January 31, 2008

Markets Risk Pricing

The market has returned 5% since it reached its lowest point in a year. So far the S&P is down 13% from its peak; hardly anything to worry about. As an investor I do not want over exuberance and I want the markets to be pessimist about events so I can find deals and discounts on businesses.

The markets is staring at a lot of negative events and it rallies 5%. That does not give me comfort. Let me recount the negatives:
  • The economy is slowing down and possibly will go into a rescission.
  • Banks have written down more than $150 Billion in assets and the meter keep running as they are faced with more uncertainties from CDO and CDS exposure.
  • Housing market is a rescission and have a huge oversupply of inventory that it is estimated to take 2 years to clear.
  • The consumer is leveraged to the tilt and just lost its ATM machine in home equity.
  • The cost of food and energy are running high further depression the baility of consumer to spend.
In face of all of this the market and banks, in particular, are rallying, which gives the impression that markets are not discounting the risk appropriately. Although I have been buying banks lately, the rally is way too soon in this group.

Even with the market down some 13% from its peak, I would not consider it cheap here. I consider some groups cheap and worth a look, but not the overall market. If you consider its PE ratio historically it is very high. Take a look at PE graph where it plots the PE ratio of the S&P, ratio is adjusted to consider the average 10 years earnings. The PE is adjusted so we abstract from the economic cycle by using
average earnings, which should cover a period of not less than five years, and preferably seven to ten years
, as Graham and Dodd used it.

The chart reveals that US equities couldn't be called cheap. In fact US equities are currently about as expensive as they have been anytime since 1929 (excluding the dotcom mania).

High valuation and rallying in face of uncertainty, gives time to pause and reconsider committing to much new money to positions. I want to buy when people are selling rather than buying.

January 30, 2008

Earnings Review

I want to go quickly over some earnings announcements of recently analyzed businesses:

Kraft Foods:

As we discussed food input costs are racing away, which makes food manufacturers hard to make any meaningful profit growth. KFT recent results just echoes this thesis. Its dairy input costs squeezed its margins. KFT is in a tough situation, as it can't raise prices significantly for fear of losing market share. Other food companies like Kellogg's came with disappointing results because of rising input food prices.

Most of food companies like UN, KFT, K have came off their highs in the last couple months declining between 10-15% in line with the market in general. however, when you consider these businesses as stable and low beta, their declines are more attributed to the tough food input costs rather than general market decline.

I still like UN as a business due to its portfolio of consumer products. Although it came off its highs, I think for a value idea I will wait a bit further.


Today MO came with its much anticipated results. As expected it delivered good quarter with growing international market and declining to maturing US market. It also announced it will spin off its international tobacco to its shareholders. Like I have discussed before, the events are reflected in the stock and it is trading at fair value, see my post here, as a result it stock did not move much with the announcement.

I think there will be an opportunity to own MO after March 28, the date for the its tobacco international spin off. MO will be dumped by significant institutional holders as they want out of a mature and litigation prone US division and will be owning the growing international business. MO will be trading at a discount and high dividend yield, I anticipate it to be in the 5-6% range, if my thesis is right. I think that when you want to consider it as a position in your portfolio, not now.

January 28, 2008

Stock Pair: Short XLF Long BofA- Part 2

Following up to my stock pair strategy, see original post here, I have did some quantitative analysis. Before I go to my analysis, here is a quick recap of the strategy:

  1. Short XLF, which is financial SPDR with a dividend yield of 2.99%.
  2. Long BofA with a dividend yield of 6.5%.
  3. The long and the short side of the strategy will be dollar for dollar.
  4. The dividend yield differential will be return on investment.
  5. The capital required for the strategy is none, so your return on investment will be quite high.

Here are my findings:

  1. The correlation of .7 is statistically significant. That means there is high degree of true underlying relationship between the two assets returns. How can't that be since BofA is the largest holding in the XLF making about 9% of the ETF value.
  2. The returns pf BofA and XLF do not follow a normal distribution, however they are positively skewed with BofA having fatter tails, i.e., BofA has more probability of outperforming XLF. See graph of the return distribution of both assets over 109 months. This signifies that the probability is higher that BofA will outperform the XLF.
  3. If I back-test the strategy I will earn 10.11% annually. the strategy had a positive monthly return of .55% on top the dividend yield deferential of 3.51% due to BofA outperforming the XLF. Take a look at the probability distribution table below; over the last 109 months the strategy expected return would have been .55% monthly.

Overall the strategy seems promising as the short will give a hedge against any losses in BofA due to the recent turmoil in baning. However my expectation is BofA will trade higher over the next two years.

Book Review: When Genius Failed

Although the book is not new, but I think reading it now is timely.

The book is about the famed hedge fund Long Term Capital Management meteoritic rise and spectacular collapse. it discusses the formation, the strategies employed by the fund, the market turmoil, and the dizzying losses by the fund.

The book is timely because similar circumstances to today's liquidity and widening spreads were prevalent at that time as well. Credit spreads were widening, lenders were no were to be found, and market liquidity dried up causing crashing asset prices. These are similar aspects to the current environment but today we have a housing recession that is adding a complicating dimension to the mix.

Here are my take ways from the book as an investor:
  1. Wall Street is less transparent than you think.
  2. It is critical that you have a focus, even the pros have focus and specialized areas that they do not stray from. LTCM was successful when it stuck to its niche but once greed took over and expanded to other areas, it suffered tremendously.
  3. Long term is superior to any other holding periods as it ignores short term economic and market fluctuations that bear no weight on assets value.
  4. We will have many market crises over our lives, it would be foolish to react to any of them without proper understanding of the causes. Never shoot and ask questions later.
  5. Individuals trading against the professionals are at an information disadvantage. Many professionals knew LTCM positions and traded against them with disregard to any economics; any individual with no such knowledge would have been killed for no apparent reason.
  6. Wall street will knows no shame. Most of the principals of LTCM have launched another hedge fund with mostly the same investors of the previous fund.

Halliburton: Earnings

The company reported its earning this morning and came with solid growth figures from its projects in the middle East. This is the only figure that I needed to check to validate my analysis from last week: see here.

Its revenue from that part of the world rose by 28% while its competitors recorded figure of 20% revenue increase. The revenue increase from this geography will continue to move upward given the recent moves and focus the company has.

January 27, 2008

Stock Pair: Short XLF Long BofA

The strategy:

Long BofA shares and short the XLF (financial index ETF) to pocket the dividend difference between the two assets ( Dividend yield differential: 3.51%).

Strategy Rationale:

  • The strategy is to exploit dividend yield differentials and it is slightly bullish on BofA.
  • The two assets are highly correlated at .7, which means a high degree of similar return movement over time, XLF has a 70% probability of positive return if BofA has a positive return and vice versa. The pair most of the time will likely yield a zero sum profit/ loss relationship.
  • With the strategy you can avoid the uncertainties in the banking sector by maintaining this hedge.
  • BofA composes 9% of the index, so a big chunk of XLF's returns are generated and explained by BofA stock movements.
  • BofA has a 6.5% dividend yield while the XLF has a 2.99% yield. The difference in yield can be the return on this hedged strategy of 3.51%, which is a bit higher than your T-bill rate.
  • BofA is fundamentally stronger and has upside potential, in my view, in comparison to other financial holdings of the index.
  • The average return for BoA is .005 over 109 monthly observation, while XLF has an average return of .002. so the strategy has a probability to achieve upside potential of higher returns on BofA compared to XLF.
  • The strategy does not require any capital except for your broker margin requirements.

