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Last week Edward Jones said that it will stop selling leveraged ETFs. This Monday UBS (UBS Wealth Management Americas)  announced that it has suspended the purchase of leveraged and inverse ETFs for its wealth management clients. Both firms cited the short-term nature of these securities as a reason. The State of Massachusetts has also launched an investigation into the leveraged ETFs. These ETFs have also received a lot of flak from the regulatory agencies like SEC and FINRA. They all say the same thing – these are for sophisticated investors only and they are not long-term investment vehicles. My question is, what made anyone think that these ETFs should be used for long term investing?

These companies have detailed brochures which outline the risks associated with leveraged ETFs. If you glance at their website, or even search for these ETFs, you will find ample details about the high risks and the short-term nature of these ETFs. The websites of Proshares, Direxion and Rydex have listed the disclaimers on their website as well. They clearly state that they seek DAILY investment result of 200% or 300% investment of the price performance of the Index they follow (or it’s inverse in the short ETFs). I am still not sure about certain allegations regarding these ETF companies trying to mislead investors hold any truth. They are not forcing anyone to invest in their products. The bottom-line is that long-term and ‘buy-and-hold’ investors should stay away from these investments or be clear about the risks they carry. They should preferably be used by sophisticated investors and day traders.

It’s very important to understand the concept of “daily performance” for these ETFs. Let’s take an example of FAS. FAS is a triple leveraged (3x) product from Direxion. FAS seeks daily investment results of 300% of the price performance of the Russell 1000 Financial Services Index. Now YTD, the Russell 1000 Financial Services Index is up 2.1% thanks to the nice rally in Financials after the March 09 lows. This does not mean that FAS would be up 6.3%. In fact, FAS is down a staggering  63% YTD. Let’s look at an inverse ETF – SDS. SDS is a product from ProShares that seeks daily investment results that correspond to twice the inverse daily performance of the S&P 500 Index. If you see the 52-week performance of S&P 500, it’s down 20%. If that leads you to think that SDS should be up 40% (twice the inverse), you might be in for a bit of a shock. SDS is actually down 32%. That’s the reason for the stress on ‘Daily Performance’. If you look at the daily performance of these leveraged and inverse ETFs, they are fairly close to the indices they track and that’s their intention as well.

During the market crash last year, inverse ETFs like SKF (ProShares UltraShort Finance), SDS (ProShares UltraShort S&P 500), BGZ (Direxion 3X Bear Russell 1000), DXD (ProShares UltraShort Dow 30), FAZ (Direxion 3X Bear Russell 1000 Financial Services), SRS (ProShares UltraShort Real Estate) and others were very popular. At the same time their leveraged counterparts (UYG, SSO, BGU, DDM, FAS, URE) lost tremendous value because they were performing twice or thrice as worse as the indices. The markets picked up after the October lows into January 2009 only to drop to historic lows in early March. After the March 09 lows, market has had a steady rise for the most part. It’s extremely volatile market like this one that makes it impossible for the leveraged or inverse ETFs to perform over a longer period. Unless your timing of buying and selling these ETFs was immaculate,  if you held these ETFs for the last year or so, they have underperformed the respective indices by a substantial margin. In a more directional market (either bullish or bearish), the performance of these ETFs might be better or at least predictable. But when the market makes historic lows and follows with a 36% rise in a matter of few months, it’s impossible for these ETFs to perform consistently.

So why do leveraged ETFs fail to perform over a longer period of time? Leveraged ETFs are traded very actively since they seek the daily performance of the index they follow. Imagine trying to get twice or thrice the return of a particular index (or it’s inverse) on a daily basis! Leveraged and inverse ETFs use options, futures, swaps and other derivatives to gain the desired performance. The leveraged ETFs ‘reset’ every day and their goal is to make sure that for any given day they give the stated performance with respect to the particular index. Let’s look at an example of BGU which seeks thrice the performance of Russell 1000 index. Let’s say for month 1, Russell 1000 index was up 10% and for month 2, it drops 10%. At the end of these two months the Russell Index is down only 1% [(1.1) * (0.9)]. Now let’s examine BGU. For month 1, BGU would be up 30% and for the month 2, it would be down 30%. At the end of the two month period, BGU is down 9% [(1.3) * (0.7)]. Theoretically, it should have performed thrice as worse as the Russell 1000 index – down 3%. The most important thing to understand here is that compounding works both ways.

