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Lemley Yarling Management Co
309 W Johnson Street
Apt 544
Madison, WI 53703
Bud: 312-925-5248       Kathy: 630-323-8422

July 29, 2011

Model Portfolio Value As of 29 July 2011

$ 543,322


July 27, 2011

Model Portfolio Value As of 27 July 2011

$ 547,315

Comment on Model Portfolio activity

This too shall pass. We view the Debt Ceiling sell off as a buying opportunity.

We repurchased Ford Warrants at $4 down from our sale price of $5.25 a month ago. Ford’s earnings yesterday were better than.

We added Ingersoll Rand to accounts as the shares dropped 15% in the last two days on a cautious forward statement after last Friday’s earnings report.

(Yahoo/Finance) Ingersoll-Rand Plc engages in the design, manufacture, sale, and service of a portfolio of industrial and commercial products in the United States and internationally. The company’s Climate Solutions segment delivers refrigeration and heating, ventilation, and air conditioning (HVAC) solutions. It offers various products, services, and solutions to manage controlled temperature environments for transport and stationary refrigeration markets and the commercial HVAC markets. This segment offers its products under the Hussmann, Thermo King, and Trane brand names. Its Residential Solutions segment offers mechanical and electronic locks, energy-efficient HVAC systems, indoor air quality solutions, advanced controls, portable security systems, and remote home management products to homeowners in North America and South America. This segment offers its products under the American Standard, Schlage, and Trane brand names. The company’s Industrial Technologies segment provides compressed air systems, tools, pumps, fluid handling systems, and golf and utility vehicles. This segment offers it products under the Club Car and Ingersoll Rand brand names. Its Security Technologies segment provides electronic and biometric access control systems and software, locks and locksets, door closers, floor closers, exit devices, steel doors and frames, portable security devices, decorative hardware, and cabinet hardware, as well as time, attendance, and personnel scheduling systems. It serves commercial and residential housing markets; healthcare, retail, maritime, and transport industries; and educational and governmental facilities. This segment offers it products under the CISA, LCN, Schlage, and Von Duprin brand names. Ingersoll-Rand sells its products through distributors, dealers, and large retailers. The company was founded in 1905 and is based in Dublin, Ireland.

We added Juniper Networks today. Juniper is off 20% today and 50% in the last three months and we think that is enough punishment for a 5 pennies earnings miss this quarter.

(Yahoo/Finance) Juniper Networks, Inc. designs, develops, and sells products and services that provide network infrastructure used for the deployment of services and applications over a single Internet Protocol (IP) based network worldwide. The company’s Infrastructure segment provides routing and switching products that control and direct network traffic. Its products include IP routing and carrier Ethernet routing portfolio, and Ethernet switching portfolio comprising T-series, M-series, E-series, MX-series, and EX-series, as well as JCS, TX, and TX plus products. The company’s SLT segment offers firewall virtual private network systems and appliances, SRX services gateways, secure socket layer virtual private network appliances, intrusion detection and prevention appliances, the J-series router product family, and wide area network optimization platforms. Its products protect the network and data on the network, enhances existing bandwidth, and accelerates applications. In addition, the company provides Junos platform comprising the Junos Space network application platform and Junos Pulse integrated, multi-service network client, which enables its customers to expand network software into application space and deploy software clients to control delivery. It also offers various other services, such as technical assistance, hardware repair and replacement parts, unspecified software updates on a when-and-if-available basis, professional services, and educational and support services. The company sells its products and services through direct sales force, distributors, value-added resellers, and original equipment manufacturer partners to wireline, wireless, and cable operators; Internet content and application providers; businesses; federal, state, and local governments; and research and education institutions. Juniper Networks, Inc. was founded in 1996 and is headquartered in Sunnyvale, California.

Robert Reich has an interesting take on Standard & Poor’s ratings and debt ceiling Kabuki brouhaha:


If you think deficit-reduction is being driven by John Boehner or Harry Reid, think again. The biggest driver right now is Standard & Poor's.

All of America's big credit-rating agencies -- Moody's, Fitch, and Standard & Poor's -- have warned they might cut America's credit rating if a deal isn't reached soon to raise the debt ceiling. This isn't surprising. A borrower that won't pay its bills is bound to face a lower credit rating.

