July 16, 2008

Wells Fargo results top forecasts, shares rise | Reuters

Wells Fargo results top forecasts, shares rise | Reuters

You got to love how media reports financial news in such skewed and manipulative way. There is nothing objective from such a headline. The headline celebrate Well Fargo's performance but there is nothing to celebrate. Its earnings are down some 23%. However the good news is they beat the forecasts.

Actually the whole thing is incestuous cycle. Analysts publish forecasts, which are given through management's "guidance", then media benchmarks results against those forecasts allowing management to manipulate the whole process. I am not saying that wells Fargo is doing this but I am talking in general.

Analysts numbers are garbage and provide no useful information as it is based on management biased "guidance". Analysts should be stripped of their title as they do not do analysis or add value in this situation. They just regurgitate data given to them by executives. Moreover analysts are saddled with other conflict of interest that stems from investment banking relationships, "sell" rating are seldom given to a company as you can be sure that whoever issued that sell rating is not getting any investment banking business.

When you hear an analyst speaks on TV recommending a stock or talking about earnings forecasts turn the TV off as 9.9 times out of 10 you will gain nothing useful.

July 14, 2008

Value Managers performance is hurting

Value investment discipline has not been paying off lately. Most value managers are hurting in a big way. Bill Miller's fund is down almost 40% in one year; he has been the superstar manager to outperform the S&P for 15 straight years. Other managers are in the same boat with average returns surpassing the decline in the S&P. Even Buffet's Berkshire is down 20% from its peak. The market fall has been very swift. And I am afraid on a valuation basis we are still got ways to go.

To value the market I use real adjusted PE ratio, basically the average S&P earnings over the last 10 years adjusted for inflation rate to get real earnings.

The market's long term real-average PE is 17 time earnings; we need another 20% decline assuming no growth in earnings to get to that level, the market's current adjusted PE level is 21. But generally speaking markets need to correct even more to balance out and the more it overshoots to the upside the more it tends to correct to the downside. If you look to the PE chart you will see that every time the market has rallied the PE tends to decline well below the long term averages.

In the 1929 bubble the S&P reached its second highest real PE ratio the market corrected in a nasty and violent way all the way to around 5 times earnings. The highest PE ratio was reached in 2000, so we are still adjusting from that peak. The process may take longer than many anticipate. The market can behave in one of the following scenarios to get to attractive valuation:
  1. Moderate growth in earnings combined with another 20-30% decline in S&P. A highly probable scenario.
  2. Above average real growth in earnings with 10-20% decline in prices, which may be not very likely in the next few quarters given all the challenges the global economy faces.
  3. Earnings will violently decline with quick price drop in the S&P. Not very likely given the decent economic activity in the rest of the world and semi-decent US economic engine.
Now nothing will move in straight line there will be some rallies and some corrections. There will also be some attractive valued companies in depressed sectors like retail and consumer discretionary stocks that will make for good buys but I do not expect them to perform any time soon but I expect them to decline less than the rest of the market as they already are trading in single digit PEs.

July 4, 2008

Distressed Investing

Below is quote from an interview conducted by CNBC with Wilbur Ross, the fame distressed investor. I do like particularly his perspective on how he views risk.

For the complete interview go here.

CNBC: Also you're not afraid of distressed businesses, which I think most people are.
WILBUR ROSS: No, we're not afraid of them if we've analyzed them properly. What we are afraid of is the question that we forgot to ask.

CNBC: Can you talk a little bit about your system?
WILBUR ROSS: When we're looking at an opportunity, first of all we look at it on an industry basis, because we've learned over the years that when companies go bad, they generally go bad as a whole industry. At one point it'll be all the airlines that are bad, another point all the steel companies, and another point the textiles. That's because what happens is you have industries that have been high users of leverage and then some catalytic event occurs, so the industry tends to have problems simultaneously. This creates two sets of opportunities, one is to fix the individual company, and second is the potential for changing the dynamics of the whole industry. If you can do both, then you get two big increments to value. So that's what we really try to shoot for.

CNBC: I read that you have a chart system? How does that work?
WILBUR ROSS: We use charts, not stock trading charts but business charts, and the way they work is, when we're looking at an industry we try to put down in paper everything we can imagine that's wrong with the industry. Usually it's quite a long list. We then go over it, and over it, and over it, and over it till we're pretty well satisfied that we've identified everything that is wrong or is very likely to go wrong. Then we start work on a second chart, which is if we have control of this industry, what would we do to fix these problems. When the two charts get more or less similar in length, that's when we get serious about investing.

