Post written by Max Asciutto. Follow me on twitter.

Elaine Garzarelli was a Partner and Managing Director at Lehman Brothers prior to starting her own company, Garzarelli Capital Inc. in 1995. Dr. Garzarelli has studied the stock market for over 25 years and was ranked First Team in Quantitative Research in Institutional Investor magazine’s All-Star poll for 11 years; she was also top ranked in Portfolio Strategy and Market Timing. In October 2012, Elaine Garzarelli was inducted into the Institutional Investor All American Research Team Hall of Fame which is a highly coveted prestigious honor.

Elaine currently uses her own self-built econometric mathematical models to predict the direction of the market and then determine the most favored sectors and industries likely to outperform the S&P 500 index. This quantitative methodology allows her to predict the major trends in stock prices and the earnings of over 80 S&P 500 industry groups. Elaine currently uses these mathematical models for stock market timing and sector selection in producing her Sector Analysis weekly reports which she issues to sophisticated investors and institutions.

Elaine Garzarelli is credited with predicting the bear market bottom in the S&P 500 price index in 1982, the top and bottom in 1984, the Crash of 87 and the upturn that followed, and the top and bottom in stock prices in 1990. She warned of overvaluation and problems with “phantom” company profits versus tax return profits as early as 1996, several months before Alan Greenspan’s “irrational exuberance” speech. She was bullish from early 1997 until December 1999. Her indicators showed an overvaluation in the S&P 500 of more than 40 percent in late 1999. In May 2000, her indicators fell to a bear market signal of below 30 percent. Her indicators were bullish at the bear market bottom in late 2002. She turned negative in January, 2008, and had a 100.0 percent hedged position for most of 2008, into early 2009. In March 2009, her indicators turned bullish.

Elaine was featured as a top businessperson in Fortune magazine and was listed in Business Week’s “What’s In” list. In addition, Elaine Garzarelli has been featured in the Wall Street Journal, USA Today, Forbes, the New York Sun, FONDS exclusiv, and other international media. She is a frequent guest on CNBC, Fox Business News and the Nightly Business Report on PBS. For over two decades, Elaine Garzarelli has been a frequent guest speaker at The Money Show throughout the country.

Elaine Garzarelli did her undergraduate and graduate studies at Drexel University where she holds a doctorate in economics and statistics. In 1992, Elaine was inducted by Drexel University into The Drexel 100 which is the University’s alumni hall of fame in which it recognizes a select group of alumni whose lifetime achievements are outstanding. In addition, Elaine has a scholarship fund at Drexel University for female undergraduates students in the Bennett S. Lebow College of Business.

Benjamin Graham, Value Investing vs. SpeculationWhile you contemplate a major investment decision, you need to ask yourself if you will be making a value investment or a speculative investment. You can use Benjamin Graham’s extensive writing about the difference between value and speculative investments to categorize potential investments you are considering.

Speculative investors bet on the Yankees in a Vegas casino. When the Yankees are on a hot win winning streak, the speculator can double his investments after each victory, but when the Yankees’ bats turn cold, the speculative investor will be walking the streets hat in hand.

Value investors buy bonds for Yankee stadium’s construction.

Speculative investors buy a stock with a hunch that the price will go up or down quickly. Value investors buy a stock after determining the long-term value of the business.

Although value investors outperform speculative investors in the long-run, value investors do not expect to outperform the market. Value investors accept the reality that no one can predict market behavior; instead, value investors work to control their own investment behavior.

Benjamin Graham’s 3 Types of Value Investments

1) Well established investment funds - examples are 5-star Morningstar mutual funds, corporate bond funds, & municipal bond funds.

2) Common trust funds (separate accounts) - High net worth investors can hand their portfolio over to a commercial bank or investment firm that will responsibly manage their money on a one-to-one basis.

3) Dollar cost averaging - Deposit a consistent amount of money at specific intervals (monthly or quarterly) into your portfolio. The easiest way to dollar cost average is to buy a mutual or bond fund (from Vanguard for example) where you can setup automated deposits - this way you don’t have to pay trading fees for buying new stocks or bonds every investment cycle. Suze Orman offers a dollar cost averaging calculator on her website.

Benjamin Graham wasn’t alive to see the days of Exchange Traded Funds (ETFs) but I would add ETFs as a fourth value investing option:

4) ETFs - ETFs allow you to buy a stock index (i.e. SPDR S&P 500 ETF - SPY) or a weighted stock sector (i.e. Ultra Basic Materials - UYM). The advantage of ETFs, is that you can buy a diversified investment without having to pay the associate trading fees if you bought a number of stocks, and the ETF management fees are considerably lower than their mutual fund counterparts, about .1% vs. 1.5% respectively.