Strategy Risk:

  • Company specific risk. In other words if BofA fundamentals deteriorate or decides to cut dividends the strategy can be a loser and should be closed immediately.
  • Historical relationship may not hold into the future. The stock market is notorious in destroying historical statistical relationship, just ask the principals of Long Term Capital Management.
  • Your liquidity risk. The relationship can hold over time but that does not mean that it will hold each single day. Some days you will be under due to daily price movements and BofA specific announcements. So your ability to maintain your short is critical, if your broker calls you to cover the margin. Do not undertake the strategy if you can't provide additional margin.
  • If you think this is like "picking nickels in front of a bulldozer" then obviously the rewards do not justify the risk. But if you believe in the statistical relationship between the two assets and it will continue to hold then you have a nice return for almost no capital.

Your input on the strategy is greatly appreciated!

Value Idea: Halliburton

Company Overview:

Halliburton Company (HAL) provides a variety of services, products, maintenance, engineering and construction to energy, industrial, and governmental customers. Its six business segments are: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Energy and Chemicals, and Government and Infrastructure. It refers to the combination of Production Optimization, Fluid Systems, Drilling and Formation Evaluation, and Digital and Consulting Solutions segments as its Energy Services Group (ESG).

Recent Transactions:

  • Halliburton Company’s Energy and Chemicals, and Government and Infrastructure segments are part of KBR, Inc. (KBR). As of December 31, 2006, the Company held an approximate 81% interest in KBR, Inc. In April 2007, the Company completed the separation of KBR. As a result, the two companies are separate and independent of each other.
  • In January 2007, Halliburton Company acquired Ultraline Services Corporation, a division of Savanna Energy Services Corp.

Business Economics:

  • HAL generates just about 50% of its business from North America much higher than its peers where international revenue dominates. However HAL has made strong moves to boost its middle east business by moving its head quarters close to its target customer base. HAL enjoys strong relationships with the ruling families of the gulf area which will help it cement more business in the region.
  • The world's oil is more frequently being discovered in remote and difficult to get places. Therefore, HAL expertise and technology will be more valuable increasing demand in the years and decades ahead.
  • If oil peak theory is partially valid, the commodity will be dear and getting it out of the ground will be a priority that will earn HAL solid revenue growth in years to come.
  • With a high percentage of total global reserves now in the hands of state oil companies, large, experienced service companies that can provide packaged assistance to countries with less technical sophistication will be especially well-positioned as the replace big oil and the major integrated companies. State oil companies have accumulated the expertise to manage those projects without the help of big oil and now they are contracting directly with the like of HAL and SLB to help them get the oil out.
  • North America business has been depressed due to low natural gas prices and in turn exploration for the commodity have slowed down due to low economic return. But the demand for gas is increasing giving its prices a boost in the future, which in turn will help increase drilling efforts and earnings for HAL.
  • The obvious risk to the company and its competitors is a severe rescission that could lessen demand for oil and thus HAL services depressing earnings.

Business Valuation:

Last Price33.0977.7072.17
Mkt Cap Billions29.192.9 22.9
Earning Yield10.86%5.40%6.22%
Cash Yield9.85%5.75%7.43%
P/E Ratio 1318.516.10
Price to Sales1.85.072.6
Price to Book5.078.584.33
Price to Tangible Book5.6416.035.87
Price to Cash Flow 10.1517.3813.46

  • All companies in this area have strong economics and business ahead of them but I choose HAL on valuation basis. They are undervalued compared to Baker Hughes and SLB.
  • HAL enjoys a discount on comparative basis to its peers, however its earning growth and return on capital is not materially different from them to justify such a discount.
  • I believe HAL has underperformed and valued less than its peers for couple of reasons:
    • Its ownership of the controversial KBR, which originated all Iraq and military scandals. Now that the unit has been spun off; Hal can be a pure oil service company with no political or military affiliation. I believe Hal is still negatively affected by that relation and that is why its share price is not responding well for the positive oil environment. The perception should correct with time making this as an opportunity to buy into a growing company.
    • As we talked above, its large exposure to north America oil and gas sector has slowed its results, but from a long term point view that segment will correct as demand for natural gas increases the demean for well drilling and service from companies like HAL.
  • A discounted free cash flow valuation pigs HAL's intrinsic value at $45-59 per share, which gives you a huge discount of 33-79% from its current trading levels.


Attractive valuation, positive trends for the bulk of HAL’s businesses, and solid cyclical fundamentals should eventually outweigh the market’s overly bearish perceptions and expectations for North American pressure pumping. HAL has underperformed the OIH index by 10% year/year, under-performing its chief competitor SLB. This is inconsistent with HAL’s strong technology portfolio, growth segments and international footprint. Perception problems about the recent scandals and recent market declines makes this a good point to buy HAL's shares.

January 26, 2008

Was the Fed dubbed into a rate cut? I do not think so

There was a lot of theories that the fed has cut interest rates in response to declining stock prices. Mainstream media and economics blogs rave that the fed has been dubbed by the massive decline in market on Monday earlier this week. I did not buy into it. There is a lot of economics problems occurring in the US economy mainly a credit problem and housing problem that needs to be dealt with and needed an action by the fed.

To have another perspective on the rate cut here is an expert from John Mauldins news letter regarding the fed cut and the reasons behind it, this one makes much more sense to me:

What Does the Fed Really Know?I believe the monoline insurance companies like Ambac and MBIA are in worse shape than most realize, the counter-party risk in the $45 trillion Credit Default Swap market is much worse than we realize, and the exposure by various banks to their problems is much larger than currently understood. The Fed understands this, and realizes that they have been behind the curve but need to catch up. Let's go back and look at this quote from my letter just last week:"If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monoline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:" 'MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share. " 'The bond insurers' business model is irreparably broken. In HCM's view, it will be all but impossible for these companies to raise capital at economic levels for the foreseeable future and certainly in enough time to work out of their current difficulties. The
performance of MBIA's 14 percent bond issue will prove to have been the death knell for this business. The market needs to come to the realization that the so-called insurance that these companies were offering is not going to be there if it is needed. The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come.'"You can bet that the $8 billion in CDO-squareds is gone. It is a matter of time. MBIA's market cap is about $1 billion [it is now at $1.74]. Current shareholders will be lucky if they only get diluted 75%."Think this through. MBIA is still rated AAA. Ratings downgrades are just a matter of time. Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers, according to analysts at Barclays Capital. Banks will need at least $22 billion if bonds covered by insurers, led by MBIA Inc. and Ambac Assurance Corp., are cut one level from AAA, and six times more than that for downgrades by four steps to A, as Paul Fenner-Leitao wrote in a Barclays report published today. Barclays' estimates are based on banks holding as much as 75% of the $820 billion of structured securities guaranteed by bond insurers. (Source: Bloomberg)The stocks of MBIA and Ambac have risen on speculation of take-overs
or a rescue. But MBIA is going to have to cover that $8 billion of CDO squareds.
With what cash? MBIA makes about $5 billion a year. It will take almost two years' earnings just to deal with the losses from CDO squareds. Not to mention the subprime mortgage exposure.But what if the above-mentioned monolines are
downgraded to junk, as was ACA when it could not raise capital? As the downgrades on various mortgage assets and the CDOs continue to increase, the ability of the monolines to deal with the problems is going to come under increasing question. The losses at major banks could be much worse than $122 billion if they are downgraded to the same junk level that ACA was. And that is just the credit default swaps (CDSs) from the monolines. What about the trillions that are guaranteed by banks and hedge funds? There are a total of $45 trillion CDSs outstanding. No one is really sure who owes what and to whom, and what is the risk that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. It may take a year or more.I think the concern that there is the potential for a much worse credit crisis than we are currently experiencing is what is driving the Fed.
They are looking at the problem from the inside, and realize that they simply have to engineer a much steeper yield curve to allow the banks to make enough profits so that they might be able to grow their way out of the crisis over time. If I am wrong and the Fed was responding to the stock market, then we will likely not see a cut this next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut the next meeting and the next until we get down to 2% or below.A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking. We will see. And it is not just the Fed that is concerned.

