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January 12, 2010

A week into the new year, I thought I’d share my 2010 outlook, in addition to some investment picks and a summary of
2009. My 12 month target for the DJIA of 12,690 (+20%) is explained in detail. Near the end of this piece I share the
performance of my picks from last year, which clearly justify the “Alpha” in AlphaNinja. As always, my 2010 goals are to
share profitable stock picks and point out positives and negatives that all equity investors should be aware of. It’s going to
be a very good year!
Some broad 2010 Themes. Some will be discussed today, some to be addressed later…

¾ The cost of capital has nowhere to go but UP. This is a major headwind for most asset classes.
¾ The yield curve is VERY steep. You’re paid only .14% to park money in treasuries for 6months…
¾ Stay away from IPO’s in 2010. Most will be offered at unattractive prices as private equity investors try to return
to the public companies that were purchased using cheap financing and nosebleed valuations.
¾ Focus on equities that offer good compensation in terms of Free Cash Flow, with downside support provided by
reasonable valuation and shareholder-friendly management.
¾ In terms of economic stewardship, trust the government about as far as you can throw it. Every announced
“stimulus” or “jobs” bill poaches the public’s tax dollars & directs it towards public employees, as the government
continues to emulate the worst of private equity’s practices, the dividend-recap.1
¾ STOP overpaying for investment management! If your advisor isn’t outperforming, then don’t pay them 8-10
times what a cheap fund would give you. The New York Times2 recently reported that 36 percent of wealth
managers said they believed they were "not fully qualified to do their job." Is your broker one of them?
¾ “Death of the C.A.P.M.” For too long, companies with zero debt have been penalized with a higher “Cost of
Capital” due to the Capital Asset Pricing Model, which assigns debt-free companies a riskier cost of capital.

Beware “Price-Blind” Arguments (PBA’s) with Regard to Investing

By “Price-Blind” argument, I mean an argument that would not change regardless of the valuation of the underlying asset.
I give you two examples: Cisco Systems and Gold.
Your stock broker or analyst could wax poetic about Cisco Systems for hours. Glorious charts will show the huge
bandwidth demands that will inevitably choke communications networks, necessitating massive capital outlays to buy
networking gear from companies like Cisco. But the argument means nothing if it could be given with Cisco stock at $80,
or Cisco stock at $24. Personally I think Cisco’s 2010 estimated Free Cash Flow Yield of almost 9% is a fantastic deal, but
I’d certainly not think the same if the stock was at $80 today with a Free Cash Flow Yield3 of 2.2%, despite the argument
about Cisco’s prospects being just as bright. That’s a “Price-Blind” argument (PBA), and whoever is pitching it is
probably compensated in an asset-gathering manner that would be poorly served by adhering to valuation-based
arguments. Note I said “based” - valuation isn’t everything, but it must be a large factor in investment decisions. [When
you speak to your broker or financial advisor, do they prattle on about a certain stock or industry theme without
giving a valuation framework? If so, be skeptical, because it might be more of a selling pitch than an
investment strategy.]
The biggest PBA of the moment is made by the gold bulls. It’s easy to attack gold bears (those who say it’s overvalued),
because one would seem to be crazy to make the anti-gold argument. Gold is looked at as the “reserve asset” to flee to in
times of danger or inflation, much like the US dollar enjoys status of the “reserve currency.” In the case of both however,
that’s only true until it’s not; a new reserve currency or asset can come take their place. In the dollar’s case, its status as
the “reserve” currency has much better fundamental underpinnings than gold does. The US, for all our flaws, is the most
stable economy on earth backed up by the strongest military on earth – yes, both give foreign investors confidence in
holding our debt. As hard as our government is working to destroy our reserve currency status, we’re holding onto it
thanks to other governments behaving just as bad if not worse. But Gold only enjoys its status due to groupthink. There

is NOTHING to stop groupthink from changing its mind one day and deciding that oil reserves or silver or land are a
better “reserve” asset than gold.
Sticking with Gold for the moment, I’ve looked at it from the long and short side, as a possible way to make some money.
I agree with the gold bulls that our government is spending its way to the poorhouse, necessitating the printing of ever
more dollars. But that argument was made when gold was at $400 an ounce. And at $600 an ounce. And $800, $1,000,
and then recently at $1,160 an ounce, at which point I wrote in response to extreme gold price projections:
“Gold is loved for many reasons, including its malleability, extreme durability, and long-term proven success as a store of value. But in terms of
practical use, it's vulnerable, as you can see in the below data from the World Gold Council. Jewelry accounts for over half of
identifiable gold demand, and it was down 30% in q309 versus q308.
Gold may keep flying, but it's only because of groupthink that this asset is chased. And as for the extreme gold predictions, like
gold at $5,000 or $8,000, stop to think about what that would say about the state of the USA and global
economy. If you own Gold and it hits $8,000, and IF you can find someone to buy it, take that money and invest
in a shotgun, some rural land, and cattle, because we would truly be in an apocalyptic situation.”

