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Archive for January 2010

Market at Fair Value … Oh, Really?

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Last week, I wrote a piece contending that the market is neither over nor undervalued but, instead, right in the middle.  As you might imagine, I was opposed in this view by more than one person, and this prompts me to make three points that should be helpful.

My original contention that the market was fairly valued last week followed from a comparison of the Wilshire 5000 with US Gross Domestic Product, and this was graphically depicted as follows:

The general rule of thumb is that the Wilshire 5000 market cap should fall somewhere between 70% and 90% of US GDP, and, at 82%, things were in the sweet spot of fair value.  Now for the opposing arguments.

First, one member of a forum group argued that the US economy is too dicey to conclude that the “water is fine, jump in,” and I agree.  As mentioned in the earlier posting, noting that the market is neither over- nor under-valued simply means that value investors should be able to find at least a small number of undervalued stocks.  That, in fact, is what I’ve found over the last several weeks.  In fact, it appears that ADM may be undervalued by as much as 40% to 50%, but I won’t know this until doing further research.  I have, however, recently added new holdings in BOLT, DIS, ISNS, NGA, ORCL, PPDI, and WMT.  Among existing holdings, I consider E, CRDN, EME, JNJ, NUE, PVX, and XOM to be sufficiently undervalued that I am considering increasing my stake in each.  By the same token, a fairly valued market (especially, one that has evidenced an inclination to “correct” after a substantial run up) may represent an opportunity to take profits in positions that are at or near fair value.  And that is precisely what I did today, selling out of FCX, BHP, PCU, and HANS (posting profits of 50.90%, 63.32%, 40.00%, and 37.52%, respectively, on a cost-weighted basis … meaning I bought each as they declined during the 2007/2008 market crash).  So, do not read my earlier posting as a recommendation to buy an index ETF of the S&P 500 or otherwise go “all in” in the market at this point.

The second objection to my earlier post contended that it is unreasonable to use a $14 trillion GDP as the mearure against which to compare the Wilshire 5000.  This forum poster favored using a GDP of $12 trillion.  Personally, I don’t have a problem with this.  Who am I to stand in the way of a depressive personality reveling in his loathing of the economy, the market, the future, etc.?  It is important to recognize, however, that $14 trillion is a known number, while $12 trillion is a gestalt figure — “gestalt” is German for instinct or gut reaction.  Moreover, at $12 trillion, last week’s Wilshire 5000 comes in at 95% of this downward-adjusted GDP estimate, and 95% is not so over-valued that an intrepid value investor can’t locate a small number of value stocks.  Besides, the alternatives to equities are not exactly enticing at the moment.  With the Federal Reserve’s balance sheet doubled from the pre-crash era, inflation makes cash unattractive, due to the heightened risk of inflation.  With interest rates at historic lows and likely rise significantly, bonds are not attractive.  With states and municipalities confronting tax-revenue short-falls, municipal bonds are not a screaming buy.  If truely convinced that we are likely to experience a double-dip recession or worse, corporate bonds are problematic.  Gold and precious metals are self-defeating, in that, if they rise in value, miners will increase extractions and supply, bringing them back into some form of equillibrium — besides, I can’t determine when precious metals are over or undervalued based on some demonstrable measure of valuation … there is no such thing as price-to-NAV with them, and forget about trying to determine their value with Discounted Cash Flow analysis.

The third objection came from an investments banker in New York City during a visit this weekend.  He argued that PE (Price-to-Earnings) are higher than normal, and, indeed, they seem to be.  Prior to my trip up north, the average PE for the non-financial S&P 500 was listed as 22.5, which is above the norm of 18.  My friend explicitly made the PEG argument, which contends that any PE multiple is justifiable as long as the growth rate equals the PE.  “Growth” is the G in PEG, and, if the average PE is 22.5, then economic growth would need to equal or exceed 22.5% for the market to be at fair value.  To contest this argument, I will need to consume some of your (the reader’s) time, but this argument is just too intellectually intriguing to dismiss.

My first response was to note that this PE of 22.5 was based on last year’s results, when the market was depressed and earnings were nearly as depressed.  If the market rebounds over the next year, the earnings portion of PE will improve and lower that figure toward the norm.  Since our conversation, the Conference Board released its leading economic indicators, in which they report:

Released: Thursday, January 21, 2010

The Conference Board Leading Economic Index™ (LEI) for the U.S. increased 1.1 percent in December, following a 1.0 percent gain in November, and a 0.3 percent rise in October.


In other words, the economy is improving.  This doesn’t mean it is time to break out the bubbly and assume a posture of “Laissez le bon temps rouler.” Remember, my argument goes no further than to assert that value stock should be in sufficient supply to warrant looking for them. If the PEG measure fails to reflect an environment of future growth, then it fails as a viable metric — some tautologies are worth asserting because they are so easily overlooked.

Of course, I didn’t have today’s announcement by the Conference Board with me during the conversation last weekend, but I did argue that the economy is improving and earnings were likely to follow suit. The second argument against the PEG model (made this weekend) asserted that, currently, the average PE is skewed toward higher numbers due to a small number of outliers on the high end. Allow me to prove it, even though this will get a little quantitative.

First, it is necessary to understand that companies with negative “earnings” post no PE. If earnings are negative, you confront the problem of dividing by zero. This pushes the average up, because companies not posting profits are not included in average. This is not an unexpected problem when it comes to calculating averages based on results derived during recessions. Companies posting losses last year but benefiting from a rebounding economy (those not declaring bankruptcy, at least) are excluded from consideration when calculating the average PE. This is significant. I did a query of the more than 6,000 stocks in the Yahoo database, limiting the results to companies with a PE greater than zero, and it returned only 2,326. In other words, not only is PE a lagging indicator at a time when the leading indicators suggest a recovering economy, only 39% of stocks quality when determining the average.  How can the average be legitimate when less than half of the stock market contributes to that average?

That, of course, skews the average upward, due to elimination (from consideration) of stocks on the low end. Making matters worse, a similar problem exists on the high end — further skewing the average. Presently, the highest PE is 979.75 [specifically, United States Cellular Corp. (USM)]. USM, while an extreme case, is not alone in disproportionately pulling the average skyward. Here is the distribution:

I’ve highlighted the PEs greater than 139.  Recall from high school (if not later) the effect of scoring a zero on a test.  If you scored 90’s on four tests and a zero on the fifth, the zero brought your average down to a 72.  This same disproportionate influence occurs with all outliers, and it is why statisticians are so concerned with “residuals” — data results that exceed three standard deviations from the mean.  In this case, the results literally skew the data toward the high end:

If you plot the results, the high end contributions are so small in number they aren’t visible, even thought they have a disproportionate influence on the average:

If you limit your consideration to just stocks with PE’s up to 150, the distribution starts to look workable (i.e., we can productively play with this set of data):

In this chart (above), I’ve indicated the outliers that serve to disproportionately pull the average above what would be normal if the data results were evenly distributed above and below the mean.  How does this compare to a normal distribution?

In this chart above, the normal (Bell-Curved) distribution is in purple, and I have drawn a dotted line from the peak down to the X-Axis (PE).  I’ve done the same with the peak of the actual PE results (dotted green line).  With the normal distribution, the dotted purple line indicates the average, but, with the average results, it does not.  Note, as well, that I’ve indicated the data points that have a disproportionate influence under the heading of “Tail Hook” — a statistician’s joke, because we call the extreme results in a distribution the “tails.”