But Standard & Poor's has gone a step further: It's warned it might lower the nation's credit rating even if Democrats and Republicans make a deal to raise the debt ceiling. Standard & Poor's insists any deal must also contain a credible, bipartisan plan to reduce the nation's long-term budget deficit by $4 trillion -- something neither Harry Reid's nor John Boehner's plans do.

If Standard & Poor's downgrades America's debt, the other two big credit-raters are likely to follow. The result: You'll be paying higher interest on your variable-rate mortgage, your auto loan, your credit card loans, and every other penny you borrow. And many of the securities you own that you consider especially safe - Treasury bills and other highly-rated bonds - will be worth less.

In other words, Standard & Poor's is threatening that if the ten-year budget deficit isn't cut by $4 trillion in a credible and bipartisan way, you'll pay more -- even if the debt ceiling is lifted next week.

With Republicans in the majority in the House, there's no way to lop $4 trillion of the budget without harming Social Security, Medicare, and Medicaid, as well as education, Pell grants, healthcare, highways and bridges, and everything else the middle class and poor rely on.

And you thought Republicans were the only extortionists around.

Who is Standard & Poor's to tell America how much debt it has to shed in order to keep its credit rating?

Standard & Poor's didn't exactly distinguish itself prior to Wall Street's financial meltdown in 2007. Until the eve of the collapse it gave triple-A ratings to some of the Street's riskiest packages of mortgage-backed securities and collateralized debt obligations.

Standard & Poor's (along with Moody's and Fitch) bear much of the responsibility for what happened next. Had they done their job and warned investors how much risk Wall Street was taking on, the housing and debt bubbles wouldn't have become so large -- and their bursts wouldn't have brought down much of the economy.

Had Standard & Poor's done its job, you and I and other taxpayers wouldn't have had to bail out Wall Street; millions of Americans would now be working now instead of collecting unemployment insurance; the government wouldn't have had to inject the economy with a massive stimulus to save millions of other jobs; and far more tax revenue would now be pouring into the Treasury from individuals and businesses doing better than they are now.

In other words, had Standard & Poor's done its job, today's budget deficit would be far smaller.

And where was Standard & Poor's (and the two others) during the George W. Bush administration -- when W. turned a $5 trillion budget surplus bequeathed to him by Bill Clinton into a gaping deficit? Standard & Poor didn't object to Bush's giant tax cuts for the wealthy. Nor did it raise a warning about his huge Medicare drug benefit (i.e., corporate welfare for Big Pharma), or his decision to fight two expensive wars without paying for them.

Add Bush's spending splurge and his tax cuts to the expenses brought on by Wall Street's near collapse -- and today's budget deficit would be tiny.

Put another way: If Standard & Poor's had been doing the job it was supposed to be doing between 2000 and 2008, the federal budget wouldn't be in a crisis -- and Standard & Poor's wouldn't be threatening the United States with a downgrade if we didn't come up with a credible plan for lopping $4 trillion off it.

So why has Standard & Poor's decided now's the time to crack down on the federal budget -- when it gave free passes to Wall Street's risky securities and George W. Bush's giant tax cuts for the wealthy, thereby contributing to the very crisis its now demanding be addressed?

Could it have anything to do with the fact that the Street pays Standard & Poor's bills?


July 21, 2011

Model Portfolio Value As of 21 July 2011

$ 565,986

Comment on Model Portfolio activity

The S&P 500 held at 1330 support on Monday and the moves higher Tuesday and today with a pause on Wednesday is positive. With the S&P 500 at 1345 at the close today a move 1% higher move through 1355 in the next few days would be bullish according to the tech gurus.

Intel was cautious looking forward and INTC shares were lower this morning although earnings and sales beat. We added shares to accounts and also added more NVDA when it sold off on INTL comments on PC sales.

Huntington Bank beat but dropped and we took a position.

We also picked up shares in Walgreen which was down $2 on the big merger news in the pharmacy benefits management area. Walgreen’s contract with Express Scripts expires at the end of the year and traders are betting that WAG will be injured by having only one company to deal with. Our guess is that the FTC and Walgreen’s lawyers won’t let that happen.

Finally we repurchased Alcoa $1 lower than our sale price a few months ago.


July 19, 2011

Model Portfolio Value As of 19 July 2011

$ 554,066

Comment on Model Portfolio activity

We added to BankAmerica when it sold off on earnings and also reestablished a position in Goldman Sachs as it dropped on earnings. Finally we doubled the position in XLF that we established yesterday.