January 24, 2008

BofA plans share offerting

BofA will offer two types of equity offering for $6 billion:
  • Perpetual preferred shares: these are quasi equity/ debt or somewhere in between. The security will entitle holder to receive fixed dividend amount with no growth in dividends and generally these shares have limited upside. But unlike debt they can be outstanding forever, at least theoretically.
  • Convertible preferred shares: similar to the above but after Jan 2013 holders can convert them to equity and as a result any holder of BofA common share will get his ownership diluted.
The split of the $6 billion between the two types is still not clear. The prospectus that BofA filed with the SEC has not identified several pieces of information like dividend rate and such.

Citi Prunes Its Branch Expansion - WSJ.com

Citi Prunes Its Branch Expansion - WSJ.com

The News: Citigroup will end a push to open more branches, concluding that the strategy has done little to increase the company's stature amid entrenched competition.

I think this is a sound strategy by Citi: focus on your strength rather than weakness as the cost to improve your strengths is very marginal compared to the cost to improve or neutralize your weaknesses. Coincidentally this action bodes well to the likes of BofA and USB as they will face less competition for market share.

Citi has one of the smallest number of retail branches in the US with just 1100 compared to over 6000 for BofA. Clearly fighting BofA or JP Morgan is a losing battle for Citi and its shareholders. Citi holds no competitive advantage or economies of scale to leverage in its fight for market share. The most logical conclusion is an orderly retreat and redeployment of cash to an area where Citi is much more competitive.

So far Citi has been doing all the right strategic moves: reshape of losing strategy, cut dividends, lay offs and cost cutting and new capital infusion. Citi is looking more attractive as a turn around story.

January 23, 2008

Today's market: Talk about moody

Today is one of these days that makes you go Hmmm!

The S&P made a 5.5% swing in few hours, measuring from the low of the day to the close, which was the high. That percentage swing is rather large for intra-day move. I am not sure if we have managed to fix the economy and all the credit problems since lunch today. Amazing!!!

Today's action is just another proof that to be successful in investing it is about following a process independent of market action and economic forecasts.

January 22, 2008

Bears and Bulls and in between

In this type of markets where uncertainties abound, there three types of investors:
  1. media types who tell you it is a buying opportunity and recommends whatever idea of the day,
  2. the cynic and those usually can be found in newsletters and blogs who tell you the world is ending and to buy gold, and
  3. there is the investor who makes money who you almost never see on TV promoting ideas or hear from on the news letter and blogs. Think about Buffett, Carl Ichan, Soros and others who are still doing deals and looking for opportunities.

To the third camp investment is their business; investing is a profession they can't stop doing it in light of economic forecasts and trends and whatever chart of the day that may be circulating the screens of bloggers. I would like to be in the third camp by ignoring the fear calls of impending doom and disaster. As well as I would like to shut off the happy go lucky optimist where risk does not mean much.

Investment is process and it pays if you adhere to that process over the long term you will get rewarded. Both 1 and 2 types are timing the market whether they admit or not. Timing is never rewarding; reading macro economic trends and reacting to them will never pay off in the long term.

This reminds me of a saying by Lau-tzu:

Those who have knowledge, don't predict. Those who predict, don't have knowledge.

BofA Earnings Summary

Today BofA announced their earnings and it was some announcement; 95% earnings decline. Here are the highlight of the call:

  • $5.44 billion trading losses; good thing that investment banking is being pared down. These earnings are volatile and undependable.
  • $5.28 billion CDO and mortgages write down; this write down bring BofA tally of just under $10 billion in write downs over the last two quarters. I think this is it for BofA as they essentially wrote down all their CDO exposure to almost nothing; about 30 cent on the dollar according to their CFO. If the market recovers you can expect a nice jump in earnings.
  • Increased bad loans reserves due to higher possibility of defaults due to slowing economy.
  • On Credit Cards: “We have seen an increase in delinquency in our card portfolio in those states most affected by housing problems. So give you a little insight, the quarter-over-quarter rate of increase in 30-day plus delinquencies in the combined states of California , Florida , Arizona , and Nevada increased over five times the pace of the rest of the portfolio. That group makes up a little more than a quarter of our domestic consumer card book. We have mentioned before that we expect to be in the 5 to 5.5% range for overall consumer card losses for the full year of '08. That compares to the 4.75% we experienced in the fourth quarter”
The bank will continue to face some issues this year but over the long run I still think it is a good business.

The markets are insane going up and down on a whim. I take these opportunities to add to my positions although ever so slightly. Buying in small quantity and periodically makes more sense than going all in at this time.

January 21, 2008

Book Review: The Smartest Guys in the Room

I have just finished a book called the Smartest Guys in the Room; a story about the Enron collapse. Although the subject is not timely, but the take aways from the book will make you a better investor. I highly recommend reading the book.

The book, at least for me, is not about Enron and corruption, it is about investment analysis. The take aways were about being a better investor, a more diligent one, and think for yourself mentality.

The book highlight the story of Enron, its players, rise to the pinnacle of Wall Street and its speedy fall. It documents the transactions and the accounting schemes to boost earnings and cash flows.

As investor there are several takeaways from the book:
  1. Thinking for oneself is a critical trait for success. All of Wall Street fell head over heals for Enron and its "new age" business model. However clues for the shortcomings of Enron were plenty in their financial statements. Crowds just followed the lead of the few into Enron and kept being fed its story.
  2. Do not invest in what you do not understand. Until now some of Enron own analysts did not understand how the company operated but they were mesmerized by its coolness.
  3. Cash is king. if cash flow from operations do not grow along side earnings be very skeptical of the company.
  4. Read the notes to the financial statements along with proxy statements carefully as a lot of Enron's illusion could have been detected, but no one cared in a bull market to do so.
  5. Leverage can unwind a company very quickly.
  6. Accounting manipulations and earning management occur more than you think in main stream corporate America, although it may at a varying degrees.
  7. The potential of investment banking fees is what determines an analyst recommendation, not the quality of company earnings or its economics.
  8. Equities and investing is less transparent than you think.
  9. You will hear the story of Enron again.
I highly recommend the investment of time in reading this book. It is not really important to know the accounting tricks as it is to understand the lessons of the fall. I highlight it some above and I am sure when I reread it other will be come apparent.

