Green Mountain Coffee Roasters (GMCR) is enjoying one heck of a ride today, after the company reported earnings for the second quarter that were by all accounts outstanding.  There is no doubt that Green Mountain’s growth potential has not yet been tapped out.  The second quarter saw the company report earnings of $.50 per share on extremely strong sales of $193 million.  The analysts were blind-sided by the incredible growth of Green Mtn. as they had only anticipated 36 cents of earnings on sales of $178 million.  Granted the analysts were already anticipating strong growth compared to a year ago, but that analysis was in fact out to be far to limited.

The stock has rocketed up nearly 40% today, well above its all time highs.  Much of the volatility seems to be a text book short squeeze as coming into the day more than 50% of the shares were held short.  These short sellers were counting on a let down in today’s numbers, but instead they got the opposite.  The result is a lot of shorts abandoning ship and the amazing quarter is attracting new interest from buyers as well.  The result is a surging stock price.

For those of you who are long on GMCR, congratulations on picking on of the top performing stocks over the last six months.  The stock has tripled since hitting its low in October.  However, in our view this stock seems due for a pull back over the next few weeks.  This is unbelievable growth even in an favorable market, but in this market we think it wise to pull profits off the table when the opportunity presents itself.  In the case of GMCR, the growth has been fantastic, but even after raising full year EPS guidance the stock is now trading at a huge premium to market.  Using the current price and mid range of expected full year 2009 earnings, the P/E multiple of 48x.  That is tough to justify, especially if you have already missed the nearly 40% pop today.

We had Green Mountain Coffee Roasters coming into the week at Fairly Valued , and after the price action this week it is very possible that next week it will necessitate a downgrade to Overvalued.  There is no doubt that this is a growth story with little compare in this market, and a new distribution deal signed with WalMart (WMT) today will not hurt at all.  But investors need not be greedy and as rich a P/E multiple as they are pulling now is substantial.  Proceed with caution on Green Mountain because investors buying in near the top of a major rally so often get burned.

Jim Cramer for the last few months has been advising viewers to hedge themselves against the real possibility of a ramp up in inflation.  In the past, I can recall him saying that a properly diversified portfolio should have as much as 20% allocated to gold and other precious metals.  While, Cramer has a tendency for hyperbole, as you can see in the quote as he  talks about “wheelbarrow currency”, there is still wisdom in hedging your portfolio somewhat against inflation.  He had this to say prior to interviewing the CEO of Agnico-Eagle (AEM) gold mining company.

“A million for a loaf of bread, or a $4 million going to $5 million bottled milk…the next thing to protect against a wheel barrow currency is to own some gold, or at least the stock of a gold miner, since the precious metal goes higher whenever inflation is ramped up or economic chaos reigns. Now that gold has pulled back a lot, as has Agnico- Eagle, one of the gold miners, I don’t think any time is better for growing a position, and they had a quarter much better than I was looking for…

Central banks have been selling less gold than at any point in the last ten years. After tonight’s big quarter, the question becomes, should we stick with Agnico- Eagle as the stock proxy for gold? Agnico- Eagle’s gold production should produce 170,000 ounces at full capacity. It’s supposed to produce 130,000 ounces this year, full capacity? They’re all going to start coming on. As the company’s production continues to grow, cash cost to decline, making them a more attractive company and less risky stock.” CNBC’s Mad Money on Wednesday, April 29, 2009

There is no doubt that the governments efforts to stimulate the economy have pumped massive amounts of money into the financial system.  As famed twentieth century economist  Milton Friedman is famous for saying, “inflation is always and everywhere a monetary phenomenon.”  The stated and obvious purpose of the actions by the government are to ignite growth again in the economy, and if this goal is eventually achieved it stands to reason that prices will rise, perhaps quickly.  After gold’s recent pull back, there is a place for holding gold or gold stocks in your portfolio right now.  Depending on your own investment thesis, perhaps as much as 20% which Cramer suggests, but that seems a bit excessive to us.  

In the last 13-weeks gold stocks have under performed the other sectors of precious metal stocks (chart to the right).  Ockham believes that AEM is Fairly Valued at present, but there are Undervalued names in the sector such as Anglo American (AAUK).

The Wall Street Journal just published a story today about the death of buy and hold at many financial advisory firms.  Realistically, this is probably a small minority of shops in comparison to the overall community.  This also smacks of “this time it’s different” sorts of mentality, which we are not big fans of.

However, at Ockham, we have been working for years to point out that the dangers of conventional wisdom never cease.  The problem with the whole crowd being buy and hold was that the whole crowd was, well, buy and hold.  Not that being a contrarian necessarily means your right, either.  Unfortunately, the market can crush you while you wait for it to realize it is wrong.

In the end, you must stick to solid principles and stay informed at all times.  It’s not that you can’t be buy and hold, its that you can’t be buy and hold forever in all cases.  The flexibility is the issue.  Emotional attachment to a strategy is even more dangerous than an emotional attachment to a stock.

An interesting portion of today’s article:

‘A Seismic Change’

“There’s a seismic change in the market,” says Will Hepburn, president of the National Association of Active Investment Managers. “The people who were buy-and-hold-oriented lost a lot of money, and they don’t want to do it again.”

Meanwhile, financial-services companies are rolling out products designed to lure gun-shy advisers. Last July, Portfolio Management Consultants, the investment consulting arm of Envestnet Asset Management Inc., introduced seven portfolios that invest in ETFs based primarily on signals from quantitative models. Advisers — who have invested over $200 million since the launch — can select how much of their clients’ portfolios to allocate to this tactical asset-allocation approach. Although many will put between 20% and 40% of client assets in them, some have shifted 100%, says Richard Hughes, group co-president.”

