Status Update on Real Estate Development

A while back I told you about my investment in foreign real estate. Now it's time to see one more step: the conclusion of the construction.

Voila. It's a beautiful construction, thanks to the clever design, effort and sweat of my investment partners at Squadra Arquitetura.

Now the numbers.

The house as it is now cost us more than originally planned, for various reasons that don't matter much here. All told, it was about 32% more than planned. This will certainly eat into our margins.

The good news though is that we raised our asking price a bit. If it goes for our current asking price, we'll be profiting 59%, which is less than the 98% I originally mentioned, but still above our minimum of 40%. So, the margin of safety is there.

Anyway, I'll be posting a final update here when the deal if finally settled. If you want more details, take a look at Squadra Arquitetura's blog (in portuguese only).


Why Does Warren Buffett Buy Entire Companies?

This might be obvious to some, but Warren Buffett buys whole companies for different reasons than the average CEO does. The average CEO is concerned about building empires, pleasing their egos, diversifying, expanding market share, etc.

Warren Buffett simply wants to make more efficient use of capital. That's it. By buying companies outright, he's essentially unlocking the free cash flow (what he calls "owners earnings") and making that available to his holding company, so that it can more profitably be employed in other businesses or used to buy shares of public companies.

Free Cash Flow

Let me explain in more details. A portion of earnings that a company retains (retained earnings) is not available (free) to be taken by the owners or paid in the form of dividends. Some of that is needed to re-invest in the business: buy new equipment, hire new people, train the workforce, invest in a brand new computer system, build a necessary office in a foreign country to support the business there, etc. After all re-investment needed to support the business is accounted for is when free cash flow or owners earnings appears.

But most companies don't pay out as dividend their entire free cash flow. They retain more earnings than is necessary, to have reserves for a rainy day.

Warren is after these reserves, which he can more ably allocate within his holding company than any single company could within itself.

But why wouldn't Buffett buy lots of shares, take a board seat and simply force the company to pay out all its free cash flow as dividends? That wouldn't be efficient from a tax perspective due to double taxation in the corporate structure. So, the alternative is to buy at least 80% of companies and consolidate their assets on Berkshire's balance sheet.

How Can Small Investors Benefit?

The rest of us who can't afford to buy their own conglomerates still has options. It has been shown that following Buffett's move -- even 30 days after the fact -- can still provide enough of a return to beat the market average over long time periods.

Current Opportunities

One current opportunity is to buy out-of-favor Kraft (KFT). Buffett purchased it last year for around $30 per share. It's currently trading for $26. So, if you believe Buffett will be proved right once again, buying below his entry point makes a lot of sense -- you'd be getting an edge over Buffett himself!

Disclosures: I own shares of KFT.


Selling Short

Long-term investors typically don't use a lot of short selling in their strategy. The reason is simple: investing is about being lazy, letting the investment work for you, and about the long-term. While going long doesn't require that one ever sell -- in fact, if one goes for solid dividends payers, then holding on forever is the master plan -- short selling requires that at some point one reverses course and buys back to cover.

However, that doesn't mean that savvy investors can't use short selling as a way to enhance returns, especially if one follows a few rules.

Short Term

Selling short shouldn't be fire and forget. It requires some more work, because at some point one needs to buy it back -- unless, of course, the company is going for total bankruptcy, which is great if you can spot that before everyone else. But typically, you want to get out of the investment before then, to avoid surprises such as delisting and trade halts which could mean you're still responsible for buying back at some point, but now you don't know when.

So, sticking to a few months is probably best and will help you sleep at night.

Margin of Safety

As with going long, in short selling one should require a margin of safety. The price of the security must be so unbelievably high compared to its value that the situation becomes unsustainable in the long run.

How much is enough? That's up to the investor to figure out, but I start with a minimum of 100% -- twice my estimated value. That's because smaller variations could still be errors in my calculation or simply a sustainable premium the market pays for some securities, which can be unlikely to revert to my estimated value in the short run.

Debt Laden

A company that has a lot of debt can quickly get into trouble. Of course, debt doesn't guarantee a company's performance will turn sour -- debt magnifies the positive side too -- but to be a candidate for shorting on my list, it must have a lot of debt. The reason is that debt-free or low-debt-to-equity companies can always fire staff, sell assets or stop producing and reorganize without having creditors go knocking on their doors.

Debt forces interest payment which forces a company to scramble to find revenues. Pressure from creditors during bad times can be a killer. So look for companies with high-debt-to-equity, especially if it's tied with the next two criterias.

Asset Intensive

A company that requires heavy investments of capital to make money can be a terrible investment. Companies such as airlines and some manufacturers that need to constantly renew their assets tend to need a lot of external capital to grow which typically comes from straight debt or dilutive equity offerings. Either way these companies are good starting targets. But that alone doesn't make a company a short candidate; it only makes it a harder job for management.

Poor Management

This is probably the most important reason to sell a security short. And it can also be the hardest one to evaluate. Poor management is the quickest way to lead a company to financial ruin.

I have talked before about how to judge a company's management objectively. These reasons still apply. Especially important is to pay attention to management's candor. Are the quarterly conference calls short and hurried and lacking in details? Do they get even shorter and more lacking when times are bad? These can be terrible red flags.

Another thing to look out for are lots of related parties transactions. Does management employ services from companies or third parties related to them, such as friends, cousins, parents, children and even spouses? A lot of that can be legitimate, but when you find this sort of thing going on in a bad apple, it's typically a magnifier of problems, so make sure to investigate the SEC disclosures regarding related party transactions. The more, the merrier for the short seller.

Never Use Leverage

This is probably the most important rule a short seller should follow: don't borrow money to short a security. Leverage adds a whole new level of uncertainties that are simply too much risk.

First, leverage means you need to pay interest and interest on short accounts are typically a rip-off. Don't give money to the loan sharks of brokerages. Second, leverage magnifies your mistakes. And it's very easy to make a mistake when going short, because, if you followed the margin of safety rule above, you probably sold a company that the market believes has good prospects (high price to value) and markets can stay irrational longer than you want to keep up with margin calls.