January 20, 2008

My Portfolio Managament

Yesterday I have talked about managing your portfolio as if you manage a business. The goal is always to grow the business or the portfolio by maximizing your returns. In this post I want to share with you my overall guidelines for managing my portfolio to see what readers think; am I on the right track or is there something I am missing.


My goals for portfolio are the following:

  1. Achieve an overall portfolio of 3-3.5% dividend yield on book value.
  2. Maintain asset allocation requirements on a yearly basis.

Asset Allocation:

I divide my portfolio to two sub portfolios that I will rebalance quarterly:

  1. Core portfolio that will hold index funds, fixed income and cash divided to
    • Fixed income and cash up to 20% of the overall portfolio.
    • US market index 12% of portfolio
    • Canadian Market index 12% of portfolio
    • International Market index 10% of portfolio
    • Emerging Market index 6% of portfolio
  2. non core portfolio that will hold individual stocks. This sub portfolio will be 40% of my overall portfolio.

Buying Process:

  • Generating Ideas: I will use screens, reading or general observation of my day to day life to come with investment ideas. What I will not use is media and analyst recommendation.
  • Analysis: I must figure the competitive advantage of the business and management track record by analysis its prior actions results.
  • Valuation: the company must offer compelling value to its market price for one reason or another for me to be interested.
  • Initiate position: buy incrementally and frequently into a stock.

Portfolio rebalancing Guidelines:

The following are my overall portfolio restraints that need to be observed to minimize over exposure to the risk of a certain investment class, once a position is over the goal it needs to be rebalanced by selling/ buying part of the position to achieve the following:

  • The overall core holding to be in the range of 60% ( this is split to 40% equity indices and 20% income producing assets and cash)
  • The overall non core holdings not to exceed 40%
  • The overall Cash position goal: no more than 5%
  • There will be no investment in more than 10 businesses in the non core portfolio at any time.
  • The overall Emerging Markets positions not to exceed 15 %
  • The overall fixed income positions to be in the range of 5 – 20% from total portfolio
  • Any individual company in the non-core position to be limited to 10% of the overall portfolio
  • The overall total small cap positions not to exceed 15-20%
  • The Major market indices (e.g. S&P, NASDAQ, TSX) not to be less than 30%
  • Rebalancing time frame: on quarterly basis on the following months: December, March, June, and September.
  • If an asset-class allocation reaches 150% of original allocation, cut it back to below the target allocation - 75% of target allocation.
  • If asset class then falls to 50% of original allocation, restore it to 150% of the original allocation(1).
  • Increase cash position/ reduce positions to specified limit when yield Curve flattening or inverting. Negative differential between 10 year Treasury and 3 month TB indicate a high probability of a recession in the next 4 quarters.

  1. [SA1]The rationale is as follows. If one asset class is appreciating much faster than the others in your portfolio, you want to ride the momentum to 150% of your target allocation. But when you are ready to trim back the asset class, it’s probably become overvalued relative to your other assets. So sell more of it than would be required to return to your “normal” asset allocation. Similarly, if the asset class then depreciates significantly, it has probably become cheap relative to other asset classes, in which case you can overweight it.

January 19, 2008

Run your Portfolio as a Business

With the market prices declining very rapidly and it seems that we are entering a bear market territory, declines of 20% or more, the question is what to do?


I am going to continue along in my process: find undervalued companies, hold for the long term and buy incrementally into them by purchasing small position frequently. I have been doing this with LOW, RioCan and BofA. With every 10% decline in the stock price, I bought additional shares. I will continue doing this until the company reaches my maximum limit of 10% of my portfolio value.

The economic climate we are in can persist for 6 months or 2 years, who knows. However, the one thing that I have learnt while running a start up is you do not close shop because the economy is tough. You continue along implementing the same process and in the long term the business will succeed. If you like me you will look at your portfolio as a business. I did not close my business when news papers said we are in a rescission, I kept plugging along. Your portfolio should be no difference.

The figure to the right is courtesy of Barron's that shows rescission duration and associated market declines. Recession duration has varied from as little as 6 months to 18 months. And market declines have been as little as 13% to a whooping 48% decline. That gives you some measure of the era that we are entering right now.

Actually as value oriented investor, I am finding more companies that hit my screens. Right now I think small cap space is way undervalued. The Russell 2000 has declined by more than 20% and several good companies have been brutalized since mid last year. The space can offer generous returns for the long run. My task now is to dig through some of these names to find companies with strong competitive advantage and strong management teams. However because the space is large one and sifting through it all will take some time, and for the fear of missing on a good opportunity, I have started buying the IWM, the ETF representing the Russell 2000.

Small caps over the long run have produced strong return and they are easier to understand and analyse compared to their brethren large caps. Moreover, if you do your due diligence correctly you will have an information advantage over analyst, as they tend to neglect these names as they do not bring much of investment banking revenues (Analyst dirty little secret: potential banking revenue is the criteria to initiate research on a stock).

I will bring some ideas that I like and present them here in the near future so stay tuned.

Write Downs will keep coming

Total write downs so far has topped the $120 billion dollar mark. Citi accounts 26% of that figure with the top 5 banks accounting for about 70% of the total. That is a very high concentration of losses in 5 banks. Below is chart displaying the carnage so far in the financial sector. As more banks to report next week, the figures will be higher, however the biggest culprits mainly, Citi and MER, have announced their earnings.

No surprise that the higher the write down the bigger the market decline. Also, the higher the write down as percentage of book value the bigger the market price drop a sock experienced. So far banks have shed 16% of their book value in write downs, while their market cap have dropped by 30% in 6 months. E-trade dropped more than any other financial institution; it dropped 87% in the last 6 months. In the figure below is a diagram showing the relation between book value decline due to write down and percentage market decline.

Bank share prices have declined by more than double the book value decline, is this a sign of over reaction? Generally market will over react on the upside and the downside as well, however markets are a discounting machines and in this case they are discounting more problems for the banks. The markets are discounting additional credit problems to appear in the following areas:

  • credit cards
  • consumer and auto loans
  • commercial defaults

Additional problems that can pose even bigger write downs for the banks is the area of credit default swaps. The following is a write up from John Mauldin about the issue (another good write up is Bill Gross, which can be found here):