FULL ARTICLE FROM WSJ.COM

Whether or not this is just a fad, we shall see.  It is important, however, to recognize that when discussing long term returns, those that are going with 90% safe, 10% aggressive or leveraged portfolios will still probably outperform the historic norm of doling out client assets to a handful of external fund managers.  Just ask those who have been in 100% treasuries for the last ten years.

The Commerce Department reported this morning that first quarter GDP declined at a 6.1% annual clip–a far bleaker number than the 4.9% drop expected by most economists.  This unrevised number is almost as bad as the decline turned in by the U.S. economy in the fourth quarter of 2008 (-6.3% annualized).  Under most circumstances, one might expect worse than expected economic news to negatively impact stocks–particularly in light of the strong rally equities have turned in off their early March lows.  Aside from the negative surprise, this marks the first time that the domestic economy has contracted for three consecutive quarters since 1974-1975, a time heretofore regarded as the worst recession since the Great Depression.

The market seems to have taken solace in parsing the data contained in the grim 1Q09 report.  A record drop in inventories accounted for  2.79% of the negative 6.1% quarterly number.  Excluding inventories, the GDP drop would have been only 3.4%.  The $103.7 billion plunge in inventories is actually good news as manufacturers and retailers are reducing their inventory of unsold goods to more manageable levels, which is a necessary prelude to any economic recovery.

Exports were a particularly ugly component of the GDP number.  Exports turned in their biggest decline since 1969, dropping 30% which is on top of an already bad drop of 23.6% in last year’s fourth quarter.  The first quarter also saw big declines in business and residential investment.  However, a 2.2%  up-tick in consumer spending (which comprises over two-thirds of economic activity) was welcome good news as consumer spending had fallen off a cliff in the prior quarter.  Durable goods in particular showed strength, advancing 9.4%, breaking a streak of four consecutive quarterly declines.

Stock investors seem to be assuming that first quarter GDP numbers will be the low point for this recession.  Inventory levels are now much more favorable and the effects of the government’s stimulus package–undetectable in this quarter’s GDP–will become much more pronounced.  Going forward, the numbers should get much less bleak, although likely not positive for a few more quarters.

Thus, at midday, stocks continue in rally mode.  Ockham would however urge caution, particularly in the financials.  Coming quarters will see continued huge challenges for financial firms as they labor to rebuild devastated balance sheets.  The pain in residential real estate seems fairly well priced-in to financial stock valuations, but continuing foreclosures and a massive overhang of inventory will inflict pain for some time to come.  Furthermore, this year’s focus for ailing financials will likely be in commercial real estate and consumer loans.  Troubles in commercial real estate could threaten the existence of some banks not deemed to big to fail.

Stocks have rallied dramatically from their nadir.  There are small signs of economic improvement (such as the above-mentioned jump in consumer spending and pick up in last month’s consumer confidence number).  Government continues to pump liquidity into the system.  These factors all point to a stock rally based on expectations of a return to economic expansion and rising corporate profits.  However, do not underestimate the damage that has been done and how much time and effort it will require to rebuild our economy.  Also, the Administration’s aggressive push in so many various policy areas which impact future economic growth and looming tax increases in 2010 could impact the strength and sustainability of any recovery.  Proceed with caution in buying stocks right now.  Stick with dominant companies which pay attractive and safe dividends and avoid stocks who have appreciated enormously of late, largely based on favorable accounting changes and lots of hope.

Qwest Communication (Q) reported a quarterly profit that was better than expected, as net income was up 37% from last year primarily due to significant cost cutting measures.  On a per share basis, last year the company made 8 cents per share, which is what the Street had expected, but the actual EPS was up to 12 cents per share.  The company had warned that revenue would be modestly lower than estimates of $3.25 billion, the reported total was consistent with that at $3.17 billion.  The stock is up about 5% through half of the trading day, partially because the overall market is up and also because of the earnings beat.  However, we have some real concerns with Qwest’s performance in the quarter.

First of all, perhaps the biggest difference between Qwest and its larger rivals AT&T (T), Verizon (VZ) and to a lesser extent Sprint (S), is that Qwest is more dependent on their wire-line telephone business and internet services.  Qwest’s competitors have more diverse offerings from both cell phone service to television service.  Qwest is in the process of transitioning its formerly stand alone wireless service to Verizon, and they do not have their own television service.  So, Qwest has been greatly effected by the downturn in the housing market and the economy in general, as people are shedding the extra and often redundant home phone service.  The total number of lines was down 10% in the quarter to 11.2 million.  Granted, some of this decline was by Qwest’s own volition as they dropped service to some of their unprofitable customers, but 10% decline in one of your main revenue streams is important to note.  In addition, Qwest was only able to add 42,000 internet subscribers which was below what analysts had expected.

Cutting costs was certainly the highlight of the quarter as the company was able to generate an impressive $339 million in free cash flow.  From a valuation standpoint, Qwest still looks pretty attractive as the current price-to-cash flow is 1.97x, whereas the historically normal range for this company is 2.94x to 7.48x.  Similarly, price-to-sales over the past ten years has normally ranged between .58x and 1.35x, the current valuation metric stands at .47x.  The dividend remains intact at a hefty yield of 8.5%, but unless there is a further increase in earnings that could be in danger.

So, there are the basics of the argument and to be honest I do not know whether Qwest is a bargain or a value trap.  The fundamentals suggest you are getting a stock that is quite attractive and with a nice yield to boot.  However, much of the fundamental strength comes from cost cutting and certainly not growth, and the historical ranges are based on an era where the hard-wired phone was not in decline.  By our methodology, we believe Qwest in Undervalued and could reach as high as $5 per share, but then again there are doubts about the sustainability of profits when there are no more costs to cut.  Thoughts?