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The stock markets look ready to open down this morning after Wall Street digests yesterday’s key events. The Federal Reserve once again lowered the Fed Funds rate about 3/4 of a percentage point to 2.25%, disappointing investors who were looking for a full point rate cut. According to The Wall Street Journal, the move was a sign that the Fed is looking to rely on other options besides interest rates to stimulate the market (in order to keep inflation in check).

The Stock Market & Bank Stocks Rise

Also making headlines were better than expected earnings at major banks such as Morgan Stanley (NYSE: MS), Lehman Brothers (NYSE: LEH) and Goldman Sachs (NYSE: GS). All three stocks had suffered over the past year from uncertainty surrounding the subprime lending fiasco.  The market reacted positively to both major news items, as the Dow closed up about 3.5%.

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There’s nothing quite like a fire sale in the stock market - except, of course, when even the buyer (who just swapped a dime for a dollar) feels ill at ease with the transaction. Unfortunately, that seems to be the case now, as JP Morgan Chase (NYSE: JPM) announced yesterday that it was purchasing ailing giant Bear Stearns (NYSE: BSC) for the rock bottom price of 2 bucks a share.

Why So Cheap?

Bear Stearns is a product of the mortgage backed security implosion that has unfolded over the past year. The amount of mortgage securities it holds (which are essentially worthless) is in the billions - making bankruptcy certain in the absence of a buyout or government intervention.

The Fed, fearing a domino effect on Wall Street if the firm were to fold quickly, has been working hard to secure JP Morgan Chase as a buyer. They have even gone as far as putting up an unprecedented $30 billion in capital to finance Bear’s illiquid assets (i.e., mortgage backed securities). However, despite the Fed’s backing, management at JP Morgan is still sweating all of the uncertainty behind the deal. This was the key driver behind the firm’s per share offer price of $2.

Shareholder Mutiny Brewing

According to an article in The Wall Street Journal, Bear stockholders are extremely displeased with the buyout price. They argue that filing for bankruptcy is a much better option, as book value of the firm is believed to be far greater than $2 per share. Still, management position is that stockholders will agree to the deal (which is expected to close in June).

The Stock Market Reaction

All of this uncertainty and panic will send the major stock market indices lower. Even with an additional move by the Fed to lower the discount rate (which was also announced yesterday), the economy and the US dollar are in trouble. So, buckle up - I think we are in for a rough ride.

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Despite an initially positive reaction by the stock market to CPI data yesterday, the market headed into negative territory after a heavy dose of bad news from the Fed and Bear Stearns (NYSE: BSC).

Take One for the Team

The Federal Reserve announced it would work with JP Morgan Chase (NYSE: JPM) to float a cash-strapped Bear Stearns funds in order to keep the company in business. Their concern is that, given an already air-tight credit market, the entire economy would collapse if Bear were to suddenly go out of business. Why? Because nobody really knows how enmeshed Wall Street is when it comes to lending between firms. If one giant falls, several more may unexpectedly collapse as well. Even though it has been given a brief reprieve, most expect that the company will be sold to a larger bank or private-equity firm within a matter of weeks. After the news, BSC stock quickly lost about half of its value…ouch.

Enter the 2nd Bear

Or, I guess I should say the market has already entered the second bear market of the millennium (irrespective of how the Bear Stearns issue pans out) . Now the question is, will it be long or short? In my opinion, you have to hope for the best and expect the worst right now. Especially because I fear a larger problem with consumer credit (i.e., credit cards) could sneak up on the economy if we’re not careful.

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I bet you wouldn’t have guessed the Walt Disney Corporation (NYSE: DIS). If you’re like me, the name Disney immediately brings to mind an amalgam of animated cartoons, theme park rides, and lovable rodents. However, while having the market cornered in the rugrat space, Disney is actually a well diversified media giant that derives over half of operating earnings from its media networks and assets. Surprisingly, these networks include ABC, ESPN, SOAPnet, as well as equity stakes in Lifetime Television, and A&E.

Durable Competitive Advantage at a Discount

According to Barron’s Michael Santoli, the stock has fallen to unjustifiable lows as of late and is literally “the cheapest it’s been in 20 years”. Indeed, it certainly seems fairly cheap given a trailing P/E of 15.7 vs. the broadcasting / cable TV average at 19.2 and the S&P 500 at 18.3. While I can understand why investors may have unloaded the stock as fears of a consumer led recession continue to mount - I still see this as a possible long term opportunity to invest in a company with a significant durable competitive advantage.

Disney is Deeply Entrenched

Really, there is no denying that Disney permeates every aspect of our lives. In fact, several months ago I made the decision to buy a Blu-Ray player over an HD DVD player. Why? I read that Disney was on board exclusively with Sony’s Blu-ray format. The thought of parents having to explain to their kids why they couldn’t buy the 47th sequel to The Little Mermaid seemed like a nightmare waiting to happen. And, lo and behold, HD DVD is (ironically) going the way of Sony’s Betamax.

Related Links:

Barron’s: The Magic’s Back (subscription required)

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Any investment has associated risks. Please read our disclaimer.

The latest edition of Barron’s brings some compelling facts about financial bellwether Wells Fargo (NYSE: WFC) to light. The bank, a large cap stock, is an efficient operator whose conservative approach has helped it weather the subprime storm. The fact that Warren Buffett’s Berkshire Hathaway is the bank’s largest shareholder isn’t exactly bad news either.

Overview

Wells Fargo is one of the top ten largest banks with a market cap of almost $100 billion dollars (it is fifth largest by assets). Per Barron’s, it derives over a 1/3 of revenues from retail banking and lending via its community banking segment. Over 1/2 of revenues come from the firm’s mortgage / home equity lending (17%), investment / insurance (17%) and specialized lending (17%) businesses, with the balance derived from wholesale banking and consumer finance.

