August 2007 Archives (Tom A's Stock Picks)

August 2007 Archives

More MBI

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Bought 800 MBI at the market price

From MBI's 8-K on 7/26: "We have carefully reviewed our credits backed
by residential mortgages and remain comfortable with our exposure to
that sector."

MBI to do a webcast tomorrow on RMBS, I will plan to listen in. In the meantime, I am increasing my position to 70% of my planned maximum, relying on the last information I have from the company as to its subprime exposures.

JNJ cost cuts

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JNJ announced cost cuts yesterday. I was initially enthusiastic, but after reviewing the article I felt that it was news only to the extent it reassured me that JNJ management is addressing the issues. Because Procrit, Risperdal, and Topamax revenues are going to decline over the next serveral years, I would expect management to reduce expenses accordingly.

They did a presentation for analysts, I downloaded a copy from Thomson StreetEvents and read it. (I dislike listening to telephone conferences.) What I got from it is that they will continue their substantial R&D expenses, which include a lot of Phase 3, as well as the Sales expenses necessary to promote growth, on the grounds that it is what they should be doing to maintain long-term profitable growth. The expenses they are cutting are related to the revenues that are going to decrease or disppear.

Consumer Products - the Pfizer integration is ahead of the original plan. In Medical Devices, six our of seven franchises are doing well. They believe the drug-eluting stents business still represents an opportunity, and that issues will be resloved.

They don't intend to try to do an acquisition to compensate for any deficiencies in their existing lines, but would naturally look at opportunities.

I added 500 shares of JNJ today, based on my favorable impression of how they are handling these difficulties and positioning the company for continued profitable growth.

MBI RMBS presentation

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MBI did a presentation yesterday on their RMBS exposure. I downloaded the slides and listened to a replay of the webcast today. I was impressed by the way they presented the situation, they seemed pleased that their policies and procedures have stood up so well under the test of current conditions. Quotes:
- No protection contract written as CDS has been impaired
- Although housing market stress is expected, there are no probable and estimable losses in our portfolio today

So far so good. I was surprised, the stock went down quite a bit today.

Strategy Review

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I had some disappointments last week, the worst of these was MBI, off approximately 10%, similar to the rest of the Financial Guaranty and Mortgage Inurance stocks. As noted previously, I think MBI has done a good job underwritng their subpirme business and I don't think they will be seriously impacted as this debacle plays out. Hopefully this will become evident over the next six months and the stock will recover, reflecting additional demand for their products and improved pricing power. I will hold the position.

I spent some time thinking about Friday's selloff and speculating about whether it will continue next week, whether it is the beginning of a serious correction, how long that would last, and so on. I gave it up. Because I am focused on the individual stock, and invested in stocks that I believe represent quality at a discount, market swings are not a big part of my strategy. From a tactical point of view, it is embarassing to make a large move and catch a downdraft in the market or a new piece of negative information on the stock involved. To limit this, I usually enter my positions on a 40/30/30 plan: 40% of my planned total to start, and two additional increments of 30% as I monitor the news/earnings and market action of the stock.

Last week I added to my position in JNJ after reviewing their cost cuts. I added to MBI because it had gone down; and, with a decent earnings report in hand, I felt that market fear created a buying opportunity. It is likely that the market will be volatile next week, and I will look for opportunites to add to my existing positions at an advantage.

Buying more MBI

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Bought 800 MBI at 49.37, market order

This is my third and final buy here, approximately 20% lower in price than my first buy. I have had mixed results buying stocks that are declining rapidly - some of my largest profits have been made that way, but I have also been hurt buying on the dips.

The thinking here was that absent new negative information on the stock, its decline was part of the panic in Financials, and I would bear in mind the size of the discount to thier nonGAAP metric - adjusted Book Value.

Buying TESS

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Placed a market order to buy 4,000 TESS, 40% of my maximum position for this stock.

