Ability to remain irrational longer than ability to remain solvent

John Hempton at Bronte Capital writes another high-quality piece about how having superior information doesn’t necessarily translate into stock market returns. It is just like people that shorted the stock market in 1999 because of insanely high valuations (or shorting Amazon in 2009 at $100/share!) – even though they might be correct, the market can remain irrational longer than your ability to remain solvent.

It is always frustrating in markets to be right, but to get the timing incorrect. This is why option markets are always so brutal to those don’t get the element of market timing to be correct. It is also an indication that even when betting against the majority, you will only be able to win if some of that majority decides to see the world your own way – this process can take years, just like it did for the former Dow Jones Industrial stock Eastman Kodak, or for the poor fellow (Alfred Wegener) that developed most of the geological theory on plate tectonics – he was completely correct, but ridiculed in his own scientific community and died before he was proven correct about 40 years after he proposed the theory.

You can also see other stocks that are on their death throes, such as nearly anything involved in newspaper or paper-based publishing. It also makes you wonder what industries today that aren’t visibly dead will be on their deathbed in the next 20 years – look around you and see what you use today, and wonder if it will be replaced with some substantial technology innovation that is just in its infancy today. Maybe this is why Amazon is trading so highly – maybe they will be exterminating conventional retail shopping?

I remember back in the late 90’s, back in the days when I started investing and didn’t know too much other than technology companies, that I did a lot of research on flat panel displays. Back then, 17″ CRT monitors were still about $500, but it was imminently clear to me that flat panel displays would be the way of the future – if anybody tried lifting up a 21″ CRT monitor you would end up breaking your back trying to move the thing. It lead me to two companies, Genesis Microchip, which did semiconductors in FPDs, and Photon Dynamics, which made diagnostic and factory equipment for the manufacturing of FPDs.

Both of these companies didn’t skyrocket like I anticipated them to and I never even invested in them, but it was worth noting that despite the fact that flat panel displays became the future of computer displays, I never was able to financially capitalize on it in the marketplace.

Present cost of portfolio insurance

I am noticing that the implied volatility of the S&P 100 is below 20% right now, which is the lowest it has been since when the financial crisis really picked up steam (September 2008). At the peak of the economic crisis this was around 80%.

The concept of portfolio insurance is simple – buying put options represents a form of insurance. You can play with these options and come up with some concepts that can be translated into English for less financially sophisticated people.

Let’s pretend you owned $100 of the S&P 500. If you wanted to insure your portfolio against any further downside for the rest of 2010 (i.e. you wanted to guarantee that you could sell your $100 of S&P 500 for $100 at the end of 2010), how much would it cost you? The answer is about $9.89 given closing option prices on December 24, 2009. This sort of insurance is good if you anticipate a possibility of the market declining, but you still want some “skin in the game” in the event the S&P 500 goes up between now and the end of the year.

We can repeat the same thought experiment, except asking ourselves if we wanted the right to sell your $100 of S&P500 for $90 by the end of 2010, a 10% loss. This insurance will cost you $6.14 to purchase.

The difference between these two values are $3.75.

What this practically means is you can bet the following ways (again, note I am indexing the value of the S&P 500 right now to 100 for the purposes of this post):

1. You can bet that the S&P 500 will not drop at the end of 2010. Reward for getting this right: $9.89 for $100 notional risk. Punishment for getting it wrong: $9.89 minus $1 for every $1 that the S&P goes below $100 at the end of 2010.

2. You can bet that the S&P 500 will not drop more than 10% at the end of 2010. Reward for getting this right: $6.14 for $100 notional risk. Punishment for getting it wrong: $1 for every $1 that the S&P goes below $90 at the end of 2010.

The “bets” to describe the results of predicting an S&P 500 level of 90 to 100 are a little more complicated to explain, but they can be done with portfolio insurance as well. Essentially you can feed any probability distribution into a model and have it crank out the optimal purchases/sales of options to correspond with your crystal ball forecasting.

