February 26, 2008

Retailers Rally

This week kicked start retailers reporting season. We have Lowes, Home Depot, Targte and more still on dick to report their numbers. Overall they are reporting horrible earnings figures with the exception of Wal-Mart, yet all them are rallying. Wal-mart is profiting at the expense of others, as most consumers are switching to the cheaper Wal-Mart to buy their goods.

The economy is facing a rescission, the consumer is tapped out and can not spend any more and businesses can't borrow to expand even if they have good earning growth potential. So are investors looking past all this into the potential recovery? Or may be the government stimulus package could hit the retailers profit statements by the next 2 quarters?

May be, who knows, markets act in strange ways. Sometimes I think that bond investors are much smarter than equity investors as they tend in general to price risk much more correctly.

Actually it is sour grapes on my part as I wanted more time to evaluate and buy few retailers while they are down but tomorrow may bring another day.

Visa IPO

Visa's IPO could be one of the biggest IPOs in history reaping $18.8 Billion. At the midpoint of its proposed price range of $37 to $42 a share, Visa's offering of 406 million Class A shares would raise $16 billion. Visa said it might sell an additional 40.6 million shares to meet demand, which could boost the proceeds to almost $18.8 billion at the top end.

Although Visa's IPO will be the biggest IPO in history, Visa will see very little of the proceeds for its operations. According to its registration statement with the SEC the use of the proceeds will be as follows:

  1. $3 Billion to go to an litigation escrow
  2. $10.2 Billion to pay out existing shareholders
  3. $2.346 Billion to be used to redeem other securities from shareholders later in 2008
  4. The balance of $454 Million will be used for general corporate purposes.
There are big differences between Visa and MasterCard's IPOs. MasterCard came with no litigation risk associated with its operation not like Visa which have a huge litigation risk hanging over its head. A large chunk of the IPO proceeds will go for litigation reserve escrow; money that will not be used for operations. The other difference is the net cash inflow to Visa operations from the IPO will be much smaller that MasterCard's. MasterCard took in $650 Million or 26% of its IPO, while Visa is taking in only a mere 2.8%, which will not contribute much to expand its operations.

Still Visa's business is very intriguing as it gives owners a sustainable competitive advantage that is worth the risk. I am still reading their prospectus to understand their exposure and risk, it is not very east to digest.

On another note, BofA along with JP Morgan are the big beneficiary from the IPO from three sources:
  1. As shareholders there are poised to make a windfall capital gains on their ownership stake, which will shore up their capital base.
  2. The two banks are the two lead underwriters of the IPO; their fees and options will provide for nice gain in 2008.
  3. With Visa off their books they can limit their exposure for further litigation risk that is plaguing Visa; it will become Visa's public shareholders problem.

February 25, 2008

CHC Helicopter Position Added

Today I added CHC helicopter to my portfolio at $30.42. I could not get at lower prices as quantities were disappearing fast and I had to enter my order at market rather than my preferred way of limit order.

The higher price will lower my annualized returns but it is still above the 20% threshold expected return that i need for this strategy. My maximum price that I would have paid for CHC to earn a satisfactory return was $20.5, so i go a bit under that which was good.

I will be adding a tight stop loss order as CHC should not drop significantly from the buyout price. If the price drops significantly it means there is a problem in the deal and I want out of the position with minimal losses.

I will keep you posted on the progress.

February 23, 2008

Value Idea: Buyout of CHC Helicopter

In a market like this where it is not expected to go anywhere, it makes sense to look for high probability small returns to boost the portfolio performance. In this case it is buying the shares of target companies in announced buyouts and mergers. This post about a case I will be buying in on Monday.

On Friday First Reserve Corp. announced the buyout of CHC Helicopter Corp., a firm specializes in oil field transportation. The deal is interesting and makes for a good case to invest in CHC to earn a quick expected return of 6%.

Here are the facts of the buyout:

  • CHC transports people and equipment to oil and gas drilling locations, is the world’s largest provider of helicopter services for oil companies.
  • U.S.-based private equity firm First Reserve Corp. has made a bid for Vancouver´s CHC Helicopter Corp. (TSX:FLY.A) valued at $3.7 billion.
  • First Reserve is offering $32.68 a share, a 49 per cent premium to CHC´s closing price on the TSX Thursday of $21.88.
  • The $3.7 billion includes a total cash component of $1.5 billion about $800 million in debt and about $1.4 billion in liability associated with off-balance-sheet aircraft leases.
  • CHC´s headquarters would remain in Vancouver.
  • Sylvain Allard will keep the CEO title, a job he has held since November 2004.
  • Chairman Mark Dobbin, son of CHC founder Craig Dobbin, will not stay with the company after the deal closes.
  • The deal is set to close in June, 2008.

