Worst-case Scenario Investing

Amateurish Error of Omission

2007-02-19T23:24:00.000-08:00

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

2007-02-14T23:44:00.000-08:00

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

2007-02-07T19:03:00.000-08:00

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

2007-02-05T15:26:00.000-08:00

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

2007-01-29T16:34:00.000-08:00

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

2007-01-27T17:46:00.000-08:00

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

2007-01-23T22:34:00.000-08:00

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.

Link: Chesapeake Energy Analysis

2007-01-18T18:34:00.000-08:00

I like Chesapeake Energy as a contrarian play. Over the last year, natural gas prices have declined from last year's peak to about $6 per mcf due to mild winters and cool summers. Even if it gets much colder in the next few months, the current glut of NG supply may still keep prices depressed. Lower NG prices is a short-term risk to what I think is a long-term trend. The company's multi-year reserve acquisition binge has ended and management will now be devoting their efforts to drilling. I expect reserves to increase dramatically as unproven reserves are proven. This will further boost the present value of the company as presented in Eric Schleien's excellent post about the break up value of the company. Even though CHK has 2x more unproven reserves than proven reserves, the unproven reserves are valued at 1/2 the value of the proven reserves. In other words, proven reserves are 4x more valuable than unproven reserves according to this analysis. The analysis appears very conservative because historically 50% of unproven reserves are converted. Coupled with the potential for NG prices to increase, we have a very undervalued asset play.

I have a position in this stock and will be purchasing more under $28. For a second opinion, check out this post at Theo Wong's site. Note that McClendon did not actually make the $9 million dollar purchase; it was a stock grant.

Book Report: Pioneering Portfolio Management by David Swensen

2007-01-15T23:12:00.000-08:00

I just finished reading Pioneering Portfolio Management: An Unconventional Approach to Institutional Investing by David F. Swensen, the Chief Investment Officer of the Yale endowment. Although not a value investing book per se, it sheds a lot of light on the whole investing process. He takes a very top-down approach to investing with a lot of data to back up claims. Although he may disagree with Warren Buffet in approach, he shares a similar view that investors in equities should either invest in fairly inefficient illiquid opportunities selling at a discount to intrinsic value or invest passively through index funds.

The following are a few interesting points that I noted from the book:
1) The more liquid an asset class or security category, the less opportunities there are for active management to generate alpha.
2) Mutual funds that concentrate in a limited number of stocks often outperform very diverse index-like mutual funds.
3) Consistent high returns from private equity firms depends primarily on the amount of value that the firm adds to the process. Buyout firms that have expertise in improving operations can be expected to do much better than firms that perform buyouts just to liquidate. A lot of buyout transactions underperform the S&P if one leverages the S&P's returns by the same amount as the buyout transactions.
4) Not much diversifying value from corporate and foreign bonds. Corporate bonds tend to have features that favor shareholders rather than bondholders, e.g. callability of bonds. Fixed income allocations should be concentrated in Treasury bills of different duration as they serve as a ballast during times of crisis or times of deflation.
5) The majority of the portfolio returns will come from marketable equities and alternative asset classes like private equity, long/short funds, merger-arbitrage funds, and real estate.
6) For those aspiring to be quants, Swensen emphasizes the necessity to pair qualitative assessments of investments on top of pure quantitative approaches. Many times backwards-looking analysis can be misleading and soft analysis is necessary when evaluating companies and funds run by real people and entities.
7) He likes to foster contrarian thinking in his investment committees. He doesn't expect immediate positive feedback from contrarian ideas. Small controlled experimental failures are often precursors for eventual success.

Like many of the other authors whom I read, Swensen believes in the importance of asset allocation, intelligent diversification, and the futility of market timing. Unlike typical value investors, he believes that value investors face likely failure unless they have a significant edge over other market participants. He also doubts most investors have the intestinal fortitude to hold onto out-of-favor companies in their darkest hours. In other words, he believes in value investing, but doesn't think that most investors can practice it with success.

