Friday, December 26, 1997
DJIA:          7679.31  +19.18     (+0.25%) 
S&P 500:        936.46   +3.76     (+0.40%) 
Nasdaq:        1511.38  +11.85     (+0.79%)
30-Year Bond  103 4/32   +3/32  5.90% Yield


United Federal Savings Bank (Nasdaq: UFRM) gained $4 to $21 after it agreed to be acquired by Triangle Bancorp (Nasdaq: TRBC) of Raleigh, N.C., in a stock deal valued at $72 million, which is roughly 3.5 times United's book value. United Federal is being priced at $22.05 a share in an acquisition that will expand Triangle's presence into Rocky Mount, Cary, and Sprint Hope, North Carolina. The tax-free transaction is expected to close in the third quarter of 1998 and will be accounted for as a pooling of interests.

Branded clothing company Cherokee Inc. (Nasdaq: CHKE) gained $1 1/4 to $14 5/8 after announcing on Christmas eve that its board had given itself and shareholders a present -- a cash distribution of $5.50 on its common stock payable to holders of record at the close of business on January 2. However, the majority of the distribution represents a return of capital (unrelated to retained earnings), coming from the proceeds of a $48 million "securitization" in which Cherokee issued notes backed by its licensing agreement (to 2004) with Target, a unit of Dayton Hudson (NYSE: DH).

After posting strong sales this holiday season, apparel retailer American Eagle Outfitters (Nasdaq: AEOS) gained $3 13/16 to $33 5/16 today. In November, the mall-based specialty retailer of casual shirts, chinos, denim jeans, flannel shirts, T-shirts, shoes, and accessories increased its comparable-store sales by 20.1%.

American depositary receipts (ADRs) of a number of Korean firms rose higher today after the South Korean market rebounded, rising 6.74% overnight (as measured by the Korea Composite Index). South Korea agreed to virtually wipe-out all restrictions on foreign investment in Korean financial markets, keep interest rates high to attract money and cap inflation, and firmly implement earlier reforms agreed to under the bailout package -- all in return for faster disbursement of the nearly $60 billion in bailout loans. Sk Telecom Co. (NYSE: SKM) rang $3/8 higher to $6 5/16; Korea Electric Power Corp. (NYSE: KEP) was energized $7/8 to $11 1/4; Korea Fund (NYSE: KF) rose $1/2 to $6 3/4; and Korean Investment Fund (NYSE: KIF) gained $5/16 to $4 1/16. Pohang Iron & Steel (NYSE: PKX) also hammered out a gain of $1 1/8 to $18 11/16.

Nanophase Technologies Corp. (Nasdaq: NANX) gained $4 3/4 to $14 1/8 after the maker of nanocrystalline materials was rated a "strong buy" at CIBC Oppenheimer with a 12-18 month price target of $15. The company develops and markets ceramic and metallic materials with particle sizes measured in nanometers (billionths of a meter), which are used in such applications as semiconductor polishing, high-performance electrodes, ceramic mechanical seals, and medical device housings, as well as sunscreens and cosmetic colorants.

A number of Japanese ADR's gained today as well. Japan's premiere car maker, Toyota Motor Corp. (Nasdaq: TOYOY), rose $1 7/8 to $56 3/8 after the car-maker announced that it intends to spend $352.3 million to boost its ownership stake to 50% in Japan's third largest cellular phone company, Nippon Idou Tsushin Corp. Tokio Marine & Fire Insurance Co. (Nasdaq: TKIOY) shot $3 5/8 higher to $55 5/8 after analysts made positive comments about the earnings power of Japan's largest non-life insurer.


A number of analysts' downgrades hurt companies today. Fitness and nutritional supplements purveyor Weider Nutrition International (NYSE: WNI) slimmed down $1 1/4 to $11 1/2 after the company was downgraded to "outperform" from "buy" at Salomon Smith Barney. New Jersey Resources Corp. (NYSE: NJR), an energy services company, dropped $1 to $38 15/16 after A.G. Edwards downgraded the company's shares to "maintain position" from "accumulate."

