May 31, 2008

Value Idea: Dr. Pepper- Part 3

Business Valuation

DPS, the No. 3 domestic soda maker behind Coca-Cola (KO) and PepsiCo (PEP), the shares at around 25, looks undervalued. On comparative PE ratio, DPS trades at 12.7 estimated 2008 profits of $2 a share. Compare that to 18 times 2008 earnings for both KO and Pepsi. DPS's P/E is one of the lowest among major food and beverage companies. The stock seems cheap, considering the strength of the Dr Pepper brand and the company's goal of generating "high single-digit" annual growth in earnings per share. DPS is trading even at lower multiples than bottling and distribution companies. Since DPS is an integrated operation, unlike Coke and Pepsi, it should command some premium to bottling only operations. DPS's PE is 12.7 compared to 14.3 and 13.9 for Coca-Cola and Pepsi bottling respectively.

PriceEnterprise value2007 EBITEV/EBIT3-year growthReturn on tangible capitalOperating margin2008 P/E Est.
Dr Pepper$25$10,162$1,00210.123%54.4%17.4%




Coca-Cola Enter$21
Pepsi Bottling$33

*Part of Table courtesy of futureBlind Blog, Yahoo Finance, Company Filings

Why is Dr Pepper trading less than its peers? May be because it gets about 90% of its revenue from the U.S. market and 80% from soda, consumption of which fell 2% in 2007 as health-conscious Americans turned to bottled water, iced tea, juices and energy drinks. Nonetheless, Americans still drink an average of 16 ounces of pop daily.

Another issue is U.K. investors in Cadbury who don't want to hold Dr Pepper probably have been selling. This temporary pressure may have created a buying opportunity. Under pressure from activist investor Nelson Peltz, Cadbury jettisoned Dr Pepper to focus on its attractive global candy and gum business. Cadbury's U.S.-listed shares (CBY) trade at 51, more than 20 times estimated 2008 profits.

DPS should trade at a multiple less than Coke, the closest comparison point, Pepsi has frito and does not make for good comparative point. We can assume DPS should trade at 20% discount to Coke due to its premium market share and international distribution profile. On the other hand, DPS should trade more that the bottlers as it derives the majority of its revenues from the concentrate business, like Coke. Coke trades at 18 EV/ ENT. Value, which will present the best case scenario and a valuation ceiling, and the average bottler trades at 12.7 multiple, bottom floor valuation. So a reasonable multiple for DPS is 14.5, the 20% discount to Coke. That makes DPS valued at an Ent. Value of $14 Billion, or 40% discount from its current valuation, or $35 per share.

I do not put a lot of emphasis on comparative valuation as there can be host of factors that can affect it and one of those is the lack of international presence of DPS. However it provided for an identifying measure for undervalued businesses to warrant a deeper look at it.

To properly value DPS, I will need to figure what is the cost of a new competitor will incur to compete against DPS by replicating its economics and operations. I will use a two part approach: determine the earning power of the company plus the economic assets it holds. Any new competitor has to pay that amount to occupy the same competitive position as DPS.

The reproductive assets of DPS does not vary significantly from its book value. A big chunk of the assets value, like any other branded consumer company, is its non tangible assets. Brands and trademarks are economic assets for any business and DPS owns a host of them. I do not feel any need to adjust the book value of these assets as any adjustment would be immaterial.

The company Earning Power is higher than its reproductive assets values. This implies that DPS does have a franchise value and management are able to garnish higher ROIC on capital employed. The figure for Earning Power Value is $34, assuming an average EBIT margin of 22% and capital cost of 10%. The valuation assumes no growth in revenue or market share any growth should be looked at as your margin of safety.

A third valuation yardstick I employ is the Free Cash Flow approach. The discounted free cash flow valuation gives me a share price of $26. The case assumes low revenue growth rates of 5%, high cost of sales at 44% (higher than DPS's historical average of 37%) and high level of recurring restructuring admin charges, which DPS's financial currently reflects. If these parameters were to change to reflect efficient operations due to DPS's recent restructuring initiatives, integration of acquisitions and lower input cost, DPS valuation would be $40 per share, again the top line assumes the same growth rate.