The bottom-line is that in this kind of a market, leveraged ETFs should be used by day-traders or experienced investors. If someone still feels compelled to invest, they should fully understand the purpose of these ETFs and risks associated with them. If you were lucky enough to make a good profit with these ETFs, it might be a good idea protect your profits rather then riding the wave on the down side – remember compounding works both ways.

Disclosure: Option Spreads in BGU and BGZ

Apple reported its third quarter earnings today. As always, it surpassed all expectations and estimates. Apple continues to prove that recession has negligible effect on its amazing performance. COO Tim Cook actually mentioned on the earnings call that they were unable to meet the high demand for iPhones and Macs. Apple sold 5.2 million iPhones – 7 times more than what it sold last year and 2.6 million Macs – up 4% from same time last year. Both numbers were higher than analyst estimates. The growth in Mac sales has outpaced PC sales. The 3rd quarter profit rose 15% from a year ago. The gross margin improved despite rising commodity costs. According to Thomson Reuters, analysts were predicting $1.17 a share on revenue of $8.16 billion. Apple knocked the ball out of the park and reported earnings of $1.23 billion or $1.35 a share on a revenue of $8.34 billion. The year-over-year and quarter-over-quarter growth of Apple continues to remain phenomenal. Apple was trading up 5% after reporting earnings. Tomorrow morning, Apple would be up more than 80% YTD.

That’s just this quarter and today’s earnings report. It’s become a habit for Apple to beat all estimates – recession or no recession. But I want to talk about Apple as an investment. In my humble opinion, Apple is one of the best growth stories – it has consistently proved that over the last several years and will continue to do so for many more to come. There are several reasons why I am bullish on Apple for the long run. As with any investment, you need to prudently manage the associated risks and protect your profits. I am definitely not recommending rushing and buying Apple at these levels. If anything, I would recommend booking your profits or at least protecting it. However, I am a fan of Dollar Cost Averaging and Apple is one company I would carefully DCA on.

1. Fundamentals: This is one company with rock-solid fundamentals.  As of latest quarter reporting, Apple has $31.1B worth of cash which is huge. Apple’s cash reserves are growing at a very fast pace. Apple would be using this cash as needed towards the research and development of innovative products, enhancing existing products, possible acquisitions, partnerships and of course prudent marketing. Let’s take a closer look at Apple’s most recent balance sheet: http://www.apple.com/pr/library/2009/07/21results.html. Apple has total assets worth $48.1 B and total liabilities worth $22.2 B. The current assets are worth $35.2 B and total current liabilities are worth $16.7 B. Apple’s balance sheet speaks volumes about the stability and cash reserves of this company. As you might have guessed, Apple has one of the largest cash reserves among all companies. Cash is king right now and it further aids Apple to develop aggressive growth strategies and come out with top-notch products.

Apple’s P/E (Price to earnings ratio) is 28 which is excellent for a strong growth company. Even better, its PEG ratio is only 1.5 (PEG ratio accounts for growth – its price/earnings to growth). Apple’s gross margin is consistently growing. Apple dominates the smart-phone and music markets. Even though Macs occupy only 9% of the personal computing market share, Apple literally owns the $1000+ computer market. 91% of the high-end and high-priced computing market is dominated by Apple.

2. Management: Apple is inarguably one of the best managed companies in the world. It’s legendary CEO, Steve Jobs is often considered as one of the best Chief Executives. Ever since his return to Apple in 1996, this company has seen unprecedented success and phenomenal growth. Just to get some perspective, Apple’s stock price in 1996 before Jobs’ return was around $5.  Apple did take a hit during the tech bubble along with all other tech companies. However, post the tech-bubble, Apple emerged as one of strongest technology companies and its stock value soared to new highs. In the last 10 years, Apple’s stock has essentially doubled every single year (1100% return in 10 years). Very few companies were able to stage a comeback from the tech-bubble era. Even big names like Microsoft, Intel, Cisco, Dell, Yahoo, HP and several others never saw their lofty highs again. After Steve Jobs’ comeback to Apple, the company consistently came out with new products and ensured a strong and growing market for itself. The iPod, iMac, Mac OS X, iPhone, Apple TV, MacBook Pro, MacBook Air and practically all other Apple products were released under the leadership and vision of Steve Jobs. Even today Apple continues to enter and dominate different consumer segments. First it was personal computing, then music and now mobile.