I think this is a good buyout to earn a quick return on the gap between the buyout price and current market price for the following reasons:

  • The deal size is just right about $2 Billion; it is not something huge that will scare the banks.
  • A majority of the buyout is equity from First Reserve so the banks are in for a smaller stake and smaller exposure.
  • This will get shareholder's approval 100% guaranteed as the needed majority of the shares are controlled by Mr. Dobbin.
  • First Reserve is not just a run of the mill Private Equity firm, it specializes in energy companies and in recent times has been focusing on the service side of things. They are building a collection of businesses that will capitalize on the lack of spending on oil fields infrastructure in the last few decades. The company makes a very strategic addition to their portfolio as demand for helicopter transportation services have exploded with oil fields getting more remote. The firm speciality makes this buyout more likely to proceed.
  • The company has great demand ahead of it and it is in the right business. It has no troubled areas to the economy.
  • The deal is very simple buyout there are no multi partners or any intended breakup of the business that can complicate its funding.
  • CHC is in relative good financial position from balance sheet perspective and has good profitability.
  • The break up fees levied on First Reserves if it walks away is double those against the company and comes to about 6% of the company value. The structure projects confidence that First Reserve will close.

Now lets look at the numbers from a probabilistic point view. There are two possible future states: the deal goes through or falls apart. I am assigning 95% chance that the deal will go through due to the reasons I explained earlier. If you agree with that probability assignment then you can expect 6% return, including a dividend payment, for your trouble. The annualized expected return is 25% which exceeds the 20% threshold that risk arbitrage operations require. The details of the payoffs are illustrated in the table below.

February 21, 2008

Sears Holdings is the hype real?

It is a question I always struggle with when it comes to Sears (SHLD), as the who's who of value investors have taken significant positions in SHLD. Lets run down the list:
  • Bill Ackman; SHLD represents 46% of his portfolio
  • Mohnish Pabrai; SHLD represent 13% of his assets
  • Bruce Berkowitz; SHLD represent 9.5% of his portfolio
  • Martin Whitman
  • Whitney Tilson
  • And many others to list
SHLD has went down 47% over the last 12 months. Is not that enough to consider it a bargain? But you forget that SHLD had a strong performance over the last few years compared to its peers. The Stock has appreciated by more than 300% since 2004 to-date, 2004 was the merger between Sears and K-mart. Compare that performance to Target's 57%, Wal-Mart's decline of 5%, Costco's 86%, and the department store as a group appreciation of only 18.71%. So I would not consider SHLD to be a bargain because it went down 47% from its multi year high.

So let us look at some fundamentals of the business.

Retail Economics
As a retail investment I do not think SHLD is sound for many reasons.

First, the shopping experience is not very attractive. I find myself not motivated to go to SHLD for anything to buy. And when I wander into the store I feel very depressed; it gives me the feeling of old and tired. Moreover I find some of their merchandise in same manner as my overall impression of the stores that is old and tired. I opt to shop at other retailers and I have no doubt you would to. Ask yourself the following:
  • Do you drive past Macy's to shop for clothes at Sears?
  • Do you drive past Best Buy to shop for TV's at Sears?
  • How many people pass up driving to Costco, Walmart or Target to shop at K-Mart?
Sears have many competitors that offer appliances and many other items that Sears sells and they do a much better job at advertising and promotion than Sears. I'd maybe buy an appliance, or Craftsman tools from Sears but I can even buy those from Home Depot and other places. The retail shopping experience is the life ot any retailers and sadly Sears does not have any of it.

Second, the business economics is not that good. Sears inventory days have been creeping up over the years and that is not a good sign for retailer to hold older and older inventory. Holding to inventory drives your costs up, slows your cash conversion cycle and makes your merchandising less relevant.

Third, retail turnarounds are notoriously hard and long and have low probabilities of success. Actually as a rule of thumb never invest in a retail turnaround story as you can earn better returns elsewhere.

I doubt that most of those investors who hold SHLD missed some of these points. However I think they are not in it for the retail business. So the question is, is it a matter of faith in Eddie Lampert, who is undoubtedly a brilliant money manager?

