TogaPF

Thoughts on Selling: How I'm Going to Liquidate TogaPF

2009-04-26T23:37:00.000-07:00

Most attention in investing is directed toward the purchase decision: what to buy, when to buy, how to buy. Much less attention is devoted to when to sell and how to sell.

These are tricky questions, and they are questions that I haven't spent much time on before. Like Buffett, my favorite holding period is ideally forever. Unfortunately, I've often fall into the trap of getting too attached to my investments and not looking actively enough to figure out the proper selling conditions for them.

There are really only a couple scenarios in which it makes sense to sell:

1. The investment rationale changes

There could be any number of negative events that could trigger this: the competitive landscape could change, the financials could deteriorate, the company could be running out of cash, and the management team could turn out to be a bunch of swindlers. For example, when credit card processor Heartland Payment Systems suffered a security breach earlier this year, I basically dumped it the next day, taking a huge loss in the process. There was a fundamental change in the business, and I was no longer interested in owning the shares. This is probably the simplest sell decision to evaluate. Note that this is different from simply selling when the price has dropped by 50% or more. If there hasn't been a corresponding business change to explain the loss, then the price drop just means the stock is cheaper to buy.

2. Switching to a better investment elsewhere

This is selling to raise funds to buy another stock that may provide a better risk/reward scenario. This one is a little trickier for me, as the question becomes whether I'm sure the investment I'm switching into is actually better than the one I'm switching out of. To me, there needs to be a clear advantage in order to justify the switch. For example, I switched out of index funds to buy BRKB at the end of last year to get both a tax loss writeoff while getting a good price on Berkshire.

3. When the investment has appreciated to "full-value" or "over-valued" status

This is the most difficult to assess in my opinion. What exactly does it mean to be fairly valued or over valued? If the market wants to create a bubble around my investment, then I don't want to sell out too early. I've read that many managers will let their winners run unless there has been a fundamental change in the business. The other way to address this is to set a cap as to how large a single position can take in your portfolio, say 25%, and to reduce the size of the position once it exceeds that allocation.

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The reason I've been thinking about selling is that I'll be liquidating a good majority of the TogaPF portfolio in the coming months. I basically want to extract about $60k cash come July/August. Regarding how best to optimize this, I've come up with the following:

1. Pro rata liquidation across time.

Probably the most common-sense approach. I basically sell a bit of everything at set intervals so that I have the $60k and the same portfolio at a smaller scale. However, the transaction costs for this may be somewhat high. There will be also some tax consequences as I'd be selling some investments with short-term gains.

2. I can categorize the holdings into "keepers" and "everything else."

And "everything else" would be sold. This is a bit like pruning the portfolio for just the best holdings. This simplifying exercise is also useful to think about what I would keep under all circumstances. So here are my holdings ranked in reverse order:

Sold!

17/18. Jan '10 Puts on Microsoft and Autodesk. Both are now out of the money, and assuming that I just hold onto them until expiration, I can earn another $1k out of them. I sort of messed up here; I shouldn't have written puts for 12 months out. If I sell now, I will have made about $1k on them, but there is just still too much time value embedded in these. In any event, writing puts has always been a form of getting higher yields on cash for me anyway.

16. Freeport McMoran (FCX). Now that there's been a run-up in the shares of this copper, gold and molybdenum miner, I find myself clueless as to what the fair price of this should be. I'm contemplating writing some calls on this to get a little extra income on it before I sell.

15. Jan 2011 USO Call spread. USO has been so disappointing with its roll spread problems. I still believe this will play out by 2011, but I may need to unwind it while I still can.

Going...

11/12/13/14. Autodesk / Digital River / Giant Interactive / NVIDIA. Now we're moving toward stocks that I don't want to sell. All of these technology companies have huge net cash balances and decent businesses that would do well in an upturn.

10. ATP Oil & Gas. Speculative oil & gas play that dropped to prices far below the value of its assets.

5/6/7/8/9. BP / Intel / Johnson & Johnson / MMM / Nokia. The big dividend payers. It would be nice to hold on to these as long as I can. If I had to choose among these, I would keep JNJ and NOK first.

Keepers:

4. Diageo. I would like to buy more - can't think of selling this now.

3. Chesapeake Preferred. I got these yielding at about 11%, and it's also appreciated about 50% since I got them.

2. Columbia Sportswear. I really like this company. Everything about it makes sense to me as an investment: simple business model, fat FCF generation, huge management ownership stake, large cash balance, big dividends/share repurchases. I've run out of synonyms for big.

1. Berkshire Hathaway. Was there any doubt? I don't expect to get these at such prices again anytime soon. Unfortunately, this is also my largest holding.

Giant Interactive - Nice Suprise

2009-03-06T15:32:00.001-08:00

The company reported much better than expected results this week and saw a jump in its stock price, versus the general market which was absolutely dismal.

The stock had suffered recently due to changes that the company had made in the monetization structure of its ZT Online game. They made these changes to emphasize purchasing items for daily consumption rather than relying on promotions, allowing smoother and more predictable revenues over time and potentially lengthening the monetization lifespan of the game. As this shift was being made in the last quarter, there was a rather large hit to earnings and the market became skittish over the idea that perhaps these changes may have backfired. The key question was whether these changes would hinder future growth prospects.

I admit that I was getting somewhat concerned about this investment, which I wrote about back in September. The financial hit in Q3 was much larger than I had expected. Despite an overflowing cash horde, strong game metrics, and a CEO with majority ownership, it was not clear to me whether the company could regain its momentum. Coupled with the deteriorating economy and a competitive marketplace, I felt that my investment thesis was being tested. After the Q4 results, I think most of my doubts were put to rest.

Here's the key information:

My takeaways:

Revenue growth and margin expansion. Slide 7 of the presentation lays it out pretty nicely. There had been an eye-popping decline in revenue from Q2 to Q3 of almost 47%, but that recoved nicely in Q4.
Gross and net income margins recovered to the low 80%, where they've been historically. Note that if you back out the sales tax refund of about $4.3M USD, it still translates to net margins of about 70%.
The company is under a tax holiday and will have a tax rate of 10% in 2009, 11% in 2010, and then the normal 25% in the years after.
Management stated that they expect the lifespan of the ZT Online to be 5 years. I'm not sure if that means they expect it to continue to grow for another 5 years or that the game will last another 5 years.
The company repurchased 14.9M shares for total consideration of $97.7M, or about $6.56 per share. They now have outstanding shares of 226M. I found this pretty amazing, since they've already burned through almost 2/3 of their $150M share repurchase authority. At this rate, they'll soon have to increase the size of their plan. Keep in mind that the company just went public in November 2007 for $15.50, where they sold about 60M shares. They basically bought back almost of a quarter of the shares they sold in the IPO just a year ago at more than 50% off, using money they raised from the IPO. That's simply brilliant. It's reminiscent of how Brad Pitt and Edward Norton in Fight Club bragged about "selling rich women their own fat asses back to them" by making premium soap out of liposuction waste.
Initiated dividend. I suppose this makes sense. They have $740M in cash on their balance sheet, and they run a business that isn't exactly capital intensive. A dividend will only cost them about $40M.
3 new game launches in 2009. This is the gravy.

Taken together, it looks like GA is in pretty good shape. They have the cash to weather a downturn, and it looks like consumers haven't stopped turning to gaming companies as a cheap source of entertainment. There's still a lot of uncertainty in the market, but I definitely feel better about hanging on to my shares for now.

More Put Ideas

2009-01-19T23:48:00.000-08:00

Selling cash secured puts continues to prove to be a profitable though fairly conservative move in these markets. I've mentioned this idea several times (here and here) in the past few months as a way to get paid handsomely while waiting for lower prices on stocks that I'm interested in owning anyway.

Why are puts so expensive? I overheard a stock broker on the streets of New York this weekend talking on the phone about the merits of buying protective puts on stocks. Basically, if you own stocks, you buy puts in order to protect yourself from any downside movement. With prices fluctuating wildly and the markets collapsing, however, this form of protection has become increasingly expensive. As such, you want to sell high on these expensive puts and buy low(er) on the underlying stocks.

One additional point worth mentioning is that it's better to do this on highly traded stocks. The added benefit of liquidity is that it's easier to close out your position. The bid-ask spreads on the less liquid options makes it pretty expensive to buy and sell options.

I recently closed out my positions in both the GE $10 March '08 Put as well as the FCX $12.50 May '08 Put. Both stocks had appreciated considerably, so the puts I sold had grown cheaper. Rather than wait for the puts to expire worthless to collect the entire premium, I decided to buy the puts back to close out the positions early and lock in more than 70% of the premium. This resulted in about a 17% return on the cash I used to secure the FCX put, and about 11% return on the cash I used to secure the GE put. In both cases, the holding period was under 2 months.

With my cash no longer restricted, I'm looking for more opportunities to sell puts. As always, make sure to do this only on stocks or ETFs that you are interested in owning anyway. Depending on your risk tolerance, you can adjust the return you receive by selling puts with strikes that are way out of the money. You should be indifferent to whether or not the put is ultimately exercised, as both outcomes are desirable. Here are some at-the-money put ideas to get ~20% return on your cash on some popular securities along with their potential outcomes:

SPY $85 Dec '09 Put - $14.50 (17% cash return, or buy SPY at $70.50)
MSFT $20 Jan '10 Put - $4.00 (20% cash return, or buy MSFT at $16.00)
AAPL $80 Jan '10 Put - $16.70 (21% cash return, or buy AAPL at $63.30)
FXI $25 Jan '10 Put - $6.30 (25% cash return, or buy FXI at $18.70)
USO $30 Jan '10 Put - $6.50 (22% cash return, or buy USO at $23.50)

I think many people would be comfortable buying the S&P 500 at its current level of 850 and holding onto it for decades. If that's the case, then selling the put on SPY should be an even better move. I collect $1,450 today by setting aside $8,500 to potentially buy SPY in Dec 2009, which I would be willing to do today anyway. I get a 17% cash return or a 17% discount on the purchase price, just by waiting a year. The same holds true for Microsoft and Apple, both stocks that I would be quite willing to buy at current prices.

To take advantage of this, I'm going to get my IRA account approved for options trading. Since this is considered ordinary income, it's best to do this in a tax-advantaged account.

TogaPF 2008 Portfolio Performance

2009-01-03T01:42:00.000-08:00

Time to assess the damage from 2008. The TogaPF portfolio launched on August 4, 2008 with $48,897 in existing holdings. An additional $35,500 was added at various points since launch. At year end (12/31/08):

Total contributions: $84,397
TogaPF portfolio: $79,063 (-20% IRR)
S&P 500 benchmark: $71,217 (-45% IRR)
Relative performance to S&P 500: +$7,800

Returns are measured based on the timing of cash flows into and out of the portfolio. The specific winning and losing trades ultimately sum up to what can be cashed out of the portfolio. The S&P 500 benchmark is the return that would have been received had the cash inflows been invested in the S&P 500 instead.

Realistically, I should include an estimate for liquidation cost that would be incurred in converting the portfolio to cash, but I'm ignoring that for now. I also haven't made any adjustment for dividends paid out by the S&P 500.

Clearly, my timing in starting TogaPF wasn't all that great. Although the portfolio did better than the S&P 500 benchmark, it's not that thrilling to be losing money.

One item that jumped out at me was $456.50 spent on commissions, not including the management costs embedded within ETFs. I expect that number to come down. $100 was spent due to establishing the TogaPF portfolio. Another $100 was spent on options trades, which I was still experimenting with. Overall, I'd like to keep transaction costs under 1% of assets per year.

Since only about 5 months have passed, these returns should be taken with a grain of salt. The real fun begins this year.