Sometimes Wall Street and people in general consider Apple as a one-man show. Several people believe that without Steve Jobs, Apple will never be the same again. No other CEO attracts so much attention from the Wall Street biggies or moves his company’s share price with a few words. Even his health issues which should be strictly personal became a cause of Wall Street debate (or dare I say national debate) and caused the Apple share price to drop significantly. Agreed that Steve Jobs is a primary reason behind Apple’s continued success, however he has assembled a team of brilliant executives and engineers. I am sure no one knows Apple better than Steve Jobs. I am also positive that he has a clear idea about his health, when he wants to retire, who he wants to see as his successor and where he wants to see Apple in the next few years. There are smart Apple executives who are mentored by their CEO. So, Wall Street and investors should quit worrying about what would happen to Apple without Steve Jobs. Apple has never disappointed its investors and it never will. Also, its no secret that Steve Jobs takes a $1 salary. Sure, he gets millions in stock options but that’s just it – it shows his confidence in his own company and the performance of it’s stock. His salary is only as good as the performance of Apple’s stock.

It will be difficult to replace Steve Jobs when he does decide to retire – especially his vision. However Apple has some fantastic executives like Tim Cook, Scott Forstall, Phil Schiller, Bob Mansfield and others who probably have learned a great deal from Steve Jobs’ style of leading the company. The bottom-line is I would let Steve Jobs worry about how he wants to steer the company from this point onwards. There is no point in senseless speculation about his health and retirement.

3. Innovation: Innovation is a forte of Apple. The reason why Apple has a cult-like following (and may I say ever increasing following) is because Apple leaves no stone unturned when it comes to innovation. There is a reason why there is so much euphoria surrounding Apple product announcements. Pick any Apple product – one thing you will note is Apple puts in a lot of effort in design and quality. It makes sure it pioneers the development of cutting-edge technology. iPods, iMacs and iPhones – all these products redefined innovation. Everyone else followed. However, it’s not easy to beat the leader and it’s impossible to beat the pioneer who constantly innovates. We see many other companies come out with All-in-one products to mimic Apple’s iMac but none succeeded. iPod is a historical success and every other person you see uses an iPod. Car manufacturers and electronic equipment manufacturers make sure they provide iPod connectivity. Other companies which tried to ride on the success wave of Apple’s iPod were either too late in the game or a complete failure.

But it’s the superb idea behind the iPhone that truly amazes me. When the rumors and subsequently the confirmed news about Apple trying to develop a mobile product hit the news shelves, Apple was ridiculed. Most people were of the opinion that Apple is a computer and music company and should stick to that. Apple’s iPhone was released in June 2007 and the rest is history. Apple put a computer in your hands and did it with style. Of course now everyone wants to make the next iPhone killer. None so far have been a success. Apple is gradually targeting the corporates and there is a very high chance it will be successful at doing that. It’s almost shocking that all the big players in the telecommunication and mobile industry never thought about a smart device like iPhone. Now everyone wants to ride the wave but it might be too late. Besides, people forget the fact that no matter how many competitors come out with a similar product, Apple will always stay a step ahead. Look at Apple’s history. It already did what everyone is trying to do now. Apple will now focus on further innovation and it’s no secret that Apple takes its Research and Development very seriously. As Steve Jobs once famously said, ‘Innovation distinguishes between a leader and a follower.’

