The reason VSEC fell was that it announced last Friday that it had not been awarded a renewal of a large contract with the Army, the "Rapid Response" contract. The failure to renew this contract is certainly significant for VSEC; the contract was responsible for approximately 41% of VSEC's revenues for the first three months of 2008.

However, I think the market may have significantly overreacted to this news. Work under the contract will begin to diminish in the next few months. But some work will continue until 2010. Overall, VSEC has a funded backlog of $706 million, equivalent to about 8.5 months of revenue. Over the next eight months, it will undoubtedly gain new contracts. VSEC has been expanding its non-DoD services, contracting to agencies including Energy, Homeland Security, and Treasury. VSEC has historically been very successful at gaining new contracts and increasing revenue.

While failure to extend the Rapid Response contract is disappointing, I suspect that it will turn out to be a bump in the road of VSEC's long history of increasing revenue. Also, while VSEC has lost the prime contract for Rapid Response, it is possible that VSEC will be a subcontractor for work under the Rapid Response contract.

The chart shows that interest rates for financial firms have gone up somewhat over the course of the month. Rates for non-prime ( A2/P2 in the Federal Reserve Board's terminology) non-financial firms have almost doubled during the month. But rates for prime (AA) non-financial firms have actually gone down a bit. (Unfortunately, the Federal Reserve Board doesn't provide information about rates for non-prime non-financial borrowers.)

I actually find this reassuring. The credit markets do not seem completely frozen up. Financial firms are finding it more difficult to borrow in the money markets. But it's not at all surprising that financial firms would find it more difficult to obtain credit given the well-known difficulties they are facing. It is also unsurprising that companies with poor credit ratings would have a harder time borrowing during an economic downturn. The market seems to be reacting more or less rationally to actual economic conditions. The low interest rates for prime non-financial borrowers indicate that the market is not irrationally panicking and withholding credit from stable credit-worthy customers. While the contraction in credit will undoubtedly continue to affect the economy, there seems to be no reason to think that it will cause a complete shutdown of our economy.

More information about money market interest rates is available at the Federal Reserve Board Web site.

The reason that illiquid assets are such a problem for financial institutions is that accounting rules require the assets to be "marked to market," i.e., carried on the books at market value. Currently, many kinds of asset-backed securities fetch a very low price in the market. To take an extreme example, Merrill Lynch sold collateralized mortgage obligations for 22 cents on the dollar in July. So asset-backed securities have had to be written down, reducing the total assets and therefore the equity capital of the companies that own them. In order for Paulson's bailout plan to help the financial institutions, the government will have to buy the institutions' assets for a higher price than market value. Otherwise, the companies would just be replacing devalued assets with an equally small amount of cash, which would not help their balance sheets.

Paulson's hope is that the prices of asset-backed securities are just temporarily depressed, but they will eventually return to normal. So the government can now pay more than the current market price, thereby helping out the financial institutions, and then patiently hold the securities until their prices return to normal. At that point, the government can sell the securities, thereby recouping all or most of the taxpayers' $700 million.

Will Paulson's plan work? Well, for us to believe that it will work, we have to believe that government bureaucrats can appraise the value of securities more accurately than the market can. Of course, the government could get advice from experts about the value of the securities. But the experts are employed by the financial institutions that are selling the securities.

Paulson has said that the government will use “market mechanisms,” e.g., a reverse auction system, to set prices. In a reverse auction, there is one buyer and several sellers who are all offering the same product. The sellers bid on the price at which they are willing to sell. The problem here is that it's very difficult to tell if different asset-backed securities are effectively the same product. I assume that the financial institutions will try to dump their worst securities on the government. The low bidder could just be the seller offering the worst product. Paulson and Bernanke have said that they can't design the auction process; that would be done by experts. Again, where are they going to find unbiased experts? It seems to me that, at best, an auction will establish the price at which it's worthwhile to the banks to sell the securities. It won't tell us what the security will be worth at some later time.

