InvestoBlog

Insiders are Buying

2008-05-11T01:36:00.000-07:00

I've wondered lately whether the downward market movement of late has been considered an opportunity. Is there evidence for that attitude?

A big part of my buying strategy has been to follow the insiders. So I've been keeping track occassionally of how much insiders have bought. Here's a simple test: have more MFI stocks been bought by insiders? This seems to be the case. It's a simple test: just the fraction of MFI stocks with insider buys, regardless of number of insiders buying or the number of shares bought per purchase. It would be really nice to have more data, but 2008 buying is significantly increased from all other buying (by t-test, P = 0.034).

This is encouraging to me to kickstart some more buying on my part.

Are LEAPS black swans?

2008-01-13T19:35:00.000-08:00

I tried two experiments with LEAPS a little while back (here and here). It's been a year since the end of the first experiment. I've now followed the same set of MFI stocks for an additional year, and can look at the change in stock and LEAP values for this additional time period. (Acually, it's not the exact same set of stocks; this depends on which stocks had LEAPS available). I'm really glad to have been able to get this extra data: just look at the last three months on the S&P in my previous post - it's been heading downwards for a while. In previous experiments with LEAPS, the market was moving upward fairly stongly. I think that this round of data provide a better picture of what may happen in using this strategy over a long period.

Of the 19 stocks in this data set, 10 were down (52%), while 13 (68%) of the options were in the red. The average change in stock value was +6.2%, +/- 50% with a median change of -0.7%. As past data might make us expect, the change in derivative value was much more variable, with a standard deviation of 157%, making the 18.5% mean increase in value less trustworthy. The median change in derivative value was -53%.

Overall, I think this is striking. Let's imagine that you could hold a portfolio with these 19 stocks. You'd have tripled the return by holding LEAPS rather than the underlying stocks.

What about if you only held a subset of the derivatives? Here I carried out a Monte Carlo simulation. It's small scale because I'm doing this by hand. (If anyone knows of freeware that will do these, please let me know.) I generated 65 portfolios of 5 LEAPS each. The average return was 21% +/- 66%; the median return was 24%. Of the 65 portfolios, 40 were in the black, and half of those were up by more than 50%. 25 of the portfolios were negative, and 12 of those were down by more than 50%.

Notice that one derivative is up by 22%, while five more are up by at least 100%. The remainder are all down. So any portfolio that's up is driven by these five derivatives.

I suspect that the randomization routine in Excel is skewed. If you look at the portfolios that have only one of the 5 derivatives that are up, the return is -13.7% +/- 26%, with a median of -13.8% out of 14 portfolios. Seems like these should have been in the majority, not the minority of the portfolios. I'm not sure that I trust the total results of the Monte Carlo simulation.

But let's go back to the aggregate result: +18.5%. This makes me think of Nassim Taleb's strategy for investing, as he described it in the Black Swan. He describes a barbell approach to risk. Most of the portfolio is put in extremely safe investments, like Treasury bonds. The rest is put in extremely risky investments like LEAPS. Say government bonds are 5% per year, and have 80% of the investment. Then the return is (80% of 5% and 20% of 18.5% for a sum of) 7.7%. That's better than either of the options of investing only in T-bills or only in the underlying stocks. Obviously it's not better than the return of only investing in LEAPS, but without the risk. What if none of the LEAPS had returned as much as they had?

I'm not sure. Maybe holding a portfolio of 19 LEAPS is sufficiently diversified that there's little risk involved. It would really take more data to understand what risks are involved in getting these returns.

Posting frequency = Market movement

2008-01-13T19:29:00.000-08:00

It's been quite a while since I posted, and I realize that my interest in posting is related to the movements of the market. Since my last post, my interest in posting is quite well represented by this graph, the movement of the S&P over the same time period. Well, no promises, but I'll try to pick it up a little.

Mockery

2007-10-04T21:06:00.001-07:00

OK, look at the market mocking me. Just Tuesday I said:

True, I had (by chance) picked stocks on the move in previous rounds, and that has been helpful when a peak turned downward.