Since I can’t forecast indexes, I’ll leave this to the gamblers. That’s what most option markets end up being. Right now, the option markets are saying that they expect volatility to be low, which keeps option prices low. This generally favours people that have strong beliefs that the markets will go rapidly in one direction or another.

Harvest Energy takeover finalized

Harvest Energy has finalized their takeover with KNOC, so their units will be delisted as follows, per the press release:

As a result of the acquisition the Harvest trust units will be delisted from both the Toronto Stock Exchange (“TSX”) and the New York Stock Exchange (“NYSE”). The NYSE has advised that the trust units will cease trading on that exchange on or about December 23, 2009 and the TSX has advised that the trust units will cease trading on or about December 29, 2009.

This is an interesting delisting schedule, mainly because if you own the Canadian version of the units, you have a tax election. If you are sitting on unrealized losses, you want to liquidate the shares immediately so that way you can claim the capital losses on your 2009 tax return. If you are sitting on capital gains, you can defer capital gains taxes to your 2010 tax year by selling the units on December 28, 2009.

(Update: I had failed to account for the fact that December 28, 2009 was a statutory holiday in Canada and the exchanges were closed this day, but the trust units were still traded on December 29, 2009, which means the election above was still available.)

The best stock pick for the past 10 years

It is always interesting to pour over historical data and ask yourself how you could have figured this out had you not had the benefit of hindsight. Everybody calls this “the next Microsoft”, but these days, they are not turning out to be revolutionary software companies.

The largest gainer in the past 10 years turned out to be Green Mountain Coffee Roasters. Back in the beginning of the year 2000, they were $0.88/share, split adjusted. Today they are $69 a share. So $1,000 invested in this company back in the beginning of year 2000 would have resulted in a cool $78,400 today.

What does Green Mountain Coffee do? While their business at the beginning of the century used to deal with selling coffee, they made an acquisition of Keurig in 2006 which turned out to be a major value-added acquisition on their part. The rights to the Keurig coffee machine, and selling the K-Cup packs has been incredibly profitable. It is a razor and blades business model, where the coffee machines take K-Cup packs. Each K-Cup is good for a serving, and typically costs about 50-100 cents to purchase for each serving.

The trick is getting as many of the machines in the public, and then collect royalties on K-Cup sales. They appear to have done that.

My only experience with the K-Cup was in the Air Canada Lounge in LAX airport. They had a K-Cup machine and it made coffee, but I wouldn’t have sold my soul for it. The fact that the machine also creates a lot of disposable junk turns me off somewhat. But somehow GMCR has managed to get enough of its razors into the marketplace, and has enough consumer adoption that they are making huge money off the blades.

In terms of the stock price, I think it is safe to say that we won’t be seeing another 78 times appreciation over the next 10 years, but it will be interesting to see whether GMCR can grow its business to the level that the stock price suggests.

How could have one seen this 10 years ago? Nearly impossible. Even 3 years ago when they took over Keurig, instinctively I would have thought “Who in their right mind would pay 60 cents a pop for their own home coffee machine when you can just as easily grind your own beans?” I’m guessing that cost wasn’t the factor, rather convenience of having to not deal with the messy parts of good coffee making. If I thought that the coffee it produced was vastly superior to the traditional methods, then perhaps I thought the company would have a chance. But I guess convenience trumps cost in this case.

FairPoint – the only bankrupt company I ever had money in

FairPoint Communications was spun off of Verizon a year and a half ago. It mainly consisted of Verizon’s rural landline businesses. They carved out the company and distributed shares to Verizon shareholders. Since at the time I had money in the Telecom HOLDR, I received a distribution of one share of FairPoint.

There was no point in selling the share – it would have cost me nearly as much in commissions as the share price. My only hope was that management would be smart and do a tender offer for small lot owners (e.g. 10 shares or less) which would relieve me of the burden of receiving useless amounts of paper concerning voting for the board of directors, etc.

The company had way too much debt when it was spun out of Verizon, and a year and a half later, it has filed for Chapter 11. I look forward to my 4.5 cent piece of paper reorganizing and vanishing out of my account.

