Sunday, August 17, 2008

CXW: Go Directly to Jail, Do Not Pass Go, Do Collect Big Returns.

Sometimes it seems to me that investors overlook some potentially high returns by overlooking "boring" companies. Occasionally I even find myself overlooking such companies. I think it's easy to get lost in the exciting share price swings of a company like Apple (AAPL) and while there is great money that can be made by taking advantage of such volatile price swings, it is important to recognize that there are other less "sexy" ways to make a healthy return.

It might seem unbelievable to you when I say that a fundamentally sound company with solid, consistent and guaranteed revenues can be an overlooked stock that trades below $30 dollars a share. However, the Corrections Corporation of America (CXW) is such a company.

Corrections Corp. has solid fundamentals and a history of profitability. Better yet, this privatized prison and jail operator has a consistent source of revenue that comes from contracts with 19 states and the district of Columbia. They operate 65 facilities and house over 72,000 inmates at all security levels.

My favorite thing about Corrections Corp. has to be the consistent revenue inflows. Since they operate under government contracts and have shown a tendency to re-negotiate these contracts in their favor in the face of rising costs, I simply do not see how this company could ever lose money. The biggest burden upon the company's management is to control costs while still maintaining the integrity of their facilities, but they have proven themselves capable of doing just that and the company has thus showed consistent profitability.

Given the above facts many of you must be wondering how is it that Corrections Corp. can be trading at below $30 a share. The answer to that it that because Corrections Corp. has such a consistent and guaranteed stream of revenues, their profitability and return to investors is easy to predict. That predictability is the precise reason that Corrections Corp. is deemed to be a "boring" stock and that is why it is overlooked.

In it's current state, Corrections Corp.'s revenue and profit will remain roughly the stable which would limit the share price growth. So, in its current state I would not recommend CXW for an investor or for a trader because it just cannot offer impressive returns to shareholders.

The reason that I do like CXW for a long term investment is that I think that the privatized corrections industry, of which they are the most dominant player, is destined to grow. Basically, the more inmates and more facilities that Corrections Corp. manages the more revenue they receive from state governments. More growth offers more returns and higher share price.

Why do I think that the privatized corrections industry is destined to grow? I think that because the prison population is constantly growing. According to the non-partisan Pew Center on the States, as of June 30, 2007 there were 2.3 million prisoners in America's prisons and jails. The cost of housing these inmates costs 55 billions dollars annually in taxpayer dollars.

The rate of incarcerated persons in the United States is growing at a much faster rate than the general population of the United States. A projection done in 2007 by the Pew Center on the States projected a 13% increase in prison inmate population from 2007 to the end of 2011 while the general population of the United States is only expected to grow 4.5% during that same period.

Currently privatized prisons and jails only represent a small fraction of the overall prisons and jails in the United States, but that is a trend that is slowly changing. Many governments are starting to see the value and cost savings that can come by outsourcing their correctional operations.

The overcrowding that plagues government operated prisons tends not to affect their privatized counterparts as greatly because the privatized facilities in many cases can cap the number of inmates. In 2007 when prison overcrowding rates in some government operated facilities reached as high as 114% of designed capacity, the private prisons were able to absorb, with compensation from the respective governments of course, 77,987 inmates from these overcrowded state and federal prisons.

When you add together overcrowded prisons and an explosive inmate growth rate, the only answer is that more prison capacity is needed. Corrections Corporation of America will stand to benefit from this trend and this should add the necessary growth and revenue to pump up their bottom line and their share price.

I am generally an options trader, but Corrections Corp. is not a company that I would try to trade options on because their share price simply does not show the type of volatility that is necessary to profit on options. The only play on CXW that will allow for an investor to catch the overall long term trend will be a long term investment.

