Our Take On VECO

Click chart to enlarge

It always amazes us how little patience some investors have. If you read the message boards, you'd think VECO is going out of business. What's wrong with a stock, or an entire sector for that matter, correcting after months of phenomenal gains? In our view, absolutely nothing. Volatility goes hand-in-hand with growth stocks. As long as a chart stays above its uptrending moving average and hasn't broken down below the bottom of its trend channel, then we really don't care what it does above those lines.

We see VECO as a company poised to experience significant growth through some time in 2012. If we didn't already own it, we would have bought some today. We fully accept that at some point these LED stocks will reach a plateau where their future growth is calculable, and that will end their 15 minutes of fame. But until you personally buy your first LED bulb, don't worry about the LED craze being over. It's already a foregone conclusion (not to mention a government mandate) that every lightbulb in the world will be changing over the next 4 years. It isn't until you're in some random deli overhearing people talk about LED stocks that you should fear their run being over.

The big-picture thinkers, like Peter Lynch, suggest that you should never look at charts with intervals of less than 5 days. That is, charts where each bar represents a week of trading. The logic behind this is that it keeps you focused on the longer term picture, where blips like this are hardly visible.

Buffett would tell you that if you liked the stock yesterday at $54, then you should love it today at $47. How true that is.

Let's stay focused on the big picture and not let the short-term thinkers and window dressers distract us.

VECO

Click chart to enlarge

(This post has been updated to reflect VECO's latest guidance)

Time to re-evaluate VECO. The chart shows that it is either well above the top of its channel, or it has simply started a new channel. This is an arithmetic chart, so "going parabolic" is not unusual for the strongest growth stocks. It's when a stock goes parabolic on a logarithmic chart that you need to run for the hills. Going solely by the channel and moving average, VECO is overbought and ripe for a correction. It is only an immediate cause for concern if its fundamentals tell us the same thing, so let's take a fresh look at them...

Over the past four quarters, VECO has posted earnings of

-.15, .16, .41 & .49, for a current EPS of 91 cents. Next quarter, VECO projects to report earnings of 78 to 90 cents per share, well above the 59 cents previously expected by analysts. For the purpose of our calculations, we're going to assume VECO will report 85 cents per share next quarter.

No one really knows how well the LED companies will do, as the number of lightbulbs in the world is an incalculable figure. History has proven, though, that during their most aggressive growth phase, companies grow by approximately 20% to 30% annually for about 5 years at a time. Beyond that, growth at that rate is unsustainable. We therefore typically use 25% as our estimate for a company's EPS growth, so as not to get caught up in a Dutch Tulip bubble.

This number should be scaled up or down depending on the size of the company. For a company VECO's size, an estimate of 25% to 30% is acceptable. As an example, we might use 20% to 25% for a company the size of CREE, and 15% to 20% for a company the size of AAPL.

This estimate yields a P/E for VECO of 30 to 36, using a PEG ratio of 1.2. As we've said before, Buffett supports the use of a PEG ratio of 1.2, so who are we to play with that number?

Using VECO's current EPS, it should be trading anywhere between $27 and $33. If we had a broad market correction right now, this may be where VECO would retrace to. And it would be a steal at that. But who goes by current EPS figures?

Looking out 3 months, VECO's projected EPS ($1.91) suggests it will be worth anywhere from $57 to $69. Even if we go with a more conservative growth rate like 20%, we'd be looking for VECO to be priced at around $48. So we don't feel that there is a lot of downside in holding VECO here, despite how "nosebleed" the chart appears.

Looking out two quarters, the 15 cent quarter will be replaced perhaps by another 85 cent quarter, giving VECO an EPS of $2.61. At that time, VECO could be trading at around $80 per share.... maybe even higher if the market is surging at that time.

Our approach going forward is going to be to hold VECO and add on dips. Of course there is a number at which we would sell, but as long as it stays below $60 or so, we won't even be considering it.

In another note, we continue to believe that the market is blowing off and about to retrace significantly enough to give us good entry points on just about every issue.

CREE

Click chart to enlarge

CREE is taking a small hit today after beating expectations. How many think it's going down because people expected better results? How many think it's going down because it was at the top of the channel? Of course we believe the latter, but it's just a difference in philosophy with no change to the actual outcome (the bottom line). We believe that if CREE had dropped to the bottom of the channel in the days or weeks heading up to the earnings report, it would have soared upon its release. So then is it good news or bad? Like all stock market news, it's neither. It just depends on where the market is when it's released. But we digress.

The point of this post is that we sold CREE a short time ago at 76 something, saying that there's little risk in selling near the top of a channel. Although we didn't catch the very top (you rarely will), we didn't exactly get locked out of the stock either. While it's tempting to buy back into CREE based on it having a bit more strength than we had anticipated, we still feel it's richly valued. We're no stranger to paying up for growth, but we'd rather wait for a really bad day in the broader market and steal the shares from someone standing on their window ledge. You're not getting a bargain buying CREE 6 points off its high.

Blowoff

Click chart to enlarge

The chart above is a chart of the Nasdaq, although the S&P and Dow look similar. We're not sure if we've ever posted about the S-curve blowoff in the past, but it should become a familiar pattern for readers of this blog. We've seen this pattern many times, and it always marks a top (at least a short term one). The trouble is finding the exact top, because the last few days of upside on this pattern can be explosive, leading to excellent gains. The general rule of thumb is that an S-curve has a centerpoint, and its lower half roughly equals its upper half. Using this concept, the market has a bit further to climb before it rapidly returns to earth. When it returns, it will typically go to the 3/4 mark, or halfway mark of the S-curve.

