LED Stocks

There was a time when our portfolio consisted of nothing other than fertilizer stocks. The pie chart above shows how little we diversify when the going is good. "Cramer, we own MOS, POT, CF and AGU. Are we diversified?"

In July 2008, the fertilizer stocks broke down, and we knew the market was done for. We got out and sat on the sidelines for a few months, eventually scaling into a few Ultralong index positions. We got into these positions a bit too early (never expected the market to drop 60%). Nevertheless, they became profitable, so we continued to hold. We let them go yesterday, putting us back to an all cash position.

Since we sold the fertilizer names back in mid 08, other than index ETF's, we haven't owned another stock since... until now.

We said we would wait for new innovation before investing again. We've found something that's piqued our interest, although granted it's not the next "internet" or "biotech" revolution.

This is a smaller innovation, but the size of its market is phenomenal. It is LED lighting.

Currently, the overwhelming majority of people still buy incandescent bulbs. They've been around for 126 years, so it's a tough habit to break. But this is about to change.

The 2008 energy bill has a section that phases out incandescent lightbulbs for residential applications by 2014. The phase-out begins in 2012. Everyone will be forced to buy CFL's or LED's. CFL's are in the running to replace incandescents, but they are less efficient than LED's, and most of them are not dimmable.

LED lighting has a bright future. But how to capitalize on this information? To do this, you'll need four tools. The first, and most important tool, is patience. This is not a short term trade. LED stocks should be bought and held for about 2 years. The second tool is a basic understanding of fundamental analysis. Right now, these stocks are all overpriced. More on that later. The third tool you'll need are the charts. Being that we'll be investing heavily in LED stocks, we'll be posting charts of the major players in the LED sector on this blog frequently.

The fourth tool you'll need is a basic understanding of the companies that make up this space.

We invite your commentary on which companies are playing "behind the scenes" roles in this technology.

Our understanding of it is that CREE is the largest pureplay in the space. While Philips (PHG) produces LED lighting, as a rule we avoid companies that are not pureplays. The basic concept behind this is that if 4% of a company's business doubles, you're not going to get much out of it. This precludes us from buying AMAT, which is involved in LED technology as well. They've got their hands in so many different businesses that even if they become the leader in LED, their architectural glass division (for example) will mitigate their success. Who needs that?

While CREE is the largest and most visible of the names, it isn't our favorite. We've had better luck in the past betting on the second or third companies because they often have more room to grow. Back when fiberoptics were heating up, we loaded up on SDLI, buying only a small stake in the 800lb gorilla, JDSU. Those of you who've been around long enough to know these names know that JDSU eventually bought SDLI.

You can also do well buying the guys down the chain... the material providers and such. If you look into the LED space, you'll find that Aixtron (AIXG) and Veeco (VECO) are two such names. Our favorite stock in the LED space is AIXG (see its chart above).

Ok, now back to fundamentals:

All of these companies are expected to have excellent earnings growth over the next 5 years. Hence the name, "growth stocks". Naturally, growth stocks come with higher P/E ratios because P/E's are a direct function of growth. As a rule of thumb, a fair value for a growth stock can be calculated by multiplying its annual growth rate by 1.2, then by multiplying that number by its EPS. The number 1.2 is known as a PEG ratio. Warren Buffett's stocks typically have PEG's of approx 1.1 to 1.2. Although your stocks as a growth investor will have higher P/E's than his, you should be content if you're paying the same PEG as he is.

So let's do the math for CREE:

Let's say it will grow by 25% a year for the next 5 years.

25 multiplied by 1.2 equals 30

CREE's current EPS is .79

CREE's EPS next quarter should be .96

30 multiplied by .79 is $23.70

30 multiplied by .96 is $28.80

A fair price for CREE right now would be somewhere around $27

Now let's do the math for AIXG:

Let's say it will grow by 25% a year for the next 5 years.

