McRae Reports Lackluster Q2, Sterihealth Gets Takeover Offer

Sterihealth at Buyout
Buyout Price	AU $ 1.75
Market Cap	AU $ 34.20 M ($ 31 M USD)
P/E TTM	8.9 x
Div yield	4.0 %
LT Debt/TBV	3.96
EV/EBITDA	5.35

McRea Industries reported Q2 revenue was up 3% but income was down 20% yoy. However Q1 was a great quarter. So H1 revenue was still up 14% and income was up 20% yoy. Profit margin was still a decent 8% in H1.

The company blamed the worse Q2 numbers primarily on 1) higher consumer sales in Q1 offsetting the Q2 consumer sales and 2) lower margins due to higher import shipping costs and consumers shifting away from premium boots, among other factors.

The stock went as high as $36 before the earnings report. Now it is $31 due to the lackluster Q2 results. I believe the Q2 numbers are more likely the norm than the exception. McRae has had a great recent run of improving sales and earnings. It's time for them to stop growing and maybe even fall back a bit. The boot business is not high tech. One reason I first bought the stock was the balance sheet. The company has no debt. With returns on equity around 15%, the company is simply growing book by 15%. The price to book ratio is currently at about 1.25. I am hoping the stock goes back to the $36 level before I contemplate selling.

In other news, the Steriheath board has accepted a $1.75 AU per share buyout offer from Dan Daniels. Dan Daniels currently owns almost 50% of the shares. After buying the stock three months ago at $1.30, I'll gladly take my money and run!

Know What You Don't Know

Over the past Christmas holidays I had some free time to pursue an intriguing project. I wanted to get some insight into the what is the best cash-stock allocation mix. In today's world of virtually zero interest yield we can think of this as the classic bond-stock allocation problem. The traditionally accepted to invest is through diversification of between stocks and bonds and also diversification within stocks. For example, Benjamen Graham devotes part of The Intelligent Investor to explain the percentage allocation of each under different circumstances. His advice is intuitive and conventional. When the market appears overvalued, allocate more to cash, up a maximum of 75%. And when the market is undervalued, put the money back in stocks. The 75% number is a bit extreme in my opinion, but I follow his advice otherwise.

As far as I have seen, though, everyone gives this advice in a heuristic manner. I want to change that. I want to find some mathematical confirmation that the conventional cash and stock mix yields a better result than just all stocks. To this end I will need to make some assumptions of the market behaviour. Under these assumptions I put in a mechanical cash-stock allocator algorithm and repeated simulate it. Each simulation is a possible realization of the stockmarket outcome over say 30 years, using my assumptions. My findings were quite surprising (to me). Try as I might, I could not beat a 100% stock strategy over the long run. So, I gave up. Though, I did not shake my belief that one must have ample cash at any time. Cash saved me in 2008-2009, and many a wise investor such as Buffett, employ this strategy. Then recently while thinking about it again, I think I answered this mystery.

Any probabilistic mathematical analysis requires some assumptions to create a model. I assumed that the stockmarket will return the same as it has for the last one or two hundred years, which is an average of about 10%. But the last two hundred years has been a resounding success for the markets. And no theory says it will continue. To assume a 7 or 10% return for the market is to put total faith in one possible scenario. We shouldn't put too much faith in the assumption because we really don't know! If we don't know what we don't know, bad things happen.

As one example consider one of the most elegant theoretical results in use in finance: the Black-Scholes formula for pricing options. It is a piece of mathematical elegance to price the option on an underlying stock assuming that stock behaves in a simplistic theoretical manner. Some blame Black-Scholes for the financial crises of 2008-2009. But I feel the problem is not the formula. The problem is with the investor who forces real world stocks to fit the Black-Scholes assumption. The Black-Scholes assumption is just one possible way of modeling stocks. This formula certainly does not factor in the human psychology that is part of every market transaction. When market participants overuse the Black-Scholes formula they can then change the behaviour stocks such that the assumption no longer holds. It is like the Truman Show. The Truman show only works if the participating is unaware of his world. If he is aware, then he will change his behaviour unpredictably.

So now back to the cash-stock mix. I realize we should always reserve some cash because we do not know the future of markets. Though I tend to think it will be somewhat like the past, the best approach given this uncertainty is to have a portion in stocks and also hedge the stocks with cash. The cash portion is like a call option on some stock at some cheap price in the future. The cost of this option is the opportunity cost. However I cannot quantify this opportunity cost because I don't know what the market will do. But I do know that the higher the market value, the less is my opportunity cost. And so I would allocate more to cash.

For me then, it is hedging for maximum benefit under all unforeseen scenarios. I know this is a bit contradictory, saying there is a optimal way to operate in a unknown world. But we have to admit we don't know something. That's a lot better than not knowing what we don't know. Investors who ignore this fact do so at their peril.

Seaboard Reports 2013 Results

SEB
Price	$ 2620
Market Cap	$ 3127.18 M
P/E TTM	15.2 x
Div yield	0.0 %
P/BV	1.26
ROE	8.3 %
LT Debt/Equity	0.13

Seaboard Corp (SEB) reported that Q4 was the best quarterly result in 2013, but for the year income was lower than 2012. Revenue for 2011 2012 and 2013 were 5746M 6189M and 6670M, respectively. Income for 2011 2012 and 2013 were 346M 282M and 205M, respectively This appears to indicate that margins are dropping. SEB has many businesses segments, all of which are cyclical commodities. So I wouldn't read too much into the drop.

The pork segment is Seaboard's largest at 1/4 of total sales. This segment made up 3/4 of the company's profit however. The marine segment turned in a loss, though it was profitable last year. Shipping is suffering from a glut of ships and rates don't appear to be improving much. Seaboard is committed to shipping however and it is investing in several new ships. I believe Seaboard wants to stay in shipping to be a vertically integrated food company.

Overall I feel the company's management has a very long term view. They allocate capital prudently with little debt. And this shows in their consistent revenue growth. The last year's numbers came in a bit lower than I would like but in my eye this is a company that is trading at 10 times forward earnings.

In other news from my portfolio, Sterihealth (ASX:STP) resported H1 earnings were $0.10 AUD, which is the same as a year ago. However, sales were up 9%. This indicates some margin pressure. Still the company trades at 6.5x earnings.

Tachibana Eletech (TSE:8159) recently announced the company will expand into Indonesia. But at the same time, Tachibana Eletech will sell ¥ 1 B (about $10 M USD) new and treasury shares! They say the purpose is for buying office buildings which would save on leases. What the heck?? What is that about?? This company has ¥ 13 B in investments, of which ¥ 8 B is marketable equities and ¥ 2 B is bonds. And yet they are issuing shares to raise a relatively small amount. Several possibilities come to my mind. Maybe it is patriotism; the company wants to keep its government bonds. Maybe management management feels the stock price is overvalued; but the company is very profitable. Maybe the company is allocating the shares to favoured shareholders. But I can't find a very plausible reason really. I am baffled. What do you think?

On the other hand, the company seems to be doing great. Sales are up, exports are up. The company just raised guidance for the year to ¥ 179 which means the company trades at 7.2x earnings. The company also raised the dividend payout for the year from ¥ 20 to ¥ 22.

