Contrarian Finance

Man, I love it when stuff gets way oversold. I bought E*Trade (ETFC) at 3.66 a share after the mini-crash that followed the Citi analyst writeup. Sold it the next day at 4.65. I'd have stayed in longer (probably until 5.50 or so) but I got jittery, pulled my stop in too tight, and got dumped. Still 27% in one day ain't nothing to complain about.

While I was at it, I added to my position in Citigroup (C), taking advantage of similar conditions there to adjust my cost basis down. I added shares at exactly 32.00. Not quite the bottom, but damn well near close enough. Oh, and I got out of BAC in favor of C.

Disclosure update, I am long both Citigroup (C) and Bank of America (BAC), as of this posting.

Normally I'm opposed to high risk strategies and investment vehicles, e.g. commodities, options, and selling stocks short. Mostly because I know I'm not savvy enough, or well informed enough, to take on other traders and win. Commodities especially is a zero sum game... one not likely to end in my favor, at least not until I get better educated. And of course, speculating, which is what buying derivative really is, in most cases, is not very contrarian.

So, back to my main idea, is it time to short Mastercard (MA) stock? As I mentioned previously, I like Mastercard as a company, and I did give a investment pick to a friend on this stock. My advice to him was to invest at under $45 a share, and to sell at $70 or above. He bought at $43 and sold at $71. Just over 65% return, not including trading costs, in under 3 months. One of my better picks if I do say so myself (and I do).

But as of the market close today, Mastercard stock is at $96.55. This stock is way overvalued in my opinion. They had some write-offs for IPO charges, etc, which gave them a Q3 loss and so the current P/E, etc, is a non-starter from an analysis standpoint. But a quick check of their forward P/E reveals a hefty 24.69. If you exclude the charges, the other common value ratios fall into line with the forward P/E. Industry peer American Express (AXP) is at 20.83, which also seems high to me. The whole industry average P/E is a perfectly reasonable 14.52. They do have above industry projected growth, 1 yr and 5yr (19.6% vs 16.1% and 15.0% vs 12.53), but that doesn't seem to justify this level of price premium.

Not that you care what analysts think, but in the last 30 days five analysts have downgraded their stock. Goldman Sachs downgraded to a Sell. The analyst stock price targets ranged from $50 to $100, with the consensus 1 year target at about $79. I think their stock will go higher, maybe to $100, or even $105, and that might be the perfect point to go short. I personally think the fair value is still above, but much closer to industry norms. Certainly the P/E should not be above American Express, a company with almost 10 times the revenue of Mastercard, but at this time barely 5 times their market capitalization. I'd still put the fair value at about $65. Which not coincidentally is why I told my friend to sell his stock if it hit $70.

A note about my stock price targets, I don't sell stocks when I think the peak value has been reached (obviously), rather I sell stocks when I think the buyers have lost their sense. Once mob rule pushes the price 10% above full value, it's time to take your chips and leave. Years ago I convinced a couple I was friends with to invest in (er, speculate on) Amazon.com stock. I told them, get in where you can, which turned out to be about $40 a share. I said, let it ride a bit. At around $250 I said, get out while you still can. Of course, it did go to somewhere around $400 as I recall, but that's not the point. After they cashed out what had started as a $100,000 investment they retired (they lied and told me it was $10,000; I'd never invest, or recommend, that much on a speculative play like that, not unless I or my friends were worth at least 10 million that is). In all fairness, they did also sell their insurance business at the same time, but it's a nice story none the less.

Anyway, the point is, as a value investor, and a contrarian, I like to get in when the stock price is below fair value, and get out when it's above fair value. That's my personal take on "buy low, sell high". I'm not trying to call the top or the bottom, to me that's voodoo or dumb luck.

