The Ten Trillion Dollar Gamble

Investing maven and market tactician Russ Koesterich recently came out with The Ten Trillion Dollar Gamble published by McGraw Hill. I've seen Mr. Koesterich numerous times in guest spots on CNBC because of his position as the Global Chief Investment Strategist for iShares and he gets the job done with his first book. He knows where all the bodies are buried on Wall Street and shares his insight on where he believes the market is going the next decade and how to play it. Although there are a lot of statistics in this book, you don't get bogged down with information overkill while reading it which contributes to a very enjoyable piece of work.

The first three chapters of The Ten Trillion Dollar Gamble are dedicated to the debt the United States has accrued: "Even at the peak of the budget crisis in 1985, deficits were approximately 6 percent of the gross domestic product (GDP). In 2009 and 2010, the deficits were approximately 10 percent of the GDP, the largest since World War II.". Koesterich goes on to say: "So where do larger deficits leave the United States? Historically, chronically high deficits have been associated with slower economic growth, higher real interest rates, and in many cases, some amounts of inflation.".

The author's main thesis of the book is that inflation will be the buzz kill of the next ten years: "It takes a while for inflation to get going, so it is unlikely to accelerate before 2012, at the earliest, given the anemic state of bank lending and the slow growth in the money supply.". He gives himself a lot of wiggle room as to when this avalanche of inflation will come: "It is impossible to predict the exact timing, but we are already feeling the foreshocks, and it will be here before the end of the decade. We are in for a long period of slower growth and higher interest rates.". Not exactly going out on a limb, but it's difficult to forecast the economy. I thought he did a good job in backing up his theories with the data he presented.

The brunt of the book is dedicated to investments you can make to take advantage of the prophesied coming inflationary period. Koesterich breaks down your options into five sectors and allocates a chapter to each one in this order: cash, bonds, stocks, commodities and real estate. Because inflationary eras lend themselves to higher interest rates, the majority of your portfolio should be relegated to cash, like savings accounts, money markets and CDs. The shorter duration of your holding periods for these instruments, the better, to take advantage of the rising interest rates. That's good news for fixed income investors and let's not forget that interests rates spiked to around 15% in the early 1980's.

However, when it comes to bonds, there are few silver linings. The author states: "The first thing you should do to protect your portfolio in an environment of rising interest rates is to reduce you bond holdings, particularly U.S. Treasuries." He goes on later in the chapter to say: "...the U.S. fiscal debt represents two threats to the bond portion of your portfolio. All else being equal, a larger supply of Treasuries will push real yields up and and prices down, and the longer the duration of your bonds, the bigger will be to the hit to their price. The second threat is less certain but potentially more deadly. High government deficit spending often leads to inflation...If you need income, look at preferred dividend paying stocks as bond substitutes.".

That last sentence is basically the gist of the stock section of the book although there was one paragraph that really jumped out at me and I believe rings true: "The problem for equity investors going forward is that despite two brutal bear markets, U.S. stocks never really got that cheap, at least when compared to other market bottoms. So while stocks are reasonably priced today, they are nowhere near the bargain basement prices that typically mark the start of a new, long-term bull market." Koesterich contends that if you wish to invest in equities, then you should look beyond the borders of the United States.

These asset classes give you some examples of what you can encounter in The Ten Trillion Dollar Gamble. The author also covers commodities and basically says: "I would recommend that investors restrict their commodity investments to just two allocations: a broad commodity fund and gold." As for real estate, he doesn't think it's a wise investment with interest rates rising. A home is one thing. Falling housing prices is another: "Slower economic growth will reduce the demand for both residential and commercial real estate, and higher interest rates will harm affordability. If you already own a house and that house represents a nontrivial portion of your net worth, you probably have all of the real estate exposure you are going to want.".

As stated earlier, I liked the book and you will too.

Acme Packet: The Ghost In The Machine

To call Acme Packet's (APKT) 25 fold rise the last two years parabolic would be an understatement. It's been more like a vertical lift-off starting at $3/share in early 2009 and hitting $77 on 3/4/11. The stock ricocheted off the top of its all time high last month, and, you could have scooped it up for $67 on April 1st, but it has since bounced back to the $75 range. The digerati like this company and it comes as advertised. Their signature technology is the science of our time.