In future posts, I may discuss potential short targets as they appear on my radar. For now, I have no short positions other than a few call and put options, which was the subject of another post.


The Two Sides of Muni Bonds -- Part II

This article originally appeared on The DIV-Net on Nov 24th, 2009.

Last time, we talked about what to look for in municipal bonds and their two sides of risk. Now, let's jump right into a few examples.

The safe side

California St. GO Bonds, 2036 4.5% (CUSIP 13062TSB1). These are general obligation of the state of California and pay interest semi-annually at a 4.5% annual rate. As GO bonds, they are backed by the full taxing authority of the state. They're currently trading for around $80 on face value of $100, for a current yield of around 5.6% (4.5%/80=5.6%) and an yield to maturity of about 6%. Just back in July, they traded for $76 and for the last month or two had been trading for $90. Since they're long-term bonds (mature in 2036), the price can fluctuate a lot, based on expectations of inflation, interest rates, and perceived risk.

I found them interesting enough to buy a small amount for $83 back in April. Now at $80, they still seem attractive given the current alternatives.

The risk is that California won't pay its debt. The state is in big trouble, so the risk is real.

The unsafe side

On the dark side, we have revenue bonds whose underlying project went bankrupt.

California Special Tax Diablo Grande, 2014 4.64% (CUSIP 958324CF0). At first glance, this seemed like an interesting opportunity. It's due soon, less than 5 years out, and is currently trading for $62, which means a current yield of over 7% tax-free and an yield to maturity of over 16%.

But consider the risks. These bonds are backed up by a special tax imposed on the Diablo Grande community, a new planned development in California expected to be home to between 5,000 and 10,000 families, businesses, club houses, winery and golf courses. However, due to various legal disputes and the housing downturn, only 400 houses have been built to date. Over 70 of them have been foreclosed. No businesses operate there yet other than the golf courses.

The downside protection is that the state can foreclose on a property that doesn't pay its special taxes. However, there can be no assurance that people won't simply walk away from their devalued properties. If there aren't enough people paying the taxes, the bonds will default.

The developer of the community went bankrupt last year. Recently, a new buyer stepped in and agreed to turn around the operations and re-open the then closed golf courses and club houses. According to local news, the site is operational again, but still there aren't many families and businesses paying the special taxes that support the bonds.

The bonds currently trade for $62 and have been as low as $39 during bankruptcy. The MSRB site does not show any special material events, so I assume the interest is still being paid.

This is one case of high-risk high-reward investment. For the time being, I'm not investing in these bonds until I can confirm how much tax income is available to support the interest on the bonds. A call to the underwriter is in the cards as my next move.

Important note: In investing, there's no such thing as a true safe investment. So, when I classify munis into "safe" and "unsafe", these are both relative terms. It's very possible that "safe" bonds get defaulted on.

Disclosures: I own 13062TSB1 at the time of writing.


The Two Sides of Muni Bonds -- Part I

I invest in municipal bonds. They serve as a place to park my cash (very short-term munis used in money market accounts) and as a component of fixed income of my portfolio (longer term maturities).

But I also buy individual issues when they're mispriced. Nine to twelve months ago was a great time to pick up some bargains. Now, some bargains are back, but one must be careful, as munis have two sides, a reasonably safe one and an unsafe one.

The safe side

General Obligation municipal bonds (GO bonds) are typically tax-free obligations of the state, backed up by its taxing authority. That means that the state must do what it takes to pay them back, including raising taxes. So, unless a state becomes empty or some huge unheard of crisis hits, GO bonds should be a relatively safe investment.

But they typically don't trade much below their face value and as such good deals are hard to find. One must look constantly for temporarily mispriced issues or other inefficiencies in the market.

Not all GO bonds are "safe" since states can still default or issue IOUs.

The unsafe side

Revenue muni bonds are typically not backed up by the full-faith and credit authority of the state. They typically represent an investment by the state in a particular revenue-generating project such as a hospital, toll road, utility company, etc.

In most cases, these bonds are guaranteed only by the revenue generated by the project. In some other cases, they are backed up by special taxes imposed on certain people (residents of an area or district) or company or both. But these taxes can't be arbitrarily increased to back up the bonds.

While "unsafe" in nature, revenue bonds can be very safe investments if chosen wisely. There are opportunities lurking in plain sight in this area.

What to look for and how to tell them apart

When I search for muni bonds, I totally disregard credit quality (those letters such as "AAA", "B+", etc issued by Moodys, S&P or Fitch). Why? Because if I look at credit, I'll be delegating to the rating agencies the assessment of riskiness of the bond. After all, it's part of my job as an investor to find those "B-" or "B3" bonds that are really "AAA" in my assessment but that are mispriced by the market (because it blindly follows credit ranking).

Maturity, yield and price. I start my search by ranking muni bonds per maturity, yield and price. The higher the yield, the best. But I prefer to see the yield being high because the price is low, not because it was issued at high yield to begin with. This is because when projects are high-yielding from the start, it's likely to be a high risk project. But they're fine too, as long as I understand the risks. I like the price to be below par and the maturity to be as short as necessary for me to get a good yield-to-maturity.

Prospectus. Once I'm interested enough in the maturity, price and yield, I go read the prospectus. Just like a company's IPO prospectus, a muni bond has a similar document too. I look it up at the Municipal Securities Rulemaking Board's website. That's where I get to know for sure what the proceeds are going to be used for, what (if anything) guarantees my principal and my interest and all other terms that I'm looking for.

Who/What Guarantees My Principal. This is one of the first things I want to know, even if it's obvious from the description of the bond. The prospectus clearly says if the state guarantees it based on its taxing power (GO bonds) or not and if not, what, if anything, backs it up. Sometimes, there's nothing backing it up, just the full-faith and credit of some private company. Run from these unless you know something about the private company in question. If special tax revenues back the bonds, go find out how many people/businesses pay this tax and how much they pay per year and what's the situation in that specific area.

