Thursday, November 29, 2012

A Tale of Two Retailers: PETM and SHLD

Petsmart (PETM) recently announced very impressive earnings. The company earned $0.75 a share vs $0.50 the same quarter a year ago. When a company earnings rises by 50%, it earns a high P/E multiple. The expected P/E for the current year is 20. The company's revenue rose 9%.

PETM is the country's largest pet retailer; the company has 1,200 stores. It is unclear to me how much more it can expand. On top of that, I heard Jim Cramer of CNBC has been touting PETM all year. Jim Cramer is as big a contrarian indicator as I have seen. When he says buy, I hear sell! I really want to unload PETM but now that it is up 2.5x, but I am reluctant because of capital gains.

While PETM is flying high, Sears Holdings (SHLD) is going in the opposite direction. The company's sales declined yet further in the most recent quarter. Comparable store sales was down 1.6% for Sears and 4.8% for Kmart. The company lost money yet again but it does not have liquidity problems. I trust Eddie Lampert to keep the company afloat and extract the most value. They have recently spun off Sears Hometown and Outlet and then Sears Canada in two transactions. Despite Eddie Lampert saying repeatedly that he didn't invest in Sears to sell its real estate, he is selling the company piece by piece to unlock value. When just the core Sears is leftover he just may shutter the best locations and sell their real estate. That's fine by me, but many would feel sad to see the decline of an iconic retailer.

Disclosure: I am considering selling some PETM and my Sears Canada position but I haven't made up my mind.

Tuesday, November 27, 2012

Why I Own CVX

Chevron (CVX) is the second largest oil company in the US. They are an integrated oil company which means that they do exploration and extraction, as well as refinement and final sale. The majority of CVX's profits comes from extraction.

I have owned CVX for 9 years and it was been a great investment. I admit I was lucky to start buying it in 2003 when oil prices were coming off historical inflation adjusted lows. Then starting at 2004 oil prices went from less than $30 a barrel to the $80-90 range today. Naturally with a three-fold jump in crude prices come record profits for oil companies. The record oil prices allowed Exxon, the largest oil company, to make record quarterly profits for any US company. Chevron also did extremely well. I didn't expect to make big gains when I first bought them, I simply wanted to have exposure to a large segment of the world economy.

We all know that our world is too dependent on oil and we need to wean ourselves off oil. But the numbers show that we are as dependent as ever. Since the oil crises of the early 80's oil consumption is steady at about 4.5 barrels per person. At current crude prices, that means we spend about $2.5 trillion dollars on crude in a year. I estimate the end product of crude sold is twice that which means we spend $5 trillion dollars a year on oil. Chevron earns $25 billion a year, which is only 0.5% of the world's oil consumption. Furthermore, CVX's business is split half and half between oil and gas. For this reason I feel now is a great time to invest in non-renewable energy. It is a huge market and investors don't give it enough credit I believe because they have this perception that oil will be phased out.

Pessimists out there emphasize that we are at the point of maximum oil consumption due to limited supply. This theory is dubbed "peak oil". I don't really have an opinion on peak oil, but I do know that we are finding oil everyday. It is getting more and more costly, but we are finding it. And at current prices, a lot of new sources of oil will become viable. Maybe we will reach peak oil in 2020, maybe 2030. But right now CVX has a P/E of 9 and it has more than 10 years worth of reserves of oil and natural gas. By 2020 or 2030 I would have extracted plenty of value from my initial investment even if peak oil happens.

My CVX investment has gone up 3x in the last 9 years. In addition to that is 3% dividends, for a total of about 17% annual return. I picked Chevron after reading a Morningstar recommendation, which said that CVX is an overlooked but solid oil company. Of course I am relieved today that I chose CVX and not BP!