There is always a chance that Corrections Corp. will not show the type of explosive growth that I mention above, but the beauty of this long term play is that there is not a lot of downside even if CXW shows minimal growth. Even in the absence of future growth, CXW will still have a steady stream of revenues and probably a share price comparable to what it is today.
(Disclosure: None)

Happy Investing


Sunday, August 10, 2008

The Follies of Finance

I was recently looking for an inspiring topic to write my next article about when I turned to a collegiate textbook from the first finance class that I ever took. I turned to the chapter about bear markets and recessions and tried to find a topic that I thought would be applicable to current market conditions.

As I read, I was shocked about how many times I found myself in absolute disagreement with the author of the textbook. There were two topics in particular that I, with now actual market experience behind me, take issue with. These topics are the textbook’s notions of consumer behavior and diversification.

After further study of these topics, I am prepared to assert that academia as a whole, not just my first finance textbook, believe generally the same thing about both consumer behavior and diversification. This not only makes me question “real world” value of collegiate finance teachings (I have always questioned that), but it also makes me wonder if the finance world is full of professionals who, due to college teachings, wholeheartedly believe what I believe are some of the “follies of finance (teachings)”.

My first issue is with the thought that actual consumer behavior can be as broadly generalized as it is in finance textbooks. In several collegiate level finance textbooks, I reviewed the idea of consumer behavior in times of recession and economic weakness and all of them stated approximately the same thing. These textbooks all made the generalization that in times of economic weakness, consumers drastically change their spending patterns and cut off virtually all discretionary spending, which allows for investing opportunities in the consumer staples sectors.

I then looked to the one of the consumer staples industries, the food retail industry, and found that, contrary to what the textbooks may say, this industry as a whole is in the red year to date. This measure even includes several foreign food retailers; it would undoubtedly be much further in the red if only the American grocers were factored in.

Take for example Safeway Foods (SWY), a company that, according to conventional “textbook” thinking, would be considered a safe haven in such periods of economic weakness. Safeway, for the year 2008, is down nearly 20% as of August 8, 2008. This is certainly not what I would call a safe haven.

Furthermore I think that this generalization ignores the various classes of wealth that exist as those with more wealth likely will not cut discretionary spending in times of economic weakness. I also believe this generalization ignores the possibilities that people may resist change in their spending patterns by using savings accounts or by use of other means.

I think that this represents an instance where academia actually may not have known what to write about. The inherent problem with textbooks is that they rely on generalizations and I believe that writing about where to invest in times of economic weakness requires precise specification. This is a type of specification which simply cannot be captured in textbooks. As a result, this type of “inside the box” thinking is prevalent in the finance world even though it is not necessarily true.

The topic of diversification is another topic that I take issue with. Diversification is something that goes much further than the scope of academia and has founds its way into the thought process of virtually everyone involved in the financial markets.

I will go out on a limb here and say something that few others would ever dare to say; diversification is a folly.

I am fully aware that in a diversified portfolio the risk of the portfolio can be reduced to approach the market rate of risk. Reducing risk is a great thing; however, in reducing this risk down to the market rate of risk, the return is also reduced to the market rate of return.

I question the hassle of even investing in the financial markets if diversification only allows a market rate of return. You might as well invest in mutual funds or money market funds if all you can achieve is a dismal market rate of return.

While I am sure that many people out there will point to such prominent investors as Warren Buffett, who is actually fairly well diversified, as an example of why diversification works. My response to that is that Mr. Buffett’s portfolio and many other multi-million dollar portfolios are diversified because of the excess of capital that they contain. With a large amount of capital it is natural that an investor, such as Mr. Buffett, would pursue many different opportunities. This leads to a portfolio which may look as if it is intentionally diversified; however, I believe that it is simply a result of an excess of capital, of which only a limited amount can be put into a particular investment.

Large portfolios like Mr. Buffett’s also have such large investments in any given stock that they can see gigantic profits at minimal stock price movement. I think that the success of such portfolios is proof of the old mantra that “it takes money to make money”. I do not believe that “diversified” success like this can be replicated by individuals with smaller portfolios.

It is the inarguable truth that smaller portfolios can only see monumental success by taking on higher levels of risk. This risk does not have to risk the entire value of the portfolio; in fact, I find that option trading is by far the best method to recognize levels of returns greatly in excess of the market rate of return while only risking the minimal cost of the option itself.