Bet against the crowd

The best returns can be achieved, sometimes, by taking the out of favour odds. Taking a long bet on the stock market right now is an out favour bet. Although it may have a low probability of occurring the expected returns can be high. US markets dropped from their peak by more than 20% while international and emerging markets dropped by more than that. The pessimism and low expectation of earning growth and uncertainty about the economic health are very rampant among investors. Given that back drop any positive event can light a match underneath equity prices.

Reading through the option figures on the S&P 500 (SPY) indicate that a 15% move to the upside have lower probability of occurring than a 15% decline. Therefore the put options are more expensive than the call options. Taking a position in deep out of the money calls may prove to be lucrative bet. So let me run the numbers on SPY Call Option Dec 2008 with strike price of 167 (current SPY price is 126):

Payoff $ (Price at expiry- cost) % Probability
SPY to go up 15% .14-.01= .13 1,300% 20%
SPY flat 0 (.01) -100% 20%
SPY to decline -15% (.01) -100% 60%
If the market stays the same or declines obviously you are out your premium on the option and if it rallies by 15% your returns are 1300%. If I assigned a low probability of 20% to a market rally by year end the expected pay off from the bet is 180%.

Now, I do not think there will be a rally, but if I want to take a directional bet I will take the bet on rally with low probability as its expected pay off far out gains any bearish bet.

Would I take a position like this? the answer is no. It is out from my style and process. There are a lot of investors and traders who implement strategies like these very successfully and earn exceptional returns. I like to stay focused on my process and earn my returns by finding good businesses. However, I like to run scenarios and see how out of favour odds can translate to excellent returns.

July 3, 2008

Exit out of Halliburton...sort of!

I have exited Halliburton (HAL) position yesterday as it was reaching the lower limit of my valuation; I have sold my position at $55. I had begged HAL intrinsic value between 50-65, see my post here.

However, since there is still more upside to the stock value particularly there is better prospect for its North American business, I have rolled some of my profits to long dated call option, Jan 2010 with $65 exercise price. I have rolled 27% of the profits made on the position into the LEAPS position. Please note that since my write up I have revised my valuation upward based on new financial information from their annual report.

I have bought HAL at $33 because it was undervalued compared to other Oil and Gas service providers, and I thought the discount was illogical. The run up in oil has helped its prospect tremendously so do not be disillusioned in my stock picking abilities.

The option will allow me to participate in the potential run up in their business while I preserve my capital and majority of the profits to deploy into other opportunities as more and more businesses are becoming very attractive. I like HAL for several reasons, and I think it will continue to deliver good numbers:
  • It still trades at a discount to its peers, particularly Schlumberger and Baker Hughes on comparative basis
  • Natural gas prices has firmed up making its North American business much more attractive. HAL has 60% of their earnings are North American based, which until last year and up to the beginning of winter was mostly mundane and declining. But since natural gas prices took off due to decline in LNG imports and colder winter, drilling activity in NA prospect is looking very good which HAL is better poised to increase its earnings than others.
  • International growth, which is occupying more and more percentage of its gross revenue, is on track to deliver 25%+ for the next few years.
The option strategy allows me to leverage a bit my portfolio to enhance its performance, however I limit the use of this strategy to only part of my profits and not my capital.

July 2, 2008

Spin-off valueidea: Lender Processing Services

Lender Processing Services, Inc. Celebrates its Spin-Off with Ringing of the Opening Bell(SM) at the NYSE: Financial News - Yahoo! Finance

This was one of the company on my watch list for a spin-off. The company provides technology platform and work flow tools for the mortgage industry. It has a large market share of the market.

I thought the stock would get dumped by investors, which can be a good value for several reasons:

1. It is in the wrong industry so it must be guilty by association, although its business model nicely isolate it form mortgages ups and downs as it service defaults as well as origination.

2. Its parent company is a member of the S&P 500, it will not be so institutional will dumb the stock.

The stock came out today with 9% upward move, but still I think there can be more upside for the company. My back of the envelop calculation on the company is that it trades at 11 or low teen PE multiples. Its discounted free cash flow on a perceptual basis with no growth indicate that it is undervalued a bit from its trading price.

I will be doing more research and analysis on its business and if its price comes down due to institutional duping then all the better.