Tuesday, July 30, 2013

Tachibana Eletech, Pfizer and IEH Corp Report Solid Earnings

Earnings season is in full swing. And my holdings are doing well.

Tachibana Eletech (TSE:8159), a small cap factory automation company reported a great start with 1Q 2013. The company reported EPS of 34 yen, a 60% increase yoy. Revenue increased 10% yoy. I presume that the yen's recent drop contributed to the company's results. Management projects 134.75 yen EPS for the year. Which translates to a PE of 7x! In addition, this is a netnet company (see previous post).

The only disappointment with the company is the paltry 20 yen annual dividend (2% dividend yield).

Pfizer reported Q2 adjusted EPS of $0.56. This adjusted EPS leaves out special items such as the Zoetis share sale. For the year, the company projects adjusted EPS of $2.10 - $2.20 and actual EPS $3.07 - $3.22. This is all not surprising. With shares trading at around $30, Pfizer has a healthy P/E in the low teens (adjusted earnings). Recently, I have sold some shares in my tax-sheltered account. But, I'll leave the rest alone. Pfizer is one of those solid stocks in a great industry that you can just leave alone without worry.

IEH Corp (IEHC) reported full year earnings of $0.40 vs $0.48 a year ago. That is a PE of 7x also. Total revenue for the last two years were almost identical. So, it seems margins slipped a bit. IEHC is also a netnet (see previous post).

IEHC is a tiny company with a market cap of $8M. They only do one thing, electrical connectors, and they do it well.  The company has very few customers. The company sells 31% to the corporate world, 63% to the military. All this is little changed from last year.

Friday, July 26, 2013

Taxes and Investment Returns

Often we think about investment as an abstract exercise: simply maximize return at the cost of reasonable risk. We often don't give enough weight to the three real-life handicaps: fees, inflation and taxes. Fees are the most manageable. With enough time and effort one can control of his own investment decisions and reduce fees to simply a few trades a year. Inflation is a double edge sword. The stock market performs best under mild inflation. But high inflation, say above 3%, is definitely damaging to the market. Inflation is something that is a inherent part of the economy and stock market which we can think of as "necessary evil", and which we have the least control. Taxes, on the other hand can have a big negative impact on returns. And it is in our control. The best way to avoid taxes is by using a tax sheltered retirement account. I know that Canada, USA and Britain all have such plans. These plans do not tax the capital gains or dividends while funds are used for investment. But they may tax during withdrawal. These accounts can take only a limited amount of money however, and so there is still the tax question for the funds that cannot be in a tax shelter.

For non-tax sheltered funds, I can think of 4 ways to mitigate taxes:

  1. move to a place with a cheaper tax rate
  2. reduce one's active income
  3. reduce turnover
  4. harvest losses.

In the USA, the federal government taxes long-term capital gains at 15%. However, the state can impose an additional tax which can be as much as 10%. So an American could choose live in a state with little or no capital gains tax.

Reducing active income to reduce taxes may seem silly, but there is a good reason to do this. If a person has a full time job and invests on the side, he may be able to achieve higher net worth by focusing on investment full time instead. In this manner, he reduces his fees to a certain extent, and also he improve his investment rate of return (ROR). So, even though initially his income is may be lower, it could result in higher net worth over a lifetime because of a higher compounding ROR.

The last two ways are related to turnover. Turnover is defined as a rate that is the proportion of one's portfolio that is sold and bought in a year. If one has a turnover of 25% that means he turns over his entire portfolio once every four years. The less the turnover, the longer funds can compound before the taxman takes it.

Harvesting losses is one argument for diversification. In this method, an investor with a large portfolio has a large number of holdings, which increases the chances of having at least some losing holdings every year. Thus, he can selectively realize the losses to cancel out the gains. The net result is to reduce the turnover rate that will trigger capital gains.

So far this is all straightforward enough. But I haven't found any detailed analysis of the effect of the turnover on the taxes paid. So I decided to do it myself.