I don't worry much about CVX and I won't sell it any time soon. It is something I put in a tax sheltered account and forget about. As I have been actively investing for more than ten years, I have seen cycles. The tough part of investing is the long time horizon, and to experience a true cycle can take a decade or more. Few are ready to give investing that much time for results. I think that is the main reason for the volatility and the poor results of the average retail investor. Oil prices are at a cyclical high, and I caught the cycle at a great time. Oil prices could continue going up for a decade or more. But after that CVX probably will not be able to get such profits and oil prices. Similarly I feel that big out-of-favour techs like Cisco, Intel and Microsoft are experiencing long period of undervaluation from the early 2000's and that's why I am sticking by these tech stocks. Hopefully I am right — about tech — and eventually the cycle will reverse itself.

Thursday, November 22, 2012

Quarterly Update: WLP, Cisco and JOE

Wellpoint (WLP) announced they earned $2.15 per share, including investment gains, versus $1.90 in the same quarter last year. They lost 2% membership in the last quarter. And WLP has a high medical expense ratio at 85%. All this needs to improve under the yet to be named new CEO.

WLP is my second largest holding and I wouldn't start selling any shares until it goes over $70. And then I would only sell to have a smaller exposure, not because I am trading the stock or that I don't believe in it.

Cisco announced they earned $0.39 per share. That is an 18% increase over the same quarter last year. Their overall revenue increased 6%. Cisco paid $0.14 in dividends. At the moment before the announcement the stock traded at $16.80. But this news was definite surprise as the stock has since jumped 10%. I have had Cisco for over a decade. I have recently wanted to close this position, but as I mentioned in a previous post, the valuation always draws me back. I have bought the stock many times when it was very undervalued, and then sold after a 10-20% gain. The idea is to reduce the exposure when the stock goes up, until zero if the share price is high enough. I don't want Cisco to be a long term investment anymore because I generally do not like technology. Technology is just too unpredictable. I cannot do a basic analysis of the financials and make a high probability bet on a good return. But Cisco right now is simply too undervalued. They have over $10 per share in cash and short term investments. They are increasing revenues and earnings.

As far as I can tell, Cisco is so undervalued because it is no longer in vogue. Their story is they sell the backbone of the internet to the world. They have done this very well for the last decade. But the stock has declined to 1/4 of its high, because that story is old. The market wants to hear about things like personal devices, the cloud and emerging technologies. I want Cisco to chase those only if they can give back a good return on investment. Short of that, I prefer Cisco to buy back shares and keep dominating the backbone. I don't think the market gives Cisco enough credit for still being in the same position as it did during it's heyday; i.e., owning 3/4 of the router market. But one day, something will happen that will make the market perceive that Cisco is hot again, something like a sea change in opinion like with cigarette companies in the last 10 years.

St. Joe (JOE) announced quarterly earnings that was very well received by the market. The company simply eked out a small profit and that was enough. I read they sold some non-strategic land for $5655 per acre. That gives me an idea of the prices they would fetch for their lower end land right now. Given that they have over 500,000 acres, their book value appears to be more than the market cap of about $2 billion. As I said in a previous article, JOE is a simple play on land for me. I bet Berkowitz, who is chairman of the board, can stem the drop in the stock price and turn the company around. So far it is working.

Saturday, November 17, 2012

AIG and McRae Industries Quarterly Update

AIG and McRae Industries are two recent purchases (meaning within the last half year). These are my two recent new ideas so I am watching them closely to see signs my thesis was correct.

I own AIG because it is a profitable business that trades at half of book value. In the 3rd quarter they earned an after-tax profit of $1.00 per share. The company breaks down the company into four segments: life insurance, property and casualty insurance (P&C), aircraft leasing and others (including mortgage related insurance). The good news is that all four are profitable. The only worrying sign to me the 105% combined ratio of the P&C segment. Combined ratio is the ratio of total insurance payouts and costs divided by the total insurance premium. A combined ratio over 100% does not necessarily imply an loss in the business however, because the business can eke out a profit through investment gains on the premiums held. In the coming quarters, we will also have to see the effects of Hurricane Sandy, but right now AIG cannot predict its affects.