The business case for DPS includes many positives:

  • Brands with stable market share implies strong competitive advantage and pricing power
  • A spinoff company, which on average spinoffs historically outperform due to better capital allocation programs and fostering entrepreneurial culture.
  • restructuring of distribution and operations will lead to better cost management and higher margins.
  • new marketing and advertising programs to boost market share.

While its negatives of higher raw material costs and competition is not something new and already reflected in operations.

At DPS's current price, the market is pricing the worst case scenario which have limited downside coupled with heavy selling due to non economic reasons. The upside, with few operational adjustments, I assume no revenue growth initiatives, is worth the risk. The risk/ reward case for DPS is compelling enough to warrant investing in this business. I plan to accumulate up to 5-8% of my portfolio value in DPS over the next few months.

May 27, 2008

Value Idea: Dr Pepper- Part 2

Part 2 can viewed here. In this post i will review some of the risks associated with DPS.

Declining US Soft Drink Volumes

Soda volume in the US is declining due to health conscious consumers. However, the domestic soda's woes largely are a cola problem affecting Pepsi and Coke more than DPS. The flavored segment in which DPS competes is still healthy. Hispanics, one of the fastest-growing segments of the U.S. population, tend to favor flavored sodas. Moreover the fruit-based drinks account for about one-fifth of DPS's revenues and posted growth of 5% last year.

The company brands are performing well in the flavoured segments. The company's leading brand, Dr Pepper, is one of the industry's best, with volume increasing an average of about 2% annually in recent years. Although Snapple, which has been tossed from one corporate parent to another, but has never quite lived up to its lofty expectation, DPS has managed to revive the brand -- the No. 3 iced tea behind Pepsi's Lipton and privately held Arizona. Snapple's sales volume rose about 7% last year, and could maintain that pace. Snapple is popular in the New York area and California. DPS is building a new Southern California plant to serve the West Coast, ending the need to truck in Snapple from the Northeast.

However, some of its brands past history is less than stellar. Dr Pepper's attempt to enter the sports-drink market with a Gatorade-like drink, Accelerade, flopped, costing it about $55 million last year. Dr. Pepper, for instance, was a pioneer in cherry-flavored cola, but now faces stiff competition from Cherry Coke, while Coca-Cola's Sprite long ago vanquished 7Up despite the latter's head start in the lemon-lime category.

Leveraged Balance Sheet

The company has a substantial but manageable load according to most safety ratios. Their debt level compared to their free cash flows is very manageable. The company now have a higher debt to equity ratio which is not a bad thing for me as it leverages the opportunity.

International growth limitations

The company does not have international distribution or sales profile. Actually there are severe limitations to achieve any results on this front. DPS has sold many of its well known brands to Coke for international markets. The company mainly operates in Canada, US and Mexico.

Quality of the financials

  • no benefit plan obligations liability and the assumptions of the plan are reasonable with LTM expected return of 5.5%.
  • Cash flow from operations growth matches earnings growth and close in absolute figures.
  • inventory growth matches sales growth trends there are no apparent channel stuffing.
  • Accounting policies do no seem aggressive


This one will be difficult to assess for a new standalone company. However, the stability of its market-share over the years as noted earlier and improvements in the performance of some of the lagers brands like Snapple, reflect positively on management capability.

The compensation plans have not been set yet. I get a suspicion that management is waiting for a decline in its stock price so options and stock awards will be set a lower price. That is a possibility and not a negative one for me. Although outright ownership of common stocks is negligible, to the tune of .01%, I will be looking for insiders compensation once revealed to ensure they are properly aligned with shareholders interest.

In part 3 I will review my valuation and rationale for purchasing DPS.

May 24, 2008

Macklowe Strikes Deal to Sell GM Building, Three Other Towers -

Macklowe Strikes Deal to Sell GM Building, Three Other Towers -

So Mr. Macklowe saga concludes with the sale of the GM building to a group of investors. He lost significant chunk of his real estate empire thank to the credit crunch. Actually it was his doing by borrowing short and investing in long term assets. It is the worst funding strategy for any real estate transaction and its risks have been magnified by the credit crises.

The deal for the GM building has many implications for the commercial real estate sector:
  • It is not the same as residential real estate. The dire scenarios will not materialize for commercial real estate.
  • Sovereign wealth funds are ready to make deals and buy trophy buildings which should give commercial real estate some support.
  • GM building valuation under duress fetched a record of $2.9 Billion and a record per square ft sale price of $1450.
  • It validated my earlier posts of the value in high growth urban office and retail real estate. Most commercial real estate indexes have been stating that commercial real estate is declining but these figures are based on thin volume and does not reflect the economics of this market. so may be with this deal some the deal flow will return and we get a clearer picture of the true market values.

