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Kraft – A Compelling Buy Based on Technicals and Sentiment

(Guest Commentary - January 4, 2007)

Dear Subscribers and Readers,

Welcome to the first guest commentary for the year 2007!  For those who had wanted to learn more about picking stocks and evaluating companies, I have again invited our regular guest commentator Mr. Bill Rempel for a quick mid-week discussion of an individual stock that he likes.  As subscribers should know, Bill has been writing a regular guest commentary for us since June 2005.  His first commentary was on The Art of Value Investing and was very well-received (that is why we brought him back on a regular basis!).  Bill is a prolific writing on the stock market and individual stocks and is the author of a very active market blog at: http://www.billakanodoodahs.com/

In this commentary, Bill is going to discuss Kraft not so much about its fundamentals (although as always, Bill doesn't leave too many stones unturned when it comes to numbers) but more about its technicals.  Specifically, the volume surge on December 29th (accompanied by a good performance day relative to the S&P 500) an event which may have potentially bullish implications especially given the high insider ownership and high short ratio.  Without further ado, following is biography of Bill:

Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see Getting on the Entercom for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.

Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

Even though I generally write about value stocks in this column, there are lots of values that I find through other scans besides the basic "value" scan.  Some of the subjects of this column have been found through the "short squeezer" scan, for example.  This is probably the first "value" stock that I've found through a purely technical scan, however.

One of the tenets of trading is that sentiment, not valuation, moves stocks.  Valuation is a clue to sentiment, and can help me find the "mean reverting sentiment play" that is a "value stock."  But sentiment doesn't directly move a stock sentiment moves dollars, and dollars move shares, and moving the shares moves the stock price often volume is a corroborating factor, but sometimes a leading indicator.

What's funny to you about this chart of KFT (Kraft)?

KFT (Kraft Foods) - No news, low volume and negative day on the overall markets, and yet, KFT has a triple-volume day. Hmm. Earnings are not due until Jan 30.

What I found funny was that KFT had a triple-volume day.  On a slow day for the markets.  Where KFT moved up but the indices moved down.  While KFT was near a 52-week high on a consolidation pattern.  On no news. 

Are your ears perked up yet?  Mine were.

Technically, it gets even more interesting, according to data from Yahoo! Finance.  Kraft is a large cap stock, mega even, at $58.68 billion last I checked.  Of the 1.64 billion shares outstanding, only 206 million float.  Insider ownership is 89%, with Altria Group, Big MO, owning most of that.  If there is suddenly demand for this stock, there's not much to be sold, meaning this stock could shoot higher quickly.  Another technical aspect of interest is that the short ratio stood at 13.8 days to cover, a high ratio at any point of the chart, but when the stock is basing within a few percent of its 52-week high, the squeeze could be on.

More tidbits about Kraft intrigued me, this time, from the fundamental side, data again courtesy of Yahoo! 

ROA = 5.8%

ROE = 15.7%

Debt/Equity = 0.4

FW Div/Share = $1.00 for yield of 2.8%

The first dividend paid on KFT was $0.13 in December 2001.  The last dividend paid on KFT was $0.25.  For the math-challenged, that is 14% annualized dividend growth, and it was done in steps of two or three cents at a time.  The stock went ex-div on 12/22/2006.

More on the fundamentals in a moment, but I want to check the fundatechnicals, i.e., the valuations.

TTM PE = 18.5

FW PE = 17.7 implying 4.5% earnings growth next year

PEG = 2.7 not very good

Price/Sales = 1.7

Price/Book = 1.9

This is definitely not "deep value" but is arguably discounted to the market by several measures, especially for a large/mega cap, a P/S or P/B under 2 is pretty rare.  The P/E is high for my tastes, because with the analyst estimated growth of 7%, my super-conservative 15% discount rate gives a two-step DCF "fair" P/E of 12.  An 11.5% discount rate gives a 19.4 "fair" P/E.  Keep in mind, I use 5 years for the first step and then revert to S&P 500 "average" growth of 6% for perpetuity when I do a DCF.

The next step in my "discovery" process is to use the MSN Money data, downloading the last 5 years and 5 quarters of data and hitting it with the spreadsheet.  While it's not the most fantastic growth curve for earnings, the financials are solid.  There will be no issues paying down debt or meeting the dividend, the book value is growing steadily, debt is being reduced, and there is no issue with share dilution through options.

KFT (Kraft Foods) financials

The next earnings date is Jan 30, 2006.  There have been no analyst's revisions to the estimates in the last couple of months, but the stock has "surprised" for four quarters in a row.  Perhaps, just perhaps, the volume is preceding a "whisper" about earnings.

Let's talk Street sentiment, from a contrarian point of view.  The last four rating actions have been downgrades, March, June, August, and September.  With 12 brokers making price targets, the mean and median are $33 and $32, with the high being $40 and the low being $24.  Kraft is currently trading for $35.70.  With 19 brokers making recommendations, there are only 4 buys, all "strong," with 11 holds and 5 sells.

At this point, I haven't read the proxies and other filings.  I would not be surprised to find some dirt, considering who owns most of Kraft MO (Altria) had some of the sickest, don't-give-a-darn about the small shareholder filings I've ever read for a large cap stock but all of the other factors make KFT such a compelling trade that I'll gladly slap a trailing stop under it without reading them.

Disclosure: I am not long KFT when I write this, but I will be long KFT by the time you read this.

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