Short VMware (VMW) As Hedge For Euro Recession

The Euro cri­sis is an excel­lent demon­stra­tion of how long insol­vent orga­ni­za­tions can per­pet­u­ate the poor cap­i­tal allo­ca­tion and spend­ing deci­sions that cre­ated their insol­vency. Pre­dict­ing exactly when the euro finally breaks down is a chal­lenge, to say the least.

How­ever, investors should brace them­selves and their port­fo­lios for a big mar­ket decline now. The shell game in Europe is end­ing, and mar­kets have yet to dis­count the struc­tural decline in the pro­duc­tiv­ity of economies around the world. These declines result from large-scale misallocation of cap­i­tal over the past sev­eral years and in the present.

And when I write “brace” your port­fo­lio, I mean take a net short posi­tion as I have in my portfolio.

In build­ing your short posi­tions, I rec­om­mend you con­sider VMware (VMW). When­ever a gen­eral mar­ket decline is on the hori­zon, the best pro­tec­tion is short­ing super expen­sive stocks with very lit­tle hard assets. In other words, the stocks that will fall the hard­est are those whose cash flows are not backed by any tan­gi­ble or liq­uid assets while their val­u­a­tions are sky high. Those stocks have noth­ing to offer investors when the growth winds turn against them. Most of their talent/assets leave when they close the build­ing every night.

VMware is a com­pany with very lit­tle hard or liq­uid assets, espe­cially when com­pared to its mar­ket value. A quick look at their lat­est bal­ance sheet reveals that intan­gi­bles at about $2.2 bil­lion are nearly five times the value of the company’s hard assets (prop­erty, plant and equip­ment) at just over $500 mil­lion. The company’s largest asset is about $4 bil­lion in cash. Not all of that would be avail­able for equity investors though. From the $4 bil­lions, one needs to deduct $735 mil­lion in debt (includ­ing off-balance sheet debt) and $1.4 bil­lion in stock option lia­bil­i­ties. So, we are down to about $1.8 billion in cash, which is dwarfed by the company’s $39.3 bil­lion mar­ket value.

Sophis­ti­cated read­ers would object to my argu­ment so far on the grounds that that stock prices are based on future cash flows not the book value of assets or cash on the bal­ance sheet, and I agree whole­heart­edly. My prior point is to estab­lish that there is lit­tle down­side pro­tec­tion to VMW stock in the event the Euro­pean deba­cle causes another Lehman-like arrest in global eco­nomic activity.

Turn­ing to future cash flows for VMW, I admit the company’s prospects are rosy. Indeed, its eco­nomic earn­ings have been impres­sive though not as strong as the account­ing earn­ings would have you believe. How­ever, the future cash flow growth baked into its stock price will make even the most aggres­sive momen­tum trader pause.

Specif­i­cally, VMW’s stock val­u­a­tion (based on lat­est clos­ing price of $94) implies 30% com­pounded annual profit growth for the next ten years. In the his­tory of the world, I’d bet that few com­pa­nies have ever achieved such growth. From 2000 to 2010, fewer than ten com­pa­nies achieved such growth, and Apple (AAPL) is not one of them. More­over, I think it is fair to say that almost no one expects to enjoy growth over the next ten years that is as good as the first decade of this cen­tury (even though it was marred by two reces­sions in the U.S.).

The take­away is that VMW’s stock price already reflects the rosiest of expec­ta­tions for future cash flows. It is priced for per­fec­tion on all levels.

Fig­ure 1 com­pares VMW’s stock price to its eco­nomic book value per share, which is, put sim­ply, the per­pe­tu­ity value of the company’s after-tax cash flow. It is also known as the no-growth value of the busi­ness. The dif­fer­ence between the stock price and the eco­nomic book value per share of a com­pany is the value of its future growth. Investors need to be wary of stocks that embed too much future growth and set impos­si­bly high expec­ta­tions. Fig­ure 1 clearly shows that expec­ta­tions for future cash flow growth for VMW have accel­er­ated over the past few years.

To put Fig­ure 1 into con­text, the ratio of VMW’s stock price to its eco­nomic book value is 7.2 com­pared to the S&P 500 at 1.8, the Rus­sell 3000 at 2.1 and the Rus­sell 3000 at 4.0.

VMW’s val­u­a­tion has its head in the clouds.

The stock has too much down­side risk com­pared to too lit­tle upside poten­tial. Really, what’s next…expectations for 15 years of 30% com­pounded annual growth? This stock is a great short in most any sce­nario and is espe­cially attrac­tive in the event of a global eco­nomic slow­down led by a reces­sion in Europe.

I also rec­om­mend you short or sell the fol­low­ing ETFs and mutual funds because they allo­cate the most out of the 5000+ ETFs and mutual funds we cover to VMW. Note that each ETF/fund allo­cates 5% or more of its port­fo­lio to VMW, and all of them except for RCKSX get a dan­ger­ous rat­ing, accord­ing to my pre­dic­tive fund rat­ing method­ol­ogy. Free copies of my reports with my pre­dic­tive fund rat­ing on the ETFs and funds are avail­able by click­ing on the name of the fund below.

1. Oak Asso­ciates Funds: Black Oak Emerg­ing Tech­nol­ogy Fund (BOGSX)
2. Berk­shire Funds: Berk­shire Focus Fund (BFOCX)
3. Pow­er­Shares Dynamic Net­work­ing (PXQ)
4. Oak Asso­ciates Funds: Rock Oak Core Growth Fund (RCKSX)

Dis­clo­sure: I am short VMW. I receive no com­pen­sa­tion to write about any spe­cific stock, sec­tor or theme