Jeffrey Saut: Rebalancing Our Positions

Excerpt from Raymond James strategist Jeffrey Saut's latest essay:

We were impressed with the Dollar Index’s ability to rally in the face of last week’s economic reports, reinforcing the strategy of reducing our long-standing anti-dollar “bets.” To reiterate, we don’t know if we are going to be bullish on the U.S. dollar for three weeks or three years, but we do know we no longer want to bearish on the greenback! The quid pro quo is that we continue to rebalance (read: sell partial positions) our beloved “stuff stocks” (energy, timber, cement, precious/base-metals, etc.).

Longer-term, we still like “stuff stocks” driven by the demand metrics fostered from the emerging markets. Therefore, we are NOT rebalancing any of our “core” mutual fund holdings in names like Ivy Global Natural Resources Fund (IGNAX/$38.09), which has gained 32% year-to-date. Near-term, however, we are worried that the “short” dollar, long “stuff stocks” trade has become entirely too crowded and continue to rebalance individual stocks accordingly.

So what else should we do? Well, since we have harvested (read: taken) numerous long-term capital gains by rebalancing many of our investment positions, we are looking to offset some of those gains by taking long-term losses in other situations that have not worked out so well. Granted, some of our “losers” will be sold for no apparent fundamental reason, but merely for tax purposes. Plainly this kind of tax avoidance strategy presents other investors with opportunities in various fundamentally sound situations. We think one such case is Outperform-rated VeriFone (PAY).

We have long prized VeriFone’s business model, but have always considered it to be an expensive stock and thus never bought it. Recently, however, VeriFone’s financials have been called into question with an attendant 50% share price decline. Recall that VeriFone Holdings, Inc. is a provider of technology that enables electronic payment transactions and value-added services at the point of sale. Its system solutions consist of point of sale electronic payment devices that run the company's and third-party operating systems, security and encryption software, and certified payment software, as well as third-party applications.

Its system solutions process a range of payment types, including signature and personal identification number-based debit cards, credit cards, contactless/radio frequency identification cards, smart cards, electronic bill payment, check authorization and conversion, signature capture, and electronic benefits transfer.

We believe in VeriFone’s favorable long-term business prospects and take the current management team at its word that the accounting irregularities announced on December 3^rd are limited to FY07. Therefore, we think investors with a multi-year time horizon will be rewarded for purchasing shares of PAY. Last week our analyst published his FY08 EPS estimate for VeriFone of $1.54, which assumes ~470 bp lower gross profit margin than previous estimates and includes $0.08 per share in incremental legal and accounting expenses related to the pending restatement.

If these assumptions are correct, at some point in the second half of FY08, after the dust settles from the restatement and if the company regains its operational rhythm of outperforming consensus, shares of PAY could trade at a P/E multiple of 20x on current-year estimates (ex charges), or $32 per share. Historically, the transaction processing sector has traded within a 15-25x P/E multiple bandwidth on current year’s earnings and enjoyed 15% EPS expansion, 10% top-line growth, and 20% operating margins.

As with Johnson & Johnson (JNJ) and General Electric (GE), we are using a tranche “in” strategy whereby we are recommending buying a one-third tranche and will look to buy additional tranches over the ensuing months until we achieve a “full” investment position. Indeed, for the well prepared investor, volatility affords opportunity. We continue to invest accordingly.

The call for this week: We have been constructive on stocks since the mid-August “lows.” However, we turned cautious at the mid-September “highs,” believing a downside retest of the August lows was in the offing. We got constructive again at the envisioned downside retest of those August “lows” in late-November, thinking the retest would be successful and said so in our “buy ‘em” report dated 11/26/07. Yet, last week’s One-Day Downside Reversal concerns us, which is why we are raising the stop-loss points on ALL of our remaining trading positions.

While the consensus believes last week’s muted FOMC rate-rhetoric was the approximate cause for the stock market’s decline, we think the week’s stronger than expected economic reports suggest the Fed did the right thing. Manifestly, import prices surged 11.4% (y/y) and producer prices leaped 7.2% (y/y). The result left November consumer prices higher by 0.8% (month/month), following a 0.3% m/m rise in October, lifting the year-over-year inflation rate to 4.3% from 3.5% (see the attendant chart).

However, taking these still understated [IMO] inflation figures at face value implies that the reported economic gains are not nearly as impressive as the headline figures suggest. For example, the recent 6.3% jump in retail sales becomes +2% in “real” terms when impacted for the 4.3% annual inflation rate (6.3% - 4.3% = 2%) as “things” continue to become "curiouser and curiouser". Consequently, our motto remains, “’Slow and steady wins the race.’ Unfortunately, it seems we have a rather narrow-minded track coach.” (W. Wiley)

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