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September 2014 Newsletter: Bulls continue to run

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Bull_2 December 2, 2014 (Chinavestor) This is the three month delayed publication of our monthly Newsletter. For current issue, along with portfolio updates, visit our Premium Service page.

You may recall the title of our previous Newsletter, “Dow hiccups at 17,000”. We said the latest dip was going to be a hiccup and not a start of a longer-term decline. This time we got it right as the Dow and all major indexes recovered from the late July dip and soared in most of August. Some may point out that September has been historically the weakest month for stocks indicating that this time it may not be any different. But we are of a view that the rally has still legs and may continue for the rest of the year.


Looking back for a moment, it is important to note that August was a very robust month. American indexes bottomed out on August 7 and rose 12 times out of the 16 trading days left for the month. The S&P 500 closed above 2,000 for the very first time at the end of the month. The Dow rose 3.2% in August and is up 4.0% YTD. The NASDAQ was on fire, advancing 4.8% in August or 10.6% YTD. Chinese stocks did well in the US but took a breather in Asia for the month. The Hang Seng Index, the most widely used indicator in Hong Kong, slid 0.1% but is still up 6.0% YTD. US listed Chinese stocks borrowed sentiment from Wall Street and rose 4.4% in August. The China ADR Index, measuring the performance of US listed Chinese stocks, is now up 6.2% YTD. Some argue that it may be time to quit the markets now that the Dow, The NASDAQ and the S&P are at records. And they may be just right. However we are of a view that the long term bullish trend is here to stay, at least for the next three months.

We continue to attribute strong market sentiment to an accommodating monetary policy. The interest rate cycle is still at a low point with no indication of a rise just yet. Despite being bullish, we continue to be selective and like to stay with value stocks. When markets are high, a correction always hits high value stocks the most. An equity at lower valuation has a lot less downside potential. Another line of thought got us to examine market cycles and rate cycles. We found that financials do best in the first three months of a bull market and the last three months of the bull market. This line of thought got us to take a closer look at the US financial sector. While we don’t know when the current bull market will come to an end, it may be a good development to rotate some assets into financials.

We have studied three stocks in particular this month. Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and JP Morgan Chase (NYSE:JPM).


Investors may recall that Bank of America (NYSE:BAC) had to swallow significant toxic assets in the 2008 financial turmoil and required a significant government bail out as a result, whereas JPM and Wells Fargo fared better. Bank of America swallowed Countrywide Financial, the single largest mortgage financier at the time. Countrywide Financial serviced 20% of all mortgages in the United States, equal to 3.5% of the GDP of the country at that time.

Wells Fargo was forced to swallow failing Wachovia in 2008, the fourth largest bank holding company at that time. JP Morgan was fortunate to take on smaller and less toxic Bear Stearns and Washington Mutual in 2008. No wonder, Bank of America (NYSE:BAC) is still in the woods. The stock price has been basically flat since 2009 whereas JP Morgan and Wells Fargo more than doubled their share prices.

Share price appreciation is one thing, and steady dividend income is another. Value investors prize sound, steady dividend income and so do we. While a 2.8% dividend yield may not sound too attractive on its own, that 2.8% additional income on top of a 4% stock price appreciation makes a huge difference in the long run. Assuming that an average investor can achieve a 4% stock price increase, a 4%+2.8%=6.8% return is well above average. Additionally, dividend income is money coming in without selling assets, a preferred way of income for investors preserving a portfolio.


Chart above on this page shows dividend income from these three banks.

Bank of America has been paying just a miniscule amount of $.01 a quarter since 2009. Wells Fargo and JP Morgan stepped up as early as 2011 and have started to pay meaningful dividends. Given that JP Morgan is trading at $60 and Wells Fargo sells for $50, dividend yield is about the same for JPM and WFC. Both pay 2.6%-2.9% dividend, in-line with companies like Wal-Mart (NYSE:WMT), IBM Corp. (NYSE:IBM) and Apple Inc. (NASDAQ:AAPL).

Another way to assess these banks is to see total size of the loan portfolio. JP Morgan has become the largest US bank by assets since 2011. There has been an ever widening gap of the loan portfolio between BAC and JPM with latter growing at a much faster pace. As a matter of fact, Wells Fargo has been growing just as fast as JP Morgan and has been catching up with larger Bank of America. This is clearly visible on the second chart of this page. Don’t be fooled by the title of the chart—”Total Liabilities” on this page. Liabilities simply mean loans deposited at a financial institution, according to GAAP. Given that JP Morgan and Wells Fargo have been increasingly profitable with healthy loan portfolios, it is obvious that these institutions are our favorites going forward. WFC and JPM have also been paying steady dividends, another plus for value investors. Bank of America may be attractive for speculative investors, betting on a potentially large stock price increase. That stock price increase may come from a fact that BAC has been underperforming the rest of the sector since 2009.

Besides the US financial sector, we will highlight one more are of interest it this month’s Newsletter. This is upcoming mega Alibaba IPO. We have been following Chinese stocks since 2003 at Chinavestor. We have seen some of the best Chinese companies going public but we also witnessed a massive fraud scheme where undeserving Chinese companies got listed on prestigious American exchanges via reverse mergers and other means. With that experience under our belt, we are here to warn American investors to stay away from upcoming Alibaba IPO. There has been a lot of misinformation and half truths about this large e-commerce company. Business model of Alibaba is somewhere between EBay NASDAQ:EBAY) and Inc. (NASDAQ:AMZN). China has a massive population and a large underdeveloped e-commerce market. However just because China is a big country and e-commerce has potential, investors should not pay an unjustified premium at upcoming IPO price.


Based on stock based compensation worth $59/share, Alibaba may shoot for an IPO price of $59/share on the first day. This gives Alibaba a market valuation of $187 billion, more than Amazon or EBay!

Some argue that Alibaba just reported net income of $1.99 billion, more than EBay and Amazon combined. But reported income is just part of the story. Alibaba is highly profitable because China’s e-commerce market is underdeveloped where Alibaba can charge high margins due to lack of competition.

Looking at key metrics of these companies, top chart on this page, and it is obvious that Alibaba is a lot smaller than EBay in terms of sales, not to mention Inc. Amazon is not profitable simply because the company invests in new technologies and markets all the time, drying up the bottom line.

We are of a view that Amazon or EBay are so much better companies than Alibaba and thus an IPO price above $10/share is too much, already.

Wish you successful investing,

Blaze Fabry


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