Volatility, So What?

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There are ways to beat the expectation game and reduce volatility to your portfolio. You do not have to wait for the press release and wait nervously whether your company beat or miss expectation. One way is to buy company with a modest expectation.

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Earning Season is always volatile to stock prices. Traders jerk in and out depending on the outcome of the report. For example, Texas Instrument (TXN) reported that its third quarter earning of 2005 rising 12% year over year. And yet, TXN fell after hour due to weak forecast. The game now is the expectation game. If the company beats, share price normally rise. If it doesn’t, share price plunge.

There are ways to beat the expectation game and reduce volatility to your portfolio. You do not have to wait for the press release and wait nervously whether your company beat or miss expectation. One way is to buy company with a modest expectation. The definition of modest varies among individuals but to me, modest expectation has a forward P/E ratio of less than 10. What happens when a company with modest expectation miss expectation? While, share price may get clobbered, I don’t think it will move much. Why? Because P/E of 10 already incorporates a 0% EPS growth. Even if EPS stays constant for the next ten years, company with P/E of 10 will return its shareholder roughly 10% a year.

Another way is to pick company that has predictable cash flow and dividend payment. Investors hate uncertainty. Companies that pay dividends eliminate some of that uncertainty. For example, a stock has a 4% dividend yield and it misses expectation for the quarter. The stock might tumble, pushing the dividend yield up to 4.2 or 4.5 %. By then, a lot of value investors will be interested in owning the stock and the drop in stock price will be less severe.

Finally, the last way to reduce volatility is to pick up companies with cash rich balance sheet. Some companies may have cash up to half of their market capitalization. For example, OmniVision Technologies Inc. (OVTI) has a market capitalization of $ 720 M. It has $ 300M in net cash, about 41.6% of market cap. With $ 300 M in cash cushion, it is hard to imagine the company to have market capitalization below $ 300 M. It is possible, but it is uncommon.

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Learning the Basics of Penny Stocks

Penny stocks are stocks that are either low in value or low in the total market capitalization. The definition of penny stocks can vary a bit from one person to another. Generally, penny stocks can be understood to mean any stock that is not a major stock. The two criteria that we have set above will determine whether a stock is a penny or not based on its price and market capitalization.

In addition, one can also consider a stock as a penny stock if it does not conform to stock exchange regulations and are thus more risky. In practice, however, it would be extremely difficult to find a large market stock that is not meeting the major stock exchange regulations. Because of this reason, penny stocks are generally understood to be those stocks whose absolute price or market capitalization is very low.

The next question that arises is ‘how low is low’? Obviously this is a little subjective and also prone to change from time to time. While there are no hard and fast rules, we can follow some rules of thumb. However, you must remember that not only are these rules not sacrosanct but also are likely to keep changing over time. Having said that, we can set some rules of thumb for considering a stock as penny stock. Any stock that is below a certain cut off price is considered as penny stock.

The cut off price is a matter of opinion. Some consider any stock below $5 to be a penny stock, while others are more liberal and consider only those stocks that are below $3 to be penny stocks. There are still others who would rather set the limit at $1, considering any stock above $1 as not a penny stock. Similarly, in the case of market capitalization, various limits are set by various people. In general, we can consider any stock with a market capitalization below $300 million to be a penny stock.

There could further classifications within this group, with stocks having a market cap of below $50 million being considered a step below penny stocks and classified as nano-cap stocks. The general idea is that any stock having a low per stock price or low market capitalization would be considered as a penny stock.

In case you are wondering what is market capitalization, here’s some information that would help you. Market capitalization (or market cap for short) is the total value of all outstanding stocks at the current price. Suppose a stock sells at $10 and there are 100,000 stocks outstanding, the total market cap would be 10 x 100,000 or $1 million. Market cap is an important indicator, because the greater the total amount outstanding the greater the stakes.

If a large number of people or a large amount of money is involved in a stock, the chances are that there will be greater control on the stock. There is one exception to this. If the stock is not traded on a regular stock exchange like NASDAQ, it is not under any regulatory control to comply with a number of regulations that have been designed to safeguard the interest of the investor.