The transaction comes at a time where sellers are holding up selling due to low bids on their assets. The transaction might be a catalyst for buyers to up their bids a bit to entice sellers to do deals.

The Value in Spin-offs

I have written and evaluated spun-off companies as value ideas. In this post I want to elaborate on the rationale and the value in spin-off investing. A good book that details this subject is Joel Greenblatt's book "You can be a stock market genius". If you can bypass the book's over-the-top title, it is actually a very good book in value investing with case studies and good search strategies for undervalued investments.

Joel argues that spin-offs are good hunting ground for value and his three criteria for picking good spin-off companies are:

  1. Institutions don't want it not because of investment reasons,
  2. Insiders participation, and
  3. Hidden investment opportunity is revealed.

Security holders often times invest in parent company for a variety of reasons that may not hold true in the spin-off company, for example, industry, size, leverage...etc. So those holders are motivated to get out from the spun-off company as soon as possible. Typically in the few months after the spin-off there is tremendous selling pressure on the spun-off company for no economic reasons. Selling is done due to investors policies and other limitations.

The rest of the post is an article I saved awhile back but I did not source, so for the author, Please forgive me for not posting credit.


Spin-offs have a limited operating history, which means there’s relatively little for investors to look at as a benchmark for future performance. Moreover, the track record that does exist is likely to be unimpressive, since the parent firm has a strong incentive to clean up its books by allocating lots of ‘grey area’ costs to the spin-off. With a limited and often unimpressive operating history, the market’s expectations are relatively low, which again leads to a lower valuation.

Analysts usually apply a premium to ‘pure play’ niche businesses which spin-off represent. However, this said, analysts will almost certainly never pick up initial coverage. Why? because, the spin off entity does not fall under the initial analyst who covers the parent company’s coverage. E.g. a medical company spinning off a chemical division. The chemical maker will not be under the medical analysts coverage and be too small, or go unnoticed to fall into another’s. This period of ‘wilderness’ for the divested entity is typically 0-9mths after spin occurs. Interesting to note, spin-offs typically appreciate 30% or more in this time. Then a re-rating begins.

Spin-offs are often cheap when they come to the market. Every single one is temporary and most will have nothing to do with the underlying intrinsic value of the business. The hype will eventually pick up if the company performs well, the selling pressure will abate as shareholders of the parent company finish dumping the spin-off’s shares. Analysts will eventually pick up coverage, the company will develop a track record and management generally finds a way to improve a business dramatically after the first year or so. The result is a improved cash-flow generation and sometimes a bit of a valuation improvement as well which often means a nicely appreciating stock price.

  • Often, spin-offs are a growth story. If the old management was holding back expansion and the new team has a clear strategy for building businesses that were starved for capital, you can bet the market will reward the risk. Also frequently, there are hidden assets, not reflected in book value, such as land holdings or lucrative brands.

Don’t forget carve outs! They are often a prelude to a full spin-off. In about half of carve outs, the parent eventually leaves the picture.

And don’t forget the parent either! Value can often be released in the parent. It will often set a business free for the most obvious reason. It’s troubled and unprofitable. Usually, the parent unloads the spin-off with baggage ranging from heavy debt to rusting plant and machinery. Incidentally, big debt isn’t a killer if the new company has the earnings to carry it.

Spin-Off Pricing Inefficiency/Technicals

Spin-offs don’t receive much publicity or hype. Typically the parent announces a spin, makes some filings, AGMs, shareholder meeting happen for approval etc.. Then the spin-offs shares quietly show up in the accounts of investors and institutions who own the parent. There’s generally not much news coverage when a spin-off hits the investor’s accounts and the valuation is set by the parent.

The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people. Once the spin-off’s shares are distributed to the parent company’s shareholders, they are typically sold immediately without regard to price or fundamental value.

Structural selling of spin-offs happens due to index fund selling (because the spin-off is not in the index) Lack of yield limited old lot selling and limited liquidity.

