Marc Gerstein

This is my final post on Reuters.com. Before the end of the year, I'll have transferred to a new position within Reuters, to a division that serves institutional money managers. I am excited about this opportunity, but I know I'll miss the dot-com world. I've been writing columns online about investing since 1999.

I've met many of you, through e-mail, and often in person at such events as the Money Show and chapter meetings of American Association of Individual Investors (AAII). Getting to know my readers always kept me clear-headed about individual investors during the height of Wall Street scandals and the ascent of now New York Governor-elect Eliot Spitzer. While many depicted these investors as lambs waiting to be fleeced, I saw something quite different: successful, resourceful, astute, curious and independent people who understood the difference between hype and solid analysis, people who continually sought to learn more and who, whether as individuals or through clubs or organizations such as AAII or National Association of Investors Corporation (NAIC), were willing to teach others.

I wish you all continued success in your endeavors and hope you will continue to let Reuters.com serve you. Thank you for having given me such a rewarding opportunity.

P.S. As a parting memento, here are links to a three of my best-received articles, a tutorial series I published on various occasions, most recently in early 2005, that gives prospective on why stock prices are what they are.

• Why $30 and not $130? 2/28/05)
• Lost illusions (4/1/05)
• The choice is yours (4/23/05)

Even bullish investors must be starting to wonder how much longer the stock market can maintain its vigor as oil price rallies alternate with corrections and as observers wonder how the Federal Reserve will resolve the tug-of-war between economic sluggishness, especially in the housing arena, and latent inflationary pressures.

The debate is sure to induce many to approach the topic of diversification more systematically. A traditional hard-times script might call for increasing allocation of funds to equities from sectors perceived to be "defensive," such as consumer products or health care. But we've seen how even those stocks can drop hard if earnings disappoint. Health care, meanwhile, has a set of completely different dynamics, especially with the Democrats having just gained control of Congress.

Another, academically purer approach to diversification is statistically based. It suggests investors supplement consideration of potential returns with serious consideration to the way returns on a particular stocks correlate with those of other shares they may be holding. It's quite possible that Portfolio A, consisting of two stocks with moderate uncorrelated returns may ultimately outperform Portfolio B, which has two very strong but highly correlated stocks.

We make an effort to cut correlation by seeking stocks with low betas in general (beta is a historical measure of share price return relative to the S&P 500) and low down-betas (the same calculation but confined to months when the market is down) in particular. Specifically, we seek betas below 1.00 and down betas below 0.25. Instead of measuring how each stock in a group correlates with each other stock, we measure how each correlates to a common benchmark.

Within this narrowly constrained universe, we then seek to identify stocks with potentially reasonable returns by confining ourselves to those that appear in at least one of our Reuters Select screens, appear in many screens or in screens that are top ranked for performance, have average analyst-rating scores no higher than 2.25 (1.00=best, 5.00=worst), and experienced an increase in analyst bullishness (reflected in a drop in the average score) in the past 13 weeks.

Here is our list:

While Sony Corp. (SNE) remains mum on initial sales of PlayStation 3, a Nintendo Co. Ltd. executive says the company's on track to meet a goal of selling 4 million Wii consoles globally by the end of the year. The risk is not geared to demand, but to its ability to manufacture enough units.

Wall Street had already expected Sony and Microsoft Corp. (MSFT) to easily sell their new-generation consoles and for manufacturing to be the issue that determines whether they meet, miss, or beat their expectations.

What's new is the fact that Wii's initially strong reception. For some early, anecdotal evidence, we find an aggregate 4.5 star rating from 165 Amazon.com customer-reviewers, versus PlayStation 3 with 4 stars from 72 customers and Xbox360, with 3.5 stars from 469 customers. If that sort of trend surfaces in other places, this has the potential to change the next-generation gaming competition from the two-horse race many expected to a three-horse race.

