Monday, December 9, 2013

Dangerous times

In 2005, I was on a sugar high with bank stocks. The amazing thing about the whole time period was that I was not even keeping track of the fact that mortgage origination and securitization was even happening on a large scale or anything was a miss in the market as it rallied higher and higher. I thought I was doing the most prudent thing by "accumulating" my holding in the financials as the market traded higher.

The human psyche is such that, as times goes from better to even better, the fear gauge keeps plummeting and the sense of security is very high. Though I was accumulating shares in small lots I was doing it at ever higher levels and my cost basis was astronomically high. It is not that I was not aware of the rising cost basis, but it was more a compulsion to be involved in the market when things are good, which compelled me to keep buying.

I get the same creepy feeling now. With the markets and my portfolio considerably up for the year, I feel the compulsion to be ever more involved in the market and increase my stake. The risk is the same as it was 8 years back. Raising my cost basis. As I look at my technology holdings, I am very nervous. they have been expanding multiples over the past year and even though their multiples are still not too high I am getting weary of my compulsion to expand my tech holdings at this point. The dangers are obvious. I will expand holdings at these levels and would have raised my cost basis to levels beyond intrinsic value (or DCF valuations as best as I come up with) and a strong correction would then force me to take drastic action.

So the new playbook states that you accumulate at these levels in the market only if your cost basis holds below intrinsic value. For example, I do believe that MSFT has some ways to run given the amount of money that has poured into it in the past few months as institutional investors add to performing assets at year end. I still feel that it will breach 40$ by end of year. However, I do not plan to add any further. My cost basis is now at 28.64$ and perilously close to the 28-29$ intrinsic value that I have on the stock. So I stop and look elsewhere for investment ideas.

These are times when the psyche has more to do with investment ideas rather than cold analysis. I reiterate my call for rotating into financials over the next 6-12 months. Interest rates are going higher and at this point, given they are yet to have a good solid run like technology, I am betting that is where the money will go and hopefully I would have built up enough holdings at a low cost basis to hold on for the long term.

We certainly live in dangerous times!

Friday, November 29, 2013

The financial rotation

It has been barren land for the financial for the past five years. With all that has gone on in the markets regarding leverage followed by easy money, the financials have never been the same. The financials have clearly underperformed the wild markets in the past year, while the tech space has been on a merry ride with the large caps spitting out enormous amounts of free cash flow (the likes of Apple and Microsoft) and the small guys (Netflix, Splunk, 3d systems) providing the enormous potential growth. But that might be about to change.

The thing to keep in mind here is that the markets are run by financials. The first rule in the market is that the market makers always make money. The unprecedented involvement of the fed in the markets have curtailed the ability of the financials to make money in the past few years as easy money is making it hard for the financials to widen their spreads. Risk taking is back and with all the money sloshing around, everyone is trigger happy on the likes of 3D systems.

In the past six months, the interest rates have shown a propensity to go higher given the risk of the feds pulling back a bit from the markets. Though the trend has not been well established, the bottom seems to have been made for the easy money regime. In the last couple of months, most financials have broken out of their trading range and headed higher. This in all probability is a trend for the next year as people start seeing the spreads widen and the financials back in the driver seat.

The problem however is my inability to value financials. They hold very high leverage ratios and their balance sheet is loaded with liabilities. This however is not to be necessarily to be feared with the leverage being a key part of their business model. But what is scary is that I cannot tell from their balance sheet if it is good or bad leverage and the true extent of leverage. I learnt this lesson with my Citibank holdings during the 2006 timeframe and paid dearly for it. However, having learnt that lesson I am not going to swear away from financials. After all, they are the most integral part of the markets.

So while I was bleeding money in Citibank in 2008 I decided that the best way to play in the space in spite of my inability to value them, is the XLF. So I open position in XLF during that time and have held it since. I accumulated some as it worked its way through the teens and held it steady for the past couple of years. Now again I see a breakout in XLF in the last two months. And I think it is time to accumulate further.

At most financials trading at 9 times earnings, I think there is some ways for the financials to run further as people rotate from tech into financials. Barring a calamity in the markets this rotation is inevitable and I think it is time to expand my holdings. This time around, however, I am only expanding in XLF and looking for an opportunity to dump C when the opportunity is right. I like the diversification in XLF and gives me a sense of security (albeit a false one) about my financial holdings.

Thursday, October 17, 2013

The Accumulation process

Eleven years into investing and I have learnt very valuable lessons regarding how not to lose money. Not that I have by any means perfected the art of not losing money, but I have become more careful in my investments to avoid obvious risks to the downside. 

One such strategy has been to move from a bulk buy model to an accumulation model. In the early years, I would invest in lots of 100 or greater there by forcing a rather significant size of a capital on a thesis that I have just come up with and am not terrible sure about. Any additions to the position would also be in lots of 100 and greater and before I know it I would have invested over 10-15 thousand dollars on an investment that could very well be based on an incorrect thesis. The argument for the lot size was also influenced by the brokerage fees that would form a significant percentage of the invested capital if the lot was not significantly large enough.

