Should You Hold On To ARM Holdings?

CNBC stock analysts Jim Cramer recently pick ARM Holdings (ARMH) as one of his growth stocks (discussed in a prior post here). Unfortunately, the Random Stock Walker didn't validate ARMH as a growth stock even though it did validate the other stocks Cramer picked (AAPL, CMG and NFLX). What's going on?

First, as a company ARM doesn't actually make anything! It is a supplier of semiconductor intellectual property. It designs chips used in smart phones but it then licenses the designs to semiconductor manufacturers. ARM provides economies of scale in R&D in what has become a commodity market (semiconductor manufacturing).

Because ARM technology is so central to smart phone design and because cell phone technology is switching from "dumb" to "smart" phones, ARM should be well positioned to ride the "mobile internet tsunami".

If you look at the Random Stock Walker models, ARM is clearly a business as usual (BAU) model driven by shocks and a "short-memory" for the stock price (see THEORY below). It is not a growth stock (long-memory for shocks and stock price) and it is not particularly well linked to the U.S. economy. Therefore, even though the performance for ARMH (in the graphic above) shows improbable growth (beyond the 98% prediction interval) for early 2011, the forecast for the rest of 2011 is for a return to the long-run attractor at a price between 20 and 25 roughly.

Analysts don't like this stock very much either (here): it has a high P/E ratio, eight-out-of-ten analysts have recently downgraded the stock and given it a price target between 10 and 12!
Cramer acknowledges that people got burned by this stock during the dot-com bubble as can be seen from the long-term Random Stock Walker forecast above. Yet, he thinks it is a compelling story. Only time will tell. From the modeling perspective, this stock does not behave the same as other momentum or growth stocks and should not be put in the same category statistically.

THEORY. The BAU model is P[t] = a + b P[t-1] + V where b is less than unity. A pure growth stock would differ in that b would be greater than one. In the random walk, of course, b is (in probability) precisely unity. Since b=1 is actually quite unlikely, what the random walk designation should mean is that the stock price is dominated by random variability and cannot be effectively forecast.

METHOD. Looking at the behavior of ARMH during the dot-com bubble around 2000, one approach would be to eliminate this "shock" from the model and re-estimate. I've re-estimated the model starting in 2003 and the results are fundamentally the same as reported above.