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Looking back at the gyrations of Mr. Market last week, it is amazing that the major indices ended in positive territory for the week. Huge injections of liquidity by central banks on both sides of the Atlantic certainly helped prop up the markets and this was repeated once again on Monday. There have been rumors about the potential of a large hedge fund blowing up and Goldman Sachs (GS) had to pump $3 billion into one of its hedge funds to keep it afloat. In addition to the two failed Bear Stearns (BSC) hedge funds, three funds from French bank BNP Paribas (BNPQY.PK) were suspended last week. It appears that the Europeans had an equally (un)healthy appetite for John Doe’s exotic mortgage.
I was very surprised to see ABN Amro (ABN) drop last week based on speculation that the takeover of this Dutch bank may fall apart. Potential suitor Barclays (BCS) took a harder hit and I am glad I liquidated our position in Barclays as discussed in the portfolio readjustment section of the August investment newsletter. A lot of investors are getting interested in the battered financial sector and indeed some of the large banks have attractive valuations while paying a sizable dividend. However the headwinds against the large commercial banks are strong with slowing mortgage originations, low interest spreads and a consumer that may finally be scaling back as seen by declining retail sales in July. Unlike Quant Investor who prefers Bank of America (BAC), the only large bank that I find mildly interesting is Citigroup (C) based on its international diversification, a 4.6% dividend yield and a 17.82% Return on Equity (ROE).
However it may be prudent to stay on the sidelines (update: I meant for new positions and not liquidating an entire portfolio) until the magnitude of this subprime mortgage mess becomes clear. The failure of a large fund or bank would put a lot of pressure on the capital markets and there is a lot of fear out there but not enough to make investors capitulate in despair. Capitulation is seen near the bottom of a bear market and it is not even clear if we are experiencing a correction or the start of a new bear market following the bursting of the real estate bubble. In the words of James Stack of Stack Financial Management “if it looks like a bear and growls like a bear, you treat it like one”.
On the flip side, I am very excited about the VMware IPO, which will raise $957 million at $29 per share and was priced at the high end of its forecast just like Chipotle Mexican Grill (CMG) last year. VMware should begin trading on Tuesday under the ticker symbol VMW. Assuming VMware earns $160 million in 2007 (profits were $75.3 million in the first half of 2007), the valuation with a P/E of roughly 66 is quite rich even at its IPO price. If the stock shoots up like it is expected to, the company will earn membership amongst the rare group of growth companies sporting a triple digit P/E. However if VMware can continue its red hot rate of growth, the IPO price will begin to look like a bargain in a couple of years.
This spin-off has helped our April 2007 pick EMC corp post a gain of 37.55% in the model portfolio and based on how well the IPO does, EMC could head even higher as it will retain an 87% stake in VMware post IPO.