I was referring to NTRI, which went from $44 when I bought it to over $70 and back down to mid forties. Well, today NTRI announced lowered earnings guidance and dropped over 30%. Ha, ha, market. You got me.

Last round of picks

2007-10-02T22:02:00.000-07:00

I neglected to report on my last round of MFI picks. As I mentioned, I felt as though I gave a very cursory at best -and counterproductive at worst- examination of the available companies for my last round of picks. I looked at things like upward momentum. True, I had (by chance) picked stocks on the move in previous rounds, and that has been helpful when a peak turned downward. But when that was the only reason to buy a stock - well, I think there could have been better reasons, that's all. Hey, it seems as though MFI stocks are generally doing poorly these days, and it's only three months, but still... I'd like to have better reasons to own a stock for a year than because it has been going up for a few days. And, OK - these are MFI stocks after all - statistically likely to outperform the market - but I've been doing a lot of reading trying to learn what to look for, and here I was ignoring it all.

With all of that, I took a much more in-depth look at stocks this time 'round. I do still believe that buying when insiders buy is a good start, and so I limited the list of 100 MFI stocks over $1M to those with recent insider buys. That still left 27 stocks to consider. Of these, I ranked them in terms of: Earnings yield, Return on capital, Piotroski Score, Insider buys (by size and number of buys), EBIT slope over the last five years. Thanks to The Dhando Investor, I added FCF valuation relative to market value of the company - Pabrai says that no company is worth more than ten to fifteen times FCF, an then should only be bought at half-price.

Top scorers in each of these categories were: EY - HLYS, (a 13-way tie for ROC), AEO and HWCC for insider buying, MVL for Piotroski Score, DVR for EBIT slope, and USMO for FCF valuation. These and other high-scorers were awarded points for rankings, and the total score lead to the following top five: VPHM, NOOF, USMO, HLYS, AEO. The current ratio was huge for VPHM and HLYS, and pretty good for AEO, NOOF, and USHS. Finally the MOS price as determined by the (black box) automatic Rule #1 MOS generator was pretty good for AEO and HLYS. My one concern with AEO was that it was largely overvalued with regard to FCF, trading at 24-times my calculated FCF value.

In the end, I picked AEO, HLYS, USHS, USMO and VPHM. Note that USMO has a 20% dividend. Also a couple of days after I bought it was revealed that the CEO of AEO had bought over 800,000 shares just after me and at prices just below my buy price.

AEO - the clothing company that is, I think, moderately popular.

HLYS - those roller-shoes that I see kids at the mall wearing all the time.

USHS - home improvement products - possibly a good alternative to buying or selling when the real-estate market is in not doing well.

USMO - wireless communications - a bit of a concern, since this is fairly commoditized, but the between the numbers and the cushion that the dividend gives, I thought this was a reasonable purchase.

VPHM - an old friend in biotech. Yes, their deal with Wyeth fell through, and that product is not going anywhere. There's the old fear of vancocin coming off patent, but the closest competitor is apparently Genzyme's Tolevamer. Recent results with that product were uninspiring, which is good news for VPHM. Maribavir is several months away from finishing phase 3 trials, but this will probably happen within my one year holding period. This means that a big swing in either direction is possible.

Down a lot

2007-08-18T09:34:00.000-07:00

I haven't commented on the massive sell-off that's been going on lately, and I don't think that I really need to all that much. The credit squeeze that has been predicted is hitting. The economist said something about it, but only after the market was taking a hit. Is it all because of the mortgage-industry lending practices? Cramer certainly thinks this is huge. In any case, it has certainly been a disaster for my total portfolio, as you can see on the chart. From the peak on July 16, my total portfolio is down 15%. On top of that, my MFI portfolio is down the most, with 8 of my 20 MFI stocks currently down by 20% or more.I've been buying stock in a few companies that I had had my eye on. Ctrip, for example is fairly low. Nowhere near as low as when I first bought it, but low. I've also taken the opportunity to make a few small purchases into the financial sector. These have unsurprisingly been hit especially hard. I've seen a number that are now selling at below book value, and several more that are near book value. I think this is a an example of the market going crazy, like luminaries always talk about. The Motley Fool guys have been saying for a while that it could come. Now that it has, one of them said he thought it was almost over, but he could be wrong and it could last quite a bit longer. The only question is how long. Maybe the Fed cutting the discount rate yesterday was the first step to recovery. The market was certainly buoyed: it jumped about 2%. We'll see...