An Investment Opinion by Randy Befumo

Valuation Matters

Valuation continues to get the short shrift these days as investors stress momentum and the "story," more often than not a set of overly optimistic assumptions about the future. Listening to some investors you would think all that is necessary for outsized returns is to invest in proven winners over the last few months no matter what the price as long as the future looks bright enough. A quick tour of the Best and Worst Stocks of 1997 suggests that this bright-eyed optimism may be exactly the sort of thing that lands you in a big loser, not a big winner. As for what the winners had in common, almost to a stock they came dirt cheap last January and became less cheap as the year went on.

The biggest winner of the year, hands down, is Jackson Hewitt (Nasdaq: JTAX). The second-largest tax preparation company in the world, Jackson Hewitt had the distinct advantage of starting out its incredible 1527.44% increase from a low valuation. At the beginning of calender 1997, Jackson Hewitt traded at $4 3/4, which was 0.85 times sales and 9.7 times trailing earnings. To put this in perspective, at that time the S&P 500 Index was trading at about 2.5 times sales and 20 times trailing earnings. There appeared to be nothing funky as far as the quality of earnings that company was generating. A look at the statement of cash flows, given that Jackson Hewitt is a franchise business that has very little in the way of fixed costs to consume the earnings dollars, confirmed that the earnings dollars were not being consumed behind the scenes on spending for plant, property and equipment. Finally, the balance sheet had more cash than debt and the company had positive working capital.

Now, it is not as if Jackson Hewitt was the proverbial no-brainer. Certainly the company did not necessarily present the best picture on the first trading day of the year as far as the underlying business went. The prospects of tax reform destroying its business were only just fading into the background. The liquidity crunch that hit the company in late 1995 that caused it to be in technical default on short-term credit facilities had disappeared, but there was no real indication that the problem would not return. Sales growth was fine, but there were still enough question marks to make investors discount a heck of a lot of risk into Jackson Hewitt's share price, pushing the valuation to the low levels described above.

Although there were some business risks present at the beginning of 1997, they were the cause of the excess returns. The 1527.44% gain Jackson Hewitt gave to investors came as a result of the picture changing while the stock had a very low valuation on an absolute basis. If Jackson Hewitt had started out at a higher valuation, it would have diminished the returns by that much. Had Jackson Hewitt been trading at the same level of the S&P 500 going into the year, for instance, the 1527.44% gain would have been at least cut in half. Surprising though it may seem, very few companies with ultra-low valuations come without some degree of business risk.

It is the perceived business risk that causes investors to push down stock valuations down to compensate. In doing this, investors remove the other big risk inherent in buying a stock -- the risk of paying too much. In fact, as the valuation gets lower and lower, you actually see the valuation risk disappear and find yourself in a situation where the downside is minimal but the upside may in fact be amazing. In the case of Jackson Hewitt, continuing to grow revenues and doing a secondary offering to end liquidity concerns forever convinced investors to re-evaluate the business and slap a higher valuation on it. Those who bought the stock while the valuation was low were the ones who made the most money.

On the other side of the equation, buying at a high valuation is often the kiss of death. The best case scenario is that the company does well and you get a market return. The worst case scenario is when you have company like TriTeal Corp. (Nasdaq: TEAL), whose business starts to fall apart after it crests at a high valuation. TriTeal sold for 6.5 times profitless sales when it came public and actually peaked at 17.4 times sales when it made a few pennies per share in the fourth quarter of 1996. Coming into 1997 with a valuation of 17.4 times sales, the company was an accident waiting to happen. Although it was not certain that the fatality would occur, the higher the valuation spiraled the more likely it was that the company could not live up to expectations and deliver the cash flows that the share price indicated investors were expecting. Investors who bought at 17.4 times sales lost their shirts, seeing the stock declining a shocking 93.3%.

Although buying at a low valuation does not guarantee excess returns and buying at a high valuation does not mean you will lose everything, these two extremes indicate a central tenet of investing that many investors ignore at their own peril. Valuation matters. When you pay an extraordinary price, you have to have a company that has extraordinary performance to make money. When you pay a dirt-cheap price, even a moderate business performance can given you a decent return. Finally, when you have a company that is dirt cheap where the business does extraordinarily well -- normally factors that in retrospect seem obvious -- you have a stock that will rise a couple of hundred percent in a year and create some millionaires. Next year investors should strive to remember this as they are sucked into the latest hot stock in the hopes of catching a big winner, and realize that the big winners of 1997 -- and most other years -- were actually companies whose valuations were low going into the year.


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Randy Befumo (TMF Templr), a Fool One

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