He is very accomplished and has a proven track record that will silence lots of his critics. He turned his mere investment of $900 Million in K-mart to $6.7 billion by taking K-mart from bankruptcy and merging it with Sears to create SHLD. He is currently using SHLD cash to buy back stock to increase his ownership in the company and its underlying value. But do you invest on faith alone?

Real Estate and Brand Value
A lot of loyalists are expecting a similar feat in monetizing SHLD real estate and its brands. SHLD has taken steps to do that by reorganizing itself along those lines, which I like very much. Several investors in Sears highlight the primary drivers of Sears value as:
  1. the underlying value of its real estate,
  2. the value of its brands, if sold to third parties: Kenmore, Craftsman, DieHard...etc,
  3. the cash that the retail business can earn over the next five years, and
  4. the potential returns on that cash that Lampert can generate over the life of the investment.
So lets assign values to those drives:
  1. Sear's Free Cash Flow that the retail business generates going forward. The TTM free cash flow is $949 Million. Its Present Value, assuming no growth or decline and Cost of capital of 10%, is: $9.5 Billion,
  2. The value of the firms underlying real estate is: $4.7 Billion,
  3. The value of the firm's brands: $3.4 Billion ( Book value of its trademarks), and
  4. Lamperts magic to reinvest the free cash in attractive opportunities is: Priceless.
Applying no premium for Mr. Lamperts ability as a master capital allocator, that puts the intrinsic value of Sears at $17.6 billion, or $127 per share, compared to its market value of $13.3 Billion, or $96 per share. SHLD is trading at about 30% discount to its intrinsic value.

The estimates above are conservatives as real estate has appreciated some from the time of purchase and will be worth more once the credit and real estate issues are resolved. Also, the brands value of $3.4 is a conservative estimate that can go much higher is sold or monetized through licensing agreements.

I still need to do more homework but at roughly the $97 a share that SHLD shares are currently offered for, and possible turnaround in its retail operations, SHLD looks more and more as a value idea that needs a long term viewpoint that will likely generate good returns over the next 3-5 years.

February 20, 2008

East invest in west and west in east

Here is an interesting observation where eastern investors are investing wealth in the west and western investors going east. The observation is anecdotal at best and I did not want to spend time to verify it but here is some recent headlines:

  1. Sovereign Wealth funds bailout of western banks from Citi to UBS.
  2. North American Investors buys record foreign investment
  3. Chinese and Middle eastern buy into the Canadian Energy sector
  4. JP Morgan to invest $.75 Billion in Asia
  5. Turkey's Buffett to invest in west
There other examples of such stories. It may be that the grass is always greener on the other side. But I think that both groups are smart investors and finding value and diversifying away their systemic risk. The morale is opportunities at the current environment can be found just look for the right value.

NY Real Estate

The saga of the NY real estate is very interesting to me. Last year Sam Zell have sold his company to the Balackstone group, for record price, which the buyer immediately broke it into pieces and flipped some properties to investors. One of those investors is Macklowe, which I have been talking about for the past two posts.

Macklowe financed the properties on one year loan with almost no equity and he has been caught swimming naked, as the credit crunch meant no more wily nelly financing. His financing package totaled $7 billion for the purchase. To compound his problems banks began at the end of 2007 with massive layoffs due to record losses from the subprime debacle. That means occupancy in NY will have to decline and cash flows from these building will be less than when he bought them making it tougher to cover mortgage payments. For example, the occupancy of the Worldwide Plaza, one of the properties, at the time of the purchase was 98.28%. The annual revenue at contribution was $152.5 million and net operating income stood at $121.4 million. The debt service coverage ratio at contribution was 2.56 times.

As of Sept. 30, occupancy at the Worldwide Plaza had fallen to 93.6%, year-to-date revenue stood at $96.9 million and net operating income only stood at $51.2 million and the debt service coverage ratio had fallen to 0.95 times - or, in other words, not enough to keep up with $53.6 million in debt service payments.

The office real estate market in NY is like no other. Investors collect these building not to earn any return while they own it but rather as prestige and trophy collection. For example the GM building, which is owned by Macklowe and being auctioned off, never made him a dime in return nor did it earn the previous owner any profit, which is none other than Trump. However, they made their returns in spades when they sold it.

Investing in NY real estate is such a leap of faith in the city and its place in the world. I am not sure I can have such faith in the future.