Benjamin Graham’s 3 Types of Speculative Investments

1) Trading in the market - Shorting stocks that have had a short-term run-up in price.

2) Short-term selectivity - Buying stocks with upcoming earning releases that the speculator believes will beat Wall Street estimates.

3) Long-term selectivity - Picking stocks with high returns in the past, or stocks with promising product releases like tech and drug companies. A risk of “long-term selectivity” is that the speculator may buy a company with an upcoming product that eventually undersells or never makes it to market. Or the speculator’s estimates were correct, and the firm’s upcoming product is a hit, but the previous market price already consider the product’s success. Or even though the speculator’s assessment was correct, he could suffer from the John Maynard Keynes’ proverb, “The market can stay irrational longer than you can stay solvent.”

Special Situations

In between value and speculative investing are “special situations.” A prime example is investing in merger & arbitrage opportunities. Companies announce mergers for shareholder approval far in advance of any formal agreements. The announcement includes a suggested buyout price, and there is usually a spread between the market price of the company being purchased and the suggested buyout price. Immediately in response to the announcement the spread between the market price and buyout price begins to close. However, up until the day that the deal is finalized (or canceled), the spread fluctuates based on investors’ assessment about the likelihood that the deal will be completed. A recent example of a successful M&A closing is 2008 purchase of Anheuser-Busch by inBev. As close as two months before the deal closed, the merger spread widened on credit concerns, causing Anheuser-Busch to sell at $64.86 a share, while the buyout offer stood at $70 a share.

Conclusion

Do you find that you are more of a value investor or a speculative investor?

I find that my natural inclination is to be a speculative investor. So before I make a trade I ask myself how easily I will be able to sleep at night, or as Benjamin Graham puts it, I ask myself if the trade promises “safety of principle and a satisfactory return.”

Skip to 1:35 to see Warren Buffett’s Axel Rose impression =)

Is he the coolest value investor alive or what?

Stock AnalysisThe Dividend Discount Model (Gordon Equation) calculates the intrinsic value of a stock based on the present value of a company’s future dividends. The model is a powerful investing tool to evaluate if a stock is over or undervalued compared to the market price. Professional investors use the Dividend Discount Model (among others) to value a stock, but for some reason casual investors have a habit of looking at a stock’s price chart to determine if a stock is a good value. The ill-fated chart approach has caused many casual investors to lose a bundle, after all - how can you profitably drive your portfolio if you’re focused on the rear view mirror?

This post is divided into the following sections: Dividend Discount Model’s equation, a sample valuation using Microsoft, and problems with the model.

The Dividend Discount Model

Where:

D1 (Estimate of next year’s dividend) = Current annual dividend * (1 + g)
r (Required Rate of Return for the Stock) = Real Risk Free Rate + (Market Return - Real Risk Free Rate) * Beta of Stock
Real Risk Free Rate = 52-Week T-Bill Yield**
Market Return = Estimate for the stock market’s return in the next year
g (Dividend Growth Rate) = Estimate for the stock’s dividend growth rate (you may calculate g by using the growth of the dividend in the past)

** 52-Week T-Bill Yield - You can find the yield by going to the U.S. Treasury Direct website, selecting the most recent year under auction date > 52-week bills > PDF of the latest auction results.

Sample Valuation

Here’s a sample valuation of Microsoft (MSFT) using the Dividend Discount Model..

The Dividend Discount Model requires two major assumptions - the return on the stock market for the next year and the growth rate for the stock’s dividend. In this example I will use an optimistic 12% expected return for the stock market, and a 10% dividend growth rate for Microsoft, based off their 2008 dividend growth. When you run the equation you can change these values to high, medium and low numbers, so that you can see a range of strike prices based on differing 1 year outcomes for the stock market and Microsoft’s dividends.

g (growth rate) = 2008 dividend / 2007 dividend
= .44/.40
= 10%
D1 = Current Dividend * (1 + g)
= $.52 * (1 + .1)
= $.572
r (required rate of return) = risk free rate + (market rate - risk free rate) * MSFT’s beta
= .55% + (12% - .55%) * 1.01
= 12.12%
Dividend Discount Model = D1 / (r - g)
= $.572 / (.1212 - .1)
= $26.98

Microsoft closing price as of last Friday July 24, 2009 was $23.45, so with a $26.98 valuation from the Dividend Discount Model, Microsoft would be considered undervalued.