In the last chapter of the book discussing the investment process, Swensen tells readers that the most important decision one can make is in deciding an investment policy, i.e. an asset allocation. Once that is set then one can worry about execution and fine-tune particular strategies. As it applies to me, my asset allocation decision is relatively simple. I recently entered my mid-twenties with approximately ten months worth of expenses in an emergency fund. I have a stable income and may be looking to buy some real estate if the California real estate market can start toppling =). The majority of my money is invested in equities. Currently I have 90% in equities, 5% in fixed income, and the remaining 5% in cash. Because the 5% cash is actually earmarked for stocks and options strategies, I am slightly off my target of 90% equities and 10% fixed income. I'll try to rectify this by the end of this year.

Overall, I highly recommend this book. In particular, chapters 4 to 8, 10 and 11 are especially relevant for the individual investor. I have to admit that this book wasn't as easy a read as say Jim Cramer's books, but there are definitely a lot more gems.

Results for 2006

2007-01-01T21:22:00.000-08:00

Happy new year! I'm just recovering from food poisoning, so I will have to keep this post brief. As of the today, my personal investment portfolio IRR for 2006 is 14.75%, which trails the S&P's 16.11% for my particular inflows. I'm pretty satisfied with my performance this year despite my lagging the S&P. I generated a lot of excess alpha in my 401k by trading into MSFT stock. The investment return for my 401k portfolio this year is 21.1%.

Over the last two and a half years, I have been able to grow my personal portfolio at 12.14%. This is not great, but acceptable given some of the bumbles that I've made since starting to invest. Let's hope 2007 is the year my investment theses come to fruition. I wish everyone the best for the coming year.

Net Current Asset Value Strategy Evaluated

2006-12-22T23:31:00.000-08:00

Net Current Asset Value (NCAV) strategy is a screen popularized by Benjamin Graham to find undervalued book-value bargain stocks. The net current asset value of the company is the total current assets less total liabilities. Current assets include cash, short-term investments, net receivables, inventory, and other current assets. A company's stock is considered a NCAV bargain (aka net/net stock) if the current total market-cap is a fraction of the net current asset value, usually two-thirds. As a value investor, I was drawn to these stocks because the risk seemed very limited if we are buying the stock at a fraction of liquidation value. Over this past year, I've experimented with this strategy by investing in a number net/net stocks that I deemed safe.

According to this site, this strategy has proven to be very successful, returning 29.4% compared to 11.5% of the S&P, spanning a 13-year period between 1970-1983. This is a real long time ago and things may be very different now. A few other sites also discuss the NCAV strategy. The Cheap Stocks blog often analyzes these net/net stocks. The stocks he invests in are representative of the best of the net/net choices. The GrahamInvestor also has a screen that lists the top few NCAV candidates. These are all good places to start.

From looking at these sites and analysis, I hand-picked six net/nets over the year. I invested in LKI, MARSB, HDL, JBSS, DHOM, and EWEB. DHOM was not a net/net stock at the time of the purchase, but is currently a net/net candidate on GrahamInvestor's screens because some long-term assets have been moved to the inventory row of the balance sheet. I held very small positions in each of these stocks and often took short-term tax losses and waited a month to re-purchase without getting hit by a wash sale. My final return on these stocks is estimated to be about 1.2%. MARSB, EWEB, and LKI were big winners, returning well over 20% each. I lost money on both JBSS and HDL, but DHOM was by far my biggest loser, with some shares declining more than 50%. I have to admit that my position sizing was a bit poor. I did not load up enough on the winners and was overweight the loser. In my defense, of course everything looks easy in hindsight. Even though one year's performance may not be representative of any strategy, it became apparent to me that this strategy holds more risk than I had originally expected. The occasional big loser can blow away any gains from the winners and the majority of the NCAV candidates will probably be losers. In other words, the strategy requires good stock selection on top of the screen.

In my opinion, there are two problems with the NCAV strategy. The first is that it was conceived and successfully employed around the time of the Great Depression, a time when there were a lot of these stocks to choose from. Nowadays only a handful of stocks satisfy these screens and you'll almost never find a company that doesn't have blemishes. Such companies include businesses that have been displaced by disruptive technologies like Handleman (HDL), a company that services CD distribution. Other companies like DHOM and JBSS may not be able to pay back their debt. And finally there are companies like EWEB that don't have much of a business model.

Another problem with this strategy is that you're putting blind faith in the company and its management to manage the current assets well. We're using a liquidation valuation to value a company that is still a going-concern. This company can very well be on a one-way trip to bankruptcy. One also has to be careful that the current assets include enough cash to handle interest payments on any debt. When a company is not able to meet its obligations and are forced to liquidate, the book value may necessarily be impaired.