  • In the Penn State study, the largest stock gains for spin-off companies took place not in the first year after the spin-off but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spin-off’s stock can perform at its best. Most likely, though, it is not until the year after a spin-off that many of the entrepreneurial changes and the initiative can kick in and begin to be recognised by his marketplace. Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spin-offs, there is more then enough time to do research and make profitable investments.


When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spin-off, stock options, whether issued by the spin-off company or the parent, can more directly compensate the management of each business.

  • Shares of a spin-off are distributed directly to parent-company shareholders and the spin-off’s incentives-stock-option plan is based on this initial trading price. The lower the price of the spin-off, the lower the exercise price of the incentive option. To promote interest in the spin-off’s stock after this price is set by the market, not before.

    Do not expect bullish pronouncements or presentations about a new spin-off until a price has been established for management’s incentive stock options when the price of management stock options is to be set.

    There are few investments areas where insiders have such one-sided control in creating am new publicly-traded company.

Many spin-offs are run a lot better as independent companies than as wards of huge corporations. You attract far better managers to a spin-off than to a division of a company. People can really see they’re making a difference in the value of the stock and their own stock options.

These four criteria can hint at an attractive spinoff:

  • Unattractive factor. Something unattractive is a plus. Too small, too obscure, or too different from the parent -- something that makes investors want to sell. Sometimes it's because investors are only interested in owning the parent; other times, it is because institutional investors have strategies that don't allow for holding companies below a certain size or outside of their area of focus. The end result of their disinterest is to sell, which can temporarily depress the price of even a very good business. For this reason, you want to closely track a spinoff in the first few weeks after it begins trading. But when it really gets interesting is when the spinoff has one of the following traits as well.
  • Growth. Some spinoffs are simply freeing a growth business to shine. The beauty of these spinoffs is often that they are free of the parent's capital allocation decisions. Once spun off, the growth business is free to retain the cash flow it generates and plow it back into the growth opportunities it sees. This was part of the strategy behind Sara Lee spinning off Coach (NYSE: COH) a number of years ago.
  • Leverage. Parent companies often use their spun-off children as a way to unload debt. It's somewhat counterintuitive, but a spinoff that is saddled with debt can be a very good investment, because that leverage amplifies the impact of sales growth and margin improvement, promoting debt repayments and lowering future interest expenses. Debt also unquestionably makes the spinoff a riskier investment, because if sales or margins fall, the interest payments get tougher to cover. Hanesbrands(NYSE: HBI), another company sprung from Sara Lee, fits this mold with $2.5 billion in debt and a sliver of equity.
  • Incentives. To catch this one, you have to be paying attention to the prospectus and filings of a spinoff. Many times, management has plenty of incentives in place to make sure the stock price of a spinoff performs. This can be an ownership stake, options, restricted stock, or stock appreciation rights. Just because incentives are in place doesn't mean a spinoff will be successful, but it increases the odds that management will be keen to decrease costs and take other actions that increase shareholder value.

May 22, 2008

IFRS vs GAAP Accounting

There will be convergence in accounting standards for all public reporting entities in the the world. For the most part the world follows IFRS while the US and Canada follow GAAP with some difference between the two countries. Beginning 2011 all public companies must report their financials adhering to International Financial Reporting Standards (IFRS) rather than Generally Accepted Accounting Principles (GAAP). US companies will still follow GAAP, however using a harmonized version with IFRS, but foreign companies listed in the US will file under the new standards.

The impact of the convergence will not be limited to financial statements presentation and finance but will transcend to all functions of the company. Some impacted areas include,but not limited to, HR, IT, hedging and foreign exchange, Taxes, and executive compensation plans. Moreover, there are significant differences between GAAP and IFRS that will impact earnings reporting. I believe that these differences and convergence will lead to investing opportunities, if the capital markets are not fully ready to understand the differences and their impact.

The new converged standards will not be "better" or "worse" than existing ones, accounting will be accounting and still will have its drawbacks and limitations to provide a true economic picture of the business. However, the convergence will serve to enhance compliance and comparative issues between companies.

Please note that some standards are still influx and I am studying to update my knowledge, so some of these notes are preliminary.