ITIC Reports Decline in Q4

Price	$ 79.90
Market Cap	$ 163.00 M
P/E TTM	11.1 x
Div yield	0.4 %
P/BV	1.27
ROE	11.5 %

Investors Title Insurance Company (ITIC) reported year end earnings that were lower than expected due to disappointing Q4 results. Premium revenue dropped by about one million yoy, or 3% of total. This along with about another million drop in realized investment gains meant Q4 net income was $1.8 million versus $3.2 million a year earlier. Note, however, that a year ago interest rates were at record lows.

Still, for the entire year, revenue was up 12% yoy. Earnings was up 34% yoy. The stock has dropped a few percent since I bought it two months ago. It went down as much as 10%. I do not regret owning it. But of course I wish I had slowly accumulated to take advantage of the dips instead of buying it all at once.

The recent results show that ITIC had a good recent run due to the low interest rates. Banks require title insurance when purchasing and when refinancing. So title insurance companies get a cut of each mortgage transaction! Even though refinancing activity may slow due to rising rates, I feel housing is bound to pick up in the coming years. Single home sales are about one million below what I would consider normal for the current population.

ITIC is also a balance sheet play. ITIC's most important metric to me is the book value, and it increased 12% yoy.

IEHC Reports Disappointing Q3

Price	$ 4.50
Market Cap	$ 10.36 M
P/E TTM	7.7 x
Div yield	0.0 %
P/BV	1.05
ROE	13.8 %

IEH Corp stock tanked 20% on disappointing Q3 earnings. Ouch!

The stock has been up some 100% since I bought it because earnings have doubled yoy for the last few quarters. Well that trend did not continue. In fact Q3 earnings were down to $0.08 from $0.11 from a year earlier. Revenues were up 12%, less than the earlier two quarters. Gross margin was a few percentage lower. But Q3 SG&A was $143k higher than last year, due to increased travel expenses. These three factors resulted in the drop in income.

Looking back I of course wish I had sold the stock at its all time high of $6. Now, I'll just wait for next quarter to improve and hope this quarter was just a blip.

Riken Keiki Reports Great Q3 Earnings, Fujimak Not So Good

Riken Keiki
Price	¥ 874
Market Cap	¥ 20.29 B ($ 198 M USD)
P/E TTM	8.2 x
Div yield	1.9 %
P/BV	0.70
Price/Netnet	1.02
ROE	8.6 %

Riken Keiki (TSE:7734) reported earnings improved 40% for the first 9 months this year versus last year. The company makes gas detectors and related equipment for industrial use. Sales were up and cost of goods were down. This shows good management of operations.

The company's year-end earnings projection of ¥ 76 / shr did not change, but I think that is a bit conservative. Book value increased 5% over the last 9 months.

Fujimak (TSE:5965) reported disappointing earnings that caused the stock to drop 10%. Fujimak makes commercial grade kitchen equipment. The company reported earnings that came 30% lower than this point last year. I believe the report indicated that the fast food segment was a major contributor to the poor results. Overall, sales were up 10%. But high raw material costs offset the sales gains. Also, SG&A costs were significantly higher than last year. The comprehensive earnings was better at 10% lower. Like many other Japanese companies, Fujimak benefited from gains in its investment holdings in yen.

Fujimak
Price	¥ 800 B
Market Cap	¥ 5.24 B ($ 51 M USD)
P/E TTM	5.1 x
Div yield	2.0 %
P/BV	0.58
ROE	11.55 %

The company did not change its current year earnings projection of ¥ 130 which would give the company a 6.3x earnings multiple for the year. For now I am not panicking.

Tachibana Eletech Q3 Earnings up 39%

Tachibana Eletech (TSE:8159) reported 39% increase in earnings for the first 9 months versus a year ago. Sales were up 14%. Comprehensive income was up a whopping 155% on asset gains (mostly securities). Earnings reflect operations, but comprehensive income reflect the change in book value. The book value is up 11% in the last 9 months. I bought the company for the balance sheet and earnings. The last quarter shows both are firing on all cylinders.

Price	¥ 1265
Market Cap	¥ 26.4B ($259M USD)
P/E	7.3x
Div yield	1.2%
P/BV	0.59
Price/Netnet	0.64
ROE	8%

Operationally, the company showed the most sales gains in their Factory Automation division and their Semiconductor division. These are the two largest divisions of the company. Exports are at 18% of sales, and I hope they improve that number.

This stock could easily trade at ¥ 2000. I don't know what it would take to get there, other than hostile takeover or huge share buybacks, which I feel the company won't allow. I am a little frustrated, but then again I am patient and I am not a believer in catalysts. I don't try to predict events. But I also cannot ignore the market price of this company because I am not Japanese, so I don't intend to hold Yen forever. When this does reach what I believe is my intrinsic value, I will sell and repatriate the money.

Why the Japanese Debt Doesn't Affect the Yen

There is a pretty dreadful argument going around that the Japanese Yen will go to zero like Zimbabwe's currency recently. The reason is the crippling Japanese government debt. Right now that debt is running at over 200% of GDP. The argument can certainly get attention and makes great headlines. But the facts fly in the face of this, at least in the short term.

Japan has struggled with deflation — not inflation — for more than a decade. Deflation is a dreadful situation that governments try to avoid at all costs. An infamous example of deflation was the Great Depression. Also, the puny rates on Japanese bonds shows that the market doesn't remotely believe in a bond default.

Japan recently summoned the political will to take drastic measures against deflation. This is called Abenomics. But removing deflation is like pushing a huge boulder up a hill. If you let up for just a bit, the gains are undone. But the Yen detractors say pushing inflation is difficult only now. Wait till they get inflation going, then it is game over. Inflation will go on forever. See figure below.

The detractors even know where is the hump in the figure. It will be the point when annual tax revenues cannot pay for the annual interest. They say we aren't at that hump only because the Japanese government can finance this debt with unusually low interest rates. And this rate will rise. I will spare you the details of why interest rates will rise. But based on this theory, people like Kyle Bass have setup funds that bet against the Yen, Japanese bond rates and the Japanese economy as a whole.

But I am very skeptical of this argument because the reality does not match the theory, at least in the short term.  It reminds me of people who believe in the efficient market theory. EMT all makes sense because as information and capital is more readily available, stocks should be less volatile. But crash after crash in the last two decades simply flies in the face of this argument.

At the extreme, why is the tipping point when the interest rate equals the tax revenue? Even when that happens, in theory the Bank of Japan can still print more money to pay the interest. Yes, it's a giant Ponzi scheme, but governments can do that with their own currency.  Also, the bond purchasers are overwhelming Japanese, so this is an internal issue of Japanese owing Japanese. If the debt is a problem, it will show up when the Japanese cannot fulfill their obligations to their old and needy. That's a very gradual process.

In the global markets, Japan bond holders won't dump their bonds for other country's bonds. The world wants Japanese goods, so demand for Yen is healthy. And even if there is a small amount of flight from the Yen, Japan has $1.3 trillion USD in foreign exchange. Nobody thinks there will be a run on the Yen. For evidence of this, simply look at what happened last week. When the world became pessimistic about emerging markets, investors converted their capital to Yen, causing the Yen to appreciate. This is market reality!

