PSB Portfolio Update April 2009

April 21, 2009

Fate of Rally Hinges on Bank Stress Tests

The market rally off the March lows is the stuff of legend.  The major market indices are all up more than 25%.  Rarely have we seen the market string together six straight weekly gains.  In fact, the Dow has put together a winning streak not seen since the Great Depression.

Amazingly, the gains in small cap stocks are even more impressive.

The Russell 2000 is up a stunning 40% from the March lows.  And, many individual small cap stocks are showing gains of 50% or more.  Just take a look at our own portfolio. Primedia up 112%. China Secruity & Surveillance Technology up 108%.  American Software up 86%.  And, ChinaCast up 68%.

In last month’s update, we questioned whether this rally is the start of a new bull market or just another bear market head fake.  We highlighted the fragility of our financial system and continuing economic decline as support for the bear case.  But, we also pointed out encouraging signs of a market bottom in the making.

We concluded the market has begun a bottoming process that will probably take several months to complete.  A process that likely involves at least one more downward move.  A potential retest of the lows set in November and possibly March.  (We hope we’re wrong, but we can’t ignore historical precedent.)

Well, the market has since registered four straight weekly gains.

Fueling the rally was Treasury Secretary Geithner’s second performance in the great Bank Crisis drama.  Fortunately, the second time was the charm.  He laid out a plan for getting the toxic mortgage assets off bank balance sheets.  And, this time around the plan included sufficient detail to inspire confidence in investors.  We credit this event as solidifying the change in investor attitudes to a glass is half full perspective.

Confidence in banks turned into a more positive outlook for the economy.

Investors began looking at the daily dose of horrible economic data in a more positive light.  They showed a remarkable ability to look through numbers on unemployment, consumer spending, housing, manufacturing, etc. which still show an economy deep in decline.  They seized upon weak month to month trends as proof the pace of the decline is slowing.

We are now once again at an important inflection point in this incredible rally.

Next month the government will announce the results of the “bank stress tests”.  These tests were done to identify which banks would likely fail if subjected to another financial shock.  The results will help the government determine if more bailout money is needed.

With the results forthcoming, investor confidence is starting to crack.

Many are reaching the unappetizing conclusion that the stress test results will stop the rally in its tracks.  While the results will show some banks are getting stronger, they will also reveal those on the verge of collapse.  This could easily spark another panic like we saw in February – which prompted the steep decline to the March lows.

In fact, it may have already begun.

Yesterday the market tanked on fears the Obama administration is considering a backdoor nationalization of the banks.  Over the weekend, the administration leaked word it might convert its preferred shares into common equity.  This would help increase the banks’ capitalization levels.  And, the administration could avoid a potentially nasty confrontation with Congress for more bailout funds.

The market reacted much as it did when the government first took the preferred equity positions in the banks.  It declined sharply with many banks posting losses of 20% or more.

Didn’t Washington get the message last time… the market doesn’t want the government running the banks.

Now that the word is out, it’s up to the administration to manage the situation as deftly as possible.  Obviously, the first priority is to use the stress test results to fix the banking system.  A second, no less important priority is to avoid undoing the heightened, yet fragile, investor confidence in the process.

The fate of the rally hangs in the balance.

Now on to the updates…

Please Note:  We don’t necessarily update every open position each month.  We focus on the positions experiencing significant news, notable price movement, or a change in recommendation.  Please refer to the Performance page on our website for our current buy, sell, or hold recommendation for any positions not mentioned in the Update.

Position Updates

. . . . Primedia (PRM) – Hold

PRM is on a tear since reporting fourth quarter and full year 2008 earnings.  The shares rocketed up 123% from the March low to a recent high of $3.55.  For the year, PRM earned $1.11 per share compared to a loss of $1.26 in 2007.  The company is seeing strong growth in its Apartment Guide and ApartmentGuide.com businesses.  Since we recommended the stock in our November issue, the shares are up more than 400%!