4. Products: It’s important to again quote Steve Jobs here because that will give you an idea about the strategy of Apple and thought process of its CEO. “A lot of companies have chosen to downsize, and maybe that was the right thing for them. We chose a different path. Our belief was that if we kept putting great products in front of customers, they would continue to open their wallets. Apple’s market share is bigger than BMW’s or Mercedes’ or Porsche’s in the automotive market. What’s wrong with being BMW or Mercedes?” Apple has never targeted volume. If Apple wanted to do that, it could easily have easily and made several cheaper models of Macs. Apple’s focus has always been quality, design and gross margin. You shouldn’t be surprised to note that Apple’s gross margin keeps on increasing consistently. It’s like BMW sells fewer cars than Toyota or GM but its profit per sold car is a lot more. Even then, Apple’s market share in the field of personal computers is consistently increasing. As per NPD’s most recent data Apple’s market share in the higher-priced ($1000+) computer market is a staggering 91%.

Apple’s hardware is what has made it so popular. This includes the Macs, iPods, iPhones, Apple TV, server products and accessories. Apple refreshes its product very often (usually annually) and strives to come out with better products each time. There are rumors of an Apple Netbook during the holiday season although Apple’s COO denied the rumors. If Apple does come out with cheaper Netbooks, it will create a huge market for Apple in this area and probably make Netbooks a lot more popular than they are right now. There have been other rumors also floating around from quite some time including Apple’ foray into the video-game world. The iPhone started as a rumor too. With Apple, it’s difficult to predict what product it might bring out next. The point is that Apple continues to dominate every industry it enters – music, computing, mobile etc. which makes this arguably the best growth story of recent times. Apple will continue enhancing their existing products and coming up with new products.

That’s the hardware part but Apple is a leader in software as well and investors tend to overlook that part. Apple’s operating system is one of the most stable and user-friendly operating systems we have today. It perfectly complements its robust Mac hardware. Apple’s iTunes and App stores also generate substantial revenue for Apple. When people buy songs, movies, books, videos, podcasts etc. from iTunes and paid applications from the iPhone App store, Apple makes money. It has made a foray into cloud computing via MobileMe service. If you own Apple products, this is one service you would love to use.

It would take an unprecedented disaster from here on for Apple’s growth to slow down. Sure, the stock itself could fluctuate with the overall market but if you have a few years horizon, an Apple investment could reap rich rewards for you (strictly my personal opinion with a disclaimer that I have positions in Apple).

5. Sales: Apple has a very strong fan following. But the important point is that the loyal Apple following is increasing exponentially. With exciting new products like the iPhone, Apple has ensured that it pioneers in innovation. This in-turn has attracted people from all walks of life and all over the world. It’s evident from the long queues you see outside Apple stores during a new product launch. The hype that Apple events generate and the consistent buzz in the Media/Blogosphere about this company and it’s exciting products further fuels the exhilaration surrounding this company. This ever-increasing Apple user base is one reason why Apple earnings continue to baffle the pundits and the skeptics. Numbers like 5 million iPhones and 2.3 million Macs sold in the last quarter almost makes you feel that many people are saving money so that they can spend it on these products. People don’t want to wait for the economy to turn around to buy Apple products and that’s one reason why this company dodges recession.

The Mac sales are outpacing PC sales and this might keep continuing as more people turn to Mac. A very high percentage of existing Mac users upgrade their operating system when Apple comes out with a new OS. This will happen again when Snow Leopard is released in early Fall. The iPhone sales are going through the roof. Apple has made the iPhones available in several countries across the world and it’s increasing its user-base by leaps and bounds. The iPhone sales also get a huge boost from a very large percentage of existing users who want to own every new product refresh. The iPhone hasn’t penetrated the corporate world much but that might start happening gradually. Apple has made an excellent move by targeting the consumer first and it will surely aim the corporates next. The iTunes store and the App store is another huge revenue stream from Apple. You cannot ignore the positive impact of the App store on Apple’s profit when more than a billion Apps have been downloaded. Apple is also generating steady gains out of its other hardware products like Apple TV, xServe and software products like Final Cut Studio, iWork etc.

Some analysts got worried that the iPod sales have declined since last quarter. That’s because many people opt for the iPhone instead. That works out even better for Apple when you factor in gross margins and revenue sharing with telecom service providers around the world. Also, iPod sales should be a lot better this quarter and next with back-to-school season and holiday season.