Insurance. Some bonds are insured by private companies. This sounds like a good thing but it really isn't necessarily and many investors miss this. First, in most cases, the insurance is for the interest, not the principal. If the state defaults, you may still lose your principal. Second, historically, the default rate on muni bonds has been low, and insurance companies know this, so they may take risks and insure more than they can realistically afford to. Now an investor has to look at the credit worthiness of the insurer and we don't trust the rating agencies, so it's more work.

Finally, (and here is the counter-intuitive part) if faced with the possibility of default, states would probably be more likely to stop paying interest on the insured bonds as opposed to the uninsured ones. Why? Because then no investor would be harmed by the state, right? After all, the state is paying for the insurance, it might as well use it when needed. That means, insured bonds are probably the first to be defaulted on and if too many of these cases happen, the insurer goes broke and the investor gets the bill. I try to avoid insured issues when other opportunities exist.

Sinking Fund. This is not as big a deal as it sounds. A sinking fund is cash set aside periodically to pay off the debt. It's typically a good thing to have, but is not a big deal in most cases. One must still look for it because it's possible in theory (though, rare) that in exchange for the safety of the sinking fund, the bonds are only redeemable at a discount of their face value. If that's the case, you need to readjust the face value and recompute the yield accordingly, if your broker or search site hasn't done so.

Call Feature / Redemption Provisions. Bonds can be called (paid for and terminated) prior to their maturities. This is typically seen as an added risk, because it limits the return an investor will get. When times are good, borrowers pay off their debt ahead of time and issue new bonds with less attractive terms. However, and here's the rub most people miss, a call feature can be a good thing if one buys a bond at a big discount. By redeeming my long-term bond before its maturity, I realize the capital gain upside earlier, because bonds are typically called at par. This means I don't have to wait until maturity and the price converges to par immediately as opposed to over time. For some of the bonds I buy, the capital gain portion can be a bigger upside than the interest paid over time.

Tax-Free, AMT Status. Believe it or not, some revenue bonds are not really tax free. I pass on those almost always since I can typically find better deals in the corporate world or elsewhere. The alternative minimum tax (AMT) status is something else to watch out for, since it can bite some investors and reduce their gains.

Putting it all together

Now you know more about muni investing than the next guy who is going by the Fitch credit rating and what his commission-hungry broker told him. So it's time to wrap up and choose your bond.

The tricky part is that there are no hard and fast rules. After reading the prospectus and assessing all the risks, one must be satisfied with the yield and maturity or not. That's a personal call.

My rule is to never buy bonds for any price above par, no matter how juicy the interest might be. I often screen them based on a maximum price of 90% of par and go down from there. This is because I want to have some upside and plus want to have a margin of safety in the case the bond gets called.

I also don't consider munis if I can get better yield somewhere else, for similar risk profile. Why settle for less? Also, if the yield is so low to be comparable to a CD or a savings or money market account, then why bother?

Next time, I will discuss current opportunities in GO bonds and a few risky issues I found on the dark side of munis.


Using Options to Enhance Returns

Options can be a valuable instrument for enhancing an investor's returns. Option investing must be done strategically or the risks and costs outweigh the benefits.

The two strategies are like are the simplest ones: covered call and put-write.

Covered Call

A covered call strategy is when an investor sells a call option, giving the buyer the right to buy the stock at a given price in the future, while holding the underlying stock. This strategy has the disadvantage of limiting the upside for the option seller, but provides current income.

I've used this strategy recently when volatility was high. I bought the Dow Jones Industrial Index ETF (DIA) for $85 back in January and sold call options expiring in March for a strike price of $86. In March, of course, the entire market dropped, so the call options expired worthless and I got to keep the $2.5 premium I was paid for the options.

I then replayed this strategy a few more times and eventually the call option expired in-the-money, at which point my DIA shares were called and I was paid $1 above what I had paid for each share, and still got to keep the premium. But I forfeited a few extra bucks the stock had appreciated when the options expired.

Put Write

Puts give the option buyer the right to sell a stock to the put seller in the future for a given price. I use put write when I want buy a stock for a price lower than the current one being offered by the market. In this strategy,  I typically sell out-of-the-money puts that are covered by cash. If the stock drops, I get to keep the premium and I get the stock for the price I established.

The downside is that if the stock drops even more, I'll be buying it for the strike price, which could be a lot higher than what the stock is trading for at the time of option expiration.

I've recently used put write to buy the DIA ETF I mentioned above for $85 back in January. I sold at-the-money January put options and a few days later I was assigned the ETFs for $85, and I still kept the $1.36 premium I was paid for the options.

I've also used put write to try to acquire shares of V and MA at lower prices. In both cases, the options expired worthless and I did not get the shares. But I still got to keep the premium.

Current Opportunities

With the market currently going up (mostly due to devaluation of the dollar, I speculate) I don't think selling covered calls is a good idea, as my shares could be called and I currently don't have temporary or speculatory positions.

On the put write side, currently I don't have many great ideas either because my entry prices for stocks are way below their market prices right now. But for someone willing to enter the dividend investing strategy, selling at-the-money puts on the Dividend Aristocrat Index ETF (SDY) is not a bad idea. One can get $0.45 for the November $45 puts or $1.45 for the December puts. SDY is currently at $45.50, so a slight drop and a premium on the puts could help one get started on a solid selection of dividend payers.


The bottom line is that there's money to be made with options. However, there are risks both in terms of loss and limiting upside. One should use options to enhance returns only when one can afford to lose in the worst case scenario.

It's important to note also that options are a zero-sum game: one investor wins at the expense of a loser on the other side. So, unless one has a clear advantage, odds are one'll be the loser just as often as the winner, or possibly more often, given that there are smart players with lots of resources and lower costs in this game.

Disclosures: Long V.


A Place for the Shiny Metal in a Value Investor's Portfolio

I'm often asked about whether I like gold as an investment medium.

