UEPS rises! And other news...

Net 1 UEPS was up nearly 10% today! There doesn't appear to be any specific reason - no announcements, no news. I can only assume that millions of people read my previous posts analyzing UEPS. Clearly, they were convinced that UEPS is a great buy, and that sent the price straight up.

Williams Controls announced earnings today. They had increased in pretty much every way. Earnings were higher than last year, and higher than expected (by the one analyst that follows them). Sales had increased in the US and Europe, and increased dramatically in Asia. The share price hit a high of +3%, but settled back to +0.3%. Sheesh!

The other shoe dropped for ALNY. They announced how many shares they're going to sell, and that sent the price down 7%. I guess the difference between the situations of ALNY and ARNA was whether they had announced how much they're selling. Now they have been affected similarly by their announcements. Argh. Seems like I should have expected this, and should have profited from it. Oh well - I'll know for next time.

Finally, Walter had some things to say about the spin-off. It turns out that buying WLT will still allow participation in the Mueller spin-off. With a ~$16 price for MWA, and 1.65 shares of MWA per WLT, this means that each share of WLT will be worth ~$23 after the spin-off. Is this a fair value? I need to look into this a little more. Just notice, though, that the Market Cap of MWA is 1.8B, and that of WLT is 2.1B. WLT owns 75% of MWA, so the market is valuing WLT as ~$750M. With 43M shares, WLT is valued at ~$18 per share. Less than the spin-off value. Is this right?

My Experiment in LEAPs

I wondered a while back whether buying LEAPs would be a way to leverage the MFI for greater gains. On August 8, I recorded the 38 MFI stocks that had options available. For each stock, I recorded the close price, as well as the close price of Jan. '07, '08 and '09 LEAPs with a strike price just below the close price of the security. Now, 4 months later, using the close as of December 8, I have determined the change in security and derivative values. LEAP values that expire in Jan. '08 and '09 changed in close accordance with stock price. (Click on the figure, and all figures, to expand them.) As the Jan. '07 expiry date approached, the LEAPs changed in price, in many cases dramatically. Of the 32 stocks that had options expiring in Jan. '07, the mean ± SD was 0.51 ± 1.05. This is a huge gain in that period of time, but much greater variability. The median change in value was 12%.

Here's another way of looking at it: What is the fraction of LEAPs that changed by more than 10%? Figure 2 shows the distribution of LEAP by amount gained, as well as the gain for each category of LEAP. I think it is valid to then calculate an expected return: multiply the fraction in each category by the return of the category for an expected return in each category. By summing the expected returns of each category, you get the overall expected return, which is 17%.

Another way to do this, and probably the most accurate, is with a bootstrap method. Randomly generate portfolios of 5 LEAPs many times, and the average return of the portfolios is the expected return of this strategy. Using this strategy, the mean ± SD is 59.8% ± 41.4%, based on 50 portfolios. Only 3 of the 50 portfolios resulted in a loss, averaging -11% ± 6.5%. By comparison, 11 of the 50 porfolios ended up more than doubling, with average returns of 115% ± 17%.

Is there a correlation to Market Cap? Piotroski F-Score? There doesn't seem to be a correlation between either and returns. The distribution of returns by F-Score is pretty broadly distributed; there aren't really enough samples at most F-Scores to say. Similarly, if there is an effect of market cap, it is slight: the Pearson's coefficient of the curve fit suggests that market cap explains only ~2.5% of the variation - really not enough to be interesting for further study.

There are definite caveats to this. It's one sample of stocks, from a period when the general market is doing exceptionally well. This would really need more thorough backtesting to have a better idea whether using LEAPs of MFI stocks improve returns. But, this data suggests that there may be an advantage to buying LEAPs of MFI stocks as compared to the stocks themselves.

December buys, part I

My goal with this round of picks was to try two things: 1) to take a little more into account when buying stocks than just insider buying and 2) to try to analyze the stocks that I buy. #1 was solved by using the Piotroski F-Score to help me pick stocks. This is also a sort of short cut to #2, but only partly. So, in keeping with my previous analysis of MFI stocks, here's an analysis of the top 100 stocks with a market cap of at least $1M. (Actually, because of errors acquiring the F-Scores of a nuber of stocks, the actual sample size was 77.) It's a skewed distribution, weighted towards stocks with 'good' company characteristics, as defined by the F-Score. If you compare this distribution to that of my last analysis, there is a remarkable similarity (comparing to the distribution of companies with a market cap of at least $1M). Also, companies with higher F-Scores had larger market caps.

Of those 77, 22 had insider purchases. Only one of those had a Piotroski F-Score of 9, PACR, so I decided on that as a definite purchase. Three companies had a F-Score of 8, but of those, two had very low insider ownership. The last of these was WMCO, so that went on the list. FCX just announced the acquisition of PD, and there is a rumor of a takeover bid for FCX itself. Also, considering the size of FCX, it's insider ownership of ~5% seems pretty high. So with a F-Score of 7, FCX joined the list. The number of insider shares purchased by GVHR (620K!) got it added to the list, despite a F-Score of only 6. Finally, the excel add-in returned an error for F-Score of OFLX , but this article and the insider purchases (6 since June, by 5 separate officers of the company) got it on the list.

This is at best a partial success - let's face it, I'm still mechanically using F-Score as a proxy for fundamental analysis and I'm considering insider buying as a substitute for my own valuation. But it's a place to start. If you look at the logic above, insider buying still trumps fundamentals, too (GVHR got in with a 6, OFLX didn't have a clean analysis). So here's some fundamental analysis, using the questions outlined by Browne:

GVHR: Current assets : current liabilities are about even, but he'd prefer to see at least 2:1. LT assets are up ~ 30% compared to last year and up 10% compared to last quarter. LT liabilities are flat yoy, but appear to have been paid down somewhat since last quarter. PB is 4.3. Cost of revenue is not going up as quickly as revenue is, so there is more falling to the bottom line. Indeed, gross profit and EBIT are up yoy. Return on capital is 60%, a nice MFI number. Profit margins are flat, though.

FCX: Current assets are 2:1 with current liabilities, so that's good. LT assets are flat, while LT liabilities declined since last quarter. PB is ~12. ROC was huge last year, ~100%, but a more modest 28% the year before.

WMCO: Current assets to current liabilites are 1:1. LT assets are flat yoy, while LT liabilities declined nearly 40%. This is the first year of the last three that WMCO is profitable. EBIT was up 27% last year, and 17% the year before. ROC was huge.

(I didn't get to PACR or OFLX before this posting.)

The question is, do these analyses indicate that these companies are good or not? None of these seem to be as good as UEPS... does that mean that I have a skewed perspective of what is good, or is that a true, objective evaluation? I still have a lot to learn. Luckily, I am learning it in an up market, so mistakes are perhaps less costly than they could be.

OK, OK, if I'm making mistakes, they have, so far, been of the luckily good kind. But until I can do more fundamental analysis, it's just luck. Actually, it's statistics - since MFI stocks historically do well, and stocks with high insider buying historically do well, I am perhaps skewing my probabilities in the right direction.

WIld ride

Wow! I'm pretty amazed at how things have been going. I am trying very hard to remain skeptical, but my overall gain is pretty exciting.

I started my next round of buying today. It actually should have been last month, but something kept me from it then. So today I bought my next round of MFI picks. Probably Monday will be my next round of Motley Fool picks. Before discussing what's new, here's a rundown of my portfolios to date.

