Today I’m going to revisit a previous recommendation, Force Protection (FRPT), spurred by an email from a subscriber in Santa Clara, California, who wrote the following:
Dear Mr. Lutts,
I have been a subscriber of the various Cabot newsletters on and off over the years and appreciate your newsletter as little by little I believe my investing is improving over time.
I consider myself a middle of the road risk taker with occasional ventures into higher risk stocks.
Based on the MRAP [Mine Resistant Ambush Protected] needs of the military, I purchased some shares in Force Protection (FRPT) this last summer, averaging down as the shares went from 24 down to 15. The stock seemed like a ‘no brainer’ given the military needs, however, the distributed purchasing of the MRAP vehicles left FRPT with less orders than expected to date. The future seems pretty bright with more orders to come and less vendors expected to fill those orders as the military has indicated it wants more standardization going forward. In the meanwhile, the stock has rebounded from its summer lows to a range of 22 - 25 the last few weeks.
My main question I have right now is with regards to the extremely high short positions in this stock - last listed as 23%. It seems like the shorts drove the stock down over the summer as the short interest peaked at over 24% of the stock (only 60M shares outstanding). I’ve been holding my position thinking that since the stock price has recovered and there are still millions of shares short, that should drive the price (considerably) higher as the shorts cover.
Is this a correct assumption? Is there a way to estimate the impact of short-covering on the price of the stock? Or is the market saying that the shorts are right and the price will come back down?
I thought this would also be an interesting question for you to answer to the other Cabot investors as well.
Sincerely,
AE”
And so it is.
First, I thank AE for writing a decent letter. Call me old-fashioned, but a letter like this, with a salutation, paragraphs, punctuation and a real sense of organization, gets a little more respect from me than a hasty “is it time to sell frpt”
So on to the stock. To refresh your memory, Force Protection is a South Carolina company with $340 million in annual sales that makes trucks for the military ... trucks that resist the force of various explosive devices. The majority of these vehicles are bought by the U.S. government, and they’ve proven quite valuable in Iraq. Some have been sold to Canada. And last Monday the British government, which has already bought 100, ordered 140 more.
I recommended Force Protection back on Memorial Day, May 28, when I wrote about the history of the holiday. Not only was the stock a natural tie-in to the occasion, it had also just appeared in Cabot Top Ten Report, earning its spot there with a three month climb from 15 to 30.
So, as the stock was trading at 28, I wrote, “looking ahead, and assuming that the big U.S. order does come through, I think the stock is cheap, and that’s why I’m recommending it today. Ideally, you want to buy when the stock corrects to its 25-day moving average down around 25. That’s also the level where the stock met resistance back in January, so it should act as a floor.
And if the stock fails from there, you cut your loss short; nothing is guaranteed in this business. But if you manage your risk properly (buying at the right point is very important in this regard), stories like Force Protection can pay off very well.”
Well, three days later FRPT hit 31, and then the decline began, spurred in part by the news that the Department of Defense had awarded competitor Navistar a $623 million contract to build 1,200 armored vehicles.
And the decline ran all the way down to 14 at the market’s bottom on August 16, for a haircut of 55%! Now, both 31 and 14 are unreasonable prices for this stock, but that’s how the market works, and you’ve got to learn to use these swings to advantage.
When FRPT was 28, and I recommended buying, it was partially because the company had a good growth story and partially because the stock was strong. In the context of that uptrend, buying on a normal correction to 25 would have been sensible.
But the company’s story changed when Force Protection’s competitor was awarded a major contract. And then the stock’s trend changed, when it sliced through both its 25-day and 50-day moving averages.
At that point, it was no longer attractive to growth investors. And it’s still not attractive as a growth stock! It fell below its 200-day moving average - a major no-no - in July. And overall, it’s performed no better than the market since January.
My correspondent however, attracted to the fundamental story and acting like a value investor, continued to buy as the stock got cheaper! And today, with the stock back up above 20, I assume he’s near breakeven.
So where to go from here?
Let’s start with the question of the short-sellers. Those shorts - currently 27% of the float, or nine days of trading - represent potential buying power, and thus could push the stock higher should investors’ opinion of the company continue to improve. On the other hand, those people have sold short for a reason, and if their reasoning proves well founded, the stock could head back down toward 14!