Personally, I don't use gold and have never used. But that doesn't mean I don't believe there is a place for gold in one's portfolio. There is. Let me explain by stating a few true facts that can be confirmed with a bit of your own research:

Pros and Cons of Gold

  1. Historically, over long time periods, gold mostly retains its purchasing power.
  2. Gold doesn't go bankrupt, doesn't overstate earnings, doesn't write-down anything (its weight, for example).
  3. Physical ownership of gold cannot be confiscated by law or by electronic methods; force is required to take gold from someone.
  4. Gold is universally accepted.
  1. Gold doesn't pay a coupon or dividend.
  2. Gold can't cut costs, become more effective, increase earnings, expand market share or come up with a great new idea.
  3. Gold can't take advantage of acquisitions, market opportunities or low interest rates.
  4. Gold is hard to value. There's little industrial utility for gold, so demand is mostly speculatory and fear-driven.
Basically,  what this all tells an investor is that 1) gold provides little in terms of a decent, predictable, long-term return but that 2) gold is a good store of value for times of political and monetary uncertainty.

Let's break it down in parts.

Little upside

As a commodity, the price of gold depends on "the market" and there is little in the way of assigning it a fair value. Bonds, on the other hand, can be assigned a value given a discount rate, inflation, maturity, credit quality and coupon rate. Stocks, though harder to value, can be valued independently of their market price too. Gold cannot.

As such, how can one "invest" in gold and expect returns from it, without having a crystal ball?

Store of wealth

On the other hand, gold has historically(*), in modern times (last 100 years or so) held its value over time.  Due to its fungibility and international acceptance it's a good medium of exchange ("currency") to have in times of trouble, war, economic instability, inflation,  and maybe even deflation. This mostly applies to physical gold held close to the investor, not in a vault or via proxies.

Gold is, then, a good hedge against inflation over long time periods.

How to use gold?

So how should an investor use gold? To me, it only makes sense to have gold as part of one's cash reserves. As I've said before, every investor, experienced or not, should have at least six months worth (more for increased safety) of living expenses in readily available currency such as money markets and savings accounts. And in my view, part of this reserve can be held in physical gold (other commodities may also qualify, but let's focus on gold here).

If one is fearful of high inflation, political or economic instability, then increasing this allocation to a year or more makes sense. It also makes sense that this extra reserve be in gold.

Currently, I don't own gold and have no intention of buying it anytime soon. The time to buy gold is when everyone is talking about prosperity, peace and low inflation. And even then, the role of gold should be limited to that half-year to a year reserve of readily available "currency", for emergencies.

* Appendix: How well does the value of gold really hold up?

I couldn't help but try to find what an ounce of gold could buy many centuries ago. Perhaps the historians could help? So, here's my uber non-scientific, back-of-the-envelope-ish analysis.

According to this site, prices in ancient Rome during the 6th century were as follows:

1 donkey = 3-4 solidii
1 lb of fish = 6 folles

Now, some units:

1 solidus = 1/72th of a half pound of gold = 226.79/72 g of gold = US$ 101 (@ 1 troy ounce = US$ 1000)
1 folle = 1/180th of 1 solidus = US$ 0.5626

Hence, we get the following prices in today's USD:

1 donkey in ancient Rome = US$ 303-405 today.
1 lb of fish in ancient Rome = US$ 3.375 today

But in reality, we see the following prices currently:

1 donkey today = at least US$ 500, sometimes close to $3000 (sources: http://www.equinenow.com/donkey.htm, http://www.littlefriendsranch.com/Donkeys%20for%20Sale.htm)
1 lb of fish today = US$ 15-20 (source: http://www.allfreshseafood.com/p-tilapia-fillet.htm)

The interesting thing is that the prices are in the general ballpark despite the centuries that have gone by. Neither the fish cost a tiny fraction of a penny nor the donkey was found to cost a trillion dollars.

So, if that's even close to correct (which I can't confirm), it means that gold mostly retains its value, but "inflation" can catch gold too -- after all, it can be mined and thus diluted.  Also, despite all the increased efficiency in farming techniques, raising donkeys and fish didn't seem to get much cheaper over the years but instead have appreciated in gold terms.

This analysis, however, is mostly for entertainment value as I can't verify the validity of the prices above. Take it for what it's worth.


Dividend Discount Model in Action -- LLY Stock Analysis

Recently, I noticed a stock on my watch list that hasn't returned to its pre-financial-crisis level: Pharmaceutical company Eli Lilly (LLY). Here's my analysis.

For a mature dividend aristocrat such as LLY, the dividend discount model is usually a good start in valuing the stock.

LLY has raised its dividend for over 25 years. Over the last 10 years, LLY has raised its dividend a compound 7.86%. Year-over-year, the minimum raise has been 4%, the maximum 13% and the average raise was close to 8%.

Meanwhile, earnings per share (EPS) growth has only compounded by 1.65%. So the growth in dividend is probably not sustainable without further improvements to the bottom line, such as cost cutting or acquisitions.

If we assume a 1% growth in dividends (to match the growth in EPS) in perpetuity, and tag it with a 9% discount (my minimum expected return from solid stocks), the dividend growth model yields a price of $25.

LLY currently trades at around $34, has a forward P/E of 7.8 due to analysts-expected EPS of about $4.25 for 2009.

LLY's 10-year average EPS is only $2.00, though. The growth expected this year and next is attributed to a strong drug demand, the acquisition of ImClone and cost cutting. The company's own EPS guidance for 2009 suggests EPS between $4.20 and 4.30. It's unclear how sustainable this new EPS level is.

Historically, LLY P/E ratio has been quite high: the average low P/E was around 22 while the average high P/E was 34. Counting on market euphoria to bring the P/E back to its historical lofty levels is never a good idea. My comfort range of P/E for a large and mature company such as LLY is between 10 and 15. Using LLY's average 10-year earnings of $2.00, we get a price tag of between $20 and $24.

Looking at dividend and EPS growth and checking the P/E ratio is only part of the analysis. I said earlier that it's usually a good start because mature companies such as LLY often have stable earnings, growth, debt load and share count. But a further look at the balance sheet is always helpful. Consider the trends in the graph below.

