The Buckingham Report

Given that legendary value investors like Warren Buffett and Al Frank have enjoyed long-term returns that have consistently surpassed the S&P 500, the widely-used equity benchmark, for more than a quarter century, most Buckingham Report readers are undoubtedly aware of what we think of the Efficient Market Hypothesis. From Investopedia.com: “Efficient Market Hypothesis (EMH) is an investment theory that states that it is impossible to ‘beat the market’ because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, this means that stocks always trade at their fair value on stock exchanges, and thus it is impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. Thus, the crux of the EMH is that it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.”

I believe that the strongest proponents of the Efficient Market Hypothesis are often folks who have their noses buried in financial text books rather than those who actually participate in market events that take place in the real world. Despite tremendous evidence to the contrary, we know that we will fail to convince many of the academics who are certain that relying on Book Smarts is the only way to invest successfully, but after topping the Hulbert Financial Digest  performance tables for the past 10, 15 and 25 years with our Prudent Speculator newsletter, we are convinced that Street Smarts will net us better long-term returns as we have little doubt that seldom are any stocks ever actually trading at their fair value.

Indeed, our history is filled with numerous examples of market inefficiencies. One of my favorite tales dates back to February 28, 2000, when a company called RF Micro Devices (RFMD) announced an alliance with Qualcomm to provide advanced power amplifiers for the CDMA market. RFMD soared from $57 to $69 in the next two days. Meanwhile, in a case of mistaken identity, RF Monolithics (RFMI) and RF Industries (RFIL), neither of which had an alliance with Qualcomm, skyrocketed as well, with the former more than doubling from $11 to $27 and the latter spiking from $3 to $7, before proceeding to rally to $16 two weeks later.

Yes, it is true, supposedly intelligent investors who are always incorporating and reflecting relevant information simply bought the wrong stock (we were owners of RFIL at the time) as they punched in RF as the company name when they were scrambling to find the ticker symbol of this next big winner! I remember this story well as we were able to take advantage of the situation by selling 25% of RFIL at $6 on Feb 28, 25% at $8 on Mar 7 and 25% at $13 on Mar 11. Four months later, RFIL was back at $4. Even though it did operate in the same telecom equipment space as RF Micro Devices, I hardly think RF Industries fair value increased 400% in two weeks, only to decline by 75% a few months later!

Prudent Speculator readers are also likely familiar with the story of Endwave (ENWV), a maker of radio frequency subsystems that was first recommended at $3.32 in July 2002, given that the company had $5.60 per share in cash and virtually no debt on its balance sheet and that it had just won a big contract with Boeing. Just three months later, the stock had dropped 90% to trade as low as $0.32 as the overall market plunged and the company continued to post operating losses. By July 2003, revenue growth, improved margins, new contracts and homeland security excitement drove the stock to the $6 level, a jump of nearly 2,000% in just nine months. Certainly, business developments accounted for some of the price volatility, but it is tough to say that the market had any idea of what fair value was for ENWV during this time span!

As if those gyrations were not incredible enough, the shares marched steadily higher over the next two years and we ultimately cashed in the last of our ENWV chips at $28 in May 2005 as the stock had reached multiples of book value and revenue that were extremely overvalued according to our analyses. Of course, frenzied momentum investors care little about valuation and the stock moved ever higher, eventually hitting $53 in early July 2005 when the price to book value ratio had jumped to 9 and the price to sales ratio climbed to 8. Did I mention that the company wasn’t making any money during the jump from 32 cents to 53 dollars?

Alas, Endwave had the audacity to actually make money (analysts were not expecting black ink!) when it reported Q2 results in mid-July, which promptly sent the shares into a tail-spin, with the stock plunging to $30 just a couple of weeks later. Seems perfectly efficient to me - a company performs surprisingly well and the stock plunges! Today, Endwave is back to losing money and the stock now trades south of $13.

More recently, we saw another stock move from significant undervaluation to extreme overvaluation in short order. I am referring to Empire Resources (ERS), a distributor of aluminum semi-finished products to a diverse customer base located throughout the United States and Canada, Europe, Australia and New Zealand. As the chart below illustrates, we initially recommended ERS in January 2005 at $3.75 because the company was trading for a single-digit P/E ratio, yielding over 4% and operating in a sector that we thought had fairly decent growth potential.

Click to Expand Image 

To make a long story short, less than 15 months later, we ended up selling the last of our ERS shares in the $30 range. Here’s what we wrote about the experience: “What luck we had with Empire Resources (ERS)! So much excitement in so little time. After three sales of a total of 19/27ths of our original holding, we felt that the reasons to take our remaining winnings and leave the table were too many to ignore, and so on May 4, 2006, we sold our remaining 8/27ths at prices no lower than $30.03. 

“The fact that the stock is now trading at more than 31 times trailing earnings might have been sufficient rationale for many, but a few more items of note tipped us over the edge. In the company's latest 10-K, Empire noted that it maintains significant concentration in both customers and suppliers. With the industry consolidating as it is on the producer side - Alcoa (AA) and Aleris Int'l (ARS) have been big buyers - the squeeze will be on the smaller folks to maintain profitable relationships in either direction of the supply chain. Plus, the metals business is one of great cyclicality. And though we remain in a positive upcycle, there will come a day when the trend turns. ERS' current valuation suggests that day is far off in the future, but the stock is too rich and our gains too great to warrant a continued hold.