Revamped Portfolio

Thanks to EditGrid, the TogaPF portfolio is now pulling in up-to-date stock quote information from Yahoo! Finance and updating the portfolio valuation. The embedded spreadsheet includes the up-to-date portfolio, returns calculations, as well as a list of all past trades.

Berkshire Hathaway Portfolio

2008-12-24T17:52:00.001-08:00

As mentioned in a previous post, I am planning on switching funds from a Vanguard index fund to Berkshire Hathaway (BRKB) in order to take advantage of the tax loss writeoff. I thought it would be interesting to see just how much of the share price is made up of Berkshire's common stock holdings and other investments.

I've been playing around with EditGrid, an online spreadsheet tool that allows for access of live data from Yahoo! Finance and other data sources. It looks like a pretty neat tool, and I'm thinking of eventually converting my portfolio tracking to this spreadsheet.

Using SEC filings and the latest 10-Q, I attempted to piece together the current value of Berkshire's investment holdings. This should update automatically so I can always look at how Berkshire is trading relative to its investment portfolio.

I estimated that about $86B of Berkshire's $145B total market cap comes from its investments, roughly 60%. Converted to A share pricing, that yields investments per share of $56,044. This compares to 2007 year-end $90,343 investment per share as stated in the 2007 annual report (A shares closed at $141,600 in 2007). Tilson Funds put out a report estimating $86,000 investments per share in Q3 '08 and $76,000 investments per-share as of 11/19/08. For reference, A shares closed at $130,600 on 9/30/08 and $84,000 on 11/19/08.

NOTE: I'm not sure if my way of calculation is the same as the method used by Berkshire and Tilson Funds. I'll need to investigate further to make sure that I'm doing it correctly.

The point of all this is that Berkshire's investment holdings make up a large portion of its current market value. That means that the implied value of Berkshire's many businesses is quite small. On November 19, you could have actually bought Berkshire at a cost nearly equal to the value of its investments, meaning businesses like Geico and See's Candies were being included for free. That makes for a pretty compelling investment argument to me. In this environment, I would much rather own a collection of (undervalued) businesses and investments hand-selected by Buffett rather than any index fund that likely includes a substantial amount of garbage.

Disclosure: The author is long BRKB. Current TogaPF portfolio holdings here.

Oil Speculation

2008-12-19T01:19:00.000-08:00

The price of crude oil has been in freefall recently on fears of less demand due to the recession. Prices on the January 2009 futures contract dropped to $36 a barrel today, down from a high of $147 per barrel earlier in the year. At $36, this is less than half of Saudi oil minister Ali al-Naimi's $75 target fair price for crude, a price needed to support investment in new fields.

This is just bizarre. It's almost enough to make one believe that oil is plentiful and cheap. OPEC on Wednesday announced production cuts of 2.2 million barrels per day, and non-OPEC producers like Russia and Azerbaijan have announced plans to cut production as well.

While the world's economic woes cannot be ignored, I don't believe that the demand issues are likely to go away. There have been no fundamental changes to warrant the decline: economies are still dependent on oil for growth, no major new oil supplies have been discovered, and no alternative energy source is anywhere near in a position to substitute for oil. While growth may be delayed for a time, developing economies like China and India will continue to have huge demands for oil. A prolonged spell of cheap oil also delays the development of alternative energies as well as the search for new oil fields, as it no longer becomes economically feasible to pursue those options. Ultimately, it's all a matter of supply and demand. Coupled with the fact that crude prices remain denominated in the ever-weakening dollar, it seems to me nearly a sure bet that prices must rise.

How to Exploit the Mispricing

The most straightforward method is to buy securities that are correlated with the price of oil, such as oil companies or an ETF that tracks crude oil like USO. A quick check shows that USO does a reasonably decent job of tracking crude prices. If crude rebounds to OPEC's $75 target, that makes for an easy double.

Buying Call Spreads

One play whose risk/return proposition appears very attractive to me is to buy a call spread on USO. USO tends to trade at about 75%-80% of the price of crude and closed at $32.73 today, versus the January 2009 futures contract which closed at $36.20.

Here is a list of USO options expiring in January 2011, over two years from today.

You can buy an in-the-money call option (OLLAX)for about $13.60 with a $30 strike price. Thus, if USO trades above $43.60, or roughly $50-$55 per barrel for crude, by January 2011, you will break even. Anything above $43.60 is pure profit.

You can offset the price of the call option by selling another call option with a higher strike - the classic bull call spread. I did this for a January 2011 call option (ZVKAH) with a $60 strike, at a premium of about $6. By doing this, I basically sell off any upside in USO above $60, which is about $75 in terms of the cost of a barrel of crude. This reduces the cost of my spread to $13.60 less $6, or about $7.60.

You can choose to construct wider/narrower call spreads at different strike price points, which will impact the net cost of the spread. I chose to buy a spread at the $30 range so that my $30 call was already in-the-money.

In this case, I will profit if USO trades above $37.60 by January 2011. I can potentially make up to ($60 - $37.60) or $22.40, assuming USO trades above $60 at expiration. I am basically betting $7.60 for a potential return of up to $22.40, which is almost a 3:1 or 300% gain.

Additionally, I can unwind the position at any point over the next two years, as the prices of the options will change depending on how USO and crude prices change. The only drawback is that the bid/ask spread to unwind the position can be costly.

I believe there is a better than 50/50 chance that crude oil will rise above $75 per barrel over the next 2 years, and I can get a return of up to 300% if that actually happens. That's a bet I'm quite willing to make. Even today, a crude oil futures contract for delivery in January 2011 is trading at $62.09. The U.S. government outlook is for $51 crude oil for 2009.

There is probably an even more lucrative opportunity to be had trading futures here, but I don't have an account set up for that currently. In any event, buying the call spread seems like a solid speculative play to me. I normally refrain from speculation, but the risk/reward was too enticing to ignore.

And What if Oil Prices Stay Low?

Somehow, I wouldn't count on the price of crude to stay this low. But if it does, that's fine by me. If oil prices continue to stay low, that should bring good news at the gas pump and to the economy overall. We can return to our profligate habits of McMansions and Hummers. You can probably pick up both now for pennies on the dollar.

Disclosure: The author is long USO.

Year End Moves

2008-12-17T23:58:00.000-08:00

I haven't had much time to post lately, so my apologies for that. I can't believe it's been over a month since my last post.

Now that the Fed has gone down swinging with rate cuts to essentially 0%, I don't expect the cash returns from savings accounts to be particularly attractive for the near future. Indeed, it was just last week that the Treasury sold 4-week bills at the mouth-watering discount rate of 0%. Clearly, if anything could be considered overvalued in this market, cash and its perceived safety would have to be a forerunner.

With the markets responding favorably to yesterday's cut, I took the opportunity to close out some positions. The problem now, as Obama noted, is that the Fed has run out of its traditional ammunition to fight recession. It's nice that they've come out saying they'll do all they can to help the economy, but it's not as though they were holding back before. Some sort of drastic fiscal response is now a near certainty. The threat of deflation is the key fear now, but these moves will likely have inflationary repercussions at some point.

Consequently, I've been adding more cash to my portfolio. As mentioned before, selling puts now seems like a much more lucrative way to put my cash to work, as well as a more disciplined way to enter stock investments.

Preferred Shares

I've also been researching preferred shares and convertible bonds as potentially safer investments that still capture most of the upside value of common stock. Companies are now readily cutting dividends on common shares to preserve capital, but are still making their payments on preferred shares and bonds.

I'm pretty new to these investments, so I'm still learning how to best dig up information about them. The data in Yahoo Finance isn't that great for looking up preferred shares, so I've found that the company website and SEC filings have been the best resource. I'm leaning toward the preferred shares of natural resources companies like Freeport McMoran and Chesapeake Energy, which have large holdings in necessary commodities. For example, I recently made an investment in Chesapeake Energy Series D preferred shares. Here is an excellent writeup on the investment case. I took a look at the features of Chesapeake's various stock classes, and also found the D shares to be the most attractive based on its offering size, its conversion characteristics, and its 10%+ yield.

Oil

Prices have come down so fast that it's almost a pleasure to go to the gas station. If you're a driver, it would be terrific to lock up <$2 prices for gas for the next few years. A number of other bloggers have written about how to construct a rough hedge on gas prices by buying ETFs that track oil, such as USO or OIL. If oil prices increase over the next few years, the pain at the pump will be offset by the increase in the value of the ETF. If oil prices decline, the ETF will fall in value but so will gas prices.

I chose to invest in USO as there is also the possibility of writing options on that ETF. As prices continue to fall, I think there may be an opportunity to write a call spread on USO.

Tax Losses

The majority of my passively managed portfolio is in Vanguard index funds. As the year wind downs, I think most index fund investors have suffered some epic losses. I've been looking to take advantage of selling some investments for the tax writeoff.

Normally, I would be hesitant to sell any index funds, as I would much prefer to buy and hold. In this environment, however, I think it does make sense to sell index funds as long as you switch to a similar investment. By doing this, you can exploit the tax savings while maintaining your original investment exposure.

For example, let's say you originally invested $10,000 in a Vanguard S&P 500 fund. For simplicity, assume that the Vanguard investment is now worth $7,000. You could liquidate the investment, claim $3,000 in losses, and invest the other $7,000 in a similar investment, such as the S&P 500 ETF SPY. When the $7,000 appreciates someday back to $10,000, you could sell it and claim $3,000 in (long-term) capital gains, which has a lower tax rate than ordinary income. There's a good explanation here.

Now you can't do this for the same investment, as that would violate the SEC's wash sale rule. The example given above is toeing the line in my opinion, but I don't think it's actually disallowed. However, since almost everything in this market has dropped 40%+ this year, it's not as difficult to find a replacement.

I plan to sell a chunk of my Vanguard Total Stock Market Index fund and switching to Berkshire Hathaway (BRKB). I unfortunately was out of the country and not following the markets when Berkshire was trading below $3,000 in late November. Here is a comparison of how the two have traded. I feel more comfortable with the Berkshire collection of assets rather than the overall market. Whitney Tilson had a solid article discussing this a month ago.

Recent Moves

Although I haven't been writing much, I've still been fairly active on the trading front (at least for me). Here's a list of my recent trades:

US Oil Fund (USO) - 12/16/08 - BOUGHT 100 shares at $36.25
Autodesk (ADSK) - 12/16/08 - BOUGHT 1 $20 December '08 put at $1.30 (closed position)
BP (BP) - 12/05/08 - BOUGHT 100 shares at $41.72
Chesapeake Energy (CHK-D) - 12/05/08 - BOUGHT 100 preferred shares at $43.50
Freeport McMoran (FCX) - 12/03/08 - SOLD 4 $12.50 May '09 put at $2.89
GE (GE) - 11/13/08 - SOLD 2 $10 March '09 put at $1.45
Nokia (NOK) - 11/11/08 - BOUGHT 100 shares at $13.76

Disclosure: The author is long ADSK, BP, CHK, FCX, GE, NOK and USO. Current TogaPF portfolio holdings here.

Selling More Puts

2008-11-13T22:05:00.000-08:00

In my last post, I mentioned selling puts to generate income. This strategy seems to me to be increasingly more attractive. There has been tremendous volatility in the market, which has been reflected in the price of options. The potential returns on cash are quite high, perhaps over 25% on an annual basis, and there is also some protection against buying too securities before dips. I'm thinking of transferring additional cash into the portfolio to take advantage of this, particularly as cash yields on savings accounts are declining more and more.

Here are some things to consider:

Do this for only stocks that I am willing to own. The worst case is that the price declines so much that I am forced to purchase shares at a loss, even after accounting for the premium. I had better be willing to own the stock at that price.