Looking at various balance sheet indicators as a percentage of sales can help spot worrisome trends. In this case, it's encouraging to see that both research and development (R&D) and accounts receivable have been moving inline with sales. Inventory had a run up in the past that warrants further investigation, but doesn't appear to be out of control. Selling, general and administrative expenses (SG&A) have been growing slightly faster than sales, which might indicate that LLY is not as efficient as it used to be 10 years ago. Nonetheless, the trend is not sky-rocketing either.

Overall, these trends are somewhat reassuring that the dividend discount model is meaningful as it shows the fundamentals are not quickly deteriorating.

Conclusion: from a purely dividend discount valuation and a check against a conservative P/E multiple and a conservative EPS estimate, my initial fair value for a share of LLY is between $20 and $25. Further investigation into drugs in the pipeline, patent expiration and integration of acquisitions is necessary to further determine earnings power and hence fair value.

Disclosures: No shares of LLY held at the time of writing.


Professional Opinion-Givers Always Have Opinions

I'm not a big fan of just criticizing. I prefer to offer better alternatives. However, today I'd like to criticize the financial media in general.

It's not that there isn't news to be reported or information to be shared. It's just that the noise-to-signal ratio is too high to have much value, unless one has special talent in tuning out the noise.

I believe the main reason for all the noise is that opinions are free and everyone has one. Moreover, when financial reporters are paid big bucks to have an opinion, they're guaranteed to have one, and possibly a different one every day, since old news is, well, just that.

When people in general focus on what they do everyday they often get so specialized that they forget that their world is not the whole world. When I go see my optometrist, she tells me to wash my eyelids 3 times a day with warm, soapy water. My dermatologist suggests that I wear sunscreen everyday, even if I spend the whole day indoors inside an office. How many times would a dentist recommend one flosses and brushes? And yet, by eating right and exercising I'd have a much bigger payout in terms of long-term health than following all the specialists' recommendations.

Likewise, financial reporters must talk about the market. And so they do. If it's going up, there's a reason for it. If it's going down, there's another reason or sometimes the same reason as yesterday -- "investor's sentiment", they'll say.

Over-analyzing stock charts and daily fluctuation of the markets has been shown time and again to be foolish. It only tells you what the majority of the market participants (by volume of money, not number of people) think the right price for the market is. Everyone has an opinion, and by following the opinion of the average market participant or that of the financial reporter at best only guarantees you're one step behind everyone else. At worst, it leads to financial destruction.

You should have your own opinion and not let those paid to have opinions -- whether the opinions are right or wrong -- guide how you should invest your money.

What to do then?

Collecting data and analysis based on data is the first step to forming your own opinion. There are respectable services out there that can help with that, such as Morningstar and Standard & Poors. However, none of these should be used as the final decision. Blindly following their star ratings is a recipe for disaster, no matter how well-trained the analysts might be.


Because it's not their money that is on the line. It's yours.

Second, because often times the recommendations are delayed, or are not updated frequently or both. And on top of that, their criteria for what a suitable investment might be is most likely completely different than yours.

As a matter of example, consider S&P's star rating system. S&P claims that their 5-star recommendations beat the market over time. But is this purely due to enlightened analysis or some amount of hindsight? After all, not everyone can beat the market by following S&P's 5-star recommendation or that would be the market's return.

The following is a chart of WMT as provided by S&P's free stock report, which can be obtained from many known online brokerages.

The red ellipses are my addition highlighting periods where their target price tag (the line in orange) changed. Were these changes due to some clever insight or a knee-jerk reaction to the price change? Is it really possible to beat the market by being one step behind it? I'll let you be the judge of that.

In summary: turn off the TV and tune out the noise. Use analysis services as necessary, but as a source of information, not as a recommendation.

Disclosures: I own WMT at the time of writing. I was not compensated in any way for mentioning the names of the companies mentioned above.


Arbitrage Results CYCL - T

I recently mentioned an arbitrage opportunity that I was involved with. The position reached a nice enough profit today that prompted me to unwind it. Here are the results:

Initial trade date: 2009-07-28
Bought: X shares of CYCL @ $7.36
Sold short: 0.28X shares of T @ $25.71

Closing date: 2009-10-19
Sold: CYCL @ $8.41
Covered: T @ $25.81

Total return: 13.8% (in less than 3 months).
Annualized return: approx. 56%

Note that X is irrelevant here. As long as the total dollar amount used for shorting was also used on the long position, this was a hedged transaction. The risk was the arbitration risk -- i.e. that the deal wouldn't close. Since the offer price was to buy CYCL for $8.50 per share, today's price tag of $8.40 was good enough for me.

Note also that I lost a bit on the short side, but as long as the prices converged to the appropriate ratio, the end result would have been beneficial, which it was.

When I mention these short-term opportunities, I can't help but feel a bit like a trader, or a short-term speculator. However, there's a big difference between an arbitrage position versus a speculatory market-timing trade -- the latter of which I do not engage in. Arbitrage is one of two short-term transactions I find suitable for an intelligent investor to attempt in the stock market. The other one being smart option investing, which I'm still to discuss here.

Disclosures: No more positions in the above mentioned securities.


Current Opportunities for the Defensive Investor

A friend recently asked me whether or not to sell some stock options from his employer and what to do with the proceeds. This is a tough question to answer because each one's situation is different. So I answered him first with a set of premises that I believe are universally true and are to be followed as general guidelines at all times. And then, I mentioned a few twists for taking advantage of the current situation as well as some precautions.

Investing Premises for the Defensive Investor
  1. Emergency Fund. Always have at least a six-month fund in cash or ultra-safe investment for eventual emergencies.
  2. Money needed in less than five years should not be in stocks.
  3. Extra money not needed within five years should always be at least 25% in stocks, typically more. A 50-50 allocation between stocks and bonds is a good, no-brainer choice.
  4. Inflation is the enemy. Be weary of anything that ties up money for a long time and has no chance of benefiting during inflationary times. Inflation is always around, sometimes to a larger degree than others.
  5. The taxman is the enemy too. All things equal, paying less taxes is always better. Avoid taxes as much as legally possible. Delaying taxes is often an option, especially if one can choose between taking a profit now or later. Typically, avoid taking taxable profits at the end of the year, since taxes will be due sooner than if you took the profits early in the year (say, selling in November gives you 6 months until tax collection time in April, while selling in January gives you a year and four months to enjoy the money -- exceptions abound, so consult your tax advisor for details).
  6. Avoid over-relying on your employer. If you depend on employment income for a living, loading up on your employer's stock significantly increases the amount of risk you take. Sell those stock options when it makes sense. If your spouse works there too, that's even more risk, you probably don't need to hold any employer stock at that point.
As they are, these are general guidelines to be observed at all times. What does that mean right now, in terms of actionable items and the current situation? Let's take a look at the current investing scenario.