February 19, 2008

Commercial Real Estate

A follow up to my yesterday's post to the value of the commercial real estate have is the record level bidding for the GM building in NY. The building got over $3 Billion offer a record level for any building sold in NY. The building was bought for $1.2 billion few years ago and have undergone some modification, namely the addition of the Apple store. The wall street journal reports:

If the high bid is accepted, it would be the most expensive price ever paid for a single building in U.S. history. The previous record was the $1.8 billion paid for the nearby 666 Fifth Avenue, a sale that closed in January 2007.
I think some real estate companies have been beat up recently in anticipation of a repeat of the housing market in the commercial real estate market, which I think is overly exaggerated. However there will be some deterioration in commercial real estate prices but it would not be a big event. So there might be some bargains in this space going forward.

February 18, 2008

Commercial Real Estate and Credit Availability

A Real estate mogul risks it all - Feb. 15, 2008

The story linked shows the perils of short term borrowing to finance long term assets. The infamous NY real estate investor Macklowe is in a bind. Financing has dried up on his recent purchase of prime commercial buildings in NY from the Blackstone Group. He is scrambling to put financing together to satisfy the short term borrowing he used to buy these buildings. However there is no one willing to lend. That might force the sale of some of these buildings, and if a sale happens the price could provide some clues to the health of the commercial real estate market.

A lot of media publications and analysts are calling for the implosion of the commercial real estate market in the same manner the US housing market is unravelling. There are a lot of retailers reducing their outlets and slamming on the brakes for further expansion. Lack of financing availability does not help either. However I do not think that commercial real estate will cause the same havoc as housing for the simple fact that commercial real estate generates cash flow to maintain its value as opposed to houses that provide only shelter to its homeowner.

The piece is good and the events to follow will be interesting to see how it will unfold. Business in such an environment is far more exciting to follow than say a couple of years ago.

February 15, 2008

Buffett buy into Kraft

Buffett disclosed a a large stake in Kraft by buying just under 10% of the company. Off course Buffett has established a smaller stake last year in the cheese maker and increased it in the last quarter.

I have reviewed Kraft, see here, before and reached to a conclusion that although it has a lot of brand names and good cash flows I did not feel it was an appealing investment. The brand names does not translate to any competitive advantages nor does Kraft can sustain market share in the face of accelerating food prices.

I always wondered what is the value and how Buffett analyzed this one but to no avail. I guess that is why he is the second richest man in the world and I am not. Does this mean I will change my mind on the kraft? No. I will stay away from it, I do not like the food business, the aging brands, the high debt level, if you strip intangibles, and the high valuation. But I will be curious to his reasoning.

February 14, 2008

Value in today's market according to Bill Miller

Bill miller the star fund manager offers his views on the current market conditions in his quarterly letter to investors. You can read the letter here.

What I wanted to highlight is his view on where you can find value investing opportunities, the letter describes the
...poorest performing parts of the market, housing, financials, and the consumer sector—with the exception of consumer staples—are at valuation levels last seen in late 1990 and early 1991, an exceptionally propitious time to have bought them. The rest of the market is not expensive, but valuations cannot compare to those in these depressed sectors.
These are the groups that I have picked some stocks from like BofA, LOW and USB. I am still researching to pick more in this are particularly retailers as they are extremely beaten in this market.

The letter also gives me some confirmation on my approach and thinking. I think it is important to validate one' views by an accomplished professionals like Bill Miller.

He also notes that the bond market is expensive as I have posted in the past as he writes that
... government bonds, which have performed so wonderfully as the traditional safe haven during times of turmoil, are very expensive. (In bond land, the only values are in the so-called spread product, and there are some quite good values there.) The 10-year Treasury trades at almost 30x earnings6, compared to about 14 times for the S&P 500. The two-year Treasury yields under 2%, and is thus valued at over 50x earnings!
If you look around you, you will find a lot of gloom and doom talk by media and blogs however if you watch some of the richest investors recent moves like Buffett, Ross, Miller and others, you can find them getting really busy these days with business deals and new investment. I will take my cue from them.

Credit vs. Equities

The two markets seem to behave in two different and diverging manner. Credit is almost non functional, while equities markets are posting strong rallies. Investors in one market seems to avoid risk and the other seems to welcome it.

