I, the author of The Curious Investor, am currently long Apple stock. In fact, it makes up nearly 10% of my personal portfolio. In my apartment are multiple Apple products including several iPhones, several iterations of the iPod, a MacBook, and an Airport Express. I believe Apple is more than just a trendy consumer products maker and that the iPhone truly represents a new growth engine as the world embraces mobile computing. As an investor, however, I understand that stocks do not only move in one direction. Valuations will overshoot and undershoot true value in the short term and a prudent investor must be aware of this and make decisions with this phenomenon in mind. It is possible for a great company to possess a not very great stock valuation (see: CSCO circa 1999-2000). So, please, leave your hate mail unsent.

Take a look at the chart below:

Apple’s stock gapped up through the psychologically significant barrier of $200/share following Apple’s earnings announcement last Monday. A headline related pop typically signals a breakaway gap, a stock gap which is typically followed by a continuation but, in this case, Apple’s gap was more suspicious. While related to good news, Apple’s Q4 2009 (FYE 9/26) results were not so much of an upside surprise as previous quarters and investors all but dismissed another characteristically conservative guidance. Moreover, volume doubled prior to the gap up and remained elevated during the stock’s near immediate fall over the last five trading periods, a tell tale signal of an exhaustion gap.

Exhaustion gaps are defined as stock price gaps which follow in the direction of the prevailing trend. A textbook exhaustion gap should be followed by a reversal soon after the gap and then move to fill the original gap. A reversal is confirmed when the gap is filled and price breaches the level prior to the gap.

I realize that I may be early to call this reversal. After all, technical analysis is not clairvoyance. Trends and reversals must be confirmed through chart movements as opposed to “predicted” by the apparent formation of patterns. Traditional technical analysts will always miss the exact top or bottom of a price movement in preference to investing with the certitude of a confirmed trend or reversal. As such, it would seem that the seeming formation of an exhaustion gap here is just a red flag. Apple’s stock has yet to fill the gap, but it has breached the initial gap and looks to be on its way to filling the gap. If so, could it be possible that the Company’s stock is headed for a reversal of its uptrend? Or, possibly entering a consolidation period following an aggressive upward move? If so, it may be time to take some gains off the table and wait for a re-entry point.

Full disclosure: Author is currently long shares of AAPL.

On Monday, a major shakeup was announced within the BDC industry. Ares Capital (ARCC), one of a few BDCs which has managed through the recession while maintaining a substantial dividend, announced that it was acquiring a former giant of the industry, Allied Capital (ALD). The acquisition is expected to be an all-stock deal where ALD shareholders will receive 0.325 shares of ARCC for each share of ALD they own.

ALD, which had breached the asset coverage covenants on its debt, has not been able to pay a dividend since the third quarter of 2008. Allied, in fact, has taken almost a year to restructure its debt agreements leading its auditors to issue a “going concern” warning in its 10Qs in each of the last few quarters. While concerns regarding the Company’s debt agreements has weighed down the stock’s value, the Company’s net asset value per share was reported as $7.49 on June 30, 2009 which includes serious write downs taken by the company over the last year.

Why then does the stock trade at 43% of NAV/share? For one, questions about the Company’s continued ability to access financing make it difficult to handicap whether or not Allied will ever have the luxury of time to “wait” for its investments to mature and be refinanced. In fact, pressure to de-lever has already forced the Company to make hundreds of millions in distressed investment sales over the year. Further, the Company has a history of questions being raised over the quality of Allied’s investments and its methodology for establishing fair value for its reporting. (See David Einhorn’s Fooling Some of the People All of the Time)

With all these headwinds facing the Company and the difficulty that the average investor would have verifying the Company’s portfolio quality, Allied was more likely a value trap than a good value investment even at <45% of NAV. But, all that has changed now that Ares Capital has decided to swoop in and acquire Allied. Ares Capital Corporation is one of few BDCs which has weathered the recent recession without having to suspend its dividend and has not seen outsized portfolio market value depreciation. Further, it is managed by Ares Management, a distant descendant of Leon Black’s famed private equity shop, Apollo Management. While a good investor should always do his own due diligence, Ares’ vote of confidence likely goes a long way to provide an investor some comfort with Allied’s current stock valuation.

Further, given Allied’s troubles securing affordable financing and continued  portfolio difficulties, Allied has little incentive not to close this transaction (though some shareholders seem to disagree). As there’s a high likelihood of completion (currently expected to close 1Q 2010), there seems to be a quasi-arbitrage opportunity presented by ALD shares and value investor’s dream opportunity to enter into ARCC shares.