Current Investing Situation
  1. Low interest rates.  Money market and savings accounts yield next to nothing, so investors will lose money to inflation over time.
  2. Threat of higher inflation in the near future. With money printing and inflation officially at its lowest point in years, it's guaranteed that the only possible outcome in the future is higher inflation.
  3. Devaluing of the dollar. With the recent threat of collapse of american financial institutions, the rest of the world is scared of the dollar -- China is buying gold and Saudi Arabia is allegedly selling oil in Euros, not Dollars. Combined with fear of higher inflation, holding US Dollars doesn't seem like a good call right now.
Intersecting the current investing situation with the investing premises for defensive investors, what is my friend, a defensive investor, to do?

Current Action Items for the Defensive Investor
  1.  Get an emergency fund in place. My friend should sell enough of his stock options and get that emergency fund in place. A good place to park it is in Vanguard's Prime Money Market Fund or a muni fund from his state if he's in a high tax bracket. In his case, the California Muni Market Fund will do it.
  2. Diversify away from the dollar and hedge against inflation. With the funds my friend will need in the next 5 years, he should put them in inflation-protected places. My favorites are TIPS funds such as Vanguard's Inflation-Protected Fund and a CD of a basket of strong currencies, such as Everbank's Commodity CD, which contains 25% of each Australian, Canadian, New Zealander and South African currencies. Another good choice is the Debt-Free CD which has among others the Swiss Franc and the Brazilian Real.
  3. Invest for the long-run. With the rest of the money he won't need in the next 5 years, I told my friend to invest at least 25% in stocks, but possibly even more. A good choice is to go 2/3 stocks and 1/3 bonds with the Wellington Fund. To be more aggressive, I'd allocate 70% to Wellington and the rest into a Total International Stock fund or equivalent.
Regarding his employer's options, I told him to lock-in most of his gains now to start the above plan right away and to keep only a small portion for future appreciation, since his options vest continuously and are replenished by his employer annually (there are more where these came from).

My advice for Entrepreneurial  Investors would only be slightly different, and it would also include to a large extent the same defensive investments outlined above. The difference between the two types of investors is the amount of time and interest they have to devote to their investments. As such, a defensive investor should refrain from picking stocks and engaging in short-term arbitrage transactions. And every investor, seasoned or not, had better stay away from market-timing folly and listening to financial commentary in general.

Disclosures: I own shares of some of the funds mentioned above: VGTSX, VCTXX, VIPSX and the Commodity CD. I did not receive any compensation for mentioning the names or products of any of the companies cited above.


On Capitalizing Expenses -- a Practical Example

This article originally appeared on The DIV-Net on October 6th, 2009.

Recently, we talked about the need for investigating capitalized expenses. Now, let's illustrate that with a current example.

Formula Systems (FORTY) is a software and technology company engaged in software consulting services, developing software products and providing computer-based business solutions. Software development means paying software programmers to write code. The end product is the virtual concept of software.

As of the end of 2008, FORTY had a reported book value of $170M and has been trading in the last four months between $84M and $122M. At first glance, it seems like a bargain.

According to the company, FORTY capitalizes "development costs of software which is intended for sales that are incurred after the establishment of technological feasibility of the relevant product". They also start to amortize capitalized software development costs "when the product is available for general release to customers". Typical amortization period is 3-5 years.

Sounds reasonable. Until one thinks about the nature of software. Unlike a building or a factory, as in our previous example, software has a dynamic nature that is unpredictable -- a new one can quickly obsolete the old one, much faster than 3-5 years.

Also, software development costs vary widely. What one company paid to develop one can seem like fortunes to another, more efficient developer. It's unlikely that a software without a moat such as Windows or Google Search can fetch a lot of money if sold to an informed buyer, especially since new programming technology can also change the cost of building new applications.

Going back to its most recent annual report, FORTY had at the end of 2008, $46M of capitalized costs and other deferred charges listed as "Other Assets".

It also had $143M of goodwill from two acquisitions that are not amortized since 2002 but instead tested for impairment every year. Moreover, the value of these assets is calculated based on future cash flows expected in the future, like our sprocket factory example in Part I of this article. We concluded then as we conclude now, that this type of valuation can be very misleading, since the future is unknown.

So, what's FORTY worth without capitalized costs? Let's subtract all the capitalized costs and assume the software is worthless at liquidation: $170 - 46 = $124M. That's more inline with its current market value.

Now assume that we don't fully trust the company's estimate of the fair value of their goodwill. If we subtract $143M, the company is worth nothing. Of course, it must be worth something or they would have been out of business by now. But figuring out what portion of these $143M are inflated is an exercise I prefer not to engage in, especially because what's left after subtracting capitalized costs is already too small a margin for my taste.

For now, I'm passing on FORTY.

Disclosures: None.


Digging Up For Coal -- NRP vs ARLP

Quick question: which company is more fairly-valued? ARLP or NRP?

Note that I'm not saying they're fairly-valued, undervalued or overvalued. I'm asking which one, relative to each other, is more appropriately valued, even if not so on an absolute basis.

Natural Resource Partners (NRP) is a coal property lessor, currently trading for $21 for a total market cap of $1.5B with a P/E of 14 and a dividend yield of 10%.

Alliance Resource Partners (ARLP) is a producer and marketer of coal, currently trading for $37, for a total market cap of $1.4B, with a P/E of 12 and a dividend yield of 8%.

Both companies are limited partnerships, thus required to pay out substantially all of their cash flows in dividends every quarter.

Now, what's your answer?