Analysis

2007-08-14T22:46:00.000-07:00

I was really disappointed in the analysis I performed on my last round of MFI picks. I feel as though I was just being lazy, and forgetting a lot of the great stuff that I learned. Since then, I read The Dhando Investor and for some reason, the explanation in that book of discounted cash flow analysis just clicked for me. I'd heard of them before, but I just did not understand them with the clarity that I think that I do now. DCFs and the Kelly Formula were the biggest takeaways from Dhando.

I formed an Investing Club with a few friends in order to force ourselves to kick our analysis up a notch. Basically it forces us to ante up. With that in mind, here is the analysis I did of Tesoro (TSO). If anyone has the time or inclination, I would greatly appreciate comments on this analysis: Is there more information you would want to see that I haven't provided? Have I misinterpreted any of the data that is presented here? Etc. (By the way, for the DCFs, I used the Motley Fool online DCF calculator. I'm sure that there are others available online.)

Factors in considering purchase of Tesoro (TSO)

1. About TSO from Yahoo! Finance, Profile: Tesoro Corporation and its subsidiaries engage in refining and marketing petroleum products in the United States. It operates in two segments, Refining and Retail. The Refining segment manufactures and sells gasoline and gasoline blendstocks, jet fuel, diesel fuel, and heavy fuel oils to the commercial customers primarily in the midcontinental and the western United States. This segment also manufactures liquefied petroleum gas, petroleum coke, and asphalt. The Retail segment distributes motor fuels to wholesale and retail customers, as well as to commercial end-users through a network of gas stations. This segment sells gasoline and diesel fuel to retail customers through company-operated retail stations and branded jobber/dealers in the midcontinental and the western United States.

2. ‘Magic formula’ characteristics:
- 21% earnings yield (reverse of PE, indicating a calculated PE of 4.76). ie – it is a cheap stock.
- Return on invested capital of 25 – 50%. ie – it is a good company.
i. According to Yahoo! Finance Key Statistics, Return on Equity is 37%, Return on Assets is 15%
ii. By my own calculations of Return on Capital (earnings before interest and taxes divided by total stockholder equity), result in rather higher numbers: >70% for each of the last two years.

3. Discounted Cash Flow analysis
- Discount rate: 12% - I believe that this is mildly conservative considering the size of the company.
i. I found online a DCF of TSO from 2003. At the time, they estimated a discount rate of 8.4% and then to be conservative jacked it up to 11%.
- FCF calculated as $647M from annual reports.
- Assumed growth in FCF for the next 5 years: 15%. This is very conservative when compared to growth over the last two years. From the annual reports, FCF growth was 38% 2006 over 2005, and 41% 2005 over 2004.
i. Assumed growth after initial 5 years: 3% for years 6 – 10, and 0% for years 10 onwards. 3% is conservative; I think that it’s more typically about half of the first five years. 0% is less conservative; I think that it’s more typically 3%, but some of these analyses say that you can’t count on anything ten years out, so assume a 0% rate after 10 years.
- Current stock price = $49.30
- Shares outstanding: 138.83M
- Excess cash and equivalents (from Key Statistics) = 169M
- Total debt = 1.79B
- Value of operating leases = $39M (the value at the end of 2006. The minimum repayment for 2007 is $5M)
- Value of outstanding stock options = $151M
- Results: Intrinsic value = $63.12 / share, with a 21.9% MOS. If it is agreed that my estimates are conservative wherever possible, then the MOS is probably greater.
- HOWEVER, I am estimating future growth rate based on past performance. Analyst estimates consider that the next five years will be considerably lower than the past, only 6% per year over the next 5 years. If correct, then this will be a LOSING proposition. I disagree with analysts because i) I think that oil alternatives will be a lot slower to come to market than popularly considered, and ii) we may or may not hold on that long; in the nearer term, I suspect that oil will continue closer to its current trajectory. With a 12% average growth rate in FCF over the next several years, we might expect a CAGR of ~ 15%.