I believe a prolonged Yen decline will be caused by structural problems of the Japanese economy. The very things that Abenomics is trying to fix. The Japanese, with the dwindling population, must fix their inefficient industries, such as agriculture. When and if that happens, I think they will recover from prolonged deflation and their malaise. In the meantime, the markets think the Yen is a safe haven that is only matched in size and safety by the Euro and USD.

My Current Reading List

Keys to Reading an Annual Report by George T. Friedlob and Ralph E. Welton. This is an excellent easy-to-ready guide which I will keep always as a reference for reading 10-K's.

Two very bullish investing gurus on weathtrack: Ed Hyman and Bill Miller. These two seem to me to be over-the-top bullish. And I am skeptical but also praying that they are right! You can view the two parts here and here.

Understanding Michael Porter by Joan Magretta. Michael Porter wrote the seminal book on the topic of business competitiveness called Competitive Strategy. He wrote that book more than 30 years ago, and it is very dry. That book and all of his works up to now are summarized in this book by Joan.

I found a treasure trove of data supplied by Aswath Damodaran of the Stern School of Business. It contains spreadsheets with individual company statistics for tens of thousands of companies all over the world. I intend to use this as the basis for making a global stock screener. And hopefully, I'll find some new neglected undervalued smallcaps.

Japan Hits Record Current Account Deficit

Just ten months ago, I opened a global trading account and began investing in Japanese stocks. I current own three Japanese small/microcaps: Tachibana Electech, Riken Keiki and Fujimak. If you want to read more about them, click on their respective labels on the right column.

I was luckily investing in the wake of multi-year lows for the Japanese stock market in 2012. Shinso Abe then began Abenomics. Abenomics' most drastic effect to me is the depreciation of the Yen. The Yen needs to depreciate to make Japanese companies profitable. But one year of Abenomics has brought a very bad downside. The Japanese current account hit an all time monthly low in November 2013. The following shows the monthly current account in units of ¥ 100M. The current account is the net outflow of a nation's currency versus the net inflow of foreign currencies. A positive number in the chart indicates a surplus — more outflows than inflows. Note the chart is very seasonal for reasons I don't yet fully understand.

The approximately ¥ 5 billion ($5 billion USD) outflow at the last point in the chart has gotten quite a bit of press lately. So, I gave it a closer look. I took five random months in the last five years and looked at the current account breakdown.

Units of 100M Yen

The huge swing between April and November of 2013 was due to 1) foreign profits repatriated to Japan and 2) a cheaper yen. And the difference between 2013 and 2010 was due to 1) cheaper yen and 2) nationwide nuclear power shutdown, which required oil imports to make up for the energy shortfall.

In any case, the Japanese foreign reserves stand at $1.3 trillion USD. So November results isn't even a rounding error. But, if this downtrend keeps up for a long long time, then the Japanese will have to make up for it somehow, maybe by restarting the nuclear plants, or by allowing more foreign investment. Otherwise, the yen could fall to a point of damaging the economy. But right now I am more relaxed after digging into the facts behind the headlines.

Why I Own ITIC

Lately, I have been busily searching the internet for my next smallcap. And the work paid off. The stock I found is Investor Title Insurance Company (ITIC:NASDAQ). And I first heard about it on this this twitter feed.

ITIC provides title insurance and associated transaction services in real estate transactions. I have always thought this is a lucrative industry. Any bank requires title insurance as a condition of a housing loan. It protects the buyer from defects in the title purchased. But there is rarely any issues as (almost) all deeds are recorded at the local city hall. And verifying the deed is a simple process in the computer ago. So, title insurance rarely pays out claims. Who wouldn't want get in on this industry.

ITIC is a smallcap company in an industry dominated by two giants, First American Financial and Fidelity National Financial. I summarize their key financial numbers below. Note they are based on the first 9 months of 2013 projected to the full year (which actually overestimates the PE).

As one can see, ITIC is more attractive than its two bigger peers because it has a lower earnings multiple, greater profit margin and a better balance sheet. ITIC has retained a lot of earnings. When I see that, I feel as if the person who sold me stock has given me the previous earnings, his earnings, to me for free! The two larger competitors don't have such a good balance sheet because they have a considerable amount of goodwill and intangibles.

Now a person new to this stock may be a bit gun-shy because it depends on the housing sector. Title companies have benefited from the recent increase in housing activity, no doubt. But housing sales have still some ways to go to return to pre-recession levels. After that however, there will be minimal growth for the industry as a whole. This is a classic no-growth value investment.

I also like the company's management. The company's is 42 years old yet is run still run by the original founder, J Allen Fine. His two son's are also executives with the company. This shows a good management continuity, dedication and track record, which is a key criteria for Warren Buffett. The Fine family owns 30% of the outstanding shares. They collectively earn less than $1 million in salary.

So, my investment thesis is simple. The company has a low PE for such a lucrative industry. The company has a great balance sheet, it is almost a netnet. And revenues are bound to go up in the near future.

WLP Sells Division

Wellpoint has announce that it will divest its eyeglass business in order to focus on its core business. The company said that this will cause an approximately $0.55 charge in the coming quarter.

So, Obamacare has begun and we have 2.1 million people enrolled. The initial goal is 7 million by the March deadline for enrolling without incurring a penalty. I think worse case is 4 million and if it is significantly above that I expect WLP will easily hit new highs.

So I'd like to, once again, summarize my thesis for WLP serving Obamacare.

1. Obamacare does not socialize or nationalize health care
2. The public, the politicians for Obamacare and the politicians against Obamacare are all either neutral or very sympathetic to insurance companies who are simply caught in the middle of this issue.
3. Obamacare is adding 7 million to the insured pool. Insurance companies like WLP know the risks and are voluntarily going in with their eyes wide open
4. I feel Obamacare is part of an overall consumer trend towards more "luxuries" as our standard of living rises.

In other news about my portfolio, I have closed my KCLI position. I feel Kansis City Life is a well-run company with minimal exposure to risky annuities. However, it has run up along with the rest of the stockmarket, and the price is now 75% of book. Still, if the market corrects and KCLI drops, I will certainly consider buying.

My Current Reading List

Starting today, I will regularly post links and reading material that I am reading. Hopefully you will find something interesting.

A series of posts by the late Doris Dungey. It is all about the insides of the mortgage industry. They were written before the 2008 crash, but still worthwhile to read today.

Another great interview on Wealthrack

Uprising by George Magnus: A very easy-to-read, thought provoking book on emerging markets.

100 Minds that Made the Market by Ken Fisher: A easy-to-read biographical history of US finance.

PetSmart Performing to Expectations

I have owned PetSmart for six years and it has tripled in that time. My earlier writeup was a year ago, so I think an update is in order.

PetSmart is the the largest pet retail chain and it owns 40% of the US market. The pet industry is a $53 B industry. About 62% of household have pets and I estimate that Americans spend about $250 on each cat and dog annually. I think our pet owners can and should do better than that!  The pet industry has been growing at about twice the rate of GDP, and trend should continue. Although I don't believe we will have much more pets in homes, I do feel that as a wealthy society, we will gradually spend more than $250 on each pet annually. So even if PetSmart does not grow market share, which it has done successfully in the past, earnings should still outgrow the GDP. The following supports this point.

