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.

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.

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.

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

5 Years After Great Recession, What's Next?

As I have mentioned in other recent posts, this summer season feels like the calm before the coming storm.

I am not predicting a September/October market crash, nor am I saying the market will shoot higher while we climb a wall or worry. I cannot predict Mr. Market. But this season is a milestone because five years ago this time we were getting close to the start of the Great Recession. The last five years covered the full force of the Great Recession as well as a seemingly miraculous recovery.

It is often said the true measure of an investor or money manager is how he does through at least one full boom and bust economic cycle. No great investor has been called great without showing that he has weathered several such cycles. Think of the likes of Benjemin Graham, Warren Buffett, Walter Schloss, Seth Kalman, John Neff, John Templeton, and on and on.

Furthermore, many investing sources will give you the past 1, 5, 10 year period performance of any mutual fund or hedge fund. So I have collected the a list of some prominent equity funds, as shown below:

Fund	Manager(s)	Last 5 YR Annualized Return
Bruce Fund	Bruces	8.6%
Yacktman Fund	Yacktmans	14.0%
Davis New York Venture A	Davis/Feinberg	2.7%
Fairholme	Berkowitz	5.2%
Pabrai Investment Fund 2	Pabrai	3.0%
FPA Crescent	Romick/Rodriguez	6.5%
Legg Mason Cap Mgmt Value C	Miller/Peters	1.0%
Hussman Strategic Growth	Hussman	-4.0%
T2/Kase Qualified	Tilson/Tongue	-2.9%
S&P 500 Total Return (Jan 2013)		3.1%

Returns include fees. Period is Jan 2008 to Jan 2013, or if not possible then a close period to it.

The list includes hedge funds, mutual funds, US equity funds and international equity funds. So, the list isn't meant to be a direct comparison but as a gauge of how various funds and their manager's strategies have fared.

The fund managers in the table are some of the most prominent fund managers in the US. They are all probably in their 40s and 50s. These are going to be our thought leaders in the coming five years. It will be very interesting to see five years from now how these funds and their managers fare!

In the last fives years we have learned a lot about ourselves and our world. One of the biggest is that our world is not going to grow as much as we would like. In the past the typical investor like myself were too optimistic about the long term stock market growth. We thought 10% to 12% is achievable. That I feel is one of the biggest reasons for two horrific market corrections in the last 15 years. Investors were sold on the idea that we can achieve high growth, if we just knew where to go. So first it was high-tech in late 1990's and when that failed, well, we'll just go to housing.

Now I, and a lot of other retail investors, are much more jaded and are much more wary of equities. I am more resigned to the overall market achieving 7% long term, rather than the 10% to 12% I expected before. This, coupled with the fact that we had a run up in stocks in the last 4 years, leads me to think we should expect much lower than 7% in the coming 5 years.

The rise of formerly developing countries like China is creating ever greater demand for commodities. I am talking about better foods, like meat, oil, water, etc. This fact by itself isn't really surprising, but its consequences can be surprising. For example, higher oil prices and innovations have caused the US to produce more oil than any other time in recent memory. And as the US produces ever more oil, the US will be able to reduce its trade deficit and the dollar will get stronger.

Next Five Years

The US Fed actions of the last five years have shown that the US dollar is a debased currency. But the Euro isn't much better with all the problems in the EU countries. Meanwhile, developing countries like China also have fundamental problems. I feel the conventional thinking is that China is a country with a tremendous amount of "animal spirits". And the country has a command economy that can direct whatever necessary for the greater good. However, I feel the conventional thinking doesn't give enough weigh to the roadblocks to China's success. China does not have long history of rule of law, nor does it have a long history with a large vibrant middle class. These and various other negatives, which developed countries do not have, can lead to corruption, discontent and distrust of the local financial system. This can have a dramatic effect on Chinese household asset allocation.

The average Chinese cannot cannot rely on the equity markets for returns because the Chinese equity markets have not proven themselves to be good allocators of capital. China's GDP grew at around 9% annually in the period from 2000 to 2013. Yet the Shanghai Composite Index has only returned about 2.1% annually over that time! Yes there are many elite and powerful people in china who have become extremely wealthy through equities, but these are mostly through connections which are closed to the average household.

In addition, the Chinese get low rates on deposits. So recent articles have pointed to a "shadow banking" sector whereby the average person can deposit money for loans to corporations through less regulated banks or institutions. The Chinese are starved for yield to combat their inflation.

It is quite interesting that the last few years of easy money all over the world has not resulted in excessive inflation. Wages are kept low and companies are achieving record margins. Money is growing faster for shareholders than wage earners. Maybe that's why inflation for everyday items are low. But we may soon see inflation of financial assets, such as bonds and equities. But it has to be quality financial assets.

According to this report, the world owns $198 trillion USD in financial assets in 2010. One third of this amount ($67 trillion) is equities. The report expects the world's financial assets to reach $371 trillion in 2020. That is a reasonable 6.5% annual increase. But the report stresses that developing countries do not invest in equities nearly as much as developed countries. This is a case of distrust of the equity markets and less sophisticated equity markets in those developing countries. But I think good equity markets are necessary for an advanced economy.

Now is only 7 years to 2020 and how is it playing out for China? Well, either the article is off the mark, or the China market is going to explode, or the Chinese will have to invest in bonds or other alternatives, or they will have to move money overseas. I feel the latter will be a big factor; that is, they will invest more and more in real estate overseas, as well as equities and bonds overseas. If they are restricted from moving money overseas, they will face lower returns. You can see this in the low returns of the stock market, bank deposits and the high price of real estate in China. And when they move money overseas, they want more to preserve capital rather than generate cash flow.

And China isn't the only developing country with growth and reform issues, as we have seen from protests in Turkey and Brazil.

So my conclusion here is that the coming five to ten years will see a resurgence of asset values in developed areas of the world; i.e., North America, Japan and Europe. And based on this I think the CAPE (10 year PE) of the US markets can remain above average for the next five years. But considering the fundamentals of the US, I don't see the market going 20% higher in the next year or two. But, I also don't see a prolonged correction in the near future.

Why I'll Pass on the Pfizer-Zoetis Exchange

I am an Pfizer (PFE) shareholder and the company is making an interesting tender offer of its animal meds division call Zoetis (ZTS).

