Focus on Individual Companies in this Pullback

The S&P 500 dropped 2.2% for the week after rallying for nine straight weeks. Bull markets, especially new ones, are difficult to get involved in because with everyone wanting in, the perfect entries are snatched up very quickly. As is often stated, stocks rise on an escalator and fall on an elevator. The pullbacks are always the clear buy areas in hindsight but fear always accompanies buying into a declining market especially when CNBC carts out all the permabears to scare us all.

The macro versus micro battle rages on

It is amazing to see how persistent the battle between the micro and the macro has been over the last year. Whenever macro worries have hit headlines the market has declined with high correlation between stocks and assets. Once we solve/delay/forget the problem stocks are freed up to continue their rally on the steadily improving micro picture.

As Zacks Investment Research laid out this week, third quarter earnings have been great on the whole. With 7/8ths of the companies in the S&P 500 having reported, we've seen 72.7% of all reporting firms do better than expected, 79.4% report positive year-over-year growth and total net income reported up 27.4% year-over-year. Full-year total earnings for the S&P 500 expected to jump 42.0% in 2010, 14.3% further in 2011. Bottom up valuation puts P/E at 14.9x for 2010, and 13.1x for 2011.

With tailwinds from round two of quantitative easing and greater clarity on the political front with the midterms out of the way, the market may be primed for greater upside. China may tighten which could impact global growth but it's not some out-of-the-ordinary possibility as they have been slowly curbing inflation for the last couple years already. And imagine that, Europe's debt woes were not perfectly and entirely fixed with the ECB's debt package; but coordinated action from officials should be able to prevent any renewed panic.

Ignore the market, find good companies

The initial move off the March 2009 bottom was fast and furious as the S&P catapulted 80% higher in little over a year. This summer's correction represented the first significant worries of a double dip and we were reminded that the developed world is still dealing with too much debt. Yet, the last two months showed the strong resilience of our markets and in short order we rallied right back to April 2010 highs.

I will be the first to say that I don't know if there's more downside in the market up here. I am very optimistic over the next year but I just couldn't tell you whether the market will go down or up next week. But, quite frankly, I don't think it matters all that much. For most of the last three years, ignoring the market's moves was nearly impossible and possibly deadly. Heightened correlation made it imperative to watch the general market closely and many chose to just trade it directly as a basket.

As we rally further though, the market is somewhat less relevant. The S&P is up 7.5% year-to-date but what has that really mattered for the likes of Apple (AAPL) up 46% YTD, Baidu (BIDU) up 169%, Netflix (NFLX) up 214%, Salesforce.com (CRM) up 56%. There are extremely impressive, innovative companies out there doing great things. These companies are rapidly growing their earnings and will perform well in any moderate market. Barring a complete collapse which I believe is highly unlikely, a company like Apple will keep making more iPads and iPhones and we'll all keep on buying them.

I think the key to not being the guy in hindsight who says that was the pullback to buy (but didn't actually buy) is focusing on individual companies and stocks that provide compelling setups. My focus is on some of the companies I've been writing about like Google (GOOG), EMC Corporation (EMC) and Potash Corporation (POT). I don't find predicting whether the market will be up or down 2-3% this week as a worthwhile endeavor but I do think EMC around $21 or POT around $130 could create very attractive entry points. Finding good stocks trading around solid levels will be my focus in the coming days.


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Long EMC, POT.

EMC Corporation (EMC) a Great Play on the Cloud

What is EMC?

EMC is the largest data storage company and biggest player in the virtualization space through its 80% ownership of VMWare (VMW). Companies and governments around the world utilize EMC's data storage solutions as more and more records are retained electronically and advanced databases are needed to manage content effectively. The Information Storage unit accounts for 76% of EMC's 2009 revenues. While this line of business saw a cyclical downturn in '09 as lowered spending in IT dragged down EMC's sales, the long-term story is quite bright. Another 10% of revenues are derived from the content management and information security divisions.

Virtualization is the exciting piece of EMC's business line and the company wisely spun off 10% of VMWare (VMW) to unlock value in 2007. EMC acquired VMWare for $635 million in 2003; VMW now boasts a market capitalization of $32 billion. After spinning off the unit at nearly the top in the equity market in August 2007, VMW has still returned shareholders 46% since inception. Virtualization allows companies to get more out of less. By using the software VMWare creates firms can efficiently split up their servers allowing them to run multiple applications from one server. This helps reduce total hardware costs for firms that previously would be required to invest in greater numbers of individual servers.

Capitalizing on a secular trend

Cloud computing has been the hot sector in 2010 and despite last week's sell-off in many cloud-related names, the secular trend is in tact. The high momentum behind these businesses has carried their stocks to extreme levels and the sell-off last week brought some of the stocks' valuations back to earth. Yet, the cloud is an extremely attractive option for many businesses across the spectrum promising an easier, cost-effective way to manage IT. Growth in this industry is likely far from over even if the valuations are a bit overheated.

The electronic storage of information is a long-term growth story with exponential growth opportunities as more companies adopt online databases and the content itself dramatically increases in size: think streaming movies as an example. EMC invests roughly 11-12% annually in research and development giving it sustainability in cutting-edge innovations.

A modest valuation given potential

EMC sells for 29 times trailing but based on analyst expectations sells for a relatively cheap 14.6 times forward. Smaller rival NetApp, Inc. (NTAP) garners a PE of 37 in the market and a forward PE of 22 even though 5-year analyst growth expectations are nearly inline with EMC. EMC has a 5-year sales growth rate of 12.5% and an astounding 82% gross margin. The company has an impeccable balance sheet holding only $3.1 billion in long-term debt against its $41.7 billion in equity market capitalization. And, with $6.7 billion in cash on hand EMC has the flexibility for future strategic investments.

EMC has guided $1.18 for the FY 2010. I believe EMC conservatively can increase earnings by 20% in 2011 given the recovery in IT spending with the global economic rebound and the secular trends in cloud computing driving exponential growth in storage needs. EMC would produce $1.42 in earnings per share with 20% EPS growth. With a PE of 21 by the end of 2011 EMC would sell for $30 per share, a 40% gain from current prices.

Risks to target

Shares of EMC are inherently volatile with a beta of 1.65 creating large divergences in returns based on timing of purchases and sales. EMC can also suffer as competitors such as IBM (IBM) and Hewlett-Packard (HPQ) encroach on the data storage space. The recent bidding war for 3Par (PAR) that drove HPQ's bid to $33, a valuation of 125 times 2011 earnings, is a prime example of the strong desire to break into the cloud arena. Also, while companies have record amounts of cash and IT investments are expected to rise, a sluggish economic environment or lack of clarity on future demand may suppress IT spending and stall EMC's growth.


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Long EMC.