MFI is kicking butt. 4 of 10 stocks are up dramatically, while 3 are down, one a lot (ASPV, nearly 20%). VPHM is flying, with DECK, ASEI and WNR trailing. VPHM discussed prospects at two health science conferences a couple of weeks ago, and the shares just kept going up over the course of those couple of days. ASEI has also been doing great lately - i was up more than $4 the other day, although it gave back ~$1.50 the next day. Really, this doesn't seem to be on any specific news - maybe Mr. Market is starting to value ASEI more appropriately? Also, notice that MFI is trouncing the indices. Finally, my IRR for my MFI portfolio is 59%, based on 5 months of data. Too short to conclude anything, but a nice start nonetheless.

The Motley Fool portfolio is also doing very nicely. This porfolio seems a little more consistent: only 2 of 10 are down, and one of those is OYO the yo-yo. The rest are all up to various extents - it's still a large range, but even the least of them is significant - NATH at 8%. The IRR of my HG portfolio is 62.6%

There's my special situations portfolio. I haven't been discussing this much, because it has until recently been only one stock. I held on to LPMA after the merger, so now it's PAY. This stock has been doing nothing but rising since the merger closed - it is up ~20% since the deal closed Nov 1. I got very nervous when PAY stalled at around $32-33, and again when the earnings announcement approached. Now they're in the clear, earnings were good, and the announcement seems fine for the coming year. By a convenient coincidence, I'm reading The Warren Buffett Way by Robert Hagstrom. In it, he quotes Buffett as saying (and I'm paraphrasing) that if you know what the company is worth, then you decide the price; if you don't then the market decides the price. As nervous as I was about what to do with PAY, I realized that I don't have a sufficiently good understanding of the underlying fundamentals to decide whether Mr. Market is crazy and overvaluing or undervaluing PAY. What I'm still trying to figure out is, what do you do if the market is overvaluing the company? Sell and possibly miss out on more upside? Wait for a downturn and sell? Or sell part of the position? I've lately been listening to Jim Cramer's radio show (as a podcast), and his quote is, "Bulls make money, bears make money, but hogs get slaughtered." I wonder whether he'd tell me to take some off the table. PAY is currently the largest single position in my portfolio.

Lately, I've also become interested in TARR. It's in the dreaded housing industry. The PE is low (it was quite a bit lower when I first found the company in a stock screen), it trades near book value and it's got a high return on assets. Also, there have been a bunch of insider purchases, many of which were at prices well above where it trades now, and by several insiders. Last but not least, they are considering spinning off their homebuilding division by mid 2007. That was the icing on the cake. I do worry a little about how highly leveraged they are, but from what I've been hearing and reading, it sounds as though the housing industry is either near the bottom or possibly even just starting to turn around. If this is true, the TARR might be a great play, with a lot of potential upside. My total return on my special situations portfolio is 21%. I won't even mention the ridiculous IRR, because there's too little data in terms of total time (100 days) and total positions (2).

Finally, there's my biotech portfolio. It's full of surprises and disappointments. CBST continues to disappoint. It gapped down today, on a downgrade by Piper Jaffray. I'm not sure how much longer I will think that the market is wrong and maintain a large position in CBST. I do think that I'm right, and that it will turn a nice profit as cubicin starts to displace vancomycin (from VPHM). If I were really confident, I suppose I'd buy more, not consider selling. This is another position that requires that I do more research. CBST also announced that they'd partnered with AstraZeneca to distribute cubicin in China. It would have been nice had they thought they could bring the drug to that market, but the royalties will be alright. Both ARNA and ALNY have risen - ARNA dropped back down, but ALNY is just going higher and higher. What's interesting about the ALNY and ARNA stories is what's similar about them: they both announced that they'd sell shares. Why? The officers must believe that the shares are overvalued. The market ignored the ALNY announcement, but ARNA plummeted (still up overall, but down dramatically from their high). Now ARNA announced the sell price, and for some reason, the stock went to well above that price. Strange - I would have thought that would have set the price, rather than selling the bottom for the price. Anyway, the fact of the companies selling shares has made me wonder whether to sell as well. Or at least to take some off the table. ALNY especially has just kicked butt, mainly, I thought, because of the RNAI purchase and speculation that ALNY is also a buyout target. Not sure what I'll do for now.

As an aside to the discussion of my biotech portfolio, I have major seller's regret over MEDX. They have been going up like crazy over the last couple of weeks, and now yesterday one of their drugs was fast-tracked by the FDA. I'm considering getting back in MEDX, but in a several purchases at a time, so that I benefit if it goes down at all (another Cramerism).

This turned out to be a long post, so I'll discuss my new MFI purchases in a separate entry.

Great returns so far - but so what?

Thanks to justadrone from the yahoo MFI group, I just calculated my annualized internal rate of return. I'm still trying to figure out exactly what an IRR is. It seems to not only give the growth rate, but also to take into account the effect of cash flows - and this is the part that I'm still working on understanding. In any case, I think that the annualized IRR for my total portfolio is pretty awesome - it's just over 50%. After nearly five months, this may be long enough to start to be meaningful. On the other hand, the market has been going up like crazy since about July or so, meaning that I'm going to try not to consider this kind of return rate anything near 'normal'.

Even if I calculate my return using a method that I understand better - calculate the percent increase, divide by the number of months invested, multiply by twelve months of the year - I still get well over 30% annualized returns.

Let's see if I can keep up something even close.

I've just been reading Fooled by Randomness - so this leads me to believe that beating the market by a few percentage points is attributable to nothing other than luck. I think that occassionally reading that book, and anything else by Taleb, will be a good way to try to stay skeptical of any success.

UEPS in the Mayo Clinic

Continuing with the analysis of UEPS as recommended by Christopher Browne in The Little Book of Value Investing, now is the part that I suppose is more art and less science, at least as compared to income and balance sheet analysis.

1. Can the company raise prices?
The answer is no. The product is for people without access to banks, or people for whom bank fees are prohibitive. These are not people who can afford to pay more. The UEPS model requires more people to be part of their network, not to charge their network high fees. Having said that, though, they are positioned to find new applications for their smartcard products - both geographically (old applications in new countries) and systematically (new applications in established countries).

2. Can the company sell more?
Definitely. Their technology has been broadly adopted in South Africa, they currently operate in Namibia, Botswana and Nigeria, and are exploring opportunities in nearby African countries, as well as a number of South American and South Asian countries. Third parties are operating their technology in Malawi, Mozambique, Zimbabwe, Ghana, Rwanda, Burundi and Latvia. I would prefer that they were operating their own technology - to me this means that perhaps they couldn't keep make the most of their technology, and so resorted to licensing it out. But it's a start. In addition, they mainly operate by distribution of social welfare and payroll distribution; but they've identified additional mechanisms for adoption, including medical welfare distribution.

3. Can they increase profits on existing sales?
Not sure. Probably not, at least not any time soon. They need to expand as much as possible. Once much better established, they could probably spend less on network expansion, increasing the number of point of sales card readers, possibly once better established they can rely on government contracts to a greater extent than they do now. But for now, they need to reinvest the money they make into expansion. Revenue has gone up, but cost of goods sold has remained constant for 2005 and 2006.

4. Can the company control expenses? What is the outlook for SG&A?
SG&A went up $6M in 2005, and $3M in 2006. I showed earlier that SG&A is declining as a percentage of gross revenue, and this seems to indicate that the company is indeed controlling expenses.

5. If the company raises sales, how much goes to the bottom line?
Comparing 2006 and 2005 as an example, revenues went up a ton, cost of goods sold was constant, SG&A went up just a bit. This seems to be asking about the net profit margin, and I showed that this is increasing yearly. So historically, they've been successful with this - the question is whether they'll continue to do so, but there's no reason to think that they will not.