If one were to successfully employ NCAV, I think he/she needs to be diversified across many issues and he/she must also be able to screen out the duds. Irwin Michael of ABC Funds does a pretty good job playing in this realm. He has a commentary site that provides detailed analysis and updates. I would recommend investing in his mutual fund over hand-picking NCAVs. Over the next year, I will be slowly unraveling my own NCAV purchases. I still own DHOM, JBSS, and HDL.

Book Report: Common Stocks and Uncommon Profits by Phil Fisher

2006-12-08T23:30:00.000-08:00

As I tackle my large list of investment books to read, I will write little summaries in my blog to remind myself of the important messages in the book. I hope these little crib sheets are useful for others who may not have time to read the book.

This is my report on Philip Fisher's Common Stocks and Uncommon Profits. I highly recommend reading this book along with Benjamin Graham's Intelligent Investor. Fisher stresses finding exceptional growth stocks that are selling at reasonable prices. Philip Fisher is probably second only to Benjamin Graham in shaping how value investors like Warren Buffet approach stocks. His investing career began with the great crash in 1929 and included many bear and bull markets. In his approach to investing, he stressed doing deep research by employing the "scuttlebutt" approach to find growth stocks. Scuttlebutt is the use of many different sources to find information about the company, the management, and the products. He used such inventive methods to find answers to his 15 points of quality in every stock he analyzed.

Here lists the 15 things Phil Fisher looks for in common stocks:
1) Do the products have enough market potential to increase sales for the next few years?
2) Does management have the drive to continue increasing total sales through innovation?
3) How effective is the conpany's R&D relative to its size?
4) Is the sales and marketing organization above-average?
5) Does the company have good profit margins?
6) How is the company improving profit margins?
7) Does the company treat workers well?
8) Does the company treat executives well?
9) Does the company have a deep management bench?
10) Does the company control cost and accounting well?
11) Does the company stand out amongst competitors in any way (particular to industry)?
12) Is the company long-range forward-looking?
13) Is the company going to dilute shareholders?
14) Does the company speak freely of the good as well as the bad?
15) Does the management have impeccable integrity?

He also gives a few short lists what investors should not do:
1) Buy promotional companies.
2) Ignore good stocks that are thinly traded or over-the-counter.
3) Buy stocks based on tone of annual reports.
4) Assume a high price already discounts all future growth.
5) "quibble over quarters and eighths."
6) di-worsify.
7) Be afraid to buy in times of political uncertainty.
8) Let what doesn't matter influence one's decisions.
9) Anchor oneself to price target even if the stock is undervalued at current prices.
10) Follow the crowd.

In the third part of the book, entitled Developing an Investment Philosophy, Fisher gives us concrete applications of the principles described in the book. I found this part of the book to be the most useful as a few of the stories and lessons resonated with me. IMHO, it's always easier to learn from examples than from lists. In this section, there was a story of a client who wouldn't buy a stock above his arbitrarily set price and subsequently missed a 50% return because it always traded fractionally above his buy-below price. I similarly missed Mastercard this year because I was not willing to pay more than $46. This was my largest mistake of this year, an error of omission.

Fisher also encourages investors to not time markets by making big moves into and out of equities. He believes growth stocks chosen carefully will ride out down-markets and staying committed to such stocks would prevent missing out on its imminent recovery. He quite accurately predicts that most market-timers will not repurchase stocks once it has started rising due to psychological anchoring to the lowest price. Even though the current market condition appears to be priced for perfection (or at least a soft-landing), I will follow Fisher's advice and stay the course. My positions should allow me to outperform even with a downturn.

What should I buy?

2006-11-29T22:51:00.000-08:00

Over the last few weeks, I have not been able to do much stock analysis. I've unfortunately been very busy at my full-time job as a software engineer. In my defense, there hasn't really been much to do as the unusual bullishness of the market has priced me out of a lot of opportunities. The gambler in me wanted to buy puts on QQQQ last week, but the chicken in me set the limit order too low to execute before Monday's fall. Such is life... It also doesn't help that APOL, OC, LM, WU, and USG have all gone up from when I first started looking at them.