Revenue and Earnings (mil)

Div yield	1.2%
P/E	18x .
PTBV	6.8
Debt/Equity	0.41

Note that the chart shows the total earnings growth. Per share earnings growth is even greater due to regular share buybacks.

The downside to this stock is the relatively high earnings multiple. I generally stay away from anything with a multiple above 20. And PetSmart is close. But I am keeping it for two reasons. One is that I hope PetSmart will do what Coke did for Warren Buffett. Buffer bought Coke in the 80's and it has returned about 12% annually for 30yrs. He also bought Coke at a high multiple, but the company's moat was worth it. PetSmart doesn't have quite a moat, but it is the leader in a superb industry. The second reason I am keeping the stock is I want to avoid capital gains tax.


In other news, we have just ended a memorable year with the US markets up 30%. Who would have predicted that twelve months ago! But 2014 is another year and another chance for the pundits to redeem themselves. The following by Tren Griffin is the funniest though.

CNBC will continue to lose viewers by trying to make its programming similar to ESPN’s Sports Center, even though that approach is *exactly* what sends ordinary investors to their financial doom and *ensures* that ordinary investors will stop watching CNBC (i.e., the CNBC ratings death spiral will continue).

That does make me a bit sad. Now that is one less media outlet to goad suckers to take the other side of my trades *sigh*. Well, I hope Jim Cramer will find another network to hire him on after CNBC dies!

Arbitrage with Sterihealth and Stericycle

Recently, I was thinking new places to look for smallcap gems, and I decided to try Australia. There I found a candidate with a colorful past.

The company is Sterihealth (STP:ASX). It deals in hazardous medical waste disposal. The company was known in 1999 as Cutters Ridge Resources. I guess it's business in resources was a failure so the company's management decided to change the company name to Stericorp and try the medical waste business. However, it appears that the management initially didn't know the business.

The company initially tried waste disposal in Argentina, which failed. Then they bought a plant from Stericycle (SRCL:NASDAQ) in Canberra, Australia, but that was also written down to zero in 2004. Then in 2005, with new CEO Daniel Daniels, Stericorp sued Stericycle for breach of contract to try to recover some of the losses. They eventually won $18 M in that suit. I think the company has stablised with Daniels at the helm. Stericorp turned over a new leaf by changing its name to Sterihealth and it bought 100% interest in ADX, a company started by Daniels.

I think it is interesting to compare Sterihealth and its much bigger former partner Stericycle. The two are both in medical waste, but Sterihealth only operates in Australia while Stericycle is a global player. The following table shows their stats.

In my view medical waste is a profitable and growing industry. Companies in the industry should easily earn returns above their cost of capital. I think that is why Stericycle commands a 37x earnings multiple. But Sterihealth couldn't be more different, it trades at only 6.6x earnings! So, does this mean Sterihealth is a severely mispriced stock? The company history should give some clues.

The company has had a troubled history up to 2005. At that time, the stock reached less than $1 from a high of around $12, and for good reason. The company had accumulated losses of more than $30M! By 2006 they had turned a corner I feel with the new CEO and had raised $15M over three years to shore up the balance sheet. By 2007 Sterihealth got another $18M from settling with Stericycle. The following shows the company's earnings.

Sterihealth Earnings (Mil $ AUD)

Note, that the above results excludes the one-time $18M gain from the Stericycle settlement. So, one can see the company is in a good industry with consistently growing revenue. Therefore, I think the company deserves a higher multiple. Or, looking at it another way, the earnings multiple of Stericycle and Sterihealth should not be as dramatic as it is today. Stericycle must either fall or Sterihealth must go up, or both.


I am long Sterihealth.

McRae Q1 Earnings Up 55%

McRae Industries reports revenue up 27%, earnings up 55% yoy. See below. The company reported the diluted earnings per class A share as $1.33 for the quarter.

Last 5 Quarters (mils)

A significant contributor was the military segment; the company now produces boots for the Israeli military! The good news just doesn't stop.


For the last few years the company has been on a tear. See below.

But the company has said that western/lifestyle segment, which is the most discretionary, typically goes on a 3-4 year cycle, and we are on the 4th year of this cycle. So McRae investors must be wary. That said, I feel much of the world today has an overabundance of life's necessities, and consequently many are moving beyond necessity to luxury. Thus there will be more demand for goods such as pet products, alcohol, healthcare, recreational drugs such as marijuana, high-end watches and the western/lifestyle boots that McRae sells. I am trying to profit on all of the aforementioned areas - well, all except except marijuana.

In other news, I found this thought-provoking article on Shiller's CAPE. I wrote, and so have many others, that the CAPE is an excellent historical measure and that the CAPE indicates the market is overpriced now. However,  this article argues that this conclusion is incorrect because accounting rules have changed and therefore CAPE values are based on inconsistent rules over time. This article's argument has huge ramifications for me because I am reducing my equity exposure as the market continually hits new highs. But if I can be convinced that the market is not overvalued I will have to reverse course! I recommend this article to any serious investor.

Why I Own Insurance Stocks

Over my investing years, I have tried to make some general rules to hopefully help me avoid trouble. Currently, my general minimum critera are:

1. low PE
2. profitable over last several years
3. low debt requirement for operations, and
4. domiciled in a developed country

I have other requirements which are desirable but not necessary: I prefer small caps, and I have touched on it extensively in this blog.

When I initially invested and wrote about it last year, AIG fits the criteria except that it hasn't been profitable recently. But that was last year. In the year plus since, it has earned money consistently. In all, AIG has been profitable the last 9 consecutive quarters. I feel that companies that don't regularly need tons of capital expenditures are in general better investments. That's in general Warren Buffet's strategy up until recently when he bought Burlington Southern.

I bought AIG over a year ago when it was $30, and was trading at around 0.6x book. Since then it has run up to $50. A year after I bought AIG I tried to find a small cap company like it. I found Kansas City Life Insurance to be a small cap that also trades at 0.6x book; 0.6x is just about the lowest book I could find for insurance companies. KCLI has since run up 30%. The following table summarizes KCLI and AIG today

AIG does primarily Property and Casualty and Life Insurance and Annuities. KCLI only does Life Insurance and Annuities. AIG also owns ILFC, which is a aircraft leasing business. Just today, AIG announced it will divest ILFC to another company, AerCap. Although I don't think AIG will have any gains or losses from this transaction, I think it is yet another sign that AIG's dark days of five years ago are behind them.

My other insurance holding is Wellpoint; but then again WLP is not really an insurance company as much as a healthcare company. I have written many times about WLP as my bet on Obamacare. I have never really heard of any other investor taking my view. Until I saw a Forbes piece on Larry Robbins. Larry Robbins runs a hedge fund that is one of the best performers this year because he made a big contrarian bet on the healthcare sector. After following the hedge fund moves in the last year, it seems like to me the hedge funds are just being too conventional when their name implies that they should act contrarian.

My bottom line is, I am really liking insurance right now!

Why I Own Fujimak

I found Fujimak (5965:TSE) while looking for small Japanese net-nets. Although Fujimak is not a net-net, it got my attention for its great earnings. The stock trades at only 5 times trailing earnings. I have only seen this in very special situations. But from what I have seen Fujimak can earn this type of earnings regularly, and without much leverage. The only negative that stands out to me is that this is a Japanese microcap. Its current market cap is only $55 mil USD.