6. Can the company be as profitable as it used to be, or at least as profitable as its competitors?
The company is increasing profitability year-over-year. I'll compare it to competitors shortly.

7. Does the company have one-time expenses that won't need to be paid in the future?

They acquired Prism in 2006, but after the end of the fiscal year. Next year will have a $95.2M charge that is one-time. There was a similar charge in 2004, for reorganization involved in the acquisition of Aplitec.

8. Does the company have unprofitable ops they can shed?

I don't see any.

9. Is the company comfortable with Wall Street earnings estimates?

They don't seem to discuss earnings estimates in the annual report. According to Yahoo! Finance, they seem to have come in within pennies of analyst earnings estimates in recent quarters.

10. How will the company grow in the next five years? How?

I've pretty much covered this one. It looks as though they have some pretty good prospects for growth.

11. What will the company do with excess cash?

Seems as though it will be reinvested in the company for continued growth.

12. What does the company expect its competitors to do?

They don't seem to discuss this much. They do discuss the risks of competitors, including retail banks as well as other companies that are direct competitors, but not much of what they think their strategy will be. Basically, the risks are that users will prefer special bank accounts that offer reduced charges, or that they will prefer their competitors.

13. How does the company compare financially to competitors?

I'll get into this shortly.

14. What would the company be worth if it were sold?

Hm. Interesting question. It seems that each industry has some 'typical' multiple of cash flow that is how it is valued for buyout. I'm not sure how to figure this out, but I'll play around with some numbers and come back to this.

15. Does the company plan to buy back stock?

I don't see plans to do so, but the company did buy back nearly 150,000 shares at $26.75, more than the price it's trading at now. However, this seems to have been somehow tied to purchases made by employees, maybe in a company stock puchase plan.

16. Are insiders buying?

One director bought a ton in June; A number of officers exercised options in June and one more did as well in September, all without selling their options immediately. Perhaps the options were going to expire; but I've read somewhere that exercising the options but not selling may be a sign that they are very bullish - that it somehow minimizes the tax implication for the potential gain.

Back to the financial experiment...

I had wondered in a previous post about why larger cap MFI companies tended to have higher Piotroski F-scores. I realized recently that I had failed to consider an important explanation. Chances were good that they didn't grow to be a large cap without being a fairly good company, especially considering that these large cap companies had high return on invested capital. In other words, the fact of being both a large cap and a MFI company should both correlate well with scoring highly on the Piotroski scale.

Part II

From the balance sheet to the income statement, it’s time for part II of the physical exam of UEPS.

Step 1: Revenue is listed for 2004 through 2006, and increased each year. 11.2% in 2006, and 34.5% in 2005. It is not particularly encouraging that revenue growth declined. Have they made the largest gains in market penetration (really, creation, given what they do)? This is probably why they are looking to diversify into new countries.

Step 2: The cost of goods sold increased by ~20% in 2005, but remained unchanged in 2006. As they grow as a company, does this indicate that they are streamlining production? Have they found cheaper labor or materials or products? It is perhaps a network effect: once the network is in place, there are perhaps only smaller charges to maintain it.

Step 3: Gross profit is revenue minus the cost of goods sold. 2006 - $146M; 2005 - $126M; 2004 - $92M. So, gross profit is increasing yearly. Browne says that he likes for this number to be stable, but clearly it isn’t. I suspect that is typically for a more mature company, but who knows?

Step 4: Determine operating profit by subtracting SG&A from gross profit. 2006 - $97M; 2005 - $80M; 2004 - $52M. As a % of gross revenue: 2006 – 32%; 2005 – 37%; 2004 – 43%. So with this number coming down percentagewise, this is probably a good thing. Browne says that this is the earnings before interest and taxes, EBIT, that is so important for the MFI, actually, and, Browne continues, this is the number that is used to value the company, including people looking to acquire it. The UEPS income statement includes depreciation and amortization in calculating the operating profit, as well as reorganization charges in 2004 and costs associated with the IPO and continued Nasdaq listing. The Nasdaq charge is probably more or less recurring, but it seems to me that the IPO cost and the reorganization charges should probably be ignored for calculating EBIT. And when depreciation and amortization are included, it becomes EBITDA. I’ve heard elsewhere that EBIT is more important than EBITDA.

Step 5: Calculate EPS. It took a little searching in the annual report to find a clear statement of the number of shares outstanding, but finally, the “Total weighted average number of outstanding shares used to calculate earnings per share – diluted” is 57.3M. So, using EBIT as earnings, EPS is 97 / 57.3 = $1.69. Using nondiluted shares EPS = $1.72, not a big difference at all. And looking at the other 2 years: 2005 – dil, $1.43, nondil, $1.46; 2004 – dil, $1.50, nondil, $1.56. A large number of shares were issued in 2005, increasing the number of shares 60%. So that explains the drop in EPS in 2005, but now in 2006, the EPS has more than made up for the dilution of ownership.

Step 6: Calculate the ROC: Divide the earnings of any year by the beginning year’s capital (ie, the end of the previous year), which is the shareholder’s equity and total liabilities. In this case, then the EBIT for 2006 is $97M, while the capital is $182M. ROC is 53%. ROC is of course one of the two measures for identifying MFI stocks, and this is a pretty high number for ROC. I’m encouraged that I came up with a number that seems appropriate for a MFI stock.

Step 7: The net profit margin is the earnings divided by the total revenues, presumably using EBIT as earnings. 2006 – 49%; 2005 – 45%; 2004 – 40%. So profit margins are increasing, which means that reinvesting cash in the company is leveraging sales.

Coming up is taking the stock to the mayo clinic. This one has more to do with everything the company has to say about their business, and less to do with the balance sheet and the income statement. This part is harder, and I’ll wait a little for it.

One last thing: I bought UEPS at $24.64. With EPS of $1.69, this gives an earnings yield of 7%. This sounds low for a MFI stock. When I get back the Little Book That Beats the Market, I’ll have to double check how EY is calculated for MFI.

But overall – that wasn’t so hard. Really.

You've taken your first step into a larger world - Obi-Wan Kenobi

I just read the Little Book of Value Investing by Christopher Browne. One of the original value investors, along with his partners at Tweedy, Browne, he worked with Benjamin Graham and Warren Buffett in their early years. I read the paper by Tweedy, Browne called, “What has worked in investing.” It’s pretty much the same sort of thing but with more hard data and fewer anecdotes. All in all, yes, I’m convinced.

The most directly useful part of the book are three chapters that discuss how to value a company. Coincidentally, the same day that I finished the book, I received in the mail the year-end report for Net 1 UEPS, one of the stocks that I own in my MFI portfolio. I decided to evaluate UEPS using the steps outlined by Browne (he doesn’t actually list them as ‘steps’ – these are my arbitrary divisions of his commentary). Here goes.

Step 1: Current assets and current liabilities. The current assets are ~$240M, and the current liabilities are ~$40M, so the current ratio is 6. Browne says at least 2:1 – UEPS is doing well. The working capital is ~$200M; Browne says the more the better. The quick ratio is the (current assets – inventory) / current liabilities. Inventory is only ~$2M, so the quick ratio is only marginally different from the current ratio.

The 2005 current ratio was roughly 5, and the working capital was ~$115M. So 2006 seems an improvement over 2005.

Step 2: Long term assets and liabilities. Total LT assets are ~$29M; Browne says to subtract out intangibles and goodwill, so he would consider LT assets as ~$11M. The only long-term debt listed is deferred income taxes, at ~$18M. How does this compare to last year? In 2005, LT assets were ~$30M, or ~$9M excluding intangibles and goodwill. LT liabilities were ~$10M in 2005. So, LT assets (excluding intangibles) went up ~20%, while LT liabilities increased 80%. However, the long-term liabilities are small compared to cash on hand, never mind short-term assets. This seems healthy.

