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November 27, 2006 6:53 pm

There is nothing better than a good bubble

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I really hate the word “bubble”. I take it personally when the word is used in polite conversation. People throw it around as if it is a phenomenon that happens every other year. As I understand it, a bubble is when speculation is so rampant that the only reason assets go up on any particular day is because they were up the prior day.

We all have our war stories of the initial public offering bubble that happened in the 1990s and 2000. Stocks were going up 10-20 per cent a day on nothing more than metrics such as “eyeballs”. I remember in 1999 being so desperate to hire people I would go down to the local Kinko’s and if any of the employees there could open up Photoshop I would make them $120,000 offers on the spot. A year later, in a 10-block radius of my office on 5th Avenue and 21st Street, more than 150,000 people lost their jobs thanks to the “bust” that followed the bubble.

Unlike many people, I am not a believer that Google at $500 is a huge buy. But I am also not saying that Google at $500 is “a bubble”, like many of the people who sleep comfortably through the night safe in the false knowledge that they are not missing out on anything. Right now, a bet on Google is simply a bet that real earnings, which Google has in the billions, will continue at the same rate. But it is real earnings. Not eyeballs.

Let us talk about that other supposed bubble – the venerable Dow Jones Industrial Average. In the past week or so this indexed aggregation of 30 “industrial” giants has hit new highs almost every day. Surely this is a bubble. Surely it cannot go up any more. I get e-mails from people insisting this is insane and that at some point our Roman Empire-style drunkenness will cause the Dow to go down 30 per cent or more.

But other than a few stocks here and there (most notably the Vice Fund favourite Altria, which is up 237 per cent since the dawn of the century), the Dow is not really up. I would argue the Dow is up to 20 per cent undervalued. To break it down I will look at where we have been and where we are going.

So far this century, Microsoft is down 48 per cent, its price/earnings ratio has gone from 53 to 21 and its price/book has gone from 10 to 5. The software company is about to have the first big releases of its Windows operating system, Office and its server of the past decade. In other words, its only profitable products are about to hit an enormous profit cycle. This is one of the fastest growing companies since The Wheel and you people treat it like dirt. Shame!

Disney. Not only the home of The Incredibles and The Little Mermaid but also Lost and Desperate Housewives. This company had a p/e ratio of 62 in 2000 when everyone was pounding the table for it. Now: 16, below the market average. Book value per share was $11.65 in 2000. It is now $15.42. Return on equity was a trickle at 3.8 per cent in 2000 – 10.6 per cent now. ABC has gone from last in the main television networks to first. But with all this, Disney is 3.3 per cent down on the century. Pathetic. Maybe Disney should go down another 20 per cent before people finally learn to treat it with a little respect.

General Electric, creator of the best new TV show of the fall season, Heroes, is down 30 per cent on the century. Hewlett Packard, while increasing book value per share from $11 to $21, is down 11 per cent on the century.

Verizon is like that old guy lying drunk in the gutter muttering about the old days when “I had 17 people reporting to me and a new a pair of shoes every four months”. People simply don’t trust it, giving it a p/e of 12 instead of the market average of about 18. It is down 34 per cent on the century with its godfather, the Dow, hitting new highs thanks to Altria and ExxonMobil. Did everyone switch to Skype when I was not looking?

And my favourite, Wal-Mart, working hard to get us practically free generic drugs, down 26 per cent since January 2000. And what did it do that was so bad? It increased its book value per share from $5.80 to $12.77. That is pretty hard to do when you have more than 4bn shares outstanding.

ExxonMobil, Altria and United Technologies are having parties in their penthouses while 20 other Dow companies are lining up for the soup kitchen because nobody will buy their shares. The Dow bust that started in February 2000 is still marching on but I feel it will end.

Not only do I think the Dow can easily hit 15,000 in 2007 but I think the best bet is to buy the dreck that the world left behind – the 20 Dow components that are negative since 2000. And then let us work to get our bubble back for 2008.

james@formulacapital.com

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