Some notable Differences, many more exists:

  • all types of inventory will be treated using the same method. Under GAAP companies can pick and choose a different treatment for different types of inventory, which companies can use to manage earnings. LIFO is prohibited.
  • It will be tougher for banks to float SIVs and other off-balance sheet entities without reporting them on their books.
  • Treatment of deferred taxes will differ as well as its presentation all deferred tax liabilities will be non current
  • Companies will no longer able to report extraordinary items separately or after operating margins. Under IFRS extraordinary items will impact operating margins.
  • IFRS will allow for some up revision of impaired asset values
  • Under IFRS banks may not had to recognize all those credit write-downs, depending on the circumstances, as IFRS calls for impairment recognition for available for sale debt instruments only when evidence of credit default exists.
  • Consolidation of entities under IFRS is much wider and comprehensive than GAAP.

Depending on capital market readiness for this convergence, I see arbitrage opportunities between adopters and non-adopters. A scenario like the following can develop where two companies in the same industry may report similar economic results but earning may differ due to the accounting standards adopted. If markets focus on the absolute figures without any adjustments, which they do usually, the company with lower earnings will be punished. Buying the lower earnings and selling the higher one may result in some gain as markets readjust. These differences can create buying opportunities due to reaction to accounting policies rather than business economics.

May 20, 2008

Value Idea: Dr. Pepper

Spin-offs can be good hunting grounds for undervalued businesses that can outperform and earn excellent returns (a lot of academic studies back-up this claim). Spin-offs tend to be orphan companies initially misunderstood by Wall Street. Their managers relish the chance to prove themselves as independent operators.

In an earlier post I have talked about the potential Aircraft leasing division spin-off idea from AIG as potentially a good opportunity to make good returns. Here is another one that was recently spun-off from Cadbury Schweppes: Dr. Pepper Beverages (DPS). I have been following this one from last summer when plans for its sale or spin-off made public.

DPS was slated to be sold to Private Equity before the credit crunch occurred for about $16B as a result of the pressure applied by activist investor Peltz efforts, however you know how the story of private equity unfolded since 2007. Needless to say the sale never materialized. Peltz put DPS valuation at $8-10 Billion; a detailed analysis of his valuation letter can be found in my earlier post here. Currently DPS is trading with a market cap of $6 Billion. There is the potential to pickup a good business with numerous consumer brands at a good discount.

A nice read about the opportunity can be found here, mine is below.

Business Economics

DPS is an integrated maker, bottler and distributor of soft drink in north America. DPS owns a host of well known brands including Dr. Pepper, 7-up, Crush, Snapple and many others. DPS holds the no. 3 spot in market share behind Coca cola and Pepsi. There are some differences between DPS and Pepsi and Coke, mainly DPS is in the business of flavoured carbonated drinks rather than the traditional Pepsi and Coke drinks.

The most critical factor in this valuation, for that matter any business valuation, are the risks poised to DPS competitive position and operations in the beverage industry. One key risk is the competitive threats poised to DPS's market share from Coke and Pepsi. So lets review all types of competitive advantage that I have review in an earlier post, read it here.

However, I believe that in the same manner that Coke can fend Pepsi poaching its customer base and vice versa, DPS can hold its market share and lock-in cu'>stomer's buying habits. This is due to DPS's competitive advantage as it owns strong brands coupled with a predictable and loyal consumption habits. If you like Dr Pepper you will continue to buy it, there is no reason to switch brands. Some of DPS's brands are, in fact, increasing their market share. According to Beverage Digest, Dr. Pepper and Diet Dr Pepper posted US volume and market share increases in 2006 and 2007 compared to flat or declining traditional Cola volumes and market share. DPS's overall market share have also been increasing in 2006 and 2007.

To test DPS competitive advantage I will look at its market share stability and sustained profitability over time. DPS market share has been stable as far back as data from Beverage Digest allows me to examine in the same manner as Coke's and Pepsi's market shares. DPS market share hovers around the 15% mark, however in the recent 3 years it is on up trend, while coke and Pepsi are on downward trend. I can not interpret this as DPS taken market share from Coke and Pepsi but it can be interpreted as they are competing in different niches. The stability of DPS's market share leads me to believe to the existence of a competitive advantage.

DPS competes in the flavoured carbonated beverage and non carbonated beverages, a niche away from a direct competition with the more traditional Coke and Pepsi. Most of its major brands are No. 1 in their categories, including Dr Pepper, Sunkist, A&W Root Beer, Canada Dry and Mott's Apple Juice. The weak link: 7-Up, with eroding volume. However, market leaders Coca-Cola and Pepsi also have targeted flavoured and fruit-based drinks—and enjoy larger distribution networks and deeper pockets. DPS brands such as Nantucket Nectars and Hawaiian Punch already are feeling the squeeze, and the company may not hit its 3% to 5% annual sales growth targets.