Step 3: Book value. Subtract all that the company owns from all that it owes: $209M. Browne suggests subtracting intangibles here as well, so the book value is $189M. The debt to equity ratio is ~0.3. This means that the company is funded primarily through investment. In 2005, this value was ~0.4, so this also seems to be improving. Browne says that even if this number is greater than 1 it’s not the end of the world, so the small improvement in debt to equity ratio seems not particularly important. What is important, I think, is that the value is significantly less than 1.

I’m going to skip step 5 for now: comparing the book value of UEPS to its competitors. This brings me to the end of the first chapter about evaluating a company, and it seems that the balance sheet shows that UEPS has a solid foundation.

Earnings Announcements, Update, and ASPV Thoughts

I've only been through a couple of earnings announcement seasons, now, but it seems like an exciting time. Like Piotroski said, something like 1/6 of a stock's movement comes over the combined four days of the year that the company annouces earnings.

DECK kicked butt, reporting $0.83 per share, up from $0.63 compared to the same quarter last year. This blew away analyst estimates of $0.54, and the stock price jumped ~ 8%.

ISNS stunk it up. BLD was flat with last year. ALDN beat estimates by $0.03, and stayed pretty much flat, also.

SCSS came ahead of analysts estimates, but said that sales slowed towards the end of the quarter and so the stock price slid 17%.

Income nearly tripled for ATHR with 74% increased sales.

ARNA lost $20M on R&D, and stayed high, still for no real reason. It seems to have settled at ~$15, and as long as it stays around here, I'm happy.

Merck bought Sirna at a huge 100% premium. This sent ALNY up ~20%, as pretty much the only independant microRNA company left. Pretty sweet.

That leaves one company, which I'll save for the end of the post. My three portfolios are up. That's a pretty big thrill for a beginner like me. The biotech portfolio is not doing as well as the biotech indices, even after ALNY's boom. I still have some faith in CBST, but it is wavering a little. Basically, as it begins to show consistent profit in the next few quarters, I'd like to think that the share price will go up. However, as I'm starting to figure out, part of that expectation is already priced in, so CBST has to perform particularly well. That is the source of the wavering faith in it. NOVC seems to have some on-deck drugs in late-phase trials. Assuming those go moderately well, it'll spike. I'm pretty happy with both my MFI and HG portfolios. These are beating the market, and kicking butt compared to the Russell 2K. There has been discussion on the MFI board as to whether the system relies on a few really big winners, or whether most stocks move towards large gains. My results so far have 3 winners above 20%, 2 more 9% or greater, several that are within 5% of even, and one big loser. This is only after 4 months, which means that this is statistically meaningless, and also that anything can still happen. Finally, half of my most recent six HG picks are in the teens of returns, and half of my first set of picks are absolutely kicking butt. WLT is at 6%, and the others are nearly flat. Pretty darn good for the first four months.

There is one major caveat that I need to keep in mind. Of everything that I bought, I was really excited about ASPV. And that has proven to be the biggest loser so far. So I'm not a good stock picker: I'm lucky. From everything I've read, the longer I can keep that in mind, the better I'll do in the long run. So from now on, every time that I pick any basket of stocks, I'm going to predict which ones will do the best. I expect that these rankings will not at all correlate with actual performance, but will instead serve to keep me humble.

Finally, I want to talk about ASPV. This one is a whopper. First, it announced that it would miss analyst estimates for the quarter. It reiterated that for the year it would make 163% of last year's earnings. But still, it dropped 10%. I thought that was way less bad than the market thought. And then they announced that their drug didn't pass phase III trials for another indication, and the stock dropped another 11%. At this new price, the PE is ~6.5 TTM, with a forward PE of ~5.3. All of this together got me thinking. The CellCept patent runs out in 2009. So shareholders can count on about 2-3 more years of great earnings, and then the well dries up. Unless, that is, the company finds either another drug or another indication for their drug. It's a bit of a desperation situation. Another way of looking at this is: the PE is the number of years it takes for the current earnings per share to pay back the investment. From this perspective, investors at this point are betting 2.3 years worth of earnings that the company will find some way to remain profitable beyond the patent protection of CellCept. If they do find some way to remain profitable, the PE should shoot up to some amount beyond the patent protection or other limit of the new drug in question. The years worth of betting on management amount to 43% of the PE. Cash per share, after subtracting the miniscule amount of debt, is $5.50. So of the remaining cost of the share, is 43%, or ~$5.60, represents the bet that management will find a new drug, or a new indication for their drug, within the next few years.

Cubist's Earnings and the Market's Expectations

Clearly, I am still learning how the market 'thinks' - how it reacts to news.

Cubist announced the other day that it had its first profitable quarter ever. But it was under analyst estimates of revenue (~$50M vs. ~$54M). So it lost 6% in afterhours trading immediately following the announcement. Whatever the analysts' estimates, though, this is still a 58% increase over Q3 last year! I would have thought that would be enough for shareholders, but apparently not. Non-GAAP income was $0.14 per share, while GAAP income was $0.09 per share, compared with a loss last year of $0.08 per share. Isn't this a good thing? After a morning low of $21.21 the day after the announcement, the market decided this was all good news, and shares peaked at $23.18. That's a 9.2% total change from valley to peak! Just because of the market being indicisive!

In The Intelligent Investor Today, Larry Swedroe makes the point a few times that the market prices in expectation. So a downturn after missed earnings is something that I can almost understand... Except that analyst pricing is notoriously inaccurate. I'd think that investors would take them as rough guestimates rather than as precise numbers. In fact, analysts have a tough time getting the direction right, let alone a specific number by a specific date. (Swedroe talks more about macroeconomic analysts, who try to estimate general market trends; probably analysts do better on specific stocks with defined products and markets.) Givn all of this, wouldn't something close to analyst expectations be at least neutral if not positive? More importantly, shouldn't the milestone of the first profitable quarter help a company rather than hurt it? Obviously, I wasn't the only one expecting good news this quarter. But was that good news priced into the stock? I don't believe that there's an answer, because the stock yo-yo'd and ended up maybe a percent or two. From the close of business prior to the earnings announcement to the close today, CBST is up 3.5%. This may be nothing but noise: The NASDAQ is up 0.76% in the same period. Is this a significant difference? Maybe it is, now that I see the numbers. But the beta for CBST is ~3, so maybe this is just chance and nothing more. In other words, are we looking at an efficient market or a foolish Mr. Market? I still don't know.

Efficient market vs. semi-efficient market vs. inefficent market

I'm reading The Successful Investor Today by Larry Swedroe. In this book, it is argued that the market is efficient. This means that all relevent news is rapidly distributed and incorporated into the price of a stock. The usually-discussed alternative is an inefficient market. Most value investing books seem to work off of this principle. I don't have specific references handy, but I'll bet on Joel Greenblatt and anyone who uses the classic analogy of "'Mr. Market." I think this comes from Ben Graham. Mr. Market is moody, and on any given day is going to change his mind about what exactly a stock is worth. In the long run, though, Mr. Market gets it right.

The Successful Investor Today describes the market as efficient based essentially on the following argument: For every buyer, there is a seller. So if someone gains, then someone loses. This is not what is usually meant by an efficient market. In fact, this describes a zero-sum market.