July 18, 2011

Model Portfolio Value As of 18 July 2011

$ 549,328

Comment on Model Portfolio activity

Portfolio value close of business 7/18/2011:  $549,328
(54.5% cash/45.5% equities)

(In the future the stock positions in the Model Portfolio will be adjusted at month end and the value posted only when we have a comment.)

We sold all our Aéropostale and a portion of Yahoo and reinvested approximately 60% of the proceeds in BankAmerica. We also repurchased a portion of the SPDR Financial at $14.54 that we sold last week at $15.08 and added to our KBE position 5% lower than our last purchases. The financials and banks are unloved and unwanted. There will be no recovery without them.

We also repurchased at $13.85 starter number of shares of Nvdia. We sold it last month at $17. And we added Ford Warrants at $4.40 that we sold last month at $5.30.

Below is commentary on current market conditions from a fellow who's calls have been right on the markets for the last three years.

Continued Earnings Beats Should Provide Downside Cushion for Equities
 Jeff Saut  7/18/2011

In last Monday’s missive I wrote, “So, my sense is that the S&P 500 (SPX) will spend a few sessions oscillating between 1320 and 1350 until the equity markets’ internal energy is rebuilt for a move higher.” Obviously, that view fell apart on the same day when the SPX closed below 1320 last Monday. Subsequently, there have been three attempts to recapture the 1320 level, all to no avail; that worries me. This year the 1320 level has proven to be an important “attractor/repellor” level. One can see that with a quick perusal of the charts. Accordingly, last week’s stock market action was not encouraging, at least not to me. It’s not that I have given up on the idea that the economic backdrop is about to improve despite last Friday’s disappointing sentiment figures -- I haven’t. Indeed, I think a lot of things are geared to go right once the debt ceiling crisis is resolved, which I can’t imagine will not happen. To be sure, the Japanese supply side disruptions are abating, as witnessed by last week’s numbers. Then too, crude oil prices have declined from~$115/bbl. to ~$97 as the world’s “mean men” seem to be falling like dominoes. Auto production is slated to ramp by 23%+ this month and capex should surge since the 100% expensing option goes away in 2012. Of course, a resolution of the debt ceiling crisis is likely going to be accompanied by a scaling back in governmental expenditures, which should give entrepreneurs and businessmen the belief that deficits are being tackled. As for the recent employment report, the June employment report is historically fickle. What you have is students leaving jobs taken while attending school and heading for home.

Weakness during job recoveries has happened before. In 2004, 2005 and 2006, which were the second and third years of prior recoveries, there were also monthly disappointments in job growth. Moreover, there were screwy seasonal adjustments in the recent employment data. For example, without seasonal adjustments, payrolls rose by some 376,000. Surprisingly, the government’s seasonal adjustments reduced the adjusted employment figures by an eye-popping 358,000. Further, the official employment numbers are in sharp contrast with the ADP employment report. Typically, when I am confronted with such conflicting numbers, I turn to the charts because in this business “price” is reality. So I pose the question, “If the employment numbers and the consumer sentiment numbers are so bad, why did the S&P Consumer Discretionary Index and the S&P Retail Index tag new all-time highs last week?” Surely, that’s a valid question and one worth consideration before one dismisses the U.S. consumer as totally kaput.

Over the past three weeks I have traveled through Europe (for two weeks) and spoken at Raymond James’ National Conference (last week). My message has been pretty consistent – I have been relatively optimistic on the equity markets, the employment situation, and the economy because of the explosion in corporate profits. In the real world, profitable companies hire and unprofitable companies fire employees. Manifestly, the way the world works is that profits explode, fostering an inventory-rebuild cycle. With the Inventory to Sales Ratio back down to the recession levels of 2008, it is reasonable to believe we will get some sort of kick to the economy from an inventory rebuild. That, in turn, drives a capital equipment cycle (capex), which should be enhanced by the aforementioned factors. When companies spend money on capex they typically begin to hire people and the economy improves. So why has job growth evaporated over the past few months? I continue to think it is because of temporary factors like Japanese auto part shortages, surging material and gasoline prices, the world’s sovereign debt debacle, and the weird weather.