. . . . ChinaCast Education (CAST) – Buy up to $3.50

As we predicted, CAST made a strong move to the upside following its strong quarterly earnings report.  The shares recently traded as high as $4.35 for gains of 55%.  Even though the stock is pulling back, we still think it offers huge long term potential gains.  The fundamentals behind our recommendation are still firmly in place.  And, the company recently announced its buying a private university in Southwestern China that will add 7,800 students to its rolls.  Management expects the acquisition will add to earnings in the third quarter.  Buy CAST on any pullbacks below our buy up to price.

. . . . Hi Tech Pharmacal (HITK) – Buy up to $6.20

HITK’s on fire!  The generic drug maker has rocketed more than 40% higher since we recommended it in March.  Not a bad return in just a month and a half’s time.  But, it still has a lot further to go.  Even with its recent gains, the stock is misvalued by the market. It’s PEG ratio of 0.72 shows the stock is trading at a hefty discount to its long term growth rate of 25%.  Look to buy HITK on any dips below our buy up to price.

. . . . American Software (AMSWA) – Buy up to $5.88

AMSWA more than doubled off the March low during the recent market rally.  This economically sensitive stock is rising on the improving outlook for the economy and the retail sector.  The shares recently reached a high of $6.33 for a gain of 37% from our buy price.  The company also announced a tender offer for the shares of Logility it doesn’t already own.  The street apparently likes the deal as AMSWA shares have risen 40% since the announcement.  Buy AMSWA on any dips below our buy up to price.

. . . . Overhill Farms (OFI) – Buy up to $4.86

This April recommendation bolted higher right out of the gate.  After we recommended it, the stock jumped up to $4.90 over the next three days for a gain of 28%.  Although the shares have pulled back recently, we still think they’ll double or even triple from here longer term.  The pullback is not unexpected given OFI’s huge 66% rally off the March low. We view it as another opportunity to get into the stock below our buy up to price.  Second quarter earnings are tentatively scheduled for May 7th.  Due to the weak economy, analysts expect a slight revenue decline and flat earnings compared to the year ago quarter.  Don’t miss out on this pick while it’s trading below our buy up to price.

. . . . GigaMedia (GIGM) – Hold

GIGM jumped 18% since our last update and shows a 22% overall gain since we recommended it.  The stock is moving higher following its 2008 earnings release.  The company reported a record profit of $44.8 million on strong revenue growth of 25%. Management provided a mixed outlook for 2009.  They expect the online gaming software business to be flat with 2008.  The severe economic downturn in Europe and the euro’s weakness versus the U.S. Dollar are to blame.  However, they expect strong top and bottom line growth in the Asian online games segment.  Given these fundamental changes, we’re changing our buy recommendation to a hold.  We’ll reevaluate our recommendation following GIGM’s first quarter earnings release on May 13th.

. . . . Ceva (CEVA) – Buy up to $9.00

CEVA is way out in front of the market rally with a gain of 60% off its March low.  The NASDAQ Composite is up just 33% over the same period.  As investor confidence grows, they’re buying up stocks with high growth potential like CEVA.  Look for this trend to continue as the economy improves.  CEVA will report first quarter earnings on May 5th. They’re expected to post lower year over year revenue and earnings due to the weak economy.  A pessimistic forecast could work to our advantage as it sets the stage for an upside surprise.  CEVA has beaten estimates in three of the last four quarters.

. . . . China Security & Surveillance Technology (CSR) – Buy up to $6.60

In last month’s update, we pointed out how the decline in CSR stock was way overdone. Congratulations to those of you who stuck with it.  The stock has almost doubled in value off the March low.  Even with the recent run-up, the shares are still incredibly cheap.  They’re trading at just 2.4x 2009 estimates and 2.1x 2010 estimates.  CSR is due to report first quarter results on May 5th.  They’re expected to post a slight rise in earnings over last year’s quarter on revenue growth of 21%.

Action To Take

•  Hold GigaMedia (GIGM)

Category: PSB Portfolio Updates