Show me the 'Green Shoots'.

It is increasingly clear that the recent rally in the stock market has been a fluke. The past 3 months has seen people talking all about the 'green shoots' that are appearing, that when economic figures are declining less than before we are expected to believe that things will get better soon. Seriously, a glance at today's paper will tell you how deep a recession we are still in.

Just yesterday, the latest figures on US consumer optimism took a surprising hit as an index of consumer confidence dropped to 49.3 in June from 54.8 in May after showing signs of a recovery for the last 3 months. Perhaps consumers have began to realize that "less bad is probably not good enough", that less bad still doesn't pay bills.

In US housing, the latest Case Shiller home price index saw house prices in 20 metropolitan areas fall 0.6% m-o-m in April compared to a 2.2% decline in March. Still, prices are 18.1% lower than last year. This potential 'green shoot' is overshadowed by the fact that delinquency rates on the least risky mortgages more than doubled from a year earlier, signaling more trouble on the horizon.

Across the Atlantic, the pound sterling reversed it's gains in recent weeks as revised figures saw first quarter GDP figures shrinking by 2.4% q-o-q, instead of the 1.9% reported earlier. In fact, this latest figure is UK's biggest q-o-q decline since 1958, while its 4.8% y-o-y drop was the largest since records began in 1948.

In the Eurozone, inflation turned negative for the first time ever since records started in 1991, as consumer prices were 0.1% lower y-o-y in June. However, this was more a reflection of the sharply lower energy costs. Core inflation stripped off energy costs still remained in positive territory.

More bad news from the ECB showed that liquidity injections have not stemmed the reversal of credit flows to the economy. In May, businesses repaid a net €5bn in loans, slowing annual rate of growth in lending to 4.4%. Household borrowing summed up the distressing news as the annual rate of growth turned negative, with loans down 0.2% on the year.

In Germany, seasonally adjusted unemployment rose by 31,000 to 3.495m, which means Germany now contents with a 8.3% unemployment rate. Seriously, where are the 'green shoots'??

ITT Educational Services Inc

ITT Educational Services, Inc.
ESI

This is one of those companies that keep you awake at night not because it is in danger of missing a covenant deadline, but because its prospects are so exciting you just can't wait to see their latest quarterly earnings filing.
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Introduction

For a company that has seen earnings grow at a compounded rate of 26.8% annually for the past 10 years, its stock has seen one of the most outrageous stock price in March 2008. Its price dropped to 45, and if you are one of those that look at a stock as owning a piece of a business, that meant that you are getting a 11.5% return with earning per share that year at 5.17.

Today, the stock trades around $92, and if this was a crappy company then it may not be the right time to purchase it. But this is a company with 1 - consistently growing earnings, 2 - higher than industry returns on equity and invested capital, 3- higher than industry profit margin, and 4 - almost no debt.

Briefly, ESI is a post secondary education provider, offering associate and bachelor program. Unlike its other competitors in the for profit education realm, ESI focuses in vocational areas like IT, computer aided drafting & design, criminal justice, and business. They also offer online programs that are a growing part of their revenue. With a student population of about 62,000, ESI serves 105 schools in 37 states and growing.
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The For Profit Educational Industry

While it is true in general to say that one of the best thing about education providers is that they operate in a countercyclical industry, people usually miss out on another salient point. We must first understand that in the case of education providers, their no 1 cash flow is the tuition fees paid by students. In fact, most of the time, students don't pay all the tuition fees. The government usually grants a certain amount of money to most students with qualifying background to pay for their tuition. In this case, government aid limits are usually set by referencing to tuition fees paid to higher cost structured traditional schools. Thus, the intense demand and government-set aid limits allow low cost structured schools like ESI to provided educational services at prices similar to traditional schools! With the availability of government aid, students tend to contribute little upfront, and this means ESI can raise rates without worrying too much about pricing out their main customer base.