Credit Default Swaps: The Continuing Crisis
As noted above, I said three weeks ago that the big story for 2008 would be the counter-party risk for credit default swaps. That story is coming faster and larger than I thought. Bill Gross of Pimco suggests that the ultimate cost could be another $250 billion dollars on top of the $250-plus billion in subprime losses. That means we have only seen the tip of the iceberg in write-offs in the financial sector.
The real problem is the "monoline insurers" like ACA, Ambac, and MBIA. Here's a quick primer on how they work. Let's say you are a small municipality and want to borrow $10,000,000 for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.
But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand.
ACA has already seen its rating go from A to CCC, which is basically junk. This puts it out of business, as no one will pay to be rated as junk. ACA now has only $425 million in capital to cover the $69 billion in mortgage and corporate bonds they insure. Interestingly, they added $20 billion of that between April and September of last year. Talk about doubling down on a losing trade. Merrill wrote down almost $2 billion in bonds that were insured by ACA. They will not be alone.
Today, Fitch downgraded Ambac Financial Group two notches from AAA to AA. That doesn't seem like a lot, until you realize that 74% of their revenue comes from that AAA rating that covers $556 billion in municipal and structured finance debt. Fitch did so because Ambac decided not to do an equity offering for $1 billion to stem the bleeding. Six months ago Ambac was at $96 or thereabouts. Today it is as $6.20. Its market cap is only $629 million, so a $1 billion offering would dilute current shareholders by around 70%. Ouch. And you can bet any offering they do now will be on terms that shareholders will not like, most likely a convertible offering that dilutes current shareholders even more.
Oh, and that means that 137,990 municipalities that were insured by Ambac will see their credit ratings drop and their costs rise. Think their customers will hang around?
Moody's says it is going to review MBIA. MBIA, which is rated AAA, raised $1 billion last week from Warburg Pincus and did another offering for surplus notes for $1 billion at 14%. As Michael Lewitt noted, that means 14% is the new price for AAA bonds. Except that today it is 23%. If you bought that note, you are not looking good right now. They are trading at 70 cents on the dollar. Of course, that is better than Ambac's 30-year bonds, which are trading at 35 cents on the dollar.
When Warren Buffett bought Gen Re, the large re-insurer, five years ago, he presciently made the decision to reduce their exposure to credit default swaps. It took them four years to reduce the number of contracts from 23,218 to just 197 at the end of 2006.
"We lost over $400 million on contracts that were supposedly 'safe and properly priced' and we did it in a leisurely way in a benign market," says Mr. Buffett. "If we had to unwind it today in one month, who knows what would have happened?" (The Wall Street Journal)
If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:
"MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.
"The bond insurers' business model is irreparably broken. In HCM's view, it will be all but impossible for these companies to raise capital at economic levels for the foreseeable future and certainly in enough time to work out of their current difficulties. The performance of MBIA's 14 percent bond issue will prove to have been the death knell for this business. The market needs to come to the realization that the so-called insurance that these companies were offering is not going to be there if it is needed. The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come."
You can bet that the $8 billion in CDO-squareds is gone. It is a matter of time. MBIA's market cap is about $1 billion. Current shareholders will be lucky if they only get diluted 75%.
Watch Warren Buffett swoop in and take that boring old municipal bond insurance business. Watch a few large hedge funds buy the remains of the monoline carriers to get their staff and experience (especially the municipal sales teams), and launch new companies with pristine credit.
If you have Ambac or MBIA insurance, as a bank you have not yet written down any debt they insured. They are still rated AAA. But that re-rating is coming. And what about the monster CDS business in the hedge fund world? Who wins and loses? There will be huge winners, and there will be total wipe-outs. There are going to be more losses in the biggest banks, and even bigger investments by Sovereign Wealth Funds. Count on it. This is a story we will return to time and time again.

January 15, 2008

BofA to reduce Investment Banking Operations

Today BofA announced that it will scale investment banking operations particularly trading activities.

I think this is a positive news. Trading earnings are volatile and unpredictable and bear no relation to BofA core operations that revolve around consumer banking. In any case investment banking was not a big revenue generator for BofA.

In this I also like management ability to take action and control expenses in light of the economy and possible revenue slow down.

Power Financial Corp: Sum of the parts greater than the whole

I have been looking into Power Financial PWF as it attracted my attention. The business and its collection of assets is attractive. I did a quick calculation of its sum of the assets value and it came to more than the market capitalization for PWF as below. The sum of the parts is 20% premium more than the market value of PWF, well there is a small debt of $250 Mil, but that does not explain the discount.

The discount is even more when you consider the discount to net asset value in its Pargesa holdings.

Do anyone have any insight or information that you can share with me about the company? or why would such a discount exist?

Citi's Earnings better than Expected!

If you call a $9.83 loss and $18.1 Billion in write downs better that expected, then sure!

So far Citi's write downs total $24.1 billion or 20% of its book value. But that is not newsworthy, it was expected, actually some analyst called the write downs better than expected as they were expecting figures in the neighborhood of $25 billion for this quarter alone.

The bank also will raise another round of capital of $14.5 billion that will bring total capital raised to $22 billion. This will represent 15% ownership dilution to the bank shareholders. However, you can argue that the dilution is already priced in the stock as it declined by 46% in one year, while the banking index declined 25% for the same period.

Citi also made the right move by cutting its dividend by 41% to $.32 from $.54. That represent a boost to its capital of another $4.5 billion annually. This was a tough call but much needed. I would have rather the bank cut the dividend altogether than raise outside dilutive capital. With a dividend cut you would take a temporary decline in the stock price, but it can recover with a well implemented turnaround plan. However with equity dilution it is permanent.

However the more disappointing news is there was no announcement to their future plans regarding job cuts, assets sales and turnaround plans.

The bank has one of best international assets around but it is big, poorly managed and lacks a vision. If the new CEO can pull a vision to unite banking units and stream operations, the business will be a huge success and shareholders will be rewarded tremendously. So lets wait and see if a turnaround plan will be articulated before investing in Citi.

I hope that Citi has thrown the kitchen sink in this quarter. I am sure that a lot of investors do not want to hear any more write downs or mortgage losses in the future, as it will be very disheartening.

January 14, 2008

New Purchase: US Bancorp

I have made another bank purchase today. I bought US Bankcorp. I think it is a solid company with good management that will face slowing earnings but the value is undeniable.

Banks in general have come under a lot of pressure, some deserved to get annihilated others got taken along for the ride. I think USB is one of the bank that was taken along for the ride. I will post a write up on the bank in the near future.

January 13, 2008

Is Tim Hortons Yummy?

Today I look at Tim Hortons restaurant chain as a possible investment idea. Tim Hortons (THI) overview (from Google Finance):

Tim Hortons Inc. is quick-service restaurant chain in Canada. Tim Hortons restaurants operate in a variety of formats. A standard Tim Hortons restaurant is a freestanding building, ranging in size from 1,400 to 3,090 square feet with a drive-thru window. As of December 31, 2006, franchisees operated 96.9% of Tim Hortons systemwide restaurants. In addition, the Company has warehouse and distribution operations, which supply Tim Hortons Canadian restaurants with paper and dry goods, and for certain restaurants in Ontario, frozen baked goods and some refrigerated products. It also has non-standard restaurants designed to fit anywhere, consisting of kiosks in offices, hospitals, colleges, airports,
gas station convenience stores, and drive-thru only units on smaller pieces of

Business Economics:

  • Business Model: THI operates a franchise model earning close to 15% royalties on franchisees store sales, in addition it charges rents to franchisees as it develops and owns franchisees' stores. The company has about 97% of its stores franchised. However the percentage diverge from Canada to the US; the US has much lower franchise rate than Canada at 85% only compared to 99% in Canada. Also the US revenue per store and profitability is much lower than the average Canadian store.
  • Product Offering: THI's sales is dominated of coffee to the tune of 40% of its sales. However in the last couple of years it started to expand its offering and menu. It has introduced several new products and expanded into the breakfast area. THI offers a quality healthy alternative to fast food and value offering to cash strapped consumer.
  • Food inflation and higher milk cost for its backed goods and coffee present strong challenges to its revenue growth. THI is very sensitive to raising prices dramatically as its sales can get affected. The company's cost of sales have risen from 54.3% to 56.76% in its latest fiscal year and up to 58% in its latest quarter.
  • THI has saturated Canada with its stores as the demand for its products is phenomenal. The exception of few growth opportunities in western Canada as number of outlets per-capita is behind that of Ontario and eastern Canada.
  • Indeed the number of outlets in the US is very small compared with Canadian numbers. However the growth in US outlets is triple that of Canadian growth rates. US growth rate in new outlets is averaging 19% annually over the last 6 years, while the Canadian figure is 3.5%. But you got to realize that the US growth rate is coming from a smaller base and it will be hard to maintain going forward.
  • Coffee wars in the states is in full swing with McDonald's competing against Starbucks and Dunkin Donuts so THI would be hard pressed to find its footing in such an environment against more established and big opponents. However, management approach to expansion is measured and disciplined as they go slowly and in adjacent states to areas where they have some clout and brand name recognition.
  • The site location although sited by management as a core competency for the company due to the extensive analysis and research done however, the closed sites to new sites ratio is high. For the year to date ending July 2007 the ratio stood at 36%, and a similar % registered for 2006.
  • Management ability to manage the company and support franchisees is phenomenal. Their quality checks is second to none. Store owners that I talked to complain about quality inspections and regular check ups from THI management as being tough and detailed. This is a very strong indication to the management commitment to support the THI's brand.

Competitive Advantage:

  • THI's strongest competitive advantage is its brand name and strong, even religious, customer preference to its coffee and breakfast menu. The brand is iconic in magnitude and size. THI has one of the strongest brand names in Canada. Line ups for coffee are a notoriously long in the morning.
  • THI has over 2,700 stores in Canada and a large concentration in Ontario, Quebec and eastern Canada gives the chain large economies of scales compared to its competitors. THI advertising and marketing per store is much smaller than McDonald's Canada and its other peers.THI competitive advantages helped the chain fend expansion plans of Dunkin Donuts in Quebec and played a major factor in establishing Tim's outlets all over Canada.
  • However these advantages are local to Canada and do not extend beyond its borders. The brand is virtually non existent in the US except for northern and eastern states in the US. THI has a small presence in Buffalo and Michigan but beyond this it has anemic brand recognition and customer base.
  • THI does not enjoy any economies of scale in the US. THI would sustain significant losses in any price war with its rivals over customers evident of its earlier attempt to expand in the northeast against a more established Dunkin Donuts, which lead to a disastrous write off for THI. Since then they reined their expansion plans. Due to its limited number of outlets in the US the cost of customer acquisition, marketing and advertising is extremely higher than their competition like McDonald's and Dunkin where they can amortize these cost among a significantly higher number of outlets. So in case of an advertising blitz to compete against each other THI will be the loser amongst the three as others can withstand expenditure without affecting their margins while THI would see huge losses. For comparison sake, Dunkin has more than 5,000 outlets in the US and McDonald's has more than 15,000 around the world and more than 8,000 in the US, while THI has only 345 stores in the US.
  • In summary, a very competitive environment and lack of strong competitive advantage in the US makes THI's expansion plans in the US a very tough undertaking and have a low probability of success.


  • My valuation puts the company's intrinsic value from $28-$34 per share. Currently it is trading at premium at the $37 level. To download my valuation analysis spreadsheet click here.
  • The run up in price is due to investor appetite for consumer staples stock in a difficult environment. In addition most investors are buying the US growth story, which as I outlined earlier is not high probability scenario and it is the big hole in any investment thesis for THI business. Moreover, the higher input costs will constrain profitability and put margins under pressure going forward. For these factors I think the stock is overpriced to offer me any returns for the long run.


Sources: THI Financial Statements, Google Finance, Dunkin Donuts Fact Sheet, McDonald's Annual report

January 12, 2008

BofA Ownership Dilution

BofA buyout of Countrywide value can be debated on both sides of the coin. However as a shareholder I need to know the impact of the deal to my holdings. I believe the deal will be 3.47% dilution to my ownership.

BofA will issue .1822 of a share for each share of Countrywide. In addition it intends to issue another $2 Billion to boost capital. Any issuance of equity will dilute your ownership and you should expect the stock price to decline and I recon the decline is about 3.47% from pre-buyout price.

I have put the following table t show the effects of the stock issuance on BofA share price. Off course the analysis assumes all things are equal. I assume that BofA PE multiple will hold after te buyout however its Earnings Per Share (EPS) will be diluted as a result of share issuance.

BofAPre BuyoutCapital IssueCFC buyoutPost
# shares in Millions4,40150.6105.4394,557.04
Capital in Millions $$2,000$4,000
Mkt Price$39.5$38.5
Projected Price$38.13

I estimate that the price should decline to $38.13 to take into account the buyout. BofA declined to $38.5 on Friday but that can be attributed to weak market condition as the entire market declined by close to 2%. I do not think BofA price still reflect the dilution effect of the deal. So I will add to my position at $38 and under.

January 11, 2008

BofA conference call on Countrywide Buyout

I have listened to the conference call this morning at 8:30 regarding the buyout and here is my initial thoughts:
  • Price tag is .1822 shares of BofA to the equivalent of $7 per share of Countrywide (CFC), or a deal of Price to book of .29 x. That is a hell of a discount for the company.
  • The deal will make BofA a leader in consumer finance and banking in every single category you can imagine in the US.
  • An additional 1,000 branches added to BofA already large network of 5,800. No other US bank is even close to that figure.
  • Cost savings of $670 million due to synergies is expected to be fully realized in 2011. A perpetual discounted value of these savings to BofA now, assuming BofA cost of capital of 9%, amounts to $6.4 Billion. BofA cost of the deal is just over $7 Billion ( $2 billion initial investment plus $4 billion for the buyout plus $1.2 billion charge).
  • CFC problem is a liquidity issue rather than a business model issues, which BofA can fix with its balance sheet strength.
  • Default cost and litigation expenses is reflected in the huge discount that BofA negotiated. BofA did not stipulate any legal structure to shield it from any litigation. The cost savings alone cover the cost of buying CFC and any additional revenue growth is pure value added to the market cap of BofA.
  • These are the times to make an acquisition to advance any banks operation ahead of its competition. You always buy when the news is bad.
  • The risk obviously is the litigation and write down losses exceeds what is factored into the price.
  • It does not seem that CFC CEO will continue after the closing of the deal. BofA CEO said "... he will go and have some fun..."

Is the liquidity crises over?

Not by a long shot! However, there is a faint light at the end of the tunnel.

The banking sector has been under pressure since the middle of last year. However several events over the last few days can be a signal that a catalyst for a bottom. Some several events of note:
  1. BofA buying Countrywide.
  2. BlackStone buying GSO Capital to invest in commercial loan.
  3. JP MorganChase buying some of Northern Rock assets.
  4. Berkshire signals that they are interested in buying a loan insurer.
  5. Fed signal that they are ready for a substantial rate cut.
  6. The convergence of the LIBOR rate to the fed rate and return of liquidity to the commercial paper market.
  7. Change of leadership in wall street firms.
  8. Increase in capital raised for distressed debt funds.
  9. $27 billion of new capital invested in Banks: Citi, UBS, Morgan Stanley and other, and it seems that there is more investment to come.
The fact that buyers exist for troubled financial entities and assets is a good sign. I am not calling a bottom because I can't; no one can time these things. All I am saying is there is an asset consolidation and deals occurring, which is encouraging.