Zoetis up until a year ago was a wholly owned division of PFE. Then it IPO'ed this year. PFE tendered 20% of its shares in ZTS, so it still owns 80%. Then PFE realized that the market was strong and this is the time to unload all of its remaining stake in ZTS. It is doing this via a exchange offering to PFE shareholders.

The exchange offering expires June 19. It gives the PFE shareholder the right to get ZTS at roughly a 7% discount to the ZTS market price. To get the ZTS shares, however he must exchange his PFE shares. This is a non-cash exchange. So the discount gets reflected in the exchange ratio between ZTS and PFE. Suppose the market price of ZTS and PFE are equal, then the PFE shareholder can get 107 shares of ZTS for each 100 PFE shares tendered.

The market price for the exchange is considered to be the average of the two stock's trading price in the three days before and including June 19.

The Pfizer shareholder has the right to get up to 0.9898 ZTS shares for each PFE shares owned. The number of shares that Pfizer will actually exchange may be different from what the shareholder asked for because ZTS is a much smaller company than PFE. If PFE shareholders oversubscribe (i.e., there wouldn't be enough ZTS shares to go around) the ZTS shares will be distributed proportionally to the number of PFE shares tendered.

So, the amount of benefit to a PFE shareholder is dependent on how much other PFE shareholders tender. If plotted on a graph this would be a straight-line relationship. I didn't bother plotting a graph but instead calculated the benefit at the endpoints if I tender to exchange $100 worth of PFE shares. The endpoints are the least and most favourable cases.

In the least favourable case, we all subscribe all our shares. The market cap of PFE and ZTS are $204.8B and $15.6B, respectively. And PFE is putting up 80% of ZTS shares. So the ratio is $204.8:$12.4, or $100:$6.05. Then to get $6.05 worth in ZTS shares I must exchange about $6.05 &divide 1.0752 = $5.63 worth of PFE. And in the end for each $100 PFE I had before exchange, I would have $94.37 worth of PFE and $6.05 of ZTS, for a $0.42 gain in the least favourable case.

In the most favourable case, few people beside myself subscribe. Then for each $100 of PFE I would get about $100 * 0.9898 * 1.0752 = $106.42 worth of ZTS. And in the end for each $100 PFE I had before exchange, I would have $1.02 worth of PFE and $106.42 ZTS, for a $7.44 gain in the most favourable case.

So, it is a guessing game between PFE shareholders; the payoff is a possible 7.44% gain. The more people exchange thinking they can get the 7% the more likely they will end up closer to 1%. The more people give up and think it isn't worth the trouble, the more likely that those who do exchange will get 7%. This is a arbitrage situation. I am sure someone in some hedge fund must be dreaming of a way to make a small gain. But one major downside is the transaction cost of executing such a trade. I don't want to do such a thing because of the small gains involved. The other reason for exchanging could be because I want to own ZTS long term. But again, I don't want to because Zoetis trades at a PE of more than 30. I wouldn't own such a stock with such a tiny discount.

So I will keep my PFE shares. Tell me what you think.

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Disclaimer: please look at the disclaimer section on the right column. If in doubt about what to do, please consult a qualified financial advisor.

Now Is Always the Most Difficult Time to Invest

I have heard that saying somewhere. A few weeks ago, I wrote an open-ended post that reflected this uncertainty. I wasn't sure of whether to load up more aggressively or lighten up on stocks. I used to think that this kind of strategy is somewhat like trying to time the market. And I know I cannot and should not try to do that.

But recently, upon reading Benjamin Graham's books again. I realize his conservative strategy is really centered on the allocation between bonds, which reflects a pessimistic view, and stocks, which reflects a bullish view. Graham says that one should allocate between 25% to 75% stocks, with the remainder in bonds. In bullish times, when stocks are undervalued, he would allocate closer to 75% stocks. In times when stocks are more speculative, he would allocate closer to 25% stocks. This has the effect of moderating the big returns in bull markets and mitigating the huge drops during bear markets. The net result of this is better return in the long term which is over cycles of bull and bear markets.

I want to follow this strategy because I don't have a crystal ball as to the direction of the market, especially now. In fact I don't even know whether stocks are overpriced or not. But if I am forced to take a position, I'd say we are most likely in an overpriced market right now.

I am not a financial guru on market valuation, so I look to others for guidance. The mutual fund filings are a good source of information. But the funds must be balanced funds that hold both stocks and bonds. My only fund holding is the Bruce Fund. I have a lot of respect for this fund because of its staying power over 30 years. They say past performance is not guarantee of future gains. But I believe the Bruce fund has the best idea of how to handle the current market. So I look back over the last 15 years when the annual reports are available on the SEC website. The following chart shows their bond and cash allocations over that period. The remainder of their fund was invested in securities, including common, warrants and preferred shares. The chart shows the bond position from the safe portion (cash) to the riskier portion (corporate bonds).

One can see how the Bruces correctly called the recession of 2000 and 2008. The fund's cash and the safer government bond positions were high in the periods before 2000 and 2006-2007. I believe this is the key to the Bruce Fund's outstanding return. But most important goal of this exercise is to figure out what to do now. It is appears that the Bruce Fund is in a holding pattern for the last 4 years. The fund is cautious but not so much like the periods before the last two recessions.

Warren Buffett is another great investor who likes to keep a cash hoard as insurance for a rainy day. His cash position is substantial but difficult to interpret as he has a big conglomerate and insurance business to run. Seth Klarman of the hedge fund Baupost is another defensive investor and he has recently said he keeps more than 30% cash.

But there there is also some compelling arguments to the opposite view that this is the time to allocate more to stocks. The current overall investor sentiment just isn't strong. The current market is full of investors running scared. Since 2009 investors have been consistently moving money from equities to bonds. Furthermore, the consumer confidence index is at 70, which is still below the normal 100 of the pre-recession days. These are contrarian indicators that makes it hard for me to imagine a bubble and the inevitable crash.

Another compelling data point is the graph I posted earlier. The graph shows the 10-year cyclical adjusted PE , the 10-year treasury yield and the inflation rate. A high inflation rate forces a high interest rate. But today we have the enviable position an of big government stimulus without high inflation and without high interest rate. And, for this reason, François Rochon of the Canadian Giverny Fund then concludes: "We believe that equities will be the best asset class in the coming years for the simple reason that it seems to be the most undervalued."

So there you have it, both sides of a compelling argument. Never is the adage that now is the most difficult time to invest been so true.