I will say that the only positive that diversification brings is a minimized risk and I question any type of participation in the financial markets if someone is so risk averse that they feel as though diversification is necessary. In the financial markets both risk and reward abound. Reward will rarely ever be realized in smaller value portfolios if risk is not first taken. It takes multimillion dollar portfolios to achieve success in such a manner as someone like Warren Buffett. And if one does not have a multimillion dollar portfolio risk is the only method to gain reward.

I will give a quick example of the type of rewards that can be achieved when risk is taken. When US Airways (LCC) was trading at below $2 per share near mid July, the August $2.50 option calls were trading for about $1.50 per contract. If one were to invest just $3,000 dollars into these options to buy 20 contracts, those 20 contracts would be worth $10,800 as of August 8 (a return of 260%). One could also have recognized a great return by trading the low share prices of US Airways, but I provided this example as an example of how options can give great reward with fairly minimal risk (in this case the maximum risk was only $3,000).

As someone who tries to make profits by understanding the market psychology, I am very interested in understanding any type of prevailing market thinking (be it regarding diversification or consumer behavior). Even though I disagree with both of these principles as they are generally taught, I understand that because they are taught as the unquestionable truths of finance they are the prevailing thoughts for most finance professionals. In knowing this, I think that those of us who use market psychology to gain an edge can better understand the prevailing market forces.

I suppose that sometimes the answers for those of us who believe that profits come from understanding the market psychology can sometimes come from such an unlikely source as an old college textbook. So, whether you agree or disagree with me about the topics from the textbooks, you cannot disagree that these topics are the prevailing market methods and in understanding them one can gain a greater understanding of the overall market movements.
(Disclosure: author is long LCC)

Happy Investing


Thursday, August 7, 2008

Drug Companies Play by Different Rules

I have found that one of the hardest things to do in the financial markets is to trade drug/biotech companies. I always like to play the markets based upon my perception of the underlying market psychology, but the problem with the drug/biotech companies is that they mostly trade upon hype about new drugs and clinical trials. This hype can be immediately killed by one negative trial result or one adverse FDA decision.

The problem with this is that it is virtually impossible to predict for anyone and, on the surface, doesn't that just mean that investors are just rampantly guessing and gambling when they put money into these stocks?

Everytime I have tried to apply my market psychology rationale to biotech companies, I have failed miserably. Initially I came to the conclusion that market psychology could not be applied to these biotech companies, but after careful consideration I now believe that market psychology may in fact be the most important factor in determining how the market prices the biotech companies.

My previous folly in attempting to trade these companies was that I tried to trade them hoping for a positive decision from the FDA or for a positive clinical trial outcome. In doing this, I now realize that I might as well have been playing blackjack in a casino because my odds were about the same. My decision was to never play the drug/biotech companies again in anticipation of an announcement, but that's not to say that I don't plan on playing them at all.

The drug/biotech companies are very much catalyst driven companies (those catalysts being clinical trial results and FDA decisions). However, it is the periods in between catalysts that the human aspect of the market, the market psychology, dictates the movements of these companies share prices.

While there are several companies that I look at regularly in this sector, there is one that continually attracts me, that is Myriad Genetics (MYGN).

I was actually attracted to Myriad initially because of the promise that their Alzheimer's drug Flurizan showed. Unfortunately, Flurizan was recently shown to have produced no effect on Alzheimer's patients abilities to complete tasks of daily life. This was a major setback for Myriad, but the stock price is has not really reflected this setback as one would expect. In fact, this stock appears to have a great deal of momentum which has Myriad near their 52 week high.

With Myriad currently in one of their in between catalyst stages, the question becomes "what will the market do with this stock price?". This is where an understanding of the market psychology can attempt to predict what the near term holds for Myriad.

From here, Myriad will either keep the momentum that it has had for most of this year or it will lose that momentum and suffer a significant collapse in share price. So, which of these two possibilities is more likely given all of the facts?