Recall, it was roughly a year ago when I began talking about the potential for some really weird weather. At the time people dismissed me as another Joe Granville, who lost his stock market guru status by predicting an earthquake that would make Phoenix “beach front” property. Nevertheless, I opined that the La Nina weather pattern, combined with more volcanic ash in the atmosphere than anyone can ever remember, was going to give us a very cold/wet winter with weird weather that should foster droughts, floods, hurricanes, and tornadoes. The culprit driving the weird weather was a huge shift in the Hadley Cell Winds (see previous reports for an explanation), which were affected by said La Nina and volcanic ash. Subsequently, I recommended being “long” energy stocks. While I was laughed at by the folks in the Northeast and Midwest last summer, they are no longer laughing. Regrettably, while the La Nina pattern is going away, it will return this fall. Additionally, while there is little news coverage about another Icelandic volcanic eruption that is four times worse than last year’s Eyjafjallajokull eruption, Mount Grίmsvötn’s eruption has spewed 4x as much ash and chemicals into the troposphere as last year’s eruption. This is certain to cause a change to the northern hemisphere’s weather. Accordingly, expect a busy hurricane season with damage to oil/gas production facilities in the Gulf of Mexico. Currently, parts of the U.S. and China are being plagued by droughts, while other regions are experiencing floods and violent storms. Expect another very cold winter. Agricultural crop yields, especially wheat, should be affected negatively. Interestingly, the drought has caused Norwegian hydro-electric generation to be down by two-thirds with attendant investment implications. Also, the Rhine River (I was just there) is so low barges are operating well below capacity. All of this has major investment implications.

The call for this week: Last Monday proved to be a 90% Downside Day whereby 90% of the total volume traded came on the downside, while 90% of total points were likewise negative. Typically, 90% Downside Days are followed by rally attempts lasting five to seven sessions. Obviously, that wasn’t the case last week and it concerns me. Also concerning is the fact the often-mentioned 1320 level was violated, and despite the three separate rally attempts that were staged to recapture 1320, it was all of no avail. This brings us to this week, where 2Q11 earnings reports will be Wall Street’s focus. Worth noting is that of the 31 companies that reported last week, 74% of them beat estimates. Unfortunately, 15 of those “beating companies” rallied, while 17 declined. Still, if the number of earnings “beats” continues, it should provide some kind of downside cushion for equities, provided the debt ceiling “thing” is resolved. Also of note is that there are a host of technical “timing points” due this week. Accordingly, while we are disappointed, we have not given up on our bullish “call,” at least not yet. That could change, however, if the SPX breaks back below 1295.

Editor's Note: The above article was written by Raymond James Chief Investment Strategist Jeff Saut.

No positions in stocks mentioned.


July 15, 2011

Model Portfolio Value As of 15 July 2011

$ 552,610


July 14, 2011

Model Portfolio Value As of 14 July 2011

$ 552,283

Comment on Model Portfolio activity

With the failure of yesterday’s strong rally and the weakness of this mornings attempted move higher we decided to sell half our positions in Hewlett Packard, Ford, Cisco, Nokia, and GE. All the positions sold were large in relation to accounts. The markets just aren’t acting like they have found a bottom yet. The major measures are still positive on the year and may have to visit the negative side before the correction runs its course.

Often when the pain gets too great and we reduce positions the markets rally. This time our guess is that the ‘deficit’ media circus will continue to depress stocks prices. Negativity gets ratings and it does affect trader/investor psyches - including our own. And the politicians can stay in the limelight for the next two weeks by dragging negotiations out till the last minute.


July 13, 2011

Model Portfolio Value As of 13 July 2011

$ 555,978

Comment on Model Portfolio activity

Until the debt ceiling issue is settled the High Frequency Traders will control the markets. Of course we like it when they push prices higher but….

We sold The Talbots common and now only own the warrants which are worthless unless Trudy Sullivan can figure out how to sell clothes. We have 4 years for her to do this- unless she sells the company to get another bonus- if she can find someone dumb enough to buy it.

We also added KBE, the large bank ETF to accounts ahead of earnings by these banks over the next two weeks. We believe the markets can’t go significantly higher without the major banks- thus the reason for our purchase.

With the sale of XLF, the Financial ETF, yesterday the cash levels in accounts are more comfortable.


July 12, 2011

Model Portfolio Value As of 12 July 2011

$ 555,423

Comment on Model Portfolio activity

We sold the SPDR Financial for a scratch profit to replenish cash in accounts and added a few shares of Nokia. If the market bottoms here we will give up some gains but we want the cash as a cushion in case more work on the downside occurs before the Debt ceiling is raised when the politicians decide there has been enough pandering and grandstanding.