The implication to me is to increase, although incrementally, some of my bank holdings. I intend to add a bit to BofA and to buy a small position in another bank. I will not go all in right now as there is a possibility that further deterioration can happen, if 4th quarter earnings are worst than expected.

January 10, 2008

BofA Countrywide deal

Fortune Magazine has presented this prospective on the deal, which I think is valid. BofA has always wanted to buy Countrywide to boost its mortgage origination business but Countrywide was flying high in their valuation, which would not stop BofA anyways as it has a reputation for overpaying. The credit crises has presented a good price for BofA but and it is big but how much losses on the books of Countrywide.

Here is parts of the article:

... Bank of America would utterly dominate U.S. residential real estate finance. The newly combined Bank of America, based on MortgageDaily.com 2007 third quarter origination numbers, would have originated $142 billion in mortgage and home-equity financings. The next closest: Wells Fargo at $68 billion.

... For Bank of America the cost savings inherent in combining Countrywide's market-leading residential lending platform with its own fourth-place effort are no doubt tempting. The bank would also pick up millions of customers - as well as thousands of depositors from Countrywide's own bank - to peddle a variety of higher-margin personal finance offerings. It would also, presumably, bail out the $2 billion investment Bank of America made in the lender in August. Prior to the news, the bank was out a cool $1.4 billion on the trade.

BofA to buy Countrywide: WSJ report

This could be one of two things, if it happens and that is a big if:

  1. A huge win for BofA, as it increases its presence in the US cheaply, or
  2. a huge mistake that will cost BofA dearly.
The win can be huge for BofA for the following reasons:
  1. BofA can use its balance sheet to resurrect countrywide and gain access to mortgage market origination that it wanted at an opportune price. Countrywide used to be a $30billion in market cap before the crises.
  2. BofA will get a market leader in mortgage origination that have higher margins.
  3. It can get a deposit base outside the federal limit as the countrywide is not considered a bank and it will fall outside the 10% limit, which BofA has reached with the purchase of Lassalle bank in the summer.
However it can also be costly adventure:
  1. No one knows for sure what Coutrywide has on its books. There can be land mines that will suck a lot of liquidity from BofA and depress earnings for foreseeable future.
  2. The higher margins in Countrywide operation was attributed to subprime lending, which all but disappeared now.
Off course all this can go away as the report proves to be false and a a market rumor. Buffett once was rumored to buy Countrywide, which proved not to be the case. However if it was true I am still undecided if it is favorable investment or not. I will need to spend sometime to understand the rationale behind it and asses its value.

January 9, 2008

Bond performance

I have discussed bonds as potential idea in a previous post, read it here. The conclusion was Emerging market Debt is a good bet but municipal bonds and high yield bonds are laced with losses despite their very attractive yields to treasury.

The credit problems have put indiscriminate pressure on all types of debt. However Emerging Market debt risks have not changed as a result of the liquidity crunch. Long gone are the days of the Russian, Mexican and Asian tigers defaults. Emerging markets economies are performing well even at the risk of US rescission their economies will slow significantly but they have graduated to more investment grade debt. Indeed the funds that I have talked about have performed relatively well compared to the market retauns have ranged from 4-10% from my earlier post. And I still think they have more to run.

Several issues from Indonesian, Mexican and other sovereign governments bent up issuers are waiting to hit the market. The demand for these bonds is expected to be strong. Off course the risks associated with this idea is the severity and the duration of US weakness. If the rescission is severe and long all world economies will falter and debt will reprice.

Municipal bonds continue to be recommended by media and analysts because their yield s have spiked to levels higher that treasuries and investment grade corporate on after tax basis. However, there are several notable risks facing munis which include, see also this article:
  • The pension payment crisis unfolding in many states and communities.
  • Increasing budget shortfalls for basic infrastructure projects.
  • Reduced tax collection due to foreclosures.
  • Rejection of tax increases by voters in communities facing economic stress.
  • Probable insolvency of bond insurance firms (ACA Capital, MBIA, Ambac Financial)
  • Falling revenue from community projects.
  • Impending court rulings about state tax interest deductibility.
  • Community investment fund losses (see Will State SIV Funds bankrupt local communities?).
  • An increasing number of bond downgrades from rating agencies.
Some reports on CNBC speculated that the municipal bonds backed by the unsuccessful Vegas monorail could default on interest payments. If you have to invest in munis then the only way I would do it is to buy what Buffett insures. He already started with a New York issue.

Sources: bloomberg, bondsonline.com, Reuters

January 7, 2008

Altria today

Altria today was on fire rising more than 3% for no apparent reason. Probably the fact that their January board meeting is getting close and some traders are speculating on the spin off and share buy backs.

I think that the stock will go higher still, is it justified? Well the company has great management, tons of cash flows and good fundamentals but it is fairly priced so it is very hard to make a case for it as a value investment.

I think that Altria US, the remaining entity after spinning off PM International, will be sold off tremendously after the spin off, as investors will dump it to hold on to the faster growing and litigation free PM International. I think the sell off will present a buying opportunity as Altria US will have a higher dividend yield and still great free cash flow stream. Off course it all depends on the detail of the spin off ratios.

I think Altria will serve its shareholders if it breaks itself to three separate companies and sell its stake in SABMiller. The three separate companies are:
  • Brand and R&D holding company

  • International manufacturing and distribution

  • Domestic manufacturing and distribution

The division have the following benefits:

  1. Distribute litigation risk among three entities

  2. Allow the manufacturing and distribution to manufacture generics since they have the economies of scale and capacity to do so. This will open additional revenue growth potential.

  3. The Brand and R&D company will license its products to the other two. Think Coca-Cola and its bottling companies.

What do you think?

Porfoilio Performance Update

So far my performance has been, predictably, bad.

Most of my funds are invested in Canadian fixed income as result of the sale of my previous business in 2006. I have been waiting to invest them in good businesses but did not find any until lately. So far I have picked up LOW and BAC and looking to add additional positions that provide good value.

Bank of America is down 10% from where I bought it and Lowe's Home Improvement is down another 5%. Banking and home retail are under pressure and will continue to be under pressure due to several economic factors. I will be adding to these two positions around earning announcement as I expect them to decline further and I expect to buy more in the next quarter as well.

I have reviewed RioCan REIT in an older post and deemed it as a value idea, read it here
With the market faltering RioCan came close to my entry price of $20, so I purchased an entry position @ $20.10. I have not committed any significant money to the position but I will add to it in the weeks to come as it goes lower.

My target is to have 80% allocation to equity and 20% in fixed income by the end of the year, currently my allocation is the opposite. Some areas I am looking for buys are banking, real estate (office, industrial and retail), and Canadian gas industry. I will keep you updated with new ideas as I finish my analysis.

January 5, 2008

Value Idea: Altria

I take a look at another consumer business; this time its tobacco. I want to analyse Altria as a business notwithstanding all the ethical arguments against investing in a tobacco stock. The arguments against investing in a company like Altria are many, but I choose to think independently of them. I may not smoke or want any one I know to smoke but others choose smoke, so we will leave at that.

