A BIG Round Trip

The last few ideas I've written about have worked out reasonably well. Not wanting to risk looking like a hero, I thought it would be a good idea to write about an idea that hasn't worked too well. So I'll write about a " round trip", when you buy a stock and ride it all the way up, then all the way back down again. I wrote here about the discount retailer Big Lots (BIG) in June of 2011. After taking a position in 2011 @ $32, the stock promptly ran right up to $46, the bottom of my fair value range for BIG. Due to lack of brilliance on my part, I didn't sell, hoping for an even better price or maybe a buy-out. Then Q2 of 2012 rolled around and company reported poor earnings and the market ran for the exits.  It appears the inventory mix combined with really weak consumer confidence, in the first half of the year was way off and sales really suffered. Then to top it off, allegations ( and FBI investigations ) have surfaced that the CEO sold $10 million in stock just prior to the lousy Q2 earning report, while in possession of material inside information. That's a big no-no, as that sale was not part of his normal pre-programmed stock sales. The CEO has also announced his plan to retire.....hmmmm... That action, has hurt his otherwise good credibility and makes you wonder if he is looking out for shareholders or just himself.

So with BIG sitting in the $28-$30 range, I'll sit still for a few more quarters and monitor the situation. BIG still has good potential, particularily as the economy improves, and would be a nice fit for a private equity firm to take private. I'd tender for $55/share.

A Little More To Do

After a quiet summer and early fall, there's been a little flurry of activity. I recently sold the last of my position in Magic Software ( MGIC ) @ $4.55, after owning it since late in 2008. This investment turned out fine, well exceeding my own expected hurdle rate.

This latest period of market volatility has provided a compelling merger arbitrage opportunity. These kind of special situations don't come around too often and can provide an above average rate of return over a short period of time. I've taken a position in the Canadian oil and gas company, Nexen ( NXY.TO ) @ $23.77. As you probably know, CNOOC ( Chinese state-owned oil company ), has offered $27.50/per share in cash (USD), to buy NXY. The big question making the headlines lately, is whether the government will approve the deal. All indications are that the deal will be approved. The Canadian government has only blocked 3 deals out of 27 in the last 30 years. The decision will be made this December.

Also, I've recently started a small position in a very large American company, that one could call the "ultimate fallen angel". This company is currently waaay out of favour, but has a bright future, now that many of it's problems ( not all ) are put behind them. There's little downside in this company over the long term, but the investing public has been slow to warm-up to the story. That won't always be the case. I'll welcome lower prices over the next little while as I build-out this position. I will provide more detail on this good business - soon.

One Bottom - One Top - The Housing Market

Regular readers will know that I normally write about specific value investing ideas that I'm working on, or have a position in. This post will be about neither. It's about housing, on both sides of the border.



It appears the bottom is in for the U.S. real estate market. Prices are rising, sales of new homes are rising and consumer confidence is improving. Combined with an improving domestic economy ( some would argue the U.S. is circling the drain ) and a liquid mortgage market, housing is back - but in the slow lane. For those that think the U.S. economy is in turmoil, just have a look around. Housing is turning, railroad stocks are at 52 week highs, cardboard companies are passing along price increases ( which they can't do in a recession ) and consumer stocks like Whirlpool are also at 52 week highs. The market thinks the economy is slow but moving in the right direction. I've been tracking the U.S. home building stocks for sometime - but due to naval gazing, I missed jumping in at the maximum point of pessimism ( last fall ). The home builders ( see below, second chart ) like Toll Brothers, DR Horton, Lennar have doubled in the past year. Investors have priced in the housing market's recovery. You can still benefit from the recovery in U.S. housing by owning companies like Mohawk ( carpet ), USG ( drywall ), Berkshire Hathaway ( carpet, mobile homes, bricks and paint ) or Bank of America ( mortgages ).





On the other side of ledger is the Canadian housing market. I've been "pounding the table" for the last year or so, suggesting that the bubble is ready to burst ( ok, maybe just deflate a little ). It appears that is starting to happen. Recent reports indicate prices falling 2% across Canada and up to 12% in pricier markets like Vancouver. There's likely more downside. I'm willing to bet 10-15%, then a long period of flattish prices. Why? Well, Canadian home prices have risen at well above average rates for the last decade. The well regarded Yale economist Robert Shiller ( yes the same Shiller from the Case Shiller home index ) concluded that home prices roughly tracked the inflation rate over the past 100 years. The chart below shows just how prices have disconnected from the longer term inflation rate over the past 10 years.