With no cash flow or earnings stream with which to value Gold, the people best equipped to trade this commodity are
those who track investor sentiment. They follow long term trends, and can get a better handle on what “inning” Gold is
in its current bull run. As a fundamentals-based investor, I have no business getting involved here.

The DJIA divided by Gold ratio is near its long term average, hurting the extreme bullish and bearish arguments:

Equally as damaging as using PBA’s to promote a bullish stance is using one to promote huge future declines in the
market. There are countless pundits who can talk your ear off about government spending run amok, our future
unfunded liabilities, unsustainable debt burdens, etc., until one is out of breath. What “doomsdayers” haven’t done (for
the most part) is turn that sentiment into actionable results for their clients, because they’re too busy pontificating on the
big picture while forgetting to look under the hood, if you will, at the stocks that make up the stock market. Take March
of 2009. I didn’t call the exact bottom, but I did make good money by taking a step back and looking at individual stocks.
The doomsday argument still made perfect sense at that point in time, but people didn’t take the time to sit back and say
“Hmm. Yes, things are bad, but now IBM is trading at $90, which is a P/E of 10times trailing earnings and 9times this
year’s expected earnings, versus historical averages in the upper teens.” At those levels IBM had a Free Cash Flow Yield
of 11% (12% if you netted out their $8 in cash per share). One didn’t have to know if the market had hit bottom to know
that an 11-12% yield on IBM’s cash flow stream was a very attractive place to put your capital.

“The Market” is fairly priced, and will likely finish 2010 up 20% from the current level, to finish at 12,690
Below is a chart of “Where We’ve Been,” from 1977-2009, before I discuss where I think we’re headed. There’s nothing
too complex about the past 33(ish) years -- interest rates ballooned into a peak in 1981, with the 10 year treasury topping
16%. With a yield like that, one would be crazy to put their money in risk assets like the stock market. From that point,
interest rates began a long decline to the low single digits, enabling an explosion in debt and speculation of every sort.
The cheaper the borrowing cost, the higher every other asset can fly, and the market took off along with the expansion in

(Source – AlphaNinja, Federal Reserve)

So where are we now and where are we headed? First, I’ll start with the scary concept that the doomsayers are peddling –
the comparison of last year’s massive V-shaped rally to the rally after the 1929 DJIA crash. The initial selloff this time
around might not have been as rapid, but the kneejerk 65% rally was MORE robust than what the market experienced
eighty years ago. Why is that a problem? After that initial rally from late 1929 to May 1930, the DJIA proceeded to lose
85% of its value before finally bottoming in the summer of 1932:

If we must compare this period to the great depression, my opinion is that we’re closer to mid 1932 than late early 1930.
If you look back, the DJIA actually shed 12 of 30 companies over a 24 month period4, something that is not going to
happen today. The 30 stocks of the Dow Jones Industrial Average include some fantastic deals.
If you bought the DJIA today (using the DIAMONDS Trust, ticker symbol DIA), the weighted dividend yield is 2.6%, a
nice annual gain BEFORE any capital appreciation from increased earnings or a higher earnings multiple. The highlighted
area in the following chart is the top 9 stocks in the Dow, whose weights account for just under 50% of the index.
Among these are Johnson & Johnson and Procter & Gamble, two fabulously run firms at low teen PE multiples, versus
average historical PE’s in the upper teens to near 20. Also among this group is IBM with a Free Cash Flow Yield (FCFY)
of 8.4% - closer to 9% if you net out their balance sheet cash. The highlighted group’s average Free Cash Flow yield is
about 8%, which is far too high considering these firms can borrow money for 10years at rates in the 4% range.
Twenty-six of the 30 DJIA components’ earnings estimates are increasing, certainly not surprising given the economy’s
jobless rebound. Skeptical of the quality of bank loan portfolios and the potential for further weakness and necessary
equity dilution? ME TOO, but you can have BAC and JPM fall to zero and cost the Dow a whopping 4.4%. I can
promise that will NOT be the case, as Fed actions have enabled banks to repair and increase capital levels by borrowing at
zero and lending higher.

...and lend here

Banks borrow here...