So, lets see if we can identify the proper distribution for the actual results.  To do this, I created a chart that shows the actual, cumulative percentages on the y-axis and compared it with several common distribution types — normal, Poisson, and gamma:

Note that the 50th percentile is indicated as the dotted purple line, extending from left to right.  It crosses the Normal and Poisson (red and green, respectively) at around a PE of 35 (red dotted line).  The Gamma and actual results post 50th percentile results (dotted blue line) between a PE of 14 and 21.5.  When I solve for the 50th percentile using the Gamma distribution, the PE comes in at 19.84.

Of course, we should adjust this figure downward due to the divide-by-zero problem and the Tail Hook problem.  By how much should be adjust?  Well, it doesn’t matter, does it?  All this math may look precise, but the market isn’t so precise that we can measure it with precision to anything approaching two decimal places.  If the actual PE for the broader market is 19, that is close enough to the historic norm of 18 to conclude that value stocks should be available, and that was, after all, the purpose of the original exercise.


Written by rcrawford

January 22, 2010 at 11:33 am

Posted in General, Investments

Is the Market Over-Valued?

with 6 comments

Hopefull by now nearly every investor is familiar with Benjamin Graham’s story about Mr. Market — the bi-polar fellow who offers to buy or sell you stock based on his mood that day.  Some days he is optimistic.  Some days he is pessimistic.  And, of course, Mr. Market is real, except he suffers from multiple-personality disorder, as well — since Mr. Market is the stock market, with millions of investors … each with their own manic-depressive tendencies.

If value investing is all about identifying the intrinsic worth of a company and comparing that worth to the price at which it is sold in the market, then there should be some measure of whether the market, in general, is at, above, or below its intrinsic value.  This is not an unworthy question, if 70% of a stock’s price movement over the short term is determined by the market’s movement.

Pleasantly, Warren Buffett identified a measure for the US stock market, in which he compares US Gross Domestic Product with the market capitalization for the Wilshire 5000.  The Wilshire 5000 is the largest measure of stocks traded on US exchanges, covering the 5000 largest publicly-traded companies.  Of course, there are more than 5000 companies in the US, even if these 5000 do account for the vast majority of the producer-side of the economy.  So, it would not be appropriate to compare the two one-for-one.  Indeed, valuing the market as a whole is not something we can calculate with absolute precision, any more than we can calculate the intrinsic value of a specific company with absolute precision.  But we can identify fair value as a range.

Specifically, the stock market is fairly valued when the Wilshire 5000 is between 70% and 90% of Gross Domestic Product.  And this brings us to the question of whether the stock market is fairly valued today.

In this chart, we have US GDP results extending back to the start of 1999 and ending with the latest results from the third quarter of 2009.  The “X” notes the level of the Wilshire 5000, and the red box is the range for fair value (based on the percentages indicate on the right y-axis).  Currently, the Wilshire 5000 is at 82.69 percent of US Gross Domestic Product, which is in the range of fair value.

There are, of course, several items worth mentioning.  First, we do not yet have the results for the 4th quarter of last year.  Second, the results for the third quarter of last year may be revised up or down.  And, third, we do not know where GDP stands today, in the first quarter of 2010.  Moreover, it may be prudent to compare the current Wilshire 5000 level to expected GDP at the end of the current year, in order to avoid having this measure lag expected investor returns.  Otherwise, we risk becoming like the worker who negotiates his or her salary based on the current market rate (seems fair) but has his/her cost of living adjustment at the end of the year based on the prior year’s level of inflation.

Regardless, taking the results and these considerations in to account, it seems evident that the market is fairly valued today.

Now, I should mention three further items.

First, the Wilshire 5000 is an imperfect measure due to the global nature of the market.  With the arrival of international trade and the ability to buy and sell stocks around the world (to say nothing of the growing percentage of companies operating internationally), both the Wilshire 5000 and US GDP represent inaccurate measures of the market’s intrinsic value.  If anything, this would suggest that, given the footprint of the US economy, this range of intrinsic fair value should be marginally increased.  The Crawford’s have two family friends who run small, private companies.  One imports coffee for US consumption from Japan from their home office in Puerto Rico, and the other is a shoe distributor in Miami with production facilities in China and sales in the US and Canada.  My consulting practice over the past three years has undertaken efforts around the US, in Africa, Portugal, Korea, and China.  Toto, we are not in Kansas anymore, and this expanding pie changes the future prospects of every firm, how taxes are recorded, and the extent to which they are reflected in US GDP and the market indexes … and this more prominently effects and benefits larger, publicly-traded firms than those I’ve just described.  This means larger firms represent a larger portion of the GDP pie and suggests the fair-value range should be shifted up further, even if only marginally.

Second, this measure of intrinsic fair-value tells us nothing about individual firms and whether a stock is likely to be over- or under-valued.  To determine this, it is necessary to do the analysis for each company under consideration.  What it does suggest is that the market is not so over-valued that looking for under-valued companies represents fruitless effort.  Indeed, even when the market is over-valued, finding the under-valued stock is still possible, even if more difficult.

Third, there is nothing about a fairly-valued market that prevents it from declining into under-valued territory.  When the market is run by a bi-polar, manic-depressive, nearly anything is possible, and, as of this writing, sentiment seems to be shifting, with the market showing signs of an over-active amygdale — the part of the brain that fires when we become frightened.

The reason for this is interesting.  Over the past decade, the market has crashed twice (dot.com and housing/financial-sector crashes), and the average investor just doesn’t trust the stock market anymore.  Who could blame them.  The market is like the spouse who keeps infecting their mate with a venereal disease. Tell the average American that retirement security is dependent on investing in the stock market and he jumps in.  Report on the nightly news that the market is booming and similarly-situated novice-investors are making a killing, and he jumps in.  And all that jumping has a trampoline effect, taking the market higher and higher until it crashes.  The media, of course, blames the whole thing on Wall Street, greedy CEOs, the Federal Reserve, Congress, and a dispeptic God, and, certainly, they played a substantial role, but the average investor exacerbated the effect, but only the average investor foots the bill.

In essence, the average investor hasn’t learned to “Be fearful when others are greedy and greedy when others are fearful,” and the average investor hasn’t been trained to value companies and stocks.  Because of this I have old friends (some going all the way back to high school and college) who were nearly wipped out by the market’s two crashes this past decade.  One friend is now a grandfather with health issues, who started and sold two profitable companies.  A God-fearing man, he is still married to his high school sweetheart and is on excellent terms with his four kids.  Between healthcare costs and stock market crashes, he is all but compelled to work until he leaves to meet his maker.  He blames his investment advisor, but, truthfully, he lacked the knowledge necessary to provide supervisory oversight to his investment adviser.  This is the problem with doing away with Social Security in favor turning this over to average Americans.  It is akin to telling a brain cancer patient to do his own surgery.

Of course, this is a positive for value investors — as is the steepening yield curve.  Why?  Well, think about it.  Whenever the average investor jumps into the market it is typically because the market seems such an easy place to secure quick wealth that a frenzy of ignorance follows — driving up stock prices well beyond the tolerance of value investors.  Instead, value investors prefer markets where rampant fear and loathing are the order of the day.  The more depressed, the better, because good companies can be purchased cheaply.

