, Lockheed Martin, and Northrop Grumman. At the same time, decreased spending may actually come as a windfall for smaller defense contractors such as United Industrial and Armor Holdings, whose projects carry a smaller price-tag and are less likely to be halted. In such an environment, smaller companies will be forced to compete with their larger competitors; the smaller companies must use their nimbleness and innovation to woo tenders their way. Aerospace and defense, up 13% so far this year, are well ahead of the Standard & Poor's 500 index, which is up only 4%. In recent months, however, defense stocks have retreated, largely due to the above concerns. United and Armor could rebound in coming months as demand for their products increases. Both stocks trade for less than their 2007 projected earnings, and sport modest P/E ratios.
Quick comment: Other plays in the small-to-mid defense companies are BE Aerospace (BEAV) and Precision Castparts (PCP).
Trading Places: HP, Dell Reverse Rolls by Mark Veverka
Highlighted companies: Hewlett Packard (HPQ), Dell (DELL), Intel (INTC), Microsoft (MSFT), EMC (EMC), IBM (IBM), Sun Microsystems (SUNW), Lexmark (LXK), Xerox (XRX), Apple (AAPL), Sony (SNE)
Summary: HP, once criticized for its inconsistency, and Dell, praised for its reliability, seem to have switched roles. For the eighth quarter in a row, HP beat the Street's earnings number. At the same time, it also increased earnings guidance. With share prices up nearly 24% this year, HP is unique among competitors such as Intel, Microsoft, EMC, Dell, and IBM, who are all in negative territory thus far, and the S&P Infotech index, which is down 5.6% for the year. Pessimists argue that its earnings are driven primarily by cost-cutting and financial engineering, not increased sales; that its lofty projections are already factored into its stock price; and that top-line growth, such as an impressive 44% gain in non-GAAP earnings, is far outdoing bottom-line growth. Even so, with net revenue growth of $1.13 billion, HP outdid all of its key competitors' quarterly gains combined. Dell met its earnings expectations, but only after lowering them in July. They also recently became the subject of an informal SEC investigation of revenue recognition and accounting matters. Currently trading at about 14 times 2007 projected earnings, HP still carries a substantial discount over Dell's multiple of 18.
Quick comment: Bear Stearns analysts recently sent a bearish note to clients outlining their stance on Dell. Some concerns: aggressive pricing has failed to result in increased sales, and Dell's non-issue of guidance numbers clouds investors' vision of their future. They favor HP, with its more favorable P/E ratio, stronger prospects, and clearer vision. In their Fiscal 3Q conference call, HP CEO Mark Hurd was asked by Ben Reitzes of UBS if he thinks HP can keep up their growth and continue to gain market share. While admitting that some macro-economic factors were beyond their control, he expressed confidence that improvements in cost structure and strategic investments would enable them to sustain their growth into the foreseeable future. Bear Sterns' analysts concurred with Hurd's views, raising their price targets to $49; the fifth time in the past year they've done so.
The Buck Stops Where? by Marc Chandler
Highlighted companies: Euro Currency Trust (FXE)
Summary: Many traders are currently betting that the U.S. dollar is poised for an imminent slide. The Commodities Futures Trading Commission's commitment-of-traders [COT] report reveals short-term speculators having amassed near-record short dollar positions. There may be, however, numerous factors that dispel this notion, at least in the extreme short term. 1) Although a large U.S. trade deficit points towards a fall in the dollar in order to bring its account to a more sustainable level, historically trade deficit has failed to significantly influence currency valuation. 2) Interest rates, often considered to be the primary determinant of currency valuation, do not necessarily offer a clear understanding of cross-currency values. While there is an undeniable relationship, it can often be counter-intuitive; some low-yielding currencies have been among the strongest performers on the international marketplace. 3) In a classic 'short-squeeze' scenario, speculators' huge short-bias means that even a modest dollar uptick could send over-margined traders scurrying to cover their positions, pushing price even higher. 4) While the Fed took a breather from its relentless interest-rate hikes in August, price pressures continue to rise, which will likely lead to further hikes in the near future. In the intermediate term, i.e. by the end of this year, a dollar downslide remains a more likely scenario. By mid-2007, the euro may revisit its all-time high of $1.3665.
Quick comment: As noted in the article, speculators can play Europe's unified currency against the dollar through the purchase and sale of the Euro Currency Trust, an ETF that mirrors the euro's movement (short-sale rules do not apply to ETFs). It closed Friday at $128.46 a share, up 9.4% since January.
The No-Money-Down Disaster by Lon Witter
Highlighted companies: SPDR Homebuilders ETF (XHB), USG Corporation (USG), Home Depot (HD), KB Home (KBH), Pulte Homes Inc. (PHM), Toll Brothers Inc. (TOL)
Summary: New homes prices have dropped almost 3% since January, new home inventories are at near record levels, and existing-home inventories are 39% higher than last year. Sales have dropped more than 10%. Yet many stock market analysts have ignored the implications of these figures, betting that housing prices will continue to rise, supported by wage-increases, inflation, and GDP growth. They may be overlooking the fact that while inflation and wages have just recently begun their climb, housing prices have run-up since 2001, and are now at unsustainably high levels. Mean-revision dictates a 30% fall over the next three years. Furthermore, examining the four factors that brought-on the housing bubble; an influx of cash brought about through the collapse of the internet-stock bubble, rock-bottom interest rates, economic history that suggests housing prices never fall, and irresponsible financing of housing purchases, gives an indication of the impact the drop may have. Some salient numbers: 32.6% of new mortgages and home-equity loans in 2005 were interest-only, up from 0.6% in 2000. 43% of first-time home buyers in 2005 put no money down. 15.2% of 2005 buyers owe at least 10% more than their home is worth. 10% of all home-owners with mortgages have no equity in their homes. $2.7 trillion dollars in loans are slated to adjust to higher rates in 2006 and 2007. Banks have begun floating home-loans, leading to negative amortization (payments not covering interest charges and the shortfall being added to the principal). Since the end of 2003, the percenatge of loans in negative amortization has gone from 1% to 47%. Once it becomes clear to investors that the housing market has begun a significant decline, it will likely take the entire stock market with it, potentially leading to a 25%-30% decline.
Quick comment: The author notes that in a recent Barron's poll, not a single money manager ranked housing-market problems among the factors likely to lead to a stock market selloff in the next 12 months. Sometimes, the 'surprise factor' can lead to the most violent and unforeseen reactions. For an opposing view, see The Impending Housing Market 'Implosion' is Overblown, where the author makes the point that despite economists' threats of impending disaster, predictions of housing-market gyrations have historically been poor. As well, the numbers behind the headlines continue to 'surprise' the pessimistic pundits. The SPDR Homebuilders ETF can be used to play the sector, as can individual stocks such as Home Depot, USG Corporation, KB Home, Pulte Homes Inc., Toll Brothers Inc., and others.
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