Rosetta Stone – posting lacklustre quarter

Rosetta Stone (NYSE: RST) posted their second quarter results today and they were below analyst estimates by a fair chunk.

Investors should keep in mind the company is still in the middle of a turnaround process to get costs down and restore some semblance of profitability while keeping their main product line viable in the world of freely offered software. The current CEO is new to the position, but has been with the company as their CFO prior to being promoted to CEO. They are trying to optimize the revenue stream and milk it for what it is worth, and this is going to be a lumpy process as they figure out what is and what is not working – keep in mind that sales and marketing has crept up from 45.5% of revenues in 2009 to 50.6% in 2010 and 60.2% in 2011; assuming you can ratchet down this ratio without adversely affecting the top line, you will be adding significant incremental profit to the bottom line. It just isn’t going to be done in a quarter.

The stock will probably get hammered about 15% in Thursday’s trading and I will consider adding to my position if it goes to the single digits.

Keep in mind that the company does have $120 million cash on the balance sheet and at Wednesday’s closing price of $13.13/share, this does make an enterprise value of $156 million. This is sure to go lower on Thursday. When you consider this is a software company with a quarter billion in sales a year, this seems to be relatively cheap, albeit in a business that is not going to grow like a weed.

High frequency trading and market confidence

I always get puzzled at articles that claim that retail investors are getting turned off the market because of high frequency trading.

If you are an active trader in the market (i.e. your sole method of generating returns is through the relatively frequent buying and selling of stocks) then I can see how that is the case. You are perpetually front-runned by computers and it is the financial equivalent of getting bitten by mosquitoes.

For most investors, computer trading doesn’t make a difference at all. The only two impacts are if you are trading on margin and some sort of “flash crash” triggers a margin call on your account, and the second impact is if you are planning on making an entry below a certain price or an exit above a certain price and you get your limit order hit.

When establishing positions in less-than-liquid stocks, however, getting front-runned is a pain in the ass and is an unavoidable cost of trading. My suggestion would be to keep order sizes microscopic to average volume and accumulate when somebody is distributing (or vice versa if your task is to exit). Another method is to wait for the company to have a poor quarterly earnings report (that does not reflect a fundamental change in your perception of the business) and when the stock gets hammered, start accumulating in measured steps. There is no science to this – the shares you want to be accumulating at the bid, somebody wants to be selling to you at the asking price and there are times when you see a ask of a sufficient size that it is just worth putting in the limit buy order at the asking price.

In general, unless if you are employing some sort of mechanical algorithm, people that trade more often than not will have worse performance.

Continuing to deploy cash

July was a fairly active month in terms of deploying cash. In addition to the two names mentioned on this site previously, there were four other candidates that came into buying range. I have taken the liberty to accumulate and am sitting at around 37% cash at present.

The portfolio looks schizophrenic at present – there are a bunch of deep value plays (under book value with a low projected P/E) and the other half are clear growth picks – one undervalued gem has two business segments, one took a significant revenue reduction for legitimate reasons, while the other segment (which is most of the business) is growing significantly faster. The automated screens out there aren’t picking up the growth because you have to do a little homework to dredge out this information. Once the market figures it out (after some quarterly results) there should be a P/E expansion (not to mention the actual EPS will be increasing as well).

My YTD so far is roughly flat, but when I do my own valuations on what I am owning in my portfolio, I would expect to see some positive gains that will outdo the indicies. Just a matter of being patient.

One other side note is that I am increasing my US dollar exposure. Most of these companies trade in the USA.

Electronic trading perils

One aspect of trading electronically is that you better make sure your algorithms are correct, otherwise you are going to make stupid trades and suffer losses. Knight (NYSE: KCG) is the victim of their own electronic infrastructure, taking a 22% hit.

During the flash crash a bunch of trades were busted, but my personal opinion is that the only way to prevent these sorts of things happening is by depriving those that made the errant orders of their capital. Perhaps it will give a bit more incentive toward those that actually program their systems correctly, or heaven forbid, give it a little bit of human manual intervention before sending a billion-dollar order that has 10 minutes to get rammed through the markets.

Genworth MI Canada reports second quarter

Readers are likely aware of my position in Genworth MI Canada (TSX: MIC) and they reported their second quarter results today. The quarter was relatively boring, with losses on claims slightly lower and investment income slightly lower (due to lower rates). Loss ratio is 32% and expense ratio is 17% (total 49%) for the quarter, which is tracking roughly on-line the previous year. Delinquency rates continue to decline, with total portfolio down to 0.17% (from 0.25% year-previous).

Portfolio is at a 4.2% yield with a 3.5 year duration, approximately 3% in cash, 7% equities and 90% in fixed income (corporate and government).

Nobody said this company will be exciting. It isn’t.

Book value, excluding intangibles, is $26.30/share. With the market value being $16.97 as of today’s closing, even if the company exhibits mediocre performance, it is still likely undervalued. They key risk continues to be some sort of collapse or meltdown in the real estate market. Also, underwriting business will be slowing due to recent changes in the Government of Canada’s policies on mortgage insurance.