Fujimak makes kitchen equipment for commercial use. The company has been around since 1950. The company only provides investors online information in Japanese. The online data only go back six years. Their equity and earnings per share are shown below.

Equity and Earnings per share (yen)

I don't have any information prior to the six years. I can only assume that the company was just humming along when earnings took off around 4 years ago. The stock price currently is 860 yen. The expected income for fiscal 2014 is 130 yen.

But digging deeper, the data is peculiar. The income increase did not come from greater sales, it came from greater margins. And what an improvement this makes.

The following table shows the gross margin is relatively constant, but the profit margin benefited greatly from improved SG&A expenses. So the improved performance comes from selling possibly less and more profitably products. Other than that, I don't have much more to add because I can't read the reports in Japanese, and even if I could I don't think they would reveal much. But whatever the reason, the numbers, if true, is compelling enough reason to buy Fujimak.

Fujimak should also benefit from the current Japanese resurgance. The USD is worth 102 yen now. Between 100 and 110 is a wonderful sweet spot for Japanese exports. And I can tell that Fujimak is pushing its expansion into Asia. They recently opened an office in Vietnam.

Installux Reports Good Q3

Installux SA continues the string of good news from my small caps. I had mentioned that the company had 10% less revenue yoy in Q1 and Q2. However, Q3 revenue was flat compared to a year ago. I hope this is a sign of a turnaround for the company. However to counter this, recent news suggest France is still struggling to get out of recession. I suppose this is why the stock jumped 13% on the revenue numbers and then gave it all back the next day. I think Installux is still a work in progress. That is, the stock is still depressed due to uncertainty, but I am betting when the uncertainty is over the stock will jump, as has happened with my other smallcaps.

In other portfolio news, I sold about 15% of my WLP holding. I had held it since the days when it was still called Anthem. I don't remember ever selling through last 7 years. But I have bought it regularly in that time. Now the stock is at an all time high of $93 and at around 10 times earnings. At this multiple I no longer regard see WLP as seriously undervalued anymore. The Obamacare discount of a year ago — which I mentioned here — is gone. So it is time for me to finally take some off the table. In addition I also sold some Berkshire Hathaway. Berkshire is a fine company run by the best CEO in the world. However, it is a huge holding company. I just don't believe it has much growth opportunity above the market as a whole anymore.

And finally, I recommend this great tutorial on basic valuation metrics. I believe the first thing a beginner value investors should learn is the set of basic valuation metrics. However, although they are mentioned a lot in the media, there are very few knowledgeable people who have explained them well. And not only does this article explain them well, the author also compares the pros and cons of each in a table, which I have never seen before.  

IEHC Jumps on Q2 Earnings

IEHC stocked jumped two quarters in a row on positive earnings. I am not totally clear on the exact reason for the rise though. Revenue and income was flat quarter over quarter. However, last quarter was an exceptional quarter and maybe the stock jumped on confirmation that the current rate of income is sustainable. At the current pace, IEHC will have its best year ever. I did not find anything worthy of note in the report. The report wording was almost exactly the same as last quarter (other than the actual numbers). The company reiterated that they have new products in the pipeline. It isn't clear to me whether the company has generated revenue yet from the new products, but it appears that sales will ramp up in the coming quarters. I am eager to see how much of an impact this will have on the overall revenue, and the market is anxious too, I am sure. But right now, my margin of safety lies in the stock price which still trades at 7 times my projected earnings.

The following chart shows the revenue, earnings and the stock price. As you can see, the stock only moves four times a year, when he earnings reports come out. I find that is the case for all the small and microcaps that I follow. This is great for the small time investor, there is little room for manipulation and hype such as what happens with the more universally followed stocks (for an recent example, think Tesla!). The small cap stock price is more likely to follow fundamentals.

Revenue and Earnings (mil) and Share Price (dollar) over last 12 months

McRae Industries Income Up 55% in 2013

McRea Industries reported great earnings for the fiscal year 2013. Net income was up 55%. Their first paragraph says it all:

Consolidated net revenues for fiscal 2013 amounted to approximately $97.1 million as compared to $75.7 million for fiscal 2012. This 28% increase in net revenues was primarily attributable to strong performance in both of our boot product segments. Our western/lifestyle products business grew from $52.5 million for fiscal 2012 to $62.8 million for fiscal 2013 as demand for both men and women's products continued to be heavy.

The report also mentioned the fourth quarter was the biggest contributor to the year's results. This could be a good holiday shopping season in US overall

I originally bought McRea as a simple value play (see my original post here). In the following 1¼ year, its operations have also grown beyond expectations. And the stock is up 65%. That's the beauty of a margin of safety, low expectations means any surprise will most likely be on the upside.

I have read or heard many great investors say that when you score in investing it isn't all your doing. A lot of luck plays into it. And the converse is also true, when you lose, it isn't always your fault. In the case of McRea, the company is doing well now because it is riding a mature bull market. Consumer confidence has risen in the last few years as housing and employment have stabilized. This has meant more demand for the luxury and fashionable items such as women's cowboy boots. This is definitely a cyclical event.

McRea also is doing well in the military boots department. McRea is has focused on this for fifty years and that is still its bread and butter. The stock jumped 13% yesterday on the earnings. However, it is still trading at 6 times earnings! I am drooling at the potential 33% gain if the stock were to go to just 8 times earnings!

My Japanese Holdings in H1

In February this year, I documented my initial purchases of two Japanese small caps here and here. The initial reason was 1. the Japanese market is oversold, 2. the economy was due for a rebound. I think a lot of investors under-estimate how often the market will revert to the mean. I think Japan will rebound, maybe not to its 1989 glory, but it will get its day soon. And even if I am wrong, I have a big margin of safety with my two particular stocks.

At the time, I did not really know Abenomics, but Shinzo Abe the Japanese prime minister has had a great effect on the economy. The market has been up about 66% during his tenure — in local currency. However it is still a lot even in US currency terms. But whether Abenomics will help Japan in the long term is still unknown.

Abenomics has directly pushed the Japanese Yen from 80 yen per USD to 100 per USD. This dramatic change has made many big Japanese exporting companies profitable, such as Hitachi and Toyota. I have read, however, that the lower yen has not resulted in more export volumes. This is somewhat worrisome, as greater volume is what will drive growth for the longer term. Furthermore, many Japanese companies are repatriating money and assets from overseas because of the increased value of foreign currencies. This can dramatically effect profitability but only temporarily.

If I had time I would analyze the financial reports of major Japanese exporting companies to carefully analyze the recent effect of the lower yen. But I don't, so instead I just analysed the results my Japanese holdings in the first half year.

Firstly, Tachibana Eletech reported increased earnings for both quarters. Tachibana is a factory automation company that exports about 20% of sales, based on my estimates. The following shows their results for the first half fiscal year. The results were much better in the second quarter compared to the first. This may be a delayed reaction to Abenomics. Operationally the company is doing better although management is still concerned about the slowdown in China and rest of Asia. But a big chunk of the delta was non-core earnings. I grouped them as non-operational earnings and extraordinary earnings.

Secondly, Riken Keiki reported similar results for the two quarters; with the second quarter better than the first. Riken Keiki must export a large percentage of their products. I even see their products on ebay.