Where To From Here? Based on my targets for each DJIA component, I arrive at an estimate of 12,690, up 20% from
here. This figure is based on my estimates for what each Dow component should yield in either free cash flow or earnings
(for the financials). This estimate could easily turn out to be conservative, at it would represent 12/31/2010 trailing
twelve month PE ratios for the thirty components at an average 16.3. At that is on earnings estimates that will likely have
risen as job cuts turn into job growth, and investors look beyond to 2011 earnings to value the index. In times of
economic stress, companies often overshoot when cutting costs, which could create a “spring-loaded” factor, where
earnings could rocket on slight revenue upside. The 16 PE cited above will also decline as companies use cash flow over
the next four quarters to reduce shares outstanding through stock buybacks.

Another way to look at the market is how it compares to “real-world” data such as annual auto sales and rail traffic. In
both cases those metrics plummeted from peak numbers, but the DJIA if anything overshot to the downside, which is
part of why I was bullish back in March, writing on the 18th:

“The DJIA has bounced just 12% from the recent lows. The five highest-weighted stocks (totaling about 40% of the entire index) trade near
half their average historical PE multiples and are poised to rebound. The bottom five could fall to zero (a possibility more remote by the day)
and cost the index a mere 2.8%. These are very bullish signs”

(Source – AlphaNinja, Railfax)

In 2010 I’ll continue with a theme of buying “great companies at good prices + good companies at great prices.”
By that I mean I’ll buy IBM (a “great” company) at a Free Cash Flow Yield in the 8-12% range and hope to sell when the
stock has risen and the yield drops to the 6-8% range. And for a “good” company like Dell, I’ll buy near 20% Free Cash
Flow Yields and sell as that yield falls to the mid to low teens.

I will continue to use Free Cash Flow Yield (FCFY%) as a barometer. It is the clearest way to evaluate what you would
get in return for buying a company (or a piece of a company, in stock). What may change is what I compare FCFY% to.
This past year, extremely low debt yields have driven the cost of debt financing to miniscule levels for great companies
and still tiny levels for “good” companies. So when I look at Dell 2012 debt5 yielding less than 2%, it’s not proper to say
that they deserve a FCFY% as low as 5% just because their debt is cheap. Their debt is cheap for two main reasons:

1. A fed funds rate near zero

2. Irrational exuberance in the corporate debt markets, pushing prices up too far and yields down too low.

Too be clear, I’ve never argued for such a low FCFY% for troubled companies like Dell, preferring to buy them above
20% and sell in the teens. Just as people occasionally value stocks using a “normalized” (higher) earnings number when
evaluating long term prospects while numbers are recession-depressed, it’s important to use a “normalized” cost of
capital when financing is irrationally cheap.

Using Free Cash Flow Yield as a valuation framework worked well in 2009, mostly because instead of talking yourself into
a PE multiple for a given company you wait for the yield to come into your comfort range. Below are the “pound the
table” stock picks I made last year. Not included are my market calls. I made a bullish DJIA argument in March and made
some good money, but later (about 20% higher) hedged with an S&P500 short position to negate about half the remaining

Also not included above are my comments about other stocks I own, including CSCO, CMCO, and WDC, because I
started recommending them before I began AlphaNinja. Worth sharing though, both the good and bad:

CMCO –> Maybe my worst pick. Off 38% while the S&P is off only 11%

CSCO and WDC –> + 41% and +184% versus +23% for the S&P500.

Bullish on DIA near the March09 bottom, up 48%:

I still own all the stocks mentioned above, as their earnings and cash flow estimates have increased enough to keep their
Free Cash Flow Yields at attractive levels. I added Qwest Communications (Q) to my portfolio last week, and shared that
with AlphaNinja readers. This would be an example of a “good company at a great price.” Among my reasons for
owning the name, as I wrote on January 7th:

“So at a more (maybe unreasonably) conservative $1.3billion in 2010 Free Cash Flow, that's a Free Cash Flow Yield
(FCFY) of 16% on the company's market cap. With cost of capital at 7%, the stock probably does not need such a high
FCFY%, and should trade higher. What's more, one could technically buy the company for $8billion and pocket the
company's $2billion in cash -->> now we're talking about a $6billion purchase with Free Cash Flow of $1.3billion...a
FCFY% of 22%. Why net out cash when I don't add in debt? Because they cover quarterly interest payments 6 times over,
a very healthy margin in this sector. And again, I'm being VERY conservative in my Free Cash Flow estimate.

This is one of those situations where the company has issues, but the yield is simply too great for me to ignore. Just
bought shares, as I expect Qwest to rise significantly.”