The credit markets all but ceased to function, lets look at some recent events:
  1. Buyout debts are sitting on banks balance sheets with no takers to the tune of $200 billion, which means no lending to occur to businesses by these banks.
  2. The municipal bond auction market with no takers at 20% interest rate. The municipalities will have a tough time refinancing some of their obligations once they are due.
  3. Banks and investment dealers are not supporting the muni auction markets.
  4. The 30 year mortgage rates have not gone down with the 10 year treasury note yield, which should match the percentage decline more or less.
  5. The high yield and investment grade debt markets spread over treasuries have been rising steadily since late last year with no reprieve in sight. The spreads make for increase in financing costs if even available to some companies. The two graphs show the yield spread over treasuries for the high yield market and investment grade market.
One can argue that risk is being priced correctly as no high yield issue should only yield 200 basis points over the no risk treasuries.

So why is the equities market rallying? Well there is always the noise factor like retail sales are up, corporate profits in Q4 are up or talk about bailout this or bailout that...etc. All none meaningful events to the valuation of investment.

And given that financing costs are high valuation should go lower. High financing costs makes the cost of capital for some companies extremely high, which means valuation should be lower as you use a higher discount rate to value future cash flow streams, which makes them less in todays dollars.

Are these rallies sustainable? Who knows,
markets can stay irrational longer than we can stay liquid

February 13, 2008

Yahoo is always early


In the article above it lists the miss steps of yahoo in the corporate merger and aqusition game. Fans of Yahoo claim it was visionary but its problem it was "early".

I think Yahoo should take the Microsoft offer and call it a day.

1. GeoCitiesYahoo paid almost $3 billion in 1999 for GeoCities, a pioneer of social-networking on the World Wide Web, only to have the social-networking site whither away under its control. As one person close to the situation told Deal Journal’s Dennis K. Berman in this recent column: “Had they done things right with GeoCities, there would be no Facebook, YouTube or MySpace.” Which leads us to…Facebook or MySpaceFlash forward, almost a decade, and Yahoo finds itself flat-footed as such social-networking sites as MySpace and Facebook increasingly become rivals.

Yahoo stood by as News Corp. gobbled up MySpace for $580 million According to the latest Fortune, Yahoo had a $1 billion deal on the table for Facebook, which fell apart after it lowered its price to $850 million. If Yahoo hadn’t lowered its price, then perhaps its share price doesn’t tumble and then Yahoo isn’t…well you see where we’re going with this.

2. Broadcast.comThis is
perhaps the most famous of Yahoo’s missteps. At $4.3 billion, the all-stock deal also is Yahoo’s most expensive acquisition, according to Dealogic. Broadcast.com, a company that specialized in helping conventional radio stations extend their reach by broadcasting their signals over the Internet, never panned out and by 2002 Yahoo had shut it down. (On the plus side it produced ever-colorful billionaire sports-team
owner Mark Cuban.)

YouTubeIt is somewhat difficult comparing deals from different eras. But Yahoo was also in the running to purchase YouTube back in 2006. It fell into the hands of Google for $1.65 billion, and Yahoo still trails Google in Web video to this day.

3. Inktomi & OvertureBy 2002, Google had gone from Yahoo partner to Yahoo rival. In response to Google’s encroachment, Yahoo snapped up these two businesses to fight back. Search engine Inktomi replaced Google for Yahoo’s search technology. Overture placed ads on Web pages. The problem was that Inktomi and Overture did not produce results as good as Google’s. Which brings us to…Google Yes, Google. Probably, the do-over Yahoo most fantasizes about. Yahoo had an opportunity to buy Google in 2001. Over dinner, Google co-founders Sergey Brin and Larry Page and former Yahoo CEO Terry Semel discussed a deal. Alas, Brin and Page wanted $3 billion to sell and Yahoo walked away, according to this Sunday Telegraph article. Today a $162 billion mulligan. Do we need to say anything more?

BofA deal for Country Wide gets more heat

It seems that the BofA deal to acquire Country Wide (CFC) got a little crowded. Third parties are throwing their hat in the race. Bill miller the famous fund manger and a hedge fund entity have taken or increased their stakes in CFC and are demanding higher price from BofA to get their approval. Bill miller owns 14.9% of CFC while the hedge fund owns under 5%.

Does BofA need to pay more to acquire CFC? May be BofA has to up its offer price to get the deal done. However I think BofA can afford to rebuff investors request for higher price and stick to their guns even if it means abandoning the deal altogether. CFC has no other bidders stepping up to the plate. Even if someone else comes BofA has the right of first refusal, as part f the proffered shares investment in 2007, and can match the price then and get the deal done. BofA also can play hard ball and force CFC into liquidity problems by calling CFC credit lines to force a deal.

Everyone now is becoming an investment banker calling for bigger payout. I think the deal gets done with no price increase and CFC should consider themselves lucky!