I would argue instead that the market is semi-efficient. On any given day that there is relevent news, that news is indeed instantly distributed and the market price of a stock more or less reflects the impact of that news. However, the daily fluctuations, and gradual drifting away from that more-or-less accurate pricing represents the inefficiency of the market. I read somewhere recently (I think it was the Piotroski paper) that 1/6 of the total change in a stock price over the course of a year occurs over the four days when the company announces quarterly earnings. Look at what happened to PLAY when their one customer, Apple, announced that it would no longer buy their product. Look at what happened to NBIX when the FDA refused to approve indiplon. PLAY lost something like 60% of its value in one day; NBIX lost 40%. That is efficient. But, the drift of any one stock, or even the market as a whole, is noise. Read Fooled by Randomness - almost everything else is noise.

So that's my conclusion. The market instantly takes into account any important news. However, it slowly seems to forget whether the news was good or bad and drifts around the price to which it revalued the stock.

I'll add one additional comment: sometimes - on rare occassions - the market doesn't seem to fully take into account particular pieces of news. I've already discussed the LPMA acquisition by PAY, when the stock was trading around $25 even though the buyout had been announced at $29. Or the other day when ASPV dropped 12% because they had missed analyst expectations. But they affirmed their yearly guidance of 20-25% growth this year! Either the market doesn't believe the company, or it doesn't take this kind of growth into account in pricing ASPV. Either way, Mr. Market is a nutbar, and cheap stocks are out there to be bought.

PS - As of yesterday, my biotech portfolio was up 1.93%, but underperforming the biotech market. On the other hand, both my MFI and HG portfolios were up 13.1%, outperforming the general market by several percent. Sweet!

PPS - I've discussed CBST a bunch. My fingers are crossed for their earnings announcement tomorrow.

New HG buys and update

My newest Hidden Gems are OYOG, SCSS, MIDD and NATH. Each of these have specific reasons for being bought, but unlike past buys, they didn't really have much to do with the company itself after my own research. The point of HGs is that they are supposed to be promising companies as determined by the pros over at Motley Fool. Nevertheless, as JG says, never trust anyone over 30, and never trust anyone under 30, either. But still, the reasons for these purchases might be a little weak if I didn't have some trust in HG picks. Here they are: OYOG is only slightly above the recommended buy price from a few months ago. SCSS and MIDD are two of the three strongest recommendations that HG'ers have made. They keep on re-recommending them, and also they are on the HG list of best places for new money. This isn't what convinced me, though. It was that they have high Piotroski F-Scores. Finally, NATH is a Tiny Gem (below the official HG radar, like ALDN), but it is on the current list of MFI picks and has 16% ownership by insiders.

While we're on the topic, here are the updates of my three portfolios. MFI is trouncing the indices. Even the new purchases are kicking in, with a great week for ASEI, up 10% in my first week of ownership, after it got a big contract from the Department of Homeland Security. DECK also had a great week, pushing past the 52-week high for ~5% gain. Finally, ISNS is recovering from its slump: from -12%, it is now only -4%.

For HG, IIVI and ALDN are doing great, CTRP is flutuating wildly, and SDA is recovering from its initial loss. The new purchases haven't had time to do anything yet, other than dilute my apparent gains (the initial set is up 12.3%!).

The Biotech portfolio is doing nothing special, down 3%. ALNY and ARNA are up, and ARNA is doing especially well, although these are both on no news. NOVC has recovered slightly, and CBST went up to nearly even, and has now fallen slightly again.

Finally, over Thursday and Friday, it was announced that the shareholders of LPMA and PAY had all voted to go through with the acquisition. I was a little surprised that the share price didn't go up on Thursday after LPMA made their announcement, and very surprised that after-hours trading of LPMA on Friday, after the announcement by PAY, didn't shoot the stock up, either. But we'll see - on Monday I'll be shocked if it isn't trading higher.

My first experiment in finances

I've been reading the paper by Piotroski about value investing. In it, he shows that a number of characteristics of companies are good indicators of whether they'll be profitable in the next year, and that all of these characteristics can be found in their most recent year-end report. Every company has a binary indicator for each characteristic, and the sum of these indicators is the Piotroski F-Score.

1) Return on Assets (net income before extraordinary items) - if positive, then 1, otherwise, 0.

2) Cash flow from operations - 1 if positive, 0 otherwise.

3) Change in ROA from the previous year - if change in ROA > 0, then 1.

4) Accrual is measured as ROA - CFO, and is 1 if positive.

5) Change in the ratio of long-term debt level to average total assets is 1 if negative.

6) The Change in the ratio of current assets to current liabilities is 1 if positive.

7) If the company did not offer additional equity (did not dilute the number of outstanding shares), they get a point.

8) If the change in current gross margins scaled by total sales is positive, then 1.

9) If the change in asset turnover ratio is positive, then 1.

Piotroki showed that the sum of these is indicative of how well a company's stock price will perform in the following year. He also showed that small-cap stocks are more likey to do better (or do better by a wider margin, on average), and that no analyst coverage was also predictive of better success.

So, I wondered how does the Piotroski F-Score correlate with MFI ranking? And with market cap? I took the current top-100 MFI stocks at $1M and $2B minimum market cap cutoffs, and compared the distribution of Piotroski F-Scores to that of a sample of random stocks generated from a random stock generator. I think that the real result is more questions than answers. Anyone with access to COMPUSTAT and some means to test hypotheses using backtesting of data, take note.

A few additional points:

• I don't know how random the generator was: in a sample of 180-odd stocks, there were five repeats. This seems high considering the sample size relative to the total universe of stocks.
• Piotroski F-Scores were found using an Excel Add-In; in some cases it returned an error. So the actual sample sizes were: $1M - 78; $2B - 92; Random - 94.
• The $1M portfolio simply includes the top 100 stocks in the current MFI screen, with the range of market caps from $15M (ANTP) to $14B (NUE), with a median value of $439M.
• The $2B porfolio has a range of market caps from $2.013B (HNI) to $384B (XOM - Exxon Mobil), with a median value of $5.59B.
• The randomly-generated portfolio had a range of market caps from $7.4M (VERT) to $60.8B (QCOM - Qualcomm), with a median of $187M.
• What is the statistical significance of this experiment? In order to be truly confident in these results, in other words, to be sure that the different distributions are not soley due to chance, this experiment should repeated some large number of times, say 1000. I think that a t-test might be valid, but I also think that there might be a problem because the MFI portfolios have a skewed (rather than perfectly normal) distribution. In case they are valid, I'll just mention that the P-vaues for the $1M and $2B portfolios, as compared to the random portfolio, are 0.0005 and 5e-12, respectively.

Click on the figure to expand it. The group of random stocks is pretty much normally distributed, while the $1M and $2B MFI stocks are right shifted. There were no stocks in the $1M portfolio with a F-Score less than 2, and none in the $2B portfolio with a F-Score less than 3. The $2B portfolio is skewed towards higher F-Scores.

It makes sense that no MFI stock has a 0 or a 1 F-Score: MFI stocks have a high earnings yield and return on invested capital, which should be closely related to accrual (or maybe CFO) and ROA. But, it is surprising that the large cap portfolio is the one that is further right-shifted than the total MFI portfolio. Both Piotroski and Greenblatt concluded from their analyses that small cap stocks are better performers when selected by their respective methods. So why does a broader portfolio score worse than a focused, high market cap portfolio? What's the difference between Piotroski and MFI? I think that the difference is important, actually. MFI uses two characteristics, but the ranking system lets the screen scale the potential performance of the stocks. In other words, the one stock with a F-Score of 2 probably scored really highly on those two characteristics - but the F-Score fails to take that into account because it is based on binary analysis for all of its characteristics. Is there some way to combine the two approaches? Sure. For every stock, rank it for each Piotroski characteristic. Combine the rankings for an ordered list, like in MFI.