Enter 2005, when I first got wind of the offer from one of my banks that a certain balance in my bank account would make me eligible for a set number of free trades. With that I have never looked back and have always fallen back on the accumulation process. Here I state some of the great advantages of the accumulation process:

1.      Allows you to enter an investment without significant capital and in case of large share price, the ability to enter into an investment
2.      The first lot forces you to start tracking the investment on a regular basis
3.      Invest based on a thesis rather than on momentum. This is very important because, it is not always that you are confident of your thesis and you would like to see the thesis show signs of playing out before you commit more capital
4.      Dollar cost averaging, in case you did not catch the bottom or you are going through a challenging macro market event
5.      Adjust your price of investment to reflect the right yield you want from the investment in terms of dividends. This is similar to dollar cost averaging except the goal of this is to increase effective yield on your overall investment

The obvious downside to this strategy is the cost of buy orders which is why it is important to use a low cost brokerage firm or a free trading platform as I indicated earlier. You do not want the brokerage fee to eat into the yield/appreciation that you have achieved through patient investing.

Having said all this, I still am looking for some ideas on how to accumulate the right way. Here are some thoughts I have:

Find the stock use a stock screener that meets your valuation requirements. I generally use one from one of the brokerage firms that I have an account. Check the trend line over the past year to see what the market has been doing to it. If the trend line is downwards over a significant amount of time like a few months, it is advisable to monitor the stock for a few weeks to see if it continues on the downward trend or bottoms out. If the stock pops right back up, no worries. There is no rule that you need to get it right at the bottom. It is more important that you don’t grab it while the market it working the stock down to its bottom. If you see a significant volume based upside for a couple of days, it might be a good time to open a position. When you do this you have to be chronically aware of a few things.

1.      The lowest price you are willing to buy the stock at after which you cannot bear the pain anymore
2.      The yield that you are getting at the current invested capital (Not the yield on the current stock price) and your target yield for the investment
3.      The highest price you are willing to pay based on fundamentals (and target yield) for the stock – This needs to be revisited on an annual basis to see if the fundamentals have changed.

In a investment thesis, patience is paramount because it is not necessary that your thesis would play out in a short period of time. And with accumulation it allows you to add to your position as you build confidence in your thesis rather that going all in right on day 1 and then regretting it for a long period of time as the market outperforms. As this waiting can get excruciating, a significant yield at your entry and accumulation points would dull the pain of waiting for the day of reckoning when your thesis actually plays out. On the off chance that you were wrong, at least your investment yielded a decent return and you can exit with head held high. 

Wednesday, September 4, 2013

The NOK call and MSFT deliemma

The NOK call was the right one. There was value to be had in the organization with such large channels and an enviable customer base. Though I was hoping for a bigger turnaround and not really a buyout. My NOK call options for January popped yesterday and since the thesis panned out I sold them at a good 250% profit. Though I am wondering now if I got out too early and should have waited a couple more days to squeeze the last out of that option.

But the bigger issue at hand is not NOK but what I should do about my MSFT holdings. From a valuation perspective, this thing looks too good to pass over. But there is just too many high profile failures for this stock to have any positive momentum. The high profile failures, mainly in the consumer devices space is not much of a shocker to me and honestly is not much of a concern from a revenue/earnings/multiple perspective. But what is concerning is the repeated sinking of money into businesses that it knows very little about. Admittedly this is being done to protect the core enterprise and PC business, but at some point these big non-performing assets that are being bought with money from the balance sheet is really hurting my view of this company. It also shows a certain level of panic that seems to have set in into the organization and the board in term of what to do next.

Looking at this in a more level headed manner, MSFT can very much afford the 7 billion it paid for NOK and I would argue it is 7 billion well spent outside the US while money is piling up overseas. MSFT also needs to fortify the Nokia story least Nokia gets cold feet and decides to go the Android way. It is arguable, what is better for Nokia, but from a MSFT perspective it was that best thing to do for Windows Phone.

If I were to look at Xbox as an analogy (ignoring Zune or Kin for a minute) Windows Phone still has a couple of years before it gets the time it takes to get into a market that has entrenched players. It would also take MSFT a few more iterations before it gets the platform right, but I do hope they preserve the Nokia organization and keep Elop the head of devices and go find another CEO. Or better yet, make MSFT a dual CEO organization so that they both have equal stake in the game and report to the board independently.

Either way, I think MSFT is too cheap to be downloaded here. Even from a breakup perspective the assets are far more valuable that its current market cap. Maybe around my original DCF of 28 I might add more to it. But for now I am in a holding pattern on MSFT.