To do this, consider a investor with a hypothetical scenario starting with $1000. We'll compare the effective return after taxes after 25 years for different turnovers. First, assume that he maintains a constant 9% rate of return (ROR) and he turns over the entire portfolio every four years. To achieve, he invests the entire portfolio initially, then he "flip" 25% of the portfolio every year. In this discussion, flip means he sells a quarter of the portfolio pays the taxes and reinvests the remainder. In the first year, he flip 25%, in the second and third year he flips the 25% of the portfolio that he didn't flip before. By the fourth year onwards, he flips the portion of the portfolio that have been in the portfolio for exactly four years. In the last year, the investor sells all.

The following table shows the amount that the investor has after 25 years and the after-tax CAGR in parenthesis.
9% pre-tax ROR
Tax Rate 0% 15% 25% 35%
every year 8623 (9.0%) 6315 (7.7%) 5119 (6.8%) 4143 (5.9%)
every 2 years 8623 (9.0%) 6383 (7.7%) 5202 (6.8%) 4225 (5.9%)
every 3 years 8623 (9.0%) 6447 (7.7%) 5281 (6.9%) 4305 (6.0%)
every 4 years 8623 (9.0%) 6507 (7.8%) 5356 (6.9%) 4383 (6.1%)
every 5 years 8623 (9.0%) 6563 (7.8%) 5428 (7.0%) 4458 (6.2%)
every 6 years 8623 (9.0%) 6616 (7.9%) 5496 (7.1%) 4530 (6.2%)
every 7 years 8623 (9.0%) 6666 (7.9%) 5561 (7.1%) 4599 (6.3%)

And the following tables shows the same for 12% and 15% pre-tax ROR.
12% pre-tax ROR
Tax Rate 0% 15% 25% 35%
every year 17000 (12.0%) 11338 (10.2%) 8623 (9.0%) 6538 (7.8%)
every 2 years 17000 (12.0%) 11546 (10.3%) 8861 (9.1%) 6763 (7.9%)
every 3 years 17000 (12.0%) 11740 (10.4%) 9089 (9.2%) 6983 (8.1%)
every 4 years 17000 (12.0%) 11921 (10.4%) 9307 (9.3%) 7196 (8.2%)
every 5 years 17000 (12.0%) 12091 (10.5%) 9514 (9.4%) 7403 (8.3%)
every 6 years 17000 (12.0%) 12248 (10.5%) 9710 (9.5%) 7602 (8.5%)
every 7 years 17000 (12.0%) 12395 (10.6%) 9894 (9.6%) 7793 (8.6%)

15% pre-tax ROR
Tax Rate 0% 15% 25% 35%
every year 32919 (15.0%) 20087 (12.8%) 14371 (11.3%) 10236 (9.8%)
every 2 years 32919 (15.0%) 20638 (12.9%) 14970 (11.4%) 10770 (10.0%)
every 3 years 32919 (15.0%) 21151 (13.0%) 15545 (11.6%) 11297 (10.2%)
every 4 years 32919 (15.0%) 21628 (13.1%) 16094 (11.8%) 11812 (10.4%)
every 5 years 32919 (15.0%) 22070 (13.2%) 16615 (11.9%) 12313 (10.6%)
every 6 years 32919 (15.0%) 22478 (13.3%) 17107 (12.0%) 12797 (10.7%)
every 7 years 32919 (15.0%) 22854 (13.3%) 17570 (12.1%) 13261 (10.9%)

The results do make sense, although it was a bit surprising at first. I expected the effect of turnover to have a greater effect that the tables show. The greatest effect is at high return, high tax rate and high turnover; i.e., at 15% pre-tax ROR at 35% tax rate, the difference between high and low turnover is 10.9%-9.8%=1.1%. But, this leads me to think, hmmm, maybe I shouldn't worry about turnover so much, and focus more on reducing the tax rate by moving?