I expect that I will be relatively busy until after the holidays. For my occasional readers, here's what to expect from me before the new years. I'll post a book review with key take-aways from Phil Fisher's Common Stocks and Uncommon Profits. Then I'll polish up my DCF calculator and publish it for everyone to use. I use this DCF calculator as a preliminary screen of stocks that have caught my eye. By publishing the tool, I'll be able to keep a history of what stocks are being screened by my well-informed readers. Hopefully I can get some good ideas from you =). Finally, I would like to work on providing podcasts of relevant earnings calls for my readers. I spend about an hour commuting every day, so podcasts would be very helpful for me to keep an eye on my basket of stocks.

As an update, Western Union and USG are two opportunities that I would jump on if the price ever came down to my current target buy-below prices of $21 and $47 respectively. In order to lock-in these prices, I sold Feb 07 puts on both stocks. Before Thanksgiving, I sold a Feb 07 $22.50 strike WU put contract for $1.10 per share. Because of Monday's drop, I am sitting on a loss with this position. I also sold a Feb 07 $47.50 strike USG put contract for $1.75 a share. For a good description on my view of writing puts, please refer to Million Dollar Countdown's post on 10 ways to minimize risk when selling put options.

In the blogosphere, I've found two other articles singing praises for USG. Whitney Tilson, a former Motley Fool columnist and now fund manager calls USG, the little stock that beats the market, while Evan Vanderveer likes USG the best. It's nice to be in good company. For those interested in Owens Corning, I would take a look at USG first. The situations are similar, but there are more gurus invested along side you with USG.

I am currently looking at increasing my position in First American Corporation (FAF), which has retreated about 5% below my original cost basis. It reported tentative third quarter results that missed analyst's estimates and may need to re-state its financial statements due to possible option-backdating. Since options back-dating usually does not impact cash flows, I view this as a temporary issue. I will need to review this past quarter's results before I make a move. I'm also considering increasing my position in Home Depot (HD). This week I made two small mechanical purchases of Advance America Cash Centers (AEA) and John B Sanfilippo and Son (JBSS). Should I buy more? I will need to do more due diligence before I increase the size of these small positions.

This blog doesn't really have that many readers, but I'd be interested in your opinions. What do you think I should buy? In times like these when undervalued stocks are hard to find, we really need to band together and share our results.

Good luck and be careful out there. The bulls are in control, but there are still a lot of uncertainties that everyone seems to have forgotten about.

Quick Valuation - Owens Corning (OC)

2006-11-11T22:29:00.000-08:00

Owens Corning recently emerged from Chapter 11 with a rights offering backstopped at $30 a share. Owens Corning is a leader in the building materials industry, supplying glass fibre and insulation products for residential and commercial applications. Over the last two weeks the shares traded as low as $26 dollars and are now currently trading close to $29. I'm interested in this company because it's a situation very similar to that of USG's. I'm hoping to apply what I learned from the USG valuation to value Owens Corning.

Looking at the company's most recent 10-Q balance sheet, the situation looks misleadingly bleak. It had over $8 billion in shareholder equity deficit. This number however is most likely not up-to-date. I think a majority of the deficit has been nullified with the recent re-structuring: cancellation of the old shares, creation of the new shares, rights offering of new shares to creditors, bond holders, etc, and creation of the 524g Trust. If I assume all the $13.5 billion "liabilities under compromise" are replaced by the new liabilities listed in the 10-Qs restructuring notes, I get a company that has a slight shareholder equity deficit. I am not sure if my calculations are correct, so I have contacted investor relations to clarify.

The old shares of the company are now cancelled. Shareholders receive rights to buy the new stock at $45.25 dollars. This price is far from the current price, so I will not factor this into my calculation of the current number of new shares outstanding. Reading through the 10-Q, there are 27 million shares given to bondholders, 72.9 million share rights offering, 3.3 million shares distributed to directors, and 28.2 million shares contingent on the failure of the FAIR Act. The total number of outstanding shares is then 131.4 million, assuming the FAIR Act does not get passed. In the 10-Q, OC management wrote that they believe the likelihood of passing the FAIR Act is fairly slim. I imagine this to be the case too with the new mostly Democrat Congress.