In these cases, even if t he market cap or the price is large, there may not be sufficient safety. In general, however, we can assume that for large market cap stocks the possibility of being outside the purview of a recognized stock exchange are very remote. The reasons for this, as well as the reason why penny stocks are considered risky will form the subject matter of our next article.

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An Analysis Of Overstock.com (OSTK)

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Why is a value investor writing about an unprofitable internet company? Because value investing is about finding dollars that trade for fifty cents; with a market cap of less than 75% of sales, Overstock.com (OSTK) looks like it may be exactly that.

But isn’t it too risky?

The greatest risk in any investment is the risk of overpaying. So, the real question is: what is Overstock worth? I think it worth at least $1.5 billion. With Overstock market cap currently sitti…
overstock.com, overstock, OSTK, (OSTK), overstock (OSTK), stock, stocks, stock market, investing,
Why is a value investor writing about an unprofitable internet company? Because value investing is about finding dollars that trade for fifty cents; with a market cap of less than 75% of sales, Overstock.com (OSTK) looks like it may be exactly that.

But isn’t it too risky?

The greatest risk in any investment is the risk of overpaying. So, the real question is: what is Overstock worth? I think it worth at least $1.5 billion. With Overstock market cap currently sitting around $500 million, my valuation certainly looks far fetched. But, there only one way to know for sure. Let take apart my argument piece by piece, and see if any of my assumptions are unreasonable.

First Assumption: Over the next five years, Overstock will neither generate truly free cash flow nor consume cash. In other words, its free cash flow margin will average 0%. Cash generation in some years will exactly offset cash consumption in other years. Obviously, this assumption is unreasonable, because there is almost no chance the cash flows will exactly offset.

That not a problem if it turns out Overstock does generate some free cash flow over the next five years. In that case, my assumption simply errs on the side of caution. If, however, it turns out Overstock actually consumes cash over the next five years, there is a problem ?possibly a very big problem. So, which scenario is more likely?

Overstock revenues are growing quickly. Gross margins look solid at 13.3% in 2004 and 14.9% over the last twelve months. Overstock unprofitability is the result of its selling, general, and administrative expenses (SG&A) which have been growing exponentially. Will these expenses continue to grow? Yes, but not as fast as revenues. Over the last twelve months, Overstock spending on cap ex has been 5.6% of sales. That number is an aberration. In the long run, spending on cap ex should not exceed 3% of sales. Considering the business Overstock is in and the expected sales growth, the company will, more likely than not, generate some free cash flow over the next five years. Therefore, the assumption that Overstock will be cash flow neutral over the next five years is not overly optimistic.

Second Assumption: Over the next five years, Overstock sales will grow by 15% annually. Is this an unreasonable assumption? Again, I don’t think it is. Very few industries are expected to grow as fast as eCommerce. Overstock revenue growth in 2003 and 2004 was over 100%. In the past year, that growth has slowed. However, it is still closer to 50% than it is to 15%. Overstock isn’t in a cyclical business. So, there is no reason to believe current sales are abnormally high.

Also, all that spending on advertising is increasing consumers?awareness of Overstock. A review of Overstock traffic data shows it has not only been gaining more visitors; it has also been climbing the ranks of the most popular web sites. While it is a long, long way from the Amazons, Yahoos, and eBays of the world (and will never reach those heights) Overstock is becoming a well known internet destination. This fact was most clearly evident in the weeks leading up to Christmas. Shoppers who visited Overstock during the holiday season obviously know it exists, and may very well return at some other point in the year. Analysts are predicting very high growth rates for Overstock; however, they are also recommending you sell the stock. I don’t put any weight in their estimates. But, for the other reasons given, I believe the assumption that Overstock will grow sales at 15% a year for the next five years is not unreasonable.

Third Assumption: Six to ten years from today, Overstock will have a free cash flow margin of 3%. Ten years from today, Overstock free cash flow margin will rise to 4% and remain at that level. Now, of all the assumptions I’ve made, this one is the most questionable. Sure, Amazon has that kind of free cash flow margin, but Overstock isn’t Amazon, and it never will be Amazon. Overstock gross margins are less than Amazon. In fact, Overstock gross margins are less than Wal ?Mart. However, Overstock fixed costs will eat up a much smaller portion of its sales than is the case over at Wal – Mart.