Determine a price that I am absolutely willing to pay. Even options with strike prices over 20% below the current trading price are paying high premiums, so it makes sense to look at prices that I think would be a steal.

Look at only actively traded stocks. Otherwise, the bid-ask spreads will be too great and the price for closing a position will also be high.

Look for contracts 3 to 6 months to expiration. This balances a higher time premium and ensures that cash will not be tied up for too long.

The market dipped significantly today before making a breathtaking rally at the close. I took a sampling of today's closing put prices, and despite the rally, the premiums available are still very juicy (all prices are at the bid):

GE Mar 09 Expiration:
$10 Strike: $1.00
$12.50 Strike: $1.55
$15 Strike: $2.35

American Express Apr 09 Expiration:
$10 Strike: $1.20
$12.50 Strike: $1.80
$15 Strike: $2.65

Freeport McMoRan Feb 09 Expiration:
$17.50 Strike: $2.23
$20 Strike: $3.10
$22.50 Strike: $4.15

Nokia Apr 09 Expiration:
$10 Strike: $.95
$11 Strike: $1.25
$12 Strike: $1.60

I wrote another 2 $10 Strike March puts on GE this morning.

GE at $10 seemed like a good trade to me. The stock would have to drop almost 40% from today's levels in order to trigger it. The likelihood seems low of that occurring. Selling it yields $1 per contract payable immediately. If GE drops to $10, the option is exercised, and I would have to buy 100 shares of GE at $10. But I've already collected a $1 per share premium, so I am still earning money. Moreover, GE pays $1.24/share in dividends, so the implied yield at $10 would be over 12%. Overall, it seems like a relatively easy way to make 10% ($1 premium on $10 strike) on cash in 4 months. The worst case is that GE falls below $9, but in that case, I would own GE at $9, which I am pretty sure I would be willing to do.

What's the worst that can happen?

This depends on whether the alternative is to sit on cash, or if the alternative is to buy the stock. If the alternative is to sit on the cash, then the worst case scenario would be if GE shares collapse, and trade at $5 on March 20. Then I would be forced to buy the stock at $10, and the $1 premium I collected wouldn't be enough to cover the losses. This is mitigated by the fact that GE pays $1.24 dividends which they recently affirmed for 2009. Management guarantees have been pretty useless lately, but assuming they are correct, the $1.24 translates to a 24.8% annual yield. The mitigating factor is that the dividend yield will be very high, and I would own the stock at a ridiculously low price.

If the alternative is to buy the stock, then the worst case scenario is if the market rebounds dramatically and GE doubles to $34. GE was trading above $34 as recently as April, so this scenario isn't that far-fetched. In that case, I would miss out on the return. I would still collect the premium from the option, which will expire worthless, but I would have missed out on a 100% gain had I simply bought the stock. I can always close my put position as well, as an increasing stock price will reduce the price of the put. I could then take my cash and use it to purchase shares. Of course, if I bought the stock at $17 and it drops to $5, that would be a far worse result.

When I made this trade this morning, GE had fallen quite a bit and the option was trading at $1.45. I sold two puts and collected about $280 in premium after commission. Assuming that GE doesn't fall below $10 in March, that's a 14% return in a little over 4 months. I selected an extremely low strike price and I'm assuming there will likely be no exercise. I could have selected a higher strike price and collected an even higher premium. Overall, this seems like a good way to take advantage of all of the current volatility in the market.

Anyways, I will be out in Costa Rica for the next week, so will be taking some time away from the market. Hopefully, nothing too crazy happens in the meantime.

Options and Commodities

2008-11-10T22:14:00.000-08:00

I've been short of time to post recently, so here's a quick update on where things stand. While there's been little blogging activity, there has been plenty of trading activity. I added another $12k on October 24.

Here are my recent trades:

Autodesk (ADSK) - 11/06/08 - SOLD 1 $20 December put at $2.50

Autodesk (ADSK) - 11/06/08 - BOUGHT 100 shares at $19.77

Nokia (NOK) - 11/06/08 - BOUGHT 100 shares at $14.67

Freeport McMoRan (FCX) - 10/24/08 - BOUGHT 100 shares at $23.53

NVIDIA (NVDA) - 10/23/08 - BOUGHT 100 shares at $6.60

Freeport McMoRan (FCX) - 10/23/08 - BOUGHT 100 shares at $26.03

Heartland Payment Systems (HPY) - 10/15/08 - BOUGHT 100 shares at $18.69

Nokia (NOK) - 10/15/08 - BOUGHT 100 shares at $15.03

Intel (INTC) - 10/14/08 - BOUGHT 20 $18 October puts at $0.30

I've also been investigating other potential investments aside from stocks, including options and commodities. I think both will likely play a larger role in the portfolio.

Options

I made a speculative option trade in Intel back in October. I honestly wasn't sure of what I was doing, and I made some silly mistakes.

The attraction of options is leverage. Buy an option instead of the underlying stock, and the price movements of the stock will be magnified by the option. The flip side is that while your upside is multiplied, the downside risk is also greater.

In the case of the Intel options, I made a bet that their earnings report would be better than expected. The problem was that I decided to purchase options in their expiration week, thinking that the potential return would be greater. Instead, they just expired worthless.

In any event, this made me list out the specific instances in which I would make an option trade. With so much volatility in the market, I think it actually makes sense to sell some of that and collect the premium. Here are the instances in which I would make option trades:

1. Sell puts.
This is like getting paid to wait to buy something at a lower price. For example, I have sold 1 put contract of Autodesk at $20, expiring December 17, 2008 for $2.50. 1 contract is 100 shares, so selling the put netted me $240 in cash upfront ($250 from the put less the $10 or so in transaction fee). If Autodesk is $20 or less at contract expiration on December 17 (about 6 weeks from now), the contract is executed, and I will have to buy 100 shares of Autodesk at $20. I'm quite willing to purchase at that price. However, since I got the $240, I'm really buying the stock for about $17.60 instead of $20. If the stock is above $20, the put expires worthless, I don't have to do anything, and I keep the $250 premium. I can write another put that expires in Jan. 09 or March 09 and do it again. I plan on doing this a lot more in the future.

There are three issues:

Need to have the cash on hand to buy the stock.
If the stock drops by a lot, let's say to $15, then I still need to buy the stock at $20. I would be at a loss immediately. However, if I had bought the stock at $20, then I would be down even more, so this is fine as long as I'm willing to own the stock.
Charles Schwab's online platform doesn't support this unless you have the highest/most speculative permissioning on options trading, which I don't. That means I need to phone orders in, which is annoying, but OK as long as I use limit orders.

2. Sell out-of-the-money covered calls.
This is the opposite of selling puts, for stocks that I own and would like to sell. I could have done this with EBAY. Instead of selling at $17, I could have written covered calls on the calls and earned the premium as well. If the stock rises above the strike, I sell it and get the premium as well. The problem is if I really want to sell. For example, if EBAY were to fall more (as it has), then the option would expire and I keep the premium, but the stock is now worth even less.

3. Buy long-term calls (LEAPs).
I would consider these for some of the more high growth plays, such as AAPL, GOOG, or VMW. It's very expensive to do this right now with all of the volatility in the market.

Commodities

I was reading Hot Commodities by Jim Rogers, and it struck a chord for me. At a high level, his argument is that commodity market movements are purely based on supply and demand. When demand exceeds supply, prices will go up. When prices go up, there will be more investment dedicated to discovering and increasing supply. However, these actions take time for the new supply to hit the market. Meanwhile, as long as demand stays high, prices must go up. Rogers believes that we are currently in a long-term bull market for commodities (although I'm not sure how his views have changed in light of activity of the past few months).

Historically, commodities have performed better when equities have come down, because they are still tangible assets that have utility. So whether this is crude oil, natural gas, aluminum, wheat, corn, copper - if there is demand for it, then price will be dependent on supply. In the face of a global downturn and a credit contraction, commodities have dipped dramatically because of concerns that the demand simply won't be there and that there isn't enough money to inflate prices. It seems unlikely to me that demand would lessen. The growth of countries like China and India will simply be pushed out a few years. The demand for commodities won't just go away. Moreover, for certain commodities such as crude oil, there just hasn't been much in the way of new discoveries of supply.

There are a variety of ways to play this. I am barely a novice myself, but this is how things break down for me.

1. Direct investment in commodities.
I'm not touching this until I understand this better. I can't do it through Schwab, and I don't know enough about specific commodities to do this effectively. In time, perhaps.

2. Investments in commodity stocks.
This is more intriguing to me. I look at businesses that deal heavily in specific commodities and invest in them. For now, this is preferable because I can better understand the companies, and they may very well pay me dividends to own them. Freeport McMoRan (FCX), for example, deals primarily in copper (80% revenue), with interests in molybdenum and gold. A look at their Q3'08 investor presentation shows how their cash flow would be affected by swings in the price of these commodities. A change of $0.20 in the price of copper (per lb), for example, would mean a change of $575M in operating cash flow.

FCX is one of the leading players in copper, and they pay a 7%+ dividend and have a strong balance sheet. They have about $7B in debt, but there are no significant debt maturities until 2015, so they should be able to weather the current crisis easily. In terms of reserves, they claim to have 93.2 billion pounds of copper, 41.0 million ounces of gold, 2.0 billion pounds of molybdenum, 230.9 million ounces of silver and 0.6 billion pounds of cobalt as of the end of 2007. Some of their mines are located in potentially unstable places, like the Democratic Republic of Congo. Any incidents, however, would likely be tempered by offsetting price movements in the commodity itself.

3. Commodity ETNs.
The largest of these is DJP, with holdings of 19 key commodities and over $2B under management (assuming the price declines in the last few months haven't been too devastating). The other choice is Jim Roger's ETN RJI, which tracks his index of 35 commodities, but it has much less assets under management.

Trades (10/13/08) and Comments

2008-10-13T22:00:00.000-07:00

A lot of activity today. The market rebounded a bit more than I thought it would, making the portfolio adjustments I discussed in my last post more expensive to execute. My thought here is that I would be happy to initiate positions at current prices and would look to add to these investments if the market continues to decline.

Here is a list of today's moves:

Sales

Spider ETF Nov 90 Call Options (.SWGKL) - 10/13/08 - SOLD 1 contract at $10.20 per share, net proceeds of $1,010.29
eBay (EBAY) - 10/13/08 - SOLD 300 shares at $17.07 per share, net proceeds of $5,108.32
Whole Foods Market (WFMI) - 10/13/08 - SOLD 143.2886 shares at 15.05 per share, net proceeds of $2,243.51

Purchases

Pfizer (PFE) - 10/13/08 - BOUGHT 100 shares at $16.27 per share, total cost of $1,639.95
NVIDIA (NVDA) - 10/13/08 - BOUGHT 200 shares at $7.59 per share, total cost of $1,530.95
Nokia (NOK) - 10/13/08 - BOUGHT 100 shares at $16.50 per share, total cost of $1,662.95
Johnson & Johnson (JNJ) - 10/13/08 - BOUGHT 30 shares at $61.16 per share, total cost of $1,847.75
Diageo (DEO) - 10/13/08 - BOUGHT 40 shares at $58.71 per share, total cost of $2,361.35

So after all these moves, this is where my portfolio stands as of October 13, 2008. You can take a look at my trading history since inception to see how I got here.

Comments

I've been remiss in addressing some of the comments on the site, so my apologies there. To be honest, I simply hadn't been paying attention as comments have been rather sparse, but I'll be doing a better job at responding from now on. Any and all comments are most welcome!

Here are my responses to Dwath's comments regarding how to find the market bottom and why the NASDAQ is so volatile (scroll down to the comments section).

