For a long time, I’ve had a note to myself saying I should write about witch-hunts. And now, as the clock ticks toward Halloween, is the perfect time to do so.
My status as a native and lifelong resident of Salem, Massachusetts means I know a fair amount about the historical kind, and my decades observing and analyzing the behavior of investors, who can act rational as individuals but who combine to form irrational crowds, means I’ve experienced many of the modern kind.
Historically, real witch-hunts spanned the period between 1450 and 1700 and resulted in the execution of tens of thousands of men, women and children in Europe.
In the U.S., there are 36 recorded witch executions, the most famous being those that occurred in 1692 and 1693 in Salem Village, an area that today is known as Danvers.
In that case, over 150 people were arrested and imprisoned; 29 were convicted, and nineteen (fourteen women and five men) were hanged. Giles Corey, famously, refused to enter a plea, and expired from suffocation while the authorities attempted to extract a plea by piling stones on a board laid across his chest. (Such were the laws of the time.)
A few modern writers have tried to attribute the odd behaviors of the people of Salem to ergot of rye, which contains precursors of LSD; to encephalitis lethargica, a disease that might have been spread by birds; and to Huntington’s Disease, a rare inherited neurological disorder.
But their creative thoughts haven’t stood up to scrutiny. The real culprit, the irrational behavior of the crowd, is the clear villain.
And where do we find “witch hunts” today? A Google search of recent news items find the term used in a variety of English-speaking countries.
In Wales, “One of Britain’s most successful doctors is calling for an inquiry into the General Medical Council over a “witch-hunt” which she says threatened to destroy her career.”
In the Philippines, “A Mindanao-based party-list group on Monday expressed fears of a government “witch-hunt” in Muslim communities following reports that the Rajah Solaiman Revolutionary Movement (RSRM) has owned up to the Glorietta 2 blast on Friday.”
In the U.K., “The parents of missing Madeleine McCann are the victims of a “witch-hunt”, the former boss of the Metropolitan Police said on Sunday.”
In Arizona, “Arizona Attorney General Terry Goddard on Wednesday accused Maricopa County Attorney Andrew Thomas of conducting a “political witch hunt” of Goddard’s office and asked Thomas to hand off an investigation to an outside agency.”
In Australia, “NSW Premier Morris Iemma says he moved to hold a broader inquiry into Sydney’s embattled Royal North Shore Hospital to prevent a political witch hunt.”
And in New Zealand, “The New Zealand Rugby Union is on a witch-hunt to smoke out the referee who analysed the World Cup quarter-final for the Herald.”
In the investing world, I can find no witch-hunt worthy of mention today. (If you’ve got a candidate, I’d like to hear about it.) I think the biggest witch-hunt in recent history was conducted by injured investors following the market collapse of 2000-2001 and resulted in the Sarbanes-Oxley regulations that have benefits but also costs.
For me, the highest cost of these regulations is the loss of some “information” that has made chart-reading a little more challenging and that has actually increased the frequency of market volatility that stems from earnings surprises.
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Which brings me to Vasco Data Systems (VDSI), a stock that has lost 43% of its value in the past eight days.
I’ve never recommended the stock here in Cabot Wealth Advisory, but I figure this is a good place to cover a number of matters relating to the stock ... and others like it.
The stock first appeared in Cabot Top Ten Report early this year. We recommended it in January at 15, February at 18, May at 23, June at 23 and lastly, in August at 29.
Obviously, it was a hot stock.
Vasco develops, sells and supports hardware and software security systems that are used by financial institutions. Currently, 62% of revenues come from Europe and only 10% from the U.S., but the prospects for future growth are terrific, because the U.S. banking industry is likely to adopt the system more thoroughly in the future.
In the second quarter, revenues grew 75% to $32.4 million, while earnings grew 125% to $0.18 per share. For the third quarter, analysts expected that earnings would hit $0.17 (which really meant they expected $0.18.)
Trouble is, when the third quarter results were announced last Thursday morning, the earnings were just $0.15 per share!
Forget the fact that revenues grew 60%, and that earnings grew 67%, numbers that most companies would kill for. The plain truth is that the market expected more - those expectations were priced into the stock - and when the company failed to meet them, it was punished severely ... or shareholders were punished.
Now, one reason I write about Vasco today is that I had recently recommended the stock - very strongly - in promotional material for Cabot Market Letter. And for that I apologize. Investors who read that and invested based on it have lost money.