So operationally, both are better and the same period last year but Tachibana's results were greatly affected by non-core income. The operational aspect could be both directly the result of Abenomics or indirectly, such as a more positive economic outlook.

These two companies are up around 35% since I first wrote about them, in local currency terms. But I think they are still way undervalued, if one simply looks at the books. However, I do understand that they are at their current price mostly because of the Japanese economic climate. My biggest concern is the huge Japanese debt. This debt is owned by the Japanese people and Japanese companies. I am still figuring out how this will all play out. If the Japanese cannot service the debt, then Japanese will default to themselves, or the Japanese can depreciate their currency so that they can afford to service it. In the latter, more realistic case, the resulting inflation will cause their goods to be more competitive in the world. The key difference between Japan and other countries with high debt is that the world wants Japanese goods! This, in my opinion, will allow for stable calm devaluation of the Japanese Yen, if it does happen.

The conclusion is, I am still very much long my Japanese holdings. In fact, I even bought a new Japanese microcap: Fujimak (TSE:5965). I hope to post a about it soon.

My Take on the OIBr and PT Planned Merger

It has been a while since I posted. In part because of work, and in part due to a dearth of news from companies in my portfolio. BTW, the debt ceiling and government shutdown are not what I consider material news.

The only big news is the recent planned merge of OiBr and Portugal Telecom (PT). I have owned OiBr for about 7 years. And in that time, I found it very hard to follow. For one thing it is in a country I have never been to, and it has an extremely complicated ownership structure that has gone through many restructurings. I was drawn to the stock because of the 10%+ dividend yield and the the BRIC story. Stocks from developing countries haven't been very kind to me. I have lost on Cemex (CX) and OiBr. I do have a nice gain in PK Telecom of  Indonesia, but the gain couldn't match the S&P 500. In the future, I will only invest in developed countries.

The PT and OiBr merger is interesting. Both companies command a huge customer base, and both are saddled with high debt. The merger is complex involving both companies as well as many companies that own parts of both companies. I won't try to explain the transaction, but I summarize the bottom line as I understand it. 

• New company is call Corpco
• PT share becomes 0.63 Corpco share
• OiBr common shares becomes 1 Corpco share, preferred shares becomes 0.92 Corpco share, I'll simplify this by saying each old OiBr share is worth a weighted average of 0.95 Corpco share
• OiBr will issue new shares which in turn will become 0.95 share Corpco in order to generate around 8 billion reais new cash
• The number of shares issued is yet to be determined
• PT shareholders will get R$5.5 bil worth of the new shares because they will give OiBr more than R$5.5 worth of equipment as part of the merger
• PT owns 13% of OiBR
• OiBr own 10% of PT (confusing enough yet?)

So the bottom line is a new company with containing OiBR, PT and R$8 billion. First, I estimated my dilution by estimating the eventual number of Corpco shares. I assume a weighted average common and preferred Oi share price of R$4.2, which is at the recent trading range.

		Corpco Shr
PT share conversion	855 PT shr x 0.63	539
-10% owned by OiBr		(54)
PT equipment contribution	R$5500 ÷ R$4.2/shr	1310
-10% owned by OiBr		(131)
Total attributed to PT shareholders		1663
OiBr share conversion	1640 OiBr shr x 0.95	1561
-13% owned by PT		(193)
OiBr Capital Raise	R$8000 ÷ R$4.2 /shr	1905
Total attributed to OiBr shareholders		3198
Total		4861

Note, that the above factors in the cross-ownership of the two companies: I assume the cross-ownership shares will be retired. This is very likely wrong but it is my best guess at what will happen. The merger announcement said the goal is 38% PT shareholder ownership of Corpco. My above calculation winds up with 34%. This means there is probably something wrong with the above assumptions and calculations. But for the purposes of this article, my estimates are close enough.

The above results in a market cap of R$20.4 bil. And I did some valuation calculations on Corpco. The company would have a trailing Ebitda of R$12.8 bil. A net debt of R$41.2 bil, post capital raise. Which means an EV/Ebitda of 4.8. This is a reasonable number. And as a OiBr shareholder, for each of my weighted average shares I have R$8.47 of debt and R$2.60 of Ebitda. Currently each OiBr shares has about R$16 of debt and R$4.50 Ebitda. So the merger is a good idea because it reduces OiBr debt profile. But the debt profile was bad before the merger, and it is still not so great after.

On the operational side, this merger will hopefully give the combined company a better debt profile so that they will get better interest rates. Right now it is running at the 9% range for new debt. And hopefully the two companies can take advantage of synergies so that their fortunes will turn around by 2015. Nonetheless, OiBr is in a complex situation, and both PT and OiBr are in countries that are suffering a downturn or worse,. In the end, I think my time is better spent with easier to understand small and microcaps. Currently, I am reducing my position and hopefully I'll be rid of OiBr completely before the merger.

For more in-depth analysis, I recommend this article

The other news, I found a thorough article on IEHC. Considering the company's tiny market cap ($9 mil) any analysis is wonderful. I didn't get any new information on OiBr — after all, how much news can you get on a $9 mil company — but it did mention some useful facts about the connector business and its competitors. I didn't know the connector business is actually big business! The press is probably helping the stock too. At $4.20, the stock is 40% up from my initial purchase earlier this year.

My 2nd Annual Schedule of Investments

It has been a year since I listed my holdings. So it is time to update. Below is a list of my 12 largest holdings, in order of size.

Position	Category
Cash and equivalents
Wellpoint (WLP)	US Large cap
McRea Industries (MCRAA)	US Microcap
Seaboard (SEB)	US Mid cap
Chevron (CVX)	US Large cap
Tachibana Eletech (TSE:8159)	Japanese Small cap
Philip Morris International (PM)	US Large cap
AIG (AIG)	US Large cap
Petsmart (PETM)	US Large cap
Oi SA	Brazilian Mid cap
Installux SA	French microcap
Bruce Fund (BRUFX)	Mutual fund
Berkshire Hathaway (Brk.b)	US Large cap

The big change from a year ago is a big allocation to small and microcap stocks. Up to a year ago, I had never bought an small cap, OTC or foreign exchange stock. I purchased my first two small/microcap stocks almost exactly a year ago. MCRAA has gone up 55% since then. But it isn't all that great for me as I slowly built up my large position in the last year. Globus Maritime (GLBS) has dropped -8% in a year. However I sold about three months ago when it was lower. If I had kept it, I would have a 10% gain.

The other big change is that I sold virtually all my tech holdings. I felt that in the last few years tech was simply too undervalued. But now it has probably reached reasonable levels. I don't believe tech is something to hold unless it is really undervalued. I think tech is structured too much for the benefit of employees. Even today, some thirteen years after the dotcom bust, Cisco still reports and focuses on the non-GAAP earnings. In the Q3 announcement, earnings were $0.46 GAAP and $0.51 non-GAAP. The non-GAAP is higher because it strips out the cost of stock options and amortization of goodwill, among other things. But like Warren Buffett says, if stock options isn't an expense, then what is it? And Cisco has been a serial acquirer. If the company doesn't write down goodwill, then it must stay in the books. But doing so would totally distort the equity value versus market cap. And the value of goodwill doesn't stay forever, it dies down many years after the acquisition.