The free cash flow of the company for 2005 was $463 million. Since this free cash flow number occurred during potentially one of the best years for building material suppliers, I don't see this as sustainable. The growth rate over the last five years appeared to be around 15% and projecting that into 2006 gives an estimated best-fit free cash flow of $287 million. Using this value, a 12% discount rate, and assumed 10%/5%/3% staged growth, I get an instrinsic value of $35 for the shares. At current prices around $29, there is a margin of safety of 17%.

At this point, I have made too many questionable assumptions for me to reliably use my IV estimate. I would like to wait for a cheaper price and more information before I re-evaluate whether or not to buy these shares.

Quick Valuation - Apollo Group (APOL)

2006-10-29T22:19:00.000-08:00

Apollo Group runs the University of Phoenix and other for-profit higher education institutions. It recently reported 12% lower net income due to higher costs in marketing expenses and retention program costs. The earnings miss, poor retention rates, higher capex, and an options backdating probe has brought these shares down 25% from last month's prices. Is this best-of-breed business worth buying? I'm not 100% sold on the business, but the valuation seems cheap.

I played with a 3-stage DCF valuation to see how bad the growth has to be for the shares to be fairly valued around $35 a share. Using my customary 11% discount rate for companies of this size and the current FCF of $435 million dollars, the company would have to only grow 5% for the next five years and 3% in perpetuity to be worth $35 per share. To put this into perspective, the annual growth rate of the company over the last 5 years has been about 17%. A worst-case scenario of 7%, 5%, 3% staged growth results in the shares being worth $41. A more likely scenario is that the company can grow 10%, 7%, 3%, resulting in an intrinsic value of $49 a share. At current prices, APOL is trading with a 27% margin of safety. There doesn't seem to be much more down-side, but I am wary of the headwinds against the for-profit education establishments.

If the price gets even cheaper from here, I will take a closer look at the company. There are just too many unknowns and risks.

Weekend Links

2006-10-27T14:44:00.000-07:00

Morningstar chimes in on Western Union, valuing the company at $32. The company reported earnings this week that beat analysts' estimates, resulting in a jump in the stock.

Eric Schleien has found an interesting natural gas company in FEC Resources. FEC owns 33% of FEP, a British natural gas discovery company with natural gas deposits in the Phillipines. Eric proposes a hedged trade that sounds promising, but most brokers have very expensive OTC trading commissions for this penny stock. MBTrading, my discount broker of choice allows me to trade penny stocks at a fixed $8.95 commission. I have not investigated how much it would cost me to short the FEP shares or if the company is so undervalued that I don't need to do the hedged-side of the trade. Natural gas exploration and extraction is not my area of expertise and I'm a bit wary if these deposits are extractable by such a cash-strapped company. I've set a limit order at $.04.

FatPitchFinancials has more value investing links for your viewing pleasure. George also runs Value Investing News, a Digg like news aggregator.

Quick Valuation - Legg Mason (LM)

2006-10-27T00:56:00.000-07:00

Early in the month, Legg Mason warned investors that it would not be able to meet consensus estimates for the most recent quarter. They cited a rotation of assets under management into lower-fee fixed income funds due to market conditions and poor performance by a number of their large cap funds, including the LMVTX fund run by legendary Bill Miller. Miller's 15 year winning streak against the S&P index may finally be over this year. Investors are probably a bit short-sighted to abandon his fund because of this temporary setback. My bet is that Miller is still a great investor and Legg Mason is worthy of a spot on my watchlist.

Legg Mason has grown its free cash flow at a very healthy 27% clip to about $450 million this year in unencumbered cash. My inputs to the DCF are 20%, 10%, and 3% staged growth with a 11% discount rate. There isn't much share dilution, about 3% annual. This gives me an intrinsic value of $110 per share. At current prices, we have a 19% margin of safety. Let's keep watching this one. I'm not very comfortable with the assumed 20% growth over the next 5 years and probably need a larger margin of safety before I buy shares. A 35% margin of safety requirement would set a buy-below price of $71.50. I would wait for a better price.

At this point, I think USG and WU are better bargains than LM. Based on my previous valuations of $30 for WU and $71 for USG, we have a margin of safety of 25% and 28% margin of safety respectively. It's a shame both stocks did not give me enough time to load up. I am debating whether to buy these stocks at current prices. At a later time, I will re-evaluate WU and decide whether or not to make it a full-fledged WCS stock pick at current prices.