3. This quarter TSO paid down all debt on their short-term line of credit. The CEO says that they don’t have any more debt that they can pay down early, so future cash flows will be put towards organic growth of the company. They had originally targeted paying off all of this debt by the end of the year.

4. Current assets (not including inventory, in order to be conservative) = $1,939,000. Current liabilities = $1,672,000 (at year-end ’06). That assets outweigh liabilities is a Good Thing. A 2:1 ratio would be better, but this is pretty good.

5. They acquired a refinery near LA, further strengthening their presence on the West Coast. (Other refineries are near SF, in Washington, Alaska, Hawaii, North Dakota and Utah.)

6. They also sell gasoline and diesel retail, at gas stations under the Tesoro and Mirastar brands, as well as through unbranded gas stations. This seems to be a no-growth part of their company, in terms of actual volume of gas sold, but it has grown revenue, due to increasing gas prices. Management is trying to take advantage of this, having made a deal in January to acquire 140 additional gas stations in CA. If gas prices fall, this may turn out to be a bad idea, but in the short term, it’s probably a great move. It depends on how much effort (ie cost) it takes to max out the volume capabilities of each gas station. I might try to focus more on finding new retail stations to sell to.

7. From the Yahoo! Finance Profile page: Tesoro Corp.'s Corporate Governance Quotient (CGQ®) as of 1-Aug-07 is better than 100% of Russell 3000 companies and 99.6% of Energy companies.

8. Some recent insider purchase: 10,000 on Aug. 9 at ~$48; May 7, 5,000 and 1,000 at $58 by two different directors.

9. Competitors: Valero seems to have a similar model – refining and retail sales. It’s about 5 – 6 times the market cap, DCF analysis gives a similar MOS given the same assumptions, it has a similar PE and a ROC of ~56% last year and ~70% the year before. It’s comparable to TSO.
- However, I like that TSO has the smaller market cap, as it typically implies more possibility of growth. Look at how VLO’s ROC declined dramatically last year relative to the year before, while TSO’s ROC was much more stable.

10. My major concern with TSO is this: it is in a hot industry. If the demand for oil were to drop, or even if the market were to suddenly stop investing in oil companies, TSO could be in for a stall, or even a drop. The recent drop in share price, from a high of ~$64, may provide a margin of safety against this possibility.

Western Downgrade

2007-07-18T21:52:00.000-07:00

I was mere cents away from my first triple. And then Western Refining was downgraded by Deutsche Bank. Sorry to hear it, WNR! The share price bounced around: WNR shed nearly $5 after the downgrade, but recovered almost $2.50 today. It'll be interesting to see whether this is just a blip or whether it changes the direction of the stock. Look at the 1-year chart. As of today, it's up 187% since I bought it.

Profits cubed

2007-07-18T21:42:00.000-07:00

Cubist announced Q2 earnings today AH. As I'd hoped, they swung to profitability this quarter, and reported great results. Earnings went from a loss of $0.09 to a profit of $0.24. Analysts had predicted $0.16. The stock price is up over 10% in AH trading. I'm off to listen to the conference call...