I also bought a few cheap Japanese stocks within the last 12 months. These stocks have not budged much in USD terms. They are trading considerably lower than my estimate of their intrinsic value. I just don't get why. Tachibana Eletech for example trades well below net-net and has 8% ROE. Why? But despite my bewilderment, I am ready to stick with them for two or three years. I am not a believer of catalysts. I prefer to put my faith in the efficiency of markets. If the companies' fundamentals and the Japanese economy and monetary policy stay on track, the companies' stock price will eventually get to my value.

Speaking of efficiencies, IEHC reported first quarter earnings recently. When the company reported year end results, the stock price didn't budge. But on the first quarter results, the stock price jumped some 15%, for good reason. Earnings were up 64% yoy ($0.23 vs. $0.14), and revenue was up 11%. I could not find any insightful explanation for the increase in revenue and profits. However they did say that:

The circular product line of connectors introduced several years ago for the medical industry continues to be very rewarding for the Company. The line has been expanded to include connector cable assemblies utilizing the circular connectors.

A new product line featuring high density connectors is being added to the Company’s product offering. This offering should be available within the next few months. The Company expects the new product line to bring additional revenue.

The sudden price movement taught me a lot. IEHC is a $9 M market cap company. For its stock to move like that means the market can be efficient even for such a tiny company; investors like me are watching the stock.

Oi Reports Disappointing Q2 2013

Oi (OIBR) just announced their Q2 results. And the news didn't improve. Revenues increased slightly QoQ but EBITDA decreased significantly to 1797 M reais from 2151 M reais a quarter ago — 1 USD is approximately 2.2 reais. This meant earnings came in at -124 M reais (-0.08 reais per share) versus 262 M reais a quarter ago. This is the first losing quarter since 2011.

Management said the 354 M reais drop in EBITDA was because of three main expenses. The followings shows all their operational expenses.

The first problematic expense is personnel. Management said the increase was due to an one-off wage benefit (100M) and a 6% inflation increase to wages. The second is marketing expenses. Oi is the official sponsor of the just completed Confederation Cup and spent 66M. The third one is bad debts (115M) which was due in part because of the downturn in Brazil's economy. So the management emphasized that the drop in net income can be explained by one-off special expenses and bad credit requirements. Bad debt is running at about 300M a quarter and should be half that. But if the sales department get picky with customers, how will that affect revenue?

To me, the crux of the problem is the margins, EBITDA margin is now 25.4% versus 30.5% a quarter ago. This is clearly unacceptable. But can the company change that, or is it that the company needs low margins to sustain the revenue? The jury is out. But from a revenue perspective the company seems to be doing ok. The newly appointed CEO Bava did emphasize costs as his first priority. The media is very positive about him, if he is that good, I think he should be able to fix the cost problem.

Debt and Dividends

The company's net debt level is now at 29.5 B reais. That is a 2 B increase over a quarter ago despite 1 B in asset disposals! The company paid 900 M reais in various fees that are not quarterly recurring. Capex was 1506 M reais. Bava said that capex will be lower next year, below 6 B reais. The company has 12 B reais of liquidity so I don't think it is an issue over the next year or two.

To help manage the debt problem, the company will now pay the legal minimum of about 500M reais a year in dividends. That works out to about $0.14 USD per share. The preferred stock last traded at $1.61 USD per share.

In addition, in the coming two quarters the company will realize more than 1 B reais cash for previously mentioned asset sales.

Final Thoughts

My original reason for buying Oi many years ago was to participate in the rise of the BRICs. Many developing countries are now hitting a speed bump. But emerging ecomonies will be the growth of the future. Brazil has a fast rising middle class that will very much need telecom services. Oi I feel is a company that just needs to get its act together. It has been under medicore mangement for too long.

Portugal Telecom, Bava's previous company and Oi's parent company, also reported poor earnings recently. In the coming weeks, I will, look into PT to see if Bava is really that good and what he did at PT. I may post my findings.
 
As another note, Fitch just downgraded Oi from BBB to BBB-. This is the last rating before junk.

Installux SA H1 2013 Update

Just after my recent post on Installux SA, the company reported their first half-year earnings. The company earned € 13.69 / shr, which is a 14% drop yoy. Revenue dropped 10% yoy. Gross margin was 56% versus 53% a year ago. EBIT margin remained constant at 11%. So the company appears to manage costs well in light of the downturn in France. And this year the company will continue to increase book value — which is larger than market cap — and pay a 5% dividend.

One Year Anniversary and Contrarian Indicators

Horray, I have consistently kept up my blog for a year.

The other day I read this in an online article:

It's just about the most audaciously optimistic investment opinion one could utter, yet a relative handful of Wall Street voices is beginning to say it, out loud and assertively: This market has passed through a 1982 moment.

1982 was the end of stagflation of the 1970's and it signalled the beginning of a two-decade roaring bull market. When I saw this I thought bingo, contrarian indicator! I think of macroeconomic considerations as just one factor in my investing strategy, but I take any individuals opinion with a big dose of skepticism. Macroeconomic issues are notoriously difficult to predict because they involve inputs from many factors and many individuals. Take currencies for example. Currencies is a huge market that is controlled by interest rates and inflation rates. It would seem so easy to bet on future direction of currencies, but it yoyos and often catch people by surprise. I would never directly trade currencies, though I would buy stock in another country without hedging.

But I have to think that now is nearing the crest of a bull market. And when I read that we are heading to a bull market like 1982, I just have to mutter, while shaking my head, "you've got to be kidding me!" The article goes on to remind us that the market went up 14-fold in the next 18 years. Meanwhile, Grantham at GMO is predicting negative returns for US stocks over the next 7 years. I hate to predict market direction, but I am thinking it is very likely that this article is a harbinger of the bull market peak. I think S&P 500 will be below 1700 for a while after the current run.

In other news, Seaboard (SEB) is the latest of my stocks to report earnings. The company reported Q2 2013 earnings of $33.07 versus $41.68 a year ago. For the first half of 2013, earnings were $81.06 versus $109.63 a year ago. Revenue was up about 10%.

Pork is Seaboard's largest segment and corn is the largest part of feed. Corn prices were reasonable in the quarter coming off last year's drought, but now, corn is starting to return to the levels of 2010-2011 when Seaboard profits were good. The power segment did well also. The remaining segments combined lost money. So this confirms my view that Seaboard will constantly struggle with thin margins. Recently the stock reached an all time high of $2948. The stock now has about a $2000 tangible book value and has a projected fiscal year P/E approaching 20x. So I think overall this stock is fair to slightly overpriced at $2948. I have sold some of my position but SEB is still my second largest holding.

2013 is a Tough Year for Installux SA

While I await Installux SA's 2013 semi-annual earnings report, I found this company report published in June. It is a message from the CEO regarding the company. I am going to paraphrase parts of the report it here in English because the report, like everything else from Installux, is in French. If you can read French, please disregard this post and read the report instead.

Revenue (2012)	€ 113 M
EBITDA	€ 13.6 M
Net income	€ 6.7 M
EV / EBITDA	2.1x
P/E	7.1x
Price shr	€ 156
Dividend yield	5.1%
Total shr outstanding	303k

In it, the CEO Christian Canty discusses how the company did quite well in 2012 despite the bad economic conditions in France. The company's sales has been flat for the last five years. And the CEO has been aggressively trying to take market share from competitors. However, the company cannot expand given the overall economic situation. So the company will wait for the European recession to pass, wait for better days.

