September 2007 Archives (Tom A's Stock Picks)

September 2007 Archives

Working on my Watchlist

Rating: -2.50 (2 votes) Vote:

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I spent some time this week working on my watchlist. During the period of high volatility over the past several weeks, I felt that I missed some buying opportunities because things were moving too fast for me to keep track.

I'm trying a new approach, using an Excel speadsheet that has information as to what I think a stock's range and buy point are. Based on the current price, it computes how close the stock is to my preferred buy point. I linked it to the workbooks I prepare when evaluating stocks. I'm a little over halfway through it, and when it's done I will be able to keep track of 80-100 stocks

The plan is, once a week, I will look up and type in the closing prices of the stocks I follow, then on anything that is near a buypoint I can update my analysis and make a decision whether to buy some stock.

Bargain vs Momentum - reasons & examples

Rating: 1.38 (13 votes) Vote:

Reasons I prefer Bargain Hunting to Momentum investing:

Buying bargain stocks, frequently all I am asking the stock to do is get back to its average valuation multiples. The momentum player is often asking a company to maintain an unsustainable rate of growth in order to support unrealistic valuation multiples.

As an example from my SLO portfolio, BJ Services (BJS, an Oil & Gas Services provider), currently trades at a substantial discount to its own historical averages on P/E, P/B & P/S. It also trades at a discount to its peers on the same metrics. If BJS traded at the same P/E as its peers, the stock would increase from 26.37 to 48.99. I did the same computation for P/B, P/S and P/CF, averaged the results, and BJS on that basis would trade at 38.69, a 40% increase.

A stock that is trading at its bottom can't go down much, often there is margin of security in price/book or price/cash flow. On the other hand, a momentum stock trading at, for example, a Price/Sales ratio of 12 has a very long way to go down.

Cincinnati Financial (CINF, a Property & Casualty Insurance Co.) was added to my SLO portfolio at a price to book value of .94. At its current price of 42.75, I have a 14% profit, and the P/B at 1.1 is well less than the peer group at 1.5. The assets behind their book value include not only the usual bonds but also a substantial amount of stocks, mostly stable dividend payers.

The value investor has better options if his position develops unfavorably. If my treasure declines in price, I usually have a dividend to console me, and I can hold through or average down, confident of value. If a momentum stock goes down, the investor's options are a) wishing he had used a stop loss b) taking a nice tax loss or c) doubling down, hoping a greater fool will materialize.

Olin (OLN, Olin Brasss, Winchester Ammunition, & Chlor Alkali Chemicals) is included in my SLO portfolio and I have great hopes for it. It pays a dividend of .80, yielding 3.72% at a price of 21.51. If OLN's price goes down, the dividend, which is regarded as secure, will provide me both income and protection. I will have the option of holding through the dip, while I monitor results to determine if my expected scenario is going to occur.

The value investor is sometimes able to get large returns with very little risk.

Tessco (TESS, a wireless distributor) added to my SLO portfolio at a P/B ratio of 1, has made money every year for the past 10 years, has negligible long term debt on its balance sheet, and closed 2007 with a current ratio of 1.6. Every year from 2001 to 2006, it was possible to buy it for less the 1 x Book and sell it for more than 1 X book. The risk involved would have been negligible. TESS now trades at a P/B of 1.44, giving me a 50% increase in a matter of weeks. I don't think it is cast in stone that risk and reward have to be proportionate.

Buying ODP

Rating: -0.20 (5 votes) Vote:

Bought 3,000 shares Office Depot, ODP, at 20.03, market order

ODP competes with Staples and Office Max in the office supplies field. It was recommended in Barron's on 8/27/2007 by Value Investor Ron Olstein, I reviewed it because his other picks seemed similar to what I buy. His main points were that margins can be improved and he is impressed with the CEO. I compared it to Staples, SPLS, and its net income as a % of revenue was lower than Staples and has increased in recent years. I felt that supported the margin idea. I read some on the financials, I saw some "investments" in international that are being expensed. International is growing well, so the money is well spent. Cash flow is strong and there have been some share buybacks.