Portfolio Adjustments

2008-10-13T02:12:00.000-07:00

Given the huge drops across the board last week, there are a lot of excellent companies that are now on sale. With all of the attractive bargains out there, it's been a bit of an overload for me deciding what my actions should be. As mentioned in Friday's post, I plan on adjusting some of my holdings to take advantage of these better prices. Here is my current thinking.

Cash and Fixed Income

It's relatively expensive to hold cash. CDs and internet bank rates are currently in 2-4% range, and probably will trend lower over the next few months if the central banks continue to lower rates. Adjusted for inflation, the real return here is practically 0% if not negative. The yield on TIPS is less than 2%.

Likewise, bond yields are also quite low. Vanguard's Total Bond Market index is yielding less than 5%.

Dividend Stocks

Meanwhile, dividend yields on some very solid companies are trading above bond yields and at multiples over the cash interest rates. Now this assumes that these companies will continue to pay out their dividends. That's why a lot of financial companies have implied dividend yields that have skyrocketed in the past few months to reflect the low level of confidence that investors have in those dividend payments.

However, the most conservative companies will raise their dividends on an annual basis. Standard and Poor's actually maintains a list of these companies, calling those that have consistently increased their dividends every year for 25 consecutive years Dividend Aristocrats. Here is a good summary on the Dividend Aristocrats Series and an Excel spreadsheet containing a list of the current U.S. S&P 500 Dividend Aristocrat constituents. The benefit here is that a well selected basket of dividend stocks will steadily increase their payments every year, meaning that the yield at initial investment cost will increase dramatically as well. This is in addition to any capital appreciation in the stock, which is generally quite favorable since an increasing dividend is a reflection of a strong underlying business.

Consequently, I'm going to allocate about half my portfolio to construct a dividend portfolio. The keys will be my assessment of the strength of their business and market position, their track record of dividend increases, the ratio of their dividend payment to their free cash flow, and their cash reserves. Here are the names I'm considering:

3M (MMM) - 3.5%. Existing position.
Diageo (DEO) - 5.5%. New holding and increases international exposure. They control most of the premier liquor brands, including Smirnoff, Johnnie Walker, Captain Morgan, Bailey's, Guinness, and Dom Pérignon, among many others. My one qualm is their debt position, as they have 2x debt to equity ratio. However, this is consistent with their historical levels and is comparable to other companies in the industry like Anheuser-Busch and Constellation Brands. Also, their business should be fairly consistent regardless of economic environment and they should be able to continue to pay off their debts via their free cash flow.
Johnson and Johnson (JNJ) - 3.0%. New position. I've always admired this company and I'm glad there's an attractive price now to start this position.
Nokia (NOK) - 4.7%. New holding and increases international exposure. Internationally, they are still quite dominant but the price has come down significantly. There are competition issues but their cash levels and track record is excellent.
Pfizer (PFE) - 8.5%. Will likely add to this position at these levels to take advantage of the high yield. I've already written about how much cash they have to support this.

Here are some other names that I would consider. I think a basket of these will do quite well and generate a solid stream of passive income.

Automatic Data Processing (ADP) - 3.5%
BP PLC (BP) - 8.3%
Bristol-Myers Squibb (BMY) - 7.1%
Coca-Cola (KO) - 3.7%
Freeport-McMoran Copper & Gold (FCX) - 5.5%
General Electric (GE) - 5.8%
GlaxoSmithKline (GSK) - 5.9%
ING Groep NV (ING) - 17.7%
Kimberly Clark (KMB) - 4.1%
Kraft Foods (KFT) - 4.3%
McDonald's (MCD) - 3.7%
McGraw-Hill (MHP) - 4.0%
Merck (MRK) - 5.8%
NYSE Euronext (NYX) - 4.6%
Paychex (PAYX) - 4.4%
Sanofi-Aventis (SNY) - 6.1%
Santander (STD) - 5.3%
Unilever (UL) - 4.5%
Vale (RIO) - 4.3%
VF Corporation (VFC) - 3.7%

Value Stocks

The other half of my portfolio will consist of undervalued stocks in which the dividend, if there is one, is not as significant.

NVIDIA, Columbia and Giant Interactive have all traded down, and I will look to add more to these positions, particularly NVIDIA. I will likely exit my positions in eBay, Whole Foods Markets and perhaps Intel and Heartland Payment Systems in order to raise capital to do this.

While I am still bullish long term on eBay and Whole Foods, both have fundamental business issues to contend with. eBay has to respond to the decline in growth of their auctions/marketplace business as well as the rise in competition from Amazon and Google. I'm also not sure about their recent acquisition of BillMeLater at over $1B in this environment. Whole Foods faces more direct challenges from the economy and also may have overextended itself in its recently scaled back expansion plans. I think both are trading at very attractive prices that reflect these issues, but I'd rather have the cash for other investments.

Similarly, there's nothing wrong with Intel, and their dividend yield has even increased to 3.7%. However, I think the appreciation potential is limited, and that a double many years out at best. I would rather put that money in NVIDIA.

As for Heartland, the stock has held up admirably given that it's in the financial sector and deals with credit cards, which is widely believed to be the next shoe to drop in the credit crisis. However, the business is impacted more by the use of credit cards rather than the extension of credit lines, but the market may not care. The company has set some ambitious goals for itself as discussed before, and it currently has a very attractive valuation. I think I'm more likely to buy more but may look to sell this for other opportunities, particularly if the company's results and outlook deteriorates dramatically as a result of the crisis.

Berkshire Hathaway is a significant chunk of my portfolio, but I lump this in with the relative "safety" half of my portfolio that consists of dividend stocks.

Options

I made an uncharacteristic trade on Friday, dabbling in 1 call contract on the S&P 500 that expires in November with a strike price of 900. I plan on exiting this position this coming week, and very likely will do it Monday morning. I normally avoid these sorts of short-term, high volatility trades. However, if there appears to be a significant dislocation in the market, then I'll look to take a small position. Right now, European markets and S&P 500 futures are up over 5% as I write this, due to the stream of positive government announcements over the weekend, which bodes well for a solid return from this move.

I will probably continue to make opportunistic trades here, but will keep this to 5-10% of my portfolio. I will keep to highly liquid options, which means only on the major indices and the bluest of the blue chips.

Two for the IRA

The TogaPF portfolio is a taxable account, but here are 2 ideas for tax-advantaged accounts:

American Capital (ACAS) - At Friday's close, this had a dividend yield over 30%. As a business development company, they are required to distribute 90% of their income to investors every year, but they do not have to pay any taxes at the company level. At the shareholder level, however, the investor needs to treat the dividend income as ordinary income, so it makes sense to own this in a tax-advantaged account. I've been trying to figure out the catch to this, but so far I haven't been able to find anything. Their track record of dividend payments has been absolutely astounding; they've raised it every quarter since their IPO. The Company's shareholder materials spend a lot of time assuring investors that the dividend is safe. I particularly like that they allocate cash generated this year to fund next year's dividend payout. As a private equity company, it's taken quite a hit along with the rest of financial sector. The blog posts and links referenced in the Top Bull Pitch writeup in CAPS have been very helpful in breaking down the company for me.
Kinder Morgan Partners (KMP) - This is the leading natural gas pipeline company in the U.S. with a dividend yield over 9%. They basically control the bulk of the distribution of natural gas in the U.S. Here is a writeup from the Motley Fool.

Conclusion

Unless the market rebounds dramatically this week, I will likely be close to 100% in the market by Friday. I still think that the markets have some room to decline, but current prices are attractive enough for me. I also plan on putting in additional funds in the next few weeks to take advantage of these conditions.

"All that jelly..."

2008-10-10T10:03:00.000-07:00

"All that jelly...and no toast."

Denzel Washington's character in Training Day was leering at a particularly hot woman when making that quip, but I can't help but think the same thing when I look at the current markets.

This past week, the markets collectively decided to have a 20% sale across the board. Everything must go! I updated my portfolio valuation as of yesterday's close, and I'm down 17% since inception two months ago. On the bright side, I'm outperforming the S&P 500 by 10%. I suppose that deserves a genuine Washington Mutual "Whoo-hoo"!

Perhaps more deserving of that accolade is that quite a few blue chip stocks are now on sale. Companies like GE, Microsoft, Johnson & Johnson are now approaching single-digit PEs and offer dividend yields far in excess of cash return rates. Even Berkshire Hathaway hasn't been immune to the repricing.

So let's consider the options here:
1. Stay the course and do nothing. Perhaps even add more to my existing positions. The question is whether these companies are the ones I want to hold.
2. Switch to higher quality holdings. I could sell off some of my weaker positions, reap a tax writeoff, and move to companies with businesses better suited to weather a prolonged recession, pay higher dividends, and have more dominant market positions.
3. Switch to riskier holdings with more upside potential. Sectors such as energy and commodities have dropped a lot more than the market and should hold long-term value.
4. Sell. Throw in the towel, but risk selling at the bottom.
5. Speculate. This is not actually a joke. Speculation becomes increasingly intriguing as the market continues to move wildly in both directions. This runs counter to what I typically do, but if the risk/reward proposition is favorable, I may well go ahead and do it. I'm currently considering buying some out-of-the-money November call options on some of the more liquid securities out there, such as SPY, FXI or GE. With 8%+ daily swings, a potential groundbreaking G7 meeting this weekend, and the increased likelihood of an Obama presidency, it looks like the upside may be considerable from current levels.

I'll be keeping a close eye and may make some moves later today.

Some Observations on the FDIC

2008-09-30T22:43:00.000-07:00

There has been a lot of press today in the wake of yesterday's failed bailout vote in the House about possibly raising FDIC deposit insurance limits from $100,000 to $250,000. When the FDIC was created in 1933, it had deposit insurance limits of up to $2,500. This ceiling has been raised over the years. The most dramatic increases were from 1966 to 1980, when the limit was hiked three times, taking it from $15,000 to $100,000, its current level. Since there hasn't been an increase in nearly 30 years, it's arguable that raising the limit is not only reasonable, but long overdue.

So with the proposed bigger backstop along with the recent rise in bank failures, the question becomes can the FDIC actually afford to do all of this? Evidently, the answer is yes they can. There have been so many wrong reports that the FDIC is "running out of money" that the FDIC issued a press release addressing the issue. They basically have two options: (1) they can raise premiums for banks with riskier portfolios to replenish the fund's current balance of $45 billion; and (2) they can borrow whatever they need from the Treasury whenever they need it, and the borrowed sums must be paid back through "industry assessments." Thus, the FDIC, in the case of insuring deposits, isn't really a separate entity from the U.S. government. Rather, it acts as a conduit for the U.S. government to provide whatever funds are needed to make good on the deposit guarantee. In the event that the FDIC needs to tap its Treasury credit lines, however, I'm not sure what happens if it turns out the "industry assessments" are insufficient to repay the borrowed amount. It's probably not very likely as the FDIC imposes liquidity and reserve requirements and maintains a watchlist of banks that are in danger of failing. The bottom line is that the FDIC will stand by the deposit guarantee.

The other question that comes to mind is how many banks are at risk of failing? The FDIC does keep a "problem" list of banks, but it wisely does not share this list as doing so could cause a run on those banks. There are some 3rd party services that attempt to rate banks for a fee, but only Bankrate offers some limited services for free. The FDIC does put out a Quarterly Banking Profile, with the latest for June 2008. This is a lot of data, so I looked for another source to analyze it. The most eye-popping stats are that the FDIC's reserve ratio is now 1.01% ($45.2 billion to cover $4.5 trillion of insured deposits), down from 1.19% in the prior quarter and the 1.2% to 1.3% range since 2004. There are also 117 "problem" institutions representing $78.3 billion in assets, up from 90 institutions and $26.3 billion in the prior quarter. Those numbers don't sound too bad, but who knows how many more banks should be on that list. Indymac, which has $32 billion in assets and failed in July, didn't make the list until June.