The bottom-line is that I stay bullish on Apple as of writing this. With the recent run-up I am cautiously bullish but would still Dollar Cost Average on significant opportunities. The last quarter is not usually one of the most exciting quarters for Apple and even then Apple blew the earnings estimates. The next two quarters should be even more exciting since Apple would get a tremendous boost from the back-to-school and holiday seasons. There are also other exciting things lined up this year including new operating system, product refreshes and possible new products.

On June 30 2009, AIG shares were trading at $1.16 at the market close. Let’s say you bought 1000 AIG shares on Tuesday. Your total investment was $1160. Next morning (Wednesday, July 1st 2009) you wake up, turn on the television and notice that AIG’s price is now $23.20. Whoa! You made $22,000 in one night on an investment of just $1160! Hardly. Unfortunately, AIG didn’t do anything amazing that would have increased its stock price by 2000%. AIG did, what we call a Reverse Split. The $20 stock price was a result of 1:20 reverse split. A 1:20 reverse split means that the stock price increased 20 times and the number of stocks decreased by a factor of 20. Overall, it doesn’t change anything. AIG is still a worthless stock. So your total investment of $1160 is still the same. Before you owned 1000 stocks, now you own only 50. Instead of 1000 stocks at $1.16 a piece, you now own 50 at $23.20 a piece. In fact, as of Friday close, AIG was trading at $13.52 – down 40% from the post-split high.

There are the usual stock splits (forward splits) and then there are reverse stock splits. There could be numerous reasons as to why a company would resort to stock splits. Forward splits are usually looked upon more favorably than reverse splits. In general, splits (forward or reverse) don’t affect the company bottom-line (market capitalization). In case of forward splits, the price of stock is reduced by a factor and the number of outstanding stocks is increased by the same factor. Reverse splits works exactly opposite – as we saw in the case of AIG mentioned above.

So, if the stock splits are irrelevant for company’s bottom-line and doesn’t really change anything, why do companies still split their stocks? First let’s look at forward splits since some investors love them. Forward splits depict a company’s confidence in their performance. Forward splits increases the number of outstanding shares and thereby the share’s liquidity. The bid/ask spread narrows with the lower share price. Can you imagine the bid/ask spread on BRK.A (Berkshire Hathaway) shares? The stock is trading at $90, 500 and it’s 52-week high is $147,000. The most important reason for a stock split is purely psychological. Some companies want to attract more investors and therefore split the stocks. If the share price gets too high, some investors (especially smaller investors) might turn away since they cannot afford it. A stock split reduces the price and it might bring in more investors. But this is purely psychological. I personally don’t agree with this because the actual effect is minuscule at the best.  I always advise people to look at the total money they are investing and not the price of the stock. Berkshire Hathaway, Google and Apple are some companies that have expressed a strong desire to never split their stocks. Apple has done splits in the past but it’s not interested in further splitting their stocks.

One of my friends mentioned that he is interested in buying Apple stock but it’s too expensive at $150. He wished that Apple would split it’s stock by 3:1. I asked him to explain the rationale for that. His response was he wanted to invest $15,000 in Apple. At the current price he can buy only 100 stocks however, if Apple was trading at $50, he could buy 300 shares. That way he would own a lot more stocks and has a potential to make lot more money. It’s a wrong way of thinking but you will find many people who think along similar lines. I cannot stress enough that what matters is your total investment and not number of shares. If Apple appreciates 30% by the end of the year from this point onwards , your $15,000 would still increase to $19,500 whether you owned 100 stocks at $150 a piece or 300 stocks at $50 a piece. Now, something like BRK.A is a different story if you don’t want to spend 100K for just one stock!

Several companies have split their high-flying stocks several times in a bid to attract more investors and increase the liquidity of shares. Take a gander at the DOW or S&P components. You will find that most companies have split their stocks at one point or other. Pretty much everyone who wants their stocks to be trading at certain price levels have resorted to stock splits. In the recent past, Research In Motion (RIMM) – one of the most successful Technology/Telecommunication companies has done 3:1 and 2:1 splits.