Company overview (source: Google Finance)

Altria Group, Inc. (MO) is primarily a holding company. The Company, through its wholly owned subsidiaries, Philip Morris USA Inc. (PM USA) and Philip Morris International Inc. (PMI) are engaged in the manufacture and sale of cigarettes and other tobacco products. Philip Morris Capital Corporation (PMCC), another wholly owned subsidiary, maintains a portfolio of leveraged and direct finance leases. As of December 31, 2006, MO had a 28.6% economic and voting interest in SABMiller plc (SABMiller), which is engaged in the manufacture and sale of various beer products. The Company operates in three segments: domestic tobacco, international tobacco, and financial services.

Business Economics Quality

  • Reduced Litigation risks: With reduced risk from US tobacco litigation some of the contingencies and reserves will be brought back to future earnings and reduce uncertainty about future charges that the company may take. Well, maybe we are not out of the woods yet, as there is the Nigerian multi trillion dollar, yes trillion, law suit against the company for health spending by the government on smoking related costs! Hmmm I am not sure what is the health care system over there but with this kind of spending I want to move there.
  • Diversified geographically: International operations accounted for 58.6% of sales and 53.4% of operating profits in the first nine months of 2007 and the balance was covered by domestic US operations. The international segment is growing at a faster pace in volume and pricing than US segment. Volume of US shipments have been declining due to high taxes and smoking bans. However the company is taking market share from competitors; MO has an outstanding market share in cigarettes of 50% as of 3rd Qr 2007.
  • New Product Lines: expansion of product line into cigars by acquiring cigar maker John Middleton, as part of Domestic Tobacco, and introducing smokeless tobacco as an extension to the Marlboro brand. The high growth market of smokeless tobacco and cigars will solidify earning growth for its US division going further. Cigars have an estimated growth rate of 4% annually while smokeless tobacco is growing faster as result of all smoking bans. MO will be able to leverage its vast distribution network to expand John Middleton products and increase revenue at an accelerated rate and even introduce the product on an international level.
  • Lingering Risks: risk of smoking bans and higher taxes and tariffs could curb revenue growth and slow international sales.
  • Overall the company is not a high growth company but it will deliver steady revenue growth and incredible free cash flows.

Competitive Advantage Quality

  • Consumer Brands: High profile and valuable brands coupled with consumer habitual purchases and strong preference to its products create strong competitive advantage for MO's.
  • Valuable Brands: The Marlboro brand is one of the top 15 valuable brands in the world with an estimated value of $21.5 Billion.
  • Market Share: A strong competitive advantage is evident in the company's strong US market share as well as internationally. the company has 50% US market share that continues to grow at the expense of competitors rather than in terms of overall volume. Its international shipments volume continue to grow at 6-7% rate.
  • Size advantage: MO is the largest cigarette maker and owns large and extensive distribution network. However size does not seem to be an advantage for Altria as its gross margins are very comparable to peers. However its distribution network is an advantage to reach potential consumer cheaply as evident by its market share.
  • To summarize MO enjoys a Strong competitive advantage evident by strong market share fueled by Strong consumer preference to the product.

Quality of Management

  • Management is very shareholder friendly and their actions are motivated by creating shareholder's value. Their actions speak louder than words. Consider the Kraft spin-off, the planned International tobacco spin-off, and the unloading of their New York head quarters to reduce costs.
  • Over the long term there was no better company in creating shareholder's value than MO. It managed to yield a stock return of 19.75% annually over the long term (1957 to 2006). Mo has beaten the likes of Coca-cola, P&G, general mills and other well established companies in shareholder's returns.
  • The company managed to raise dividends consistently even through the tough times of 1990s and the massive litigation brought against it.
  • Strong and consistent Return on equity, return on assets and return on invested capital through the years as seen in chart.
  • Barron's has consistently ranked Altria as one of the most admired companies in the US; in 2007 it was in the top 70 and it could have ranked higher. If it was in a different type of business, management would gotten more votes but since the votes against it is votes against tobacco rather than management quality per se.


The separation of International Tobacco (PMI) is beneficial for several reasons:

  1. PM-USA and PMI will each be able to use its financial strength with more flexibility if each were a separate entity. For example, PM-USA may set a higher dividend payout policy, while PMI may be inclined to have a lower pay-out ratio and instead buyback more stock and/or make acquisitions.
  2. By separating the two divisions you can isolate the risk of a potential Food and Drug Administration regulation in the U.S. away from the business practices at PMI. Also if the litigation environment to become onerous again, PMI would be away from any potential liability.
  3. PMI should trade at a higher multiple due to PMI ability to grow operating profit and earnings at a faster rate than PM-USA with a very attractive return on investment and significant free cash flow generation potential. In fact international tobacco companies have an Enterprise Value/ EBITDA multiples much higher than US companies; internationals have multiples of 14.7 as opposed to 7-8 for US companies.

A sum of the parts valuation of MO indicates that the company is fairly valued at current market levels. A dividend discount model also yield that MO fair value is $75, assuming a growth rate of $4 and cost of capital of 8%.

EBITDAMultipleEVLess:LTD$ Per share

However, sum of the parts and multiple valuation is a point of time look at the company and only tell relative valuation today. I use asset reproductive value and Earning Power Valuation analysis to ascertain my results. The valuation also yields a comparable figure of $79 per share.

Item based on 3rdQBVAdjustmentAdj. FigureNote (amounts in millions of dollars)
Current Assets20,7471720,764To add allowance for doubtful debts
Fixed Assets8,0748,09716,171Adjust for properties and plants owned by the company to yield market value of these assets
Intangibles8,57414,80021,500to add the value of the brand of Marlboro its flagship product. BusinssWeek estimates its value to be $21.5 B
Other Assets10,422010,422No adjustment needed
SABMiller Investment3,911-3,911-A competitor would not reproduce this investment as it is not required to compete in the tobacco business. However I will add it as separate item in the final valuation
Total Assets51,728114,143
Current Liabilities19,184019,184No adjustment needed
Long term liabilities34,489034,489No adjustment needed
Shares outstanding2,110
BV per share$8.17$37.75
EPV Valuation
EBT12,658.4Adjusted for economic cycles by applying the 10 yr average EBIT margin to current revenues- 2006
Earnings8,481.15Less 33% taxes to eliminate any tax schemes
Add Depreciation1,804need to deduct actual capital expenditure that the company spends to maintain its revenues rather than meaningless accounting depreciation
Deduct Capex2,454
Adjusted Earnings7,831.12
Cost of Capital9%I estimate it is 9% given uncertainty about litigation, however if this uncertainty to be removed it should be lower.
EPV per share41.24
Intrinsic Value per share78.99it would be BV of assets plus EPV
Value of SABMIller per share5.97

In summary the valuation techniques used resulted in intrinsic value per share between $75- 85 per share. The current price of MO sits at the low end of the valuation spectrum. The company does not offer any margin of safety. Moreover the company breakup will not unlock any significant value. It seems that the market got this one correct. However I do believe that the shares will go higher due to speculation of PMI spin-off and new share buy backs that management has announced. But that is not enough of a reason to buy the stock, any stock for that matter.


Sources: Altria web site, BusinessWeek, Barron's, Forbes, Yahoo Finance, MSN Money, Google Finance