Fierce Bioanalysis

2007-07-13T23:42:00.000-07:00

A recent editorial on Fierce Biotech discusses the Biotech industry, and I thought it was pretty interesting. http://www.fiercebiotech.com/node/7553

RNAi rocks

2007-07-09T21:26:00.000-07:00

A big deal was announced between Roche and Alnylam today. Roche bought about 5% of ALNY for $42m, so the whole company is worth about $840m. But that's not all. They also paid $331m to license the RNAi IP, and additional aspects of the deal could make it worth as much as about $1B. FierceBiotech called it a billion-dollar lesson in the economics of RNAi. It just keeps on sounding as though the management of ALNY is doing all kinds of things right. As one of the couple of companies with IP on RNAi, it seems that they are going to leverage it into big deals rather than selling out.

I'm understanding a little better how investing in biotech works. It seems that you need great technology and really good management. That's obviously true in other sectors, but these are especially important in biotech because it's typically such a lag between the company going public and the product coming to market. Once the product is in the market, the only risk is market risk, ie will the product sell as well as expected. CBST is an example that I've discussed before of a company that may be having exactly this sort of problem. (We'll see after next Wednesday's earnings announcement whether CBST has figured this out.) At the stage where ALNY is, though, there's also the risk of whether the technology will deliver on its promise. When Sirna was bought by Merck last year ($1.1B!), the market saw it as a validation of the technology, and ALNY went up to about $22. Since then, ALNY slowly dropped down to $15 prior to today's announcement. (The funny thing is, I was just thinking last week that ALNY was looking cheap. D'Oh!) Now RNAi is again validated by the interest shown by Roche. Right now the market cap is $868m. Is the future growth of RNAi worth more than the valuation from this deal with Roche (ie, $840m)? I think so - it would be more than the $28m difference, I think.

But what happens in the next couple of days? What I've seen before has been that after the excitement wears off, the stock price will drop a little until it finds a new equilibrium. A great example of this is what happened with Novacea recently when they announced a deal with Schering-Plough. I suspect that this will happen with ALNY as well, unless they make another announcement in the near future (which the CEO John Maraganore hinted at in one of the stories I read about today's deal). Also, they'll be announcing earnings in just under a month. It won't be a surprise, but they'll probably be beating whatever analyst estimates there were. Will the stock price respond? Barring earnings surprises, I wonder whether the stock fluctuation exhibited by Arena is more typical - two peaks and three valleys over the last year. All of this makes me wonder whether investing in biotech could be enhanced by maintaining an investing position while also having a trading position. Today I wouldn't mind selling part of my ALNY position, but I guess I'm a little afraid of it not following the pattern I've seen before. (It's already down a bit in afterhours trading.) I sold off a position in Medarex before, and got a little burned by that. Like MEDX, ALNY is a company that I believe in long term. Should I just hang on to what I've got?

Congratulations

2007-07-04T22:31:00.000-07:00

Congratulations to VeriFone CEO Douglas Bergeron for being named 'Entrepreneur of the Year' by Ernst and Young. Hopefully this accurately reflects the great leadership that he brings to the company.

MFI Turnover

2007-07-02T22:04:00.001-07:00

I turned over my MFI portfolio today. I also turned back the clock a little, and picked new stocks based largely on insider purchases, but also influenced marginally by market caps, Piotroski F-Score, Rule #1 investing and insider ownership. I actually had some difficulty making a few decisions, and debt was often a deciding factor. Here are my new picks:

AMEN - A Texas-based power and land company. Seems that they've been moving their resources to power and their EBIT increased hugely y.o.y. last quarter. I like the idea that if the land and housing market were to turn, this company could become even more profitable.

CHKE - This is a company that owns several brands that are sold at stores like Target. It's done very well over the last year, but the stock price has dropped dramatically after a disappointing quarter. Apparently, both the CEO and the CFO think that the drop has been excessive, and I'll join them in buying shares. About an 8% yield.

HERO - They provide services to oil exploration and drilling companies. They've got very high corporate governance scores at Yahoo! Profiles.

NPLA - They make 'proprietary emerging technologies,' including digital pens for tablet PCs and feedback switches. No debt. Last quarter was huge, and they've been going up since then. Normally, that would make me cautious, but 'the tools' that Phil Town introduced me to are all a strong buy. After the bell today, they announced that the CEO/CFO was resigning. I'm afraid that this will put the brakes on the stock. On the other hand, the price was up 1% after hours.