“And so the final sale yesterday made sense. For just under three-quarters of a year average holding period, our transaction-weighted return of 480% is one for the record books. Yet another example of our winners winning more than our losers lose!”

But the Empire saga does not end with our sale. Greater fools (hard to call them investors) decided that a hot stock with tremendous fourth quarter earnings comparisons (Q1 numbers were not out yet) and a sky-high relative strength reading had to be bought, no matter the valuation and ERS shot higher, eventually hitting $64 on May 4.

At that point, the company (an aluminum distributor for crying out loud!) was trading for more than 60 times earnings, a level that a decent Q1 earnings report (ERS posted a 9% increase in first quarter net income) could not justify. Plunging off a cliff might not be strong enough a description to explain what has happened to Empire’s stock price in the past three weeks as the shares now trade in the $20 range!

And ERS ain't exactly cheap at the current quotation, given that it still trades for 18 times our current forward-looking earnings estimate. By way of contrast, Empire's #1 customer (15% of Q1 revenue), Ryerson Inc. (RYI), trades for a forward P/E of 9 and Empire's #1 competitor Alcoa (AA), trades for 11 times estimated earnings. Care to guess which two aluminum stocks we are recommending today?

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The information contained herein is believed to be reliable. However, such information has not been verified by us and we do not make any representations as to its accuracy or completeness.

Opinions expressed are those of John Buckingham, which are subject to change without notice and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

Past Performance is no guarantee of future results.

The annualized Book Value performance of Berkshire Hathaway (BRK/A) stock (for the period 1965 - 2005) and the annualized performance of The Prudent Speculator (TPS) newsletter (for the period 03/10/77 - 03/31/06) were used and compared to the S&P 500 index. The average annualized return on BRK/A for the above period is 21.50%. The average annualized return for TPS for the above referenced period is 22.17%. The average annualized return of the S&P 500 for the period 1965 - 2005 is 10.30% and for the period of 3/10/77 - 03/31/06 is 12.79%. All performance numbers includes the reinvestment of dividends.

The Hulbert Financial Digest (HFD) is a publication dedicated to independently monitoring investment newsletter performance. Total return performance results are calculated using proprietary and undisclosed methods of the publication's editor. A newsletter’s Hulbert Financial Digest’s Ranking is based on an average of its several portfolios in the event it recommends more than one (and includes portfolios that the letters have discontinued). As of 03/31/06, The Prudent Speculator is ranked #1 out of 82, 57 and 14 newsletters monitored for 10, 15 and 25 years, and #2 out of 32 newsletters monitored for 20 years, respectively. Hulbert currently monitors approximately 300 newsletters. For more information about The Hulbert Financial Digest call 866-428-6568 or go to www.hulbertdigest.com.

Neither the information contained in the Buckingham Report, nor any opinion expressed, shall be construed to be or constitute an offer to sell or a solicitation of an offer to buy any securities.

Previous, successful recommendations may not be indicative of the results for all past recommendations. Certain previous recommendations have not resulted in profit, and in fact have resulted in losses. Of the 1,290 stocks recommended in The Prudent Speculator since 3/10/77 through 03/31/06, 72.25% were sold or otherwise closed out at a profit or are presently in a profit position if not closed out. The average holding period for each of our recommendations has been 6.65 years and they have shown an average annualized rate of return of +21.06%, not including dividend reinvestment, advisory and trading costs or leverage. A complete list of all past recommendations is posted on our website at www.prudentspeculator.com. Each investment decision you make should be determined with reference to the specific information available for such investment, and not based upon the success of past recommendations.

Al Frank Asset Management, Inc. (AFAMI) is adviser to its own proprietary mutual funds and is the manager of individual client investment accounts. As adviser to its own proprietary mutual funds and manager of individual client accounts, AFAMI may purchase, sell or hold positions in the securities referenced in the Buckingham Report. Also, AFAMI employees may hold, purchase or sell securities mentioned in the Buckingham Report subject to AFAMI’s Insider Trading policies.

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About Al Frank Asset Management

Al Frank Asset Management, Inc. (AFAMI) is an Investment Adviser, registered with the Securities & Exchange Commission, is editor of The Prudent Speculator (TPS) newsletter, editor and publisher of The Prudent Speculator TechValue Report (TVR) newsletter, and is the Investment Adviser to two value oriented no-load proprietary mutual funds and individually managed accounts.

Al Frank Asset Management, Inc. is committed to assisting our customers build wealth. We are a leading resource for value-based investor information in the financial community, where we combine our simple, proven philosophy of buying under valued securities for their long-term appreciation with our experience, hard work, and intensive research to give you actionable investment information that can be used on a daily basis.

For information on separate account management, please call us toll free at (888) 994-6837. Or, visit us at www.alfrank.com.