So far to date, this is the only company that I have held shares in that went bankrupt. All other companies I sold well before their Chapter 11 filings.

FairPoint is a viable operation; it just needs to reduce its debt by some 70-80% in order to be financially sustainable. Considering that most of its debt was inherited from Verizon (Verizon decided to take a $1.2 billion dividend out of it before spinning it out), one would think that they would have known that leveraging the company before giving it away would have killed the equity holders.

What ever happened to Menu Foods?

Menu Foods was a company that ran into a huge amount of trouble for distributing pet food that contained Melamine, which caused kidney problems in pets, sometimes leading to death. The first precautionary recall was in March 2007 and then it took another month for them to isolate what exactly was causing the problem. It was through a supplier, ChemNutra Inc., who used wheat gluten that was imported from Xuzhou Anying Biologic Technology Development Co. in Wangdien, China. The whole history of the case is documented on the company’s website here.

These series of events took the company’s units from seven dollars a share to about one dollar less than a year after the news broke. Financially, the company is not on solid ground – although it was somewhat profitable before this incident (making about $24 million in distributable cash in calendar 2006), its balance sheet was quite leveraged, with a net debt of about $100 million.

Fast forward a few years, it still has the debt – some $105 million. The only difference is that $75 million matures in October 2010. The company breached its covenants in 2007 (primarily due to the aforementioned recall) and as a result had to cut its distributions to zero and pay its creditors a rate of LIBOR plus 5.8%.

Lately, however, the company seems to have recovered from its near-death experience: they have settled the lawsuit, and they are now generating cash again – about $11.1 million in free cash in the first 9 months of 2009. Their units, in response, have gone up from about 80 cents at the beginning of the year to $2.50 currently; at 29.3 million units outstanding, that is approximately a market value of $73 million.

The primary hurdle for Menu Foods at this point seems to be the renegotiation of their $75 million debt. If they can achieve this, then unitholders will be sitting pretty and perhaps distributions could continue after they have continued to deleverage their balance sheet. It is interesting to note that a company that was originally on its deathbed is now positioned to survive, in no part due to investors’ risk preferences being expanded in the zero interest rate environment.

A quick look at the top 10 Nasdaq stocks

The following is a very superficial look at the top 10 capitalized companies trading on the Nasdaq (not the NYSE), their market capitalization, and the P/E based on the next fiscal year’s analyst consensus estimates. Also added in are some very quick notes on the respective companies. In order for the index to rise, the top 10 usually must rise as well. I typically do not invest in large capitalization companies because you implicitly are giving up an advantage as a small investor that most large investors do not – the ability to be nimble and build substantial positions in small companies.

Amazon – $58B – P/E 53, pricing in INSANELY high growth, both top line and margins
Amgen – $57B – P/E 11, patent expiration on Epogen coming soon
Apple – $170B – P/E 20, lock on the digital music market, perhaps not the hardware side though, probably under-valued amazingly enough.
Cisco – $139B – P/E 15, essentially a ‘commodity’ network hardware company now
Comcast – $49B – P/E 14, boring cable company
Google – $186B – P/E 22, profiting on any mouse clicks on the internet, decimated traditional media, probably has reached upper end of scale.
Intel – $112B – P/E 14, commodity CPU maker
Microsoft – $264B – P/E 14, commodity OS maker, eroding margins from open source software
Oracle – $113B – P/E 13, commodity DB maker, same thing as Microsoft (they really should merge)
Qualcomm – $75B – P/E 17, basically half the cell calls on the planet (CDMA) make a profit for this company

Why analyst calls are useless

Everybody that is seasoned in the market know that analyst research and projections are designed with the purpose of providing institutional business to the underlying investment brokers. As a result, you very rarely hear analysts giving sell recommendations, unless if the firm in question has already burnt its bridges with the company in question.

At best, this research usually reflects the market consensus, plus or minus a few cents on the earnings per share projection. Analyst research is never the basis for making a trade – instead, it is a quasi-benchmark for how you think the company in question will really perform.