Here's what I think we know about the price the government's going to pay: (1) it's going to be more than the market price; (2) the government has no reliable way of determining what a fair price is; (3) we don't even have any good reason to believe that the market price is too low; (4) in general, the private sector is better than the government at figuring out what assets are worth. Moreover, there's a lot of room for politics to influence prices. Politically connected investment banks might be able to sell their assets to the Treasury, which is headed by a career investment banker, for a lot more than they're worth. I don't know that will happen, but I'm afraid that it will. So we don't know whether the government will pay a fair price, but it seems likely that it will overpay.

Paying more for the securities than they're worth is equivalent to buying the securities at fair value and then giving the financial institutions a gift. Generosity is a virtue, of course. But given the huge federal debt, I'm not sure American taxpayers can afford to be so generous. I think the federal debt is one of the American economy's greatest long-term problems. Our economy has been supported for years by continued borrowing from foreign governments at low interest rates. But I'm afraid that at some point they're going to decide that's not such a good deal any more. Once that happens, the cost of financing our increasing debt will increase. Ultimately, I expect a dramatic devaluation of the U.S. dollar in order to make our debt manageable. Paulson's plan, therefore, may solve a medium-term problem—unavailability of credit—at the cost of exacerbating a much more serious long-term problem.

I was not wild about the government intervention in Bear Stearns, or the conservership of Fannie and Freddie, or the bailout of AIG. But I could live with those three. In each of those cases, the business owners and other responsible parties suffered some loss. Bear Stearns' shareholders saw the value of their stock fall dramatically. Fannie's and Freddie's CEOs were fired, stockholders lost a lot (the stocks may yet go to zero), and dividends on preferred shares were eliminated. AIG's CEO was fired, and the government loaned the company money at a punitively high interest rate. The people who made bad business decisions suffered (at least some of) the consequences, which is how capitalism is supposed to work. But in the case of the proposed $700 million bailout, the financial institutions that made really stupid decisions will be able to unload their bad debt at above-market prices with no penalty whatsoever. I think the moral hazard here is overwhelming. It seems that investment banks will have a strong incentive in the future to make risky investments.

There is another problem related to the compromise of capital principles. The financial services industry in the U.S. is too big. It accounted for 40 percent of total corporate profits last year. That level of activity is not sustainable. If individual financial institutions are going to be profitable (without continued government support), we need to have fewer of them. The bailout will prop up weak institutions and delay their failure.

I agree with Paulson that we need to address the lack of credit availability. It is difficult for businesses to even survive, much less flourish, without access to credit. Also, in most of the country, housing prices appear to be nearing fair value. The housing market can begin to return to normal if home buyers with good credit can get mortgages. This is unlikely to happen unless lenders can replenish their equity capital. However, there are numerous superior alternatives to Paulson's plan. For example, the government could inject capital into financial institutions by purchasing preferred stock, as was done with Fannie and Freddie. This would at least give taxpayers some upside if the institutions become profitable in the future. Also, "Why Paulson is Wrong", an interesting short article by Luigi Zingales, a professor at the University of Chicago business school, proposes an interesting solution. He suggests that creditors be forced to accept equity in exchange for debt. This amounts to a sort of instant Chapter 11. This would increase the equity capital of financial institutions not by increasing their assets, as Paulson's plan would do, but instead by reducing their debt. Since there are better ways to restore credit availability—some of which require no financial support from taxpayers—Paulson's plan should not be adopted.

Note: MMPI closed on September 17 at $0.99

Meruelo Maddux owns and develops residential, industrial, and commercial real estate in the Los Angeles metro area, primarily in downtown LA. As a development-oriented real estate company, Meruelo Maddux has a negative cash flow; the expenditures for development of its properties exceed its rental revenuewhich makes it difficult to value using commonly used metrics and ratios (such as price/earnings ratio).