It's also possible that Wii may expand the market by attracting new gamers, something it expressly set out to do with its less-tech-intensive design philosophy and its new motion-sensitive controller. It's not clear right now to what extent, if any, this is factored into the price of retailer GameStop (GME) shares. Analysts have been focusing mainly on the impact of hardware availability. The possibility that Nintendo may expand the market is something that, if it materializes, would likely be visible around, or possibly after, mid-year.

Analysts have 7 Buy ratings, 5 Outperform ratings and 3 Hold ratings on GameStop stock, for an average of 1.73 on a scale of 1.00 (best) to 5.00 (worst).

A 0.1 percent decline in November same-store sales at Wal-Mart Stores Inc. (WMT) was not what the market wanted to hear on the first trading day after black Friday, judging by the approximately 1 percent decline in the S&P 500. But there's no reason to assume Wal-Mart's fortunes have any relevance beyond the company itself.

In response to a market worry nearly a year ago, we published a column suggesting Wal-Mart's struggles were entirely due to its own situation and had no bearing at all on how retail as a whole was doing. Let's review how things turned out for retail investors, and for Wal-Mart shareholders, over the past 12 months.

Wal Mart stock is down 5.1 percent. That's certainly not bottom-of-the-barrel.

The Home Depot, Inc. (HD) and Lowe's Companies, Inc. (LOW), impacted by the housing slowdown, are off 11.1 percent and 10.1 percent respectively. Wal-Mart's recent aggressiveness on generic-drug pricing contributed to 15.1 percent decline in Walgreen Company (WAG), and concerns over spending have helped clip 11.8 percent from the price of shares in Amazon.com, Inc. (AMZN) over the past 12 months.

But there have been other places where retail investors did quite well despite the scare Wal-Mart threw into the market a year ago.

American Eagle Outfitters (AEOS) is up 97.2 percent; CarMax, Inc is up 56.3 percent, GameStop Corp. (GME) is up 55.0 percent, Sears Holdings Corporation (SHLD) is up 48.1 percent, and J.C. Penney Company, Inc. (JCP) is up 49.4 percent.

The average share price change for the top 50 retailers, based on market capitalization, 14.65 percent, was considerably better than Wal-Mart's 5.1 percent decline. Among all the 274 retailers in our U.S. stock database, the market-capitalization average 12-month share price increase was 8.7 percent.

As goes Wal-Mart, so goes retailing? Not quite. We'll stick with our Jan. 6, 2006, assertion that "as goes Wal-Mart, so goes Wal-Mart."

Google Inc. (GOOG) crossed above $500 today. Yawn . . . Sure, it's an exalted level. Of the more than 8,000 companies in our domestic stocks database, only 16 others can make that claim. Of that batch, only six have market capitalizations above $1 billion. Two companies, TouchTunes Music Corp. (TTMX) and NewAx Inc. (NWXJ) were below $10 million. It goes to show that if a company has a sufficiently small number of shares outstanding, 1,034 and 7,414 respectively, getting up in price can be pretty easy. Even bigger, better-known firms in the $500-plus club, such as Berkshire Hathaway Inc. (BRKa) and Chicago Mercantile Exchange Holdings (CME) get there by having a small number of outstanding shares and steadfastly refusing to split their shares.

The real issue is whether Google's valuation is high. As it turns out, the stock is not cheap: It's priced at about 36 times estimate 2007 earnings per share. But as valuations go, there are others at or above that level: 337 as of Monday.

Right now, Google's forward price/earnings (P/E) ratio is nearly double the S&P 500 level. Let's assume that shrinks to a 25 percent premium five years hence. Assuming further a risk-free interest rate of 5.5 percent and a future S&P 500 P/E of 18.2 (1 divided by 5.5, based on the "Fed" model which suggests that over time, fair value of the S&P 500 has been the inverse of the risk-free rate), we might assume Google's five-year-hence P/E will be 22.75.

Now let's assume investors holding Google require a 15 percent annual return. This sort of thing is always hard to nail down. But if we keep our assumption of a 5.5 percent risk-free interest rate, add in an assume 4-5 percent annual equity risk premium (consistent with long-term historical experience), and apply the traditional capital asset pricing model, 15 percent would work as an appropriate "required annual return" for Google if the Beta, the measure of share price volatility relative to the S&P 500, comes in at 2.11. We don't have a long-enough history of trading data to compute a beta for Google, but we do note that the figure for Yahoo is 1.91. So 2.11 for Google seems in the ballpark.