Myriad does have a solid balance sheet, with a high level of cash that has increased thus far in 2008 and a very low level of liabilities with absolutely no long term debt. This is a very positive sign for a company that relies so heavily on research and development of drugs that may not produce a revenue for years to come and sometimes never.

Working further to Myriad's advantage is the fact they have a diversified portfolio of drugs that are currently under development and testing. The cancer drug Azixa (currently in phase II trials) is likely their most promising drug, but it is still nowhere near production. Further down the pipeline are drugs for HIV/AIDS and Thrombosis, which are currently in phase I trials.

Myriad does have a fairly solid stream of revenues from their current royalties. Though they are projected to have a loss for the upcoming quarter and for the year 2008, their revenue stream is very strong especially when compared to some of their peer companies.

One possible issue that I see for Myriad based solely upon my knowledge of market psychology is that their stock price is very close to their 52 week high. The 52 week high can be a significant psychological resistance level and may pose a significant threat to the stock's momentum especially in light of the recent failure of the drug Flurizan.

So, what conclusion have I arrived at for Myriad Genetics and why is it that I cannot seem to ignore this company?

I think I am attracted to Myriad because they have a solid base of cash with few liabilities and such a tremendous long term upside. While I think that Myriad is due for a share price correction that will likely see them touch 60 a share, I believe that after that the market will give Myriad its momentum back and will see it break through the 52 week high.

This is based upon a careful study of the market psychology and particularly upon the option market open interest levels which heavily favor the call side of Myriad. In my observations, I have seen that the market has a difficult time abandoning a company that has had such strong momentum for such a long time and that is why I think that the market will come around to Myriad again soon.

This strategy is not without risk, but I think catching the surging momentum train that will return after a slight correction will be give traders a chance to make some quick money.

The bottom line is that deciding which way to play a biotech company can be a mind-numbing prospect and is one of the most stressful prospects in all of the financial markets in my opinion. If I listened to conventional wisdom I would probably stay away from the biotech companies that I have lost so much money on in the past, but I like the challenge. That challenge is what I find so exhillerating.
(Disclosure: none)
Happy Trading


Sunday, August 3, 2008

Too Many Reillys, Too Many Issues: Why It May be Good to Short Lamar

Those of you who follow the company Lamar Advertising (LAMR) know that, with only two exceptions (one rather brief and one lasting roughly two years), the company's stock price has been extremely range bound. That range has been, more or less, between $30 and $40. After a recent bull run, which saw Lamar's share price touch $70, the stock has recently entered this range again.

With the shares trading at $37.53 as of Aug. 4, 2008, it is actually at the high end of this range and I think that Lamar's upcoming earnings report on August 6 may disappoint and send the share price back down to the low end of this range. This could give traders a chance to pick up some puts or short some of Lamar's shares and make what could potentially be a quick profit.

I do think that Lamar may miss their earnings target on August 6, but even if I am wrong about them missing their upcoming earnings, I still view Lamar as a good medium term short play, or at least until the share price touches the low end of what has been a consistent range. Traders can potentially play Lamar's shares over and over again, shorting the shares once they touch the top of the range (near $40) and covering once they touch the low end of the range (near $30).

First of all, the main reason that I see Lamar missing on their upcoming earnings is because of the high put activity that I am seeing in the options market. I have found that time and again, the options market is a reliable (but not infallible) indicator about upcoming earnings.

I compare the ratios of calls to puts by looking at the open interest levels for the single option with the highest open interest and also the total call/put ratio. For the August options, the August 35 puts are showing the highest open interest at 5,739. The straddle option for this put would be the August 40 calls which are only showing an open interest level of 1,496. This means that the straddle call/put ratio is a high 3.8 to 1.

I generally also look at the same strike ratio for the option with the high open interest as well as the opposite ratio which compares the option with the highest open interest against the option on the other side (call or put) with the highest open interest. In the case of the Lamar options, the same strike (35 calls) also happen to be the calls with the highest open interest, meaning that the same strike ratio and opposite ratio are the same in this case, the ratio being 1.8 to 1 in favor of the puts.