Accordingly, I will analyze MMPI's value in terms of the price that shareholders effectively pay for the company's real estate holdings. I believe that Meruelo Maddux provides the opportunity to buy real estate for substantially less than it is actually worth. When you buy a share of MMPI, you are, in effect, buying a share of Meruelo Maddux's real estate holdings plus a share of the company's other assets). For this, you are paying the share price plus your share of Meruelo Maddux's debt. For simplicity, I'll analyze this in terms of the value of the entire company. Given its recent price of $1.24/share (September 8, 2008), MMPI has a market capitalization of $107 million. The company's total liabilities are $385 million. So you're paying a total of $492 million for the company's assets. You get Meruelo Maddux's real estate assets plus $23 million in other assets. Subtracting out the $23 million in other assets, you're paying $469 million for Meruelo Maddux's real estate assets. How much are those assets worth? $773 million according to Meruelo Maddux's balance sheet. So you're buying Los Angeles real estate at a 39 percent discount (if Meruelo Maddux's real estate is carried on the balance sheet at its actual value).

Is Meruelo Maddux's real estate carried on the balance sheet at the amount it's really worth? Well, the value of real estate is typically understated on balance sheets prepared in accordance with Generally Accepted Accounting Principles, particularly if the property was purchased a long time ago. Real estate is typically carried on the books at the original purchase price, less depreciation for buildings. But over the long term, well-maintained buildings generally appreciate rather than depreciate, and land also tends to appreciate. However, Los Angeles area real estate appreciated rapidly from 1997 to 2006. It seems reasonable to think that it became overvalued at some point and has not yet fallen back to fair value. So I will discount Meruelo Maddux's real estate holdings according to their acquisition date. For this, I will use estimates from the Global Insight/National City Bank Housing Valuation Analysis. For example, I will discount properties acquired this year by 11 percent, properties acquired in 2007 by 24 percent, and properties acquired in 2006 by 28 percent. I will assume that properties acquired in 2003 or earlier have appreciated. Using this method, I estimate the value of Meruelo Maddux's real estate holdings to be $716 million. Given this estimate, buying MMPI is equivalent to buying Los Angeles real estate at a 34 percent discount. I consider it reasonable to invest in real estate when you can acquire it at a discount of least 20 percent.

Of course, the most I have established so far is that if you want to invest in real estate, buying MMPI is an attractive way to do so. But you might well think that is a huge if. We hear about the real estate crisis everyday in the news. Surely real estate is just going to go down, down down! Even at a 34 percent discount, real estate is a bad investment. Well, a year or even six months ago, I was inclined to agree with this sentiment. However, real estate in Los Angeles has now fallen 25 percent from its peak. I believe Los Angeles real estate prices may be getting near fair value. Recall also that MMPI is trading at a 34 percent discount to the estimated fair value of its real estate holdings, not to their market value. This estimate assumes that Los Angeles real estate is still overvalued by about 5 percent. This estimate may not be exactly right, of course, but a 34 percent discount provides some margin of safety.

Moreover, there is another somewhat conservative element of my analysis. I treat properties as worth their purchase price (adjusted for appreciation or depreciation) plus the cost of improvements. However, the point of developing property is to increase its value. If all goes as planned, Meruelo Maddux's properties will be worth more than their cost once development is complete.

I also think that downtown Los Angeles is a relatively promising location. Downtown LA is undergoing a significant transformation, e.g., population grew 20 percent between 2005 and 2007. While I don't expect downtown LA to turn into Manhattan overnight, I do expect continued gradual renewal, partly because high gas prices provide an incentive to live closer to work. There are currently about 500,000 jobs downtown but only 30,000 residents. This is a much lower ratio of residents to jobs than other major West Coast cities. Downtown LA is also beginning to get the attributes, such as restaurants, entertainment venues, retail stores, and a major supermarket that make it desirable and feasible to live downtown.

Of course, a 34 percent discount and a promising location will mean nothing if Meruelo Maddux goes under. And given all the problems in the credit markets that we keep hearing about in the news, isn't that a probable outcome? That certainly seems to be what the stock market thinks. However, while it is a live possibility that Meruelo Maddux will go bankrupt, I think it is unlikely. For one thing, Meruelo Maddux has been able to roll over its maturing debt so far this year (at reasonably good interest rates for the most part). In the first two quarters of this year, seven of Meruelo Maddux's loans matured. In each case, the loan was either extended by the lender at the same interest rate or Meruelo Maddux was able to refinance the loan at the same interest rate. In another sign that the credit crisis isn't completely crippling Meruelo Maddux, the company was able to obtain an $84 million construction loan to complete a high-rise multifamily residential project. The terms of this loan are not particularly favorablethe interest rate is 12 percent. Still, it is encouraging that Meruelo Maddux was able to obtain a loan since financing is reportedly so hard to obtain nowadays.