Going further, let's take $500 as a starting point for Google stock. Assuming no dividends, if it returns 15 percent per year over the course of five years, that would mean its future price will be $1,005. If the P/E is 22.75, we'd need Google's 2012 EPS to come in at $44.17 for today's $500 price to turn out, in retrospect, to have been reasonable.

Can Google reach that target? It would represent a 26 percent annual growth rate starting with the $13.79 per share analysts assume the company can earn in 2007. On balance, analysts think it's do-able. The consensus Wall Street long-term EPS growth-rate forecast is 34.31 percent, ranging from a low of 15 percent to a high of 61.80 percent.

Obviously, there are many unknowns here. Would one feel crushed if Google, instead of reaching $1,005, winds up at, say, $805, which would represent a 10 percent annual return? That would require a growth rate of 20.75 percent. On the other hand, if Google's relative (to S&P 500) P/E comes in at 1.5 instead of 1.25, it would mean a growth rate of "only" 14.6 percent per year would suffice.

What-if scenarios can go on and on and on. But one thing is clear. The kinds of numbers we're talking about, while high, are not nearly as spectacular as one's first impression of a $500-plus stock price. Bottom line: Skip the stock-price headlines. Worry about the growth rate.

For a long time now the consumer has had good reason to surrender: higher interest rates, higher oil prices, sluggish economic activity, the psychological and financial impact of the housing slowdown, and so forth. Yet for some reason, that hasn't been happening. And now, it looks like the cavalry is on the horizon.

Wal-Mart Stores, Inc. (WMT) is lending a helping hand with redcued pricing, a move that may be replicated by some rivals. Whether Sony Corp.'s (6758.T) high-priced, high-feature Playstation 3 will succeed is an open question, but it seems likely at least that its release will help generate a reasonable level of consumer buzz. Oil prices have fallen sharply from recent peaks. And if economic activity remains lackluster, interest rates may soften. Bottom line: the U.S. consumer looks set to keep marching ahead.

It's not all great news. Starbucks Corp. (SBUX), for example, came out with lower profits. But there's good news elsewhere, such as at Nike Inc. (N), which sharply boosted its dividend.

When all is said and done, consumer stocks should continue to offer opportunities even in the face of dour headlines here and there. Here are the top 10 stocks from this area currently on Reuters Select screens. (Click here for an explanation of how we rank the stocks on the overall list.)

Reuters reports that Wal-Mart Stores Inc.'s (WMT) annual holiday price-cutting may pressure rivals more than usual this year. Undoubtedly, this will be good news for shoppers and will make great theater for observers of the retail scene.

It's likely just a sideshow for equity investors.

There are two broad strategies retailers use to bring in the money. One approach involves low-margins and, presumably, high turnover; in other words, sell cheaply but make up for it by moving stock quickly. The opposing strategy involves living with slower turnover in an effort to make more on each sale.

Financial theory is neutral on which strategy is better. Return on capital is what matters and one way or another that's calculated with reference to margin and turnover. Companies can excel through either strategy. The weight of anecdotal experience seems neutral too. A stock can just as easily get hammered by news of excessive markdowns as it can by news of overstocked shelves.

Interestingly, a preliminary glance at data covering the past 12 months suggests neutrality may, indeed, be the right answer.

We looked at share price performance for 164 retailers in our database over the past year and did a quick fundamental comparison of companies whose shares outperformed the S&P 500 (the "better" group) versus those that underperformed (the "worse" group). This is not a back-test; in other words, we are not saying that shares of companies with such-and-such characteristics as of November 2005 were more/less likely to outperform in 2006. It's a contemporaneous test: we compare 52-week share price performance since November 2005 with financial data that gradually came out over the same time span, thus measuring the extent to which share prices tracked fundamental trends as they unfolded.

