Amateurish Error of Omission

I just noticed that Lesco is getting acquired by Deere & Co for $14.50 a share. It's usually a happy occasion when a stock of mine gets acquired, but not this time. Not only is Deere buying a company from under me at a 10% discount to my intrinsic value estimate of $16.70, but I only bought 1/3 the total number of shares I originally wanted to buy. This is a HUGE error of omission. I should have backed up the truck when this dipped to the low 10s last week. Another case of shoulda, coulda, but didn't.

This experience shows me how horrible I am at asset allocation and that I need to take quick action when my processes tell me that a rebalancing is in order. For the last three weeks, I've been dragging my feet on adding to the four stocks I listed in my previous post, mainly because I was pretty much fully invested in my portfolio. My last few posts have been all about rebalancing my portfolio, but I haven't taken any action. The only bright side to all this is the hope that my quality large cap positions will eventually pay me many times over than this fast 40% gain in LSCO that I missed. The gains on LSCO are now capped compared to my other positions. If LSCO gets much closer to my $16.70 valuation, I am going to sell it to buy some more Crown Crafts (CRWS).

Sigh, such is life...

Stocks to Watch, Links to Read

This is just a quick update. I'm looking to buy more Crown Crafts (CRWS.OB), Chesapeake (CHK), Lesco (LSCO), and Nicholas Financial (NICK). By my quick DCF calculations, all of these companies are at least 35% undervalued. With so many stocks to choose from, I haven't been hunting for any other bargains. Check the VIC website for good write-ups on all of these stocks.

Here are a few links to articles that I find worthwhile:
1) The Value Plays blog gives a good recap of what's been happening with Home Depot.
2) He also has an older post on Owens Corning. I should revisit this company.
3) Envoy Global Research rationalizes CRWS.OB's 20% drop after it reported decent earnings today.
4) Eric Schleien recommends CHK as a way to profit from the oil boom.

In my previous post, I decided to sell some of my Microsoft shares. Unfortunately, the stock moved down and MSFT is no longer the stock with the lowest margin of safety. I will hold onto my shares and wait for a better price. There is really no rush.

Portfolio Weighted Discount to Intrinsic Value

I try to invest in companies that are selling at a large discount to the intrinsic value. This discount to intrinsic value is the margin of safety I require before I invest in any stock to guard against any incorrect predictions and assumptions. I typically adhere to a strict 30-35% margin of safety to conservative estimates of intrinsic value. Over the weekend, I wanted to evaluate the discount to intrinsic value of my whole portfolio to confirm my suspicions that I need to rebalance my portfolio, which is heavily concentrated in Microsoft stock.

To do this, I multiplied my estimates to the discount to intrinsic value for each company by the portfolio weight of the position. For example, I estimate MSFT's current margin of safety to be about 10%, meaning I think the shares are worth about $33 dollars compared to the current price of $30. Because 20% of my portfolio is in Microsoft, the 10% margin of safety gets multiplied by .20. Summing up the weighted margins of safety across all my positions gives me a current portfolio weighted discount to intrinsic value of about 18.75%. For me, a margin of safety in the teens is not desirable. I would much prefer to have a portfolio margin of safety around 25%.

In a tax-free and commission-free world, investors should replace stocks with low margin of safety with stocks that have high margin of safety, thereby raising the portfolio margin of safety. Looking down my portfolio, the following stocks have margins of safety below my weighted portfolio margin of safety of 18.75%: DRL, ACUS, MSFT, BUD, PFE, HD, JBSS, ENH, and MMM. These are sorted from lowest to highest margins of safety. As a first step, I've already sold off DRL and ACUS, because these are moonshots with questionable margins of safety. Unfortunately, these were very small positions that had negligible impact on the portfolio margin of safety. Swapping Microsoft with high margin of safety companies will have a much larger impact.

Although selling Microsoft and replacing it with my current best ideas with the highest margins of safety will automatically give me greater than 25% portfolio margin of safety, I am hesitant to make such a drastic change. Microsoft had a huge 40% run in the latter half of last year, but most of my gains are still short-term. Short-term capital gains will eat away a lot of my profit and I'm not convinced that Microsoft won't give above average returns even if it is fully valued. Out of all the positions listed, only BUD and ENH have long-term gains and some shares of MSFT, MMM, and PFE are long-term. At the end, I decided to sell off 30% of my position in Microsoft. With this money, I will buy more shares of Chesapeake Energy and USG Corporation, my current best ideas. This portfolio rebalancing should put me over 20% portfolio margin of safety. More modifications will need to be made this year, but there is no rush. These stocks with low margin of safety are all very high quality companies.

The portfolio margin of safety is not an easy number to calculate. You need the margin of safety of every position before you can calculate it. I recently did this for my whole portfolio and it took me the whole Saturday. Despite the laborious number crunching, I find this very useful for making rebalancing decisions. The large amount of work is also incentive to run a more concentrated portfolio of one's best ideas. As the year goes by, I will give more thought to unraveling some of my smaller positions.

Carnival of Investing Recap

I'm very excited that my post on the sub-prime lenders is featured in this week's Carnival of Investing and Festival of Stocks. Hopefully, new readers can look critically at my reasoning and poke some holes in my argument.

