Taking Advantage While We Can

Yesterday was an interesting day in the market. You may have been reading the headlines after the close and noticed a headline saying the Dow was down a paltry 12.64 points. Eh, not much of a day, you may have thought, sort of like a police officer at an accident scene with a megaphone proclaiming, “There is nothing to see here. Please move on.”

However, you dive into the rest of the story, and hello! The S&P 500 was down by a little more than 1%, and the NASDAQ was down nearly 1.5%. What the heck are we supposed to make of that unusually wide divergence? 

Most stock indexes are market-cap weighted, meaning the impact of a stock on the index is proportional to what it is worth in the marketplace. Makes sense. However, the Dow Jones Industrial Average is unusual. It is a price-weighted index, meaning that the stocks with the highest price have the most impact on the index.

Yesterday, the index member with the highest stock price, IBM, had a strong day, advancing $5.04 to $155.69. This limited the losses of the Dow Jones Industrial Average, which is why it looks so much better in comparison.

That’s a good illustration as to why the Dow is not the best index to tell us what’s really going on in the market. It’s important, yes, but more because of its history and the fact that it is so well-known and reported in the media.

By most measures, yesterday was a tough day. In fact, the S&P 500’s 1% drop was its biggest down day in over two months. So is this something to be concerned about?

No. There will be more down days, as we saw today, but that is both expected and healthy. The S&P is still up 23.5% since its late August lows and has hardly stopped to catch its breath in the process, so further profit-taking and consolidation is likely.

But the bigger trends still strongly favor generally upward momentum. There’s the earnings growth we’ve talked about and are in fact seeing as the early reports come out. Overall, fourth-quarter earnings are projected to be more than 30% better than a year ago.

There will be fits and starts along the way, as we saw with Citigroup’s (C) report Tuesday that was considered a disappointment. (We’ll talk in depth about that in just a moment.) But then there were other banks like Morgan Stanley (MS) posting a 60% increase in profit, and last Friday JPMorgan (JPM) was a complete blowout. (Oh, and by the way, Goldman Sachs might have “disappointed” the Street, but they still found a way to make $2.4 billion in profit and for every partner to take home millions in a bonus package.)

Second, there are trillions of dollars sitting on the sidelines or ready to be transferred from bonds to equities. We’re seeing it now, and I expect it to continue because of fears of a bond bubble that is ready to break combined with expectations that the economy is finally off the ventilator.

And the other force still driving stocks is the Federal Reserve. Concerns remain over possible deflation, so the Fed continues to provide more than ample liquidity. Yes, this raises longer-term questions about things like inflation, and that makes it all the more important for us as investors to take full advantage right now.

What’s the best way to do that? First, we take advantage of good buying opportunities. Each week, I let you know which of our stocks are most attractive. (We’ll talk about this week’s Top Buys in a moment.) We also want to exploit down days like yesterday and today. Several of our Breakout stocks have moved above their buy limits in recent weeks, and these pullbacks brought some of them back under attractive entry points. For example, E-Trade (ETFC) fell below our $16 limit today, MoneyGram (MGI) fell below $2.75 today, and Popular (BPOP) dipped under $3.20 yesterday.

We will also keep looking in every corner of the market for new Breakout stocks that are under $5 and have strong catalysts to drive them significantly higher. In fact, my desk is piled high with research right now on a small biotech company that, so far, has all the makings of a doubler or more. Stay tuned, as I expect to tell you about it soon.

And third, we will move out of stocks that are no longer in position to deliver us the kinds of profits we expect and redeploy that money in stocks that are. Let’s talk about one right now whose story is changing as we speak.

Sell EAR

HearUSA (EAR) sells hearing aids and other hearing products. I was expecting 2011 to be a turnaround year for the company, but unexpected news has cast doubt on the company’s future, and it is now too risky for us to own any longer.

As I posted on the EAR message board on Tuesday, Siemens Hearing Instruments, a supplier of hearing aids to HearUSA, may pursue an acquisition of HearUSA that could bring shareholders nothing in return. The word got out in an SEC filing on Tuesday from Siemens AG (SI), the big conglomerate that owns Siemens Hearing Instruments.

EAR owes Siemens several million dollars – a $1.9 million payment that was due at the end of December and a $2.2 million payment coming up at the end of this month. Representatives from both companies met on December 22, when HearUSA said it wouldn’t be able to make all of the payments and asked for help. Siemens agreed to let the December payment slide a month, but that was it. Siemens owns about 14% of HearUSA already, and with a small company like HearUSA, it wouldn’t be that much of a stretch to just take it over.