As for the yield curve, the steepening curve is good for value stocks because it promotes bank profitability and lending to companies best positioned to benefit from lending and most desireous of it — namely, value companies.  Growth companies don’t need bank lending during bull markets because they more cheaply undertake secondary offerings.  So, with the economy depressed and getting more depressed by the hour, with the market fairly valued (or slightly undervalued), and with the yield curve steepening, this is a good time for patient value investors.


Subsequent to publishing this piece, an old friend from one of the on-line forum communities responded with several criticisms of using GDP/Wilshire 5000.  I’ll leave it to the interested reader to dive into the give and take found there, but I want to respond graphically to the argument that the average PE ratio for the market represents a superior measure of market valuation (which isn’t possible in the comments area).

If rank ordering the PE results from a Yahoo Finance query conducted last weekend, where individual PE’s are located on the y-axis, you get:

With a 21-bin histogram of:

and desriptive statistics (including skew and kurtosis) of:

Consequently, you get a mean that is so far above the normal average as to suggest the market is wildly over-valued but the absence of negative PE’s (can’t divide by zero) and the disproportionate influence of >3 sigma outliers makes use of average PEs unreliable as a measure of market valuation.

With mean of 34.48 and standard deviation of 64.99, 38 entries exceed three sigma and 12 exceed six sigma.

Written by rcrawford

January 14, 2010 at 10:01 am

Posted in General

AEO — American Eagle — Update [01/10/10]

with 2 comments

Well, I just noticed that today’s date is all ones and zeros.  Not as momentous as the Armistice that ended World War I (the eleventh hour of the 11th day of the eleventh month), but, for a numbers geek, this is what suffices for entertainment.

My last posting on American Eagle (AEO) was on August 29 of 2008; although, I did include the stock as a current holding in the Bull series completed this week.  Two acquaintances from one of the on-line forums made seperate assertions that prompted me to look at the stock and its performance more closely, and what I discovered was a surprise.  Amazing, actually.

The first comment asserted that the stock market and the economy are in the toilet and will soon be at the solid waste disposal facility.  The second questioned why the stock did not enjoy a boost in price with the most recent earnings announcement and higher guidance.  The easy conclusion is that the first comment answers the second, even though they were not presented in the same thread on the message board (i.e., line of discussion).  My take is dramatically different than either, but it is not dramatically different than prior assertions.  In short, the market is more than inefficient, it gets some stocks badly wrong over protracted periods.

Of course, you might expect that I would take this position, since I am long (own the stock).  Indeed, recent research into human psychology notes the difficulty we have admitting mistakes and reversing our prior positions; especially, those taken publicly.  Given this, allow me to repost my response from that message board but, unlike the original, provide the charts and graphs in support and a small number of additional comments (based on the ability to post the graphs and charts).

Question:  “Why is AEO trading down? I thought these results would cause AEO to [go to] at least go to $20. Yet it’s under $17. What am i missing?”


Why? Good question.

The current PE is 25.36. This puts AEO above 73.93% of all stocks current trading (the non-financial firms). Consensus for next year is $0.32 per share in earnings, which equates to a PE of 54.25, and that is above 99.50% of all stocks currently trading. (Percentages based on regression-fitted gamma distributions.)

On the other hand, AEO is currently selling at a price to net asset value of 2.37, which puts it among the cheapest 5.42% of the market (just 1.68 times replication value —  $17.36 (current price) divided by $10.32 (Replication Value).

So, the stock appears to be overvalued based on earnings, while it is undervalued based on assets. The reason for the difference (I suspect) is the uncertainty over of the consumer, for all the reasons my pessimistic friend mention.

It may be helpful to recall that the company guided above performance just prior to the market crash, with expansion plans into two new demographics and sales overseas, with sustained growth of 12%-to-14%.

Now, it is important consider the limitations associated with basing valuations on earnings. This is why Buffett looks at Owners Earnings, rather than GAAP earnings.  GAAP earnings include such non-cash items as depreciation, amortization, and changes to “Goodwill.”

For me, the bigger measure of management success is shareholders equity growth, since this more accurately measures the value of a company today.  Shareholders equity is calculated as total assets minus total liabilities.

To FULLY assess AEO’s shareholders equity, look at the percentages of free cash flows and owners earnings converted to shareholders equity.

The five year average is around 80%. This would have been higher if not for significant funds invested in upgrading operations in 2008 and 2009 (around $278 million in 2009, alone).

So, while some have complained about the company’s expenditures on growth, estimated maintenance CapEx appears to have dwarfed growth CapEx in 2007 and 2008 ($203 million and $278 million versus $84 million and $0 million), leading to $94 million and $105 million spent on maintenance CapEx above declared depreciation levels.

This is important because it informs free cash flows retained as shareholders equity and cash flows used to repurchase shares. CapEx represents the company’s investment in the future, while shareholders equity is the value of the company to which I (and you) are part owners.

So, has the company been investing in the future to our detriment? Well, before the crash, shareholders equity was $1.155 billion in 2006 and grew to $1.417 billion in 2007 (a 23% increase). It dropped to $1.340 billion in 2008 (the crash), rebounded to $1.409 billion in 2009, and is currently at $1.523 billion. This actually represents a 7% improvement over pre-crash levels, despite its CapEx expenditures.

That, however, doesn’t tell the full story, either. The company has bought back shares (from 233 million in 2006 to 208 million currently — just under 11%).

This is important because it alters the per share value of shareholders equity. It was $4.96 in 2006 and currently stands at $7.33.

That is a 10.26% compounded annual growth rate —

That is the result for those who have held the stock over the last several years.  Going forward?

This chart (above) provides the shareholders equity per share results with a trendline, a measure of the trend’s accuracy, and the equation for that trendline.  At R-Squared 0.9788, the line is pretty close to a perfect 1.0 (just 0.006 variance).  The bolded red figure is the slope (recall from school the equation for a line — Y = MX + B –, where M is the slope).  So, AEO is adding $0.65 to the per share value of shareholders equity, and this equates to 8.9% growth for the coming year if the trend continues.  That is more than double the rate generated by the 10-year US Government bond.

So, the company invested in growth, invested in current operations, bought back shares, absorbed losses due to auction rate securities, kept its current ratio at 2.60, maintained its total debt ratio at 0.27%, ***AND*** grew shareholders equity per share at more than 10% during the worst economic crash since the Great Depression.

Impressed?  If not, you never attended business school or didn’t pay attention while there.

So, did Wall Street get it wrong when not rewarding the company for better than expected earnings and forward guidance? I don’t know, but all of this does suggest they have been pretty clueless for the last three years.

Recall that Warren Buffett has maintained that the great lesson of Charlie Munger is a willingness to pay a fair price for a company possessing excellent management.  If needing evidence that American Eagle possesses excellent executive leadership, this posting should prove the point.

If not satisfied, the burden of proof is entirely yours.

Written by rcrawford

January 11, 2010 at 9:22 am

Bull III

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In the previous two postings, we addressed AEO, BPT, PVX, BHP, CRDN, E, EME, FCX, FRX, HANS, JNJ, MCK, MSFT, PCU, PG, SHLD, SLP, and UNH.  This posting will address hold decisions during the recent crash for EMC, LRCX, NKE, NUE, PFE, TEVA, TSM, UNH, and XOM.