Ben from the Money $mart Life blog hosted this week's Super Bowl edition of Carnival of Investing. The following are my favorite articles from this week's carnival:
1) FreeMoneyFinance summarizes Charles Schwab's interview into two recommendations to invest in index funds and to concentrate on one's career. One of the key lessons is to learn how to communicate, something that I should spend more time on.
2) SearchLightCrusade discusses the high cost of waiting to buy a home. My fiancee and I are discussing purchasing a home in the Bay Area. This post is definitely food for thought.
3) A Financial Revolution discusses the benefits of limit orders. I always use limit orders, but I would caution against setting limit orders to try to pick up stocks at daily lows. Often times, the stock won't hit that low again and you'd miss out on a stock that you really wanted because you were penny-wise pound-foolish.

From Ashish's compilation of this week's Festival of Stocks, I found the following posts interesting:
1) Precious metals is not in my circle of competence. Investor Trip discusses ways to play uranium, a source of clean energy. I've always been interested in an Australia ETF because of Australia's large deposits of natural resources.
2) The Skilled Investor blog claims most individuals are poor investment portfolio managers. As someone who is slightly trailing the S&P for the past 2 and half years, I'm a little bit worried that I am a poor investment manager. I have to admit that keeping abreast of all my positions is definitely time consuming. If I didn't love the stock-picking process so much, I would be the first to switch over to using index funds entirely. Hopefully, my long-term stock picks will pan out well in 3-5 years.

Every week, I hope to spend some time reading through the blog posts from others interested in investing and stocks. There is a wealth of knowledge out there and I hope to aggregate information and lessons from the blogosphere's best value investors.

Article: James Montier on how CAPM is CRAP

Today's "Outside The Box" piece from John Mauldin's free InvestorsInsight newsletter debunks beta as a useful measure of risk. Beta measures a portfolio's volatility when compared to the market. The article illustrates why beta is a poor measure for risk by using multiple empirical studies. In my own investing, I use a stock's margin of safety as a measure of risk.

In recent months, I've been deciding whether or not I need to calculate a Sharpe Ratio for my portfolio. The Sharpe Ratio is a measure of outperformance normalized by the amount of risk taken and highly regarded by my quant friends. In the end, I decided that I did not want to spend the time to calculate this ratio. My main reason is similar to the reasoning against using beta. Specifically, risk should not be measured by the short-term variance of one's returns. At the same time, I have also decided to measure investing success by maintaining 12% IRR at year-end instead of comparing results with the S&P. Although I will still compare results to the S&P for illustrative reasons, I will not beat myself up if I don't match the S&P. Beating the S&P year-over-year is a game that mutual fund managers need to play to separate a fool from his money.

Blog Link - Nicholas Financial VIC Analysis

Randy from the Stock Notes blog is the one who wrote the most recent Nicholas Financial Value Investor's Club (VIC) recommendation. He has write-up posted it on his blog. Great write-up! I'll be buying more in the next week or so.

Reasoning about Two Sub-prime Lenders

Early this month, I invested in two sub-prime lenders, Nicholas Financial and CompuCredit Corp. Nicholas Financial purchases sub-prime auto loans at a discount and services them. Nicholas Financial makes most of its money buying loans at a discount from dealerships and charging high interest rates on those loans. CompuCredit provides credit and related services to the sub-prime borrower market, those without access to conventional forms of credit. The majority of its revenues comes from credit cards with high interest rates and from fee-based cards.

I have not gotten a chance to do full due diligence, but have read very convincing analyses of these two stocks. Nicholas Financial has been recommended at the Value Investors Club multiple times. VIC is a really great resource for those looking for value picks. The analyses by members are much better than what I can present to you. Guest access to the site has a 45 day lag, but the most recent write-up of NICK recently appeared on the guest access page. As for CompuCredit, Tom Brown from Second Curve Capital and Bankstocks.com recommended it a few months ago, calling it one of his best picks in the financial sector. I have only done some cursory DCF analyses but the margin of safety for both stocks appears to be greater than 35%.

Folks have been very wary of sub-prime lenders because of the fear of rising defaults from the overextended American consumer. This is especially true for sub-prime mortgage lenders who have extended exotic loans to finance the housing bubble. It's unclear how all this will play out, but all sub-prime lenders are being punished in advance of a potential rise in defaults. Is this rational? If I were a sub-prime mortgage lender, I would be worried. Many adjustable rate mortgages (ARMs) will be re-adjusted soon and many borrowers will realize that they cannot meet the minimum payments. This will cause a rise in the default rate, sending many more of the sub-prime lenders into bankruptcy.

Given the likelihood of further pain in the sub-prime mortgage lender industry, how will this affect NICK or CCRT? I argue that there will be minimal impact. These companies service a different segment of the credit-strapped consumer and have demonstrated conservative loan operations. CCRT's clientele does not even qualify for credit cards, so taking on mortgages would be out of the question for these people. There may be more overlap between people borrowing money to buy a car and people borrowing money to buy a house. However no auto loan financier in their right mind would take on a loan from someone whose monthly income could barely pay off an ARM monthly payment. For these reasons, CCRT and NICK should not be batched together with other sub-prime lenders. The only major risk I see is the risk of a recession. Defaults are likely to rise during a recession and these two stocks will go lower (along with the whole stock market). If there is a recession, it will be the time to load up on these two stocks. Both companies have been around for at least one credit cycle and know how to run a tight ship when the going gets rough.

From this reasoning exercise, I conclude that NICK and CCRT are lower risk than they appear and are in fact significantly undervalued at current depressed/stagnant prices.