In hindsight, the recommendation was flat-out wrong.
But could it have been avoided?
No. Knocks like these are going to happen when you invest in growth stocks.
The simple action of the stock on Thursday, when thousands of disappointed investors combined to push the stock down 33%, tells you the disappointment was nearly universal.
And increased research would not have revealed a problem. One of the side effects of the Sarbanes-Oxley regulations is that information that previously would leak out of companies - in a hundred small ways - has been bottled up tight. No one’s allowed to talk anymore, so the truth only spurts out four times year.
Even the charts aren’t quite as useful as they used to be, particularly around earnings time.
But if your portfolio is properly constructed, and you’re diversified in a group of strong stocks, there will likely be more positive surprises than negative surprises. In our Cabot Market Letter, in fact, that’s been the case this third quarter ... so far.
But if you’re not diversified, and you get hit with a shock like VDSI’s, it can hurt.
And if you are hurt, what should you do? In most cases, you should sell and move on. VDSI is not a leading growth stock anymore. It’s not an undiscovered young stock. And it’s not an old languishing value stock. Stocks in those categories can make you money.
But VDSI is now heavily damaged. There are investors who are disappointed, who still haven’t sold; they’re waiting for a bounce, and when they get one, their selling pressure will push the stock back down.
Technically, in fact, VDSI is now likely to bounce, as the stock has fallen to its 200-day moving average at 24. But that’s doesn’t mean it will embark on a new uptrend!
And what about what’s actually happening at the company? Not only did earnings disappoint, but also management revealed that the backlog is shrinking. Experience shows that the next news out of the company is more likely to be bad than good.
So if you own it, I suggest selling and moving on. This, of course, means admitting that buying the stock (and, in my case, recommending the stock) was wrong. Some people don’t like to be wrong, but they’ve got to learn that in the stock market, it’s not about being right or wrong; it’s about making money.
When you’re wrong, you admit it, sell and move on. You don’t let your money sit where it’s not helping you; you take it out and put it into an attractive stock where the odds are on your side! In the end, that’s what it’s all about.
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So, today’s recommendation is a stock where the odds are definitely on your side.
In fact, it shares many of the characteristics of those dry-bulk shippers I wrote about last week that performed so well after I recommended them in March (the best, remember, was DryShips (DRYS), which gained 512% in eight months). When those shippers first popped up early this year, I remember thinking that it was hard to imagine a less exciting investment.
But with Alpha Natural Resources (ANR) we have a contender.
Alpha first popped up in last week’s Cabot Top Ten Report, and here’s what Mike Cintolo wrote.
“Alpha operates 62 coal mines in Virginia, West Virginia, Kentucky and Pennsylvania. As a commodity producer, the single biggest determinant of the company’s success is the one it can’t control ... the price of coal. And the price of thermal coal has been soft in the past year, a factor that led to negative trends in both revenues and earnings in the past year. Happily, there’s now booming demand for metallurgical coal, which is used in steelmaking, where demand is driven by construction in China and India. What’s interesting about Alpha is that it’s a fairly young company, founded in 2002 by affiliates of First Reserve Corporation, a private equity firm, who joined with current management to buy the majority of Pittston Coal (a subsidiary of Brink’s). In the following year the company added Coastal Coal, American Metals, Coal International and Mears Enterprises. And the acquisitions have continued, with the biggest, the acquisition of the Nicewonder Coal Group, coming in 2005. Bottom line: Alpha is not changing the world, but it might be a big beneficiary of some of the world’s changes. Third quarter results will be released before the market open on October 31.”
So, the future is bright, but there’s the risk that the earnings report (like VDSI’s) could disappoint. Making that less likely, however, is the fact that ANR’s advance is not as mature (so it has less downside risk) and the fact that other coal stocks are acting strong, too, because the major factors impacting the company are not inside the company but outside.
Aggressive risk-takers will buy now, before the earnings report. More cautious investors will wait for the good news, and then wait patiently to buy on the next pullback. As a result, they may buy higher, but they’ll buy safer.
Bottom line, I think the fact that coal companies in general (like those dry-bulk shippers) are unloved and uninteresting, combined with increasing global demand for their products, means that there’s great long-term growth potential here.
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Editor’s Note:
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Yours in pursuit of wisdom and wealth,
Timothy Lutts Publisher Cabot Wealth Advisory