Before starting, I should note that I mention Joe Ponzio and FWallStreet.com several times in this post.  If you are new to investing or are a self-trained, experienced investor, visit Joe’s blog.  Not only is he a friend, but he is the best writer about value investing on the planet (more clear about the nuts and bolts of doing it than Warren Buffett).  In fact, my understanding of value investing is easily 25% Joe’s doing (with the rest divided between Warren Buffett, Benjamin Graham, and graduate business school studies).  In fact, I’ve learned more from Joe than during four graduate financial management classes.  While I have not yet read it (I’m shamed to say), Joe’s well-received book is now available, and, at less than $11, it represents a value investment in itself.

EMC Corporation (EMC) is a software creator whose principle product allows one computer to imitate other operating systems — a benefit to programmers and IT departments across industries.  It got a big thumbs up from my wife, the most alluring computer geek I’ve ever met.  So, in that sense, this was like Peter Lynch hanging out in America’s malls to monitor store foot traffic.  The portion of the Lynch approach many over look is the second part of the model — namely, the due diligence side of things (which includes crunching the financial numbers).  I initially purchased the stock on October 8, 2008 for $9.98 a share, when it was over 70% undervalued by DCF.  With CROIC just under 15% and owners earnings just below 2007 levels, my only concern was a total debt ratio of 45%.  This led me to look at the two components of ROA — profit margin and asset turnover:

Both seemed sufficient stable over recent years to conclude that the discount to intrinsic value provided an adequate margin of safety.  Today, the stock is fairly valued (or marginally undervalued, up to 30% if FCF’s grow at the 10-year median of 14.6%).  With sustainable ROE at less than that (7%), consulting the sensitivity analysis table (see the Bull II posting for an example) indicates the stock is undervalued by just 5% at a FCF growth rate of 5%.  This would suggest selling the stock, but I’ve elected to hold because the company is producing cash at a respectable pace and is still in the growth phase of the company life cycle — with earnings value exceeding replication value in all but two of the last 10 years and, currently, CROIC exceeding WACC:

This is important because holding delays payment of capital gains taxes while the company continues to earn compounded growth, with management paying the taxes.  With the stock up over 70% since buying it, I’m in no rush to sell or share the proceeds with Uncle Sam.  At this point, however, a stop-loss may be in order.

Lam Research (LRCX) provides simi-conductor support, and the story of this investment represents another example of DCF weakness and the benefit of reversion to the mean among firms operating in cyclical industries.  It also represents the success of the DCF approach advocated by Joe Ponzio at FWallStreet.com.  When I first purchased LRCX for $41.52 on May 16, 2008, its decade-long financial history was one of impressive and successful growth — posting an average ROE over the prior five years of 20%, $513 million in FCF, and, at 20% growth, a 60% discount to intrinsic value by DCF.  And then the market crashed, the company posted losses for two years, and intrinsic value by DCF dropped with alarming speed.  Today, by those same measures, the stock is over-valued:

Today, however, simi’s are turning around, and the stock (which I bought again on October 21, 2008 at $21.85) is up around 35% on a cost-weighted basis.  The reason for the turnaround is the improved prospects for simis, but the reason my position is up is due to Joe’s recommendation that the FCF growth rate be based on the median of running three and seven-year running medians with a suitable discount (I use 15%, which is more than double some of the systems you will find on the internet).  This, coupled with requiring a 50% margin of safety with uncertain stocks, meant that I bought at a discount, with sufficient confidence to make a second purchase at further 50% discount.  That second purchase was based on my conviction in the company’s leadership strength in the industry and recognizing the role of IT obsolescence for businesses — coupled with the company’s ratio strength:

So, LRCX is a turn-around stock, presently.  Its merit was the margin of safety.  Is it a buy, sell, or hold currently?  For me, it is a hold, but I wouldn’t list it as a buy today because the price to NAV is 3.27.  This takes it out of the value investing realm, even though the company remains a growth stock by EPV/RV and CROIC/WACC.  In short, I can no longer identify the margin of safety, despite the company’s strength and improving prospects.  I have little doubt the stock price will continue to improve, but, if I cannot value the company, this deep-discount value investor will deploy new money elsewhere.

Nike (NKE) is similar to LRCX, except it wasn’t a value stock (by much) when I bought it at $61.77 in October of 2007.  I was new to investing, and I bought it because “Baby Needs New Shoes” and always will.  It is up marginally after all that time.   It is over-valued by 24% (DCF with FCF growth of 12% — with ROE at 12%).  I’m holding the stock because I am overweighted in cash, will soon be taking some profits, and, when that happens, I’ll be even more overweighted in cash (earning little).  I’m holding NKE for two reasons (no matter how much I want to reduce cash, I won’t keep a stock that is wildly over-valued, because even 0.0% growth on cash is better than a loss in equity value that isn’t justified by the company’s worth).    Here are the reasons:

In words of Sally Fields (altered just a little), “This company likes me … it really likes me.”  It has been buying back shares, despite the market downturn, and this has grown shareholders equity per share.  In fact, ShE/Shr has increased by over 30% since I bought the stock.  And, here is the second reason, this shoe company is a growth stock:

EPV exceeds RV in all but two years.  Of course, this is not a stock I would buy today (if knowing then what I know now).  But, it is better than cash when it comes to the question of where to park a small amount of cash.  In short, this company is exceedingly well run (look at the ratios), and the current stock price (or the price at which I bought it) is not the fault of the company.  I screwed up on this one, but the company’s ability to compound the owner’s stake is now being realized by the market, to the owner’s benefit.

Steel producer NUCOR (NUE) is another difficult-to-value stock.  Don’t look at the DCF side of the house, since this is supect, but, instead, look at the price to NAV:

The yields are not bad either.  NUE is a China growth and commodity play, whose ROA and ROE are in the single digits.  Despite this, ShE/Shr continues to climb nicely:

There are other reasons for holding the stock, primarily due to operational efficiency and, in the past year, significant expenditures on sustaining this competitive advantage.  These should benefit the company in the future:

And I like companies that invest in the future, rather than doing the stupid stuff short-term investors “demand.”  So, I’m holding.

Next is Pfizer (PFE). Talk about a tough stock to value.  I bought PFE twice — once in March 2007 at $25.45 and once in February 2008 at $22.69.  The stock is down by more than 20%, due to pipeline issues.  Well, Buffett likes it, but I should have understood it better.  Pharmaceutical companies that are focused on novel drugs (those enjoying patent protection) require an advanced understanding of healthcare to value them appropriately.  Well, I am a professor of healthcare management, and it was still too complex for me.  With PFE, I liked the stockpile of cash, the ability to invest in R&D or aquisitions, and the demographics.

Of course, we all know about the boomers retiring — it is in all the papers –, but many don’t realize the extent of this coming shift.  While the boomers started retiring on January 1 of this year, the country did not suddenly become gray, clutch its chest in cardiac discomfort, or have trouble reading the road signs due to small fonts.  Those effects, however, are in our future … to say nothing of cellulite creating an eyesore on Florida beaches.  Well, here is a chart that should start to put this into proper perspective:

Now, this chart shows the rate of old-fart growth projected by the US Census Bureau, based on 2008 projections.  I think it is conservative, because it doesn’t include the relatives of immigrants expected to arrive in the US — providing support for our tax base, in an attempt to address the growth in seniors (and the costs associated with them).  Regardless, this chart shows the raw number of seniors (those older than 65) out to 2050 and, equally important (more so, in fact), the percent of the population attributable to my generation of boomers (increasing from 12% to 20%).

