2006 Brand Name Watch Update
(January 19, 2006)
Dear Subscribers and Readers,
We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 – giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. Judging from the recent negative reactions to many earnings reports, the negative action in the international stock markets, and the very overbought conditions of all these markets, there is a good chance that the markets will be lower in price a few weeks to a few months from now. Keep in mind that declines in the stock market (especially after a sustained powerful up move on good breadth) usually take a long time to play out – and this one will be no different. We will continue to reevaluate in the days ahead but conditions are now in place for a significant top in the stock market – that is, we are now at a point where the market is shortable. That is why we switched to a 25% short position in our DJIA Timing System at a DJIA print of 10,840 yesterday morning (from a completely neutral position) – with an intent to shift to a 50% short position should the market bounce from here on weak breadth or low volume.
It has been early September 2005 since we last did an update on our “brand name watching” commentaries. The annual list of the Top 100 Global Brands for 2005 was released by Interbrand.com during July 2005 in conjunction with Business Week. This article is a must-read. For those who are unfamiliar with our work on brand names, please refer to our initial April 24, 2005 commentary "The Importance of Brand Name Watching" on this topic. In that article, I stated: "Readers who are familiar with our work could probably recall the tremendous amount of importance I put on the concept of "a brand name" when it comes to evaluating a company or an investment in a company. A brand name is part reputation, part familiarity - not to mention the unquantifiable/psychological thrills that a consumer gets when he or she purchases something that bears his or her favorite brand name (such as a Porsche or a LV handbag). The concept of the brand name first arose with the advent of advertising and mass media in the 1930s - further compounded by the advent of the 40-hour work week - which allowed consumers more time to enjoy the things that they bought (it is not a coincidence that Disney was founded during this time - as people were working too much to watch cartoons prior to the 1930s and as its major asset was its brand name). For readers who are interested in reading more about "branding," you can surf to the Interbrand.com website. One of the important theses of this week's commentary is this: In a healthy, cyclical bull market, the shares of most of the biggest brand names or the fastest-growing brand names in America should be doing extremely well - i.e. the relative strength (vs. a major index such as the S&P 500) of most of these companies should be rising. At the very least, the share price of these companies shouldn't be falling."
Of course, we all know that the small cap indices have been outperforming the large caps by a significant margin – but, by definition, most investors will have little or no investments in small caps and mid caps. That is, on a purely domestic basis, we are still stuck in a “trading range” (or a secular bear market as bears would like to label it) that have been in place since January to March 2000. The last time small cap indices outperformed large caps in such a significant way was during the 1975 to 1983 period, and from 1975 to 1982, both the Dow Industrials and the S&P 500 essentially went nowhere. This is an additional reason why the broad market cannot rally on a sustainable basis without the support of the brand names.
As I had mentioned before, the top ten list in 2005 actually does not change much from the list in 2004. Nokia moved up two places from No. 8 to No. 6 while both Disney and McDonald's declined one place, to No. 7 and No. 8, respectively. The rest of the top ten list did not change. More importantly, the top five list actually remained the same from 2004. This list contains (in order of most to least valuable) Coca-Cola (KO), Microsoft (MSFT), IBM, GE, and Intel (INTC). Comparing the recent action of these five stocks to their action back in early September – there has actually been a slight underperformance – with the notable exception of GE. Looking at the list, it is fair to say that the gist of our “brand name message” does not change. That is, even since early to mid 2004, the performance of the major brand names is still not up to par. And the longer these major brand names underperform the market, the greater the danger will be for the broad market to correct in a significant way. Given the hugely overbought conditions currently in the stock market, this author will not be surprised if we see this happen in the next three to six months – especially given our mid-cycle slowdown scenario and the uncertainty of Ben Bernanke's policies as Fed Chairman going forward.