For what it's worth, Forbes ranks the FDIC chairwoman, Sheila Bair, as the 2nd most powerful woman in the world in 2008. That's right, number 2 in the world, right behind German chancellor Angela Merkel and well ahead of other more recognizable ladies like Condoleeza Rice (#7), Nancy Pelosi (#35) and Oprah Winfrey (#36). The FDIC chairman is appointed for a five-year term by the President and approved by Congress. Bair was appointed in June 2006, so she'll be in the position till 2011, which is a lot more than what some of the other officials that have been prominent in this crisis can say. It's a big mess to clean up, and it would make anyone nostalgic for a past life as a professor and part-time children's book author.

Things certainly don't look good, but they can get worse. To put things in perspective:

4,004 banks failed in the first 2 months of 1933 during the Great Depression; 13 banks have failed in 2008.
The Dow dropped 777 points yesterday, but that represented only an 8% decline. The New York Stock Exchange has "circuit breakers" in place that halt trading after significant drops to prevent market crashes, but these are triggered only after a 1,200 point decline. Given all of the uncertainty in the market, it looks like we're heading to the point where trading will be halted one of these days.
The carnage occurred despite the SEC's ban on the short-selling of "financial" stocks, which began on September 19. By the way, unless the SEC extends the ban, it is supposed to terminate at the end of October 2. The SEC does have the option of extending the ban through October 19. Who knows what happens after the ban is lifted?

As highlighted in prior posts, there will be a number of bargains out there, but I think it would be wise to see how some of these larger issues play out before committing too much capital.

What Do You Buy in this Market?

2008-09-26T02:40:00.000-07:00

What do you buy in this market? With the outcome of the bailout plan still up in the air, it looks like there will be quite a bit of uncertainty in the days ahead. While most would advise caution in this environment, there may be an opportunity to jump in on some quality companies.

The key is quality. But what is considered quality, especially in today's markets? Here is what I would be looking for, which would be on top of solid free cash flow generation. I covered some of my technology sector ideas earlier this month, but really the same principles described there can apply to just about any sector.

1. Strong balance sheets

No matter what fiscal or monetary assistance the government will ultimately provide, it looks like we should expect some lean years ahead. These are the times when the weaker companies fail and the stronger companies take market share. Having a strong balance sheet will be critical to tie companies through these tough times.

That basically means cash is king, and short-term debt is undesirable. Let's just say it would be preferable to not have to raise money (debt, equity, whatever) in the next few months or even years. To have a lot of short-term debt coming due is probably not the most desirable position to be in right now. Not that long-term debt isn't worrisome either, but I'd like to indulge in some wishful thinking that market conditions will eventually be much more favorable than the current environment. It would be less than ideal for a company to take desperate action now to meet short term commitments by raising money at unsavory terms. This basically rules out substantially all financial stocks, retail stocks, industrial stocks, etc.

It's also why technology companies look pretty good right now. Here are a couple of well-known names, with their latest cash balance, short-term debt and market cap:

Apple (AAPL): $20B / - / $117B
Cisco (CSCO): $26B / $500M / $138B
Dell (DELL): $9B / $129M / $33B
Google (GOOG): $12B / - / $138B
HP (HPQ): $14B / $4B / $117B
Intel (INTC): $12B / $175M / $104B
Microsoft (MSFT): $23B / - / $243B
Nokia (NOK): $17B / $2B / $75B
Oracle (ORCL): $13B / $1B / $105B

Considering the price Goldman Sachs just paid for their cash infusion, and considering what some financial firms would give for just a fraction of this cash, I'd have to say these balance sheets look pretty valuable. The sum of these cash balances is almost $150B, which is over 20% of the proposed $700B bailout package.

Of course, this isn't limited to just technology companies. Here are a handful of other well-known companies with a high ratio of cash to short-term debt. They do seem to be confined to pharmaceuticals, energy and technology, however.

Chevron (CVX): $8B / $1B / $180B
Exxon Mobil (XOM): $40B / - / $419B
Johnson & Johnson (JNJ): $13B / $5B / $194B
Merck (MRK): $10B / $1B / $69B
Nike (NKE): $2.7B / $0.2B / $32B
Pfizer (PFE): $27B / - / $126B

It's kind of strange that these companies are trading at such low multiples. I think traditionally higher multiples have been reserved for high growth companies. I'm not sure whether those expectations for growth would still hold in the environment we are facing. I would think the safety of these balance sheets would eventually be valued more.

2. Safe dividends

An online savings bank like HSBC Direct pays 3.25% currently. However, that interest is taxed as ordinary income, while dividends, for the time being, are taxed at a more favorable 15% rate.

Companies that have the cash balance and free cash flow generation to pay dividends should be at a premium. Many of the companies mentioned above, even some of the tech companies, have tax-adjusted dividend yields that rival the online savings bank rates.

3. Niche domination

So the companies listed above are generally safer, but they probably won't enjoy really spectacular returns either. To double your money with Microsoft, you'd have to wait for it to become a half trillion dollar company. That might be a long wait. The same holds true for the other companies on the list as well. This is where having smaller companies with similar characteristics of a strong balance sheet, safe dividends and free cash flow generation might be more enticing.

Here are a number of smaller companies that hold large shares in their markets. Most of these markets still have quite a lot of room to grow.

Autodesk (ADSK): $960M / $120M / $7.7B
Akamai Technologies (AKAM): $290M / - / $2.9B
Chipotle Mexican Grill (CMG): $200M / - / $1.9B
Columbia Sportswear (COLM): $350M / - / $1.5B
Dolby Labs (DLB): $400M / $2M / $4.1B
NVIDIA (NVDA): $1.6B / - / $6.4B

4. Sector ETFs

I generally prefer looking at individual stocks over ETFs, but I would consider them in growth sectors as a sector index fund, or if the holdings include companies that are difficult to purchase from the U.S.

Here are two that interest me:

Alternative energy - Market Vectors Global Alternative Energy ETF (GEX)
China - PowerShares Golden Dragon Halter USX China Portfolio (PGJ)

Alt Energy Stocks includes a fine writeup on alternative energy ETFs and mutual funds, and why GEX is preferred. GEX has a solid mix of international and U.S. companies, holding 30 stocks with an expense ratio of 0.65%. While alternative energy has sort of been a fad in the past, I get the feeling that this time it will have some more staying power. It seems likely that the next administration, regardless of who wins, will have to implement policy changes that will benefit green energy, either as the primary goal or as a compromise for increased drilling. I still need to pick up Tom Friedman's new book addressing the matter. The bottom line is that I believe alternative energy will become a much larger industry over the next decade, both in the U.S. and internationally.

Among China's ETFs, FXI is the largest with over $6B in assets, but I prefer the PowerShares offering PGJ as it provides a more balanced industry distribution in its holdings. FXI is weighted almost 2/3 energy and financials. While not as large as FXI, PGJ still has over $400M in assets and a 0.69% expense ratio. China has taken quite a hit this year, but the fundamental growth story and demographics shift to urban middle class remains the same. The RMB should also aid in investment returns relative to the U.S. When it comes to investing in these, I expect to build positions on the dips.

TogaPF Design Change - No More Frames

2008-09-25T03:26:00.000-07:00

I decided to change the design of this site after all the frustration of not being able to link to individual posts. Consequently, I've gotten rid of all of the frames on this site. There really shouldn't be any impact to the actual "look" of the site.

There are still a number of bugs to be worked out, although they only seem to appear in Firefox. Internet Explorer seems to be working just fine. For about 1/3 of the posts, clicking on the link or typing in the URL directly redirects me back to the home page. I have no idea why that would be the case, but I'm working to resolve it. Please let me know if there are any other bugs out there. Thanks.

Buffett and Goldman Sachs

2008-09-24T22:40:00.000-07:00

There's been a lot written up about Buffett's $5 billion investment in Goldman Sachs. Most of the press has been calling it a vote of confidence in Goldman by Buffett. I think the more accurate description for it may be a celebrity endorsement, or even extracting a pound of flesh from Goldman. Both of those posts have excellent writeups detailing why Buffett's move is both juicy and virtually riskless. It is certainly a better deal than his adventure with Salomon back in the 80s and 90s which turned into a major headache. It seemed like there was little chance that he would venture back into the business after that experience, but it looks like the Goldman deal was too good to pass up.

Fortunately, Berkshire Hathaway shareholders are going to see the full benefits. I'm not sure if this deal would have happened at such favorable terms without Buffett. There must be a fair number of companies and investment funds that could have just as easily put up the $5 billion, but I doubt that any of these investors could have negotiated the deal at the same terms. Goldman certainly paid up for the value of the Buffett name, and I don't think they would have agreed to do the deal at those terms with any other investor. A sovereign wealth fund or a foreign bank just doesn't send the same positive signals through the market as Buffett does.

So with the Goldman investment and the Constellation Energy purchase, Buffett has spent close to $10 billion in the past week, or nearly one-third of Berkshire's cash balance. I think that's a good endorsement on Buffett's part that there are definitely good values to be had. Even after the moves, Berkshire should still have over $20 billion in cash, so there should still be future moves in store.

Interesting bit of trivia: now that Goldman Sachs and Morgan Stanley have decided to become commercial banks, that now leaves Raymond James Financial as the largest investment bank out there. Here's a pretty devastating graphic depicting the current state of the investment banking industry.

Getting out of BAC

2008-09-19T11:01:00.000-07:00

I plan on taking the opportunity that the government has provided to sell my BAC stake. The whole financial sector, and to some extent the U.S. and global stock market, has become tied to the decisions of the Fed and Treasury department. Speculation over what the government will do is driving price movement. I believe the gesture is the correct one, as it provides some much needed stability. I'm sure Lehman Brothers, AIG and Bear Stearns are all applauding the timeliness of the decision. However, now that the government has become a deus ex machina in the investment thesis for BAC, I don't see the point in owning it anymore. I don't like it when it is used in fiction, and I certainly don't want it determining whether I can profit or not.

The government backstop basically ensures that BAC will survive this crisis, answering one of my two key questions for owning BAC. The question as to whether the dividend is safe, however, no longer has a clear answer after the announcement of the Merrill Lynch acquisition. Ken Lewis has indicated that cutting the dividend is now an option, a far cry from his assurances back in July when he made the following statement:

"Given these parameters our outlook for the economy and our earnings potential we have not changed our philosophy about the dividend. I will recommend to The Board that we maintain the current dividend of $0.64. Given our current economic outlook we believe the drivers of earnings for the remainder of the year will be most of our core businesses along with the continued tight grip on expense levels across the company."

Now none of this means that the dividend will be cut for certain, but it doesn't bode well given what other financial companies have done with their dividends. Coupled with the huge task of integrating a 65,000 person company in Merrill and a 50,000 person company in Countrywide, there are certainly execution risks as well. The temporary ban on short-selling has forced them to liquidate their positions, driving up the stock price today. It's not clear what will happen in 2 weeks when the ban expires. This isn't the first time the government has stepped in, and this crisis may well demand further action.

With uncertainty in the dividend and current prices in the mid to high $30s, I'd rather have the money than be subject to more 20% swings, even if it is to the upside. There will be better uses for that cash.

Some Tech Stock Ideas

2008-09-19T00:58:00.000-07:00

As Warren Buffet put it, "Be fearful when others are greedy and greedy when others are fearful." Looks like it's time to get greedy, and even Buffett made a purchase today.