Other indicators backup Shiller's argument. House prices as measured by a multiple of household income have also risen well above the "norm". For example, in Vancouver, house prices are currently almost 10X household income (current national average: 5X eek.), compared to a long term average of 2.70-3.0X. Consequently, homeowners have record debt levels and a negative savings rate. When interest rate rise, highly levered homeowners will feel additional pain. If you are in the market for a home, it would be prudent to not to exceed the 3.0X of household income and put as much cash down as possible. Equity is a cushion that you don't appreciate until you need it, and it prevents you from being forced to do something at the precise moment you don't want to ( sell under pressure ). There are opportunities in this housing market. Some Canadian financials have underperformed as the market has punished them ( more than necessary, creating opportunity ) for their exposure to the housing market. Companies like Genworth MI ( MIC.TO) a Canadian mortgage insurer and Home Capital ( HCG.TO ) an alternative mortgage lender both have good management and significant market share in their respective areas of the mortgage world. I don't own them - yet.



Remember: the word mortgage is French for " agreement until death ".



Disclosure: I own Berkshire Hathaway, Bank of America and USG shares.

The New Name

On June 2nd I wrote here about a new holding that I've been adding to my portfolio. Well, the winner is Oracle Corporation (ORCL), a large cap U.S. based technology company. Large cap tech stocks have been out of favour for some time, even though their fundamentals have held up reasonably well during this sluggish economic recovery. Without boring you - I hope - I'll touch on a few key points about ORCL.

Oracle is a giant in database software business. They control roughly 60% of the global dbase market.
What's great about Oracle and others in the business ( like IBM and SAP ) is that when you purchase their database, you generally purchase a long-term service contract with the product. So, as a customer you are tied to their products for the long-pull. As you use their database, and build reams of very important data, you are less likely to want to switch database providers and risk data loss. A major data loss could be devastating to your business. So - Oracle's customers are sticky - that's good. Some 43% of ORCL's revenue comes from software licence updates and product support - all high margin business.

ORCL also sells some hardware (server and storage products), which is generally a low margin commodity business. They are scaling down this side of the business. They are also in the cloud computing business, which is a huge growth area going forward. SaaS, software-as-a-service, is the next platform for large companies.

Here's just a few numbers to outline why ORCL is a good business;

10yr revenue growth 12.5%
10yr earnings growth 18%

Net profit margins ( 5 yr avg ) 31.6%
Return on equity ( 5yr avg ) 28%
Cash per share $3.50/share ( net of debt)
Returning cash to shareholders: dividend: 0.24/share, share buy backs.
CEO: Larry Ellison owns 22.4% of the company - remember this is a $150 Billion company, his eye is on the ball - except for his recent purchase of a whole Hawaiian Island - hmmmm. If he buys England, I will really worry.

Overall, ORCL has a great track record with a good future, with great management, which early in June (@ $26.50), was all available for under 10X earnings. ORCL is conservatively worth $40-$45.





ORCL has moved up sharply, so don't run out and just buy ORCL. For a margin of safety ORCL is a buy in the high 20's.

Fairfax

Prem Watsa, the CEO of Fairfax Financial (FFH) has been in the news a lot lately, regarding his continued purchasing of RIM shares. Fairfax now owns around 10% of RIM. Watsa is also on the board @ RIM. Watsa reminded the the market not to focus too much on the purchase as it's only a $190 million commitment. A drop in the bucket, when compared to Fairfax's $4 Billion+ common stock portfolio. Not to mention the $17 Billion, cash and bond holdings that FFH has.

I recently added to FFH @ 374/share. FFH has traded down this year from a high of $440. FFH's recent quarter was good, helped by solid insurance operations. Premium prices ( the price you pay for insurance coverage ) appear to firming up, a nice change from the soft market of the last several years.
Watsa has a lot of dry powder to deploy when opportunities arise. We won't know when that will be, but being hitched to his wagon has proved to be prudent. FFH, has also proved to perform well in down markets, making it a good hedge to my portfolio should the markets "tank". You might be wondering why I'd invest in a company where they have more cash than ideas (this will be old news for WatsaWatchers) and the guy who runs it, is buying stock in companies that are in trouble. Well, if you can take the ups and downs, and look out a few years, here's why: Watsa's record of value creation is truly extraordinary. The growth in book value ( a proxy for the true value of the company) at FFH is detailed below:


As of December 31, 2011
                                                                     5Yr        10Yr       15Yr       20Yr      Since Inception
compounded annual growth in book value                            19.4%     12.0%    12.4%     16.1%    23.5%
source: 2011 Chairman's Letter

So, I'll be watching the developments at RIM, but at the end of the day, if the RIM investment doesn't work, FFH will still do fine. For the record, I don't own a BlackBerry.

Mo Magna

I've added to Magna (MG.TO) yet again, during this market malaise. I added yesterday @ 38.50.
Please buy a car.