HearUSA responded yesterday with CEO Stephen Hansbrough saying: “We are very disappointed that Siemens has taken this negative and heavy-handed approach. We are also concerned that the statements made by Siemens in its Schedule 13D fail to provide all of the facts about our relationship with them and our position. We raised legitimate contract issues with our strategic partner concerning their approach to our commercial relationship in what we understood was a confidential discussion on December 22, 2010. In spite of our disagreement with their positions, we continued our attempts to resolve the commercial issues and we clearly advised Siemens of our commitment to meet our obligations to them.”

Hansbrough also said that the company would report a loss for the fourth quarter and the year, but that average daily order dollars are up 13% here in the first quarter and that it still expected to be profitable this year. Makes you wonder if Siemens is playing hardball here because they also see an opportunity to get a good asset on the cheap.

The stock has fallen sharply on the news, dropping from $0.90 last Friday to a low of $0.37 yesterday. It has since climbed back up to $0.54. I usually avoid joining in on panic selling, and we have indeed gotten a bounce that we should take advantage of while we can and sell EAR. Those of you who were members of Penny Stock Winners will remember that we transferred the stock into our Breakout Stocks Under $10 portfolio on June 1 when it was at $1.03, so it is down 48% since then.

I hate taking the loss, but the future of HearUSA is just too uncertain, and I’d be willing to bet legal battles will be a part of what happens next. The bottom line is that Siemens is a huge conglomerate while HearUSA is a little-known small cap, and there’s a real possibility that HearUSA will be taken over with shareholders left holding nothing. This risk/reward scenario has changed dramatically, and it’s time to sell EAR and put that money to work in better opportunities like this week’s Top Buys.

This Week’s Top Buys: COWN, SNV, MEA

Here are three stocks currently on our Breakout buy list that are especially good buys this week. Look to these first if you’re just joining us or have new money to put to work. As always, here’s a quick written summary of the stocks, and be sure to watch the video below for my more detailed examination of each:

1. Cowen (COWN) is an exciting name because it has businesses that have market-sensitive revenues, and given the more-than 20% rise on the S&P 500 since August, I expect some positive earnings news here in particular. The company won’t report until late February/early March, so now is a good time to buy. Assets under management continue to increase steadily, and the recent market gains should help this trend continue. With an attractive valuation, COWN also has the potential to be a takeover target. I’m targeting more than a double from current prices for this stock. Buy COWN below $5 for our $10 target.
2. Synovus (SNV) is another promising financial turnaround story this earnings season, and it releases results next Friday (1/28). As we talked about last week, trends in credit have turned dramatically for the better. Total net charge-offs have declined significantly, and loan shrinkage has stabilized. Synovus is following suit: After a strong December, the company announced a restructuring just last week that will provide an additional $100 million a year in cost savings. SNV is a buy under our $3.15 for our $5.50 target.
3. Metalico (MEA) preannounced positive fourth-quarter sales results on Tuesday that were way ahead of expectations. I believe the company has the capability to easily surpass previous earnings highs when it releases the full report in March, which should drive the stock higher. Despite the recent market rally, shares remain below their 52-week high due to weakness in the steel scrap industry. While the recycling end of business is projected to be weak in the fourth quarter, management is talking about improvements here in 2011. Buy MEA up to $6 for our $8 target.

Putting C’s Earnings in Perspective

Citigroup (C) reported earnings on Tuesday, and the general consensus was that they were disappointing. I agree with that but only to a point, as the foundational elements of the business continue to improve.

As I posted on Tuesday, C earned $0.04 a share, which was well short of expectations of $0.08. Citi was hurt by a bad fixed-income trading environment, which also impaired results at Goldman Sachs, JPMorgan and Morgan Stanley. More particular to Citigroup, the company posted weak market-making results in currency and interest rate trading. There will always be volatility in trading results, and trading is one of my contributors of revenue at banks, so it would be a mistake to judge the quarter based on that.

More important are the positives: Credit losses continued to decline, both from the previous and year-ago quarters. Citigroup also set aside smaller reserves to cover bad loans. The company’s provision was $4.8 billion in the quarter, down from $5.9 billion in the third quarter and $11 billion in the fourth quarter of 2009. The balance sheet also continued to strengthen, and consumer banking in Latin America and Asia continued to grow with revenues up 11% and 7%, respectively.

Overall, Citigroup’s improvement in operations remains intact, and that’s what I expect will continue to drive the stock here in 2011. C pulled back from $5.10 to $4.80, so it is now back under our buy limit. Buy C while you can get it under $5 for our target of $9.

LLEN’s CFO Resigns

L&L Energy (LLEN), which owns and operates coal mines in China, announced this week that its Chief Financial Officer, Rosemary Wang, resigned for what was called “family reasons.” David Lin was appointed interim CFO while the company searches for a permanent replacement. Lin actually just joined LLEN in December as Director of Accounting. He’s based in Seattle and China, and he  has had credible experience at reputable firms including Arthur Andersen, KPMG and Deloitte.