Folks, we have hit the tipping point.  Of course, you may conclude from this chart that things are not as dire as the experts proclaim, and, of course, you would be wrong … and not just a little.  This seemingly manageable level of growth is exacerbated by the realization that over 70% of healthcare costs are generated in the last five years of life.  But even this seems like a small concern until factoring in inflation of healthcare costs, increasing medical science that extends life expectancy, etc.  So, lets look at some conservative assumptions.

Currently, average life expectancy is right at 80 years of age, so the last five years span between 75 and 80.  Life expectancy is increasing (up from 45 in 1900 and improving at a faster rate).  With the arrival of nano-tech, etc., figure that we gain an additional year of life every three years.  Since this additional year of life does nothing to prevent us from getting older and the age at which age-related conditions arrive (God has not gotten better at this aging thing, even though medical science has), we can expect that the onset of our elder years will continue to arrive at age 75 (actually earlier), even though we will be living longer.  If growing healthcare inflation at just 3% per year (no faster than inflation for other goods and services), you end up with the following chart for healthcare costs attributable to those 75 and older in the out years:

See the problem?  If not, get thee to a statistician quickly!  If you are a boomer, no problem.  If not, prayer seems appropriate.  In fact, note that healthcare costs will double in 10 years based on the senior populaton growth, even if assuming that healthcare inflation rises at the same rate as everything else.  Well, everything else would require roughly 24 years to double if growing at just the rate of inflation.  The difference is the sheer size of the boomer generation.  What is the difference?  Take a look:

The gap between the blue line and the red is the difference in healthcare costs attributable to an increasing population of seniors and longer lives versus the rise in healthcare costs due to average inflation alone.  If healthcare inflation rises more quickly than average inflation (a rise commensurate with the risks associated with R&D, for example), the blue line increases at a faster pace.

In other words, PFE needn’t be too undervalued to warrant purchase.  It need only be financially strong to afford R&D and M&A flexibility to warrant a long-term wager.  The demographics will do the rest.

Pfizer's Summary Valuation Results

Of course, it doesn’t hurt that sustainable ROE is at 8% in a down economy (well below the median FCF growth rate of 16% for the past decade).  DCF modeling at this rate indicates a stock that is undervalued at 64% today, and a price to NAV (1.89) that is below 97.24% of similarly strong stocks .  So, while the bears are looking at the pipeline and the move of Lipitor into generic status, I’m looking at a Goliath which can buy its pipeline and wait for the demographics to make my heirs rich.  If you have a 10-year horizon, this is a great investment.  If your horizon is next year, you’ve come to the wrong blog.

The same holds for United Healthcare (UNH) and Forest Labs (FRX), which were addressed in a prior posts, as a health insurance provider and generic pharma producer, respectively.

It, also, applies to Israeli generics provider TEVA Pharmaceuticals (TEVA) — the largest generics pharmaceutical company in the world.  With $150 billion in patent-protected medications going generic, that translates to $45 billion of new industry revenues after writing down the cost by the normal 70%.  Moreover, Teva has a growing footprint in emerging markets, in addition to its 20% market share in the US, and a significant and growing role throughout much of the first world.  On the other hand, Teva has behaved like a growth company but produced non-growth results:


The stock, however, is selling at a reasonably low price as measured by its 2.58 price to NAV.  Both shares outstanding and shareholders equity per share have risen.

Currently, TEVA appears to be fairly valued if expecting 10% growth over the next decade.  The company just announced expectations of 15% growth over the next five years (making the stock undervalued by an unimpressive 10%-to-15%) at $56.84 per share.  I bought at $43.96 in November of 2007 and, if the price falls, I’ll add.  The demographics are just too attractive.

I have already mentioned United Healthcare (UNH), which is next on my list.  With a glass of wine in hand, I can’t recall how thorough that assessment was, so let me just provide the following graphic (which includes some new data):

The actual discount follows from a DCF model that has free cash flows growing 23% per year.  Remember, the boomers are coming, the boomers are coming.  Moreover, due to the health reform efforts coming out of DC, the stock has been beaten down, such that it now sells at just 1.7 price-t0-NAV (lower than all but 1.98% of stocks posting ROEs of 15% or better).  I’ve added the current PE and median ROA and ROE results for the past decade, with comparisons to the current percentage of non-financial stocks listed in the Yahoo universe.  At some point, I’ll try to explain how I do this, but, in general, I get a listing of all stocks and their results for a given measure.  Then I create a histogram with a large number of bins, followed by calculations of percentages attributable to each, and then I create a cumulative Gamma or Weibull distribution that mirrors the percentage distribution.  This allows me to connect the dots, as it were.  So, the stock, selling at $32.70, is posting a PE of 10.81, which is in the top 15.76% of listed stocks.  Similarly, the ROA of 9.14, which doesn’t seem that impressive, is, in fact, in the top 26.20%, and the ROE, at 23.33%, is in the top 19.53%.

Now, the reason I write this blog is education (your’s and mine).  It forces me to think about all of this stuff, seeking a different perspective in understanding all the results.  So, lets use UNH as an example.  First, here is a chart you have seen previously with other stocks.  It is based on one originally produced by my friend Joe Ponzio at FWallStreet.com.

In his version, if memory serves, free cash flows and shareholders equity appear.  His teaching point was that the investor should look for predictable growth if seeking to value a stock based on discounted cash flows.  If the results are all over the map, DCF is not appropriate.  This is an important concept, which is emphasized by Warren Buffett, and it dates back to John Burr Williams, who originally created DCF analysis.  What this allows us to do is value a stock just as we would a bond, whose cash flow streams are known.  Again, if memory serves, I’ve added book value and the second axis for cash return on invested capital.  The difference between book value and shareholders equity is, roughly, the more liquid assets retained by the company, and CROIC should typically be above 13% to insure the company can withstand market and economic downturns (also, a point made by Joe).

Additionally, I began including a line for cash from operations with many of my charts due to the sage advice of Bill Ellard.  Bill noted that cash from operations can be more important than free cash flows if the company is investing in future growth through capital expenditures.  The problem investors confront with this is the inability to distinguish between growth CapEx and maintenace CapEx (capital expeditures necessary to maintain current operations).  In general, maintenace CapEx should equal depreciation over time, and Columbia Professor Bruce Greenwald provides a means of calculating the two in “Value Investing” — which can be purchased at an Amazon near you.  In any event, this led me to create this chart:

It shows cash from operations, the level of expected maintenace CapEx (i.e., depreciation), and, per Professor Greenwald, the ESTIMATED levels of maintenance and growth CapEx.  In the case of UNH, it appears they have under-invested in maintenance CapEx, but his is less of a concern for a services sector company than for one with significant hard assets (plant, property, equipment, etc.).