Andre

Nibbling At A New Name

This past Friday, I started a small opening position in a large cap - technology company. This market weakness is providing opportunity to pick away at my wish list and put some capital to work. This company is well known, extremely well financed, has a good track record and shareholder friendly management. It's a 60 cent dollar - and that dollar will grow over time. The downside is limited. I expect this company will become a 5%-7% position, but I'll buy slowly. This period of market weakness may not be over. I haven't heard the big flush yet, a day when people throw in the towel. There may be some event, like a bank default ( Europe not U.S. ), a country leaving the Euro or a log jam in Congress over the debt ceiling, that will cause people to turn really pessimistic. That will be the day to buy - and buy big.

I will provide some more detail in the future on my new holding - as I build out my position.
In the meantime - you can be sure that I'm not buying Facebook and Rim.

Mr. Market Is Cranky

Mr. Market is depressed again. Prices are down, the bad news flow is up. Today, I added to my position in Magna International @ 41.55. You can read more about Magna here

What Happened?

I returned from China on Friday. Our trip went well. It was very interesting get my feet on the ground in China, to observe the current state of the economy (not just in Beijing - but in secondary cities). Many pundents have proclaimed that China's economy is going to have a "hard landing". Well, I'm not sure about that. What I can tell you is that China's economy has definitely slowed. The pace of building is much less than 1 year ago. In Xian, we saw nearly 100 ( not a typo ) apartment buildings that were half completed, and had no sign of recent construction activity. There were some buildings that were completed but seemed only partly occupied. The pace of infrastructure building was also subdued as compared to a year ago. The central government has recently asked local governments to submit infrastructure projects for fast track approval. Policy makers have also lowered interest rates to spur demand. China's current benchmark interest rate is around 6.5%. All that being said, after two weeks of observation, I think real estate prices have further to fall ( they've been falling for 4 months ) but the underlying economy is still fairly brisk. I'd expect commodities to rally a little over the next 6 months, as demand perks up in China. But don't run out and load up on commodities, they are simply going from expensive to more expensive ( oil not included ).

What happened while I was gone? The S&P is down 8% from the May 1st highs. That's a full blown correction, that, we needed. Also, there were several "blow-ups" over the past 3 weeks, that whacked several companies, taking them way down from April//May highs. These blow-ups could provide some buying opportunities -  subject to further research.

JP Morgan - down 20+% from $46 to $34 on their $2 billion "trading loss"
JC Penney - down 35+% from $42 to $26 on a very bad quarterly earnings report.
Cisco - down 20+% from $21 to $16 on a soft quarter ( and soft outlook )
Lowe's - down 20+% from $32 to $25 on soft quarter and some market share loss to Home Depot

These are very large, well known, companies that collectively have had $20+ billion of market cap wiped out. It's clear the market is jittery of any company that doesn't report stellar results. The market is not willing to look-out over the valley. This kind of market environment(it's the volatility that's good, not the price of the market - it's still pricey) is a value investors dream. Many of these companies will continue to prosper over the long-run and these set-backs shouldn't bother investors with a long-term orientation.

Bank stocks have also come down during this correction. I've added to BAC, yesterday, at $6.85.
It's not a bad time to put new money to work, but at a measured pace - this sell-off could continue for a while.


Disclosure: I own Cisco and Bank of America (BAC)

Heading East....Way East

I'll be heading to China today for 2 weeks on an important personal trip. You can follow our travels here if you're interested. In the meantime, with markets at close to all time highs, I won't be watching the daily ups and downs very closely from Xian, Shaanxi, PRC. I'm waiting for lower prices to add new money to the markets. I have added a little to BAC over the past 2 weeks, but overall, I'm a net seller (raising cash). However, on this trip, I'll pay close attention to what's happening in China. There is a lot of talk of a hard landing ( in an economic sense, and hopefully not my B-777's landing in Peking ) in China. I hope to visit some condo developer sales offices, as I did on my last trip, to get a sense of the status of the "property bubble". You will be the first to know.

U.S. Banks Improving

Despite all of the negative news on the U.S. banks over the past year, they continue to post good numbers.
This past week J.P Morgan (JPM) and Wells Fargo (WFC) both reported quarterly results. While I don't take quarterly results too seriously, it's always a good read to see what's happening in the business and it's industry. I'll focus on WFC since it's a portfolio holding. WFC reported a record quarter, with net income totalling $4.2 billion, on $21.6 billion in revenue. That's a 14% and 20% jump, respectively, from the previous quarter (annualized #'s). Wells is firmly back in growth mode. I won't bore you with all the nitty gritty of the numbers, but the key take-aways are:

        * improved revenue and income growth, thanks to Wachovia subsidiary taking market share
        * improved quality of loan portfolio, net charge-offs fell to 1.25% from 1.73% a year ago
        * improved tier 1 capital to 7.81 ( a measure of health for banks, under new Basel III rules )
        * BIG dividend raise (83%) to $0.22/share/quarter. $0.88/share/year. Now yielding >2.5%
        * continued reserve releases ( money set aside to cover bad loans-released back into earnings)

With this solid performance, combined with management's comfortable outlook, it's clear the U.S. economy is getting better - not worse. While WFC is not the cheapest bank out there, it is arguably one of the best. Wells deserves a premium, which will happen over time. WFC is good value at <$30. As I have noted before, the market has come quite far since the lows of last fall and is in need of a breather. It's a good time to have cash ready to deploy at lower prices - which may come sooner than you think.