Okay, I didn't give you enough information. Fair enough.

My point is that nothing you can fish out of Google Finance or ratios from Reuters or Morningstar will make answering this question any easier.

This is because exploration companies such as NRP and ARLP are a special category of business. Their fair value depends heavily two things: a) the price of coal and b) their proven reserves.

For this exercise, we can ignore the price of coal, since we're talking about relative value here. If the price of coal changes, it will change for both companies.

Now, proven reserves. That's the amount of coal in the ground that is available for mining. This is a determinant factor because even if one company can extract coal more cheaply than the other, due to it having better technology, cheaper labor or being closer to cheap transportation, this fact may still be irrelevant on the long run if one company will live three times as long as the other one.

Consider this: As of December 31, 2008, NRP owned or controlled approximately 2.1 billion tons of proven and probable coal reserves, while on the same date, ARLP had approximately 686.3 million tons of proven and probable coal reserves.

So, it looks like NRP is the one that may live three times longer and distribute more of their cash flows to shareholders over the long term.

While this simple analysis does not answer the question, it brings up an important point to consider when dealing with exploration companies: the value of their proven reserves.

The real answer requires a little bit more "digging" (pun intended), but not in the ground; rather in the balance sheet of the companies. In specific, how accurately are the proven reserves reflected in the balance sheet? Also very important is the companies' capitalization structures -- how much debt they have, since interest on debt gets serviced ahead of common shareholders.

I'll leave this as an exercise for the reader for now. But unlike high school books, I will answer this question eventually in a future post. Stay tuned.

Disclosures: None


On Capitalizing Expenses

Expenses are costs to the company and as such they are typically recorded as a charge against revenues or sometimes surplus. But in some cases, expenses are capitalized. That is, the costs incurred are not charged against revenue or surplus, but instead built into the balance sheet as assets.

Sounds backwards? But there are valid and legal reasons for this. Imagine that you build a factory, that costs $1M to build over two years. Some expenses incurred can be capitalized because the factory you built is now an asset that is worth something if sold in the market. That's what capitalize means -- to convert into capital.

The problem starts when one needs to decide how much of the total cost should be capitalized. If the factory when ready is worth in the market $2M, then an argument can be made that $2M is what should be capitalized when the factory is ready. But if out of your building cost of $1M, some $300,000 went into buying new equipment that was stolen during construction, then an informed buyer of your factory wouldn't need to repay you that much, since he could rebuild the factory himself for only $700,000. So an argument could be made that the asset is worth only $700,000.

Moreover, if this factory is used to build sprockets that can be sold for $15 each and it can build them for $5, at the rate of 10,000 per year, then one could use the $10 spread, times the volume built to value this factory as one would value a bond or a dividend-paying stock. For the sake of the exercise, with a 9% discount rate and depreciating the factory over a period of 20 years, the fair value of this factory would be $912,854. Such projections can be misleading and are not proper accounting methods, but it illustrates how widely one can value assets.

So, what's the fair value of this hypothetical factory? In my mind, I would treat the monthly expenses for the two years it takes to build it as just that, expenses. The income statements and the balance sheet should both reflect the costs incurred. After all, it's hard to value a partially-built factory and if bad times happen and the company needs to raise cash, it will find itself in a precarious position and unable to sell the factory for what it has paid thus far. After construction, I'd call an appraiser and have the market value of the factory be reflected on my balance sheet.

Of course, this is being very conservative and is very lumpy, especially at the end. Most companies don't do it this way, but instead capitalize some or all expenses as they are incurred.

But an investor should be on the look out for abuses. AOL, during the dot-com boom, once capitalized advertising expenses, as they argued that the money used would soon be reflected in the form of new customers and increased revenues. Another company capitalized its Christmas party, under the excuse that it would reap the benefits of increased morale.

In another post, I will discuss a likely undervalued company that has many capitalized assets that need some intricate adjusting.


Recency Bias and One-Time Gains

Stocks have value for two reasons only: 1) their liquidation value (what their assets are worth after subtracting what they owe) and 2) because of the expectation of future earnings.

Regarding 1), it's uncommon for stocks to be valued purely based on their liquidation value since most companies are not meant to be liquidated, but rather to continue as going concerns.

Regarding 2), a stock's history of earnings has no bearing on its future value other than as a proxy for what it could earn in the future. But if the future prospects for a company are really dim, then no glorious history of past earnings can lift the stock much beyond liquidation value.

So what does all of this has to do with recency bias and one-time gains? Well, everything. First, businesses, like life, have their ups and downs. So the recent past might not be a good proxy for judging the future earning power of a company. Even though this is stating the obvious, Wall Street too often forgets this and assigns too much weight to recent events such as improved earnings, one-time gains, a rough patch, etc.

Think about it: The past is bounded, but the future is unbounded. So what a company did last quarter or what it will do next quarter should have close to zero effect on its value in perpetuity.

In summary, when appraising a company, make sure to adjust one-time gains (or charges) and look at earnings over a long period of time (at least 5 years, typically 10 or more) to smooth out recent effects. Averaging the returns after adjusting them can also help you gain a basis for projecting future earnings.

At the same time, make sure to discount recent events that may not have much long-term meaning such as launching new fad products, some types of planned changes in management (especially when a successor has been groomed for many years) and small divestitures or acquisitions of subsidiaries that are unlikely to have a material impact.

When recent changes appear meaningful, ask yourself whether or not they fundamentally change the characteristics of the business on a permanent basis. Is buying that piece of equipment or installing that computer system going to enable the business to earn more or keep more of what it earns permanently in the future? Does it change the nature of the business?


Don't Confuse Price for Value

Philip Fisher was a great investor. Despite his focus on growth, he was well aware that the more you pay the less you keep, and hence the smaller your returns will be. Fisher also warned his readers that price and value are not equal and that just because a stock's price has been stable for a long time does not mean that a) it's correct nor b) that it can't change when events change or the market's mood swings.