In the wake of recent CNBC reporting questioning the company’s finances, investors questioned whether Wang’s resignation was really for family reasons or if there is more news to come, and the stock has continued to fall since the announcement came out.

The stock has been highly volatile for the last month or so as CNBC’s Herb Greenberg has talked about it on several occasions, and there were concerns at the end of 2010 that China would try to keep growth in check to avoid inflation. Well, we learned just yesterday that China’s economy grew 10.3% in 2010, so growth is hardly coming to a screeching halt. We also know that China’s strong growth is driving huge demand for coal. The tragic floods in Australia are constraining supply even further, so the fundamentals remain exceptionally strong for LLEN’s industry.

As I posted on the LLEN message board on Tuesday, given all the noise surrounding the stock, I wanted to take a hard look at all of the recent developments. On the one hand, the recent news about the stock has clearly caused some investors to bail out. On the other hand, despite some of the implications of Greenberg and others, this is a real company that really does own and operate coal mines in China, and it’s indisputable that the demand and price for coal are very strong right now.

My conclusion: I think it would be a big mistake to follow the herd and sell LLEN based on the current buzz. News is fleeing, and it doesn’t reflect the whole picture. To listen to some of the reports, you would think the company is a complete scam, which is just not true. Here are some of the main reasons why:

• The company really does own and operate mines in China. This is not some paper-only fabrication.
• There isn’t really anything that new in the recent news reports. Those of you who have been with us here in Breakout Stocks Under $10 for a while may recall that back in September there were concerns about LLEN’s auditing firm, Kabani, which was facing questions about its work with other companies that operate in China. I talked with the company at the time, and they confirmed to me they were looking into upgrading their accounting and auditing operations. The stock hit its recent low around $7 at that time and then ignited for a run to over $13. We could easily see another pop if management is smart in selecting its new CFO and possibly announcing a new auditor as well.
• At the beginning of this year, LLEN shares began trading on the NASDAQ Global Select Market, which NASDAQ says has the highest initial listing standards of any exchange in the world. It’s hard to imagine that a company that is smoke and mirrors would survive the screening process.
• Last August, L&L Energy appointed a respected former Congressman and U.S. Transportation and Commerce Secretary, Norman Mineta, as vice chairman of its board. A sham of a company usually won’t get someone of that stature to agree to join it.

I’m not saying founder Dickson Lee and others are complete saints; there are things they should have done differently in their careers. But honestly, that could apply to an awful lot of founders and CEOs. It doesn’t mean the company is a fraud, and it doesn’t mean the death knell is ringing either.

I’m buying more LLEN shares at these very low prices and continue to recommend it. It will likely remain volatile, so make sure you’re comfortable with that. I look for the momentum to reverse as investors recognize the powerful demand for coal in China and the company continues to take steps to enhance its accounting – starting with a smart decision in selecting its next CFO.

Breakout News & Notes: WEN, ETFC, CRBC

Wendy’s Arby’s Group (WEN) gapped higher at the open today and finished up 7% on news that it plans to put its Arby’s sandwich chain up for sale. This is a good move, as Arby’s is a drag on the more popular Wendy’s division. To give you an example, sales at Arby’s in North America fell 6% in the last quarter and more than 7% in the quarter prior to that. This should not only improve WEN’s bottom line, it also will makes the company more attractive to potential buyers – a big reason we own the stock. Continue to buy WEN under $5.

E-Trade Financial (ETFC) will release its results next Wednesday, January 26. Expectations are for $0.04 a share, up slightly from $0.03 in the third quarter. That seems right to me, given the uptick in the firm’s daily trades in October and November and the slight decline in mortgage delinquency trends recently reported by ETFC. If the market behaves as we expect, earnings could get a boost from improved customer activity in 2011. ETFC is currently trading right around our $16 buy limit, and I am maintaining our $20 price target ahead of earnings.

Citizens Republic Bancorp (CRBC) follows E-Trade and reports next Thursday, and another loss is expected. As credit expenses remain high, the company will likely continue to shrink its balance sheet to improve capital ratios. On a more positive note, nonperforming assets should continue to decline. They are already down 27% in the past year.

While CRBC still has a lot of credit issues to work through, I am hopeful that improvements in the Michigan economy will help return the company to profitability. CRBC remains a buy below $1.10.

Have a great weekend, and I’ll talk to you again next Thursday or be in touch with an alert if there’s anything urgent in the meantime. And keep those comments and questions coming on the message boards! I’ll be talking with you there in the meantime.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10