Back in the late 1990's George Gilder used to evangelise about the telecosm and how increased use of broadband would engulf us and dictate consumer and business behavior. Well that time has come. Acme Packet is serving notice that they are in an elite class of technology company and are building a global franchise. They seemed to be locked in to the fertile ground of growth which is the backbone for Internet 2.0.

If you aren't familiar with Acme Packet's technology, they are, "basically building a signaling network for the Internet.", says founder and CEO Andy Ory in a recent Investor's Business Daily article. They're like the traffic lights on the information superhighway. Essentially, they provide Session Border Controllers (SBCs) which reside at the outer seams between the loose confederation of IP networks that make up the World Wide Web. When you send anything digital, whether it be text, voice, picture or video, it is broken up into small packets that are sent via many different routes throughout cyberspace to get to its destination. Acme Packet's hardware and software enable that data to smoothly travel through the disparate connections on the Web and reconfigures the bits and bytes once they get to the end of their journey.

Infonetics Research estimates that, "Acme Packet's market area... is expected to grow to $865 million in 2014 from $326 million in 2010 for service providers and enterprises.", as reported in The Boston Business Journal. The article also went on to say that, "Competitors include Cisco Systems (CSCO) and Sonus Networks (SONS), but neither has anywhere near the market share of Acme Packet, which Infonetics puts at 62%.". Standard & Poor's concurs with this assessment of the company's dominant position and states that it is over 50%. In the 2010 annual report, Mr. Ory claims that they have nearly six times greater market share than any competitor. Whatever the number is, it's enormous and they have a big head start on their rivals which now includes Juniper Networks (JNPR). A battle royale is brewing, however, Acme Packet has first mover advantage.

Acme Packet's current customer list includes 92 of the top 100 telecom service providers in the world, along with 11 of Fortune 25 enterprises. The key takeaway from the latest conference call is the potential market ready to unfold in the next five years. CEO Ory estimates that more than $20 billion of legacy systems have been deployed globally to support the old voice landline telephone network and they will have to be replaced with the newer IP technology. In addition, they recently acquired a prized possession in Newfound Communications, an innovative provider of IP session recording technology and believe that this could significantly increase their addressable market, although not beginning until 2012.

Before we call Acme Packet a stock for the ages, I'm going to throw some cold water on the romance and check out the valuations. According to the average analyst estimates on Yahoo Finance, the company is slated to earn $1.08/share for 2011 and $1.44/share for 2012. That translates to a current P/E ratio of 69 and a forward P/E Ratio of 52. Not exactly sticker shock, but still very high when you take their estimated growth into consideration. CAGR for the next 5 years is projected to be 25%, but, I'll kick it up a notch to 30% just to give them the benefit of the doubt for our computations here. At 30% growth, we get a PEG Ratio (price/earnings/growth) of 2.3 for 2011 and 1.7 for 2012. Not too bad if you own it, but much too expensive if you want to buy it.

There's a lot to like about Acme Packet. Their opening gambit against more formidable opponents was not checkmate, but they've got their rivals scrambling to take advantage of the big land grab which is the buildout of the backbone of Internet 2.0. Acme Packet has a healthy R&D budget and a global reach. In fact, 40% of business is from international markets. Besides the competition, one large headwind they will be experiencing is managing their growth. They've already begun hiring in advance of the anticipation of amplification of business. SG&A expenses could put a damper on earnings going forward. There is also their high BETA of 1.45 according to Standard & Poor's. If the market corrects, small caps like Acme Packet will get hammered. You could pick it up at a much more reasonable valuation.

After doing a fairly substantial amount of research on market direction and valuation, I'm betting that P/E Ratios for individual securities and the indexes will contract in the next decade. That's why I am out of the market at the present time. However, there will be growth in some global market sectors. The expansion of Internet Protocol networks will probably buck the trend of any slowdowns in the global economy and Acme Packet will surely be a beneficiary. The question is, what do you want to pay for it and at what metric? That decision is entirely up to you.

Dolby Laboratories: The Sounds Of Silence

Dolby Laboratories (DLB) has suffered a reversal of fortune since the beginning of the year. On January 3rd, the stock sold for $67/share and has since gone south closing at $48 at the end of trading on April 1st. That's roughly a 30% haircut for the quarter. The primary reason for the demise is that management guided earnings lower for fiscal 2011 because of a slowdown in PC sales which is a large market of theirs. In fact, 10% of their business comes from Microsoft (MSFT). Before you make a snap judgement and dismiss them as snakebitten, I'd like to take a look at the company because I believe that savvy investors with presence of mind may want to include Dolby Labs in a portfolio or watch list.