Bond Insurer battle

The bond insurer is shaping up to be a good one. You have the following parties duking it out:
  1. Buffett, the opportunist, and his newly formed muni insurance unit that is looking to shore up market share in the muni bond insurance.
  2. Wilbur Ross, the turn around specialist, who is eying a deal with one of the re insurers.
  3. Bill Ackman, the relentless hedge fund manager who is short the bond insurers for 5 years.
  4. The rating agencies who are in tough bind. If they downgrade they will set in motion a chain reaction of write downs and possible defaults for banks and hedge funds.
  5. The regulators who are scrambling to find a solution to the monoline entities.
Today Wilbur Ross has called Buffett bluff, see video here. He also dangled a carrot in front the insurers to come to him as he is preparing for a plan that benefit both parties rather than one way stream. However I think Buffett has made the proposal knowingly that he will not earn any business from his proposal. I think he made the proposal to promote his new insurance unit and moreover he did it to force the hand of the regulators to do something about the situation.

In the meantime Bill Ackman is doing all he can to force the issue of downgrade on the insurers. He may have liked the action of Buffett as it plays to his hand. The Buffett move publicized the weakness of the insurers business even more that he was able to do.

The saga continues, however this is no place for individual investors to profit from any of the actions. You are simply out from the information loop that goes behind closed doors with the regulators and the rating agencies. I will continue watching but I will stay away from any investment opportunities.

February 12, 2008

Bond Insurance

I am sure that you are aware of the bond insurance problems plaguing the debt market. These insurers are leveraged by a magnitude of $100 to $1 of capital and hold insurance contracts on some of the most speculative debt that was once rated AAA.

Today Buffett offered to insure their muni portfolios, see story here. no one should mistake the offer as a bailout, as Buffett, the businessman, is not in the business of bailing out business. Make no mistake Buffett wants to make a pretty penny on this offer and when I say pretty penny it is in the magnitude of more than 400% return.

I have no idea what is the offer but from previous transactions I know he bids very low to the potential value of the asset. For example, he offered to purchase the Long term Capital Management positions in their time of crises in 1998. He offered some $250 million for a portfolio worth $4 billion. Also his offer usually eliminate risks; in the case of LTCM he offered to buy only the assets with no management personnel or the the partnership structure.

In the case of the insurers' offer it does not solve their problem at all. He is offering to insure something that have default rate of less than 1% historically, while leaving the problematic structured debt.
"The muni market is not what's causing the difficulty. It doesn't solve the underlying problems, which is mispriced premiums on the structured finance transactions."

Bond insurers have lost billions of dollars by moving beyond their traditional business of backing muni bonds and insuring risky subprime debt. The losses could result in the insurers losing their coveted triple A debt rating, which is crucial for their business.

In the end I think the offer will fizzle and amount to nothing because no one in their right mind will accept it. I do not think that Buffett will buy any one of them becasue he already established a similar business and in due time will take all their clients. Also, I do not see any private entity will step to buy them as no one will want to compete against the better capitalized Buffett reinsurance. The only solution is a government bailout.

February 10, 2008

Analyzing Consumer Packaged Goods Company

In today's post I will list several factors and criteria I use when I look at a consumer packaged good company. Examples of a consumer packaged goods companies are the likes of P&G, Unilever, Colgate, Clorox, Avon, Loreal...etc. A company in this industry typically hold a portfolio of various household products with slow but steady revenue growth as a result they have a low price earning multiples relative to the overall market. Currently the industry is concentrated in few large players that I think production costs are not enough to produce a competitive advantage between the players. I will even be bolder and say that cost structures are similar across the industry so cost in any analysis can not be the determining factor to invest in a company. So what is important?

Key to Analyzing Consumer Goods Companies

In my mind these are the most two important keys to pick a good investment in this space:

  1. Management ability to read and understand shifting consumers' tastes and preferences.
  2. Marketing skills and talents are what ensures success between industry players. As more or less cost and the function of the products themselves are relatively the same. Marketing is the true weapon that created brand loyalty and occupies consumer mind share.

There is not a lot of number crunching in analyzing these companies at the end it comes to your judgement and ability to spot key marketing and sales skills. Success in sales and gaining market share in this industry comes down to flair, insight and market research and strategy.