Another recently initiated position is America Online (AOL), which was spun out from Time Warner last month. This
stock would be a new category that I’d call “marginal companies at ridiculous valuations.” From December 10th:

Dating Advice for America Online = STAY SINGLE AWHILE (AOL, TWX)
AOL shares are being spun out of Time Warner. For every 11shares of TWX stock owned, 1 share of AOL will be given. This
equates to about 106million shares of AOL outstanding, for a market value of $2.5billion. With Free Cash Flow of about
$1billion expected this year and next, the shares are a BARGAIN.
AOL shares are off today, and Wall Street is pretty bearish this morning, with several analysts initiating coverage with a SELL

Don't get me wrong - AOL/TWX was likely the biggest merger failure in HISTORY, and AOL's business is a wreck, in a
downward spiral that will be difficult to correct. That said, I compare this situation to one I saw with Western Digital (WDC)
last fall. People were absolutely FREAKED about the threat to WDC from solid state drives, or flash drives. It was a decent
argument, but my point was that WDC was trading at a level where you would literally make your money back in Free Cash Flow
before that argument over competitive products was even completed.

Could be a similar case here, with a potential Free Cash Flow Yield of 40%. You could buy the company outright and make your
cash back completely, while people still argue about AOL's viability.

STOP Overpaying for Underwhelming Investment Performance

Before closing, I have one recommendation for people in 2010 – a “checkup” with your financial advisor or broker. I
started AlphaNinja for three main reasons. Number one, to share actionable, profitable stock picks. That has been a
success so far. Number two was to take companies to task when they do not act in the best interest of common
stockholders. In that respect I think I’ve also been successful. The third reason I started AlphaNinja is due to the level of
TERRIBLE financial advice being peddled by Wall Street and its extended network. While I believe superior investment
advice or performance should be rewarded handsomely, the vast majority of people are paying big fees for very little
added value with regards to their investments.
The following is from a piece I wrote in November, in which investment planners were reassuring nervous clients by
including cash contributions to their equity portfolio’s performance:

"If you were Rip Van Winkle and had fallen asleep for a year, you wouldn't have known we had a crisis—and you would
have saved a lot of sleepless nights," says a Washington, D.C., financial planner.

That's from a recent WSJ piece called "Surprise! That 401(k) Account Is Looking Good."

I'll give the author the benefit of the doubt and assume she's calming investor jitters over their nest eggs. It's a great point to remind
investors that their position might not be all that bad considering the market recovery and added benefit from regular contributions.

The worrisome aspect is the quote above from the financial planner. OF COURSE the portfolio is doing better thanks to
contributions. Below is an example of a $100,000 portfolio over two years, in a fund that mimics the S&P500. The red line shows the
account value without any monthly contributions, and the blue line includes contributions of $1,000 per month. With contributions,
the account is positive over the period. Without them, it is down almost 20%, just like the index.

If the investor received a $50,000 inheritance windfall, would the adviser claim that the investor's account is performing fabulously
thanks to this? "Hey Frank, wow your account's up $50,000 in a day!" It's not much different than the above points.

It's reasons like these that the NYTimes recently reported that 36 percent of wealth managers said they believed they were
"not fully qualified to do their job."

Pulling the wool over investors' eyes by intentionally confusing performance with account value confirms that this industry
peddles awful advice.

This chart below demonstrates what the financial planners were doing. They were citing the higher blue line as client
performance, which included monthly cash additions to holdings. [Call your broker and ask how your equity
portfolio did last year. If they can’t answer because it’s “confusing” due to contributions, just ask how it
would have done had you not made any cash contributions. If they still can’t accurately give you a comparison
of your equity performance to the S&P500, then why are you paying them to manage your money? It’s akin to
giving your mechanic access to your checking account, and him being unable to tell you what you were charged
for a new transmission.]

The reason I included the above attack on Wall Street is due to the major effect that fees can have on one’s quality of life
later on. If you find that your broker or fund is not generating outsized returns, then you MUST put that money
elsewhere. Depending on your horizon (in this case below for a 25 year old), the 1% you save by switching from a
high cost to low-cost equity fund would result in a 20% increase in monthly retirement income. That’s just from
cutting fees. (This example ignores the shift toward fixed income that would be appropriate for a portfolio as one ages)

In conclusion, I expect this year to be incredibly interesting for investors. While I established a firm DJIA target price for
December 31st 2010, I expect volatile swings in the market to afford us opportunities to purchase shares with juicy (high!)
Free Cash Flow Yields. I have a better record of being right on individual stock picks rather than broad market calls, so
that will be where I focus my energy in the coming months. The biggest variable on my mind is interest rates, which
directly affect the cost of capital I use to decide what level of Free Cash Flow Yield is acceptable. I expect the 10year
treasury yield to climb at least 1%, but I also recognize the amazing ability of the Federal Reserve to throw its weight
around to keep rates artificially low. Whether rates rise or fall, I try to invest with a margin of safety by buying Free Cash
Flow Yields that are still very attractive even if rates were to jump several percent.

Thanks for your patronage in 2009 and I wish you the best of luck in 2010! Feel free to contact me with questions,
comments, or requests for specific portfolio advice.