McRae Industries Reports Third Quarter Earnings up 46%

McRae Industries (MCRAA) reported revenues up 22% and earnings up 46% from the same quarter a year ago. Operating margins were the same as a year ago, but SG&A expense was 18.6% of revenue this quarter versus 21.4% a year ago. This made the difference in the tremendous improvement in earnings.

The company earned $1.3M in the quarter. In each of the first and second quarter the company earned $1.9M. I consider the drop in earnings acceptable. From what I hear about earnings this year, companies that sell domestically have outpaced the market as a whole. That would explain McRae's outstanding results this year. Consumer sales now account for about 2/3 of sales. McRae's biggest product is women's cowboy boots. And the recession's effects must have depressed earnings last few years. But this year they appear to be back in a big way. The earnings for the first 3 quarters are $5.1M. Projected over the year that is $6.9M. The company market cap is approximately $54M, for a PE of 7.8!

Granted women can be fickle and earnings could go south very quickly. But with the end of the recession (hopefully) and consumer confidence back I think the upside is much greater than the downside. Furthermore, the balance sheet offers protection for the investor. The following chart shows their balance sheet numbers:

The company is a netnet and it is earning good money, money which goes straight into making a bigger and bigger netnet! My intrinsic value on this stock is $32. It trades at $22.35 today.

How McRae Reports EPS

The company's financial statements are straightforward, except for the EPS calculations which has myself and otcadventures stumped. But today I finally solved the mystery by speaking with Marvin Kiser, the CFO. Marvin explained to me that the formula for the EPS calculation came from the SEC and was blessed by their auditor. So they just go with it.

The cause of the EPS anomaly comes from the treatment of the class A and class B shares. The class B shares are the big voting shares, and they are like preferred shares and they mostly lies in the hand of the insiders. Class A is what us common folk own. There are about 5 class A shares for each class B share.

The reported basic and diluted class A EPS is:

Now if you think like me, the reported EPS just makes no sense. Is the dividend somewhere in the income statement as an expense? No it isn't. So, it appears the reported EPS is double counting the dividend amount, which was $0.09 last quarter. Go figure!

From now on, I will ignore the company's reported EPS and use my own EPS, as I have given above as the net income divided by total class A shares. But it isn't a big deal, as the EPS has no real bearing on the shareholder's bottom line. What really matters to the shareholder is his dividend and his share of the equity.

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McRae Industries is one of my largest positions.

Investing in Tachibana Eletech Isn't Hard

Tachibana Eletech (8159:TSE) recently reported impressive earnings for year ending March 31, 2012. Earnings increased 18% yoy, despite revenue increasing only 4%. I had worried that the company is a low margin business, but now the management appears to be tackling the margin issue.

I summarized the 2012 results in the chart below.

In an earlier post I mentioned the company as a net-net with good earnings. I calculated net-net or net current asset value (NCAV) as current assets minus current liabilities. But Tachibana, and possibly all Japanese companies, reports assets as the sum of the following components:

1. current assets
2. property and equipment and
3. investments and other assets 

And I had previously considered the last component as non-current. However, upon reading the 2012 report I realized 90% of it is marketable securities or government bonds. They are very liquid and therefore should be treated as part of net-net. When I did this, the net-net value is much better than I previously thought! The above chart reflects this.

Tachibana Eletech is an industrial company specializing in supporting manufacturers. The Factory Automation (FA) Division is its main division accounting for almost half of its sales. The other main division is the Semiconductor Division. The Japanese expertise in manufacturing could be very useful for developing Asian countries. And the company is trying to increase exports. However, its Overseas Division is only 17% of sales right now.

For 2013, the company is targeting a 3% increase in revenue and 5% increase in income. In good times this is achievable, however an economic downturn could easily make both numbers negative as was the case in 2009 and 2010.

The company's ROE is 6.8% and its earnings yield is 10.7%. Its dividend yield is 2%. In summary, I think Tachibana 1) has a decent growth story, 2) trades at small P/E multiple and 3) its book value is not priced into the stock. I estimate its intrinsic value as 1450 yen per share. It is trading at 1100 today. To me, investing in Tachibana is a no brainer.

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Disclosure: I added to my position in Tachibana after reading their earnings report.

Seaboard First Quarter Earnings $47 per Share

Seaboard Corp reported earnings of of $47 per share, which is a 21% drop yoy. However, Seaboard Corp is a diversified agriculture company with five main segments. So, to understand the company, one should break down the operating results by segments. I decided to analyse the segments by detail.

The following table shows the most recent quarter's results, as well as that of the same quarter a year ago. And it shows the yearly results for the last three years.

Segment		Q1 2013	Q1 2012	2012	2011	2010
Pork	Revenue	409.3	400.7	1638.4	1744.6	1388.3
	Income	32.3	52.9	122.6	259.3	213.3
	Margin	7.9%	13.2%	7.5%	14.9%	15.4%
Commodity	Revenue	800.8	724.5	3023.5	2689.8	1808.9
	Income	12.3	25.7	71.9	43.2	34.4
	Margin	1.5%	3.5%	2.4%	1.6%	1.9%
Marine	Revenue	230.2	233.7	969.6	928.5	853.6
	Income	-3.3	0.5	26.1	-3.9	47.6
	Margin	-1.4%	0.2%	2.7%	-0.4%	5.6%
Sugar	Revenue	66.2	73.6	288.3	259.8	196
	Income	16.5	17	60.2	65.1	31.7
	Margin	24.9%	23.1%	20.9%	25.1%	16.2%
Power	Revenue	73	35.5	255.4	111.4	124
	Income	12.9	5.8	55	60.8	13.4
	Margin	17.7%	16.3%	21.5%	54.6%	10.8%

Total quarterly revenue was up indicating the company is growing and/or higher prices for commodities. However, profits are down due to the Pork and Commodities Segments.

Pork Segment

Looking at the Pork Segment, the company indicated corn (feed) prices were higher yoy. This may explain the lower margin. Pork cost is very dependent on corn prices. The following table shows the pork and corn price indices over the same periods. Unfortunately, in Q1 2013, the price of pork dropped at the same time that the price of corn rose. But good news is coming, the good rainy season we have now will mean corn prices will drop in the coming summer and fall. So, I anticipate the Pork Segment's profits to rise.