TESS is a distributor of wireless products. Their most recent earnings report was a disappointment, and the stock has declined rapidly over the days leading up to and after the report. Trading volume is not heavy and my order is taking a while to fill, the first 40 shares were at 10.65.

Before placing the order, I updated my worksheet on TESS and listened to the webcast on their earnings report. Two analysts asked questions, that is fairly typical as the stock is not heavily followed. What I got out of the call was that the company recognizes the need to expand their customer base and product offerings so as to become less dependent on capex from national carriers. As with many distributors, margins are thin, and management continues to address this problem.

They have a sales initiative aimed at broadening the customer base to get more enterprise business. This is increasing SG&A and does not help immediate earnings. They recently made some sales organization changes aimed at improving execution of this initiative.

On margins, they are developing and presently selling a proprietary product line which gets higher margins. They have also opened a center that does the packaging and I believe some light assembly to convert bulk shipments from vendors to retail packages. This will be an expense savings over outsourcing and provide better control of inventory.

The company has been an active buyer of its own shares, based on my observations they buy low, a plus.

The current price at 10.65 is 10.3 X TTM earnings. Based on the history of Price/5 Yr Avg Earnings and Price/Sales, I see a midpoint price of 17.50/share, and would look for TESS to return to that price level when earnings and revenue growth reflect success of the sales intitiative and margin enhancements.

Buying More OLN

Rating: 1.00 (2 votes) Vote:

Placed a market order for 2,000 OLN

The stock was down about 8% from my first buy. OLN reported its 2nd quarter on 7/26, .48/share, above guidance. Of the three segments, Metals showed better earnings and Winchester has the .50 caliber contract from the US government. Chlor-ALkali had earnings of 55.3 million vs. 67.2 in the 2nd qrtr of 2006, better than I was expecting. I updated my worksheet. Because the last two quarters were better than management's guidance, I marked the current guidance up accordingly and used it in my projections.

This brings my position up to 70% of my maximum for this stock. I will plan to put off buying the last increment until the PONR acquisition is completed.

Buying more TESS

Rating: -2.00 (1 votes) Vote:

Placed a market order for 3,000 TESS, the stock was at 9.30

This is getting very close to its tangible book value per share, which I figure at 8.90. This has been a very good buy in the past when bought close to book value.

Buying CINF

Rating: 1.33 (6 votes) Vote:

Placed a market order to buy 1,500 Cincinatti Financial (CINF), the stock stood at 37.30. This is 40% of my maximum position for this stock.

CINF is a Property & Casualty Insurance company, writing through the Independent Agency system, very agency oriented. Most insurance companies invest primarily in bonds, due to statutory considerations. CINF has a large amount of Equity investments also, because they have capital above and beyond statutory requirements.

I reviewed their Financial Statements and completed my workbook to look at their financials and form an opinion on value. It lists thier equity investments, which are primarily in conservative, dividend paying companies. Their investment strategy is dividend oriented.

Property & Casualty results have been excellent, similar to what others in the industry have been achieving, with combined loss and expense ratios in the 90% area. In the past, this was very unusual in the insurance business, but has been more common lately. Normally, insurance companies compete by writing new business at discounted rates. Lately more of them are doing share buybacks or special dividends to return the excess profits to shareholders. That, together with the concerns about the quality of bonds, may make them more circumspect in competing at a loss, diminishing the effect of the softening market.

At the current price, CINF is trading under its tangible book value per share. It has generally been a very good buy at that kind of price. I think this stock is worth more like 45-50 per share and would look for it to rise to that level as the fear around financial stocks subsides and as their fine, conservative underwriting and investment style is appreciated.

Weekly Review

Rating: 1.00 (1 votes) Vote:

I started the week planning to watch the my portfolio and increase my existing positions if any buying opportunities arose. As it happened, with the extreme volatility, a couple of stocks that I follow got down to buy points so I added two new positions: TESS, a wireless distributor (two buys) and CINF, an insurance company. They both recovered nicely today, giving me gains of 12.35% and 8.36% respectively.