But overall I am very pleased with the quarter and I am surprised that the stock price dropped more than 10% since the earnings announcement. Of course great investors all advise others to tune out the short term noise. So I try to ignore the crowd and remind myself that AIG has $69 of equity per share yet trades at $32. I may add to this position if AIG drops more.

McRae Industries is one of my two small cap holdings. Its market cap is a little over $50mil.

McRea makes high quality work/western boots and military boots. The company just finished its 4th quarter this summer and announced it earned $2.27 per diluted share for the year, versus $1.84 the previous year. Revenue was flat, so it indicates the company is able to increase margins. The stock trades on pink sheets recently at around $17. Its book value is about $20.50. And its net-net value is about equal to the market value. With such a strong balance sheet and a P/E of 7.5, what is there not to like?

I only found this stock after I started this blog and I documented it in this entry. So my entire history with it has been and will be documented on this blog. We shall see how it goes.

Saturday, November 10, 2012

SEB 3rd Quarter Update

This blog has been up three months. And I am still here writing! Three months is also the length of a quarter. I have relatively small amount of holdings, so even with a full-time job I have time to focus on my larger holdings.

Seaboard Corp. (SEB) is my largest holding and last week they announced earnings. It was surprisingly good considering the economic climate. As I wrote in my first SEB post, SEB is a conglomerate with business lines related to commodities. I own SEB because I believe it has good management and the management's interests are aligned with those of long-term shareholders.

The market feels that the world is in a slowdown mode and cyclical sectors such as commodities will lose revenue. To make things worse, we had a record drought in the US which raised corn prices. Corn is the largest component of pork feed. And pork is the largest SEB segment. All this meant I was expecting a bad quarter, but instead they managed to earn $61.92 per share. At this rate they would earn $250 for the year. That means they would have earned over $250 in each of the past three years, which gives them a average P/E of 9 over that time!

The table below breaks down the results in their various segments. The operating profit is revenue minus cost of sales minus administrative costs. It does not include taxes, interest, etc., nor does it include profits from investments. All amounts are thousands of dollars.

Segment Revenue Op. profit
Pork 413,077 29,863
Commodity Trading and Milling 675,649 16,662
Marine 242,330 13,006
Sugar 69,025 13,615
Power 75,778 18,649
All Other 3,557 93
Total 1,479,416 91,888

The table shows that SEB operates low margin businesses. If management makes some missteps, a segment could lose money. For example, the pork segment lost money in the years around 2008. Now pork profits are stable (quite a relief to me!). The marine segment impressed me because shipping is suffering a slowdown worldwide. In 2011, the power unit sold two power generating plants but has since built new plants and this segment has the best margins in the company. So from the quarterly numbers, I think management has managed well the margins in all segments.

If management can keep up this kind of earnings for several more quarters, I think SEB can break through $3000 for the first time. And don't forget, SEB adds $250 of equity every year.

Sunday, November 4, 2012

On Predictions and Housing

Back at the start of the new millennium, an now-infamous New York Times article asked 10 superinvestors for their one stock pick to hold for the next decade. Now ten years on, this basket of stocks in a equal wasted would have gained over about 35%, versus about -10% for the S&P 500 index. This is cumulative, not annualized. But the period from 2000-2009 was a terrible decade for stocks with two big crashes. On the surface it seemed like the 10 superinvestors did decently. As a group they did what we expect them to do, beat the market with their expert knowledge and skill. However, looking at the list closely. It outperformed the market only because one stock, Henry Schlein, carried the entire basket, rising 600% over the decade. Only one other stock, Waste Management, gained money. The remaining eight lost money. Overall, this basket did beat the market and in theory I would be ahead if I put my money with these experts. But the ten stocks individually tell me a much different story. I believe the experts picked ten easily justifiable stocks. An average reader can't fault them for their choice, they picked the high fliers of their day and they stated the known bull case. Yes the article was unfortunately written at the peak of the dotcom bubble. But the great investors must perform through both good times and bad. The New York Times, as with any other financial outlet, makes money by getting readers to their articles. The momentum view attracts the most readers because it agrees with the most readers. In essence, the media is biased towards the status quo. As are most mutual funds. But a follower of the status quo pays a heavy price. This article is one of my best case in point for contrarian investing. It illustrates the risk of following the consensus or the crowd. One of them, JDS Uniphase, even dropped 99%!