July 11, 2011

Model Portfolio Value As of 11 July 2011

$ 558,525

July 8, 2011

Model Portfolio Value As of 8 July 2011

$ 573,570

Comment on Model Portfolio activity

We switched Medtronic to Nokia and Ford.

The major markets indexes are down 1% this morning because the June Monthly Employment Report said only 18,000 jobs were created. 57,000 where created in the private sector and there was a loss of jobs in the public sector.

The Wall Street gurus can’t have it both ways. They want government to quit spending which means job losses in the government sector- while at the same time selling stocks when the Employment report shows a net loss of jobs because of job losses in the government sector.

The Kabuki Theater will continue with the deficit until a deal is announced that will kick the major budget cuts eight years down the road (it’s a ten year plan). There will be time for the Congress to adjust spending when that time comes.

See Krugman today:

Enjoy the weekend.

July 7, 2011

Model Portfolio Value As of 7 July 2011

$ 579,276

Comment on Model Portfolio activity

Dictionary.com word of the day

futilitarian \fyoo-til-i-TAIR-ee-uhn\, adjective:
Believing that human hopes are vain and unjustified.
Futilitarian is a satirical coinage from the 1820s combining "futility" and "utilitarian."
(As in many politicians seeking compromise for the good of the country as opposed to their individual needs for reelection.)

We repurchased part of our Nokia position lower after the dust of last quarters report has settled.


July 6, 2011

Model Portfolio Value As of 6 July 2011

$ 568,854

Comment on Model Portfolio activity

From http://seekingalpha.com/article/277936-american-eagle-outfitters-a-prime-buying-opportunity-for-value-investors?source=yahoo

American Eagle Outfitters: A Prime Buying Opportunity for Value Investors

                                                                Geordy Wang

Value investors like to look for good stocks that have fallen out of fashion with the market, and there is one such company today whose business is to remain very much in fashion. American Eagle Outfitters (AEO) is a clothing retailer that targets the 15-25 year old demographic of image-conscious young men and women in the United States. They currently operate three brands: heritage American Eagle, Aerie, which sells dormwear and intimates for women, and 77kids, a new concept designed for children 14 and under.

Along with Aeropostale (ARO) and Abercrombie & Fitch (ANF), American Eagle is one of the three players that form the triumvirate of so-called "teen apparel retail" in America, a label more apt perhaps for Aeropostale, who markets to teenagers exclusively than the other two, who also target older and more sophisticated consumers in their twenties.

Since its IPO in 1994, American Eagle's stock has been on a tear, reaching all-time heights in the $30s in 2007. Its story took a turn for the worse when the recession hit, consumer discretionary spending fell, and the company's profits followed suit, as it was forced to resort to heavy markdowns to clear its inventories. The stock dropped like a knife and never recovered, closing last week at a price of $12.99, a shadow of its former valuation. I believe that at this price point, American Eagle trades at a significant discount to its underlying value, and offers by far the best buying opportunity compared to its competitors today.

When looking for bargains in a depressed economy, we must first make sure that a company's decline in earnings can be attributed mostly to the cyclical downturn and not to any game-changing deterioration in the fundamentals. I believe this to be the case with American Eagle.

By evaluating its performance in contrast with that of its competitors, a clear pattern emerges. According to the average price points of their assortments, the big three teen retailers are ranked like so: Aeropostale at the bottom, with the cheapest clothes, American Eagle sandwiched in the middle, and Abercrombie at the top, with the most expensive threads. Since the economy's collapse in 2008, their respective financial performances inverted in relation to their prices as the consumer budget tightened. Abercrombie saw its same store sales decline by a whopping 28% over the next three years, American Eagle's fell 15%, and Aeropostale, as a countercyclical performer due to its low cost assortment, saw its comparables actually rise 23%.

More comparisons: Gap's (GPS) comps dropped 19%, Macy's (M) fell 5%, and Hot Topic's (HOTT) fell 9%. As a medium to high-priced retailer, American Eagle's decline was to be expected, and not outsized compared to the setbacks the industry as a whole experienced during the economic downturn. Though consumers have spent less money at its stores over the past few years, American Eagle's brand equity has not suffered materially: user reviews at social media site viewpoints.com awarded the American Eagle brand 4.39 out of 5 stars, and its denim business received an even higher score at 4.46. Reviews of individual stores at yelp.com generally range from 3 to 4.5 stars for American Eagle locations in the country's most populated cities. Its flagship store at Times Square received 4.5 stars, compared with 2 stars for rival Abercrombie & Fitch's Fifth Avenue flagship.