Sunday, August 18, 2013

MT thesis

Acting on my thesis on PM from the previous post, I am now looking for a new investment that I want to fund with the money I raise by selling PM. as you can see, I am selling PM with a very heavy heart since it has truly been the shining star in my portfolio. But given all the signs I am seeing, I would rather be wrong on the "opportunity loss" side of things than the "loss of capital" side of things. So what exactly am I looking for in my new investment to replace the star performer. Let me list the characteristics:

1. Low Market cap to book value - Indicates market is not valuing its assets for whatever reason
2. Strong dividend - This is to get paid as I wait for my thesis to play out
3. High free cash flow - So that they are strong enough to fund the business without borrowing too much
4. Low P/E - So that the market is not already paying a premium for the earnings
5. Strong market presence - Should be a good diversified leader in its market

As you can see PM was a start in all these factors 2 years back. It is the (1) that bothers me the most about it now. So I went looking for another stock that I could buy and would have good prospects in the next 10 years or so.

Enter MT. (ArcelorMittal) is the leading steel producer around the world. Steel? Really - you say?

Well here is my general thesis and then I will go about comparing it with the factors I had listed above. The steel industry has been consistently beaten down since the "great recession" and will probably continue to get beaten down further with bad news coming from across the emerging markets. The most telling, to me, regarding emerging markets is what John Chambers said about Cisco's quarter. With negative growth in emerging markets, Cisco is truly the indicator that emerging markets is slowing. though the traders have stopped seeing Chambers as the bell weather, I think the man has predicted approaching slow downs with great accuracy. Assuming the slow down continues for 2-3 years, MT should start turning around in 3 years or so when countries start rebuilding infrastructure in response to expanding GDP. Steel producers are in the forefront of this turnaround and MT is the most diversified producer of steel and other basic materials with a huge mining division that feeds the raw material for their production.

Trading at half book value, MT blows out the (1) criteria listed above. The market thinks very little off their assets (mines, factories, human capital etc) probably because of the capacity and glut that it is currently experiencing. Given the rate at which emerging markets has declined, it might be a fair valuation at this point due to the level of under performing assets. But it is at nearly 50% and I assume at this point that it is an overreaction to the current state of affairs.

What is not to love about the a 5% dividend. If I can get enough position built up at 5% yield, I would be happy to wait for the thesis to play out. The pay out ratio is also fairly under control at below 50% of cash flow from operating activities even in these challenging times. The yield is at this level mostly due to the suffering stock price, but I would take it any day.

Free cash flow is one area were MT is concerning. This mostly due to the macro economic challenges that MT is experiencing at this time with Europe and Asia suffering a slow down. However this could significantly improve if the cost of revenue starts to decline with more assets performing at average levels in the long term.

P/E is a bad indicator for MT at this point due to very spotty earnings and write downs on assets in the past couple of years. Referring to the book value and the market cap, I am ignoring the P/E for now.

MT is one of the most diversified and entrenched player in its space around the world. One of the statistics I read is that MT steel feeds only 10% of the steel market when it was still the largest company out there by leaps and bounds. So there is significant potential to gain market share in this space.

Overall, I am basing my decision on a thesis that should play out in the next 5-10 years. I think I probably have about 2-3 years to accumulate MT before the market turns. I was encouraged by a sudden pop in MT with large volumes last week when news of a healthier Europe was emerging. This is encouraging even if it is misguided for the short term. It shows an underlying interest in the equity if the thesis were to play out. 

Tuesday, August 13, 2013

Turning on PM

Once upon a time I had taken a long position in PM based on the DCF calculations that I had presented. I have to admit that I never expected to be this right on the call. But here is now a case to sell my position. This has been bothering me for the last couple of quarters and now it is really making me nervous.

Let me start with a negative book value. Over the last couple of years PM has been borrowing money (albeit at a very low interest rate) to fuel their buyback program which has been on a tear. The borrowing has been at such a ferocious pace that they have increased long term debt by over 35% in the last two years. This in itself would not have been so bad except for the rather flat income growth over the past year. Flat income paired with accelerating debt is a bad sign except you cannot see that in their EPS because they are shrinking the float at such a fast pace. The borrowing is supporting the dividend payout which is now at staggering 61% of net income.

All the above can be overlooked if they had tremendous growth potential or favorable market forces working for them, neither of which is not the case. Growth is flat to minimally positive while there are tremendous forces acting against them in various countries to curtail the use of tobacco products.

So all in all I don’t see anything good to hold on to this stock at these levels. The only thing that is keeping me from selling at this point is that my cost basis is so low that the true yield I have on that stock is enviable at over 6%. But I know that is no reason to hold to until I start seeing capital depreciation.

I guess I should stop talking and start selling.

PS: I graciously eat humble pie on Facebook (my previous post). Good thing I did not act on it on the short side. But I still believe FB will struggle to show consistent growth which should promptly bring them back.