The results are in Table A show average results for each group. (The conclusions would not change if we were to switch to median results instead.)

Table A

Data is for the trailing 12 month period.

It appears that the higher operating margins achieved by the better group mitigate against the low-price-high-volume strategy. But in truth, it's not so clear. Price cutting would more likely be apparent in gross margins, where differences between the better and worse groups seem much less significant.

There isn't much indication that investors care about how quickly goods fly off the shelves, either.We do see that the better group achieved stronger returns on investment, again supporting the view that investors will accept either strategy, as long as the company succeeds in its chosen course.

We do see that the better group achieved stronger returns on investment, again supporting the view that investors will accept either strategy, as long as the company succeeds in its chosen course.But before we go all out tipping our hats to the ivory-tower crowd, let's check Table B.

Table B

Data is for the trailing 12 month period.

That's a huge edge for the better group, so much so as to induce us to check median data, to guard against a small number of exceptionally large numbers. These results are in Table C.

Table C

Data is for the trailing 12 month period.

The sales impact is not replicated in reported earnings-per-share figures, but it's possible that non-recurring items may be causing distortions. Meanwhile, the significance of sales growth is consistent with casual observation of the growth-momentum quality of recent market rallies.

Referring back to the last row of Table A, we'd like to believe capital efficiency counts. But Tables B and C raise questions.

In any case, Wal-Mart's annual round of price wars are just as risky for the Bentonville giant as for rivals: If the next 12 months look anything like that past period, Wall Street will be looking at dollars, not necessarily foot traffic. Rivals should note that Wall Street will probably be looking at more closely at dollars than margins.

Bottom line for retailers: whatever the strategy, at the end of the day, just show the money.

Reuters reports that Wal-Mart Stores Inc.'s (WMT) annual holiday price-cutting may pressure rivals more than usual this year. Undoubtedly, this will be good news for shoppers and will make great theater for observers of the retail scene.

It's likely just a sideshow for equity investors.

There are two broad strategies retailers use to bring in the money. One approach involves low-margins and, presumably, high turnover; in other words, sell cheaply but make up for it by moving stock quickly. The opposing strategy involves living with slower turnover in an effort to make more on each sale.

Financial theory is neutral on which strategy is better. Return on capital is what matters and one way or another that's calculated with reference to margin and turnover. Companies can excel through either strategy. The weight of anecdotal experience seems neutral too. A stock can just as easily get hammered by news of excessive markdowns as it can by news of overstocked shelves.

Interestingly, a preliminary glance at data covering the past 12 months suggests neutrality may, indeed, be the right answer.

We looked at share price performance for 164 retailers in our database over the past year and did a quick fundamental comparison of companies whose shares outperformed the S&P 500 (the "better" group) versus those that underperformed (the "worse" group). This is not a back-test; in other words, we are not saying that shares of companies with such-and-such characteristics as of November 2005 were more/less likely to outperform in 2006. It's a contemporaneous test: we compare 52-week share price performance since November 2005 with financial data that gradually came out over the same time span, thus measuring the extent to which share prices tracked fundamental trends as they unfolded.

The results are in Table A show average results for each group. (The conclusions would not change if we were to switch to median results instead.)

Table A

Data is for the trailing 12 month period.

It appears that the higher operating margins achieved by the better group mitigate against the low-price-high-volume strategy. But in truth, it's not so clear. Price cutting would more likely be apparent in gross margins, where differences between the better and worse groups seem much less significant.

There isn't much indication that investors care about how quickly goods fly off the shelves, either.We do see that the better group achieved stronger returns on investment, again supporting the view that investors will accept either strategy, as long as the company succeeds in its chosen course.

We do see that the better group achieved stronger returns on investment, again supporting the view that investors will accept either strategy, as long as the company succeeds in its chosen course.But before we go all out tipping our hats to the ivory-tower crowd, let's check Table B.

Table B

Data is for the trailing 12 month period.

That's a huge edge for the better group, so much so as to induce us to check median data, to guard against a small number of exceptionally large numbers. These results are in Table C.