As mentioned above each ALD share will be exchanged for 0.325 shares of ARCC. ARCC and ALD closed today at $10.61 and $3.20, respectively. As such, if the deal were completed today, ALD shareholders should receive the equivalent of $3.44 per share in ARCC stock which implies that ALD is currently trading at a 7.75% discount. Now, if you’re not interested in investing in the BDC space and simply would like to take advantage of this pricing irregularity, you could buy ALD and short ARCC and simply wait to pocket the spread – a “riskless” arbitrage of this merger. (Caveat being that if the merger falls apart the whole these blows up in your face.)

But, I believe that ALD’s current discount is even more compelling from a value standpoint. By my estimates based on June 30, 2009 reporting, the combined Allied and Ares should have a net asset value around $15.30/share. At today’s $10.61 closing price, Ares is trading at just 70% of combined entity NAV and at 95% of its own reported NAV of $11.05 (post a recent dilutive share offering). This would seem a pretty good discount for a BDC which has proven its ability to manage through a very difficult market environment and a demonstrated ability to access financing, the key trait necessary to realize value from Allied Capital’s portfolio.

But, you don’t have to settle for ARCC’s discount to NAV. As mentioned earlier, ALD trades at a near 8% discount to its conversion price. So, by just purchasing ALD shares today, you can enter ARCC at a below market value discount at a significant discount simply for taking on 6 months of risk as the merger approaches its closing. Is it worth it? More diligence probably needs to be given to Ares’ debt portfolio, but I would say on the surface ALD shares have gotten significantly more appealing.

Full Disclosure: Author has no position in the stocks mentioned in this post.

The Mobile Productivity Device
In my post on the Apple Tablet, I talked about my image of the perfect mobile device being shaped by the viral Microsoft Origami Project videos circa 2006. Well, leave it to Microsoft to drop yet another follow on which I think once again targets my mobile productivity desires – the Microsoft Courier.

E-mail, a quick and simple input system, and a large enough format for reading larger amounts of text, editing pictures, and watching videos. It’s just the type of device I’d like to add to my tech tool belt.

Apple’s Media Tablet
It seems that recent rumors show Apple to be taking a slightly different tact with regards to the tablet. According to iLounge, the Apple Tablet is slated to be, for all intents and purposes, a large format iPhone. It will run iPhone OS and is meant as a slate-like replacement for books and magazines with the added functionalities of an iPhone.

Should this be written off? Well, I don’t think it’s as powerful or as compelling a consumer product as the Courier (which is no where near production ready). But, this product does seem to fit Apple’s business model very well. They’ve struck gold once with a personal media player and content ecosystem (iPod + iTunes) and e-reading has gained much more momentum through the release of Amazon’s Kindle. With an increasing amount of browsing and video watching being done on iPhones, maybe a large format device is just what the doctor ordered. Further, Apple will have the benefit of being able to add more content for sale through its iTunes distribution channel.

Granted, there’s no news on an input system, and if it is through a on-screen keyboard, this device will be severely handicapped from a productivity standpoint. At a $700 price range, I just don’t know that I’d be interested in purchasing such a piece of hardware.

So, now it’s your turn! What do readers out there think? Which product would you like better? Do you see more potential in one approach versus another?

What is your economic forecast for 2010? Are there specific economic markers that you find particularly useful and upon which you rely on in making your prediction?