In case you are wondering, here's a ranking of "cheapness" of the banks in my portfolio. The higher the rank - the cheaper the company - the more bang for your buck.

      1st place -  Bank of America
      2nd place - Citigroup
      3rd place - Wells Fargo

You'll notice that there are no Canadian banks listed. The "big 6"  banks in Canada are fine institutions, but they are not cheap.

 

The Bond Market Knows Best

There's an old saying in the markets that the bond market "knows" more and has more wisdom then the stock market. Well, something amazing occurred this week in the bond market - a run in bond yields. Say what? If you have a hobby more exciting than mine - than you might find this as boring as watching paint dry. But here we go... The yield on the U.S. 10 year Treasury Note ( 10yr Bond ) jumped over 15% from around 2.00% to 2.30% (so bond prices fell).  While that might not seem like much, in the big/deep world of bonds (32 trillion worth, in the US alone), that's a big move. It's clear that bond investors are finally anticipating growth ( and inflation ) and don't want to hold longer dated bonds. It's unclear whether this is the end of the 30 bond bull market, but I think it might be.

So what does this means for a bottom-up stock picker? Well, it means three things:
1) the bond market is telling us that the world is not coming to an end - the economy is getting better and inflation in coming. Inflation doesn't always have to be bad - owning stocks can protect you from inflation.
2) the bottom might be in on depressed life insurance stocks. You'll see in the chart below how the insurers (the chart shows Manulife, Sunlife and Great-West Life)  ran-up this week, as much as 15%, as 10 year bond yields soared. The insurers, invest the premiums you pay them in bonds, so they can generate income to pay-out claims and turn a profit. With yields so low over the last few years, the insurers have been suffering. With the pick-up in yields, the insurers will roll over capital into higher yielding bonds which means better earnings going forward. Just a 1% increase in yields can generate an additional $1 billion a year for Manulife. There is a positive correlation between bond yields and the stock market indices. So, markets could continue higher if yields continue higher. Yikes!!!
3) stay away from longer dated bonds. If you have to own bonds then you'll want to stay with maturities of less then 5 years - and hold them to maturity.



With all this talk of cheap insurers, I did sell some ( just a little) MFC this week. Say what??? It should be noted, that this transaction was a portfolio decision to raise some cash. It is not a call on the valuation or quality of MFC. I will continue to hold my remaining position. MFC is probably worth around $20/share.

If you are a Manulife customer - thanks for your business. If you aren't a customer - you should be become one.

Raising Cash

The market has been on quite a tear since the November 2011. The market has cycled from pessimism to optimism. While there is good reason for the markets to trade higher, like an improving economy and declining unemployment, I'll proceed with caution. Overall, the prices for most common stocks are no longer dirt cheap. Remember, the markets have more than doubled off the march 9th, 2009 bottom of 676 on the S&P500. Interest rates are at all-time low's and we (North American consumers and businesses) are still chugging (when we should be sipping)  from the low-interest-rate punch bowl. Who would of thought we'd see 5 year fixed money at 2.99%? I'm firmly in the camp that says it's time to raise rates ( I can hear the collective - gasp!!!). So I'm raising cash - selling into the strength. In the meantime, I'll continue to look for value opportunities that may arise. On that note, I have started a position in a large oil company, that's currently way out of favour (read cheap), but still has good prospects going forward, and plenty of oil/gas in the ground.

On another note, this week 19 major U.S. banks were stress tested by the Federal Reserve. I fully expect most of the super-majors ( C, BAC, WFC, USB, JPM, GS) to pass. Some, may come closer to the line that I'd like, but remember, these are tests based on hypothetical severe economic conditions. All eyes will be on BAC, as it's my largest U.S. bank holding and >10% position in my portfolios. With these tests complete, that will likely pave the way for increased dividends and share buy-backs. The uncertainty (warranted and unwarranted) around many of these banks has started to lift and their stock prices will react accordingly over time. Several of these majors are still cheap. But if your adding new money to the banks, then wait for a pull back.

 

In case you missed it: I'm long BAC, C, WFC