Although its market share has been stable, it operating margins have not compared to its peers, as you can see from chart 2. DPS's cost of sales have jumped in 2007 reducing margins. The increase in the cost of sales is the result of aquisitions that DPS has completed in 2006. I expect that management will be able to restore margins once they fully integrate the aqusition. Another issue is the cost of sale for DPS contains manufacturing and distirbution, unlike Coke and Pepsi. This item in its cost of sales has increased due to increase in input costs like aluminum, plastics, and energy.

DPS enjoys economies of scale in key markets. As the country's No. 6 soda brand, with a 5.9% market share in 2007, it's particularly strong in Texas, Louisiana, Oklahoma, Missouri and Arkansas. It has distribution and bottling centres in these markets that will lead to lower cost of goods sold on per unit basis. DPS will realize lower costs as it is improving its distribution network to a regional hubs around these strong regional markets rather than central distribution.

I am comfortable with the integrity of DPS competitive advantage and competitive position and I see limited risk to its market share.

In my next post I will review other risks and DPS's valuation.

May 19, 2008

A new purchase

I have bought an entry position in Dr. Pepper Snapple Group (DPS). A recent spin-off from Cadbury.

In my analysis the company appears to be undervalued compared to its peers. The company has host of good consumer brands and good position to expand into Mexico and capitalize on the Hispanic population increase in the US.

Although the company has a high degree of leverage, as the parent loaded it up with debt to buy the bottling business, I think it is manageable as the company free cash flow is excellent.

Next post will be part 1 of my evaluation of the company. Part 2 will follow with share valuation.
Since now I own DPS I have to switch from Coke to Dr. Pepper or Canada Dry.

May 17, 2008

Circle of Competence

Buffett talked at length about investing within your "circle of competence". Warren has never let himself get excited about a deal that he doesn't understand. In the height of the tech boom in the late 90's Buffett stayed out of tech companies. Media have wrote him off as a savvy investors as illustrated by Barron's headline "What's wrong Warren?". He understands his weaknesses, limitations, and the types of businesses that he gets. He said that it is critical that investors clearly recognize what they don't understand, and place their time on businesses that allow them to bet big on what they do understand. He said that it's
... not so important how big the circle is, but it's important that you know where the perimeter is, and when you're outside of it.
So in my investment journey I need to articulate what is it that I am comfortable with and what should I stay away from. I think every investor should do an inventory and articulate that list, it will be very rewarding.
What I am not good at:
  • Spotting undervalued businesses with growth potential. Unlike Buffett and others, I am not able to find these business like Buffett find in railroads and BNI. As a result I need to have an event to trigger the idea like spin-offs, restructuring, and other corporate events. Other ideas can come from copying other investors smarter that I am, but I have to go through the process of valuing these businesses on my own and understand for myself why I am owning it.
  • I have time and resource limitation to analyse large businesses and understand them, so I try to avoid large cap businesses with different operating line of businesses and complexities. I will always strict myself to businesses in a single industry.
  • I am not good at realizing or discovering new emerging trends to profit from.
  • I have no knowledge of complex industries with technical details as I have limited knowledge in technical fields. As a result I will refrain from investing in pharma, bio-tech, technology and other related fields where science is key factor.
  • I have limited knowledge of legal implications and details so my ability to understand and asses risks in certain events will be limited. As consequence I will avoid investment opportunities where legal issues are paramount to valuation like bankruptcies.
  • I am not comfortable in forecasting revenues and analysing growth prospects, so I will always look "down rather than up". Risk is easier to assess and can be derived from good information rather than looking at your magical ball to arrive at growth forecasts.

What I am comfortable with:

  • Accounting and analysing financial statements.
  • I have knowledge of good valuation methodologies and their pitfalls.
  • I have a background in few industries that I can leverage to assess the business. I have good knowledge in commercial real estate, consumer businesses including retail and transportation businesses.
  • I think in scenario and what if situations, so that should be the basis of my evaluation for any business.
  • I understand equities more than debt and derivatives, so my portfolio focus will be in equities.