The three apparel retailers are similar in size as well as product offering: all three operate about a thousand stores in the US. However, their market caps are vastly different: Aeropostale trades for 1.4 B, American Eagle for 2.5 B, and Abercrombie for 6 B. Though it has the lowest market cap compared to the number of stores it owns, Aeropostale also operates much smaller stores, and on a per square foot basis, you're getting Aeropostale's 3.7 million gross square feet of retail space for roughly the same price as American Eagle's 6.4 million. Abercrombie is the odd man out here: though it has slightly more selling space, clocking in at around 7.7 million square feet, its market cap is more than double American Eagle's and more than quadruple Aeropostale's.

From the standpoint of trailing P/E, Aeropostale trades at slightly less than 8, American Eagle at about 16, and Abercrombie at over 33. During the course of my research, I've found no justification for the premium investors are being asked to pay for Abercrombie compared to American Eagle and Aeropostale, but I also don't believe the stock to be overpriced. As a cyclical company, Abercrombie's current earnings aren't reflective of its average expected earnings power, and in a rational market, it should trade for a higher P/E during a trough in the business cycle such as the one we're experiencing now. Instead of Abercrombie being overpriced, it seems that American Eagle and Aeropostale are bargains right now.

However, Aeropostale's seemingly good value is deceptive: as a countercyclical player, it will not benefit from an economic upturn nearly as much as its competitors (indeed, its earnings may even fall as the economy improves and consumers start buying up). Another concern: the company recently lost Mindy Meads, one of its co-CEOs who was responsible for a lot of the merchandising. Not one quarter later, Aeropostale's earnings got cut in half due to poor merchandising decisions, leaving investors with doubts about whether or not the company can stay on top of fashion trends without Ms. Meads. So that leaves American Eagle.

American Eagle's trailing P/E of 16 is misleading - last year's GAAP earnings were reduced due to one-time charges related to discontinued operations and a non-cash loss from the sale of its investments in auction-rated securities at a discount. Smoothing out these adjustments to account for the company's true earnings power, American Eagle actually trades for a trailing P/E of around 13. For a cyclical company that's been beaten down by the recession, and consequently is perfectly positioned to benefit enormously from an economic upswing, this stock is ridiculously cheap. Peter Lynch has said that he likes to buy cyclical stocks at high P/Es during a down cycle and sell at low P/Es during an up cycle - American Eagle, at the price it's trading for today, represents the rare opportunity to buy a cyclical stock at a low P/E during a down cycle.

There's no reason for a company to sell for so cheap unless its fundamentals have deteriorated, and American Eagle remains a fundamentally strong company. It has a fortress balance sheet, with over $600 million in cash (25% of its market cap) and practically no debt. The strength of its financials is particularly impressive considering the company's conservative accounting practices - for example, it depreciates its buildings over 25 years instead of 30-40 years like many of its competitors, and equipment over 5 years instead of 10 years. This may be one of the reasons why the company's total free cash flow over the past three years is 40% higher than their total earnings over the same time period.

American Eagle's strong financial position gives it the freedom and resources to capitalize on its growth opportunities, of which it has several. Though its main brand is reaching maturity in the US and 77kids is still being run through the preliminary trials, Aerie has proven to be a successful concept that can stand on its own, and with only 150 stores across the country, it has a lot of space to grow into. American Eagle is also beginning an aggressive international expansion program, with five successful stores in Dubai, Kuwait City, and Hong Kong and more to come.

Unlike its stores at home, its international stores operate under a franchise model, which requires no capital investment for the company and supplies a continuous revenue stream with much higher margins than their domestic business. These signs all point to one conclusion: American Eagle is poised to make a significant turnaround when economic conditions improve, and as such, its shares are remarkably underpriced today.

Company insiders agree - in the past six months, insiders have acquired more than half a million shares, and sold only forty thousand. Two of the biggest buy orders year to date came from director Jay Schottenstein, who bought 500,000 shares last September, and director Michael Jesselson, who bought over 100,000 shares at around the same time. These weren't option exercises - these two insiders spent a combined $8 million of their own money on open market purchases.