In the tradition of our earlier commentaries, let's start with the company that has the world's most valuable brand name as ranked by Interbrand.com. That company is none other than Coca-Cola – where more than two-thirds of its value (over $65 billion) is tied up in its brand name, according to Interbrand.com. The brand name and the history of Coca-Cola is nothing short of amazing – as I have discussed in some of our past commentaries and posts on our discussion forum. Think of it this way: Why does Santa wear red? If Germany had won World War II, there is no doubt that Coca-Cola would have survived in his current form – perhaps stronger than ever, as Coca-Cola was nearly as famous and valued in Germany than it was here in America during that time. The director of operations in Germany was a fanatic. Towards the end of the war – when it became clear that Germany was losing – he resisted changing the name of the company at the risk of being transferred to a concentration camp. He persevered, and immediately after the war, they found him in a bombed-out bottling plant trying his hardest to bottle soft drinks and meet demand. There was no doubt he would have become the head of international operations at Coca-Cola (and most likely, second in command next to Robert Woodruff) should Germany had won the war. I used this quote in our last commentary but I will use it again. The following paragraph from Mark Pendergrast's "For God, Country & Coca-Cola" contains a famous anecdote about the wide-reaching arms of Coca-Cola - even in Germany during World War II:
In early 1945, a group of German prisoners of war debarked in Hoboken, New Jersey, apprehensive and lonely in a foreign land. When one of them pointed to a Coca-Cola sign on a nearby building, the prisoners began excitedly gesticulating and talking among themselves. Taken aback, the guard yelled for order, demanding an explanation from a prisoner who spoke English. "We are surprised," he answered, "that you have Coca-Cola here too." Such a global reach was unimaginable back in the early 20th century – and the brand remains as powerful today. Today, KO still has one of the best business models around, as it is mostly a low-cost syrup producer and marketing machine and has a return to equity ratio of more than 30% - which could easily be sustained going forward.
What matters at this time, however, is the fact that KO actually topped out in early 1998 (which actually topped out the same time the NYSE A/D line topped out in the last bull market) at approximately $80 per share – a price which KO has not come close to since then. Following is an update of the chart that I posted in our previous “brand name watch” commentaries - a weekly chart of KO (along with relative strength vs. the S&P 500) dating back to January 2002 (courtesy of Decisionpoint.com):
Please note that KO actually topped out relatively early in this cyclical bull market – at a price of approximately $52.50 during April 2004. While KO experienced a brief bounce in early to July 2005, it has recently again declined below both its 20-week and 40-week moving average – suggesting that KO is still mired in a strong downtrend. The fact that KO has been significantly underperforming during the last 21 months tells me that at some point this year (especially given our mid-cycle slowdown scenario), there is a good chance we will experience a significant correction in the market – one that should be the most severe out of all the corrections we have seen in this cyclical bull market so far.
The second name on our Top five list is MSFT – the leading “manufacturer” in operating systems and in office productivity software. The competition in the internet search market and in collaboration software is still ongoing – and whether MSFT can continue to be the dominant player going forward is an open end question. However, MSFT has beaten many formidable players in its short 30-year history – and at the same time, its financials continue to be impressive, with annual revenue at close to $40 billion with an ROE of approximately 20%. Moreover, Microsoft's new operating system – Vista – is schedule to be released late this year. Such a release should trigger a new wave of IT spending – and should give another boost to Microsoft's bottom line. The following weekly chart signals an improvement since our July 7th commentary, but the action continues to be frustrating, especially for a software company with such high margins and domination of the world PC market:
The $30 stock price that many analysts were calling for in light of the huge one-time dividend that was announced at the end of 2004 still has not seen the time of day. Shouldn't the price of MSFT be now reflecting the release of its new OS, Vista, late this year? MSFT is also now trading at approximately the same level it was when last provided an update of our “brand name” commentaries in early September 2005. The bulls continue to be frustrated – note that MSFT was essentially trading at $27 a share in September 2003 – meaning (one-time dividend not withstanding) that the stock hasn't really moved much in over two years. As we said in the above chart, relative strength vs. the S&P 500 continues to be dismal and is now again below its 20-week exponential moving average.