Is this necessary? Maybe not. Greenblatt argues that EY and ROIC are the major determinants of performance. And I think that MFI and Piotroski analyses are supposed to give comparable returns - possibly even MFI is superior, I think. So is Piotroski diluting the effects of the MFI characteristics by including the 7 other characteristics? What are the relative effects of each Piotroski characteristic? Rerun the Piotroski analysis 9 times, but for each rerun, make one of the characteristics worth 3 instead of 1. If this results in superior outcomes in terms of portfolio change, then you've identified a more important characteristic. This can be confirmed by systematically dropping one characteristic from the Piotroski F-Score, and looking for an increased drop in portfolio returns relative to dropping any of the other characteristics.

Finally, how does this affect my stock buying strategy? I'm not sure so far, because I'm not sure that I want to mess with something that's working. My current MFI strategy is:

• Pick stocks from the top-100 stocks with a minimum market cap of $1M.
• Buy 5 stocks every 2 months.
• Prefer stocks with recent insider purchases.
• Prefer stocks that have high insider ownership.

I'm considering adding the following rules:

• Only buy stocks with a high Piotroski F-Score.
• Only buy stocks with low or no analyst coverage. I rather like this one, as it typically means that Mr. Market has a worse idea of how to value any given stock.

I suspect that few stocks will meet all of these rules. This might involve checking the MFI top 100 more often than every 2 months and buying whenever I find a stock that does meet all of these criteria.

A homegrown screen?

Using the Fidelity stock screener, I made a stock screen based more-or-less on MFI principles (I think - I leant someone the book), along with some of my own:
1) Small cap (<$1.8B)
2) Highest 20% in the market for Earnings Yield
4) Top 40% in the market for each of Return on Equity, Return on Investments and Return on Asests
5) Lowest 20% Institutional Ownership
6) Highest 20% Net Insider Purchases
7) Covered by 4 or fewer analysts.

I came out with three companies. And the winners are...

Second Round of MFI

The time has come for my second round of MFI picks. So, here they are:

WNR: Western Refining produces fuel in West Texas, Arizona and New Mexico. The company recently announced the buyout of Giant Industries, which I think is now their only source of debt. They first went public in January at ~ $18, now trade for ~ $22. Insiders have recently bought a ton of shares, and I got to buy at a lower price than they did.

ASPV: I had seen articles about this company when I started investigating my new purchases a couple of weeks ago. I was really excited about Aspreva: they are a drug company that takes approved drugs and determines whether they can treat new indications. Then thstreet.com published an article on them, and the share price shot up about 10%. I'm only a little less excited. They are a profitable drug company which is probably very undervalued: their PE is ~ 8, compared with other profitable drug companies like Genentech (PE = 53!), Bristol Myers (PE = 16), GSK (PE = 18) and TEVA (which sells generics of drugs, like Pfizer's Zoloft, PE= 234!). Insiders haven't bought recently, but they already own ~ 65% of the company! How much more could I hope for them to buy? Debt is less than 1% of their cash on hand, and they've got a (small) pipeline for new products. An exciting company.

ASEI: They make x-ray machines that are used in airports. Some of the various machines that they produce are supposed to detect all sorts of prohibited items. Unfortunate that this is a growth industry, but it is. This company was a Hidden Gem bonus pick several months ago, when it was at $69, and originally it was a Rule Breaker pick. They've reported less-than-predicted earnings lately, and that's made the stock price tumble. The lumpy earnings is supposed to be normal in the industry, but Wall Street responds in the short term, so one poor quarter makes this a buying opportunity. Also, I'm not quite sure how to interpret non-open market purchases by insiders, but ALL of the principals bought at over $50 in June.

PWEI: They make pipes and fittings for commercial and industrial plumbing. A perfectly boring industry! Just like Lynch recommends. BUT a hedge fund is buying tons of the company, and really shaking the boat. AND they're called PIRATE Capital - how much better does it get? This hedge fund is apparently known for shaking things up in order to increase shareholder value. On top of that, the company authorized a $40M buyback despite the fact that the share price has gone up nearly four-fold in about the last year. It's gone up that much, but the board still thinks its so undervalued (PE is under 5!) that the best way for the company to increase shareholder value is to buy back shares? That's encouraging.

UEPS: They're bringing debit cards to underdeveloped societies. Seems like a lot of growth is possible. Debt is nil, insiders hold 31.3% and one of the diretors recently bought a ton more. Looks good.

A couple of notes:

It will soon be time for my next round of Hidden Gem picks, so stay tuned! Also, it was announced that the second-to-last hurdle for the PAY acquisition of LPMA was cleared: the DoJ said that there are no antitrust concerns. Now as long as all of the shareholders vote the right way... Finally, BLD was in a slump, but then an analyst ranked them as a strong buy and they shot up! From about -12%, they are now about +2%. In all, my initial 5 purchases are up ~15% total.

A new portfolio

I'm glad to announce that I'm starting a new portfolio. This will cover the 'special siutations' that I learned about in 'You Can Be A Stock Market Genius.' A few things fell into place to convince me that the time was right, and that it could be worthwhile. I discussed LPMA in my last post. Everything seems good (more checking to do, but so far...) so I bought today ahead of PAY (the acquirer) announcing earnings.

On top of that, there's the ACV spin-off that I still haven't completely figured out (I think that it will take their last SEC filing prior to the spin-off for that).

And today, senatornovus of the MFI group started a yahoo group dedicated to the special situations described by Greenblatt. I've already learned that Sara Lee will be spinning off Hanes (the underwear and apparel brand). This looks like a classic Greenblatt-style spin off, and may very well be a good value investment play. A post elsewhere (that I haven't yet confirmed the facts of) suggests that the officers of the new company will stand to benefit from share price being low initially. So they're making it unappealing to mutual funds and other large investors, which should trigger a massive sell-off in the first little while. This should depress the price unreasonably, and make Hanes a very attractive investment. We'll see.

In other news, I panicked a little and sold MEDX when it was announced that they might default on convertible notes. I think that it was a panic move because it looks as though they've got the cash on hand to cover the debt. But, I wanted to lock in my 12% gains. Medarex is a pretty reasonable long-term investment with several products in late-phase clinical trials and a strong pipeline. We'll just have to see tomorrow morning. I might change my mind about this move, and I might be kicking myself. As an aside, the low trading fees of MBTrading is the only thing that makes this possible; otherwise I definitely would have stuck it out.

LPMA

JG's writing taught me to look for special situations. Justadrone mentioned in his blog that LPMA is possibly being acquired. They've announced that there will be votes taken among shareholders mid-September. The risk/reward looks pretty interesting. I guess that this is essentially a situation called risk arbitrage, where the difference between the current price and that of the premium for the merger is the risk that people are willing to pay for. JG says that in most cases, it's pennies and not worth the risk. But in this case, LPMA is selling for $24, but the price if the deal goes through will be $29. That seems almost too good to be true. I've started looking through the latest SEC filing that I could find. As far as I could tell, there are two reasons that the deal might not go through 1) the shareholders will vote against it and 2) there will be some sort of antitrust situation and the acquisition will not be permitted to go through. I will still look into this further, but the premium is pretty large. It might just be worth it. We'll see.

Update

As the time for picking new stocks approaches, I thought it was time to update my picks to date.

I am very impressed with the MFI portfolio. VPHM announced phase Ib results yesterday that were positive, and the market put it up over a buck in after hours trading. For me what this really means is that the company knows that it needs products to take over from vancocin, and this means that they're on their way. A pipeline can't hurt, that's for sure. TRLG announced that they're opening stores in Palm Beach, I think NYC, and now Latin America. There are rumors that they're shopping themselves out to be bought out. It seems that this is common for MFI stocks: there've been a couple, and IVII (not IIVI from my HG portfolio) just announced that they were being bought out at a 30% premium yesterday. DECK announced great earnings, and that shot them upwards. It's not as clear what's going wrong with the two that are down.