Commodity Trading and Milling Segment

The biggest subsidiary is the Commodity Trading and Milling Segment which is like a middle man for wheat, corn, soy and etc. Commodities for this segment are generally higher than last year, however the profits are down. That is troubling. In the report, the company states

...The decrease primarily reflects lower margins on commodity trading sales to third parties and non-consolidated affiliates, especially on sales of wheat and corn. The decrease is primarily the result of unfavorable market conditions and certain inventory positions negatively impacted by the decrease in commodity prices in the first quarter of 2013 compared to favorable market conditions and certain inventory positions positively impacted in 2012 from increasing commodity prices.

which seems to indicate that commodities purchased in Q4 2012 were sold in Q1 2013 as commodity prices dropped. Indeed, wheat prices dropped 20% from Q4 2012 to Q1 2013. Similarly, corn prices dropped 15% over the same period.

Management said in the report it cannot predict the results from this Segment for this year. Most of this Segment is in less predictable foreign countries.


Sugar Segment

The following chart shows the price of sugar. The results of the Sugar Segment follows sugar prices. Unfortunately, sugar prices were down in the quarter.

Other Segments

The Marine and Power Segments shouldn't be the main sources of income for Seaboard, although a newly introduced power facility did help in the quarter. In addition, their 50% interest in Butterball suffered a $5 million loss, versus a $8.9 mil gain in the same quarter a year ago.

So overall, the first quarter has been a disappointing start. But even if all other Segments run at the current rate, and pork prices rise and corn prices fall, the company could still earn more than $200 per share.

Seaboard is my largest holding and I bought this stock many times at below $2000 per share. Now the stock trades at $2700. My estimated intrinsic value is also about $2700. So, I may reduce my holding soon as I feel it is fully valued.

Riken Keiki Reports 2012 Earnings Up 22%

Riken Keiki (7734:TSE) recently announced 2012 earnings which rose 22% yoy, while revenue dropped slightly yoy, as the following chart shows.

Anyone dealing with Japanese stocks must bear in mine that the Japanese yen dropped dramatically in the last year. A US dollar was worth 80 yen initially and now it is worth 102 yen.

The drop in revenue could be partly attributed to the 2011 Japanese tsunami, which increased demand for Riken Keiki's products in 2011. The different directions between the revenue and earnings was due to a $1 bil decrease in cost of goods sold in 2012, and, to a less extent, greater one-time charges in 2011. The company management appears to be good at reducing costs to improve profits.

The company, unfortunately, forecasts lower profit in 2013. Which is surprising considering the recent drop in the yen. The company also proposes a 17 yen dividend, which is a 2.5% yield.

Riken Keiki is a small cap company that makes gas detectors. Other than their financial reports, which are in Japanese, there is almost no news on the company. I own this stock because I believe the company holds a valuable niche in industry. What it does must be hard to duplicate well. As well, it trades near net-net. And, being a Japanese company market cap at about $150 mil USD, the company is below the radar of the big money managers. So, I have a lot of margin for my lack of information.

On a final note, starting with this blog entry, I will reveal my estimated intrinsic value of my stocks if it exists.

My intrinsic value for Riken Keiki is 930 yen. It is 777 yen today.

Why I Own Kansas City Life Insurance

I have been watching Kansas City Life Insurance (KCLI) because it is a profitable company that trades at 55% of book value. KCLI is a insurance company that offers life insurance and annuities. It is a hundred year old company.

The first thing I ask myself is why is it so cheap. To me, it is cheap because it is a boring company in a very regulated industry. Life insurance companies are long-term businesses with little growth prospects. The following chart shows the growth in book value per share with and without dividend reinvestment.

Period	Annualized Equity Growth	Annualized Equity Growth w/ reinvested Dividends
Last 5 yr	3.4%	5.5%
Last 10 yr	3.4%	5.7%
Last 14 yr	2.7%	4.8%

The data shows the company also does not have ambition to grow beyond its area of competency. We all know that Berkshire Hathaway touts it's own equity growth at more than 20%, while KCLI is growing at 5.5%. But the plus side is that it trades at 55% of book. So the growth relative to market cap is 10% ( 5.5% / 55%). That's the earnings yield.

Other than the above, there is not a lot of noteworthy things about KCLI. KCLI is a small cap company with a market cap of about $400 mil. The company is run by the Bixby family. The company trades with a very little volume.

The company has a large balance sheet and so I was concerned about the consistency of its earnings during a downturn. Looking back, the company only had one losing year in the last 15 years: in 2008 it lost $1.50. This consistency makes KCLI a very defensive stock for downturns. And this is the biggest reason I am holding this stock now.

As a final note, the following table compares KCLI with some of its competitors.

Company	Ticker	P/E	Dividend Yield %	Price / Book
Torchmark Corporation	TMK	11.66	0.97	0.72
Assurant Inc	AIZ	9.09	1.77	1.41
MetLife Inc	MET	19.67	2.92	1.41
American Equity Investment Life Holding Company	AEL	14.28	0.95	1.71
Citizens Inc	CIA	81.97	0	0.83
FBL Financial Group Inc	FFG	11.99	1.03	1.21
Kansas City Life Insurance	KCLI	16.08	2.86	1.85
Unum Group	UNM	8.77	1.85	1.13

Where Is the Market Headed?

I focus this blog on discussing the market as it pertains to my portfolio. I try to follow the Benjeman Graham school of value investing. So I don't try to predict the market. I look at current value, and discount predictions of the future.

But now, the S&P 500 is at an all time highs of 1615, and we are in uncharted territory. I am trying hard to get some visibility of the future. We have just come from two huge bubbles in ten years. Now four years after the second bubble, we appear to be well into recovery. But the recovery in doesn't feel like a normal recovery. This recovery seems to be artificial creation of the major central banks. The central bankers of the world seem to be in a race to debase their currencies.

In such uncertain times I look for wisdom from financial thought leaders. People I really respect are the likes of Buffett, Berkowitz, Munger and Robert Shiller.

Robert Shiller is the co-creator of the Case/Shiller index, author of Irrational Exuberance, and the person who predicted both bubbles in the last fifteen years. Robert Shiller created the inflation adjusted cyclically adjusted price earnings ratio (CAPE). He says CAPE is much better than the traditional PE because it captures the effect of a whole business cycle on earnings. I have plotted the CAPE earnings yield (simply the reciprocal of the CAPE) along with long term interest rate and the inflation rate from data in Shiller's website.