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Earning Power

Looking specifically at ESI, it had an easier time hiking up their tuition fee in recently times even though it is already pretty expensive to get an education at their schools ($40,000 associate degree; $72,000 bachelor degree). This is because a degree from a ESI school is well worth the money. In fact, while new students earned $17,000 a year before they enrolled, they usually find work quickly after graduation and command annual salaries in excess of $30,000. As a result, ESI has considerable pricing power.
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Student Loan Credit Risk

However, as good as it sounds, there remains certain risks that investors have to be wary of. Because of the turmoil in the credit market recently, ESI has signed an agreement with private student loan lenders to ensure that all debts by students are paid off, or the debt will be passed on to ESI after a certain level has been breached. ESI has also increased internal lending to students, which may run the risk of increasing bad debt expenses.
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Profitability

In terms of profitability, ESI provides one of the best returns to shareholders amongst education providers. Return on shareholders' equity over the last ten years has been phenomenal and way above the industry rate of 36.3% in 2008. (99-08 ROE: 42.2, 42.5, 43.1, 49.3, 40.3, 38.5, 35.8, 114, 173.7, 157.1%). Some of us might prefer to look at returns on invested capital to get a better picture of the way a company funds its growth. Because debt reduces shareholders equity, a high-debt company would have a higher ROE than a low-debt firm. Return on invested capital (ROC) is similar to ROE, except it also considers long-term debt. In this case, ESI's performance has been stellar. Industry ROC average was 32% in 2008, ESI was at 60.8%.

A good sign of a sustainable growing company is its profit margin. The higher the profit margin, the higher the chance the company has a strong competitive advantage that allows them to price their products higher than their competitors. In ESI's case, net profit margin was 51.5% higher than the industry average (20.0% compared to 13.2%).

Furthermore, a key difference in the industry is that education services are very scalable. Each additional student helps improve profitability. And this is one reason why it has been able to grow without too much capital expenditure on assets or plants like other companies.
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Debt

Debt wise, this company never even had long term debt until 2006. In fact, its so called $150m of long term debt is a revolving credit facility that allows them to repurchase their shares. The first agreement filed in 2006 matures in 2009 and as of the latest 10-k filing, the agreement has been amended and restated in 2007 to borrow up to $160m under two revolving credit facilities: one in the maximum principal amount of $50m and the other $110m. They now mature in July 2010. As of Dec 31, 2008, the borrowings totalled $150m, secured, and interest are at 0.59% per annum. Approximately $158m of ESI's investments and cash equivalent serve as collateral. Even with the additional debt, it still managed to outperform the industry return on capital average by 30 percentage points. It just goes to show how good this company's business model is.

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Growth

In terms of earning per share or cash flow per share, the company has never ever stopped growing. While most companies experience dips in earnings during the recession in the early part of this century, or in the recent credit crisis, this company has never reported a dip in its earnings before for the past 10 years. Earnings per share grew at a compounded rate of 26.8% from 1999 to 2008 (.48, .57, .72, .94, 1.27, 1.94, 2.34, 2.72, 3.17, 5.17), while cash flow per share compounded 17.7% annually in the same period.

Because earnings visibility of this company is clear, it is easier to forecast its earnings in the next few years. 1Q' 09 has seen it hit $1.59 per share, a 47% jump, and it should not be hard for them to hit $7 a share this fiscal year. At the price of $92 that I bought, that is almost a 8% return on investment on a company which has a stellar business model that churns out outsized growth and profits each year.

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Valuation

ESI has always had a higher PE than its peers in the industry because of its outperforming profitability and margins. Yet because there is a lingering doubt about the credit risk they are taking in partnering with private student loan providers , their price has taken a beating over the last year (with respect to other listed for profit educators) due to the market's psychological fear of any company that has any exposure to loans of any kind. In fact, their current trailing PE (17.8) is lower than the industry average at 20, even though their prospects are better.

This company impresses me because it has grown tremendously with very little debt. I suggest stocking up on ESI should it fall below $92, a 10% discount to the industry average PE valuation. In fact, if this recent market rally proves to be a fluke, ESI may fall even lower in the short term like it did in 2008. And when that time comes, I will be stocking ESI up like there's no tomorrow.

Investors' optimism has returned very quickly. Too quickly.

Financial stocks have been rallying ever since March when Citigroup hinted that its trading performance in 1Q had been better than expected. The number of American banks tightening lending standards has fallen for 2 consecutive quarters. 3 months LIBOR has fallen below 1% for dollar loans, and investors in high yield bond, the riskiest form of corporate debt enjoyed returns of 11.5% in April.

In short, there seems to have been a huge shift in attitudes towards risky assets and the market seem to be in a bull rally. Furthermore, the ECB president declares on the cover of FT today that the economy has 'bottomed out'.

Yet, an observer who had woken after sleeping for the past two years would be alarmed at some other numbers. Nominal GDP in America has fallen for 2 consecutive quarters for the first time in more than half a century. Industrial production is still dropping at a double-digit annual rate in America, the euro zone, and much of Latin America and South East Asia.