Let's now take a look at IBM. Since the early 1990s, the company has continued to re-invent itself in order to first survive and then to thrive. Today, IBM is no longer a computer company – but mainly a global services, IT outsourcing and software company. In today's globalized world where outsourcing is all the rave, IBM should be one of the main benefactors. However, the stock has continued to underperform since December 2004 – and is still trading near its March 2003 level – which some would argue represented the beginning of this cyclical bull market:
Please note while the recent bounce (and the fact that IBM reported satisfactory earnings on Tuesday evening) is encouraging, the fact that the third most valuable global brand name is still underperforming and is more than 15% below its most recent cyclical bull market high should be a cautious sign for anyone wanting to go long here. Just like other stocks on this “brand name list,” IBM is trading at valuations not seen in a long time (in IBM's case, since 1997). With a forward P/E of less than 15, IBM should offer a compelling value – so why aren't investors biting? And given that other investors are not buying other brand name stocks as well, what does that say about the market? This author would like to conjecture two immediate implications: One is that a huge number of investors are still sitting on the sidelines – these folks have been burned in the late 1990s bull market and have taken a pessimistic view of corporate America's prospects going forward. The second implication is that for retail investors who are willing to invest or speculate in the stock market, they are taking more risks instead by buying mid and small caps, along with international stocks. Neither conclusion should be bullish for the future prospect of the major market indices – unless we experience an at least a short-term “exhaustion” of sellers – which would most likely be preceded by a significant correction in the major market indices.
Like I mentioned before – out of the five “brand name stocks” that we have been keeping track, GE has been the best performing of them all since our last September 2005 update. The following weekly chart of GE should be etched into your memory going forward. Since our last update, the 20-week moving average of GE had been trading below its 40-week moving average – something that has not occurred since the end of the last cyclical bear market. This signals technical deterioration. Please note, however, that the 20-week moving average is now on the verge of breaking above its 40-week moving average, thus negating this weak technical condition. Therefore, the GE earnings report tomorrow (January 20th) morning and investors' subsequent reaction should be very important – not only for GE but for the entire stock market going forward:
In the case of GE, whether the 20-week moving average can break above its 40-week moving average is a significant event and should continue to be watched in the days ahead – not only because GE is the fourth most valuable brand name but also because GE is the second largest company in the world (by market capitalization behind Exxon Mobil) and given this hasn't happened since the end of the last cyclical bear market during May 2003. That is, with the exception of the period dating from September 2005, the 20 WMA of GE's share price has not declined below its 40 WMA at any time since the cyclical bull market began. Should the 20 WMA fail to break through the 40 WMA in the days ahead, then not only will GE be in danger, but the broad market will be as well. Given our 2006 mid-cycle slowdown scenario, my guess is that GE will break down sooner or later.
Given that Intel supplies over 80% of the world's computer processors, and given its ambition to continue to be an innovator in their industry (note Andy Grove's motto “Only the paranoid survives”), it is no surprise that Intel is the fifth most valuable brand name in the world. As one can see from the following chart, Intel's stock price has not been so hot since our early September 2005 update – mostly due to the negative reaction to the release of its latest earnings report on Tuesday evening:
Interestingly, the performance of Intel has more or less tracked the performance of the Philadelphia Semiconductor Index (the SOX) from January 2004 to December 2005 – but has clearly diverged since that time. Sure, INTC did also bounce in the first five trading days during 2006, but it made a lower high compared to a higher high in the SOX – with the most recent decline speaking volumes on the weakness of INTC:
That is, the performance of Intel has been relatively dismal – suggesting that investors are still ignoring the proven, brand name stocks in favor of mid caps, small caps, international and energy stocks. Could the SOX be correct? That is, are Intel's woes confined mainly to the company (some would argue “yes” given that AMD just surged 12% in pre-market trading this morning) or will INTC lead the SOX into a decline for the foreseeable future? Can a whole industry continue to rally without the participation of its bellwether? This author would argue “no.” While the fundamentals of the semiconductor industry are now at the best we have seen in over five years (take a look at AMAT), the recent rally of the SOX has most probably been too fast and too much. We are definitely due for a correction in the SOX here.
Conclusion: Given the continuing dismal performance in the major brand names – along with the homebuilders, our 2006 mid-cycle slowdown scenario, and the current overbought conditions in the stock market – this author is still signaling “caution.” The longer these brand names underperform and the longer the stock market goes by without a significant correction (in the order of 10 to 20%), the more dangerous the market becomes. In the immediate future, the GE earnings report will remain all-important. I will attempt to look at more of these brand names in next weekend's commentary – most probably brand names I have covered before but which should also include new ones, such as Citigroup (the most valuable brand name in financial services) and Nokia (the most valuable brand name outside the U.S.). For now, we will remain 25% short in our DJIA Timing System – and possibly looking to go 50% short in the coming weeks should the major market indices experience a bounce in the days ahead.
Henry K. To, CFA