I had previously reviewed on 6/22/07, when it stood at 34.73 and came up on a screen for Hi ROE, Lo PCF, Debt/Equity <.35. My impression at the time was that it was a good buy at a price/ 5 yr average EPS of less than 20.

I was going over my watchlist due to the market being down, and ODP was down about 9% on the day and it was at a buy point on that basis. I noted after I had bought the shares that it had been downgraded by Goldman Sachs. I plugged their estimates into my spreadsheet, that did not change my opinion, I like to buy a stock at a forward P/E of 10.5. Goldman's price target is 29, mine is 30 as a midpoint: in any event, a 50% increase will be good enough for me.

Using 15% of portfolio as a maximum position and going for 40% of that on my first buy, I bought the 3,000 shares. This leaves me room to add to the position if it declines further.

Selling MBI into FOMC rally

Rating: -0.33 (6 votes) Vote:

Sold 800 Shares MBI at prices from 61.97 to 62.46

MBI (MBIA, a financial guaranty insurance company) has had a large short interest open against it, 10 days when last I looked. I got the idea of checking short interest from a post by John Czerw, which covered the topic as it related to his SLO picks. After looking at the short interest and recalling that MBI was up very strongly on 8/17, when the Fed cut the discount rate, I was watching for a similar increase if the Fed cut today. MBI was up as much as 9% on above average volume, short-covering, and I felt it was a good time to reduce my position.

I started trimming, using limit orders, and sold 800 out of 1,800. If the stock behaves the same as it did before, it will start giving back its gains over the next few weeks. While I believe MBI will escape material damage to its balance sheet as the result of the sub-prime situation, I suspect that they will have some losses to report before the end of the year, which may very well create another buying opportunity.

Selling TESS to raise cash

Rating: 0.70 (10 votes) Vote:

Yesterday and today I sold 300 shares of TESS at 16, using a limit order for 2,100 (half my holdings). It filled slowly at prices just above the limit. This books more of my profit on this stock, which is up over 50% from my last buy at 9.95. I will place an order to sell 1,800 shares tomorrow.

TESS (Tessco, a wireless distributor), at a P/E of 15.5 is trading near the middle of its range. It may still have further to go, but could do poorly if its next earnings report is as disappointing as its last one.

I think the FOMC rally was wonderful, fun to watch, but the economy still has very real problems in terms of the slowdown in housing and the sub-prime losses, which still have not been clarified as to who is holding the bag. As this reality drags on, I think the market will give back some of the gains from this rally, creating more buying opportunities. Hence, this sale, to raise some cash.

Rate cut - reaction & strategy

Rating: 1.24 (63 votes) Vote:

Going into the FOMC meeting, from a tactical point of view I was looking for an opportunity to take some profits and increase cash, hopefully by taking advantage of short-covering I expected on MBI. This occurred and I sold all but 200 MBI and more or less half of my remaining TESS, both written up and posted earlier this week. This leaves me with about 250,000 in cash and a smug feeling because MBI is now trading well below where I sold it.

With earnings season around the corner, I will be operating on the basis of the following scenario: 1) choppy, sideways trading. 2) Greater variability of earnings, with a corresponding increase in the intensity of investor reactions. 3) Lower interest rates, combined with uncertainty about earnings, will make dividend payers with consistent earnings more attractive. 4) The dollar's weakness against other currencies will a) make US industry more competitive and b) make profits earned in other currencies more attractive. 5) Recovery in housing and related industries has been made possible, but will develop slowly until the securitization process begins to function smoothly, with some industries recovering sooner than others.

My strategy is to buy stocks when they are trading low in their historical range according to various metrics, typically price/5 year average earnings, and sell them as they hit the midpoint. I find myself selling somewhat lower than the midpoint in the interest of avoiding round trips and having cash on hand for opportunistic buying. Most of my remaining portfolio holdings fit into the scenario outlined above and I have cash, so my main focus will be shopping for beaten down stocks.