What's more interesting is that these guys aren't your typical insiders. Schottenstein, who previously served as CEO of American Eagle for ten consecutive years, knows much more about the company's operations than your run-of-the-mill director. Jesselson is a seasoned investor himself, and runs New York investment company Jesselson Capital Corporation. All their shares, as well as shares bought by a number of other insiders, were acquired at a price higher than the price American Eagle is trading for today.

Charlie Munger has said that it's important to always invert, or to look for reasons why you shouldn't buy a stock when you're analyzing it. No investment opportunity is perfect, and American Eagle is no exception. Its management, though more than adequate, isn't stellar. While the company never posted a quarterly loss during the recession, which is admirable in its own right, competitor Gap actually managed to increase its earnings every year during the economic downturn, in the face of declining revenues. However, Gap is the exception, not the rule, and it has its own set of problems to deal with, though inefficient management isn't one of them.

American Eagle's management has since recognized the drag their bloated SG&A is taking on their bottom line and has begun to initiate cost-cutting initiatives. Though some weight has been shed from their operating expenses in the last few quarters, only time will tell how effectively they can execute on this strategy in the longer term. Another thing to watch for: management has recently indicated that they're monitoring about 100 underperforming stores across the country and evaluating the possibility of closing some of them down over the next five years in order to clean up the company's operations. The impact this move will have on the company's bottom line remains to be seen.

When performing an equity analysis, the conservative investor should make cautiously optimistic projections for the upside and forecast the downside as pessimistically as possible in order to retain a margin of safety. Even under such a scenario, I believe American Eagle Outfitters to be a prime buying opportunity for value investors at today's prices. With an unassailable balance sheet, great brand name, and profitable opportunities for expansion both at home and abroad, the company is poised to witness a massive rally in its shares when the broader economy picks up. And with a 3.4% dividend yield, investors can afford to wait until it does.

Disclosure: I am long AEO.



Hewlett-Packard: A Mean Reversion Strategy for Patient Value Investors

                                                Tom Armistead

Hewlett-Packard (HPQ) makes a lot more sense if you temporarily tune out the market, the analysts and the commentators and consider the phenomenon of mean reversion. Mean reversion isn't infallible, but over any substantial period of time it's a force to be reckoned with. In HPQ's case, the probability of mean reversion is enhanced because management has correctly identified the company's issues and is in the process of resolving them.

Mean Reversion - The Numbers

Projected 5 year average EPS, using 4 years actual plus revised GAAP guidance of 4.17 for 2011, works out to 3.79, after adjusting for the fact that share counts have been decreasing at 4% per year. Over the past five years, which include the financial crisis, HPQ has traded at an average PE5 of 19.8, very close to the 20 that is typical for high quality. At recent prices in the 37 area, the company is trading at a multiple of 9.8 on that metric.

As a point of reference, Benjamin Graham recommended that conservative investors should not pay more than 15 X some long term average EPS, either 5 or 7 years. I've had good results working with this rule of thumb, typically buying at or below 15X and selling around 20X. For cyclical or lower quality companies 12 X is more appropriate.

Applying a multiple of 15 to projected 5 year average EPS, I arrive at a mean reversion target of 15 X 3.79 = 57, by the end of 2012. From a price in the 37 area, that implies an annual return of 33%, to which could be added a 1.3% dividend.

Issues and Opportunities

Hewlett-Packard has issues (most value candidates have issues), however the company also has opportunities. The analytical task is to determine whether management has identified the issues and opportunities, developed a plan to address them, and marshaled the resources to implement the plan.

CEO Léo Apotheker's prescription for Hewlett-Packard has been evolving as he becomes more familiar with its operations. His initial approach, as reflected in the letter to shareholders (with the 2010 annual report) was "steady as she goes." By the time of the HP Summit presentation on 3/14/2011, he was presenting a common-sense, broad-brush approach, and focused on the opportunities:


Optimize traditional environments

Build and manage cloud-based architectures

Enable seamless transition to hybrid models

Define and deliver the connected world from the consumer to the enterprise


The FQ2 2011 earnings conference call, preceded as it was by a leaked email to senior management, highlighted two problems:

Some members of senior management were not on board for the planned strategy (the reason for the leak).

Revenues, margins and earnings are not developing as expected.

There has since been a management shakeup, and individuals reporting directly to Apotheker can be expected to stay on the same page.