Problems With the Model

For high-growth stocks, the growth rate (g) may be higher than the required rate of return (r), in which case the suggested stock value would be a negative number.

It is important not to use the Dividend Growth Model by itself, but rather as one tool in the value investing toolbox we’re constantly building on this blog

Feel free to ask me any questions you may have in the comments section below..

Merril Lynch’s David Rosenberg predicted the recession in January of 2008, when the downturn was in its infancy and the Dow Jones was only down about 10%. Rosenberg gave credit for his great insight to Merril Lynch’s former investment analyst Bob Farrell’s “10 Market Rules to Remember”.

Rules one through four, which include the belief that markets always return to long-run averages and excesses in one direction are invariably followed by excesses in the opposite direction, are applicable to this decade’s housing cycle, Rosenberg said.

Farrell’s rules “were a compass in terms of guiding me through the past three years,” said Rosenberg

- Bloomberg, “Merrill’s Rosenberg Inspired by Farrell in Foreseeing Crash“ 

Farrell’s 10 Market Rules to Remember:

1. Markets tend to return to the mean over time.

2. Excesses in one direction will lead to an opposite excess in the other direction.

3. There are no new eras — excesses are never permanent.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

5. The public buys the most at the top and the least at the bottom.

6. Fear and greed are stronger than long-term resolve.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names.

8. Bear markets have three stages — sharp down — reflexive rebound —a drawn-out fundamental downtrend.

9. When all the experts and forecasts agree – something else is going to happen.

10. Bull markets are more fun than bear markets

For a detailed analysis of the ten rules, check out this MarketWatch article.

Even with the stock market finding a pulse of late, the overwhelming investment sentiment is clearly pessimistic. I can’t stop thinking about October of 2007 when the Dow Jones was at 14,000. The investment community and average investors were unified in their optimism to equal levels that they are now pessimistic. I love Farrel’s ninth rule - when all the “experts” agree, something else is going to happen. I’m still firm in my belief that Mr. Market has given value investors a great opportunity to buy.

Any thoughts on Farrell’s ten rules?

This post focuses on a technique to attain medium risk in your portfolio with a value investing approach. “Medium risk” seems to be an elusive term, which was well illustrated in the bear market of 2008. In Nassim Taleb book he shares his brilliant “barbell” investing strategy that comes as close to the essence of a medium risk and value investing portfolio as I have come across. He advises that we invest 80-90% of our portfolio’s in Treasury bills, the safest investment class on the planet. The remaining 10-20% should be invested in high risk bets like options.

Taleb’s strategy is unconventional, but lets take a closer look. In the past year we have seen overwhelming proof of investors and economists inability to speculate. Millions of shares of Bear Stearns were bought above $100 before their sale to J.P. Morgan for a couple of dollars and the majority of “sophisticated investors” were only mildly bearish in January 2008. By investing 80-90% of a portfolio in T-bills you create a safe nest-egg. The percent of your portfolio devoted to options gives you a floor on your possible exposure to massive losses in the equity market - you cannot lose more than 10-20% in any given year. At the same time, if your option bets are successful, you have a large upside.

Let us consider the medium risk math - the most recent 10 year treasury notes sold for about 4%  interest rate (which is near the historical low). Lets estimate that all your option investments have a wide range of 50% returns or 50% loses in a year. If 80% of your portfolio returns 4% that effects your portfolio with an overall increase of 3.2% (80 x 4%). The 20% dedicated to options with a +/- 50% return will deliver a 10% increase in your overall portfolio or a loss of 10%, at either end of the spectrum. So overall in a good year of 50% returns on options your overall portfolio will increase 13.2% (3.2% + 10%) and in a terrible year of 50% loss on options your overall portfolio will decrease 6.8% (3.2%-10%). By a show of hands how many people would be happy to have only been down 6.8% this year?

If you are considering treasury bills you can research rates and buy t-bills at the goverment website - http://www.treasurydirect.gov.

Taleb’s proposal is an interesting blend of very low and very high risk that appears to attain true medium risk. I am interested to hear what you think and if you would consider Taleb’s diversification method. The method came from his bestselling book, The Black Swan: The Impact of the Highly Improbable. Taleb is a sucessful hedge fund manager and professor who studies human’s poor ability to make predictions and the effect of “Black Swans” or random, unpredictable events. Taleb’s book is available on Amazon.com:

Happy Holidays!!

Post written by Max Asciutto. Follow me on twitter.

Charles Ponzi

The Madoff scandal may have you asking: What exactly is a Ponzi scheme?