Partly that will come down to what's on sale. A value strategy frequently winds up in sectors that are out of favor, for good reason, and relies on waiting for conditions to improve. In an effort to reduce this slow timing difficulty, I have been trying to develop some ideas as to the probable sequence of recovery: that is, what sort of sector rotation to expect.

One factor I would consider is how much bad news is still out there waiting to be revealed in the financial statements. Homebuilders have mostly disposed of non-core businesses and negotiated sizable lines of credit during happier times. While they will show reduced profits and may write off more land or options, I think most of the bad news is behind them. They have a relatively clean track to run on once qualified buyers begin to appear. Mortgage finance companies, banks, and financial guaranty insurers still have losses that have not yet occurred, or of which they are not yet aware. P&C Insurance has its own cycle, but should recover quickly to the extent depressed valuations reflect fear of the unknown in their bond portfolios.

Basic materials and building supplies should recover ahead of the homebuilders, on the theory that the materials have to be bought and put into the houses before they are sold. Because they will have cut expenses during the downturn, they should show good profits as soon as revenues increase.

Business services and office furniture and supplies should recover gradually along with those they serve. I have value candidates among electronics manufacturing services, semiconductor equipment, and semiconductors, all of which are not directly linked to housing. Both MSFT and IBM look relatively inexpensive to me.

After all of this, I get back to the fact that I am a bottom up investor. I start with the individual company, examine it in its industry setting and relative to its peers, and try to select value companies with strong management and well-defined strategies. A strong competitor in a difficult industry can often be a good buy as it takes share from weaker competitors or participates in the consolidation process. Sometimes sufficient homework gives me an opinion that is based on factors others may not have considered or fully appreciated, or I have a different perception of risk and will be rewarded if correct. By sticking with my natural style, I do better in the long run and don't have to worry about second guessing myself in areas where I am not fully informed.

Buying Homebuilders

Rating: 0.00 (6 votes) Vote:

Homebuilders are now trading at attractive prices, many at or below 1x Book Value. I have studied historical prices for many of them, going back 10 years, and you could always make money within a year or so if you bought a homebuilder at or below 1x Book. Many of them have traded as high as 2.5x Book, so the potential for long-term appreciation is excellent.

I hold various Homebuilders in my personal portfolio, with a fair size loss to date. I elected to disregard an article I read in Barron's dated 8/21/2006, which cites Larry Jeddeloh, chief investment officer at money manager TIS Group, as follows: "Jeddeloh says he won't be convinced that the stocks have bottomed until they're at 80% of book.."
I saved the article and just looked at it again as I was going over my thinking on the Homebuilders. A nice call, in retrospect.

Yesterday there was an article in the WSJ, citing Homebuilder "horrors." Today's article says investors may want to "shun" them. Today's new home sales came in worse than expected, the initial reaction was slightly positive. I think we are getting near a bottom now.

All homebuilders have debt and debt is difficult to repay when business conditions deteriorate, creating risk.. On the other hand, some homebuilders have generous lines of credit, negotiated in happier times. From a cash flow perspective, most homebuilder have several years supply of land and don't have to replace each lot they sell. This means they can generate cash by reducing inventory.

Without going crazy trying to do "what if" analysis on their financials, I decided to add a selection of homebuilders to my SLO portfolio, sticking with the ones I am familiar with.
Maximum combined position size would total 20% of my portfolio, so starting at 40% of that I bought 80,000 worth, spreading it evenly among my five picks. I can add to the positions if they move against me. I used market orders and paid an average .70 X book.