Quick Valuation - Western Union (WU)

2006-10-22T23:12:00.000-07:00

Over the weekend I skimmed over the Western Union spinoff information kit with unaudited pro forma financial statements. While looking at the previous 5 years worth of historical cash flow, I noticed that the growth rate in free cash flow (net cash - capex) diverged significantly from the growth rates that I am seeing used in DCF calculations by other bloggers like Mike. Interpolated from these numbers, free cash flow has grown at about 18% over the last 5 years. Since others already consider it cheap at 10% fcf growth rate, this makes WU an interesting investment opportunity. Greenblatt always said to investigate spinoffs as they usually present good investment opportunities.

My current estimate of the intrinsic value of the WU is $30. I used a 2-stage DCF model with growth rates of 10% for the next 10 years and 5% terminal growth. I used a 11% discount rate, justified by the company's enduring brand and global presence. In the worst-case, I can't imagine this company having lower growth rates than 7% for next 5 years, 5% for the following 5 years, and 3% in perpetuity. The intrinsic value in this highly unlikely worst-case configuration of growth rates is $19. Any purchase under $19.50 has a 35% margin of safety from my $30 IV estimate and is fairly valued in the worst-case. Sounds like my kind of odds!

In a future post, I will discuss the merits of the Western Union business. I will discuss why we need not worry about immigration legislation and why we don't have a buggy whip business on our hands.

Full Disclosure: I have a 2/3 full position in this stock. My original shares were spunoff from First Data Corporation (FDC). I have also recently made purchases at $19.40 and at $18.50.

More findings on USG

2006-10-21T19:58:00.000-07:00

Berkshire Hathaway recently announced a $7 billion reinsurance deal with Lloyds of London. As part of the deal, Berkshire Hathaway will take over the float and daily operations of the Equitas division. The main driver of this deal is to acquire a large $8.7 billion dollar float in Equitas's reserves. Warren Buffett is betting that he can generate enough returns from this float to cover all asbestos liabilities. I mention all this because it is a good example of developing one's circle of competence, a trait that Charlie Munger, Buffett's lifelong partner in crime expounds upon. Buffett no doubt used the knowledge he acquired while researching USG to assess this deal.

I recently found an article describing the older FAIR Act, which was tabled by the Senate in early 2005. Apparently, it did not get passed by a very small margin of one vote. This is good news to me as the new FAIR Act may fair better with new updates to address issues brought up by the opposition. Still, I will not add any additional value to my intrinsic value estimate of USG because of this. I'm still looking to buy a large position at $46 and will nibble at $47. Maybe next week =).

I also wanted to note that D. E. Shaw, a highly successful and quantitative hedge fund is the second largest shareholder of USG. It's reassuring to be with such good company when exposed to some litigation risk.

Worst-case Scenario (WCS) Stock Pick - USG

2006-10-07T01:36:00.000-07:00

I was initially drawn to USG by the constant news wires about Warren Buffett purchasing boatloads of this stock. His most recent acquisition of 371,200 shares at $46.10 occurred the day after my own purchase of my starter position at $46.84. It appears he is buying this stock whenever it approaches $46. He now owns about 19% of the company, about $800 million of the 4.24B market cap company. Over the last three months, USG grew from a 1% BRK holding to a 3% holding. I think WEB is onto something here and we may have an opportunity to tag along for the ride.

According to the most recent 10Q, USG emerged from bankruptcy on 6/20. This is good news to the company, but the stock price subsequently dropped by over 60% from its highs. No doubt this was because of the announced rights offering to generate cash for the Proposed Plan to emerge from bankruptcy. It was to offer shares to shareholders at an additional $40 per share in order to raise $1.8 billion. After the rights offering, each share is equivalently worth $80 if we are to believe the correct valuation is the previous $120 valuation.

In the most recent 10K discussing the Proposed Plan to emerge from bankruptcy, USG plans to set up a Section 524(g) asbestos personal injury trust fund from which all litigation payouts will be drawn. USG will initially fund it with an $890 million dollar in cash and then write a contingent note for $3.05 billion of additional funds. The note will be cancelled if the Fair Act of 2005 is passed into law and is not challenged as unconstitutional. The note is payable if the Fair Act is not passed into law. In that case, USG's total payout for asbestos litigation will once again be unclear.