Here's a paragraph from his book Common Stocks and Uncommon Profits that I find extremely important and possibly one of the main "hidden" lessons in the book:

When for a long period of time a particular stock has been selling in a certain price range, say from a low of 38 to a high of 43, there is an almost irresistible tendency to attribute true value to this price level. Consequently, when, after the financial community has become thoroughly accustomed to this being the "value" of the stock, the appraisal changes and the stock, say, sinks to 24, all sorts of buyers who should know better rush in to buy. They jump to the conclusion that the stock must now be cheap. Yet if the fundamentals are bad enough, it may still be very high at 24. Conversely, as such stock rises to, say, 50 or 60 or 70, the urge to sell and take a profit now that the stock is "high" becomes irresistible to many people. Giving in to this urge can be very costly.

Fisher goes on to explain that fortunes are made when stocks are let go many times higher than what the investor paid for the stock, precisely because he bought them when they were undervalued or fairly valued and growing. He also added:

The only true test of whether a stock is "cheap" or "high" is not its current price in relation to some former price, no matter how accustomed we may have become to that former price, but whether the company's fundamentals are significantly more or less favorable than the current financial-community appraisal of that stock.

This rings true with value investors and growth investors as an investor is he or she who makes intelligent decisions about investments, and does not speculate on market events that have no bearing on the true value of a company.

The danger of getting too hooked up on price is so high that Fisher introduced its "influence" as follows:

This influence is one of the most subtle and dangerous in the entire field of investment and one against which even the most sophisticated investors must constantly be on guard.

Know the value of what you own.


Mini-Tender Offers: Awful Deals in Disguise?

From time-to-time my broker sends me correspondence regarding various types of "unsolicited tender offers" and "non-mandatory reorg tender offers". These are also known as mini-tender offers. You can read more about them in the SEC's site. They're basically offers by some company or private party to buy less than 5% of the outstanding shares of a public company directly from shareholders.

Okay, so what's the deal?

These "offers" are typically below market-value offers. They can be legal scams in disguise. Basically, weak retail investors will hear the term "tender offer" and will jump the gun in excitement and agree to surrender their shares for less than they could get in the open market!

In the last few months I got one such offer for shares of Bank of America (BAC). And more recently, one for Pepsi (PEP). When I first read the one for Pepsi, I almost thought it had something to do with Pepsi's acquisition of one of its bottlers, Pepsi Bottling Group (PBG) or PepsiAmericas (PAS). Then when I stopped for 3 seconds to think about it, I realized it couldn't be: I don't own shares of either PBG nor PAS. This must be someone trying to buy PEP (the syrup maker) from me. Why?

Another 3 seconds revealed the truth: some funny people at a company called TRC Capital Corporation are offering to take my shares for a discount to market! How awesome is that?

Why would anyone fall for this, you ask?

I don't know. They're probably the same type of eager people who fall for "a one-time business opportunity with the president of Nigeria".

This is what Pepsi had to say about the offer:
PepsiCo does not endorse TRC's unsolicited mini-tender offer and recommends that shareholders not tender their shares in response to this mini-tender offer.
In other words: what a steal! You can read Pepsi's note in full here.

Don't pull the trigger without a bit of investigation. Most offers are not what they seem to be.

Read more about the man behind TRC.

Disclosure: I own shares of PEP, BAC at the time of writing.

Don't Let Your Investment be Diluted

This article originally appeared on The DIV-Net on 2009-09-02

High return on equity (ROE) and a reasonably high dividend yield are good things to have in stock investment. But investors focusing on just these two metrics (or any other few metrics) might be surprised to discover they are losing money.

This is the case of CenterPoint Energy (CNP), a utility company with interests in electricity, natural gas distribution and pipelines. Since 1999, CNP has returned $8.78 per share to shareholders via dividends. The average annual dividend yield since then has been between 3.11% and 6.83%.

The return on equity has been solidly between 10.3 and 34%, with the average just over 21%, which is pretty good considering that an average business gets less than 12% and utilities are lucky to strike above 8% ROE.

But long-term investors received little for holding the stock for the last 10 years. In fact, they lost money after inflation, through equity dilution.

An investor who was lucky to buy a share of CNP in 1999 at the lowest recorded price for that year ($22.75) and held on until the very peak price in 2008 ($17.35), would have gotten a total cumulative return of around 8%, including dividends, which translates to 0.89% annualized. That's less than inflation.

Even if we consider that in 1999 the market was very inflated and in 2008 it was really low overall, this exercise assumed an investor was lucky enough to buy at the trough and sell at the peak. Most investors won't get these prices.

But let's exclude 1999 as it was a local market peak and also 2008 since it was an abnormally depressed year. Let's continue to assume our investor was lucky and bought at the lowest point in 2000, collected dividends until the top of 2007 and sold at that high price.

Even in this scenario, the cumulative return amounts to only 24% or 3% annualized, barely keeping up with inflation.

The table below summarizes why.




Price: High$32.50$49.00$50.45$27.10$10.49$12.32$15.14$16.87$20.20$17.35


Price: Low$22.75$19.75$23.27$4.24$4.35$9.66$10.55$11.62$14.70$8.48


Dividend per Share1.501.501.501.070.400.400.400.600.680.73


ROE (%)3414.314.810.326.414.418.730.323.723.2


Yield on avg price5.43%4.36%4.07%6.83%5.39%3.64%3.11%4.21%3.90%5.65%


Shares outstanding286284292299306364336324341343


Long term debt$5,666$5,701$6,448$9,149$10,783$7,193$8,568$7,802$8,364$10,181



$ Return% ReturnAnnualized


Return from 1999 low to 2008 high$1.888.26%0.89%


Return from 2000 low to 2007 high$4.8224.41%3.17%

CNP has been diluting shareholders returns via stock options and outright sale of stock and at the same time maintaining or increasing its debt. These management actions proved to be unfriendly to shareholders and thus investors should continue to shun this stock.

Dilution of shares and high debt are characteristics of capital-intensive companies with high fixed charges. Careful investors should be on the look out for such companies and invest only when it makes sense to do so.

Value investing is not only about finding bargains. It's about finding wonderful businesses at reasonable prices.

Disclosure: no position in CNP at the time of writing.