So that’s all about forward splits. But why reverse splits? Why would companies increase their stock price and decrease the number of shares traded? Why would they decrease the liquidity and make it less attractive. History shows that reverse splits usually don’t bode well for companies. Sun Microsystems comes to mind when we talk about reverse splits and of course AIG is the most recent example. Companies might resort to reverse splits for a number of reasons. In general companies that are battered resort to reverse splits in a bid to make their stocks look more attractive. This hardly works if ever. Sun Microsystems (Java) did a 1:4 split in November 2007. Their $5 share went to $20 after the split. Many institutional investors follow strict guidelines as to what companies to invest in. For example, they wouldn’t touch companies whose shares are trading below certain price levels. This is one reason why Sun did a 1:4 reverse split – try and attract institutional investors. It didn’t happen. Even after the $20 price-tag, Sun’s share prices fell below $3. The only saving grace for Sun investors was the buy-out offer from Oracle. AIG also split it’s stock for the same reason.

Sometimes companies also split so that they can maintain price levels to keep trading in certain exchanges like NYSE. Others do it because they want to prevent artificial manipulation of their low-priced stocks. This is evident from the way stocks like Citigroup, AIG and several other fragile companies are manipulated and traded. However, in the end it doesn’t matter much! If the company’s fundamentals are shaky, the shorts will come and steam-roll it. In fact, reverse splits for certain battered companies is an open invitation to shorts.

Other stocks which split recently are the triple-leveraged finance ETFs (FAS and FAZ). FAS which is a 3x bullish financial ETF did a 1:5 split and it’s bearish counterpart, FAZ did a 1:10 reverse split. Before the split, the trading volume on the stocks was extremely high because of the low share prices – 300 M shares traded per day. The split was aimed at decreasing the volume and avoid heavy price manipulation. This is a strong indication that leveraged ETFs are dangerous plays and not meant for all investors. They never ever give the theoretical 3x performance and are not meant to be long term trading vehicles.

It’s official now. Today morning after GM filed for bankruptcy, it was evicted from the prestigious Dow 30 where it reigned since 1925. But that was not all. The decision-makers at Dow also decided to remove Citigroup. GM and Citi were replaced by Cisco (CSCO) and The Travelers Companies (TRV) respectively. As I mentioned in my previous post, Cisco was kind of expected. But Travelers was a surprise entrant especially considering the history of Citi and Travelers. In 1998 Travelers combined with Citibank to form Citigroup. The then CEO of Travelers took over as the CEO of Citigroup.   Travelers Group first became a part of Dow 30 in 1997. Then in 1999 it was replaced by Citigroup (after the merger in 1998). In 2002, Citigroup decided to spin-off Traveler’s Group. Travelers then merged with St. Paul Group. Even after the spinoff, Citigroup retained the red umbrella logo which it sold back to the Traveler’s Group in February 2007. Today the tables turned. Citigroup was evicted from the Dow 30 today morning and it will be replaced by Traveler’s group. Pretty interesting, isn’t it.

GM and C will still be shown as a part of Dow 30 until June 8th. Thereafter, CSCO and TRV will officially be considered a part of the prestigious Dow 30. Does it make any of these stocks more exciting than they were last week? I don’t think so – definitely not by the virtue of being a part of Dow 30. I have never considered TRV interesting enough – yet. Since Dow considered it worthy enough to be added to  Dow, I would definitely be interested in doing more research.

Cisco on the other hand, is definitely a good technology company to own. It was a great stock to own even before it’s inclusion in the Dow 30. It’s a stable company with great fundamentals. It has $33B in cash and around $10B in debt. Cisco has made some good acquisitions in the past and it will continue doing so especially in this economy. There are some exciting buys for Cisco in this market (more about that in another post). So yes, Cisco will be a part of my portfolio – soon (disclaimer: I owned Cisco before but do not have any positions currently).

I am still not happy with the Dow 30 choices. Isomewhat agree with the argument that since Dow is a Price Weighted index, addition of Apple ($140) or Google ($427) might have made a huge impact on the Dow Jones Industrial Average. In the Tech sector, Dow already has IBM which trades at $100+. So addition of Google or Apple might make it slightly more prone to tech sector fluctuations. But, if that’s the case may be Dow needs to revisit it components as well as the pricing model! The current pricing model of Dow is just the sum of the stock prices of all 30 components divided by the DJIA Divisor. The divisor keeps changing every now and then to reflect events like stock splits, dividend payments, change in Dow components etc.