Can USG remain solvent if the $3.05 billion note becomes due? My conclusion is that it can. USG's total obligation is $3.95 billion. It raised $1.8 billion from the rights offering, has $1.577 billion in accumulated cash, is owed $1.1 billion in expected tax refunds, and can raise an additional $1 billion in financing. Subtracting the obligations out leaves $1.57 billion in cash, about enough to finance 5 years of capex (~$1 billion), lease obligations ($227 million), and interest payments (~$20 million). Even in the worst-case, this company will remain solvent.

As the cost leader in the wallboard industry, it has a wide moat. This moat allows the company to generate significant cash flow in good years and bad. The average generated free cash flow for the last 5 years totals about $240 million dollars. The projected growth rate of cash flow is about 15% a year. To be conservative, I will use the average cash flow instead of next year's projected free cash flow as input to a 3-stage DCF calculation. Using an 11% discount rate, a 15% growth assumption for the next 5 years, 7% for the following 5 years, and 3% in perpetuity, the estimated intrinsic value of the company is $71 per share. By starting off with a conservative estimate of free cash flow, I allow myself some leeway in adjusting the growth rates. Using even more conservative estimates for growth of 7%, 5%, and 3%, the instrinsic value is $48. In the worst-case, we have a stock trading at fair value.

Some may say that there are two main catalysts for the price to go up. I argue that even without these catalysts, the stock is undervalued. The first catalyst is continued interest from Warren Buffett. From looking at his recent purchase history, I don't see him buying a larger stake unless the stock drops to under $46. The second catalyst is the passing of the FAIR Act of 2005. I don't see our bipartisan Congress passing such a law, but there is still a chance. Because the stock is worth much more even if the FAIR act is not passed, this catalyst comes free. Besides litigation risk if the Fair Act is not passed, there is the risk of a hard landing if/when housing heads south. As the low cost producer, I don't see USG's business being impacted in the long term.

I recommend buying this stock at $46, a 35% discount to my calculated intrinsic value of $71.

Two other bloggers whom I follow have also written about USG. George from FatPitchFinancials thinks that USG is a fat pitch, while F K Soft at Stockblogs.com concludes that we have a great business selling at a good price. Please refer to their posts for their detailed analysis.

Full Disclosure: I picked up a 1/3 starter position at $46.84 two weeks ago, but I wish I had bought more. I am looking to invest more under $46, but will pick up more shares at close to $47.

Current Portfolio Composition

2006-10-04T19:19:00.000-07:00

It's not a good sign when a new blog does not get updated for almost two months after the second post. The lack of momentum in this blog probably foreshadows a quick death, but I'm going to try to breathe some life into this blog over the next few weeks.

To start off, I'm going to disclose my current holdings so that readers may have a frame of reference as to the type of stocks that I am interested in. I haven't made many stock trades since 7/30, so readers aren't missing much from my hiatus. Throughout July and August, I was fully invested. Before a two week vacation in September, I lightened up some of my heavier positions to generate some cash. In hindsight, this proved to be the wrong thing to do but that's OK. It's always good to have some dry gunpowder for future bargains that arise.

MSFT - 24.30%
FAF - 8.81%
DELL - 8.08%
VGTSX - 7.39%
MMM - 6.78%
HD - 6.46%
AEA - 5.37%
OAKMX - 5.12%
BUD - 3.71%
PFE - 3.66%
COP - 2.45%
FDC - 1.66%
RCII - 1.50%
UNH - 1.42%
WU - 1.42%
GPS - 1.40%
ENH - 1.38%
USG - 1.35%
TYC - 1.22%
HDL - 1.09%
JBSS - 1.05%
ACUS - 1.01%
DISCA - 0.93%
DHOM - 0.86%
DRL - 0.83%
EWEB - 0.77%
-------------
Total - 100%
Cash equivalent to ~8% of investments.

Readers will notice that I run a somewhat concentrated portfolio, 80% of my money are in my top 10 positions. The majority of my money is concentrated in good companies selling at decent prices. Rounding out my portfolio are a bunch of starter positions in undervalued companies and a bunch of distressed Grahamian cigar-butt-type securities. Over the next 6 months, I want to reduce my number of holdings as keeping up with all these symbols has become unwieldy. I'm considering selling Rent-a-Center (RCII), First Data (FDC), Tyco (TYC), and Gap (GPS).