As I continued down this journey of learning (call it “ignorance mitigation”), I questioned whether shareholders equity truly reflected accumulated value if it didn’t include dividends paid to the investor.  Additionally, if Warren Buffett more strongly values Owners Earnings over Free Cash Flows, should this be monitored, as well?  And, if CROIC is the rate of free cash flow return on long-term liabilities, shouldn’t there be something called OEROIC (Owners Earnings Return on Invested Capital)?  I came to a “Yes” conclusion and decided to make Joe’s chart even more confusing:

Now, realize that I invest for personal satisfaction and because my wife of 22 years still believes she should be earning a return on her investment in my MBA.  That set of motivations is different than why I write this blog (when the mood strikes).  So, I realize this chart may be confusing to some (perhaps, most), but it informs me and my investment choices.  For example, it allows me to monitor the gap between cash from operations and free cash flows — which tells me how much the company earned or lossed due to cash from other sources (investments and financing).  It tells me whether there has been significant gap between free cash flows and owners earnings, with FCF’s reported far and wide and OE rarely reported (providing information the average investor lacks).  It shows the effects of dividends on how much the company has available to deploy for future growth, when compared to shareholders equity.  And it shows the rate of return difference between CROIC and OE.  Often the difference is significant, as it is here, with UNH.

Of course, there is something missing from all of this.  FCFs matter because that is the money a company can put in the bank, which a banker will accept.  During the Dot.com bubble, high tech companies were being valued based on future prospects, rather than actual cash deposited.  Enron was a case of churning cash between subsidiaries, giving the impression of earnings greater than what could be deposited in the bank.  So, Joe is right to consider FCF and CROIC to be of paramount importance.  What I have noticed, however, is that many companies post impressive FCFs and FCF growth rates without a commensurate increase in shareholders equity.  Well, price-to-NAV relies on shareholders equity, so it is important to look at the conversion of FCF and OE to shareholders equity.

To calculate this, I look at the change in shareholders equity from one year to the next and divide that by FCF and OE.  Clearly, a company can’t grow shareholders equity at more than FCF or OE, unless they can grow money on trees or pass the had among employees.  So, any figure greater than 1.0 (100% of FCF or OE) is suspect.  Despite this, rates higher than 1.0 are not uncommon for a year or two, and this suggests the funds are placed in conditional accounts (set aside for defined purpose) and pulled out when needed.  In other words, it is a convenience of accounting (legal but obfuscating for investors).  So, I have drawn the 5-year moving average of OE, and it appears that around 60% of OE actually shows up in shareholders equity (ShE).  That’s pretty good in comparison to many other firms, but it also gives me a sense of the efficiency with which any form of earnings contributes to the value of the company.  This is important because Wall Street values companies based on earnings — even if using the inadequate and inaccurate PE multiple.

Why is this important?  Well, I was just approached by my mother-in-law about a friend of ours.  This friend is a young lady, recently divorced with a little daughter, who recently came into some money — a malpractice settlement from her childhood.  So, I looked at the Dow 30 stocks to see if any are undervalued — thinking a strong, stable investment was in order, since she is in early career as a professional and not wanting to suggest anything risky and speculative.  Unfortunately, nothing among the non-financial Dow 30 is selling at a signficant discount to intrisic value (ORCL and JNJ are the best of the lot, with MCD NKE, AMGN, MSFT close behind).  Well, these are stocks that every investment house analyzes closely, and it is unlikely that any will sell at a strong discount (50% or better) at any given time.  This means that value investors must look for that which Wall Street and institutional investors overlook in areas where they are less likely to look, and it is this sort of analysis that provides that competitive advantage (between me and the professionals in New York City and elsewhere).  Otherwise, the efficient market rules.

The last of the stocks held throught market crash is Exxon (XOM).  XOM is an interesting investment for several reasons.  First, petro is now considered a sin investment — right up there with tobacco, alcohol, and gambling.  Help me, Jesus, for I have sinned.  Second, there is that pesky issue of gas as a commodity.  As a commodity, however, there is an additional level of influence when valuing this stock.  Gas trades on the commodity exchanges, with the price of a barrel (refined, unrefined, etc.) fluctuating.  OPEC changes its posture monthy or quarterly.  Investors get all moist (giddy and anxious) from one day to the next based on the movement of these prices.  Talk about volatility!

Well, here is chart that looks remarkably immune from volatility:

Yes, things appear to have tanked over the trailing twelve months, but those results are less firm than yearly data.  They aren’t as closely audited.  There are seasonal issues.  And, if we have hit “peak oil” or are close, it is folly to expect that the world is prepared to convert to solar in a matter of years.  Indeed, no source of energy (save nuclear) is as efficient a supplier of power to propel cars as gas, and I don’t expect to see mini-Chernobils placed under the hood of Land Rovers in Africa anytime soon.  Other forms of energy may be better for the ecology (I’m with you on that one), but we will not be converting to alternative energy to prevent the melting of Antartica … or a significant portion … any time soon.  The CAP 15 confernece, despite the President’s abundant charms, fell apart on this very issue.

[If you are thinking of posting an indignant response, save your fingers.  This is an investments blog, and I don’t plan to read or respond to arguments concerning ethics.  The stock is valued based on the present value of its future cash flows.  Besides, I am not compensated for writing this blog, but I will consider responding if paid for the annoyance].

So, is XOM fairly valued? Well, after all of this writing, you tell me.  Here are the charts:

The next posting will be more forward looking — recounting stocks recently purchased, rather than those held or increased during the crash.  This, however, has been an update on my investment decisions made over the past year.  The key theme was that, as the market started to tank, I divested every holding that was remotely suspect, took a short position on the S&P 500, and added to strong companies selling at rediculously low prices.  I’ve made an abundant number of mistakes (perfection does not reside between my ears), but, with long positions, you are limited in your losses, with no such limit on up-side prospects.  In other words, you needn’t be perfect or consistently right to do well.

Lastly, I should note that I will soon take profits on several of these investments, if the price starts to fall.  Specifically, EMC, FCX, MCK, PCU, and BHP.  In most cases, profit taking is designed to preserve substantial gains and will not include a complete sale of my holdings.

And, as always, do your own analysis and verify my conclusions.  You are responsible for the choices you make.  When I become capable of predicting the future, I’ll let you know.

Written by rcrawford

January 10, 2010 at 11:22 am

Posted in General

Bull II

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In this posting, I’d like to discuss the stocks I held during the market crash.  While some are up nicely, none represent key decisions made during the swoon that puckered my sphincter.  Given this, you may wonder why they warrant a blog posting.  Well, the reason for holding a stock (or, for that matter, selling) is as important to success as which stocks you favor with your hard-earned savings.  I’ve discussed selling decisions in the past and will do so again … shortly.  There was, for example, the blog post about why P&G was a sell (even though I didn’t sell and should have) and posting about the sale of GE (a low Altman Z-Score got me out before the stock tanked and the problems with GE Capital became evident).  It certainly wasn’t evident to me for quite some time.