Preliminary results for the first four months of 2013 are bad, but not unexpected given the economy. For the first four months ending in 30 April, 2013, the company's sales are down 10% and operating profit down 24% compared to a year ago.

My biggest worry with this company and my Japanese holdings is the difficulty of gathering information; I can only read English. But this report sooths my nerves a bit. Installux makes aluminum products for housing in France and some other countries. I feel this is a solid , boring, small company. The perfect type for a small-time value investor like me.

---

Disclaimer: the information on this post was the result of Google Translate and my interpretation, neither is guaranteed to be accurate.

WLP, AIG, KCLI and CVX Earnings

More earnings releases from my holdings:

Wellpoint (WLP) reported Q2 earnings of $2.64 and raised the year's earnings forecast to $8.00. Since the news, the stock has barely budged at around $85. In their conference call, they emphasized they are expecting excellent growth in their medicare business because of Obamacare. Overall, management expects revenue to grow from the current $71B to $90B by 2016, in no small part due to Obamacare! This is the first quarter under the new CEO Joe Swedish. I liked hearing his plans to squeeze more efficiency out of the company.

AIG reported quarterly earnings of $1.12. AIG stock jumped to $48.33 on the news. AIG book value is $66 per share. In the earnings release, the company generated a lot of press when it declared a $0.10 dividend. This marks a milestone as this is the first time AIG returned capital to shareholders since the bleak days when it was bailed out.

Kansas City Life Insurance (KCLI) reported earnings of $0.98 for Q2 2013. They earned $1.45 for the half year. The stock trades at $42.88 which is only about 2/3 of book value. The stock has risen about 15% since I first wrote about it and bought. I am waiting the stock price to inch closer to book.

Chevron (CVX) reported Q2 earnings of $2.77 per share versus $3.66 a year ago. Earnings for the half year is $5.95 per share versus $6.93 a year ago. The company is diversifying into natural gas. The company needs new sources of revenue. This is just the volatile business of energy (or any other resource). CVX is one of my oldest holdings and I am not concerned about the earnings blip.

My OI S.A. Fiasco

May a year ago I found a Brazilian telecom company that paid more than 10% dividends. I was amazed, and bought it without understanding too much about it. The company ticker was TNE. I watched the stock as it climbed while still giving me 10%. And even when it dropped I thought oh ok I still made good money on this stock considering the huge dividends I got over the year. Then about a year ago, the stock started a incredible slide. And being comfortable being an owner for many years, I bought some more earlier this year. But it continued the slide. The stock has dropped some 80% to date.

Background

Before I continue the story, let me recap the company's history. Brazil is a country with quite a lot of regulations. And company's have complex structures as a result. The company was Tele Norte Leste Participacoes. In 2008 it merged with Brazil Telecom, and after several reorganizations, the company became Oi S.A. (OIBR ticker). Oi is the brand name of the mobile phone service they provide. Oi is one of the four biggest cell phone providers in Brazil, and it has biggest landline network in the country. It is also the second largest telecom company in South America.

As of last year, the company was losing customers. So the company hired a Franciso Valim as the CEO and initiate a turnaround effort with heavy capex spending. In turn the company has slowly started to increase its customer base. But today still, the company's mobile business is not great compared to the other three big mobile providers in Brazil. It's landline business is losing customers, although the company is trying hard attract new business with its internet offerings. In January, Valim was suddenly ousted and replace with an interim CEO.

But the company's biggest problem is its debt. This debt is the result of paying for its acquisitions and its huge dividend. The company currently has net debt of 27.5 billion reais — 1 USD equals 2.2 reais. The company calculates net debt to be total debt minus cash and equivalents. In addition, the company plans to pay about two billion reais per year in dividends. This is the primary reason the stock is depressed: the company's net income is only about a billion reais a year! The company can only dole out such high dividends by adding to debt, and the debt is nearing its limit.

The dividend and debt is this screwed up because the company is majority owned by Telemar and Telemar needs the dividend payments to finance its own debt. And I never realized this until recently! This is a very hard lesson on doing my homework.

 

Recent Events

The recent bad news started with the first quarter's results in April. Earnings came in at 0.16 reais. But most disappointing was the 2.5 billion reais increase in debt. About 1 billion reais was for dividends, but that still leaves a 1.5 billion reais cash burn. That was the cause for the stock's slide for the recent months.

Then in June came news that a star CEO Zeinal Bava will run Oi. Apparently, Bava is famous in Europe. He ran Portugal Telecom and apparently did a good job. Portugal Telecom is also part owner of Oi and Bava was on Oi's board.

EBITDA	9.0 billion reais
EV / EBITDA	3.8x
P/E	3.9x
Interest coverage	>1.75x
Price preferred shr	$1.85 USD
Price range Apr'13	$1.44 — $2.50
Total shr outstanding	1.6 billion
1 USD	2.2 reais

Next, in quick succession, the new CEO did the following:

1. ousted the CFO and some other key executives 
2. canceled a planned 2 billion reais debt raise
3. raised 2.4 billion reais by selling company assets 
4. and stopped the coming planned billion reais dividend 

With each piece of news the stock yoyo'ed. It was a sickening ride. The table on the right shows the key stats based on the last 4 quarters.

In times like this with so much negative sentiment regarding a stock, it pays carefully and objectively look at the facts. The company's funding has been a persistent issue, but disregarding that company is profitable enough. EV / EBITDA is a common metric to gauge a company's value for a takeover. For Oi it is 3.8x. As a comparison Sprint, which is in buyout talks, is at 6.4x. So, if someone could pay the enterprise value that person would get a profitable business.

And buyout isn't the only option, an equity raise is another, this is just an illustration to put it all in perspective. If the company can fix it's debt problems, what remains is a good company and the stock will naturally appreciate.

Debt

But seeing that debt is the key issue, it's good to know how Oi got here. The following shows the increase in debt over recent quarters. Clearly the dividend was a big chunk and removing that from now on will help. It isn't clear what the working capital drain is for, but it should be matched by something else on the balance sheet. The escrow item is mostly judicial deposits. I am amazed at how much Oi is being sued. Maybe that's just how things work in Brazil. Escrow is the requirement by law and is not the same as provisions, and could be reversed in the future. But by far, the largest items that affect the debt are EBITDA and capex. EBITDA has to improve, hopefully Bava will make it happen. Capex was targeted at 6 billion reais this year. Oi needs the capex to be competitive. But hopefully it will go down next year.

And so now, after hearing all the negative sentiment online, I know much more about the company. And now I must objectively decide what to do regarding my Oi position. So, I ask myself, if I didn't own any Oi stock, would I buy? And my answer is I am not sure. Oi has screwed up operationally, but the company has turnaround potential. In addition, the Brazilian stock market has fallen close to a five year low. My feeling is that it is oversold. So, part of Oi's fall was in sympathy with the market, and it will rise also when the market reverses.

In any case, investing in Oi takes faith. I believe that Bava knows what's going on in Oi after having been on its board and he took the CEO job because he was confident that he can turn the company around.

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.