Lastly, the total put to call ratio adds all of the open interest up on the put side and divides it by the total open interest on the call side. In the case of Lamar Advertising the total put open interest is 14,197 versus a total call open interest of 5,647. This gives a ratio of just over 2.5 to 1 in favor of the puts.

These ratios are all on the high side and are an indicator that the options buyers, for whatever reason, are under the impression that Lamar may miss their earnings and that Lamar's share price will be below $35 by the third Friday of August.

The options open interest levels are why I think that Lamar may miss on their upcoming earnings report, but they are not the reason that I think Lamar will be range bound for a long while to come.

The first issue that makes me wary of Lamar Advertising is the prevalence of members of the Reilly family in corporate governance and operation. Though the company is publicly traded, the Reilly family controls 67% of the corporate voting power by virtue of their ownership of Lamar's class B shares. The class B shares, created by CEO Kevin Reilly Jr. and COO Sean Reilly, carry an incredible 10 votes per share. This means that the Reillys have free reign over the fates of Lamar Advertising and there is nothing that any discontented shareholders could do about it.

Reilly family members hold the aforementioned positions of CEO and COO. Furthermore, Kevin Reilly Jr. also holds the title of Chairman of the Board, Wendell Reilly holds a seat on the board of directors and Anna Reilly also serves as a director.

While the fact that the Reilly family holds stern control over Lamar is not an issue that should sit well with outside investors, it does not automatically disqualify Lamar from being a profitable company. The biggest issue with Lamar is the nature of their business in outdoor billboard advertising.

Outdoor billboard advertising can be a profitable business, requiring a large upfront cost followed by only minimal maintenance costs and a steady stream of revenues. The problem with the business is the lack of growth that the industry has historically shown.

Since the days of LadyBird Johnson, billboard advertisers have met resistance with virtually every new billboard that they attempt to erect. Many people view billboards as eyesores that detract from the natural beauty along the nation's highways and also as accident causing hazards that attract people's attention away from driving. The billboard opponents have been very successful in the courts at severely limiting the construction of new billboards. In fact, if you are to look at Lamar's recent headlines, there are always several news articles dedicated to legal battles that are currently ensuing regarding the construction of new billboards.

As a result, new billboard construction is not a reliable source of growth, but Lamar has adapted to this over the past years and has produced growth by constant acquisition of smaller outdoor advertising companies. The issue with this type of growth is that it will eventually be terminal, and also one has to assume that Lamar and its competitors have already purchased the best of these available companies.

A new type of billboard, the digital billboard, is offering Lamar a new opportunity that will offer many times more revenue and much higher margins than the traditional billboard. Many on Wall Street are expecting that digital billboards will give Lamar and other outdoor advertisers a significant boost, but the problem is that digital billboards are meeting even stricter resistance from the public and local governments.

Lamar has faced a legal battle for many of the digital billboards that they have constructed in such cities as Omaha, NE, Mufreesboro, TN, Fayetteville, NC, Kansas City, KS and many more. Opponents claim that the flashing billboard signs cause an even greater distraction to drivers and still present just as much of an eyesore as their predecessors.

The end result is that Lamar's growth is stunted by an inability to construct new billboards. There certainly is an ample supply of customers for Lamar and other outdoor advertisers even under these weakened economic conditions, but without the ability to produce new billboards Lamar cannot recognize maximum revenue potential.

The bottom line is that many factors point to Lamar being a good short play in both the short term and the longer term. The August 6 report could shed further light on the current situation for the company, but I think that this is an excellent short play going into that report. The options market is pointing to the short side for Lamar's report and several other indicators are pointing to the short side for the longer term. In my view, Lamar simply has too many Reillys and too many issues.
(disclosure: author intends to take a short position in LAMR)

Happy Trading


Saturday, August 2, 2008

Ecolab: Why Public Health is the Right Business at the Right Time.