We begin with American Eagle (AEO), a stock I have touted loudly and publicly, to my embarrassment.  AEO is an example of the short-comings of Discounted Cash Flow analysis.  Let me explain, starting with a chart:

Note that free cash flows was rising nicely in 2007, when I first bought.  Note, as well, that the crash did nasty things to cash flows in 2008 and 2009, due to no fault of this excellent retailer.  When I bought it, DCF indicated the stock was worth just over $40, but Alan Greenspan had other plans (unintended).  This is important because many investors believe DCF analysis is flawed because it requires that the investor accurately project the cash flow growth rate generated by the company.  This leads to many disputes between longs and shorts as both argue over the prospects of the company, rather than the likelihood of an economic crash.  In the case of AEO, I’ve kept the stock because it is undervalued by another metric — namely, price-to-net asset value.  Currently, NAV is 2.4 times, which is less than 6 percent of stocks generating 15% ROE’s.  AEO is not generating that level of return on equity, but, once the market rebounds, it will.  The bigger recognition is that this strong, competently-run company never posted negative results for the crash years, nor did it suffer a substantial decline in shareholders equity, and, by purchasing a company with strong cash return on invested capital, it was able to keep its head above water when other retailers’ prospects were less certain.

BP Prudhoe Bay (BPT) is a dividend pay as a petroleum trust.  It has been down and up (currently up just over 40%), but I don’t care because I’m earning over 10% in dividends.  Provident Energy (PVX) is a similar story, except it is down over 30%.  Recently, PVX has risen nicely, and some speculate the company is so cheap it is a take-out opportunity.  Again, I don’t care.  Between the two, I can afford to take my wife to dinner at really nice restaurant twice a month (complete with bar tab).

Ceradyne makes ceramics which are used in military body and vehicle armor and photo-voltaic products (along with a small number of other uses).  The stock is down 10%, after a drubbing due to the Obama election.  The market believed we had elected a pacifist.  While that may be true, the stock has rebounded nicely with the President’s plan to increase troop levels in Afganistan and with a new contract for vehicle armor through OSK.   The company did go through a year of declining contracts, and the market got surly with the stock price.

This chart (above) shows the results.  I’ve included the Owner’s Earnings results, as well as the smaller number items with the prior chart for AEO, and I have done so because free cash flows fail to note the severity of the decline.  Not only have I held the stock, I’ve added to it several times recently.  Why do this if peace is breaking out and Kum Ba Ya is likely to become the national anthem?

Well, as the figures above indicate, the yield on free cash flows is a whopping 22%, the yield on owners earnings is even better (32.48%), it is earning a 31% yield on operating cash flow, and the stock is selling at less than its net asset value.  The 0.12% figure indicates the percent of stocks selling this cheaply in comparison to net asset value.  The discount figure is my projection of the discount using discounted cash flow analysis (DCF), but it isn’t necessary to describe the assumptions supporting it, given the other figures (and taking into account the problems with DCF, mentioned earlier).

ENI is a petrolium provider in Europe.  While I’ve lived and worked in Europe for more than 5 years during the course of my career and have enjoyed many Wanderungs in Germany, I am not convinced that Europe will give up automobiles for transportation.  The trains are cheap, but they aren’t that cheap.

As you can see, there is a common theme developing here when it comes to value stocks.  Focus on the yields and the price-to-NAV.  To put this into perspective, here is a chart that compares the current price to several measures of intrinsic value:

Currently, it is selling at just over Replication Value — the amount of funds necessary for a new market competitor to achieve equal standing.

EMCOR (EME) is in construction — industrial buildings and roads and bridges nationwide.

EME is interesting because it has increased shares outstanding, which is normally something that bugs me, because it dilutes my equity stake.  Amazingly, however, the company has expanded nicely and to my benefit as part owner — as this comparison of shares outstanding to shareholders equity per share indicates:

Shares in millions is indicated on the left, while shareholders equity per share is indicated on the right.

Forest Labs (FRX) produces generic pharmaceuticals.  Like EME, it is up marginally.

By DCF, this stock is cheap.  That DCF model uses the median growth rate of free cash flows over the past decade (23%), which seems possible since the boomers start retiring this year.  Of course, it is helpful to check this growth rate against sustainable ROE (i.e., ROE once subtracting dividend payments).

The solid lines indicate ROA (red) and ROE (blue), and the sustainable ROE is purple.  The average is around 20%, recognizing that the recent declines (last two years) are due to the economy.  This means the 23% growth projection is marginally suspect.  So, it is necessary to do some sensitivity analysis, looking a under/over valuation at different FCF growth rates.  Here are the results:

By DCF, the stock is 54% undervalued (right column) if FCF growth is 15% (left column).  More importantly, if the company fails to grow FCFs (0% growth), the stock is still undervalued by 11%, according to this measure.  This is why I bought more on December 18th at $31.57, and, if the market keeps offering it at stupid prices, I’ll add more.

Hansen Natural (HANS) makes and sells Monster Energy drinks.  Personally, I’m more of a cappuccino guy since we bought the Delongi Magnifica (and it is “magnifica,” by the way), but I like Monster when driving all night from North Carolina to New York to visit relatives.  HANS is a growth stock, with a median FCF growth rate for the past decade of over 70%.  It posts a sustainable ROE of 24%, and it is undervalued by 18% if expecting a 20% growth rate.  The stock is up 36% since I bought it (should have sold when it was up more than 50%).  I’m keeping the stock in the portfolio because the company is a combination growth/value stock, as indicated by this comparison between Earnings Power Value and Replication Value:

At some point in the future, I’ll provide an explanation of how to calculate these (there have been requests), but, for now, you’ll have to trust me … or not.

Johnson and Johnson’s (JNJ) is a Buffett stock.  I purchased it based on the explanation of Buffett’s probable logic by my friend Joe Ponzio of FWallStreet.com, satisfied that it was 20% below intrinsic value.  Despite the market downturn, my own analysis indicates that this bellweather is 17% below intrinsic value today.  It isn’t a large holding, and, currently, my biggest problem is finding stocks to purchase, rather than selling those which are marginally undervalued.  At the time I purchased it, finding value stocks was difficult.  So, I don’t regret the purchase, even though it has barely budged in equity value.

At this point, we are half way through the list, and it is 2 am.  So, I’ll tackle the rest later.

Written by rcrawford

January 7, 2010 at 12:13 pm

Posted in General

Bull Durham: My Experience As An Investor Over the Last Year … and More.

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Do you know just how hard it is to be “Greedy when others are fearful,” much less “fearful when others are greedy?”

Well, it has been a while since I’ve blogged, much less blogged about investing.  I stopped when WordPress couldn’t accommodate my charts and graphs and that was something of a blessing.  Not only was I spending less time on the blog, there seemed to be an inverse relationship between my blogging and the performance of my stocks.  Simply put, when this blog went “dark” my investments lit up nicely.  Of course, this blog had nothing to do with the most significant economic meltdown since the 1930s, so the link between my investment performance and the economy was a matter of inverse correlation (they moved in opposite directions), and the two had nothing to do with each other.  Correlation is not causation, but, when it comes to streaks, as Keven Costner (Crash Davis) tells Susan Sarandon (Ebby Calvin LaLoosh) in “Bull Durham” :

Crash Davis: I never told him to stay out of your bed.
Annie Savoy: You most certainly did.
Crash Davis: I never told him to stay out of your bed.
Annie Savoy: Yes you did.
Crash Davis: I told him that a player on a streak has to respect the streak.
Annie Savoy: Oh fine.
Crash Davis: You know why? Because they don’t – -they don’t happen very often.
Annie Savoy: Right.
Crash Davis: If you believe you’re playing well because you’re getting laid, or because you’re not getting laid, or because you wear women’s underwear, then you ARE! And you should know that!
[long pause]
Crash Davis: Come on, Annie, think of something clever to say, huh? Something full of magic, religion, bullshit. Come on, dazzle me.
Annie Savoy: I want you.

