Thursday, October 18, 2012

Why I Own Intel (INTC)

Intel (INTC) is the most profitable chip maker in the world. I bought Intel last year when it hit $20 a share. Intel dominates the x86 processor market with a 80% plus market share. x86 processors go on all PCs running Windows and Macs. So, these processors are everywhere, in the majority of homes and offices in the world.

Intel has established a wide moat around its business. And this is not typical for technology companies. It has a wide moat because of a number of barriers to entry. This technology has been refined for over 30 years and key aspects are patent protected, only AMD and Intel have the patent rights. Intel has unmatched name recognition and marketing clout. And most of all, Intel is the leader in chip manufacturing technology. For these reasons, we have seen the x86 architecture and Intel thrive for 30 years. Very few other technology companies have had that much staying power.

But Intel is a very cheap stock right now because of a perception that the chip processors of the future will be mobile, which are smaller and less power hungry than Intel's chips. The best selling design right now is by ARM. But ARM's product is an Intellectual Property (IP); i.e., code. ARM gets royalty from this code inside billions of mobile phones and tablets. But code, especially less complex code, can easily be copied or replaced. So there is no guarantee that ARM processors or some derivation will be in our mobile devices 10 years from now. And Intel has mobile offerings that are getting more power efficient. It is conceivable to me that, given enough time, Intel's x86 code can evolve to be as efficient as ARM.

But Intel's biggest technological advantage lies in Intel's fabrication (manufacturing) capabilities. They have their own exclusive in-house fabrication that is the most advanced in the world. Their fabrication is one full generation ahead of the rest. Intel's competitors using ARM and Advanced Micro Devices (AMD) all must use third party fabs. Fabrication of the coming generation has simply gotten so expensive that only Intel can do it on its own. Intel being one generation ahead means their chips have transistors - transistors are the most basic building blocks of a processor - that are cheaper, less power hungry and faster.

The fab advantage is most evident on the other extreme: in server processors. Intel has a 90% plus market share. AMD, Intel's only competitor in servers, is trading at 3 year lows due to poor sales and execution. This removes pressure from Intel to reduce server margins, which are the biggest in the processor space.

As for the Intel financials, they are similar to Cisco and Microsoft. Intel earns $2.40 a share. Its free cash flow is about $2.00 a share. Its dividends are $0.90 a share per year. All this on a stock price of less than $22! Their balance sheet has plenty of cash and they are buying back stock.

The recent headline news is depressing Intel share price because 2012 is clearly a bad year for computer sales. And a bad year simply means an earnings drop of less than 10%. But I don't think of a short term problem as a big deal. I've read some analysts project a long-term 6-8% growth. That's fine by me. Intel is a net-net company. This means their financial assets exceed all their debt. Intel has equity of $10 a share. This is the value of all their fixed assets and intangibles. Intel can easily issue bonds at interest rates below 3% but buyback Intel shares that yield 10%. Intel has bought back significant stock and continues to do so. I hope it does so before the stock gets much higher than $20.

Disclosure: I also own Cisco and Microsoft. I also own a negligible amount of AMD.

Wednesday, October 10, 2012

Sins of Omission (Part 1)

Many successful investors analyze their past mistakes as well as their successes. In fact, they probably believe their mistakes teaches them more than their successes. Any investor will vividly remember his worst stock purchases, because the loss from the stock is real. These are the sins of commission. But an investor may not vividly remember the situations where he found a good stock but didn't buy. In this case the opportunity cost is really equally high. These are the sins of omission. I am going discuss several of my sins of omission.

Fairfax Holdings (FFH)

Fairfax Holdings (FFH) is a Canadian property and casualty insurance company. It operates similarly to Berkshire Hathaway, only smaller. It is run by an India-Canadian, Prem Wasta. Some have dubbed him the Warren Buffett of the north. One difference between FFH and Berkshire, other than size, is their volatility. Berkshire is a company with much more consistent gains than FFH. Prem Watsa joined Fairfax in 1985. It had a great run before hitting a bad patch in the early 2000's, which is when I bought in. I call this FFH a sin of omission because I sold it shortly after buying in, and missed out on the subsequent runup.

In 2004 when I bought in, FFH was just listed on the NYSE and it was receiving a lot of bad press. Many argued that a number of shorts were attacking FFH, and was responsible for much of the bad press. Shorts are people who borrow shares and sell them with the intention of buying them back when the share drops. They have a vested interest in seeing the stocks drop. I read the bad news on the message boards. There was primarily a negative spin on every piece of news. And the worst part was that FFH lost money in 2004 and needed a $300Mil transfusion through a private placement. I knew that there was a big short interest at the time but didn't know who to believe. The stock went up a bit and dropped to my buying price of $150 in late 2005. I sold then.

I was in the habit of reading financial reports but I wasn't as wise then. In their, 2004 shareholder letter, Watsa wrote:

Investment performance in 2004 was hampered by our very conservative position which included not reaching for yield, maintaining large cash positions and hedging a significant portion of our common stock holdings against a decline in the equity markets. The $81.5 million unrealized loss in our hedges flowed through our income statement as realized losses.

In 2004, FFH lost $17Mil, so all of it was due to an unrealized loss based on a bearish bet on a bullish stockmarket. I think I read their financial reports but probably didn't recognize the significance of that.