When an analyst is brave enough to see a company that is clearly overvalued and makes a sell recommendation, he is usually looking for an exit out of the firm. For example, a brave analyst called Brian Kennedy made a sell call on a company called CardioNet. He was basically forced out of the company, but his negative projections turned out to be correct.

Note if you cut-and-paste the URL into Google, you can view the entire article.

The moral of the story is that analyst research has a function; but the incentives that analysts have serve the investment banking arms of their companies. Anybody doing very sharp research is most likely trading on that information rather than releasing it to the public, as it is far more profitable to trade with superior information than to try to drum up investment banking business.

Limited Brands Reports Q3 results

I will begin this post by saying I don’t understand the shopping mall experience. Perhaps because of my gender, I just don’t understand why people, usually women, like to “go shopping”.

However, I can understand what goes before my eyes, and that is people shop. I might not understand fashion retail, but I understand the economics of it – something about the marketing works. It gets people to pay more for a product that inherently has very low marginal cost to purchase. The embedded marketing costs, however, are huge.

Earlier this year, I invested in some corporate debt of Limited Brands (NYSE: LTD) – the 2033 series of debentures, which has a coupon of 6.95%. Investors back then assumed that retail was going to get thrown out the window along with the rest of the economy and especially for a discretionary retail shop like Limited Brands (their primary brand name is Victoria’s Secret), droves of people would be not shopping for lingerie. Or will they? According to their last quarterly report, they are on track to bringing in about $500-600M in free cash flow, depending on how the Christmas season works out.

For 35 cents on the dollar, I figured that the debt would be a good buy. It was tough to rationalize how being rewarded 20% interest a year (plus another 4% capital appreciation) under the assumption that Limited Brands would not blow up could lose money. And indeed, it has not lost capital – the same debt is trading for around 71 cents if you shop around carefully. This will still net you 10% a year in coupon payments, and about 1.5% a year capital appreciation compounded over the next 23.8 years.

If you look at their balance sheet, they have about $2.9 billion in debt, covered by $968M in cash, and positive earnings. Although I have no idea whether the retail chain over the next 23.8 years will survive, at least right now it is looking quite good.  The following is the debt maturity schedule from the Q2-2009 SEC filing, which shows they have staggered out their debt financing fairly well:

15. Long-term Debt

The following table provides the Company’s long-term debt balance as of May 2, 2009January 31, 2009 and May 3, 2008:

May 2,
2009
January 31,
2009
May 3,
2008
(in millions)
Term Loan due August 2012. Variable Interest Rate of 5.18% as of May 2, 2009 $ 750 $ 750 $ 750
$700 million, 6.90% Fixed Interest Rate Notes due July 2017, Less Unamortized Discount 698 698 698
$500 million, 5.25% Fixed Interest Rate Notes due November 2014, Less Unamortized Discount 499 499 499
$350 million, 6.95% Fixed Interest Rate Debentures due March 2033, Less Unamortized Discount 350 350 350
$300 million, 7.60% Fixed Interest Rate Notes due July 2037, Less Unamortized Discount 299 299 299
$300 million, 6.125% Fixed Interest Rate Notes due December 2012, Less Unamortized Discount 299 299 299
Credit Facility due January 2010 15
5.30% Mortgage due August 2010 2 2 2
Total 2,897 2,897 2,912
Current Portion of Long-term Debt (7 )
Total Long-term Debt, Net of Current Portion $ 2,897 $ 2,897 $ 2,905

Another similar corporation that is debt-free is Abercrombie and Fitch (NYSE: ANF), which seems to defy everybody’s expectations during recessions by coming back from the financial netherworld to make insane amounts of money. I can see the appeal of Victoria’s Secret – sex sells – but Abercrombie? When walking into the two stores to do some ‘consumer research’, I just don’t understand what keeps these names afloat in the retail fashion world.

However, I can at least invest and make some cash off of it while the going is good. Will I know when it is time to liquidate? Who knows.