I also added to my positon in OLN, (Metals, Winchester & Chlor-Alkali) when it was down about 8% from my first buy, and was rewarded with a 10.22% increase today.

I feel that the fear factor has been lumping all Financials together, dragging some of them down far more than their exposure to subprime would call for. As Friday progressed, the market started sorting things out, so that CINF and other Property & Casualty or Multiline Insurors were up while the Mortagage Insurance and Financial Guaranty Companies were down for the most part. I will hold my position in MBI, a Financial Guaranty Insuror, because I think they have done a good job underwriting their subprime exposures and they are going to have fewer losses than most investors expect.

At this point I have approximately 80% of my funds invested. I am happy to be showing a profit after putting that much money to work in such a volatile market. It is good to have cash on hand to take advantage of opportunites as they arise without agonizing over what to sell in order to make the next buy. With that in mind, I will continue to hold about 20% cash so I can have the freedom to respond aggressively as situations develop.

Am I running a Quant Fund?

Rating: 2.00 (7 votes) Vote:

I have to ask myself that question after reading in the WSJ that Thursday's peculiar market action, with good stocks down and bad stocks up, was caused by leveraged "Quant" Funds unwinding their positions. Quant Funds, as described by the article, run their portfolios by means of computer programs, assuming that stocks will conform to various statistical patterns and taking both long and short positions accordingly, meanwhile applying leverage in the form of borrowed money.

My system starts with the assumption that a stock's range, in terms of either its Price/Sales or Price/5 Year average EPS, is a lognormal distribution. I review ten years worth of historical financial information, and make the assumption that the high and low Price/5 Year Average EPS (or whatever metric I am using) are 4 standard deviations apart. I assume that the midpoint price of the stock is halfway between the extremes. My Excel workbook assigns a percentile to the stock's current price on that basis, and I make my stock selections from among stocks that are trading below their 30th percentile as I compute it, generally buying somewhere around the 5-10th percentile. I start selling at the 50th percentile, generally I am out by the 70th.

This relies on the assumption that the stock price will revert to its mean, the same sort of assumption that the Quant funds have been relying on for many years. I have reinvented the wheel. For the past three years, this system has worked for me when I was long the stocks involved. The reverse concept, shorting stocks that are high in their range as I see it, has been hazardous: I made a small amount of money doing it, but approximately 1 in 5 short positions went against me badly. The right hand side of a lognormal distribution can extend out a long way. Fortunately the SLO doesn't permit shorting, so I will stay out of trouble.

By no means do I make my decisions on a mechanical basis. To begin with, the minimum and maximum Price/5 Year average EPS ratios are sometimes so extreme that I discard some values as outliers. Also, many companies have "one time" charges or bad years that need to be looked at and left out or included in. Small changes in these assumptions can lead to big changes in the expected price ranges. Some companies have a bad business model or an obsolete product or technology and being cheap doesn't make them a good buy.

Frequently value candidates developed by this system have problems with slowing growth or shrinking margins. I operate under the rebuttable assumption that management will resolve the issues. This is where I read Management's discussion in the 10-K or 10-Q, to see if I can develop an affirmative answer, that they have identified some solutions to the problems and are actively pursuing corrective action. If they have a strong balance sheet and cash flow, they have the resources to perform their task; and, unless they misdiagnose the problem, improvements will occur over time.

Also, this system performs poorly when an industry is in transition, going from a series of fat years to lean years, or vice versa. For example, it got me out of various steel and energy stocks when those industries started to experience improved margins, which were more durable than I thought they would be. Homebuilders, which are now suffering loss of both revenue and margin, would be another case where I question if my methods are workable. This is a critical point where judgment is required.

The positive aspect of this approach is that I don't make a lot of serious mistakes working the way I do. A stock's price movement has three dimensions - direction, magnitude and timing. Direction I usually get right. This is a plus, because you need to go up 100% to compensate for a 50% loss. On magnitude, I don't catch a lot of big moves, but I catch the easiest part and reduce the number of round trips. To improve magnitude, I am working on making fewer trades, focusing larger amounts of my resources on my best picks. Like many value investors, I tend to sell early. Timing is a question of patience. I will wait for as long as two years before I give up on a situation.