There have been other favorable developments recently as well. In August, Meruelo Maddux received $14 million in a settlement of an eminent domain dispute with the Los Angeles Unified School District. (The total amount of the settlement was $50 million; the rest had already been received.) In August, Meruelo Maddux also sold another property for $35 million (for a profit of $14 million). I think it is likely that Meruelo Maddux will be able to obtain financing for some of its projects and that it will be able to sell non-core properties to fund the rest. Meruelo Maddux management has identified nineteen non-core properties for possible sale and has received written offers for eight of them.

Even in a “worst-case” scenario in which some of Meruelo Maddux’s properties were foreclosed on, this would not necessarily result in a loss to MMPI shareholders. Since Meruelo Maddux’s real estate holdings are worth $243 million more than shareholders effectively pay for them, there is a significant cushion to absorb some loss due to foreclosures or distressed sales. I should point out, however, that the continued revitalization of downtown LA is very important to Meruelo Maddux’s prospects. Meruelo Maddux’s success, and perhaps even its survival, depends on its ability to rent out luxury apartments in downtown LA at rents close to those currently achievable.

In sum, I think the market’s overreaction to credit crisis and to the fall in real estate prices has provided the opportunity to acquire valuable real estate at an attractive price by buying MMPI stock. It is certainly not without risk, but the upside is very attractive. I expect that the housing market will hit bottom and then begin the rebound within a year or two. There will most likely be an accompanying easing of the the credit crunch as well. Once that happens, I expect MMPI’s stock price to appreciate to the point where it no longer trades at a discount to the value of the real estate holdings. Since the real estate holdings are worth $716 million and there are other assets of $23 million, the total assets are worth $739 million. Subtracting out liabilities of $385 million leaves us with equity of $354 million. Since there are 86.4 million shares of MMPI stock, the price per share should reach $4.10.

AMCON's earnings per share (from continuing operations) have grown dramatically over the last several years, from a loss of $1.11 in 2005 to a gain of $1.82 in 2006, to $4.89 in 2007. Earnings per share are up by 147% for the first two quarters of 2008. How has the company been able to increase earnings so fast? Will it be able to continue to grow?

When we think of growth stocks, we generally think of companies that are expandingby opening new stores or developing new products, for example. Certainly we think of increasing sales. AMCON is not doing any of this. In fact, the company's revenue fell by 5% in the most recent quarter. AMCON is instead growing its earnings simply by reducing its debt.

AMCON had acquired a large amount of debt in the course of moving into the bottled water business and making a related misguided acquisition. These money-losing divisions have now been sold or discontinued. As a result, the company currently has considerable cash flow (in the most recent quarter, $5.38 million before debt service) and is using it to pay down debt. AMCON reduced its debt by $5.59 million in the most recent quarter, thereby reducing its interest expense by $220,000. I anticipate that AMCON will be able to pay back $4 to $5 million of debt for each of the next 5 to 6 quarters. This will enable the company to increase earnings about 30% through 2010, with growth leveling off after that. To summarize, I think that AMCON can continue to increase its earnings, at least for the next several years, although not at quite the breakneck pace of the last three years. Given the stock's extremely low P/E, I consider it a strong buy.

Of course, distribution of consumer products is not the best business to be in during these times of near-recession and faltering consumer demand under pressure of high fuel and food costs. Health food retailing might be even worse. Organic groceries and other health food items are a luxury that consumers can cut back on during tough times. Also, the health food business has become increasingly competitive, as Whole Foods Market is expanding and regular grocery stores are increasingly stocking health food items. However, I am somewhat reassured by AMCON's geographical focus. The states served by AMCON's distribution business are relatively strong economically, at least as I read the Fed's Beige Book. The retail health food division serves Florida, which is weak, but also Oklahoma, Missouri, Nebraska, and Kansas, which are relatively strong. Moreover, the earnings that I estimate do not depend at all on any assumption of increased sales.