The median earnings yield is 6.5%. Today, the yield is 4.5%. Compare that with the inflation and interest rate, we can see that the yield is reasonable. But still, it is lower than the median. And is the inflation rate reasonable? Can we expect this to continue in light of central banks printing so much money? That is the billion dollar question. I certainly don't know. But I am very wary because we are in such unprecedented times.

I also said in a post last year that, who knows we may hit a all time high on the S&P 500. That has happened. But I am really uncertain what's next. I just don't see how it can go much higher without coming into pricey or even bubble territory.

Do you have any comments?

Why I Sold Globus Maritime

Globus Maritime (GLBS) reported Q4 earnings yesterday. And it was quite a revelation to me. Their operating loss was to be $2.8 mil. However, they took a $80 mil write down of top of the small loss! I bought this stock a year ago because its book value was more than 5x its market cap. Now, with one stroke of a pen, it is less than 3x.

GLBS is a small shipping company. The company owns only 7 bulk ships. As with all shipping companies recently, the company's earnings were hit hard by the global glut of ships. The report says they expect the situation to persist until 2014. But the company has $10 mil of current assets. So cash flow is not a problem in the short term while management waits for the end of the shipping glut.

However, all this makes me realize that shipping is a hard, competitive business. Something that all veterans of the business know. While companies like GLBS are trying to wait out the downturn, others like Diana Shipping are using this opportunity to buy ships on the cheap.

For me, this is a lesson learned. GLBS may actually be cheap right now. I really don't know. But I know shipping investments are risky and they aren't for me, like airlines aren't for Buffett. And so, as a result, I have sold out my GLBS position, at a 10% loss.

Why I Still Own WLP

Wellpoint reported earnings of $2.94 for the first quarter 2013. This is an excellent start for the new CEO Joe Swedish. If we project this earnings to a full year, it is a P/E of about 6! However, for some reason, WLP projects earnings to be $7.75 only. I am not sure why. The company did say integration costs of Amerigroup will be a drag on earnings. Still at a current price of about $73 per share, WLP is compelling.

WLP is a managed care company. The company has the Blue Cross/Blue Shield license in 14 states. Late last year, the company agreed to buy Amerigroup, a Medicaid manager, for $4.9B.

Last year I was bullish on WLP because it suffered from several big headline events. First was Obamacare's victory in the Supreme Court. Most had expected the mostly Republican Supreme Court to strike down Obamacare. Second was disappointing earnings for Q2 2012. Shortly after that, then CEO Angela Braly left. The following chart shows these events' affect on the share price. WLP was normally a stock with a P/E less than 10, and then in Fall of 2012 it drops more than 33% following two events.

Shortly after these events, WLP issued more debt and bought back more stock. That is a great idea. The company get debt at around 2.75% interest and get stock that yields 15%. In addition, WLP bought Amerigroup. And last quarter earnings shows that WLP at the moment is a cash cow.

Still the biggest overhang on the business is Obamacare. In October, as part of Obamacare, all states will implement exchanges. Exchanges are government run marketplaces where individuals and business can go to compare policies and premiums. Note that all this does not necessarily mean that the government will compete with managed care companies like WLP. In fact based on what I understand of government and healthcare, the government likes to outsource management. For example, more than 70% of all Medicaid enrollees use managed care companies like Amerigroup. With the expansion of Medicaid and insurance coverage overall, managed care companies now have 30 million more potential customers.

The flip side is fear of government regulation. Right now, government restricts benefit expense ratios to be 85% or less. Wellpoint's ratio is 86%. So it is within reasonable limits.

I am purposely being vague in my analysis of the Obamacare situation, because Obamacare is a confusing topic. It affects almost everyone in America yet I don't think the majority knows how it will affect them come October. How it will play out is very unclear, regardless of whether you are a lobbyist, politician, doctor or a WLP executive, we are all pretty much in the dark. But, to me, managed care companies have tremendous potential and WLP in particular has a huge margin of safety.

In my post last year, I listed some negative headline events that unnecessarily depressed decent large cap stocks. I participated in some of these events, namely Philip Morris. Now, the future will tell if Wellpoint is another. If it is, then I believe the WLP bears will capitulate when the dust begins to settle on Obamacare. That could take two to three years. By that time, who knows, WLP could double.

Why I Sold Intel, Microsoft and Pfizer

Recently, I noticed that people have read my old bullish posts on my holdings, for example, Intel. So, I want to update folks about my recent sells.

I closed my Intel position. I sold Intel in part because it was languishing in the low twenties, and near term I don't see any reason for the stock to move in either direction. Their recent earnings point to a P/E of just a bit over 10. But I was shocked to hear the recent news that PC sales are down 13.9% year over year. I generally don't heed the sensational headlines, like tablets are replacing PCs. But this statistic is a wake up call. I just don't see Intel as that attractive an investment. I bought it at about $20 a year ago. I made about 12%.

I reduced my position in Microsoft because of the aforementioned PC situation. Also, I don't see Windows 8 or their tablet push or their partnership with Nokia working that well. On the other hand, I still think Microsoft is a worthwhile investment.

I reduced my Pfizer position because it has doubled for me in the past four years. I was lucky to get a bunch during the financial crisis. Pfizer had a lot of headline problems due to patent expirations. But that headline risk is gone now, it being such a large cap stock, I don't see how it can grow profits much. I still have some left, but only because I want to avoid capital gains tax.

So, a lot of these sells are because I am in the process of changing my investment style. I want to invest in less large cap stocks. I still do own large caps but my positions will be much more concentrated.

My Investment Performance in 2012?

As I look at the other investment blogs written by small investors like myself, I often come across a summary of the author's past year or quarter's returns. I can't do that though, because I just don't know. I classify my assets as equities (not counting cash and bonds) and everything else. I have some idea of the gains in the equity portion of my portfolio. I think I am regularly beating the S&P 500 total return index, but I can't be sure. At any given time I may add cash to my brokerage accounts, or the holdings may generate cash through dividends or capital gains. I may also take away cash to pay bills or taxes on April 15. So with all the mish mash of money going in and out, I can't figure out what is my return without excessive effort. And I am too busy tracking news from my holdings. Even if I could track my returns over a short term of a year or quarter, I don't think the information will be very useful. Instead, I like to look at my individual holdings and break them down into components and estimate how they fared in 2012.

Health Care / Contrarian

This group has the out of favour stocks that I love to own. I own Wellpoint (WLP) and Pfizer (PFE). Wellpoint is a real stinker right now because 1) it's margins are worse than it's competitors recently and 2) Obamacare could mean stricter regulation and scrutiny. Well, since these two factors really came into light last fall, WLP has gone up more than 30%. Pfizer has similar problems and is also rising with the market.