Anyway, the table is food for thought for now. I am sure I'll refer to it later.

Saturday, July 20, 2013

How Benjamin Graham Actually Invested

I have been intensifying my research on the internet and I have been surprised at the little gems of info you can find by looking hard. I have found the annual reports of the Graham-Newman Corp, hedge fund letters, and even free copies of financial books. From this experience, I have gained valuable insight into the opaque money management world. And I am going to share my conclusions here because I don't think any other bloggers have expressed such views.

Benjamin Graham is the father of value investing. Money managers try to make money using various styles of investing. But a huge subset of these managers use the value investing style.

To me, value investing is buying a equity at below some intrinsic value which is calculated based on current earnings and balance sheet. Many investors try to follow Graham's methods with their own individual touch. For example, Warren Buffet buys top notch firms for good value. However, not everyone can have success being a value investor. I like the following quote by Charlie Munger:

I think the idea that everyone can have wonderful results from stocks is inherently crazy. Nobody expects everyone to succeed at poker."

But some money managers are failing not only because of the law of averages. I see that some hedge fund managers are losing at the value strategy also because they aren't truly following Graham. And I am expounding on that here mainly to remind myself how I can go wrong and to avoid it.

Benjamin Graham ran the Graham-Newman Corporation as a investment partnership between 1936 and 1956. It beat the market on average by 2.5% and it could be a template for hedge fund managers. Benjamin Graham wrote The Intelligent Investor and in it he described how he invested for his firm. His value approach practically assumes the future is unknowable and thus to discount future growth projections. He devotes a chapter to Margin of Safety, which covers outcomes that may go against his investment.

Graham eventually closed his firm because he wanted to move to California and focus on other interests. He wasn't challenged by investing anymore because it became mechanical. That's the holy grail! To beat the market by 2.5% without creative thought required! That should be the investment strategy of any long term investor. Graham and Walter Schloss have done that.

But many of the the value money managers out there do not follow this strategy. One big reason is the incentives. A hedge fund's management fees is based on its performance each year. They typically get 20% of the profits from the previous year. And if the fund has losses the previous year, the manager must recoup the loss before collecting his 20% fee. So the manager is motivated to shoot for the moon, and if he fails at it, especially if the fund blows up, then just close it. And this strategy is especially effective when starting a hedge fund in the middle of a bear market, because a bear market is the easiest time to make money.

An investor cannot make good money long term investing this way because this investing style is too risky. It is almost like gambling. But I think many investors fall into this because they are impatient. Long term investing means waiting over a entire bull and bear market for the above average returns.

As an example I came upon the letters of Seller's Capital, a value hedge fund. Seller's Capital started in 2003 in the middle of a bull market and had tremendous returns, until 2008. Shortly after, the management started talk of winding down the fund. It finally did in 2010. At 2008, it had concentrated positions in Contango and Premier. Contango is a driller of oil and natural gas. The pros for Contango sounds great, it has low cost, rights to great sites, etc. But each trade involves two sides, a buyer and a seller; thus, the trade must involve a pro and a con. So I have heard the pros but what is the con? In hindsight one con appears to be the crash in gas prices due to the proliferation of fracking. Premier also went very wrong in part due to a lawsuit over the rights to the Titanic wreckage. Both these cases teach us what can happen to a portfolio if we do not invest with an adequate a margin of safety.

When I looked closely at Graham's partnership, I was most surprised at how diversified his investments were. His disciple Schloss was even more so. Some have said diversification is a defense against ignorance. But this is not. If one diversifies to the extreme across all sectors and all markets and all types of companies then that's investing to match the market. Graham and Schloss invested in many companies of a peculiar class as an added margin of safety. Graham mostly invested in four types of securities:

  1. Arbitrages: e.g., mergers
  2. Liquidations: e.g., company shutdown
  3. Related hedges: for convertible bonds or preferred shares
  4. Net-nets: as in value of the equity minus intangibles and long term assets; buying companies with net-net less than market cap

Schloss mostly liked #4, which is my favourite, also called picking up cigarette butts. In this manner Graham and Schloss are taking luck out of the equation, and they made money because their investment strategy was right.