So, not posting was the reason my portfolio was up 30% during the worst market decline in nearly a century, and, candidly, I’m a little worried that posting this now will break the spell.

In any event, I’d like to bring you up-to-date on my value investments and then discuss some things of benefit to the reader.

First, at the start of the market’s evident decline (things were clearly starting to go to hell … quickly), I took the measure of my holdings – selling the profitable, getting rid of the mistakes, and, most importantly, buying a short ETF of the S&P 500.  As described at the time, the short ETF was not designed to benefit my portfolio (i.e., make me rich at the expense of my fellow longs) but, rather, to limit my losses.  This was not, alas, my idea, but, instead, it came from my brother – an investment banker in New York City.  As he argued at the time, if my short position was of the same size as my long positions, AND if I was confident in out-performing the market with my long positions, the difference in the results (long minus short) would reflect my competence as an investor.  Well, I didn’t exactly take his advice, in that my short position was just half of my long positions, but this kept my notional losses to a maximum of 20% when the market tanked 50%.

Second, near the bottom, I sold my short position.  This was not because I “knew” the market was at a bottom based on some impressive piece of technical or fundamental analysis.  It was nothing more than intuition.  I reasoned that, if the worse market declines hovered around 70%, my downside risk was less than my upside .  So, I sold the short.  And the market promptly took another leg down.  So much for intuition!

This caused me to reinstate the short … sort of.  Having recently sold the earlier short, I couldn’t just re-purchase the same ETF if I wanted to avoid the short-term capital-gains taxes.  So, I bought a 2X short ETF of the S&P 500.  To this day I do not know why but that ETF moved in the same direction as the market.  This wager that the market was going down further ended up rising when the market rose and declining when the market tanked.  At the time, Jim Cramer made some nasty remarks about this ETF, and he was right.  Regardless, this 2X short ETF sent me down to the low of 20% from the market high (Dow 14,000, or so).  So, I sold the 2x short quickly.

With the proceeds, I kept half in cash (my largest holding at the time) and, with the rest, bought some stock.  Those purchases made a world of difference in the results today. since they were purchased near the bottom.  With the government bailing out everyone but me, I wagered on an inflation scenario.  The Federal Reserve was doubling its balance sheet, and it seemed reasonable that the government would finance the debt with bonds.  This, I thought, would undermine the dollar, and imports would cost more – including work-in-process goods imported from outside the US.  So, I added strongly to existing positions in PCU (Southern Copper), FCX (Freeport McMoran), and BHP (BHP Billington).  These are commodity stocks and are likely to benefit from inflation.

Equities Discussed with Performance Results Percentages

I also bought MSFT (Microsoft), because it was cheap at the time, and I believe in “reversion to the mean.”

None of these were “conviction” buys … they just made sense in the midst of anarchy.  I also bought more of UNH (United Healthcare), SHLD (Sears Holdings), and QSII (Quality Systems), because they were undervalued based on cash flows (and, in each case, other reasons), and I took an opening position in a hail-mary called SLP (Simulations Plus) – also undervalued but trading near de-listing prices.  This was a passive-aggressive move, borne of the conviction that, if the market declined further, the wife, kid, and I would end up in a soup-kitchen line.  It was an Armageddon play – if things worsened, the banks would default en-mass, and we’d be wipped out, regardless of what stocks I owned.  This is not an exaggeration!  Amy and I actually opened a new account with a different bank and deposited an amount sufficient to cover living expenses for two months, just in case Wachovia failed.

The “other reasons” for adding to UNH, SHLD, and QSII are several and different.  QSII was marginally cheaper than when first purchased, and I continued to like the story and the results.  SHLD is (and continues to be) the equal of a squeeze play for shorts.  It is a questionable retailer (along with K-Mart … hense, “Holdings”), but Eddie Lampert (president) is a savvy hedgefund guru who knows how to turn a loss into a gain.  In this case, he has taken the cash flows and enhansed them by not investing in operations (increasing profits) and has used profits, savings, and, even, debt to repurchase shares in such large quantities that shareholders equity per share remained below net asset value for most of the year (it is now just above that threshold), despite a sequence of squeezes that has shorts shaking their heads and opening their wallets.  This has been the most brutal exercise to watch … and the most entertaining (having written about the strategy here and elsewhere many times).  UNH is health insurance, and I made a wager that government would not (indeed, could not) convert US healthcare into a socialized medicine system (politacally or financially).  This was questioned by several commenters on this blog, but the end result of the latest legislation has proven me right.  As a healthcare and health policy professor, this wasn’t exactly a fair fight, but it is gratifying to know that my students are purchasing the services of an instructor who can still convert opinion into profitable, market-driven results.

Well, PCU, FCX, and BHP  are up big, and I’ve taken partial profits in each (we are now playing with the proceeds of my initial investments in each).   While SHLD is still down by 16.41%, this is an improvement over being down 70%.  SLP (bought at $1 a share) is up over 30%, and even UNH (crotch-kicked by the healthcare debate) is now up by just over 1% and should head higher as cash flows betcome fairly valued — absent the concerns over what DC will do with healthcare.  MSFT was a laggard (slow to rebound), but it is now up 24% today, and QSII, which I bought on a lark, increased 82% before selling.  In short, Peter Lynch was right – it only takes a small number of very successful choices to overcome ineptness (the market’s or mine).

And that is where my portfolio stood for the better part of a year.  I didn’t buy or sell beyond my wife’s ESOP (Employee Stock Option Plan) with MCK (McKesson).   MCK, however, is an unusual case.  As an employee, she has the ability to buy the stock quarterly at a 15% discount up to 20% of her income (if memory serves).  I did the analysis of MCK and concluded that it was undervalued before taking into account the discount.  So, we backed up the 16-wheeler and that sucker is now up more than 40% and is our largest holding.  This increase is not as large as QSII or some of the other holdings, but, as the biggest holding, it has had a disproportionate impact.  Even if backing-out the 15% and crediting the portfolio with a 25% increase, this handily beat the market over the last two years.

The reason for this recounting is not to assert that I am brilliant as an investor.  Instead, the intent is to recognize that outside advice (my brother’s) can be important (when it makes sense), that not all ideas are beneficial (the 2X short), that buying on the way down runs contrary to what you might expect (it enhances the rebound – even if a “dead cat bounce”), and, shamefully, that it is next to impossible to do the right thing at the crisis moment.  You see, when the market was WAY down, I held cash … a lot of it.  When others were fearful, I was with them.  All that research into Warren Buffett and Benjamin Graham was wasted … even as the market moved up strongly.  While my invested portfolio of stocks is up 30% over the previous market highs (prior to the meltdown), my cash holdings are significant.

So, I’ve been buying recently … and probably at something other than the best available time.  The description of that will follow in the next installment, and then we will move to the beneficial stuff.  Nevertheless, if this is a recounting of my life as an investor, warts and all I should bring you up to date on my experience in investment-land.

Written by rcrawford

January 7, 2010 at 9:59 am

Posted in General