Another contrarian stock is Seaboard (SEB). It's my biggest holding and went up around 50% last year. I am selling a bit here and there.

Result: beat the market average

Old School Tech

I bought into this group in the last few years because they are just too cheap to pass up. No, I am not talking about Google or Apple or Facebook. I am talking about Cisco, Microsoft and Intel. The darlings of 13 years ago but who the markets now perceives as behind the times.

This group is continuing to be undervalued, I sold a bit here and there when I need the money for something else.

Result: (probably) lagged the market a bit

Resource Stocks

I own Chevron and Transcanada. Chevron has been really good to me. I have had it for almost a decade. The last time I added to my position was when 2008-2010 when it dipped. I just wish I bought more. Transcanada is a stock I don't really understand. This company makes money mostly through transporting natural gas over its pipelines. Its rates are fixed, but it has a P/E regularly over 20. I was a bit wary of the high P/E and sold most of my position in the last year. I still have a bit left because I want to avoid capital gains tax.

Result: beat the market average

Small Caps

My smallcap portfolio is well documented on this blog. I may be beating the market a bit, but it is really too early to judge this recent group.

Result: beat the market average

Everything Else

This is an eclectic bunch, from Berkshire Hathaway to Sears to Brazil Telecom. The Brazil Telecom investment (called Oi) is a real drag. However, their dividends are lumpy, and it could be as high as 20% in some years. I really am not sure how the stock has done considering the huge dividend. I suspect a small loss. But a small loss in a rising market is a blow.

Result: lagged the market

So the conclusion is I am doing ok. I track the S&P 500 more than most people's portfolios. But looking at a short term like a year isn't really useful. It would be much better to look at the markets over a full business cycle. I have gone through two crashes, in 2000 and 2008. And I came out of them ok. I think I am beating the S&P 500 total return by a bit over that time. I think!

Why I Bought IEHC

Recently I bought IEH Corp (IEHC), my sixth small cap. IEHC is really a tiny company, only $7 mil market cap! I came across this in the value blogsphere and found it very well suited to my style. It is extremely profitable (relative to market cap) and it is trading at net net.

Below is the summary of the financials.

IEHC, like so many of the attractive net nets serve a niche in the US military complex. IEHC makes special electronic connectors that can stand the stress of movement and require little force to install. The company appears to be very good at its product, but it is quite dependent on the military. I think that is one reason the company's price is discounted. Recently the company has tried to branch out to commercial applications, and it now has 31% of its sales in the commercial space.

Because this is such a small company I have very little source of information. The company's website says the business goes back 80 years. IEHC used to be listed on the NASDAQ, but moved to the OTCBB in the 1990s because it was too small. The company has been in the connectors business since the 1990s. It is amazing that a company can make the same type of connectors for so long and be growing so much. But then I think of it, my most common computer problem has been the connections. In fact, recently my computer failed because of a loose harddrive connection that eventually disconnected over time.

The company website says that the company was founded by the forefather of the current CEO Michael Offerman. The company used to be called Industrial Heat Treating Company. Somewhere along the line it changed to making electronic connectors. It wasn't doing that well in the 1990s and the stocks was regularly below the $1 range. The company was sometimes losing money, sometimes making money in that decade. Then starting in the early 2000's sales and profit really took off. The following chart shows its yearly profits.

In 2000 Offerman owned 17% of the company. At that time the company was only worth $0.5 mil! Then suddenly he upped his stake to 41%. Talk about getting control of a company on the cheap! The bet didn't pay off right away but it did a few years later. Virtually all the money in the 2000s went into equity which then is reflected in the stock price. The stock price at the very least follows the net net value. The company hasn't used its cash flow for anything but capital expenditures, paying off debt and for inventory. If the company keeps the earnings up, eventually it will build a cash hoard, then it'll be interesting to see what management does with the money.

McRae Reports Solid Earnings, Bruce Fund Update

My small cap portfolio is at five stocks, McRae Industriies (MRINA) is my largest. The company reported earnings of $1.26 and $2.13 per share for the second quarter and first half year. The current first half year earnings are a 69% improvement over the first half last year. The stock jumped 10% on the news. This confirms to me that even small pink sheet stocks will move with earnings.

The chart summarizes McRae's financials. The earnings are based on the projection of the last two quarters.

McRae is the first of my five small caps. See this earlier post for the list. My small caps stocks have a few key common themes:

• they are geographically diversified
• their country of origin is a leader in their industry; e.g., Greece is well-known for its shipping industry
• they are all either trading at net-net or, in the case of Globus Maritime, the stock trades at a small fraction of book value
• they have consistently been profitable in at least the last five years

I am a conservative investor and this is a very conservative portfolio. Some blogs I have read contain stocks that are losing or barely making money. I avoid them. This selection criteria has turned out well (for the most part) in the short time I've owned these stocks. Of course, as luck would have it, Globus Maritime had its first two losing quarters just after I invested. Nonetheless, I have added to my position after a 33% drop.

I do wonder, however, if this blog has any short term influence on the prices of my stocks. If it does it is definitely not intentional. Firstly, I would tell any listener that if he or she wants to invest, the only way is to do his or her own research. Don't rely on second hand information (like this blog), especially for small cap low volume stocks which can be easily manipulated. Secondly, I am a long term investor. My holding time is typically 3 to 5 years. So any short term effect from this blog would fade by the time I want to sell.

On a final note, I just got the semi-annual report from The Bruce Fund. This is the only mutual fund that I own. As I mentioned earlier, I feel owning it adds something of value to my portfolio.

I admire the father and son team that run the fund. They charged $1mil (in a half year) for managing a $300mil fund. I feel that is a small change to collect for performing in the top 1% of their category for the last decade. Partly because of this, they aren't influenced by their investors and the whim of the markets. They stick to their guns.  In the last half year the fund's results lag the market, 4.72% vs 5.95%.

I pay attention to what they say. They now have the fund in a very defensive position with less than 50% common stock. They anticipate "equity deflation" and are only finding value in large caps, stocks with dividends and special situations. I am thinking I agree with them, that's why I am patiently waiting on my CSCO, MSFT and Intel to go up.

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This post initially had incorrect data and was corrected.

Two recommendations: "Margin Call" and "Free Capital"

In this post, I'll take a break from stocks and instead recommend a movie and a book.