There have been some wild swings this week. Currently, there is a rather large upward spike due to reports that the government will step in to bail out institutions by buying their risky mortgage assets at a discount . Before that announcement, it looked like the market was heading for certain panic. That may still happen. I think it will be relatively easy for the market to get fooled into thinking that a meltdown is imminent, that more companies will collapse, and that converting investments to cash is the prudent strategy. That strikes me as the same misguided thinking that led to the widespread belief that real estate is a safe investment and always appreciates.

I don't expect the announcement to mark the bottom. There will likely be more fluctuations in the coming days, weeks and months. The upside to these massive fluctuations is that a good many stocks will be selling at mouth-watering prices.

I want to highlight a few names in technology that look interesting to me, particularly if they drop in price significantly. Technology is looking pretty good in this environment, as they typically have a lot of cash on their balance sheets, don't require large capital expenditures to operate, yet generate a lot of free cash flow. Many have strong positions in industries and markets that should continue to grow despite tough economic conditions.

Autodesk (ADSK)
Most people know this company for AutoCAD, but check out their product list. They actually have quite a few leading software offerings. Overall, this looks to be a solid business with solid financials. They have close to $1B in cash, a small amount of debt, and free cash flow generation of almost $500M per year. The current market cap is about $7.5 billion with a $33 share price. I don't consider this company to be too undervalued, but I think the risk reward is reasonable given the strength of its business. Adobe is another company that is very similar in that it dominates its niche software market, except that it's about 3x bigger than Autodesk.

Demandtec (DMAN)
This is a small company that went public last year. They provide software that lets retailers optimize their merchandise mix and helps them set pricing and promotion strategies to maximize their profit. They have such big customers such as Wal-Mart, Target and Best Buy, which they sign to multi-year contracts. Of their $275M market cap, about $70M is cash. They are free cash flow breakeven/positive, although their net income is still negative. The weak economy will likely push out their ability to sign new customers, but since the software ultimately helps retailers maximize profit, this should be something that has an easily demonstrable return on investment.

eBay (EBAY)
The stock has come down with the rest of the market and now has a market cap of $30B. The company has guided $2.4B in free cash flow for 2008, which is an 8% yield. This is already one of my larger positions, but I won't mind adding to this position.

Google (GOOG)
I never thought that this company would ever drop to a price that I would consider investing. They have a pretty awesome cash generating machine, which throws off over $1 billion in free cash flow every quarter. Of course, that machine in search is basically all they have right now, which is a risk. However, that machine looks fairly safe right now, given its market dominance as well as the turmoil affecting its competitors. I think they may even benefit in a downturn, as that would simply accelerate the shift from other forms of advertising to more measurable online advertising. I would like to see their spending practices reined in soon, but those may simply be potential cost savings that may simply act as a catalyst later on. In the meantime, they have $12B in cash, despite almost $3B in annual capital expenditures. The stock has flirted with the $400 threshold, which would imply a market cap of $125B. If we can assume that they will grow free cash flow from the current $4B level to about $10B in the next 3-5 years, then that price would seem quite reasonable.

Microsoft (MSFT)
For all of the reasons to not like Microsoft, consider the following:

$30B in cash and investments
A steady record of growth in free cash flow, with $18.5B in FY 2008
Returned over $55B to shareholders in the past 3 years ($11B in dividends, $46B in stock repurchases)
Dividend yield is about 1.8% now, and only costs about 20-25% of free cash flow
Market cap of $230B, which implies about 8% in free cash flow yield
9.1B shares outstanding currently. In 2003, there were 10.8B shares outstanding, which means that on average about 300M shares are retired annually

Of course, this case could have been made for each of the past 8 years. But then, the case just gets better and better each year.

Nokia (NOK)
Similar argument to Microsoft. It's now a $75B market cap company, with $17B in cash and $10B in free cash flow generation last year. Additionally, they have a 4% dividend yield, but the dividend only costs them about 25% of free cash flow. They also repurchase $4B to $5B in stock annually. The last time they were this low was when the market thought Motorola's dominant clamshell phones meant the beginning of the end for Nokia. That didn't really play out, and Nokia has since expanded its market share to 40%. The question now is how much of an impact will the iPhone have on Nokia. This may be significant, but at Nokia's current valuation and financial results, the margin of safety may be sufficient.

Market Declines Can Be Good

2008-09-16T02:04:00.000-07:00

It was too bad I couldn't wait until Monday to execute my Friday trades. Oh well.

In eventful trading days like today, I think it's helpful to remember that market declines can be a good thing. If you plan on being a buyer of stocks over the next few decades, then the ideal scenario for you would be for stock prices to decline. As your earning power increases, you're able to invest your money in securities that are cheaper to buy. In fact, you would only want stocks to increase in price when you are looking to sell.

So while today's news on Lehman Brothers, Merrill Lynch and AIG are symptomatic of the rotten state of our markets, a fair number of decent companies have likely been dragged down with them. It's been some time since our last full blown downturn back in 2002, when market sentiment overshot in the negative. In this investor psychology scale, , I'd have to put the current market squarely in the fear, panic and contempt category. The sense I get from reading the financial press now is to expect things to get a lot worse before they get better. This is much different from earlier in the year, when the press was more prone to wondering whether a bottom was imminent - I think the consensus now is that it is not. Capital preservation and caution are now the recommended strategies.

So now to assess the damage to my portfolio today. Except for Bank of America dropping 21% due to the Merrill Lynch purchase, my portfolio wasn't really impacted. I find it interesting and encouraging that BAC has been so active on the acquisitions front. Given the current state of the markets, I doubt that they would or could pursue anything too reckless. I would have to think that BAC is dealing from a position of power when it picks up companies like Countrywide and Merrill Lynch, the latter at a sizable premium. It's certainly better that they're shopping for companies rather than shopping their business units for quick cash. The questions that concerned me when I took a look at this stock in my initial portfolio evaluation still hold: what are their chances of survival, and can they afford to keep their dividend payments. But their actions would suggest either that they are confident they will survive and continue their dividend payments, or they really like to gamble. Somehow, I don't think they would be interested in any sort of gamble at the moment. If BAC continues to drop, I will be interested, but I think there are going to be even better opportunities elsewhere.

Bought NVDA and GA

2008-09-13T07:57:00.000-07:00

I made the following purchases yesterday morning:

NVIDIA (NVDA) - 250 shares at $9.75 per share, for total cost of $2,445
Giant Interactive (GA) - 300 shares at $7.95 per share, for total cost of $2,394

I had written up my thoughts on both NVIDIA and Giant Interactive earlier this week.

With NVIDIA dropping over 10% this week, the risk reward proposition became even more compelling for me. As noted previously, $3 of the share price is cash, and the stock is supported by a large share repurchase authorization that could potentially cover approximately another $3 in share price. Given that NVDA is still generating substantial free cash flows, I assume a conservative floor at $6 per share. From current levels, that's a potential $4 per share loss. The potential gain could be significant as the stock was trading above $30 just 12 months ago and above $20 just 3 months ago. If market sentiment returns to NVDA's favor, and I think it will given their market position, cash flow generation, solid balance sheet, and management team's track record, I think the potential gain could easily be 3x or more the potential loss.

Giant Interactive (GA) - Giant Opportunity

2008-09-12T01:55:00.000-07:00

Fan has been clueing me in on chinese gaming stocks, namely MMORPGs, so I decided to take a look at them. I think it's basically a given that the industry in China will do well - the real question is which company will triumph. However, despite the market being as competitive and overcrowded as they come, many of these stocks have fallen so far that it almost doesn't even matter which one will win. In any event, I think we've come to the agreement that Giant Interactive looks to be the most attractive of these.

Here's a list of the major publicly-traded players:

Perfect World (PWRD)
Shanda (SNDA)
NetEase (NTES)
The9 (NCTY)
Giant Interactive (GA)

There are many more, but these are essentially the main players. This is a fascinating industry, characterized by high growth and insane margins. The9 is an interesting little company as it has the license to operate the highly popular World of Warcraft game in China. Unfortunately, that's also just about all it does, so I'm avoiding that one for now. I've ruled out the first 3, because they simply don't look as attractive when compared to Giant Interactive.

This is an interesting article giving a nice background of the company and some of the things that set GA apart. GA's strategy is to target the middle market. GA's key title ZhengTu Online is geared toward mass adoption as it is free to play and requires only a 10Kb connection to play. Similar to how Wal-Mart grew its business by staying away from major metropolitan areas, the company has concentrated its 2,500 person marketing force on medium and smaller sized cities in China. The goal is for players to become addicted to the game and fork over real money to purchase upgrades like weapons, gear, or clothes for their in-game characters. The company evidently has become really good at executing on this plan as it now has 2.1 million peak concurrent users (2nd most in China) and the highest ARPU (~300RMB per quarter) in the industry.

The MMORPG model is attractive because once a game reaches a certain critical mass, it essentially becomes a self-contained money machine. It basically takes virtual goods and converts it to real hard cash. The only expenses are the R&D to create it and the marketing expenses to spread the word.

Here are some other interesting findings gleaned from the 2007 annual report, IPO prospectus, the Q2 08 earnings call transcript, and the company's investor relations site:

The company went public in November 2007 at a price of $15.50, raising net proceeds of $780M. The stock is now roughly half that level despite delivering stellar returns.
The CEO/founder Shi Yuzhu owns 49% of the company, and principal shareholders and entities own 70% of the company.
$835M in cash and equivalents as of June 2008
Announced $150M share buyback in August
The company is planning to launch ZTOnline in Vietnam - perhaps the first of many such launches. The game's minimal tech requirements are conducive for this type of expansion.
Active Paying Accounts: 1.76 million, 41% growth YoY. However, slightly decreasing ARPUs. The company recently changed its revenue model to grow paying accounts at the expense of ARPU, part of the reason the stock's been hammered.
Net margins of 70% - but this will likely come down
Operating Cash Flow of $203M, free cash flow of $188M in 2007
No taxes paid in 2007. Their 2007 annual report says that they have a 50% tax holiday from 2008-2010, or 7.5% effective tax rate in those years.
The last quarter's results were also tempered by the Sichuan earthquake as well as the Olympics distracting people from playing games.
GA is the only Chinese gaming stock (and one of the few Chinese stocks) to trade on the New York Stock Exchange rather than NASDAQ. I thought that was interesting as NYSE tends to be less volatile and more expensive than NASDAQ, while NASDAQ is more often associated with technology stocks. Here's a breakdown of the differences between NYSE and NASDAQ.

Decision:
I'd have to think that the downside to this stock is limited. At under $8, this is a $1.9 billion market cap stock with an enterprise value at about $1.1B. With the share repurchase plan, the company can afford to buy back almost 20M shares. This is over 15% of the 114M share float according to Yahoo Finance. The company certainly has the cash balance and cash flow generating ability to to buy back more shares.

The operating margins are sure to come down though. Operating expenses was close to 33% of revenue in Q2, with the bulk of that coming from marketing. Taxes will also play a larger role going forward. However, even factoring those in, this is still likely a conservative 40% to 50% net margin business with very limited capital requirements. The company only has one hit game for now, but they do have a few in the works with new game Giant Online reaching 344k peak concurrent users. Even if you disregard the other games, ZT Online can be a cash cow for GA for quite a number of years given its track record and critical mass, and it is still growing. It seems highly probable that GA can generate at least $150M in free cash flow annually over the next few years just off of ZT Online. Any additional value from new games or from newly acquired businesses would just be gravy.