My biotech portfolio has had some ups and downs. I'm looking forward to CBST turning profitable, possibly as soon as next quarter. MEDX is finally up, but it is basically on no news. Same for NOVC being down. I guess I suspected that NOVC was being driven by speculation and also by the institutional investors, which have now bought up 12.7% of the outstanding shares. I had thought that buying when I did was low enough, but maybe one or more mutual funds had to sell off as the price dropped. Who knows? I still think that the companies I have are great for long-term plays, but none are going to really quickly go up by some huge amount. I've invested more in this portfolio than I'd originally intended (a little too much enthusiasm, that I recognize as a beginner's mistake) so I may sell off some of this portfolio in an effort to balance the three portfolios.

My HG portfolio is doing well. Only about a month, and it's up almost 5%. I can't really explain any of this, though. Nothing seemed to have happened for SDA to have dropped, or for IIVI to have gone up (apparently I bought it at the bottom of an upward run). ALDN went up 8% around the end of the conflict in Lebannon (it's an Israeli company). CTRP went up, down and is now up again. Funny, I would have thought that it would have been the fastest riser, but of course this is way too short to say anything meaningful about that.

As I begin to look at MFI picks, I discovered something funny. As I've learned more about what to look for, I am finding fewer and fewer stocks immediately appealing. I'm not sure that I'm looking at exactly what is important, but I'm way too type-A to just pick randomly (like MFI says you're supposed to).

Was it a mistake?

As I mentioned, CBST was down dramatically (>15%) in the past couple of weeks. Should I have bought? I have some confidence in the company, it will turn profitable, and probably soon. But I didn't buy more of it while it was down. I have cash, but I had decided that I was as invested as I wanted to be in my One Up portfolio. In fact, I invested somewhat more than I had initially intended. The cash that I have is earmarked for my other two portfolios, which both have more regimented buying strategies. So was it a mistake not to buy into the downturn of CBST?

Similarly, NOVC has also plunged dramatically in the last few days, I'd guess around 40% or so. Today it gained back 12%. I have less confidence in NOVC than I do in CBST, but regardless, this looks like a bargain. Was this a one-day turnaround, or is it heading back upward? I have no confidence in timing the market, but Mr. Market just can't seem to make up his mind with these biotech stocks. What is the right move?

Exciting week

There's been a lot of excitement this week in my MFI and One Up portfolios.

Cubist's competitor Theravance (THRX) announced results of a clinical trial that were OK but still had some toxicity issues. CBST had dipped by about $4 over the last several weeks, and had been working its way back up. On these results, CBST jumped ~ $1.50 to about $24. Their antibiotic Cubicin is now predicted to be profitable for quite a while. Cubicin will be first-to-market, and is expected to pick up the market which can be anywhere from $200M to $2B or so. And this will only increase as the anti-infective vancomycin increases in failures when antibiotic resistance spreads, probably several years from now. Cubist is on its way to profitability. I expect (and analysts generally agree, from the couple of reports that I looked at) for CBST to achieve profitability as soon as next quarter, and to increase market share for a while to come.

Despite this good news for Cubicin, a product in competition, vancocin (the trade name of vancomycin) did not suffer. Yesterday, the stock price of VPHM was surprisingly unaffected by the good news for CBST, and now today Cowen upgraded VPHM, which sent that stock up as well. The prediction there is that a generic will take longer to hit the market than initially thought due to procedural changes at the FDA. Seems to me that this makes generics of vancocin a nonstarter: I would predict resistance to vancocin to be widespread within a few years, making it not worth the money to develop. But what it does make for is a good MFI stock, with a limited time to hold onto, and a (loose) timeframe for sale.

In the meantime. MEDX has been creeping upward over the last couple of weeks. After it's most recent low point, it is now up 13% (not all of that is gains for me, unfortunately), and has now topped $10. Nice! What I really like about MEDX - what sold me on the company - is their pipeline. Something like 30 monoclonal antibodies, several in phase II and III trials.

CBST, +7% (but still down a little)

VPHM, +8% (up 22% total!)

MEDX, +13% (up 6.9%)

Risk and leverage

What is the big benefit of investing in real estate? It's not the return on investment - it's usually around, what, like 5-10%, I think. (OK, the last couple of years were exceptional here in SD, but the market is tanking now.) The magic of real estate is the leverage. You make a big initial investment, make hefty mortgage payments, sure, but the return is on the total value of the home. That's the sweet part.

You get leverage on stocks by buying long-term options, LEAPs. Another lesson from Joel Greenblatt.

So how can I take advantage of this? I was thinking of buying LEAPs for some of my MFI picks. It's a really aggressive and risky strategy. Maybe more risky than I am prepared to accept. But the idea would be that one or two of every five stock picks from the MFI list would be a LEAP instead of the underlying stock. If the term of the LEAP is longer than the period that I plan to hold the stock, it would take the company tanking for the LEAP to lose all of its value. Especially since I have flexibility in sell date - MFI traditionally says to hold for about a year, and arrange selling to minimize tax effects; because this is a retirement account, that's not a concern. Instead, I can hold for about a year or as much as two years (Greenblatt says that two years should be about the same as holding for one, according to an interview mentioned in the discussion group). So is the riskier strategy worth the potentially higher rewards? I'll have to think about it. Maybe do some investigating into LEAPs of current MFI stocks, and follow their value over the next 6 months to a year. That might be a good test.

Alberto-Culver

In 'You Can be a Stock Market Genius,' Joel Greenblatt says that spin-offs are a special situation that can lead to extraordinary returns. So I've been trying to keep my eyes open. ACV has a well-publicized spin-off coming up, of their Sally Beauty section. It's currently trading at ~$48. At the spin-off, there will be a special dividend of $25. A private equity firm will acquire 47.5% of Sally Beauty for $575M, so they've valued the spin-off at $1.2B. With 92M shares, they are valuing Sally at $13.05 per share. So then Alberto should be valued at $10. How can I find out how this valuation compares to the actual value of the company? I have a suspicion that this undervalues the new companies, but I'm really not sure. The spin-off is expected to occur sometime in Q4. Not long before then, there will need to be at least one SEC filing that will give more details regarding the spin-off. I'll be sure to keep track.

And, to keep my eyes open for more spin-offs.

Scorecard

Here's how I'm doing so far. Don't read too much into this: My first purchases were made July 5, the latest were on July 28. So some of these results are from as little as one week worth of activity. In separate panels are my own biotech picks, my MFI picks and my Hidden Gems picks, and relevant indexes for comparison. What are the highlights? DECK has been nice to watch. They just announced earnings that were way ahead of guidance, but not that much improved relative to last year. Nevertheless, I guess the street liked what they heard. Everyone seems to be talking about Simple, UGG and the return of Teva sandles. Which is great for DECK.

The biotech portfolio is disappointing - the whole industry is down, and the stocks I've picked are especially volatile. But it's been way too short a period to say anything meaningful about these stocks. Let the companies have the chance to report on earnings for a few more quarters (CBST) or hopefully some other surprises (MEDX and maybe ALNY in particular). These picks are speculative, based on the probability of the technology paying off. And are definitely buy and hold plays. NBIX spectacularly showed how that could end up - on the downside. More in later posts.