The essence of a Ponzi scheme is better known today as a pyramid scheme.

In 1920, a Boston investment broker named Charles Ponzi told investors that he could earn them 50% returns on a 45 day bond, from his mysterious investing technique. Within the 45 days, Ponzi would recruit larger investors, and use their investments to pay interest on the last round of investors. When word spread that Ponzi had been delivering on his high yield promises, huge lines of eager investors formed outside his office. In his own words:

“A huge line of investors, four abreast, stretched from the City Hall Annex . . . all the way to my office! . . . Hope and greed could be read in everybody’s countenance. Guessed from the wads of money nervously clutched and waved by thousands of outstretched fists! Madness, money madness, was reflected in everybody’s eyes! . . .To the crowd there assembled, I was the realization of their dreams . . . The ‘wizard’ who could turn a pauper into a millionaire overnight!”

- Charles Ponzi

Bernie Madoff

“I really think very highly of him, people make mistakes,” wrote a Madoff confidant and NYSE broker. At a party over the weekend I met a nice girl from Boston University, and I forgot to ask for her number when I left. THAT was a mistake.

Bernard Madoff, former chairmain of the board at the NASDAQ stock exchange stealing $50 billion through a Ponzi scheme is no mistake. The losses stem from a deliberate and deceitful crime of a magnitude only rivaled by Ken Lay and his chefs that cooked Enron’s books in 2001. The day before his arrest, Madoff told his sons that his investment firm “is all just one big lie.” And with great deciet, comes a captivating storyline including big name victims, a surfacing video of Madoff claiming an “impenetrable regulatory system”, a decieving investment strategy, and another SEC failure.

Mr. Madoff initially used his Wall Street reputation as a former chairmain of the NASDAQ board to recruit early investors at the finest country clubs around the country. He then created fictional returns that attracted more investors….investors who would eventually tell their friends, “I’ve got my money invested with Madoff and he’s doing really well. You can’t get in unless you’re invited…but I can probably get you in.”

Whenever a firm or individual requested money, Madoff would pay them with principal from other investors. Even though Madoff claimed gains throughout this 2008 financial crisis, many of his clients asked to withdraw their stock investments, until the withdrawls got overwhelming and he wasn’t getting new investors to furnish the old.

Blockbuster Names Go Bust With Madoff Securities

Among the big names with considerable investments in Madoff Securities were international banks, hedge funds, and wealthy private investors; some of whom invested 50-95% of their assets. New York Mets owner Fred Wilpon invested tens of millions of dollars of both his and the Mets organization’s money with Madoff. Other notables include Steven Spielberg’s charity, real estate magnate Mort Zuckerman, the Elie Wiesel Foundation for Humanity (Why couldn’t Madoff just say no to charities? Does he have no heart?) and Norman Braman, the former owner of the Philadelphia Eagles. Investment firms taking the biggest losses include Spain’s Gruopo Santander, France’s BNP Paribas, and Fairfield Greenwich Advisors.

Jeff Fischer, a top divorce attorney in Palm Beach, says many of his clients were also Mr. Madoff’s clients. “Every big divorce that came through my office had portfolio positions with Madoff,” he says.

Two of his investors said that among his clients, Mr. Madoff was considered a money-management legend; they would joke that if Mr. Madoff was a fraud, he’d take down half the world with him.

- WSJ.com: Fund Fraud Hits Big Names, December 13, 2008

Watch A Video of Bernard Madoff Lying Through His Teeth

Mr. Madoff’s words to his sons “it’s all just one big lie,” is definitely not an understatement..

Madoff’s Proposed Investment Strategy

Older, Jewish investors called Mr. Madoff “ ’the Jewish bond,’ ” says Ken Phillips, head of a Boulder, Colo., investment firm. “It paid 8% to 12%, every year, no matter what.” Mr. Madoff explained his smooth returns by claiming that he bought baskets of stocks, and in case the market crashed he placed put-options. Hedging with options is a pretty damn common practice, but it never delivers small gains for dozens of consecutive quarters of changing market environments the way Madoff’s fund did.

“He was a low-key guy,” said Ms. Manzke of Maxam Capital Management, “he would say, ‘Look, I’m a market-maker, and I don’t want anyone to know I’m running money.’ It was always for select people. He was always closed, he wasn’t taking new money.”

The SEC Is Inept

I’m going to go on a limb and assume that no one at the SEC has heard of Frankie Valli or his hit lyrics, “you’re just too good to be true, can’t take my eyes off of you.” Clearly Madoff’s 1% monthly gains every month should have set off flags - either he was cheating the market or he was cheating his clients.