To answer my own question, quantitative methods are a tool, a starting point, and not a substitute for qualitative decision making.

BJS vs Oil & Gas Services & Equipment Peers

Rating: 1.00 (2 votes) Vote:

BJS has not been doing well, and is hurting me in SLO and also in my personal portfolio. Under the cirmcumstances, I decided to compare it to its peer group. Taking a list of its peers from an S&P report, I created a portfolio in Morningstar, weighted by market cap, and got a report listing P/E, P/B, P/S and P/CF for each stock and the group as a whole.

BJS is lower than the peer group average on all of the 4 metrics. If it traded at the average, its price would be 37 rather than the current 25.50. Looking at total return ytd, BJS is down 12.7% while its peer group is up 37%.

My interpretation: lack of momentum. There are a lot of momentum players out there, and once a stock loses momentum it is shunned. I am not a momentum player, although I do look at growth as a judgment area when selecting stocks.

What I see is a stock trading at a P/E of 9.8, with TTM and 5 Year growth both at 17% in revenue and higher in EPS. I think this industry is going to grow long term, because it requires more technology to squeeze additional oil from declining or unconventional fields and demand for energy will be increasing indefinitely and exponentially. BJS is a solid player and will participate in this growth.

I will hold and wait.

Buying CB

Rating: 1.67 (6 votes) Vote:

Placed a market order to buy 1,200 Chubb (CB), stock stood at 48.85

Chubb is a large property and casualty insurance company, operating in three areas of the buinsess: personal ines, where they are strong in meeting the needs of high end customers, commercial lines (when I was in the business, they had a reputation for skillful and disciplined underwriting), and specialty insurance, to include Directors & Officers and Professional Liabilty (not easy classes of business, requires expertise.)

At 48.50, they are trading at 10.7 X my projected 5 Year Average EPS. This is the lowest price on this metric that they have had in 7 years. Five year results include some Asbestos liability reserve increases in 2002 & 2003 which are beginning to fade into ancient history. I sort of half look past them, they were so long ago, although in the insurance business it seems like there is always something like that over any substantial period of time. They took a hit on Katrina but still made money, also included in their 5 year average EPS.

Insurance is a cyclical business, and historically the companies have not been able to stand prosperity. Anytime they start making real money they have a price war until they lose money and one or several of the weaker players approach insolvency. I think the current cycle, which is starting down after several outstanding years, will deteriorate more slowly than in the past.

Insurance companies also invest heavilyin bonds, to include Mortgage Backed Securities. I read the section of the 10-K for 2006 which summarizes their exposure. After reviewing it, I am confident that they will not be involved in meaningful losses from any subprime that may exist in their portfolio. As a practical matter, many of their liabilites come from long-tailed lines of insurance and they would of necessity be careful to make safe long-term investments.

Reason to expect that the P&C price cycle will moderate: 1) companies, to include CB, are showing a preference for using their profits to buy back shares rather than underprice new business 2) the bad press around credit risk will give them every motivation to continue to make underwriting profits, since investment profits may be more volatile than reason would call for.

Putting all this together, I see a stock at an extreme buy point. I am starting with 40% of my planned position. This buy is going to give me a heavy concentration in insurance: however, I was in the business for many years and I am comfortable investing in it. I have made good money over the past 3-4 years on insurance stocks, to include CB.

AMAT earnings & conference call

Rating: 2.50 (8 votes) Vote:

AMAT reported 8/14, EPS & Revnue were a little above expectations, bookings and backlog were down. Market reaction has been negative, the stock at 20.55 is off .69 or 3.24% as I write.

I listened to a recording of their conference call, available at their website. AMAT has multiple segements and many of the analysts seemed to be trying to pick up a little information to improve what would be relatively complex models. I don't attempt projections at that level of detail unless the stock only has one or two analysts and I might be able to get something others would not have.