An in the 2005 annual report dated April 2006, Watsa gave an ominous warning:

.... we are very wary of the risks prevalent in the U.S. As we have mentioned ad nauseam, the risks in the U.S. are many and varied. They emanate from the fact that we have had the longest economic recovery with the shortest recession in living memory. Animal spirits are alive and well and downside risks have long been forgotten. Having lived through the telecom bubble recently and the oil bubble in the late 1970s and early 1980s (and perhaps again today), we see all the signs of a bubble in the housing market currently.

Two years later, the world learned that Watsa was right on. FFH profited handsomely in 2006 and onwards, in a lot due to credit default swaps (bets) against the US stockmarket. Today it is $380 / shr.

The following table shows the FFH annualized appreciation of its stock and book value over the years. After this experience, I am more grounded in what I believe. I am much more subjective when I choose who to listen to.

Since I sold
Dec 2005 — Oct 2012
Since Inception
1985 — Dec 2011
FFH Book Value23.5 %
FFH Stock Price14.1% 20.7%
S&P 500 0.1 % 7.9 %

DR Horton (DHI)

DR Horton (DHI) is my second sin of omission. DHI is the largest homebuilder in the US. Like all homebuilders it was very profitable in the early to mid 2000s. By 2008, the housing was a disaster beginning to unfold. But I thought this is a good time to take advantage. I bought DR Horton after it was already down 50% from its peak in early 2007. By the time the market really crashed in 2008-2009 DR Horton was down to $5. But still, this was much better than some banks, AIG, Fannie Mae and Freddie Mac, which effectively went to zero. But by 2011, DHI was hovering above $10 for 3 years. I threw in the towel and sold it at $12 in 2011. Now, with the beginning of a housing recovery it is over $20.

After these two investments, I have learned to pay more attention to stocks that I consider selling. It is true when they say selling is harder than buying.

Tuesday, October 2, 2012

Why I Own SHLD

I first bought Sears Holdings (SHLD) in fall of 2007 at around $135 (it is $57 today). Back then the financial crisis was just beginning to reveal itself. That summer, we heard the first tremors of the earthquake from the large banks, but by the fall of that year the S&P 500 was actually at new highs. I, like many others, did not heed the warning and pull out. Instead I was looking for new ideas for investment growth. I knew the market was priced quite rich. So, I had to look in harder for companies with good earnings, cash flow or book value. Without realizing it, I was looking at more risky companies which had good numbers on paper. That was one thing I learned from the financial crisis: don't force yourself to have some investment target, if the market doesn't offer you any bargains just sit out.

Anyway, back to SHLD, I opened my position in 2007 mainly because of a very bullish Barron's article, which you can find here. The article actually doesn't add much more than what is known about the company. SHLD is a retailer run by Eddie Lampert. Its main holdings are Kmart and Sears, two underperforming retail chains with storied histories. Lampert is someone who avoids the limelight. He does not give guidance. He does not give interviews. But he does give shareholders his thoughts in his quarterly letters to shareholders.

Ever since he took over Kmart during bankruptcy in 2002, Lampert has been slashing investments in the stores while using its cash flow to buy back shares. This strategy has allowed him to increase his stake in the company. Now he owns 64% from less than 50% before (Kmart took over Sears in 2004). The financial performance is another story. The annual revenue has declined from $50Bil to closer to $40Bil now. SHLD is trading at around 1.2x book value. The market cap of $6Bil is less than the inventory on the books. SHLD has been moderately profitable in past years but that may end this year. The market wonders how this can continue. While stores like Walmart and Target are investing in stores that make shoppers experiences pleasant, SHLD is minimizing spending.

The one ace in SHLD is the real estate value of their 2700 stores in USA and Canada with 250Mil square feet of space. Many articles have touted this, including the 2007 Barron's article. The market speculated that Lampert planned to monatize the real estate when he first merged Sears and Kmart. But that did not play out. Instead Lampert first tried various retail concepts, Sears Essentials, Sears Outlets, novel store formats, etc. But they all performed mediocre at best. And then the 2007 recession hit. Last year, sales lagged to the point where Lampert agreed to sell 11 stores for $270Mil and also close another 120 stores.

Lampert clearly wanted to make retailing work, but on his terms. And his experiments met with disappointment, he then tried to unlock the value of his holdings by spinoffs and store sales.

I think Lampert has done a decent job of being a capitalist. Although investors who ride with Sears Holdings, like myself, may have been disappointed, he does what he needs to do to further his wealth. 1/3 of the company's float is short. That means a large segment of the the market is counting on Sears to go bankrupt. I do not for a minute believe that will happen. I believe Lampert's share of Sears will appreciate. But I also believe Lampert will allow the Sears brand to keep sliding. Meanwhile, all of us shareholders have no say in Sears, except Lampert, and I am very unclear as to what he will do next. His letters to shareholders do indicate that he is a committed retailer but gives little hint as to a long term exit strategy. I don't believe he will cheat us minority shareholders, but SHLD is too unpredictable for my taste. So over the years I have gradually sold off all my shares. I have about broken even now. And I only keep my remaining shares to avoid a tax gain.

Disclosure: As well as owning SHLD, I have in the past received shares of OSH in their spinoff. I have sold those. I also recently received SHOSR shares — SHOSR are rights to purchase the future spinoff of some Sears stores under the ticker SHOS — [update] I found out I couldn't trade SHOSR anymore so I did the next best thing, I exercised my right to buy the SHOS shares at $15 and I intend to sell SHOS as soon as I receive them.