25 multiplied by 1.2 equals 30

AIXG's current EPS is .32

AIXG's EPS next quarter should be .42

30 multiplied by .32 is $9.60

30 multiplied by .42 is $12.60

A fair price for AIXG right now would be somewhere around $11

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Seeing as how CREE is currently trading at $56 and AIXG is currently trading at $33, it's tough to pull the trigger. Certainly if the market corrects, these "momo" stocks will get hit hard and fast, giving us a great entry point. Then they'll bounce back as quickly as they fell, making new highs long before the market itself.

So do we wait to buy CREE at $27 and AIXG at $11? No. Unless there's another economic meltdown and market panic, you won't be that lucky. Even if these stocks correct, they won't go that low. This is for two reasons. First, corrections take time. By the time the market corrects, we'll be further ahead in their fiscal year, giving them higher EPS's. The above figures would have to be recalculated. Second, the above figures are conservative. What if these companies grow by 30% a year, thereby deserving of a P/E of 36?

You can't be a value investor and a growth investor at the same time. You have to accept that you're going to pay up for growth and popularity if you want to ride the train. But that doesn't mean you have to buy at the very top. Wait for a dip and buy some. Then wait for a broad market correction and buy some more. Scale into your position as the market drops, and as the stock gets reasonably close to a price that you're comfortable paying for it. Then have patience. If you're going to hold it for a couple of years, then you have to believe in it. Your belief in it, according to Peter Lynch, can be a very simple thing. What intrigues us about LED lighting is the sheer number of lightbulbs that need to be replaced over the next 4 years. Basically every light bulb in the world will be replaced. Think about that. Then hold your LED stocks through thick and thin until they become a household name.

We waited to see if LED would catch on before deciding to start scaling into it. The reason is that the growth market is largely a popularity contest. Two companies with identical books can be treated very differently in the same market. Whichever one inspires awe in people will win the race. (Then go to zero, of course.)

We welcome any commentary about LED stocks or our investing methods, as always. If you know of any other new innovation that looks promising, please let us know about it as well.

Let's work together to triple our portfolio values!

S&P500

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We may be seeing the first signs of slowing momentum for the indexes today. There has been no break of any trendline or average, but this is not how a healthy Stage 2 chart rallies following five weeks of consolidation. The horizontal line drawn at the upper left on the chart of the S&P500 index above acted as resistance for over a month. Once broken, the chart should have rallied strongly to new highs without any hesitation. This would be textbook of how a chart breaks out into a higher trading range. Today's backpeddling just days after a feeble breakout does not bode well for the broader market. If this market doesn't pick up steam quickly and follow through on the rally it started, we may just be right that it's in its early stages of forming a top. If this is a top forming, the market will drop, then launch a rally that fails to make new highs. This would be the next sign. Finally, after failing to make new highs, it would break through the bottom of the trend channel and moving average. This is the scenario we're hoping for, but it's way too early to call it yet.

We're Out!

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We just sold the remainder of our Ultralong index positions, which we've been holding for just over a year now. The market is still in a Stage 2 uptrend, trading above an uptrending moving average, so there is no clear sell signal. Still, we see this end-of-year window dressing rally as an opportunity to exit the market and begin a new year. One of our New Year's resolutions is to use the S&P500 index (above) as our default index instead of using the Dow.

We feel that the market cannot go up forever at this pace (67% in under a year), especially in the face of rising oil prices. We just feel it's time to not get greedy and instead start to focus on our next adventure... LED lighting.

Indexes

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The chart above is of OEX (the S&P 100 index). All of the indexes have the same formation, so this could just as well be the SP500 or the Dow, it wouldn't matter which. There is a clear ascending triangle forming on the indexes. Resistance has been well defined over the past 6 weeks or so, and the charts remain in a Stage 2 uptrend, trading above uptrending moving averages. It is our strong feeling that it will not be long before the indexes break out to the upside. We also believe that that final surge to the upside (the blowoff) will mark a top, for the time being anyway. But one thing at a time... let's wait and see if there's a blowoff rally first. If so, we'll be selling the rest of our index position and getting back to 100% cash.

