September 22, 2010

When the Risk/ Reward Proposition Changes

Price is what makes an investment attractive or not. Price changes the risk reward proposition of any business even good ones. As such there is few issues that have to exist my portfolio: Dr. Pepper and some credit instruments.

I am going to sell some of the preferred issues that I bought during 2008 and early 2009. The risk reward proposition has changed significantly. I have discussed how investors are becoming yield pigs and I want to exist before the party is over. The low yield environment is forcing some instruments to trade higher artificially. Some of the credit issues like junk bonds, bank loans and preferred shares made sense in late 2008 and early 2009 but now it is

Here is an example of an issue I bought in November 2008, Brookfield Asset Management (BAM) issue BAM-O. I have bought additional issues from Brookfield as well like a yield floater, detailed here. The O issue gave me an IRR of 36% when I bought it, now it is yielding 2.5% to 6%, depending on the redemption or conversion of the issue. This issue trades at fair value now, if you consider the IRR to be the equivalent of YTM, then a BBB issuer like BAM is trading around the 6% mark. if I hold to maturity the upside is an expected rate of return of 4%, the downside is significantly more than that. I would never buy this issue now given its price so it is time to exist.

I am existing also most of my bonds positions however I am keeping a couple of floater preferred shares because they should do well in rising interest rate environment, given that there is no market surprise.

I sold Dr. Pepper (DPS ) as well for the same reason: risk reward profile changed. DPS is a spin off investment that was loathed by the market: too much debt, weak earnings and declining US carbonated volume sales. However, the reduced expectation and the strong brand portfolio made it a good investment. Now it is a good business but not a good investment. DPS has managed to drive efficiencies to its distribution and supply chain network, promote brands and gain market share, reduce debt and increase cash flows and dividends. The turnaround in operations made it a good business and share price followed. The risk reward profile changed. DPS is not fully valued at this point I reckon $40 is the mark but from where I sold it at $ 36 the upside potential is not significant to justify risk losing if they had a bad quarter.


GroovyGeek said...

In a similar boat here. My non-retirement investments have been in CDs for a while now, and a week or so ago I took my retirement savings from junk and government debt into cold hard cash, except for the potion that my employer controls in an index fund and will not let me touch. This is a rough time for us savers, the CDs yield 1.2-1.4% if you are lucky, and I have way too much money earning nothing. At this point I find nothing that I want to invest in. Argh!

Sami said...

it is an engineered environment to bid up asset values. any asset right now is going up which in normal times should correlate that closely. Gold, treasuries are going up at the same time which is usually should move in opposite directions. One should fight inflation while the other is fighting deflation. Yield chasing is propping all kinds of financial and real assets as well.

that is why stocks and junk bonds will move up in the near term to medium term.

yes savers unfortunately will suffer.

Anonymous said...

Any thoughts on the Motorola spin off situation?

Sami said...

i have not done any work on it to have an opinion. they have a lot of patents so that is very valuable and a definite asset they can generate a lot of money if they sell or litigate. unloved company in hot sector could have a classic spin off characteristics.

but i know that mobile makers are looking for margin squeeze as competition flood the market. will MOT expand their margins is the question if this a good opportunity. Unfortunately I did not do enough research to know an answer.

Anonymous said...

hi sami,

your blog has been in hibernation.. are you planning on writing in near future..

Sami said...

I am just too busy to post at the moment. I would like to. atone point I would love to have this my main focus but not at the moment. I am thinking in a year I would have gotten out from some business commitments that will allow me to post regularly and quality posts

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