The movie recommendation is "Margin Call", a relatively understated suspense drama about the unravelling of a major fictional New York investment bank in 2008. As one can guess, the drama is caused by Mortgage Backed Securities (MBSs), the crap that brought down Lehmans Brothers and Merril Lynch.

I liked the movie because it is very believable and it did not over-dramatize the tense, career breaking, life shattering moments of the movie. I'll support my points a little without spoiling the ending too much.

The movie plays out in a 36 hour period and starts as a do-good manager is shown the door during a massive layoff. Before he leaves, he hands a subordinate some files he has been working on. Those files purport to show that the company's exposure to the MBSs are about implode. Over the course of the evening, morning and next trading day, the drama plays out as executive after executive and finally the CEO is alerted to the info and they attempt to contain the fallout.

I enjoyed the drama, because firstly I didn't see the over-dramatization and the overacting that is so prevalent in Hollywood. Secondly, I liked how the movie shows that all people are complex and torn by greed and principle. I couldn't find a clear villain in the movie although certainly some are more responsible than others for the mess. And everyone in the end was able to be bought for the right amount of cash. And thirdly, I found that the movie portrayed bankers more as clueless buffoons than the stereotypical knivving fat cats. This is also my view from several books about the 2008 crisis.

My second recommendation is the book "Free Capital" by Guy Thomas. I read about it in oddball stocks. The book is the first that describes people with nonfinancial backgrounds who become full time investors. The book mentions a dozen millionaires, all between 40 and 60 who now manage their own money. A few of the subjects have financial backgrounds but most just stumbled on investment by accident. For example, one could be dissatisfied with his job, or another may do it out of necessity because he could not find another way to generate income. This book contains many insights and lessons from others that may help me in my investments. It is definitely one of the top books I've read on finance.

Why I Own Installux SA

I just bought my fifth small cap stock. It is Installux SA, a French manufacturer of aluminum products. I found all my previous four small caps on various screeners. But I found this one an article in another investor blog.

The company's English website explains what it does:

The strategy of the Installux Group rests upon three major principles: the use of a single material, aluminium, the distribution of products via a network of professionals (metal workers, ironsmiths, silverers, awning dealers, fitters, partition dealers, wholesalers), and the targeting of niche markets rather than big volumes.

We are present in three distinct yet complementary business sectors: building and residential improvement (Installux Aluminium), ready-to-install (Roche Habitat), fitting of tertiary and commercial spaces (Sofadi-Tiaso).

Installux is like most of my other small caps. It is consistently profitable, with TTM PE of less than 10, and it has a great balance sheet. See chart below.

As the chart shows, the company trades at almost the net-net, which I define as total current assets minus all liabilities.

I used translate.google.com to read the company's financials in English. But I admit it is still tough going. The valueandopportunity blog mentions the company is majority owned by Christian Canty. I cannot find confirmation of that but I will assume that for now. I do know that Mr. Canty, who is 67, is grooming his son to run the company. I have had good experiences with family majority owned businesses; namely, Seaboard and McRae Industries. It makes sense that you can trust such companies more because the majority owner who effectively runs the company has exactly the same long term objectives as shareholders like me. This contrasts with a CEO who has a small share of the company and who is compensated by stock market performance. Think of a CEO who has a large stock option package. That CEO is motivated to create volatility in the stock price. If the price goes up, the CEO gets stock option payoff, but if the price goes down, he doesn't have to return the payoff. And he may even get more shares at the lower price. Talk about rewarding bad performance. This illogical situation extends to the hedge fund world. A hedge fund manager typically gets 20% of profits, but he doesn't have to return 20% of his losses

On a final note, I have built a portfolio of five small cap stocks now, most of which are foreign based companies. I expect to end up with about ten such stocks in this portfolio, with a value of about 25% of my net worth. To do this, I have sold some of my other holdings. I have closed out my St. Joe position, with a +20% gain. The following table summarizes my small caps. All gains are in local currencies.

Stock	Market	Notes
McRae Industries	OTC (USD)	+15% in 6 months
Globus Maritime	NASDAQ USD (Greece headquarters)	-30% in 6 months
Installux SA	Paris (Euro)
Riken Keiki	TSE (Yen)	+10% in 2 weeks
Tachibana	TSE (Yen)

SEB Quarterly Update

Seaboard (SEB) report year-end earnings last week. They earned $234 per share for the year. I liked their recent consistent quarterly performance. To me, SEB is in a very cyclical and low margin business. But for the last three years the company consistently earned more than $230. This gives SEB a PE of 12. I like companies with PEs around 10 that are consistent and boring. SEB fits the bill. The following chart shows the company's balance sheet and earnings. I have multiplied the PE by my ideal ratio 10.

The chart shows the market cap starting to get high relative to earnings and net-net — I define net-net as total current assets minus total liabilities. I feel if it enters $3000 per share from $2800 today, my SEB story would have played out and I would liquidate as much as taxes would allow. In fact, I am selling a bit here and there as I find better investments.

Why I Own Tachibana Eletech

In my last post I picked up Riken Keiki,  my first Japanese small cap (actually my first stock from an overseas exchange). I bought it for two simple reasons: consistent great earnings and a great balance sheet. The PE is less than 10. And the balance sheet I can illustrate with the following chart. It is quite compelling.

Today, I bought another Japanese small cap for the same reasons: Tachibana Eletech (8159:TSE). This company sells factory automation and electronics equipment for industrial uses. The company mostly sells in Japan but it is expanding overseas, in particular Asia. The company's operating margin is only 13%. And this is the only thing that worries me. But I guess this comes from being primarily a distributor.

Like Riken Keiki, Tachibana Eletech is consistently profitable. Both companies trade at PEs below 10.  Tachibana Eletech's balance sheet chart is also impressive.

I can find almost no news on the company so all my information has to come from the company's website. Fortunately, the site has complete investor documentation in English. I see the company has a large accounts receivable. But the company seems to have no problem collecting on its bills. The company's balance sheet shows a reserve for doubtful accounts that equals only 2% of the total accounts receivable. The accounts receivable is a third of the years total revenue, so the company can get paid in three months, on average.

I believe that Tachibana Eletech is a good company that focuses on its competencies. The company is 90 years old. And it is the type of company that has helped make Japan so dominant in manufacturing.