If you compare Overstock to other online retailers, you will see that if Overstock does experience strong sales growth, a 3% free cash flow margin six years from now is not unreasonable. I assumed Overstock sustainable free cash flow margin will be 4%. There a case to be made that 4% is too high. I won’t make that case, because I don’t believe in it. Remember, that 4% number comes ten years out. That gives Overstock plenty of time to grow sales and thus reduce SG&A as a percentage of sales.

Fourth Assumption: Six to ten years from today, Overstock will be growing sales by 12% a year; eleven to fifteen years from today, Overstock will be growing sales by 8% a year; thereafter, Overstock will grow sales by 4% a year. Let see what this really means. According to these assumptions, Overstock sales will be as follows:

Today: $707 million

2011: $1.59 billion

2016: $2.71 billion

2021: $3.83 billion

2026: $4.66 billion

2031: $5.67 billion

2036: $6.90 billion

Seven billion dollars is not an unreasonable target ?if you have thirty years to achieve it. To put that figure in perspective, Amazon.com currently has sales of about $8 billion. So, even after thirty years, these assumptions don’t lead to Overstock reaching the same size as today Amazon. Don’t forget these numbers assume some inflation. For instance, if inflation averages 3% a year over the next thirty years, Overstock projected $6.90 billion in sales only translates to $2.84 billion in today dollars. So, these assumptions only lead to a fourfold increase in Overstock real sales over a period of thirty years. I think that pretty reasonable.

If you take these four assumptions together, you get a value of $1.5 billion for Overstock. Today, Mr. Market is offering it for $500 million ?that why I’m writing about an unprofitable internet company.

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Penny Stocks Risks

The first point to remember is that large market cap stocks are likely to be registered on a national stock exchange such as NASDAQ. The reason for this is that when large volumes and amount are involved, which by definition is true for a large market cap stock, it is extremely difficult to get all that trade done outside a stock exchange. Although it is theoretically possible for a large stock to be traded on Pink Sheets and OTCBB, it will be difficult to sustain high volumes on these, because many people, who trade on recognized stock exchanges, may not trade in these stocks, particularly in large volumes.

Registration with a stock exchange involves a number of formalities that have to be complied with. These formalities are aimed at making the whole process more transparent so that the investor has access to relevant information. The availability of information helps you to verify the facts and also to check out on the soundness of the company more thoroughly. When these are missing you are operating under insufficient information and therefore are exposed to higher risk. Thus stock exchange registration by itself reduces the risk involved in investment.

Apart from this, there are other reasons why a penny stock is more risky than large market cap stocks.

Stocks registered with a recognized stock exchange are required to maintain minimum standards. These include requirements such as

Minimum number of publicly traded shares – this should be 1.1 million shares in the case of NASDAQ. The publicly held shares should also be a minimum of 10% of the total shares of the company.
Minimum Shareholder Equity
Minimum Operating income
Availability of market makers
The specified minimum amount should be available in assets, total revenue and listed securities.

There are many such requirements that a company has to meet in order to stay registered with the stock exchange. Basically, these requirements ensure that the stocks are widely held, and the company is running properly. These safeguards make the listed stocks less risky than unlisted ones, which do not have to follow any such requirements.

Penny stocks also generally do not have a history behind them, and suffer from low liquidity position. They have less room to maneuver. Because they are more risky and less preferred they will also have difficulty in raising money for new ventures or expansion. In some cases they may have difficulty in raising money even for operations. Companies generally raise money by borrowing or raising new capital. The amount that can be borrowed is limited for a given equity base. Suppose the company has $100,000 in capital, lenders may be willing to lend $200,000 or some such amount. If the company wants to borrow more money, it will have to first increase its capital base. This is more difficult in the case of penny stocks.

Finally, it might not be equally easy to find buyers in the case of penny stocks particularly if you have a large number of them. This will affect your own liquidity in the short term and also make it difficult to offload these stocks if the going is not too good.

These are some of the reasons why a penny stock is considered more risky. However, penny stocks have their brighter side too. They can give you much higher returns. We’ll see how this is possible in the next article.

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