AAPL

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We recently voiced our opinion that AAPL was getting ahead of itself on a valuation basis. We now see deterioration in the strength of its technicals, too. It broke its trendchannel and 50dma. If this chart appeared at a time when the market was beginning to melt down, this would be a screaming sell. But considering the market remains bouyant and other techs (particularly GOOG) appear healthy, this is not a 5 alarm fire. Nonetheless, now is not a good time to back up the truck and load up on AAPL shares. This is one chart that will see $200 again sometime in 2010, so there's no rush to buy.

In our ideal world, the market itself would "blow off"... rally another few hundred points (maybe even to 11,000), then top out in a big way, possibly retracing to 8,500 or so before stabilizing. If this scenario plays out, then in hindsight AAPL would have been exemplifying investor's current true feeling about the market. And that is that we're at a point where stocks are getting overpriced. We've come too far too fast. But whether or not our feeling is the concensus remains to be seen.

Gold Corrects

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It was exactly 2 weeks ago today, with GLD trading at $109 that we said... "We're not saying it can't go higher, but that if it does, it will inevitably return to its current price sometime in the next few months. In other words, it isn't about to get away from any potential buyers at this point. Don't chase it."

The concept behind that post was that stocks only move so far away from their averages before they return to them. There's no harm in selling when a stock moves far above its average. Or at least lightening up as it advances into the nosebleed section. If you have the patience, you'll be able to buy it back again at the same price, so there's no risk. If you're lucky, it may just drop the day after you sell, setting you up for a nice trade. Beware of tax consequences.

As for the future of Gold, it hasn't broken any trendlines nor averages. It's still in an uptrend, trading above an uptrending moving average, so it is not a short candidate. If it moves lower from here, support is in the mid 90's. But it has already corrected approx 10% from its highs, so the worst may be over for now.

AAPL

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We think AAPL has gotten way overextended. Maybe it breaks down from here, with a significant and decisive break of both its moving average and trendline. Or maybe it manages to keep itself within the channel, wedging itself into the little triangle formed by the ascending trendline and the horizontal support created by its October and November highs. From there, of course it could break strongly to the upside. But there's no way of making either of those calls right now. Our warning on AAPL shares are more rooted in the company's size than anything else. AAPL is simply too large to keep growing at its current pace, and it has once again nearly maxed out how far it can comfortably push the upper limit of its valuation range.

Let's suppose you could accept that AAPL will grow by 20% annually for the next five years. We find this hard to believe, but let's give them the benefit of the doubt. In that case, paying a P/E of 25 for the stock would be reasonable. Not a bargain by any stretch, but not outrageously expensive either. It would just be a fair P/E for the stock. Let's give AAPL the benefit of the doubt and calculate its current EPS using what they project to make for Dec 09. That would give AAPL an EPS of approx $6 per share. With a pricetag of $196, that gives AAPL a P/E of approx 33. Looking out about 12 months from today, AAPL is expected to have an EPS of $8 per share. If it stayed at today's price of $196, its P/E a year from now would be 25. So there you have it, a stock that should go sideways for the next 12 months, if indeed it wanted to return to a level where its price matched its value.

Considering the stock "should" be at its current price a year from now, there's little risk in buying or shorting it at these levels. It may go higher or lower, or maybe just sideways. But either way, at some point about a year from now, it'll be back at $200 again. We posted similar comments about AAPL's valuation last time it reached the $200 mark. So how do you profit from this? What we like to do is plant this seed in our head, and then watch the chart. If AAPL continues moving higher, our interest in shorting it increases. Perhaps in a month or two, it'll be trading on 2011's EPS. That would make shorting it a whole lot easier. If we thought it was high at $200, then it'll be a screaming short at $250... with a P/E of 42.

We don't actually short individual stocks, especially ones that are trading above an uptrending moving average. But it's still worth keeping tabs on where the four horsemen of tech are trading. They give you valuable insight into how rich the market is becoming. AAPL strengthens our thinking that the market itself is in its early stages of an overbought condition. Each step higher from here, the market is playing an increasingly dangerous game of musical chairs. When the music stops, there won't be any buyers left to fill the sell orders of those who want to take a seat on the sidelines.