What I heard was a belief on management's part that they will be able to mainatin or slightly improve current margins, which are generous. Over the next year or two, demand for memory should improve due to the amounts required for mobile storage and the amount required to accommodate VISTA when that achieves corporate acceptance. Foundries have been achieving higher utilization rates before resorting to capex, and the move to 65 nanometer has been slower than anticipated: both trends are expected ameliorate over time. They have held or or made small incremental gains in market share where they are dominant and gained share in other areas.

LCD TVs are doing well in the marketplace, but orders for the equipment have not kept pace. Flat panel displays is a growing market as far as I can see.

Cash flow has been good and was used (in part) to buy back shares at an average price of 19.99, a bargain in my opinion and as such it improves the value of the remaining shares. R&D expenditures continue: I think it is a strength of the company that they have the ability to fund as much R&D as it takes to achieve their product enhancement/development objectives.

The solar is ahead of target - they raised their goal from 400 to 600 million in orders for the year. There are a multitude of technologies contending for dominance in this market, AMAT is determined to use their substantial resources in order to be a major factor in this field, and they are not placing all their bets on any one technology at this point. Their point, which I think is well-taken, is that this business is dependent on reducing the cost per watt of solar generated power, and they directing their efforts in that direction.

After putting all this through the blender, I feel AMAT's resutlts are along the lines of what I was looking for. The solar will take years to develop but is ahead of target. My position is less than full size and with a favorable impression of their progress to date, I can add to it. Because the stock is going down right now and the market is volatile, I will defer action in the hope of getting a better price.

Buying more BJS

Rating: -1.50 (2 votes) Vote:

Bought 2,000 BJS at market, filled at 23.99

The major indexes were down more or less 2%, BJS was down along with the rest of the Oil Service Sector, more or less 10% down from my first buy. As planned, I added another 30% of my maximum for this stock. Its not really that much fun feeling for the bottom this way, but I have done my homework on BJS and I think it is a good buy at this price.

Selling some MBI

Rating: -1.50 (4 votes) Vote:

Placed a limit order to sell 800 (of 2,600) MBI at 60.50

It filled, slowly, at 60.74.

The market, and Financial Guaranty stocks in particular, was up very strongly due to the Fed's unexpected action in lowering the discount window rate. While I believe MBI will ultimately escape the sub-prime fallout without material damage, the stock has been very volatile. This reduces my position back from 100% of its planned size to 70%. I am well represented in Financials with the recent additions of Chubb (CB) and Cincinatti Financial (CINF). If MBI continues its yo yo action, I can always buy some more.

Weekly Review

Rating: 2.22 (9 votes) Vote:

Market conditions were chaotic, a week long roller coaster ride. A lot of the action was in the Financials, and fortunately for all of us the actions taken by the Fed seem to have forestalled a general panic and total breakdown of credit markets. As a contrarian investor, I am accustomed to working in sectors that are out of favor or having difficulties. As such my SLO portfolio is heavy to Financials, all insurance companies. My three insurance companies, MBI (Financial Guaranty), CB & CINF (Property & Casualty) all did well. I focus more on value than on sector diversification, but I was a little nervous about the amount of Financial I had and reduced it slightly today, selling 30% of my MBI.

I got a big boost from last week's buys of Tessco, a wireless distributor (TESS). It had reported earnings which disappointed many shareholders, and in the volatile market there was an over-reaction, not unusual in a small growth stock. For the past 6 months I have been able to find a lot of value in large caps and have mostly stayed with larger companies: however, I have owned TESS in my personal account from time to time for several years with good results and I still follow it, so it was easy to make a quick decision and add it to my portfolio.

What also was working was defensive stocks, JNJ and PG, both of which I added to my SLO portfolio during the first week based on the observation that they are trading on the low side of their historical ranges - JNJ in particular.

I don't have any definite plans for next week - I am 80% invested a

Tom A's Stock Picks

Tom Armistead

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