On the more complex issue of revenues, margins and earnings, discussion can be interpreted to indicate that necessary investments (to include personnel) in the Services segment were not made. Hewlett-Packard needs to have additional resources in place to provide what customers are asking for. This is entirely consistent with the big picture evidence provided by examining the EDS acquisition and its aftermath.

Briefly, EDS was a sinking ship when acquired; revenues were declining and the company operated at a loss. Revenues for the last full year were 22 billion, but when added to HPQ's 2008 revenue of 104 billion, the result was 2010 revenue of 114 billion. HPQ was profitable during this period, which included the financial crisis.

The EDS business was predominantly services. It is easy to envision a meat-cleaver approach to cost-cutting and restructuring the struggling acquisition. It is possible that muscle and bone were cut, in addition to the fat. The discussion of "investment" simply highlights the obvious, that resources must be available to meet customer demand.

Investment Defined

"Investment" ordinarily refers to the expenditure of money to acquire assets, preferably tangible, along the lines of capex. From a bookkeeping point of view, you credit (decrease) cash and debit (increase) assets.

However, entrepreneurial management will sometimes use the word in a different sense, where the investment takes the form of expenditures on hiring, sales salaries, research and development, etc. The bookkeeping is, you credit (decrease) cash and debit (increase) expenses. This has the effect of reducing reported earnings. It's not really all that popular on Wall Street.

The conference call includes many instances using the word in its second, less acceptable sense:


We continue to make investments in the business with new innovations and incremental R&D spending.

Second, we will accelerate portfolio investments in higher value-add services. We will deepen industry content and form a Business Solutions Group to create more strategic value for our customers. We will enhance our Services offerings in emerging areas, such as cloud services and consulting, application modernization, business analytics and mobility.

Total operating expenses were $4.2 billion, up 10% year-over-year, with increases in R&D and field selling costs, both of which are expected to enable revenue growth in coming quarters. As we have said before, we actively monitor and evaluate all investments against key milestones as we work to achieve our objectives and deliver results for shareholders.

In Q3 of fiscal '11, we expect Services margins to be 13.5% to 14% as a result of lower revenue growth in local currency, unfavorable mix and investments we are making to further enable higher-margin business.


Industry Growth Rate Favorable

Research firm Gartner, a respected source of industry information and estimates, has increased their 2011 estimate for tech spending, from 5.6% to 7.1%. Hewlett-Packard is an important force in the industry and can be expected to participate.



Apotheker is correct in his diagnosis: Investment is required. Margins will be reduced, hopefully on a temporary basis, until revenue ramps to cover expenses. Hewlett-Packard has the financial resources to implement this corrective action. Internal impediments to constructive solutions have been addressed. When the appropriate human and technological resources are in place HPQ will participate favorably in expected industry growth and regain lost stature.

Obviously this conclusion must be verified by future performance. The investor can monitor presentations and conference calls on a regular basis, looking for evidence that the appropriate actions are being taken. Earnings, for the short term, are secondary. Remember, these investments will be booked as expenses.

An analyst meeting is planned for September, at which point management can be expected to have some visibility into FY 2012.

Strategy for Investors

With a 1.3% dividend, strong balance sheet, steady reduction of share count, and corrective action in process of implementation; the stock is suitable for patient value investors, based on a mean reversion strategy. As discussed earlier in the article, corrective action needs to be monitored for implementation and efficacy. ….


…….Disclosure: I am long HPQ Jan 2012 32.0 calls, short HPQ Aug 2011 41.0 puts and HPQ Nov 2011 35.0 puts


July 5, 2011

Model Portfolio Value As of 5 July 2011

$ 570,304

July 1, 2011

Model Portfolio Value As of 1 July 2011

$ 574,151


We plan on being in business for at least the next twenty years and with this in mind we are changing the frequency and content of our internet posts. We will maintain our concentration on market activity while we simplify our business day. We have been writing about the markets for 27 years - on a daily basis for 12 years - and giving investment advice for 45 years. Our guess is that while we haven’t seen and said it all we are pretty close to having exhausted any new words of wisdom we might wish to convey. Markets don’t repeat but they do rhyme. By not posting dally we will be freed up to do some summer/winter activities such as gardening/snowshoeing, riding our horses, walking the dogs and spending a bit more time with the prince and princess when they visit. And so we are going to end our lengthy daily comments but we will continue to post periodically when market events warrant and/or when there is activity in the Model Portfolio.




















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Summary of Business Continuity Plan

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