Companies are still defaulting on their debts at a steady rate; 40 issuers did so in April and Moody's expects the default rate to reach 14.3% by next March.

The economic data may have improved, but only from some terrible lows. It would have been amazing, given the amount of stimulus thrown at the economy in the form of lower oil price and interest rates, quantitative easing and fiscal deficits, if there had not been some kind of rebound.

The danger is that sentiment has flickered higher rather as a dissected frog's leg will twitch when an electric current is applied. The world is still drowning in debt, unemployment is still rising, wages are stagnant and the threat of higher taxes hang over consumers. This was not a conventional downturn; it is unlikely to herald a conventional recovery.

Selling FCX - Freeport McMoran Copper & Gold

I would be selling my entire stake in FCX today after making a 65% profit since buying 130,000 shares ($27.80) on the 5th of January, and another 100,000 ($21.77) on the 23rd of January. Briefly, the initial reason for buying into this stock back then was due to the general pricing climate of its commodity, and its over sold stock.

Firstly, commodities prices have been bashed up badly at the end of 2008 as demand of anything was assumed to be going down. My belief then was that gold of all commodities will rise because the US govt was generating uncertainty to the world's reserve currency by printing money to fund its stimulus plan.

Secondly, while all commodity related stocks were badly affected, none has been more hurt than FCX. While FCX chalked up huge losses in 08, investors bailed out in droves, sending its market valuation crashing to unbelievable values. If there was one mining company that has the most prospect for growth, it had to be this one.

I'm selling it off today, because I think the price of FCX has reached the point where I no longer feel comfortable holding it anymore. It's management has one of the worst records in the industry. While the industry's 5 year return on equity had been 9.43, FCX stood at -34.42. 5 year avg return on asset is also a paltry -5.27 while the industry is still decent at 6.43.

Making moves soon

The market has reached a new low. I will probably be making some moves soon.

Stop Shorting

Well I think it's apt for me to start my first blog post with an update of what I have been doing with my portfolio. I thought I was obliged to shed some light on how my portfolio works on kaching, espeacially when a good 122 people are following me.

Firstly, I've been busy closing my short positions. It was rewarding in the past year or so to be shorting almost any stock at all (except maybe Volksvagen), especially for financials. I made most of my gains in the past 6 months shorting the main protagonists in this crisis: Lehman Brothers, Bank of America, Fannie and Freddie and many others that made me a ton of obscene returns. But I've never particularly liked shorting stocks.

We all know that if you buy a stock at say $15, and it goes bankrupt, your loss is 100%, $15. But everyone needs to know, and be VERY AWARE of the fact that if you short a stock, your total loss exposure is much more than 100%, in fact, technically, your loss could be infinite should the stock reach sky high valuations.

So unless you are dead sure that US corporations are on the verge of total annihilation, I think it's time to cover your shorts. Don't run the risk of losing more than your initial capital.

My belief today is that yes, the US is in deep trouble, and the world is at a turning point today. Government actions today will largely determine what kind of recession will we go through. But it is no longer a sure bet that every company's stock will continue to decline, even if the economy deterioates further.

Everyone knows that stock markets undergo corrections once in a while. It is part of the process that makes it a more efficient valuation system. But sometimes, due to circumstances, the market gets either too euphoric like the tech bubble in 01, or too downcast.

In fact, it is now my belief that dear Mr Market is now over pessimistic, as the headline news get more and more terrible by the day.

Just look at how, day by day, the players have withdrawn from the market. As the market plunged to its low in Oct 08, most retail investors would have taken all their money off the desk after being burnt repeatedly. Subsequently, even the institutional investors started to withdraw. And then, even hedge funds begun to face massive redemptions. And of course, there was Bernie Madoff.

If we just stop and ponder, we would realise that many market players have chosen to withdraw their positions not because they think that valuations are still too high, but because of external pressures like the fear of the unknown, redemption calls, and a total loss of confidence in the market. And day by day as more capital gets withdrawn from the market, the stock prices declines even further due to selling pressure. This fear then feeds on itself, and wreaks further havoc onto the market.

Fears regarding the viability of some of the best run public companies in the world makes no sense. These businesses will definitely face earning pressures as the economy worsen. But years from now, these firms will survive. For certain stocks of companies to be trading below their liquidation value is laughable, but it is also a chance for investors to pile in on these bargains.