Another example of dubious predictions comes from Barron's yearly forecast. Barron's gathers a dozen or so of the well-known expert investors and ask them for their opinions of the market in the coming year. Each makes a prediction of the S&P 500 index value in one year. Invariably they predict the market will finish up around 8% of where it started. Why 8%? Because that is about the typical return of the stock market. If I was forced to predict the S&P 500 one year from now, I would postulate a probability distribution that centers around 8% also. I know that my prediction has a small chance of being right on. The outcome could be higher or lower that my prediction, but I just don't know which. I do know most likely my prediction is wrong! Benjamin Graham's philosophy is the future is unknowable, therefore do not try to bet on it, instead build a margin of safety for whatever happens.

I used to read the Barron's yearly predictions until I realized it is just a pointless exercise, it's a waste of newsprint.

The future is unknowable, I often remind myself when I invest.

In August I explained in my blog my WLP holding and why despite Obamacare I am bullish on WLP. Several posters called me ignorant, except they didn't use the word ignorant. WLP is depressed (it has a P/E of 8 after all) so the majority sentiment is negative. The prevailing sentiment today is to shun risk for safe havens. Safe havens are US government bonds, gold and high yield stocks. I recently wrote about another holding: Intel. Intel's earnings also yield 10%.

Both Intel and WLP are active buyers of their own stock by issuing debt. Their bonds mostly yield less than 4%, and their earnings yield 10%. So why not pay 4% to get back 10%? This is possible because investors, despite monetary easing by the Fed, are crowding out safe havens. I don't see how this won't end badly. Bond buys are eventually going to suffer zero or negative returns if inflation picks up to the 3-4% range.

I want to be on the other side of this trade. A lot of my investments, like Mircosoft, Wellpoint, Intel, AIG and Sears Holdings are issuing debt and buying back stock at the same time. I also like housing as a way for a small investor to easily do the same thing. Housing can be a dangerous investment, as the world has recently learned. But now, I like US owner occupied housing as a way for a small investor to easily be on the other side of the debt trade. In the US now, housing is roughly at the 2003 nominal price level. But considering real values by factoring inflation, housing is 19% cheaper than in 2003! US homeowner mortgage rates now are about 2.75% and 3.50% for 15 and 30 year terms, respectively. Typical property tax rates are 1% of home value. But US homes interest is tax deductible. So for a typical working person, the cost of borrowing a large amount of money to buy and live in a house is about 3% a year. That includes interest, taxes and insurance minus the effect of tax deductions. That is about the inflation rate. So a homeowner whose house rises with inflation essentially lives in his home for free! The only catch is the risk of a house price drop. Recently I heard Gary Shilling, one of the most bearish voices on housing, predicting houses could drop another 20%. So I take that 20% is a floor on price. In this scenario, I expect houses to then go up after this worse case drop. Many experts like Warren Buffett have said housing is a great investment, but it is impractical for someone with his capital base to take advantage. I can. I believe housing today for the small retail investor can play the role of gold. The major currencies are all in bad shape. That's why gold is at all time highs. But just as these fiat currencies can possibly have a bad fate, so can gold. Gold has no intrinsic value, it's value is so arbitrary, I can see a scenario where the US government gets its act together and holds down the debt. In that scenario I see that gold can drop by half its value. That kind of risk is speculation. Isn't housing a lot better bet?