This is the Graham style of value investing, which I want to emulate. I am not saying it is the only way to be a value investor, because the notion of value investing is subjective. But this is how the father of value investing did it very successfully.

I also like to read fund letters and the histories of famous investors who made big mistakes, because life is too short to make all the mistakes yourself. The investing world is full of the carcasses hedge funds that have blown up. A good post-mortem can save ourselves the same grief.

As a final note, below is the Graham-Newman Corp Annual letter from 1950. Enjoy.

Wednesday, July 3, 2013

Wellpoint and Obamacare Today

The White House announced today that the Affordable Care Act (aka Obamacare) would extend the deadline for medium to large companies to provide health insurance by one year; from Jan 2014 to Jan 2015.

This is an interesting development but I believe the Obamacare is proceeding mostly as planned. I have followed Obamacare closely because Wellpoint (WLP) is my biggest holding. The stock has run up 50% since the lows of last year. So, this stock is becoming an ever larger portion of my portfolio.

WLP is the managed care organization (MCO) with the largest number of individual subscribers. And Obamacare will have the biggest effect on uninsured individuals. The individual mandate will take affect Jan 1, 2014. As that day approaches, I pay more and more attention to WLP.

Coming in 2014, each state will offer an exchange for individuals to choose health insurance offered by private MCOs like WLP. I think the exchanges are ready for 2014 and will not be delayed like the company mandate. Parts of Obamacare have been in force since 2010, but the individual mandate is the most significant part of Obamacare for WLP because WLP is a large provider of individual insurance. And the mandate was challenged all the way the supreme court, but it survived. The individual mandate means an additional 30 million Americans who otherwise don't have insurance must either now go to an exchange to get one, or pay a penalty tax.

I see two big possible risks to WLP in the coming year. The first is fear of government oversight of the managed care industry which would restrict profits. One part of Obamacare dictates that the portion of premiums that at least 85% of premiums must go back to pay for costs (this is called the medical loss ratio). This law reminds me of the government's taxation of tobacco companies to pay for health problems resulting from smoking. The resulting effect of that law is actually greater market share by the dominate tobacco companies. This part of Obamacare, like other government regulation of businesses, will fatten the big dominant companies (like WLP) at the expense of the smaller ones, because of their greater scale.

The second is the possibility of losses from serving sick individuals who previously don't have health coverage. WLP voluntarily participates in the exchange system because it relies on individual customers for a large portion of its business. This is a known issue and WLP, like all participants, enter exchanges with their eyes wide open. They should be able to judge the risks and begin conservatively. Also, the biggest positive is that the government designed the individual mandate to spread out the risk by forcibly adding a previously uninsured pool of 30 million people.

Getting a Bigger Piece of the Pie

When I invest I like to think contrarian and not overweight headlines. With MCO companies the statistics and information about demographics and costs can be overwhelming. I think the market tends to get too caught up in the numbers while failing to look at the big picture. The bottom line is the US spends 17% of GDP on healthcare. And much of that 17% goes through MCOs. The following illustrates the coverage of all people in the US. As one can see 69% of people are covered by MCO. About 16% are uninsured, and time will tell how much of this 16% will participate under Obamacare, maybe 8%? maybe 10%. The other 15% are various government agencies such as Medicare and Medicaid. But both of those have private MCO options. At the time the chart was made, in 2010, 12 million people use Medicare through MCOs, by 2015, it is projected to be 16 million. So the MCOs are eating into the government's piece of the pie, and the government is ok with it! In any other industry where the market is growing by millions of customers per year, the market would drool. But, it doesn't seem so with managed care.

Health Coverage for all US Persons