Disclosure: I hold this stock in my own accounts.

by Adam Thompson, m10 member and mFOLIO Master

You can see from Adam Thompson's Performance Zones (click here), that 41% of his gains have come from the Energy Sector. So when he writes about a stock in this sector we listen.

I believe that global demand for oil will continue to increase over the next several years although there might be a lot of volatility along the way. That’s why I have 34% of my portfolio in energy stocks. But drillers have been hit hard over the last year from the oil and gas price volatility and right now, I believe there are better buying opportunities with drillers than with exploration and production stocks. As long as the price of oil doesn’t drop back to the $40s, we’re still opening up new wells and re-opening old exhausted wells and drillers will be in demand. So even if oil prices don't increase and remain relatively high we can benefit and we should have some downside protection as long as oil doesn't drop fast, far, and fairly permanently.

Patterson-UTI Energy (nasdaq: PTEN) provides oil drilling services to oil and natural gas producers. It operates 403 rigs, giving it the second largest land-based drilling fleet after Nabors Industries. Oil and gas drilling stocks in general have fallen considerably over the last year. Patterson-UTI is down to $22.04 (3/12/07) from its high of over $35. I believe this is a considerable overreaction. Petroleum prices have declined, but it's still very profitable to drill for oil and gas at the current prices of almost $60 per barrel for oil and over $7 per thousand cubic feet for gas. These prices, and Patterson-UTI's profits, will undoubtedly fluctuate, but I believe the current trend is up. I think the world economy will continue to grow, especially in China and India, and these countries will use more and more oil as they become more industrialized and more of their residents buy cars. It's also likely that U.S. consumption of natural gas will continue to increase. For one thing, the population is shifting to the South, with its high air conditioning use. More energy will be needed for all those air conditioners, and at least some of it will come from natural gas. How much comes from natural gas will depend on political factors and public attitudes toward pollution (natural gas is much cleaner than energy sources like coal) and nuclear power.

Patterson-UTI earned $4.02 per share in 2006, giving it a P/E of less than 6. That's the P/E of a stock that the market has very low expectations for. But I think Patterson-UTI has good long-term prospects, even if 2007 is somewhat uncertain. These good long-term prospects also make Paterson-UTI an attractive takeover target, I believe.

Disclosure: I hold this stock in my own accounts and in most of my clients' accounts.

by Adam Thompson, m10 member and mFOLIO Master

I originally recommended FreightCar America, Inc. (nasdaq: RAIL) at $55.45 (12/29/06). FreightCar America makes railroad cars, primarily coal-carrying railcars. Over the last two months, the prospects for this stock have dimmed considerably, and the stock has fallen to $48.63. It is now pretty clear that the company will exhaust its current backlog by the end of this year. Once they do that, their revenue will fall considerably, and they may even lose money, at least for a few quarters. However, they are diversifying into other types of railcars, and there is a decent chance that demand for coal cars will pick up by the end of the year, around the time their backlog is exhausted. Unfortunately for FreightCar America, TXU Generation has greatly reduced the number of new coal-fired power plants it plans to build (this was part of the terms of the recent buyout of TXU). Since FreightCar America had a large order from TXU, this is a big negative for the stock.

However, FreightCar America's 2006 earnings per share were an incredible $10.07, giving the stock a P/E of less than 5. At that price, I think the stock is still worth buying, even with all the negatives and uncertainties. I believe the price of oil and natural gas will remain high and that coal will therefore continue to be an attractive fuel. At some point, coal cars will need to be replaced, and FreightCar America's earnings will increase. Of course, this depends to a large extent on how willing people are to tolerate the pollution that coal usually produces.

FreightCar America's current assets exceed its current liabilities, even when inventories are excluded from current assets. Its long-term debt, including pension costs, is about $59 million, compared to $204 million in equity, so it is not very heavily leveraged.

Disclosure: I hold this stock in my own accounts and in most of my clients' accounts.