Valuation not a sufficient criterion to short

Lululemon (Nasdaq: LULU) announced quarterly results a couple business days ago and you can see the market reaction as follows:

They made 39 cents per share in the quarter (which was positively affected by a tax adjustment regarding their transfer pricing) but that isn’t exactly the story. Even when you annualize their earnings or take the next year’s analyst estimates of $2.07/share, you still have a stock that is very pricy for a retail clothing company.

However, it brings me to one of my fundamental rules of trading, mainly: valuation is a necessary, but not sufficient criterion for shorting the stock. As tempting as it seems, you will need to know the psychological catalyst that will bring the company’s stock down or in disrepute before shorting. If valuation is the only reason, your short sale will likely lose money.

Short selling is a very difficult business because your position size concentrates as it moves against you, and decreases as it moves into your favour. Managing your position size and dictating your risk in explicit terms before-hand are two ways to mitigate this negative mathematical aspect of short selling.

I do not have any positions in LULU and do not intend to establish any either. This observation is purely for spectator sport purposes.

Sometimes, doing nothing is best

Letting your winners run is an art. When you do this, capital compounds on capital – if you bought something and it goes up 10%, suddenly you have 110% of your original investment in play, and a 10% gain on top of that will not result in a 120% investment, but rather at 121% of the original investment. In a more extreme case, when something you own doubles, it only requires a 50% gain from that point to amount to another double on the original investment.

This must be balanced off with knowing when to take gains. That time is not now. Everything in my portfolio at present I have a reasonable price target of above the current market value. If anything, I should be adding to the positions.

So the best action I can take is to twiddle my thumbs. People feel fearful of the equity market at present, which is good.

Assurant

Assurant (NYSE: AIZ) is a diversified insurance company with the majority of its profits in the specialty property market.

When looking at the metrics, the company is in very good shape financially and taking all of its assets and liabilities at face value, you have a corporation with a tangible book value of about $49.13/share, using the June 30, 2012 share count. When considering the market value of the shares are about $34/share and considering the company is slated to earn about $6/share in this fiscal year, it makes you wonder why the market is so severely underpricing the company.

There has been persistent stories for the past couple years from state regulators that have been pursuing the company over pricing of its forced-placed insurance, which are policies that are written when a homeowner no longer has insurance on his mortgaged properties – the lender can place the policy on the home to insure their (financial) interests in the property. The forced place policies were apparently too profitable for the firm.

If this turns into a reduction of premiums, or penalty, or both, it will have a material impact on the company’s financial statements, but there is a huge valuation cushion that makes it seem unlikely it will go beyond the large discount presently placed on the shares of the company.

Notably, the company has been buying back its own stock in a very aggressive manner. The following are the basic shares outstanding as of the end of the quarter:

Q3-2010 106,474,301
Q4-2010 102,000,37
Q1-2011 97,931,049
Q2-2011 94,994,982
Q3-2011 92,926,138
Q4-2011 88,524,374
Q1-2012 86,508,372
Q2-2012 82,392,454

On July 26, 2012, the company had 81,084,645 shares outstanding.

Normally I am not a fan of management buying back its own stock, but when a company is trading at 30% below tangible book value, every dollar spent on its shares purchases about $1.43 of value. Assuming you have your assets and liability structure correctly calculated, each share purchased increases the book value further. Considering that the company has historically generated cash at an impressive rate, it makes a compelling value argument.

The risk in this company appear to be in the regulatory aspects of their property insurance. It almost reminds me of what happened with Philip Morris (now Altria Group, NYSE: MO) back in the early 2000’s when they were in the middle of their litigation with the US government. Although their business metrics were fantastic, their shares relative to the valuation were in the gutter. This appears to be the same case with Assurant.

One technical analysis negative is that the company is a listed S&P 500 component. Since its market cap is well under the prescribed $5 billion level, it may get demoted to the midcap index – this typically causes a rush of advance selling as traders anticipate the supply dump from index funds removing the component. It would probably be a good time to make an entry at this point.

That stated, I am a little impatient and started a position around $34/share. I normally do not deal with S&P 500 companies, but sometimes I do make exceptions.

Summer doldrums

I have not been doing much equity research over the last little bit as recreational matters have generally dominated the landscape. One chart I have been curiously watching, however, is the 10-year note yields, which has dipped from its 1.4% minimum:

Which way are the yield winds blowing, up or down?

The Canadian 10-year note equivalents have a similar yield curve and are trading about 15-20 bps above US treasuries in yield. One would think that you could do better than 1.8% over 10 years by taking a little bit of risk…

The decline of Dell

Dell stock is down another 6% today, reaching lows not seen since the economic crisis; before that, you have to trace back to 1997 to match their current share price ($11.57 as of this writing). A “buy and hold” investor from 1997 to today would have seen a 15 year performance of precisely zero in their Dell investment. Fortunately, not many people are 15-year investors in equities these days.

I will post a lifetime chart of Dell:

Dell did mostly nothing in its first year and a half in its public existence, but as the chart depicts, the real meaty part of the growth curve was between 1995 to 2000 when an investor would have multiplied their money by 75 times. Catching this part of a company’s trajectory is the most profitable.

Of course, this is not going to happen now with Dell – the PC cycle is long since done and the company is mature. The question for an investor is – what other types of companies out there are selling products that will become as popular as PCs, and when will they have this type of growth curve? There is one that I have in mind which I have invested in where there is a feasible Dell-like scenario.

Companies in their pre-explosive growth curve typically have smaller market caps (e.g. under a billion). Cases like Apple (where they have already been public for a considerable period of time, having gone through a few product cycles) are relatively unusual.