While I was waiting in line on a recent visit to Starbucks (SBUX), I couldn't help but notice a woman behind the counter who, with notebook in hand, was hawkishly observing every move that the baristas and food handlers made. Intrigued, I took a quick glance at the logo on this woman's shirt. It read "Ecosure". My brain ran through all of its stored files, but was just drawing a blank on the name Ecosure. I quickly jotted down a note in my phone and looked Ecosure up as soon as I could get to a computer.

Come to find out, Ecosure is a division of the Company Ecolab (ECL). Ecolab produces various products specifically geared toward ensuring sanitary conditions at all types of food service establishments. They provide, among other things, dishwashing equipment, hand care products, surface cleaners, cleaning systems and antimicrobial products all mainly geared toward usage in the food service and hospitality industries.

There has been plenty of good news recently regarding Ecolab. They have just declared a regular dividend, they saw second quarter results jump 26% year over year and they have an international business segment that is producing great growth potential. All of that is great, but it is not the reason why I am starting to get excited about this company. The reason that I am starting to get excited about Ecolab is because of the Ecosure division.

The Ecosure division of Ecolab provides food safety services to businesses or other organizations that serve food to the public. Ecosure provides on-site evaluation of processes (this is likely what I witnessed at Starbucks), program design for food servers and supplier audits. Furthermore, they offer classroom services taught by certified trainers for any food service worker.

Initially I was intrigued by Ecosure because I thought that any outside service that Starbucks was willing to pay money for, especially given their recent cutbacks, is a service that is probably necessary and thus is likely being used by other food service providers. This alone was enough to get me interested in Ecosure, but it wasn't quite enough to get me to consider investing in it quite yet.

I started considering Ecosure (Ecolab) as a potential investment when the recent events of the jalapeno salmonella outbreak caused a nationwide tomato ban and then ultimately a restriction on the importation of jalapenos from certain suppliers. Now, I don't want to go as far as to say that these events caused any sort of public panic, but they certainly did make people feel a little uneasy about eating fresh tomatoes or jalapenos.

This ban and subsequent public uneasiness did take a financial toll on food service companies and it is something that all food service and hospitality companies would like to avoid. That is exactly where a company like Ecosure comes in.

Imagine how devastated any food service company would have been had the salmonella outbreak been traced back directly to them. It would be hard for even larger companies to persevere through such an occurrence. For a food service company, it is certainly worth the preventative cost to ensure that no such occurrence is even remotely possible. In providing supplier audits, process evaluation and food handler training, Ecosure stands to benefit from that preventative cost.

I think, especially in light of recent events, Ecosure is in the right business at the right time and they will undoubtedly be a profitable part of Ecolab. I think this alone is enough to make Ecolab a good investment, but there's one more reason why I think Ecolab is a good buy.

The last reason that I think Ecolab is a good investment is that they are a company that benefits from public fears. What do I mean by this? Sometimes when a story about an illness, be it the Avian flu or salmonella, becomes widely publicized, the public becomes a little more cautious and perhaps even fearful of the said illness. Again, I wouldn't go as far as to say that the public goes into panic mode, but they do tend to ask (especially of schools, local government, hospitals, etc) "what are we doing to prevent this illness from occurring here?"

A situation like this is where Ecolab's public health division could stand to reap a nice bit of business. Ecolab offers products and services for infection prevention, cleaning/control products and procedures and pandemic preparedness for such illness causing organisms as Avian Influenza, Mad Cow, E. Coli, Hepatitis A, Influenza, Listeria, Pandemic Flu, Salmonella, SARS and a myriad of others.

I don't think I'm being too presumptive when I say that Ecolab stands to profit from the public reaction to any publicized illness, particularly food borne illness. This again just proves to me that Ecolab has found a nice business niche.

The bottom line is that Ecolab, in providing services that ensure public health, is not only providing a necessary public service, but also reaping nice profits. These profits can only be increased by the international expansion of the company and I think it's a good idea for investors to consider picking up some shares in Ecolab.
(disclosure: none)

Happy Investing