“Madoff Securities is the world’s largest Ponzi Scheme,” Mr. Markopolos, wrote in a letter to the U.S. Securities and Exchange Commission in 1999.” Markopolos was one of many members of the investment community baffled by Madoff’s returns, see: “Madoff tops charts, skeptics ask how” from a 2001 hedge fund magazine.

The SEC investigated Madoff Securities when they last filed in 2006 and the commission didn’t find any reason to further their investigation.

I thought the SEC was asleep at the wheel when it missed a decade of banks overleveraging and designing fantasy CDOs, but I’m getting the feeling they’ve been wide awake, just inept.

Conclusion

I need your help, I can’t remember the phrase… something about “good” and “true”? No one beats the stock market, not even Madoff the “market maker.” For every trade their is a buyer and a seller; both of whom might be the most “sophisticated” of investors, but only one will have made the right decision a year from now. Thousands of speculative investors may be early buyers into the next hot industry, but its doubtful they will be correct for years in a row. There is no game if someone always wins.

Sources:

In October, Verizon Communications (VZ) raised their quarterly dividend 7% to $.46 a share from $.43 cents, with a dividend yield at today’s price now 5.67%. Verizon should be able to defend its dividend in the next 12 months. The communications company is estimated to grow EPS 4% in the next four quarters, a slower rate than 2008’s 8%, but enough to cover the current dividend. The expected dividend payout ratio for 2009 is 69% percent of earnings, which is comfortably nested between the payout ratios from 2007 - 70% and 2008 - 67%. However, at today’s market price the company appears to be trading at a premium.

Verizon In The Bear Market

Two aspects of Verizon that I believe really help them in the current market conditions are their contract agreements and bundled services. The majority of Verizon Wireless customers are locked into a 2 year contract, with a steep termination fee of a couple hundred dollars, which will help retain customers through this recession. Secondly, Verizon has created a value bundle of their home product line that includes FIOS high speed internet, digital TV, and phone lines. Revenue for their bundled packages was up 45% year-over-year in the 3rd quarter reported in October. When families consider cutting their bills in these hard times, the Verizon package has strengthened its attraction.

Company Strengths

“Can you hear me now?” Verizon spent $2.5 billion on its successful advertising campaign in 2007, continuing to grow its already powerful brand name. 

Verizon has two product and service segments - wireline and domestic wireless that serve businesses and consumers.

The wireline segment was 54% of revenue in 2007 with sales of $50 billion and an above industry average 27.3% EBITDA profit margin. Wireline consists of voice, VOIP, internet access, and digital television. The segment has 41 million lines in 150 countries, with 85% of revenue comes from the United States. 

The wireless segment is run exclusively in the U.S. and in the most recent quarter Verizon added a net 2.1 million subscribers. The EBITDA profit margin for the wireless segment is 44.2%.

Company Risks

The two major risks for Verizon are cut-throat competition and the Telecommunications Act of 1996.

The company faces both solidified communications companies and cutting edge start-ups. Most notably, the company’s wireline phone services have to compete with low or zero cost voice-over-internet-providers like Vonage and the MagicJack which plugs into the a computer USB port and only costs about $20 a year.

The Telecommunications Act of 1996 permits competitors to buy Verizon’s services at a discount and resell them in the marketplace. This cuts into Verizon’s profit margins and ability to add subscribers. However, since the act was put into law in 1996 the company’s bottom line has risen tremendously, so you can make the case that the act has only a slight negative effect that hurts every company in the industry equally.

Additionally, Verizon has a unsettlingly low current ratio of .68 and debt-to-equity of .88. The firm clearly uses a lot of debt to aggressively grow earnings, and if they begin to lose market share from stiff competition their high leverage will backfire.

More Information on Verizon

You can visit http://investor.verizon.com/ to read Verizon’s latest quarterly and annual report.

Conclusion

Verizon is not poised to break any earnings growth records in 2009, but the company is competitively positioned with its bundled packages to fight this recession and retain past growth rates when we return to a bull market. I believe that if Benjamin Graham could comment, he would conclude that Verizon is not a value investment at today’s price of $32.47. The company does not meet the 2-1 current ratio requirment, nor is it trading 40% below its 52-week high. But, if you can buy shares between $25-$28 the company becomes much more attractive and you can benefit from a sturdy dividend yield between 6 and 7.5%.

Full disclosure: None.

Post written by Max Asciutto. Follow me on twitter.

This parody on the big three bailout ad cracked me up, so I thought I would share..