600 CTX at 25.94
1,200 PHM at 13.51
700 KBH at 24.30
800 TOL at 19.86
800 RYL at 20.99

MA - attracive but risky at today's price

Rating: 2.33 (48 votes) Vote:

Mastercard is a well known brand. Their operation is essentially data-processing and not exposed to the actual risk of lending money. Revenue and EPS growth have been outstanding. For their last quarter, revenue increased 17.8% over the same period in 2006, while total operating expenses increased 3.2%, excluding special items. The cashless society is a reality - you can swipe your card at the grocery store, the gas station, or the hamburger stand, paying next month or next year for a hamburger today. As this trend goes global, Mastercard stands to process an ever larger number of transactions without proportionate expense increases. This is an attractive scenario. If revenue growth continues to outpace expenses, not unlikely in what is essentially a data-processing business, an exponential increase in earnings will follow.

The shares have increased from 46.00 when MA went public in May 2006 to a high of 174.60 on 7/13/2007. At a current price of 147.97, it is tempting to look for a rebound after a temporary setback during the past few weeks. I would avoid doing so, because I have significant reservations about the sustainability of their recent growth and margins, as well as the possibility of adverse developments on pending litigation. MA is attractive but overpriced compared to the risks involved.

My analysis starts with 5 year average EPS - in this case, 1.32/share. MA, at 147.97, is trading at 110 times its 5 year average EPS. That kind of a number gives me pause. In reviewing the past five years results, grounds for concern emerge. During the years before they went public, their results include substantial charges for legal settlements arising from restraint of competition, as well as a 400 million charitable donation made when they went public. Even looking past those items, their historical margins are much less than they have achieved recently. For the most recent quarter, net income as a percent of revenue is 25.2%, which I regard as unsustainable, based on past history and the realities of competition.

I went to the SEC website and read their most recent 10-K and 10-Q reports, with attention to the legal proceedings. There are a number of restraint of competition issues pending for which they have not recorded any reserves. That is possible under GAAP, given the contention that they can't predict the outcome: but, in view of the previous substantial settlements, which created a loss in 2002, I would be concerned about the risk of adverse legal developments.

The most recent 10-K is also informative on the nature of competition in the US and global payments business. Competitors include: Visa, American Express, Discover, and JCB. Visa has a significantly greater volume in the global general purpose card industry than Mastercard. American Express and Discover do not utilize formal interchange fees and as such have generally avoided the regulatory scrutiny and litigation challenges Mastercard has encountered. JCB is dominant in Japan. China Union Pay has been established as the predominant domestic card acceptance brand in the People's Republic of China. I don't believe this kind of competition will permit the current high margins MA has achieved to continue indefinitely.

Case in point - On 9/25/2007, America Online Co-founder Steve Case announced the launch of an internet-based payment system that claims to reduce merchants' cost for accepting cards by 75%, from 1.9% to .5%. Those 25% profit margins will draw a thundering horde of competitors. Any kind of global slowdown would make retailers pay very close attention to a 1% or more reduction in the cost of processing payments.

Selecting a proper P/E multiple is tricky here - Discover (DFS) and American Express (AXP) are publicly traded and have P/Es of 14.3 and 18.1 respectively, compared to MA at 28.7. However, they are not directly comparable as they have the credit risk of holding customer balances on their books, at least while awaiting securitization, while MA is a data-processor and not a lender. Visa has plans to go public, but that has not yet occurred and so they are not available as a comparable. S&P places MA in the Data Processing and Outsourced Service sub-industry, checking the peer companies listed, I noted several P/Es comparable to MA's.

Revenues can fluctuate due to circumstances beyond MA's control: historical examples would include the SARS epidemic, the Iraq War, and the aftermath of 9/11.

Taking all of this together, my impression is that MA is priced at a multiple that reflects annual revenue growth of 15% for a substantial period of time, with margins holding steady or increasing from today's high levels. In today's market, small shortfalls from optimistic projections are punished severely. Given the risks inherent in regulation and litigation, together with the prospect of insurgent competition, I would not be interested in owning the stock at current prices - my maximum buy point would be 125 and I wouldn't get aggressive at prices above 100.

Tom A's Stock Picks

Tom Armistead

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