As for new investments, I am currently most interested in adding to my positions in Advance America Cash Centers (AEA), Western Union (WU), and US Gypsum (USG). USG is new position that I started last week. My next post will include a worst-case scenario analysis of USG and why it's undervalued even in the worst-case.

State of the Portfolio - 7/31

2006-07-31T01:03:00.000-07:00

I try to run a very concentrated portfolio despite my tendencies to nibble at the latest investments that seem promising. My current top 10 holdings include MSFT, FAF, HD, MMM, DELL, PFE, AEA, BUD, FDC, and FII. I would not hesitate to add to any of these holdings at the current market prices. For disclosure, my other positions include COP, UNH, RCII, LKI, GPS, ENH, DHOM, TYC, JBSS, DISCA, DRL, and ACUS. I hope to get around to discussing these smaller positions, but I will be spending most of my time analyzing and updating on my largest positions.

A number of my holdings have been beaten down over the past 2-3 months. My portfolio has suffered and I am currently flat for the year (lagging the S&P by 4% for this year's cash flows). Despite these "setbacks", I am ecstatic about the opportunity to buy more of these stocks with such a large margin of safety, i.e. discount to its my estimate of the intrinsic value.

Mega-caps like MSFT, DELL, HD, and WMT should prove to be good buys for the long term. The stock prices have been stagnant the last few years, not because the businesses have been performing poorly, but because investors paid too much for growth during the bubble. The PE ratios have now fallen into the low teens. The PEs are at historic lows and seem inappropriate for superior businesses like MSFT and WMT. Microsoft and Walmart in particular have huge moats and should provide excellent returns for many many years to come.

Currently, all of my top 10 investments are Motley Fool Inside Value newsletter picks. Some of these stocks I owned before the recommendation, but many of them were introduced to me by the newsletter. Inside Value is a great service and well worth the $150 I paid for the subscription and for access to the discussion boards. Their recommendation prequalifies a stock for me and it immediately earns a spot on my watch list.

For my next post, I will analyze either Home Depot or Dell. I think these are currently the best buys on the market. I'm crossing my fingers that Dell will drop down to $19 a share again.

Welcome to the Worst-case Scenario Investing blog!

2006-07-25T19:09:00.000-07:00

This is the first entry in what I hope to be a very illustrative blog used for documenting my own investment decisions. I graduated from college two years ago and am currently a software engineer in a large corporation. I've been investing for a little over two years, have had some luck, but also have made some investment mistakes along the way. I am by no means an expert in the investment field, but i have been an avid reader over the last two years of great investors like Warren Buffet and Benjamin Graham. I am currently ploughing through Damadoran's Investment Valuation textbook to familiarize myself with common valuation models instead of just using black box implementations available from the web.

Every investor has an investment philosophy. I want to be a value investor who runs a concentrated portfolio with 75% Buffet-type investments and 25% Graham investments. In other words, 75% of my portfolio should be in my top 10 best investments for the very long term. These should be companies that have wide moats and throw off tons of cash. The remaining 25% of my portfolio will be diversely invested in either small Grahamian NCAV cigar-butt companies or possibly special situations like the ones documented by Greenblatt. These allocations are not hard rules, but I intend to stay close to them. The main motivation of a concentrated portfolio is to avoid my own tendency to collect different stocks, i.e. diworsification.

As a student of machine learning and pattern recognition, I am also interested in taking advantage of the short-term through programmatic technical analysis, but I realize that long-term movements are mainly governed by fundamental qualities of a company. This means that I will reap the most benefit from concentrating on fundamental analysis while I am starting out. Technical analysis will be a hobby that gets very little of my investment dollars.

To distinguish this blog from the other value investing blogs out there, I will attempt to pinpoint what the worst-case scenario could be for different stocks that i am interested in. This type of floor analysis will give me the confidence I need to run a concentrated portfolio. For cigar butts, I'll probably look at what's on the books to calculate a liquidation value. For growing businesses, we can perform a discounted cash flow valuation with a range of possible growth estimates. The lower end of the range will constitute what might be the worst case scenario.

I hope I have piqued your interest with my investment philosphy and background. The next post will disclose the components of my current portfolio and I will briefly explain my top picks.