I'm old enough to remember when Dolby technology was introduced to the mass market back in the 1970's. It removed the hiss in the background of cassette recordings which was a major problem back in the day. Noise reduction in audio recordings is something we take for granted now with Dolby's de facto industry standard creating a much more enjoyable listening experience. Its technology is used in: "movie soundtracks, DVDs, television, satellite and cable broadcasts, video games and personal computers", as stated in the most recent ValueLine report. ValueLine's analysis also discusses Dolby's thrust into the new frontier of tablets and smartphones: "Management is focused on capitalizing on this emerging market, which should position Dolby for the long haul and lead to solid growth down the line.".

Dolby Laboratories' most significant revenue stream is from the licensing of their technology to other companies. Although licensing was as high as 84% of total sales in 2008, it has since decreased in steady increments the last three years to 77% in 2010. The reason for this reduction is that their products division has grown at a brisk pace and accounts for 20% of business now. According to a 3/26/11 Standard & Poor's report: "Product revenues involve the sales of digital media servers, which load, store, decrypt and decode digital film files for presentation on digital projectors in theaters, as well as sales of digital 3D products.". The remaining 3% of revenues comes from the services division.

I think there is a lot to like about this company: plenty of patents, over 10% of sales is allocated to R&D, a global presence with 66% of revenues spread out internationally to 85 countries, minimal debt and then there is the valuation. Earnings per share for 2010, 2011 and 2012 as reported and projected by Yahoo Finance break down to $2.46, $2.72 and $2.96 with a 5 year CAGR of 17%. This gives them a current P/E Ratio of 17.6 and a PEG Ratio (price/earnings/growth) of one. That's very reasonable, however, the stock keeps falling and needs a catalyst to not only stop the bleeding, but to propel Dolby Labs higher. I'm of the opinion that this may come from their subsidiary Via Licensing with it's major foothold in Near-Field Communications.

Articles about Near-Field Communications (NFC) are beginning to spring up on the Internet because both Google (GOOG) and Verifone (PAY) are going to test market the technology in an unspecified urban area using Google's Android operating system on smartphones, and, Verifone's point-of-purchase terminals. This is the science that enables you to make credit card purchases with your cellphone among other capabilities. It's already in use in Japan and some parts of Europe, and, is inevitable that it will be adopted here, too. As reported in a recent Wall Street Journal article: "California based market research group iSuppli predicts explosive growth for NFC technology over the next few years...iSuppli says that this year's worldwide shipment of 52.6 million NFC-equipped phones will quadruple to 220.1 million units in 2014. This means that 13.1% of all phones shipped will feature NFC, up from 4.1% in 2010.".

Via Licensing will benefit from the uptake in the use of NFC because they provide patent licences for any company that utilizes the technology. They get a cut of every single NFC enabled phone that is sold. Via Licensing is able to do this from their position as patent pool administrator for several broadcast, wireless and audio technologies which include NFC, RFID MPEG2 and 802.11 based WiFi. A patent pool, "... is a consortium of at least two companies agreeing to cross-license patents relating to a particular technology.", as reported by Wikipedia. It basically standardizes the industry. However, this does not necessarily mean Dolby Labs will earn huge amounts of money from this smartphone advancement, at least not at the outset, but may turn the tide on investor sentiment.

In the next 12 months when NFC technology becomes more of a household name to the consumer, investors may boost up the stock prices of most companies that reside within the sector. Just look at cloud computing or wireless today. Even if you are a minor player in these fields, the P/E Ratios of equities that are in these industries are astronomical. The fortune of a stock's sector plays a significant role in the price of a security. A tide that rises all boats if you will. I believe that when investor psychology kicks in, Dolby Laboratories will be a benefactor of the hype that will surround it. This is on top of the already great story they have to tell.

If you are a momentum investor, Dolby Laboratories is not the hot hand you want to be playing. As a value investor, a good, solid company that lost its luster is something you might want to take a look at. I know I like it, but not at $48 because I believe the stock is still a falling knife and continues to slide. I am also out of the market right now and am of the school we still haven't experienced that long awaited correction. Dolby is not the dog with the least fleas, but with its huge sphere of influence, is best in show.