Opportunity

While Wells Fargo did suffer losses from home equity loans, it remained disciplined when it came to mortgage lending. In fact, its conservative lending practices prevented it from taking market share during the housing boom. Further, it is more adept at cross-selling products and services than other banks, and operates more efficiently than its peers.

Metrics

According to Barron’s, two key metrics come to the fore. First, WFC’s product cross-sell rate is twice that of other banks (an average of 5 additional products sold to every customer). In addition, its ratio of non-interest expense to revenue is the lowest among the top 5 banks at around 58%.

A quick look at ratios shows a below average trailing twelve month P/E of 12.5 vs. the industry average of 16.4, but its Q4 ‘07 price / book value of 2.0 is slightly higher than the industry average of 1.6. Its 5 year sales growth rate is 2 percentage points below industry average at 14%, but some of this may be attributable to its conservative lending approach. The highlight, though, is a 5 year average Return On Equity (ROE) of around 19% vs. the industry average of 16%. Finally, a dividend yield of 4% serves to sweeten the deal.

Risk

While WFC looks attractive on the surface, banks and the stock market have a rough road ahead. In addition, the company continues to have exposure to home equity loans (which can also suffer in a further deteriorating credit market). While the stock is 20% off its highs, it could certainly fall further with the rest of the banking industry.

Summary

All in all, Wells Fargo is a large cap with long term promise. The fact that Warren Buffett is a majority shareholder and has started increasing Berkshire Hathaway’s stake bodes well. However, investors should maintain a long term focus, as shares could continue to fall as the US treads further into a recession.

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The stock market news wire is humming this morning on an announcement that Citigroup (NYSE: C) has barred investors in its CSO Partners hedge fund from withdrawing their investments. According to the Wall Street Journal, investors in the fund attempted to withdraw almost 1/3 of fund assets due to fear concerning mortgage backed securities. However, the fund has refused, explaining that they would have to sell valuable securities at huge discounts (which would hurt all investors).

So, is that Really so Bad?

True, the fund did make disproportionately large investments in leveraged securities (even breaking trading policies set within the firm). However, the fund was down only about 11% in 2007, and the previous manager has since been replaced. If you are a diversified institution this fund should only be a small percentage of your portfolio. Therefore, a loss of 11% is not so bad given the amount of risk involved (whether or not all information is truly available about the underlying securities).

Further, according to various sources, CSO is a corporate debt fund, not a fund focused on mortgage backed securities. By keeping investors from redeeming assets, Citigroup is essentially preventing them from making a knee jerk reaction that will guarantee all investors lose money.

Where There’s Smoke, is There Fire?

However, uncertainty drives the market and institutional fund managers are under pressure to “not do worse” than market benchmarks. This will lead many to head for the door as soon as they can. Their argument will undoubtedly be the proverbial: “where there’s smoke there’s fire”. Given the current market situation, I guess I can’t say I blame them.

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According to the Wall Street Journal, large cap bellwether Microsoft Corp. (NASDAQ: MSFT) has offered to buy search engine Yahoo Inc. (NASDAQ: YHOO) for around $45 billion. The proposed deal, a 60% premium to yesterday’s closing price, works out to around $31 / share.

Competing with Google

Undoubtedly, the move is a play to gain traction in the search engine space and compete, according to Microsoft, in a market “increasingly dominated by one player”. Come to think of it, I wonder if there are any opportunities for competition in the PC operating system or web browser space? Those seem to be markets dominated by one player as well…hmm. Seriously though, the deal probably makes sense and could ultimately give Google a run for its money if it goes through.

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Ouch! French bank Societe Generale announced today it was the victim of fraudulent trading by a lone trader at its futures desk. The fraud is somewhere in the neighborhood of $7 billion, putting it well ahead of the Barings bank implosion of the 90s (subject of the film “Rogue Trader”). The news does not bode well for the bank, who’s stock has already taken a beating as a result of the subprime lending crisis.

Related Links:

IMDB - Rogue Trader (Starring Ewan McGregor) 

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According to Reuters, Southwest Airlines (NYSE: LUV) announced today it nearly doubled its profit from $57 million in Q4 ‘06 to $111 million in Q4 ‘07, exceeding analyst expectations.  A good portion of the budget carrier’s increase came via a 154% gain in its fuel hedging positions (up from $118 million to about $300 million).  The announcement, while positive, did little to allay the market’s concerns about rising fuel costs and their impact on airline stocks moving forward.

A Glimmer of Hope 

Still, Southwest offers a small glimmer of hope in a tough industry, and continues to maintain a focus on customer service through conduits such as its Rapid Rewards program and Business Select offering.  Further, it continues to innovate.  Per CEO Gary Kelly, Southwest will start testing inflight internet connectivity on several of its aircraft this year.

Related Links:

LUV Q4 2007 Webcast

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No doubt about it - when investors think technology, high growth, and innovation - one of the first companies that comes to mind is Apple Inc. (NASDAQ: AAPL). However, despite quarterly earnings that beat analyst estimates, shares of the tech giant shed about 12% in after hours trading yesterday. Per Reuters, the selloff came in response to lowered Q2 earnings guidance by the company of $6.8 billion vs. Wall Street’s expectations of $7 billion.

Recession Fears

Was the selloff justified? Maybe, maybe not. However, with fears that a recession is rapidly descending on the US economy, it does appear that investors are betting on a decrease in personal consumption and exiting this stock. Even so, this is still a stellar company and I believe it will continue to take market share in the personal computer space moving forward.

Related Links:

Apple Investor Relations

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