So, this is the story of my second, but not last, Japanese small cap. I cannot predict my Japanese stocks play out but I expect it will eventually play out well, maybe in a year, maybe in five years or longer. I cannot predict Mr. Market, I can only control what companies I buy and I can vaguely guess how much they will earn.

Why I Own Riken Keiki

I feel investing is a learning and evolutionary process. When I started this blog I thought of myself as a conservative value investor. In the last six months I have evolved into a more aggressive and independent investor. I am now willing to go into less covered areas of the market, in particular small caps. In the meantime I have found a small subculture within the blogging community that covers these cases. On my blogroll on the left you'll see a list of such blogs.

My first smallcap purchases were McRae Industries and Globus Maritime six months ago. Over that period, they have been a mixed bag (+10% and -30%). However, six months is too short a time to tell anything.

The next stock that I found is Riken Keiki (7734:TSE). Riken Keiki makes devices that detect hazardous gases. Its products are mostly for industrial purposes. The company has a long history going back more than 80 years. The company has a market cap of about $130M USD. The company is consistently profitable. Its current PE is less than 10 and it pays a 3% dividend. Riken Keiki is also a net-net company, meaning its current assets exceed its total liabilities.

So the reader may wonder what is the catch? I certainly want to know, if there is one. But I cannot find any so far. In fact, I found the entire Japanese market is full of such profitable net-net small caps that trade at very low PE multiples. I have been following many outstanding investors of today to see what they are doing. For this I really recommend Wealthtrack. Wealthrack is a gem of a financial news show that you can get on youtube. A common theme of several Wealthtrack guests -- what the host Conseulo Mack calls Thought Leaders -- is that Japan is an undervalued market. I agree.

But I admit, I don't know too much about what this company makes. I cannot even access their reports in English. And I don't read Japanese. Based on advice given here, I used translate.google.com to decipher their quarterly reports, which is a far from ideal solution.

My strategy on Japan is to make my own basket of Japanese small caps, starting with Riken Keiki. I am not really trying to stock pick but to take advantage of a inefficiency of the world markets. I believe this opportunity comes because too many people have been burned from twenty years of recession. I know that people have said Japan is a good investment for much of the last twenty years, and have been proven wrong. But from my judgement, I feel this is the time to invest in Japan.

I feel judgement is a huge factor in investing. Judgement is not quantifiable, but someone like Buffett has it in spades. My feeling in part comes from Benjamin Graham. Back in the 1930s, in the heart of the great depression, he wrote articles that listed many companies that are selling for less than their net-net value. And I thought, wow, if only I can get in on such opportunities now. But surely today, in our more efficient markets, such opportunities are impossible, or are they? The investing world today is more liquid than ever and it is very volatile. Two recessions in a decade proves the latter point. I thought about it and reasoned that in such a big investing world, surely some market somewhere is undervalued at any given time. So it just may be possible that the situation Benjamin Graham describes happens very often, maybe now, maybe Japan!

As I mentioned in a previous post when I first thought of being aggressive with small caps. Buffett's thoughts greatly influenced me to this path. He often talks about the great deals he found in the 1973 recession. He compared the depressed Korean market from about ten years ago to that time, like 1973 is the gold standard for an undervalued market. I can just imagine him saying Japan is like that today. The recent decline in the yen helps also. I believe that opportunities, like bubbles, crop up more often than we think. It is just hard to recognize an opportunity at the time.

Pfizer, PMI and Cisco Report Solid Earnings

Pfizer reported GAAP earnings of $0.43 per share in the most recent quarter. GAAP is the benchmark I feel we should use GAAP as a starting point for understanding a company's earnings performance. But a lot of companies have factors that would skew this result. Pfizer is one such example because the company acquired several large companies, most notably Wyeth in 2009. Acquisitions affects the company's earnings because of the marked value of inventories from acquired companies. Pfizer explains away such purchase accounting with a adjusted income value. Pfizer's adjusted income is $0.53 a share. I give Pfizer the benefit of the doubt and use this figure for Pfizer's income. I then estimate Pfizer trades at a PE of 13 (current price divided by adjust income). In addition, Pfizer has saved more than $7 billion in each of the last two years due to synergies from their acquisitions. Pfizer's report does not state how much it can save in the future but I hope that these savings can bring the company's PE close to 10 in the next two years. So to summarize, PFE is nothing too fancy, just a solid performer in a lucrative industry. I have a long term hold on it.

Philip Morris International (PM) recently announced that it earned $5.17 per share for the most recent year. This is an increase of 7% over a year earlier. The company has a 3.7% dividend yield. But as it trades at $91, it's PE is getting close to 20. And to me that is getting close to overvalued territory. As I mentioned before this is a sea change in opinion from a little more than a decade ago, when the market thought tobacco companies were getting sued to oblivion. I have sold a bit here and there as PM rose above 60. I will sell more if it goes above $100.

Cisco is another stock that has experienced a sea change of opinion in the last decade. The market once made it the most valuable company in the world. Now, the company just announced that it earned $1.49 GAAP per share last year. This gives it a PE of 14 with and a net-net of $4 per share. I consider it a value investment at this price. Cisco is my fifth largest holding mainly because of legacy positions and recent purchase as a value play. I would like to close my position however if it gets from $21 today to around $25; I generally do not like tech investments.

McRae Industries Reports 38% Earnings Gain

Earlier this month McRae announced great results. The company had earnings of $24.9M and earnings of $1.9M or $0.87 per share. This is 24% improvement in revenue and a 38% improvement in earnings over the same quarter last year.

I was very happy to see that the biggest contributor to the sales increase was from their consumer products, and not their work (military) products. The reason for this increase was mostly due to a better economic environment. With all indications from recent economic data pointing to a healthy economy, I expect this earnings trend to continue. At this rate of earnings improvement, this year earnings will be $3.13 per share which would give the company a forward P/E of about 6!

I feel that McRea is a value stock with training wheels. No large investor can be bothered to invest in this company because it is so small it cannot make a difference in any large portfolio. Only a little guy can feasibly invest in it. In addition, their financials are so plain and simple that any person can grasp it. And their business is also simple, it is just boots that you and I could wear.

I am contemplating adding to my position at the current price of $18.30. However, that is simpler said than done. McRea is so lightly traded that the spread between bid and ask can be around close to 10% of the stock's value! So if it trades at $18.30, I would be lucky if I can buy below $19. So, I think I will be paying attention to McRea looking for any sign of a dip in price to add to my position.