The list of competencies are much shorter than what you are not good at. It is only logical that you have fewer things that you know and you should ground yourself in that fact. Another thing is the amount of effort, time and energy to learn a new discipline is much more involved than to strengthen and deepen your understating of what you know. Therefore I will not try to learn new industries rather I will focus to deepen my knowledge of what I already know.

Probably my list of what I am not good at will grow with time. Do you know the edge of your circle of competence?

May 12, 2008

AIG Leasing Unit Mulls Split-Up -

AIG Leasing Unit Mulls Split-Up -

Related: ILFC founder weighs Spilt from

This an interesting special situation that can yield value for investors who are willing to do some research. AIG is an insurance company that is planning to spin-off one of its subsidiary. One of AIG holdings is an Aircraft leasing company that AIG might spin-off to its shareholders. The rationale for the spin-off is articulated in the news article and it is not the concern of this post. My concern is the value opportunity that might arise from this special situation, which can yield handsome returns.

If AIG performs the spin-off, investors will hold another security in aircraft leasing. Most investors, retail and institutional are holding AIG for insurance exposure. I bet that they will sell the ILFC subsidiary as most of them do not want to hold an Aircraft leasing company due to over exposure to the sector or the size of the subsidiary is small to be held in their fund. This dynamic might create a bargain price of the spin-off company and a value opportunity for investors to take advantage of it.

Leasing companies trade at P/E of 10-13x trailing earnings. AIG's subsidiary (ILFC) made $1.08B in annualized profits based on Q1 of 2008. A back of the envelop calculations makes ILFC valued at $10-13 B dollars in market cap. Typically companies are separated so they can create value and enhance their business. An Aircraft leasing tangled with an insurance operations might not be able to execute to its full capability.

I am not a buyer of AIG to get the shares rather I will wait for a bargain price in ILFC shares. If one is presented to me, I will take a position. Spin-offs typically yield good returns based on academic research and ILFC is powerhouse in the industry.

Off course this a very preliminary identification of the opportunity, I will have do more research and scenarios plotting to see what type of a case I can build for such an opportunity. I have to look at management and their proposed compensation structure, valuation and potential risks in the leasing industry.

I will be writing more on the subject in due time, so stay tuned.

May 10, 2008

Behavioural issues in investing

The following is a quote from John Mauldin book "Bull's eye investing. It is a list of several emotional traps that investors get tangled in their investing process. I believe that 90% of success in investing is emotional discipline rather than intelligence or identifying the next "big thing".

I do not endorse some of John's views on investing as they come with certain self-serving biases. For example his view on index funds. To promote his hedge fund business he slams index funds for the benefit of active management of hedge funds. I think that index funds should be a stable of any retail investor who is busy enough not to be able do business research. Moreover the long-term historical evidence of their effectiveness is irrefutable, no matter how the hedge fund industry tries to challenge it.

However the read fromthis particular section of the book is very interesting. From time to time I like to reread some of these behavioural issues and try to identify them within my behaviour. I have been guilty of some of them. Can you find some of the mistakes in yours?

1. "Fear of Regret - An inability to accept that you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon." This is part of a whole cycle of denial, anxiety, and depression. As with any difficult situation, we first deny there is a problem, and then get anxious as the problem does not go away or gets worse. Then we go into depression because we didn't take action earlier, and hope that something will come along and rescue us from the situation.

2. "Myopic loss aversion (a.k.a. as 'short-sightedness') - A fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective." Basically, this means we attach too much importance to day-to-day events, rather than looking at the big picture. Behavioral psychologists have determined that the fear of loss is the most important emotional factor in investor

Like investors chasing the latest hot fund, a news story or a bad day in the market becomes enough for the investor to extrapolate the recent event as the new trend which will stretch far into the future. In reality, most events are unimportant, and have little effect on the overall economy.

3. "Cognitive dissonance - The inability to change your opinion after new evidence contradicts your baseline assumption." Dissonance, whether musical or emotional, is uncomfortable. It is often easier to ignore the event or fact producing the dissonance rather than deal with it. We tell ourselves it is not meaningful, and go on our way. This is especially easy if our view is the accepted view. "Herd mentality" is a big force in the market.