Steps to Analyzing a company

  1. Evaluate a companies existing product lines by answering the following: How does the company maintain its current market share and growth rate? Does the company achieve this by spending a lot of money on promotion and advertising? Is sales directly correlated to its advertising spending?
  2. Analyze the company's research and development capability to introduce new products: Like any company, consumer goods companies introduce new products and invest heavily in promoting these products reducing their profits for years to come until they reach critical market share and consumer loyalty so they can reap future profits. These products will age and consumers will wander for better and newer competing products, the company must offer either product extensions to prolong the life cycle of these products or offer completely new products to offset the decline in revenues from mature products. So you have to answer questions like: does the company spend enough on research and development? Does the company have an adequate product pipeline to offset declines in mature product revenue? Are the company's product lines old and tired?
  3. Understand management ability to adapt to change and sense consumer preferences: Good managers are able to have a keen understanding of their customers habits and preferences by performing effective marketing research. Do management have insight into the feeling and attitudes of their buyers? Does the company have a strong and accomplished management team compared to the competition?

Questions to ask yourself before investing:

  1. What is the company marketing strategy? Does it fit their product lines use by consumers?
  2. What is the competitive strength of the company's major brands?
  3. What is the percentage of revenue spent on R&D?
  4. Does the company sells oversees? If yes what is the breakdown? and what is the percentage of their earnings attributable to currency fluctuation?
  5. What is the depth of management talent? Do management have talent on the top only or are they developing their file and rank?
  6. What is the company's market share for its existing product lines?
  7. Does the company depend on limited distribution channels or does build a product franchise so it frees itself from the dependence on few large retailers?

A last issue for you to consider is there are two main categories of consumer goods companies: the personal and the utilitarian. There is a lot of differences between the two. Utilitarian like toiletries are price-sensitive and impersonal; a consumer can replace one for another based on price only. On the other hand, personal items like cosmetics are more preference driven and depends on individual tastes. As a result utilitarian products have low barrier to entry to new competitors and any investment in a company in this space should be made with great care.

February 8, 2008

BCE: Special Situation Value Idea

The buyout of BCE present a risk arbitrage opportunity for the aggressive investor type. Private Equity has agreed to take BCE private for $42.75 per share in the summer of 2007.

I have spoken about it in the past, see post here. At that time I did not like the risk/ reward profile but since then the payoff profile changed significantly, as BCE shares declined due to skepticism that a deal that size can get done with the credit turmoil. The BCE opportunity promises a good return on investment compared to the risks involved. Let take a look, here are the facts:

  1. Current BCE price is $34.72.
  2. One additional dividend payment in April of $.365 per share.
  3. Take out price is $42.75 which is expected to be concluded in 2nd Qr 2008.
The payoff, if the deal is completed as announced, is 24% in 3 months, which is in excess of 100% annualized. However, such juicy opportunity would not last long. The market is voting that the deal won't get done at least at its current price.

The risks are two folds: financing and lawsuits from bondholders. There is a risk of a lawsuit from the bondholders to block the deal on the grounds that the deal will devalue their investment, as BCE take on more debt. Most legal opinion think this lawsuit will be dismissed and won't be an obstacle. The big obstacle, however, is the financing of the deal.

Most parties affirmed that they will go ahead, But will they get the needed financing. Big banks are sitting on $200 billion of backlog of LBO loans that they are trying to sell since mid of 2007 with no luck. Most LBO debt done in the summer of 2007 have gone down in price to the level of 75 cents on the dollar, see Businessweek table. Will banks extend credit with high probability of seeing losses to the tune of 25%? The smart money says no they won't.

Given this risk, lets take a look at the payoff in a probabilistic fashion. I will beg completing the deal at the proposed price at 40%. Moreover there is a possibility to getting the deal done at a revised price. The revised price can be anywhere from $35 to $42.75. Further more I will assign probabilities for each price point on an equal basis for all possible renegotiated prices in the mentioned range, then the expected payoff drops to 17.58% for 3 months. Not too bad.

But what happens if the deal gets dissolved. I expect the price of BCE shares to go to around $30 per share, its pre-buyout price, about 14% drop from its current levels. So an investor is faced with a 17.58% upside compared to 14% downside, these are good odds to work with. I think the risk reward profile of BCE arbitrage situation is well worth the risk now.

Off course if you want to protect your downside you can purchase at the money put which trade about $4 per share, therefore limiting any downside if the deal gets scrapped. However your expected payoff in this case decline to 5.5% or 22% on annualized basis; still not bad in such choppy market.