I don't see this stock dropping below $1.2 billion in market cap, which is basically its cash balance plus two years of free cash flow. That translates to a bottom of about $5 per share, or a loss of less than $3 per share from these levels. However, the upside here can be quite substantial. If we assume the company reaches $300M in free cash flow in 3 years (CY 2011) and the market values the FCF conservatively between 9-12x EV/FCF, that translates to a market cap range of $3.5B to $4.5B, or $14 to $18. Even a return to its IPO price of $15.50 would yield a 100% return. When this sector and company return to the market's favor, the limited float and high margin/high growth characteristics of the business could potentially justify a multiples expansion and yield a return several times higher than that. The risk/return proposition appears very favorable, and I'll be looking to build a fairly substantial position here.

Looking at NVIDIA

2008-09-09T00:53:00.000-07:00

Work has been pretty busy lately, and I haven't had much time to think about stocks over the past few weeks. However, a lot has happened in the markets in that time, with the end result being that prices have come down quite a bit. NVIDIA (NVDA) is one that has caught my eye.

This one has come down nearly 70% since the start of the year, when it was trading in the low $30s. Even though I would normally stay away from this industry, with the major players swapping positions on an almost annual basis, the stock looks very attractive with limited downside at $11. Coupled with today's slide fueled by a downgrade by UBS based on competitive issues from Intel's Larrabee that are already known, it looks like the market is being overly pessimistic about NVDA's opportunities.

The key question is how much further can the stock fall? With $1.6 billion in cash and securities, nearly $3 of the company's share price and over 25% of the company's market cap is basically cash. The company also has a $2.7 billion stock repurchase plan in place, having added $1 billion to the authorization in August 2008. They have used up $1.16 billion since the plan's start in 2005, leaving over $1.5 billion in repurchase capacity remaining. Now this capacity does not guarantee that they'll use it to repurchase shares, as they only bought back $327M in 2007 and only about $60M each in 2006 and 2005. Any repurchases will also be offset by share dilution, which has averaged about 3% to 4% in the last 4 years. However, potential repurchases should provide a guard against excess selling pressure. Taking into account rule 10b-18 trading limitations for repurchases, the company could theoretically buy back its own shares every trading day for the next 2 months. This is unlikely, but there is a vast source of latent buying power in the stock that should support it against future price drops.

Moreover, despite all of its problems, the company is still generating free cash flow. They can do this because as a fabless company, their capital expenditure requirements aren't too high and average about $60M per quarter. Even in its disastrous Q2, which included a $196M charge to cover customer warranty issues, cash flow from operations was still $81M and free cash flow was $27M for the quarter. Certainly, this isn't as good as the $250M in free cash flow that the company averaged per quarter in 2007. But once you back out the $196M one-time charge, adding back about $120M to $150M tax-adjusted to the bottom line, it's not as severe as the Patriots losing Tom Brady for the season. Yet, those results basically cost the company about $3 billion in market value when they were revealed in early July.

So of NVDA's $6 billion+ in market cap, a quarter is cash, and another quarter the company has indicated it may repurchase (and could very well fund from free cash flow). That more or less implies the actual NVDA business is worth about $3 to $4 billion. That's down from close to $20 billion just 12 months ago.

Has anything happened in that time span to warrant such a decline? Probably the most significant would be Larrabee, Intel's foray into NVDA's bread and butter business announced last month. This probably isn't the best news for NVDA. With the amount that Intel spends on annual capital expenditures, they could basically buy an NVDA at today's price every year. On the other hand, Larrabee probably shouldn't fall into the Sarah Palin category of unexpected news developments either. It would appear that the market may have overreacted to the news. Larrabee won't be introduced until 2010, but based on market sentiment, I would have surmised that NVDA's chances of survival were about as good as the hapless barbarian tribe against Maximus' Roman legions. Even after the introduction, I don't think anything is necessarily guaranteed for Intel. It would take at least a few years for it to unseat NVDA, and that's assuming Larrabee meets expectations. There will be formidable competitive pressures, but it's not like NVDA hasn't faced that before. But who knows?

Actually, Larrabee doesn't worry me as much as whether or not this falls within my circle of competence. Can I say I really understand the business? Well, yes and no. I can't really claim to know the technical differences between the various offerings from NVDA, AMD and Intel, just as I can't really claim to know what technically makes Coke different from Pepsi. I can only look at market share and profitability. The company is in a perpetual race to make high-end and highly demanded widgets faster than anyone else. For some generations, NVDA will come out on top and dominate. For other generations, one of its competitors will be in the driver's seat. There isn't much pricing power; if a competitor slashes prices, everyone needs to follow suit. As the company's 10-K puts it, their markets are characterized by "rapid technological change, evolving industry standards and declining average selling prices." It's not the most compelling business model, and I don't expect Buffett will be backing up the truck on this one.

But at some price, the risk/reward becomes too interesting to disregard. I think it's approaching that price. The company generates solid free cash flows, has a strong market position in a large growing industry, and has a solid management with significant ownership stakes (albeit with a board that has some shareholder unfriendly practices). It has the cash to weather a downturn for several years, and is in a great position to reap profits once the economy improves. If I do invest, this will be something that will fluctuate a lot, and will demand a lot of attention to monitor new developments. It will be a high maintenance investment. The fluctuations, however, will likely be confined to the upside, as I do think the downside is limited. Not sure if I'll make a move, but it's something to keep an eye on.

TogaPF Investing Philosophy

2008-08-17T19:33:00.000-07:00

I thought about my philosophy: so here it is. There's nothing original here. I generally like Mohnish Pabrai's Dhando Framework, so there's quite a bit of overlap. Anyways, this is all subject to change, and I hope to refine it over time.

1. Stay within my circle of competence

I often fall victim to jumping in too quickly to an investment in a business that I do not fully understand. My initial portfolio had plenty of these types of stocks. To stay within my circle of competence, to pass on ideas that are simply too hard to understand, that's really what investing comes down to.

I don't think this is easy to do. I could always trick myself into thinking that if a business is making money, surely the business model has merit. But who could actually explain why some of these financial companies make money? Or when Internet stocks or BRIC stocks or solar stocks were skyrocketing, could I honestly dissuade myself from jumping in, or explain their performance was rational or justified?

It's important to note that dismissing an idea as too hard to understand does not necessarily indicate intellectual weakness. Sometimes, there are companies or sectors that Mr. Market moves rather inexplicably. If I can't understand the merits of the underlying business, should I be involved, despite the enticing rewards that may be reaped? This is really about staying the course, and sticking to my investing principles.

Of course, I'd like to expand my circle of competence, but its important to know and stay within my limits.

2. Keep it simple, stupid

It's easy to create a lot of work when it comes to investing. I want to invest the time to perform the right analysis, yet I want to keep my lazy side happy as well. The easiest way to adhere to this is to avoid excess work. This means making few infrequent investments. The fewer the better, and the less there is to keep track of. Indeed, I'd want to be fully invested in my best ideas anyway.

3. Invest in businesses with a sustainable, durable competitive advantage

Anything else, and it's just not worth the effort. See Rule #2.

4. Free cash flow - for real

This is to remind myself that ultimately, it's the cold hard cash that is returned to the shareholders that count. Other metrics will sometimes be trumpeted, perhaps revenue growth, perhaps EBITDA, perhaps earnings per share, but none of these have the impact to shareholders the way free cash flow does.

However, there are many ways of calculating this, many accounting tricks that may be applied, and many adjustments that can be made along the way. I need to make sure that the numbers I'm looking at are indeed the numbers I want to be looking at.

5. Margin of safety: 2x in 3 years, 3x in 5 years

I want to find opportunities that will yield outsized returns. Limiting my investments to those that I think can double in 3 years or triple in 5 years should do the trick. If I can find opportunities that also have a margin of safety to those return benchmarks, all the better.

I'm more wary of pure-play value investing situations in which the assets might be sold for more than the stock price, or a sum-of-parts type breakup that might unlock additional value. In these situations, the underlying business often just isn't that attractive anymore. That's why I think simply a 25% discount to intrinsic value is insufficient. There must be a way for that value to be captured or recognized, or else that discount might get baked in for a long time.

6. Don't lose too much money

A play on Buffett's famous rule #1 (and #2) of investing, which is humorous but does not really say much. Along with buy low and sell high, don't lose money is a nice bromide that sounds wonderful in theory but is impossible to put in practice. Ultimately, it makes you want to keep all of your money in CDs and TIPs.

I much prefer Mohnish Pabrai's rule to find opportunities in which, "Heads I win - Tail's I don't lose too much." If I'm to find an undervalued opportunity, I will be risking my capital. The trick is to find opportunities in which the outcome is uncertain, but the downside risk is limited. I think that is a much more reasonable guide than Buffett's advice.

7. Know where the exits are

While I would like to own my stocks for Buffett's preferred holding period of forever, that probably isn't practical until I learn to select stocks the way Buffett does. In the meantime, what happens when I buy something with the intention of holding on forever, but then the business hits some snags? I need to know under what conditions I'm willing to exit, whether its business deterioration, changing industry dynamics, or an excessively rich valuation. I need to know this going in; otherwise, my investment will be stuck in limbo and I won't know what to do with it.

Evaluating the Current TogaPF Holdings

2008-08-17T16:03:00.000-07:00

Many of my current holdings are not what I would consider keepers, so I want to evaluate them to see which I would sell to make room for more attractive investments. Here's a quick rundown of where I stand on my current portfolio holdings.

Bank of America - BAC

As a customer for many years, this was a stock that I had been keeping an eye on for quite some time. Valuation-wise, however, the stock had for a long time been too rich for me. At the onset of the current credit market woes, however, the price started dropping, and I started purchasing starting in November 2007. My average purchase price was $36.39; the price at the inception of TogaPF was $32.62, and the current price is $30.70.

I admit there wasn't much in the way of financial analysis here. By that, I mean that I don't have a good sense of what the intrinsic value of BAC ought to be. The purchase decision was based primarily on the strong dividend yield and growth record, as well as qualitative observations on the strength of the business and the brand. I frankly wouldn't know where to start in terms of evaluating the state of their balance sheet, but which I would assume does not differ too significantly from its peers.

The key questions for me are (1) whether they can survive the current downturn and (2) whether they can afford to keep paying $12 billion a year in dividends. On question 1, I would assume that they do survive, that they are one of the banks that are simply too big to fail. Whether they can continue to operate at their current size and rate of profitability is questionable. However, the troubles affecting BAC are affecting the industry as a whole. As Bill Miller points out, at some point the credit crisis will end, the housing crisis will end, consumers will resume spending, and the economy and stock market will move higher. Once that happens, I think BAC will be better positioned when we finally emerge from these troubles, given its resources to survive and the ability to pick up assets like Countrywide on the cheap.

On question 2, the dividend yield is pretty attractive at about 8% right now. It's grown by about 15% annually from 2003, from $1.26 to $2.56 today. While it's been difficult of late to take anything a bank CEO says seriously, the company did confirm the dividend for September. There is still a good chance that the dividend will be cut, but I would think that if BAC really needed to cut the dividend, they would have joined the others that have done so already. Even after a cut, the dividend yield would likely still be higher than the 3.5% promotional yield you could get from HSBC Direct right now. However, the recent volatility in BAC has made the tactic of using BAC to juice cash yields a dicey proposition.

In the long-term, I view this as a pretty attractive investment, although it will never be a home run. Conservatively, I would estimate a dividend yield of at least 5% annually, along with some small level of stock appreciation in the 5% range. That would yield over 10% per year in returns, which will grow over time as BAC resumes its practice of raising its dividend annually.

However, there will likely be more attractive opportunities elsewhere, so I am open to trading out of BAC to make those purchases. Even within financials, I think there are bound to be better opportunities that I need to investigate such as AXP or NYX.