Table C

Data is for the trailing 12 month period.

The sales impact is not replicated in reported earnings-per-share figures, but it's possible that non-recurring items may be causing distortions. Meanwhile, the significance of sales growth is consistent with casual observation of the growth-momentum quality of recent market rallies.

Referring back to the last row of Table A, we'd like to believe capital efficiency counts. But Tables B and C raise questions.

In any case, Wal-Mart's annual round of price wars are just as risky for the Bentonville giant as for rivals: If the next 12 months look anything like that past period, Wall Street will be looking at dollars, not necessarily foot traffic. Rivals should note that Wall Street will probably be looking at more closely at dollars than margins.

Bottom line for retailers: whatever the strategy, at the end of the day, just show the money.

TiVo Inc. (TIVO) hit Wall-Street paydirt today. Its announcement that it would expand a service that brings Web video to regular televisions sent its stock up nearly 5 percent as we approached mid-day. Perhaps this might be what the company needs to distinguish itself from the proliferating digital cable-boxes that include TiVo-like programming features. But it not not be enough to be right; it may have to be right quickly. Just as real estate is about location, location and location, emerging technology may depend on cash burn, cash burn and cash burn.

Table A shows trends in major cash-flow categories since the fiscal year that ended Jan. 31, 2001.

Table A Key cash flow trends ($ mill.)

Note: First three columns may not add to net change in cash due to decimal rounding.

Through Jan. 31, 2006, we saw a general, albeit imperfect, trend of improvement in operating cash burn with external financing helping to keep overall liquidity manageable. But there appears to be a substantial reversal in the first half of the current year. Table B sheds more light on that by showing trends in key components of operating cash flow.

Table B Key operating cash flow trends ($ mill.)

Note: Deferred revenue column also includes LT deferred revenue.

From the table, it looks as if the annual "run rate" for the most basic components of operating cash flow, net income plus depreciation, has shown little improvement. Indeed, it has deteriorated. This year's first-half tally, -13.6, compares with +1.2 in the six-month period that ended July 31, 2005.

We also see, this year, significant downward turns in deferred liabilities and deferred revenues.

The latter is a generally erratic figure that represents liabilities accrued but for which the company has not yet been billed. That's probably just a matter of timing; through July 31, 2005, accrued liabilities were similar, at -13.0.

The decrease in deferred revenue, which generally encompasses subscription revenue received from customers in advance of future periods and, hence, not yet recognized on the income statement, is an eye-opener. This year's -12.6 tally compares with a positive 3.2 million year-ago result.

With $60.5 million in cash at July 31, 2006, TiVo's back is not presently against the wall. But risk may rise if today's announcement doesn't translate soon to a boost in subscription, something that should manifest itself initially as a boost in deferred revenue.

Bears turning chicken Short interest data is an interesting double-edge sword. On the one hand, its disconcerting to see high numbers, evidence that many investors expect a decline in stock you may own or in which you have an interest. On the other hand, your share ownership could be that much more profitable if things go well for the company and the short sellers need to close positions. The list below identifies companies appearing in at least one Reuters Select screen which have also experienced a meaningful decline in short interest. http://blogs.reuters.com/2006/11/10/bears-turning-chicken?src=daiblog Bears turning chicken

Short interest data is an interesting double-edge sword. On the one hand, it's disconcerting to see high numbers, evidence that many investors expect a decline in stock you may own or in which you have an interest. On the other hand, your share ownership could be that much more profitable if things go well for the company and the short sellers need to close positions. The list below identifies companies appearing in at least one Reuters Select screen which have also experienced a meaningful decline in short interest.

This is not to be taken as a set of Buy recommendations. There's no assurance that those who are covering short positions are right. Perhaps the first decision to go short in the first place was correct and that they'd be better off being patient. Ultimately, though, stock selection is a balancing of probabilities.

Among all Reuters Select stocks, we narrowed the list to 60 by identifying those for which short interest two months ago amounted to at least 10 percent of the float. The list below identifies those that then had the largest percent decline in short interest (again measured as a percent of float) in the latest month.