So back to Mastercard... my idea here is basically the inverse of my classic strategy: sell the stock (short) above the fair value and buy the stock (cover) below or at the fair value. If it climbs to $105 or so (5% above the highest price target if you're wondering where I got that number), and it probably will, then short there and wait for the wheels to come off the cart. If I had to guess, I'd say when they post next quarter's numbers, which should be positive, and the actual, not just forward P/E ratio (among other things) sinks in for folks they'll rethink the mini-bubble they've created. And when they run, so will the speculators, and technical traders will start to pile on as shorts... well, you get the picture. Cover when the price drops to $70 or below. That's a tidy profit. You could always hedge against the possibility that the insanity isn't done with an out of the money call, but that's a whole other post. And I need sleep.

Oh, one last though, for you technically inclined types (not technologically, but technical trading types) out there, you could probably use some kind of volume/support indicator to pick the top a bit better. It's too far afield for me, but I offer it for what's it worth. Oh one other thing I forgot to mention, from September 10 to October 10, the number of short positions increased from 3.47M to 5.84M. I'm guessing the recent run-up scared (or forced by margin call) some of these guys into covering, but they'll be back, and in greater numbers.

Let me know what you think. Full disclosure: I do not own shares of Mastercard stock, nor am I short Mastercard stock. For that matter, no one I know personally is long or short either.

As promised, here is my complete analysis of Citigroup (C). First of all, of love the fundamentals (well, most of them anyway). Citigroup is your classic "blue chip" company. They have a multi-national footprint, and they are what's known as a Bank Holding Company. Which to me means, exposure to things that are good about being a bank (like underwriting and servicing mortgages) without one bad division (apple?) being able to drag down the whole company, like say, when real estate goes cold on you.

Let's talk price ratios for a minute. Yes I know, some people think these kind of measures are outdated, but that's what makes me contrarian, right? As an aside, if you do your homework you'll find that the historical P/E for the S&P ties right back to inflation and corporate earnings growth (and ultimately GDP). So while it may not hold for a given company and a given moment in time, these numbers always bear out in the end (note to self, this could be the subject of a whole other post). Anyway, Citigroup has a current P/E (as of close of trading on the date of this writing) of 12.1 versus an industry P/E of 13.4. Which is saying something when you consider ho much of the "industry" is in fact, C. Price/Sales (2.83 vs 3.37) and Price/Cash Flow (10.5 vs 11.2) are below industry peers as well, and Price/Book (2.14 vs 2.04) is about on par, though slightly above. All of these are well below the S&P ratios, with the lone exception of Price/Sales.

Let's talk dividends, yes, you heard me, dividends. I know what you're thinking: BORING. Exactly. Which is what everyone else is thinking too... I think you see where I'm going with this. Citigroup has grown their dividend at an astounding 27.62% over the last five years. In fact, they've raised their dividend every year for almost the last 20 years. Reinvesting the dividends can really boost your return over the long haul too (this a key component of my Tier 2 strategy, more on that later).

Now, I don't think they can sustain these growth rates, after all, they're HUGE. The analysts, who are down on C, have their 5 year earnings growth estimated at 10.5% a year. So let's use that for the next five years, then dropping 1% point every other year until we get to the GDP + Inflation growth rate (6%). So that's 10.5, 10.5, 10.5, 10.5, 10.5, 9, 9, 8, 8, 7, 7, and 6 for forever after. For a financially responsible company, which Citigroup is, in my estimation, they aren't likely to grow the dividend faster than earnings growth. But matching the growth is a reasonable assumption, given our conservative growth rates. Do a little magic in Excel, and you'll get a DCF value for the dividend stream of $53.85. But wait, you say, that's below their last close of 50.22! And so you are starting to see the method to my madness.

Citigroup is also a an all time high for dividend yield of 3.94%. Given their history, and financial status, we have no reason to believe the dividend will be going down, or even staying the same. The historical average yields are mostly in a range from 1.0% (low) to about 2.2% (high). Even if it trades to the high end of that range, it wouldn't be at all crazy to see the price move to $90 (a 2.1% yield). Let me save you pulling out your calculator, that's almost an 80% return. Oh, plus the 4% yield. Even if it took three years to come back to the high end of the range, you could see a 20%+ annualized return... not bad right?