Berkshire Hathaway - BRKB

I'll always keep at least one share of Berkshire in order to receive the annual report and to attend the annual meetings. However, given its size, it's unlikely that it will continue to beat the market. There are also some drawbacks to owning this, including a conglomerate discount due to the unlikelihood of Buffett selling any of his businesses, and a perceived Buffett premium for his being at the helm. He has been diversifying recently though, picking up additional busineses and stepping up to provide financing on major deals like Wrigley / Mars. I would always welcome purchasing this at a good price, but I would also trade out of this if I found a better opportunity.

Columbia Sportswear - COLM

The CEO, Timothy Boyle, and the chairman, Gertrude Boyle (his mother), own close to 59% of this company. Pretty rare to see these days, but it's good that the managers and the shareholders are one and the same here.

I own a few Columbia items (fleece and jacket) and have been pretty pleased with them. I don't know if I'd pay premium prices for them, but their stuff is definitely solid. The financials have also been pretty solid, with FCF generation of about $100M in each of the past 3 years. At a market cap of about $1.4 billion, this is about a 7% FCF yield. Growth has been satisfactory at about 10% a year recently, the current 2008 outlook calls for a 3% sales decline. They have over $300M in cash on the balance sheet, and only $20M in debt. Dividends are only about $20M per year, and they've been buying back stock. They'll probably need to start a new share buyback program soon as they only have about $40M left under the $400M authorization from 2004.

There is huge short interest on this stock, however, at close to 40% of float (but factoring in the Boyles' holdings, short interest is closer to 13%. This short interest is mostly likely due to the fears of reduced consumer spending. It seems to me that given the strong balance sheet and continued FCF generation, there is very little downside to the stock.

Overall, like the product, this is a very solid company without much flash. I really like how it's a family business and how the family still owns a huge controlling stake while managing the company very conservatively. I can see it staying under the radar and showing significant gains over time. Growth opportunities are there outside of the U.S., and each of the 3 geographic regions outside of the U.S. had sales growth in Q2 08: EMEA (13%, 9% due to FX), Canada (18%, 11% due to FX), LAAP (20%, 3% due to FX). I will likely buy more on price dips.

Digital River - DRIV

I've never fully understood how this company makes it money, but their financials certainly are marvelous. They are the leader in providing outsourced e-commerce services, specifically the technology and infrastructure for online stores that sell software downloads, among other digital products. They also provide online marketing services to drive traffic to these online stores. However, there is significant customer concentration with Symantec accounting for close to 30% of sales, and Microsoft likely accounting for another 10%+.

Revenues have grown from $220M in 2005, to $349 M in 2007, to 2008 guidance of $401M with $202M in the first half. They've been one of the few companies that has continued to perform well in a weakening economy. Capital expenditures have been pretty small and have been about 4 to 6% of revenues. The business has generated over $100M in free cash flow in each of the past 3 years. They bought back $138M in stock in Q108 and still have $587M in cash and investments, although $195M in debt outstanding.

The stock appears to be fairly valued. The current 2008 EPS guidance of $2.00 implies about a 22x PE ratio, which seems reasonable given the growth rate. Based on a market cap of $1.7 billion, the FCF yield is about 6-7% and should continue to grow in the future. With their financials and their business position, they should be able to weather any prolonged downturns and should be able to pick up a few acquisitions at depressed prices. They themselves may also be an attractive acquisition target further down the road. I'm holding onto DRIV for now.

eBay - EBAY

I made a big investment 2 years ago at $27 per share and haven't done anything since then. The thesis then hasn't changed much. They still have a dominant online auction business and a potentially huge business in PayPal. PayPal has a run rate of about $2.4 billion in revenue, with 45% growth in international vs. 30% in the U.S. Skype was never much of a factor in my original analysis and eBay did take a huge $900M impairment charge a mere 2 years after the acquisition, but Skype still has a $500M revenue run rate (Q2 08 annualized) and has 338 million users overall.

The auctions business hasn't been very pretty recently, growing only 13% in Q2 08. I've never been a heavy eBay user, but it's always seems like there's room for improvement. Despite all the press about how dissatisfied the core eBay users are and the lack of attendance at the most recent eBay Live event, the fact remains that people go to eBay because that's where all the listings are. Certainly, the new management needs to take care of its core customers but it looks like they are trying. All attention seems focused on Marketplaces, but the share of revenue from Marketplaces has steadily declined. Of total revenue, Marketplaces now accounts for 57%, PayPal 26%, Marketing Services 11%, Skype 6%.

Meanwhile, every quarter the company generates at least $500M in free cash flow. On top of that, they have $4 billion in cash on the balance sheet with no debt, though $2.9 billion of the cash sits outside the U.S. For 2008, the company is guiding close to $9 billion in revenue, and about $2.4 billion in free cash flow. With a market cap of $34 billion, that implies about a 7% FCF yield.

Unless new competing services start gaining traction, eBay's businesses are still the dominant offerings within their respective markets. At its current price, it looks like there is limited downside to the shares. I will look to add to my position.

Heartland Payment Systems - HPY

This company provides bank card payment processing services to merchants such as restaurants, gas stations, retailers and hotels.

The CEO Bob Carr owns close to 24% of the company, and the CFO Bob Baldwin owns another 3%. Really like that owner operator structure. Moreover, they don't pay themselves all that much either, approximately $350 to $450k in each of the past 3 years.

They recently introduced a new stock option plan for senior management and IT workers, except employees can't convert the options to shares for 5 years, and can only do so if HPY's revenues grow at an annual rate of 15% and EPS grows at a rate of 25% in those 5 years. While I'm not sure if those are the criteria I would use, I certainly like it better than simply a plain vanilla stock option plan. The plan ostensibly would incent the key employees to stick around for 5 years to see this through, which is quite a long time. However, if the options fall underwater on any of these criteria, I wonder what detrimental effects there may be.

In 2007, they had diluted EPS of $0.90, and net revenue of $303 million. By 2012, assuming the stock option plan criteria are met, this would imply diluted EPS of $2.75 and net revenue of $610 million. A PE multiple of 10x-20x would imply a stock price between $27.50 to $55. However, there is also a good chance that they'll exceed those criteria as well, in which case the upside could be higher. The company recently affirmed their $1.13 to $1.17 EPS guidance for 2008.

They currently have $40M in cash, and close to $115M in debt, which is a little on the high side for me, though $75M was due to financing the Network Services acquisition in May. They generated $12M in FCF in Q2, and spend about $3M in dividend payouts.

This is a company I need to spend some more time understanding. However, the growth prospects, owner/management, and business all point to potential outsized market returns. At $900M market cap, this could be a compelling opportunity.

Intel Corp. - INTC

Maybe this should go in the too-hard pile for me. I don't really have any interest in semiconductors, don't really follow the market, don't really understand it.

But what I do understand is the market leadership position, the high operating margins, the huge cash flow generation, the solid balance sheet. The forward dividend yield is now 2.3%, and the payout ratio is only 40%. They also have a good track record of buying back huge amounts of stock.

However, I wouldn't mind trading out of this stock. It's been very profitable, but it's also very cyclical and very capital intensive. Revenue growth has been less than 10% recently. I'm not going to get much in excess returns from owning this. I might as well diversify my risk and get a similar return and dividend from the S&P 500.

3M Company - MMM

In one of my management classes, this company was singled out as the paragon of innovation, with a track record of over 100 years. Overall, this is about as solid a company as they come. Steady growth, excellent margins, 50/50 split between international and U.S. revenue, very long record of dividend payouts and dividend increases, strong balance sheet. Valuations right now are as low as I've ever seen them (which doesn't really say much) at 14x LTM PE and 12x 2009 PE. This is a company I feel comfortable owning for a long time, adding to my position on dips in the stock price.

Pfizer - PFE

This is another dividend play for me. They have close to $30 billion on the balance sheet, and dividend payouts are about $8 billion per year. Free cash flow generation is also $11+ billion annually.

The question marks here have been around several key drugs coming off patent protection (primarily Lipitor) and the state of the pipeline and growth. I have no idea how to evaluate their pipeline, but then few outside of Pfizer would be in a good position to do so. My thinking has been that Pfizer is always in the position to acquire new promising drugs and does not have to rely on internal development.

In any event, I'm quite ready to place this in my too-hard pile and cash out of this position. The dividend yield, however, looks quite juicy and fairly safe given their solid financial position, so I'm holding it steady in the meantime.

Whole Foods Market - WFMI

I'm preparing a much more detailed writeup of this company. Suffice it to say that this one has intrigued me for many years, and it is now at a price that I wouldn't have dared to dream of even a few months ago. However, the recent suspension of the dividend, the downgrades by Moody's and S&P further into junk territory, reduced store growth investment driven by a lack of capital and financial strength, and a lingering antitrust issue, makes me wonder if there are simply too many red flags here.

Actually, I agree with many of the moves made. They do need to shore up their balance sheet, which has too much debt ($840M) and not enough cash ($25M). They were basically running at FCF breakeven with all the expenditures needed for new store development. Now that new store expansions have been slashed, they can return to generating positive FCF, assuming the weakening economy does not prevent people from shopping there.

I still feel that the business model works, and that many of their key markets are undersaturated. The big question for me is financial viability. I'd love to see some more cash on the balance sheet, but not sure if they'll be able to raise it. There's definitely the risk that this could turn into a falling knife. I plan on holding on for now, and look to future quarters to see whether their balance sheet starts to improve. If they continue bleeding cash, I may have to sell.

Conclusion

This wasn't very encouraging. There are some decent holdings here, but the portfolio isn't where I'd like it to be. There will be some changes coming pretty soon.

Based on my above commentary, here is my current ranking:
1. EBAY
2. COLM
3. HPY
4. BRKB
5. MMM
6. DRIV
7. WFMI
8. PFE
9. INTC
10. BAC

Setting up the TogaPF Portfolio

2008-08-05T01:37:00.000-07:00

I finally got around to putting up the portfolio. I'm including approximately $49,000 in cash and securities. My benchmark has been and will remain the S&P 500.

The holdings here are stocks that I've owned from my prior portfolio. I haven't kept up-to-date on each of these, so I'm not sure if holding each of these investments still makes sense for me. Ideally, I'd like to hold a smaller number of stocks, something in the 6 to 8 range. I don't think I have the inclination to keep track of too many more stocks than that.

TogaPF Portfolio

For TogaPF, I've reset my holdings as though I had purchased all of these securities at today's (Aug. 4, 2008) prices. I've assumed a $10 expense for each stock as the cost of establishing the position.

I started my original portfolio back in October 2004. My portfolio IRR since October 2004 has been approximately 7.5% versus 1.0% for the S&P 500. I calculate portfolio IRR to account for all of my cash inflows and outflows. This is before any capital gains taxes and after commission expenses for purchases. I benchmark against the S&P by assuming the same stream of cash flows are invested in the S&P 500. I assume transaction costs and holding costs for the S&P 500 are $0.

To calculate portfolio returns, I employ a model that is similar to that of a mutual fund. I assume that the portfolio has an initial share price of $100, which translates to a purchase of 488.97 shares of the TogaPF portfolio. The share price of the portfolio fluctuates as the underlying stock holdings fluctuate. Future inflow and outflow transactions occur at the share price on that date.

For example, let's say I want to invest $10,000 in a year's time. If the portfolio stays at $100 per share, I can by 100 shares at that time. However, if the stocks appreciate and the implied TogaPF share price increases to $120 in one year's time, my $10k investment would buy only 83.333 shares. Since I plan to add more funds over time, this approach allows me to calculate my returns from each investment date.

The below table shows that my TogaPF shares are now $99.80, as a result of factoring in my opening commission costs.