From my perspective, the United States economy for the last decade has serial bubbled its way to the illusion of wealth. First the internet bubble and then cheap credit financing a housing bubble lined the American consumer’s pockets with a seemingly endless growth in wealth. Now, without the benefit of another asset to quickly inflate, it would seem that we’re facing a longterm retrenchment of the consumer as he begins to realize that the last ten years of “wealth creation” may have been quite illusory. To make matters worse, declining consumer demand and tightened credit markets have pushed unemployment rates to new highs further burdening the consumer. To me, any real sustainable turnaround in our economy will have to be lead by a sustainable growth in demand from the American consumer and for this to tangibly affect the “real economy.” That is the provision of tangible goods in the United States as opposed to our tail-wagging-the-dog reliance of financial services as an engine for growth. In the above graph, we see a decided inverse relationship between U.S. Manufacturing Capacity Utilization versus the Unemployment Rate. Now, this may be a little bit of chicken or the egg, but it’s clear to me that the linchpin of any sustainable economic rebound will be a rebound in real production through manufacturing. Increased capacity utilization improves employment, spurs new investment which in turn spurs finance, and thus feeds the demand for corporate services and other “soft” services in the industry. So, how will we know that we’re on solid footing again? I believe that close attention must be paid to three statistics compiled by the economic census – manufacturing shipments, orders, and inventories. In the above graph, quarter-over-quarter inventory growth clearly mimics and leads manufacturing capacity utilization. Admittedly, the link to inventories does not seem predictive enough for those of us hoping to get ahead of the rebound. My proposal is to use a metric derived from the census orders and shipments data which I call national book to bill. For those unfamiliar with book-to-bill ratios, it is the number of orders in a company’s order book versus the number of orders filled in a given period. Typically used in the technology sector, this number gives us an idea of whether or not there’s sustained demand for a company’s supply. Similarly, we can create such a metric based on census numbers by dividing new orders by shipments. Book-to-bill ratios greater than 1.0 imply order demand in excess of supply and less than 1.0 imply insufficient demand. Above, we see book-to-bill graphed against quarter-over-quarter change in inventories between 1997 and 2009 which incorporates both bubbles. First and foremost, we see the beginnings of a deterioration between book to bill leading inventory accumulation. Instead, particularly between 2003 and 2005, inventory accumulation begins to lead the book to bill ratio. To me, this is a tell tale sign of unsustainable growth through “inventory stuffing” – the build up of inventory due to euphoric projections of the future. Most recently, we see book-to-bill making a small turn ahead of the bottom in inventory growth and could well signal that we’ve reached the bottom for our current cycle. Obviously, in my mind, we will not be truly in the clear until the “national book to bill” ratio improves above parity (1.0) and along with it comes increased plant capacity utillization and employment.

So, for those that know a little about probability, there are (56C5)*46=175,711,536 different permutations of numbers that you can choose. Rather than go through all the probabilities of winning, the lottery actually publishes its own listing of probabilities to help you out. Check it out below:

So, knowing these probabilities, let’s calculate expected values. Expected values are calculated simply by multiplying the expected result by the probability of it happening. Here’s how we would do it for playing the Megamillions.

1. Subtract $1 from all the payouts listed in the above table (the cost of playing)
2. Multiply each payout by the probability of it happening and sum them
3. Calculate the probability of not winning anything (1-sum of the probabilities of winning)
4. Multiply the probability of not winning by -$1 (the cost of playing)
5. Add this to the result from Step 2

At a $252 million jackpot, the expected value of buying a lottery ticket is $0.61. That means that if you spend $1 to buy a ticket, you can expect to see a return of 61 cents, or less than you “invested” in the game. Probabilistically, it’s entirely not worth it to play.

What would the jackpot have to be to make it “worthwhile” to play? Backing into an expected value of $1 for playing yields a target jackpot of $320 million.

Obviously, the above scenarios ignore two important facts. First, you face taxes on any money you win (except winnings <$600 which you can get in cash at your local convenience store and probably not report… not that I advocate not paying your taxes…). Second, the “lump sum” jackpot is usually approximatly 40% less than the headline jackpot number. So, the real “breakeven” expectation jackpot is more like $904 million!

So, let’s bring this back to some practical lessons for investing. First and foremost, “rational” investors should never play a game that has an expectation below the amount you pay to play. Yet, somehow, the record Megamillions jackpot is $365 million. Thus, it would seem there’s a large amount of people out there willing to play the game well before any rational expectation of winning, let alone a miniscule probability of winning the jackpot. If so many are willing to spend even a dollar on the lottery, how are we so sure that capital markets are efficient!?

Arguments against popularly held market theories aside, it’s clear that people are irrationally willing to play games of chance. If this is true, then might this point us to an interesting investment thesis? Why not invest in purveyors of games of chance? Casinos and gaming is a massive industry and there are many publicly traded options available. Publicly traded casino operators include MGM Mirage (MGM), Wynn Resorts (WYNN), and Las Vegas Sands (LVS) all trade publicly. Some racetrack and slot machine operators are publicly traded as well like Churchill Downs (CHDN), Penn National Gaming (PENN), and Empire Resorts(NYNY). Then, there are the Companies which supply these gaming operators – International Game Technologies (IGT), Bally Technologies (BYI), and WMS Industries (WMS).

Or, you could just go after investments in all things vice – gaming, tobacco, and firearms – as described in my article from February of last year – Indulge Your Vices.

Full disclosure: No positions in any of the stocks mentioned in this post.