Cubist

CBST is my biggest single investment. Partly, this was an exuberence purchase, and that is completely a mistake. However, I do think that it is on its way up. It's product, cubicin, was approved by the FDA for sale in the US. Q2 revenue increased $7M from last quarter, and 68% from Q2 last year as the company began to sell the product. Overall, they posted a Q2 net loss of $0.09 per share, when analysts were predicting -$0.05. The market reacted poorly. However, I don't understand the nature of this sell-off. 5 cents of this loss was due to stock compensation. My understanding is that this has to do with new laws regarding how companies account for stock and stock options granted employees. Discounting this loss, the income statement is slightly better than expected by analysts. Another 10 cents of this loss has to do with early debt repayment. While I would normally expect this to be good news for the street, in this case, I agree with notching it in the con column. CBST took on more debt, which was partly used to repay this old debt. So its a net even as far as total debt goes. The point is, though, that revenues are increasing by quarter and year-over-year. This is lesson number one of Investor's Business Daily - follow the earnings.

Reading List

I have read these:
Get a Financial Life - Beth Kobliner
9 Steps to Financial Freedom - Suze Orman
The Little Book That Beats the Market - Joel Greenblatt
You Can be a Stock Market Genius - Joel Greenblatt
One Up on Wall Street - Peter Lynch
Beating the Street - Peter Lynch

This is on my nightstand:
The Intelligent Investor - Benjamin Graham

I discommend these:
The entire 'Rich Dad, Poor Dad' series.

I read two books in the series, got really frustrated, found a critique and am happy to warn everyone away from Robert Kiyosaki's book series. Sadly popular.

Lesson #1

(Initially posted 06-14-06)

First lesson already. I was caught buying high.

Towards the end of last year, I bought into an emerging market fund. It rather quickly gained 50%. Excited, I made a substantially larger investment in the fund. That quickly rose 10%. And then May hit, and the markets tanked. I am now losing money on the investment.

Lesson #1: When I'm excited about my gains, it's time to sell.

Savings

(Initially posted 06-14-06)

Just to clarify about savings... I didn't mean that saving is a bad idea. The point is that I've pretty much got that part down. Given the salary I make, I think it's fair to say that I save a pretty good amount. So the question won't be about whether I save enough - it will be about whether the returns I get are sufficient to turn my savings into 'enough.'

The Starting Line and the Strategy

(Initially posted 06-06-06)

I've got three relevent savings accounts. One is just a regular savings account. Two are for retirement. One of those is a Roth IRA - save after-tax dollars, but no tax is paid on it ever again. The other is a 403(b) - like the more popular 401(k), but for people who work in an educational institution - money is saved tax-deferred. The three accounts are in the same ballpark in terms of dollar figures. This is my starting line.

I'm just getting started. How to go about it? Here's the plan: Use one of these accounts to invest in the stock market for now. This is something of a tester year. What am I comfortable with? How do I do? My regular savings account is possibly going to be needed in the next few years in the form of a down payment on a house/condo. My 403(b) can't be used for stocks - those are the (annoying) rules that the employer made. So, I'm going to use my Roth IRA for investing. I've found a deep-discount online broker - they charge only $0.01 per share ($1 minimum per trade). I'm going to form three portfolios in my Roth IRA, and compete three strategies against one another:

A. Use the MFI. The basic strategy of MFI is to rank all stocks in terms of earnings yield and, separately, return on invested capital. Combine the ranks (eg., if #1 on EY is also #153 on ROIC = combined rank is #154). Choose randomly from the top few percent of that list, such that 5-7 stocks are bought every few months until a portfolio of 20-30 stocks is built up. Hold each stock for a year, then sell and buy new stocks. (There are normally tax implications about exactly when to sell - a little less than a year for losers, a little more for winners - but I don't think that exactly applies in this case, since it's a Roth IRA.) I'm not going to choose 100% randomly - I'm going to also screen for companies in which insiders have recently bought shares. This has been shown to be effective (an online discussion group that I subscribe to posted a report with data on this, and there is an investment company dedicated to this strategy, as well). I'm learning what sorts of financials should be looked at, and starting to learn a little about analyzing companies as well, and these will inform which companies that I invest in.

B. The Motley Fool's Hidden Gem portfolio. Similar approach, but a less mechanical, more research-driven portfolio. Great returns over the last 4-odd years. After what I found about savings vs. returns, the cost for a years subscription seems much more worthwhile.

C. Something along the lines of the One Up on Wall Street approach. I haven't read the book yet, but I think I get the gist: my PhD should be good for something. Maybe it's good for having a superior understanding of the biotech market. For example: I am interested in ALNY. I recently read an analyst report that tried to rank ALNY by using the financials of companies that it called 'comparables.' One of those companies was DVSA. Yes, they are in the same general industry, but no, the business that they do is completely different. DVSA is an established, though still small, biotech company that focuses on producing industrial products using a well-founded technology. ALNY is aiming to produce therapeutics using a technology that is as yet unvalidated. If the technology works, ALNY will clean up, because they have cornered the market on all of the relevent IP. But to compare ALNY to DVSA is actually ridiculous. I'll definitely have more to say on ALNY in the near future.

In addition, I'm going to keep at least 10-15% in reserve, so that when markets tank (like they have in the last three weeks or so), I can buy into them and get great margins of safety.

Just waiting for my account to be funded... It could be up to 10 business days still! For the love--!!

Primer

(first posted 06-06-06)

I've lately become interested in investing in the stock market. I started several years ago investing in index funds. I wasn't interested at the time in getting exceptional returns - just getting returns and not having to think about it. Well, I put my money into an index fund at the top of the bubble, watched my index fund lose 1/3 of its value, and actually found a way to make this seem positive. (I was able to take advantage of dollar-cost averaging! What a coup!) Well, now I want to actually do something with my savings. So I've started to do a little reading.

My initial reading, years ago, was a book called Get a Financial Life. Next was Suze Orman's The Nine Steps to Financial Freedom, which was basically the same basic message as the first book. The investing that I had been doing was right in line with what was suggested by these books. I'm not sure what changed, exactly, but more recently, I became interested in reading about stock investing. I happened to hear about a book called The Little Book That Beats the Market. It came with a Magic Formula for ~30% returns (known as MFI, for Magic Formula Investing), and backtesting showed that the formula worked.

I read quite a while back about the magic of compounding. But yesteday and today, I played around with some numbers and was surprised to see how amazing it really can be. It seems pretty common to assume a $10K starting investment, so I've done that here. "Average returns" is the (more or less) 11% historical return of the market. "Modest savings" is $4K per year, the amount to max out a Roth IRA. The maximum investment in a Roth is bound to go up, but I left it at $4K for the entire time of the series. "Aggressive savings" assumes that the amount saved will go up every few years - to $6K in 3 years, to $8K in 6 years, and so on. "Amazing returns" is the 30% suggested by MFI.

For the first few years, saving helps a lot. But within ten years, MFI beats the more moderate returns. Here's a zoom on the first twelve years. (I added in a data set for amazing returns with moderate saving, because that is realistic - and in this case, average returns, even with aggressive savings, never wins.)

Another way to look at this is: how long until this hypothetical $10K has been turned into $1M? The difference in time scale is surprising. This was the data that made something very clear to me: The classic Suze Orman example of how to save an extra few bucks for retirement is to not drink coffee every day. That $4 at Starbucks really adds up! Well, I don't even drink coffee. As far as I'm concerned, I've saved a huge amount given that I've only ever been a graduate student and a post-doc. And if I listened to Suze, I'd never save enough to have even $1M at this rate - and my expenses are only going to rise.

There was a bit of a bait and switch there - when I complaind that my expenses will only rise. My salary will as well. But this small analysis tells me that the question is not how to save more - even a lot more, like after my salary makes a major jump when I get a real job. The question is how to get exceptional returns. That is what this blog will be about.