Part of their reasoning, I’m guessing, concerns the stock’s valuation. The stock is selling at 78 times this year’s estimated earnings and 37 times next years. But earnings are growing fast - 712% is estimated this year and 126% is estimated in 2008 - and if this growth continues, the shorts may eat their hats.
But the shorts are betting that this growth won’t continue, and to a certain extent they’re right; companies that grow this fast always slow down. The question is how much, and by extension, how investors will react to the slowing. And there are no easy answers there.
And there’s a new wrinkle to the story! Back in August, Force Protection sued its founder and its ex-CFO, who had split with the company and started a competitor, claiming that the two men had stolen trade secrets. And two weeks ago, the two men counter-sued, claiming “widespread corporate fraud, interested transactions by board members, and securities violations.”
Some of these shenanigans (to use a mild word) date back to 2002 through 2004, when FRPT was still selling in the single digits, and such activity is not unusual in companies that are just getting off the ground. Force Protection has since worked hard to straighten up and fly right, even instituting a “Transparency Project” in 2004.
Still, the questions remain, which leads me to an important conclusion; management at this company is not top-notch. Remember, I love to own companies that are led by excellent, innovative management; they’re the #1 determinant of a successful investment! Most managements are capable, and that I can live with. But management that may be sub-par? That’s a recipe for trouble, especially when the going gets rough.
For the last word, however, I look at the chart.
In the short-term, I see the recent rally back from the August low at 14, followed by a tightening at 24 that could have developed into a base from which to launch the next advance. This rally saw some heavy buying volume; overall, it’s a nice pattern.
But stepping farther back, I see that this looks like the right shoulder of a classic head-and-shoulders pattern. The left shoulder is the January peak of 24, and the head is the May peak of 31.
Adding validity to the pattern are the symmetrical dips down to the 14 area between each shoulder and the head.
And today the stock began to build the downward arm off that shoulder, as the stock sold off on big volume following the news that the company had found “material weakness” in its accounting system that might lead to restatements!
This is not good, and to me, combined with everything written above, it’s reason enough to sell.
Remember, to win in the market as a growth investor, you’ve got to put the odds in your favor, keep your losses small, and let your profits run. As the negatives have piled up in the Force Protection story (competition, sub-par management, weak stock chart, and now accounting irregularities), the odds have worsened. In short, FRPT is no longer a stock that’s attractive to growth investors.
Finally, let me add a warning about falling in love with a stock or company. It’s a human failing and it’s sometimes very costly. We’re all susceptible to it to some degree, but the vaccine against the disease is a solid grounding in chart-reading, combined with an appreciation of the fact that the stock knows everything, and is always looking ahead.
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For today’s investment idea, I’m turning to a value selection, mainly because last week’s sharp Thursday afternoon sell-off suggests to me that the all-too-common October correction has now begun, and that the safest place to be - aside from cash - is a pure value stock.
To find one, I turned to the latest issue of Cabot Benjamin Graham Value Letter, and then to the Classic Value Model, which uses the exact investment formula develop by Benjamin Graham over 60 years ago.
Happily, this system is all computerized now, so what took Mr. Graham days of work with his #2 pencil and eraser is now accomplished fairly quickly by computer, despite the fact that there are thousands more stocks.
The factors this system measures are debt vs. assets, current ratio, earnings growth, current PE ratio, price/book value ratio and dividend yield.
So, the result of my search is a name that’s reassuring to most of us, though perhaps not heart-warming.
It’s AT&T (symbol T), trading at 42. This is the company that sold AT&T Wireless to Cingular and then bought Cingular, changing the name of the whole to AT&T. This is the company that I pay every month for my family’s four cell phones and my own iPhone service plan. And this is the company whose stock is 30% cheaper than it was back in 1999 and 2000, despite the fact that earnings are now about 25% higher.
Today it boasts a fat profit margin of 14.6%. It pays a plump annual dividend of 3.4%. And its stock is moving up; after basing at 40 from March through September, the stock spurted to 43. Today, having pulled back to kiss its 25-day moving average under 42, I’d say it’s an attractive buy for conservative long-term investors.
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Editor’s Note:
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Yours in pursuit of wisdom and wealth,
Timothy Lutts
Publisher
Cabot Wealth Advisory