We sold CREE a bit early, and are suprised by its continued strength. We cannot, however, justify its valuation, and therefore feel safer invested in VECO at the moment. If the market is experiencing the kind of blowoff rally we believe it's in right now, we'll be picking up more shares of VECO when it retraces. Although a quick buck may be able to be made by buying into the current hype, it's a dangerous game and will typically end in a loss when the dust settles. Euphoria has set in to the market, but will only last a short time. We feel that now is a time to be cautious. Not fearful, but cautious. Others are getting greedy, and markets that run on greed are always short-lived.

LED Valuations

We've had a great run in the LED stocks recently, and that calls for a fresh look at the numbers to see how they're currently valued, and where they may be headed. Let's put aside the events of the past couple months and focus on the only question that matters now... "Would we buy these stocks if we just discovered them today?"
First, we have to estimate their growth potential and earnings growth timeline. From this standpoint, the LED stocks are still attractive. People have not yet even started to buy these products, and government regulations are soon going to force people to do so... worldwide. This suggests that the LED stocks still have a way to go. But what do the numbers tell us?
Going on the assumption that the actual earnings growth peak for these companies will occur when people first start buying these items in quantity, it suggests that these companies may not hit the top of their growth cycle for another 2 years or so. This means the stocks will hit their peaks in about 15 to 18 months (6 to 9 months before the earnings growth tops out).
Being conservative, the LED companies can be expected to grow approximately 20% to 25% a year over the next 3 to 5 years. This gives them fair P/E's of somewhere between 25 to 30.

VECO
Current EPS= -.22 -.15 + .16 + .41 = .20
Current P/E= 47/.20= 235
EPS in 3 mos= .16 + .41 + .46 + .54 = 1.57
P/E in 3 mos= 47/1.57= 30

CREE
Current EPS= .13 + .18 + .30 + .38 = .99
Current P/E= 77/.99= 78
EPS in 3 mos= .30 + .38 + .43 + .46 = 1.57
P/E in 3 mos= 77/1.57= 49

The above numbers show that while their current EPS's suggest that these stocks are way overvalued, a very different picture will emerge just a few months out. These numbers also suggest that CREE is about 65% more expensive than VECO. This makes sense, seeing as how the 800lb gorilla always attracts the most investors, and therefore carries the highest valuation.
It is our opinion that CREE is overpriced at $77 considering that if it stayed at its current price, it's P/E would be 30 in approx 9 months. That means that it will go sideways for the next 6 months or so before it has room to move higher. Don't believe it? Watch. It may go higher and then drop, or lower and then rally, or just go sideways. Either way, you'll be able to buy CREE at $77 again later this summer or in the Fall. There's no rush to jump in at its current price.
VECO, on the other hand, will have a P/E of 30 in just 3 months if it stays at its current price of $47. We would buy VECO here if we were just discovering it today. Even better if it corrects into the low 40's. The closer we can buy it near a P/E of 30, the better off we'll be in the long run. We're currently looking for an entry point for VECO, and to a lesser extent a re-entry point into CREE.
So where will these stocks top out? There are too many variables involved to give an answer to this question. And truth be told, nobody knows. But from where we stand now, the numbers suggest that at their peak, CREE and VECO could both be trading at approximately $100.
(assuming a P/E of 40 and an EPS of $2.50) It won't be long after their EPS's reach about $2.50 that widespread talk of lower margins, cheaper LED's, expiring patents, newer products, etc, will cause these stocks to put in a top.
If you want to really prepare for the LED craze, we suggest that you get yourselves margin accounts. When these stocks top out, they are going to fall very hard. Any company making products that can easily be duplicated cheaper in Singapore will crash in the end. This isn't a Google where the brand is irreplaceable. This is cut-throat competition for cheaper prices.
When these stocks begin their fall from grace, we will immediately discontinue our love affair with them and reverse course. The LED stocks will be headed to zero like all other stocks. But until then, let's enjoy the ride to $100 by setting up sniper posts and picking off a few shares here and there on those days when people just sell with passion for no reason whatsoever.

Chart of CREE

Click chart to enlarge

Snot sells CREE

Click chart to enlarge

We sold all of our shares of CREE this morning, after a UBS upgrade put the stock up 7 points. We have nothing against CREE, and will likely repurchase it at some point in the near future. We just feel overexposed at the moment to stocks that are trading at or above the tops of their channels, well above their moving averages. The chart of VECO above illustrates this.

We chose to sell CREE rather than VECO today because VECO offers better value at the moment. Both companies are expected to report approximately $2.00 or better by the end of 2010. With similar EPS forecasts, we'll take VECO in the 40's over CREE in the 70's.

VECO announced that it will be releasing earnings on Monday, April 26th. If the stock surges prior to earnings, we may be selling it as well.

We feel that the broader market is not ready to run out of steam just yet. One of two scenarios will likely happen. In the first scenario, the market will continue its climb to about 11,600 or so. Then it will correct about 10% sometime this summer. In the second scenario, the market will continue to climb to about 12,500 or so, then experience a 15% to 20% correction sometime in the Fall (perhaps October). In either scenario, these LED stocks could easily remain bouyant for the next several months, possibly putting in some very impressive highs (CREE at $100 and VECO at $80?). We plan on being on board for the ride, but are also very well aware that at some point between now and October, people are going to remember that the reality of the current economy is in no way suggestive of anything more than Dow 12,000. The upside is limited from here for the broader market, and any fluff will quickly evaporate. Although we aren't looking to get back to 100% cash just yet, we are going to be more conservative going forward considering these stocks have already posted some very impressive gains. Our sale of CREE today marks a transition in our investing mindset from one of "everything's peachy, buy and hold" to "sell into strength, don't be caught overexposed".