4. "Overconfidence - People's tendency to overestimate their abilities relative to
individuals possessing greater expertise." Professionals beat amateurs 99% of the time. The other 1% is luck. The famous Clint Eastwood line, "Do you feel lucky, punk? Well, do you?" comes to mind.In sports, most of us know when we are outclassed. But as investors, we somehow think we can beat the pros, will always be in the top 10%, and any time we win it is because of our skills and good judgement. It is bad luck when we lose.

Commodity brokers know that the best customers are those who strike it rich in their first few trades. They are now convinced they possess the gift or the Holy Grail of trading systems. These are the people who will spend all their money trying to duplicate their initial success, in an effort to validate their obvious abilities. They also generate large commissions for their brokers.

5. "Anchoring - People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs." If you believe that NASDAQ stocks are the place to be, that becomes your anchor. No matter what new information comes your way, you are anchored in your belief. Your experience in 1999 shows you were right.

As Lord Keynes said so eloquently when forced to acknowledge a shift in a previous position he had taken, "Sir, the fact have changed, and when the facts change, I change. What do you do, sir?"

We expect the current trend to continue forever, and forget that all trends eventually regress to the mean. That is why investors still plunge into index funds, believing that stocks will go up over the long term. They think long term is two years. They do not understand that it will take years - maybe even a decade - for the process of reversion to the mean to complete its work.

6. "Representativeness - The tendency of people to see patterns within random events." Eric Frye did a great tongue-in-cheek article in The Daily Reckoning, a daily investment letter ( He documented that each time Sports Illustrated used a model for the cover of their swimsuit issue who came from a new country that had never been represented on the cover before, the stock market of that country had always risen over a four-year period. This year, it is time to buy Argentinian stocks. Frye evidently did not do a correlation study on the size of the swimsuit against the eventual rise in the market. However, I am sure some statistician with more time on his hands than I do will brave that analysis.

Investors assume that items with a few similar traits are likely to be associated or identical, and start to see a pattern.

McQuill gives us an example. Suzy is an English and environmental studies major. Most people, when asked if it is more likely that Suzy will become a librarian or work in the financial services industry, will choose librarian. They will be wrong. There are vastly more workers in the financial industry than there are librarians. Statistically, the probability is that she will work in the financial services industry, even though librarians are likely to be English majors.

May 7, 2008

I am not swinging yet...

Most of the businesses that I have on my watch list have rallied significantly, some 20% plus. Sometimes in the back of my mind a voice tells me to jump in and buy before I miss a major move. But I have to keep reminding myself of:
  1. I don't "need" to buy, if my money is sitting in a money market fund that is ok.
  2. I need to make good investments.
  3. My first priority is to limit my downside risk, and I do not mean the statistical kind.
I always remember Buffett analogy of investing is like a baseball game but with no strikeouts, so you do not have to swing at all. You can always wait for that perfect pitch and load up big. I am fine with that approach I actually prefer it. So if the market recovered and I missed some opportunities, others ones will pop up some other time.

It is important that any investor to do well to "pick their spots" in several ways:
  1. businesses that you are familiar with and have some expertise from work or general interest
  2. investing process that you are competent in executing to analyze a business
  3. price levels that gives you comfort and confidence that you are not overpaying.
So do not feel pressured that you have to buy something, so watch risk carefully as it is more important that eying returns.

May 1, 2008

CHC's Plan of Arrangement Approved by British Columbia Supreme Court

CHC's Plan of Arrangement Approved by British Columbia Supreme Court

I have bought CHC on the hopes of earning a return on the spread between the buyout price and the market price at the time, for more details see here. So far the probability of the buyout occurring is increasing for several reasons:

1. shareholders approval of 99%, my votes are included in the 99% somewhere,
2. granting of court and regulatory approvals,
3. credit issues are easing a bit to allow the already small financing portion from Morgan Stanly to fund the buyout.

Given these developments, I can put the buyout probability of occurring close to 99%, 1% for idiot factor.

However, opportunity cost for these type of strategies are key. These strategies are not worth pursuing in an up market and the market in April has recovered in a major way. So far the position is outperforming the market since I initiate it. But if the market continues to perform in May as it did in April, I will under perform. The good news is the buyout is scheduled to close in June at that time I will be able to allocate capital quickly before missing any other opportunities.

Performance of CHC vs major indexes:
CHC 5.12%
TSX 3.52%
S&P500 4.04%