February 6, 2008

Pricing Risk II

Risk planning, in my opinion, is the only thing investment should be about. Success in investment is about risk management and assessment more so than picking good ideas. In my view there are 4 types of risk:

  1. Business specific risks: where you lose because of management incompetence, increased competition, and financial insolvency.
  2. Valuation risk: there is an adage that says "not all good companies make good investment". This means that you can find an absolutely great management, fantastic product, great prospect, and good sustainable competitive advantage. So where is the risk? The company is overvalued by investors leaving no room for good return and little margin for error.
  3. Systemic risks: these risks are general economic risks that are not unique to one company but rather impact most companies to one degree or another.
  4. Your own liquidity risk: there may be circumstances that could force you to sell great undervalued businesses prematurely at depressed market prices, therefore you realize losses.
All of these risks are present in any investment you make. Realizing their existence and planning for them is as important as researching and analyzing any business idea.

Risks # 1 and # 2 are under your control entirely by performing prudent due diligence you can eliminate these risks. Some will argue diversification can illuminate them as well, sure it can but it comes at the expense of your portfolio performance. I would rather invest my time to analyze and research one great company rather than buy two average businesses. And to avoid #2 simply do not overpay. Avoid companies that are in the headlines news or the ones that your annoying brother in law recommends to you.

Risk # 3 is outside of your control but you can plan for it nonetheless. You can have a good asset allocation mix between equities, bonds, and real estate to diversify this risk as generally in rescissions bonds tend to do better than equities.

Risk # 4 sometime no matter how you plan for it, it will happen but again you can minimize this by only investing the sum of money that you can do without for indefinite amount of time. You should not invest if you are running a startup business, or your foresee you need capital for an upcoming financial obligation. Any investment should be made with the assumption it is forever.

Risk and investment is two faced coin. You have to be able manage both well to succeed.

February 4, 2008

Tops ...bottoms...and valleys!!!

Many experts are talking about how market has bottomed because the credit crisis has stabilized and such. Well such calls are extremely dangerous to your potential returns as it leads you to make decisions for all the wrong reasons. You should tune-out anyone who foresees market directions. period.

What you should do is look at the market from a valuation perspective. And the only relevant question is: Is the market over or under valued at the present?

I have talked about this in a previous post that the market sans some groups are not undervalued by any means. A superficial look at the current market Price Earnings ratio (PE) may lead you to believe that the market is actually undervalued or cheap but you should look a bit deeper.

The nominal PE for the S&P is around 17 x TTM earnings, which is close to its long term average of 15x (average monthly PE since January 1871). Also the current ratio has declined from a recent high of 19.5 in September 2007. However the stock market is fairly expensive one Q4 earnings are factored in.

Q4 earnings have declined a whopping 19.3%; a pro forma PE is around 22 at the current market level. However this measure is also misleading.

A look at the inflation adjusted and 10 year average earnings PE tell another story. The real-adjusted PE stands at 28 x earnings well above its long term average of 17. See graph for the difference between nominal and adjusted PE over time. The adjustment is necessary to normalize the effect of economic cycle on earnings as the cyclical affect of economic expansion can distort the ratio.

The current market although declined by about 13% is nowhere close to being cheap. However it can become cheap by either:
1. A huge decline in prices o offset the decline in earnings, or
2. Side way movement while earnings go up once the economy grows, and this will happen very quickly in a growing economy.
Either way there has to b an adjustment and an alignment to long term averages. I am hoping for the real-adjusted PE to come under its long term average before I buy more. Therefore I am hoping for one of these scenarios to happen to buy more and redeploy my fixed income part of the portfolio.

February 1, 2008

Market Volatility

Taking a look at the chart published by BusinessWeek indicate to me that market volatility is returning to normal rather than being abnormal. Volatility have been reduced in the previous 5 years but the market was no stranger to it and you should not react and base your investment decision on it.
Financial crises like this one seems to be occurring at a more frequent pace than before. And they will continue to do so until investor, regulation and institutions catch up to the financial innovation that occurred in the past 20 years. The frequency in credit and liquidity crises are mainly as a result of financial derivatives. Now I am not knocking derivatives like Warren Buffet as they think they are useful as risk management tools. However, any tool created can be abused by lack of regulations and fraud and this is what is happening in the market today. Markets are left on its own to police itself on the use of derivatives and lack of oversight encouraged fraud.

However, I think that human and society ability to adjust and deal with issues like this will overcome these challenges. In the meantime as an investor I will keep looking for good buys not deterred by the "sky is falling crowd".