Of course, I wouldn't even think about selling until the price pushed the yield near the 1.0% percent mark, which would put my target price at $190. OK, I'm dreaming, but I also don't mind holding this stock... forever. Yes, I put this in the Warren Buffett category. Just buy and hold it forever, unless somehow it gets really pricey (and it has in the past; twice in the last 20 years).

Oh, and I'd also reinvest the dividends. Through the Citigroup DRIP (which is fee free, by the way). Unless of course it got too pricey.

So here's the summary: I love this stock under $50. I like it under $55. And I'd still hold onto it up to about $90 or so, at which point I'd start selling it off in chunks. I'd reinvest the dividend stream as long as the yield is above 2.0%. Another tibdit: the 5-year high P/E for Citigroup is 21.8, which is about $90 based on their current earnings.

I welcome, as always, your feedback and comments. And yes, if you must, your criticism.

A parting shot... not that you care what Wall Street types are doing, but check out Citigroup on Gurufocus.com. Dodge and Cox upped their stake in Citigroup by almost 40% earlier this year, at an estimated price of about $46. That brings their total shares to over 40 million.

Before I dive into my more detailed analysis and recommendation of Citigroup (C), I need to explain a few things about my overall investment philosophy. I'll give a lot more detail on this in a later post, but you'll need the framework to understand where I think Citigroup fits in my portfolio, and to make an intelligent judgment about whether or not it might work for you. And let me be frank, this pick won't make sense for everyone.

Investing, especially contrarian investing, is a highly personal affair. Your own beliefs and convictions about a given investment, about the market in general, and about investing in general will all color your judgment. As you will learn if you stick with me, I am really big on risk analysis and risk mitigation. In that spirit, I think the number one risk a contrarian must mitigate is himself or herself. After all, what if I'm not smarter than the average person, and as a result, my investment choices will underperform the market.

To mitigate the risk of myself, I follow what I call a multi-tiered investment strategy. The tiers are basically groupings of risk/reward scenarios, and an unique investment growth trajectory, because the savings rate plus the investment rate implies a timeline for reaching financial independence. So, more specifically, Tier 1, for me, is the "market return" tier. This strategy assumes that I am, in fact, not more clever than the average person, or more accurately, the average fund manager, I suppose. Tier 1 then, is an annual savings rate, that when compounded by a reasonable (which is to say, conservative) market return, will allow me to retire comfortably at about 60 years of age (not coincidentally when I can start withdrawals from an IRA/Roth IRA without penalty). I know I'm speaking in sweeping generalities here, but I promise I'll give details and examples later. Target return here feels like 10% or so.

Tier 2, for me, is then a "market outperform" strategy, that ideally should beat the market return, but with greater risk. Since this strategy hopefully offers a higher return, it should act as a "bonus" return to the return of Tier 1, thus shortening the timeline to financial independence. I only "fund" this strategy in a given year when I know that Tier 1 is or will be fully funded. But note that this is still a somewhat conservative strategy, in that it seeks to better the market return only by a few points, but to do so consistently and with low fees. Generally I follow a "buy and hold" strategy here. I am also focused on terribly un-sexy things like "value" and "dividends". A great return here would be 15%.

Tier 3, for me, is finally the "home run" strategy, that ideally produces a Peter Lynch "10 bagger". It is super risky, and generally speaking is growth focused (though not blind to price) and will definitely engage in profit taking. My Mastercard (MA) pick from earlier this year falls into this category. Please note, I wouldn't touch MA with a ten foot pole now, unless I was feeling really daring and thinking "short." I'll recount the history of that pick, and the actual returns (a friend of mine executed my strategy). I don't invest in Tier 3 opportunities unless Tier 2 is "fully funded" (more on that another time as well). The target return here is 30% or better.

The overall idea here is that excepting un-mitigatable risks (e.g. nuclear war), Tier 1 leads you to a comfortable retirement, at a decent age, even if you lose money consistently chasing higher returns in Tier 2 and 3. Hopefully that gives you some of the context you'll need to make sense of the Citigroup post (coming right up).