ROK - Rockwell Automation provides power and control services for industrial automation. Total debt is about 2/3 of cash on hand and the stock is cheaper than the Rule #1 margin of safety. They closed an aqcuisition today, of ICS Triplex, a maker of control and safety equipment.

I struggled in considering a couple of other companies: RURL, KNL and SPLS. Staples (SPLS) of course is the well-known business supply store. Rural/Metro (RURL) operates ambulances in rural areas, and Knoll Inc. (KNL) makes office furniture. Both of the latter two had a huge amount of debt relative to total cash, and that was what eventually got me to decide against them. As for SPLS - I really have no good reason not to buy them based on the level of research that I did. Which, frankly, could've been more. Oh, well, we'll just have to see.

Welcome aboard!

A couple of additional notes. I decided to keep half my holdings of DECK. This was basically for one reason and one reason only: 'the tools' still call it a strong buy. As soon as those turn, I'll sell it and forget it. So my realized gain for this first portfolio is about 34%; the IRR after one year of MFI is 40.5% (only for my MFI stocks).

And this brings me to my second note. My special situations and 'One Up on Wall Street' portfolios are definitely slowing down the rest of my investments. I'm not ready to sell them off, but I am ready to start backing out of them. Over maybe the next six months or so, I'm going to try to make some tough decisions and pare these portfolios back by about 50%. I still believe in some of these companies, but I realize that I've held on to others for too long and there are still others that I shouldn't have bought in the first place.

Spin-off article

2007-07-01T20:49:00.000-07:00

I came across this article about spin-offs. Not much new here (the only reference is to You Can Be A Stock Market Genius) but maybe some useful links for further information.

Almost a year

2007-06-25T21:36:00.000-07:00

It has been very nearly a year since I started investing. My first round of MFI picks have done really well. Let's recap. Viropharm was my first stock to hit a 100% increase, and then backed off to end at about 55%. I was pretty interested to learn about what they're doing. True Religion was a bit of a rollercoaster, up, suddenly down, gradually back up and today it was up 10%. I don't pay too much attention to retail, and this was partly an introduction. Baldwin was mostly flat all year, and luckily it ended up about 10%. Image Sensing Systems was up and down in fits and starts, but mostly up. It ended up about 20%. Finally, there's Decker's. I knew of Uggs, Tevas and Simples, but never had any idea that they were all owned by one company, and that company was going to be a rockstar of my portfolio. It's up about 150%. So, to summarize:

VPHM - 57%
TRLG - 27%
BLD - 12%
ISNS - 20%
DECK - 150%
The weighted average return is 55%

By comparison, here are some indices:

Wilshire 5000 - 18%
Dow Jones - 20%
S&P 500 - 18%
Russell 2000 - 15%

Obviously I'm pretty thrilled with these results. Now I have to ask one question. I've generally tried to use additional criteria to choose from the top 100 MFI stocks over $1 million. At the start it had a little more to do with looking only for insider trades, with a preference for smaller cap stocks. Over the course of each round of picking stocks, I tried to incorporate more analysis of the fundamentals of each company. (I've still got a ways to go on learning how to analyze businesses and opportunities, but on the way to learning that, I've looked at a lot of underlying stats.) Has it helped?

My second round of picks are up about 28%, annualized to about 34%. The third round is up about 2.5%, annualized to 4%. Finally, my last round of picks is up 19%, annualized to about 55%. Altogether, my MFI portfolio is up about 24%. Hm. I don't think this tells me anything. For my next round, I think that I will focus mostly on what made my first round a winner. We'll see.

Options revisited

2007-05-20T20:27:00.000-07:00

A little while back, I posted on an experiment in options, testing what sort of returns one could expect from a portfolio of options derived from a handful of MFI stocks. The experiment is pretty simple: collect the close price of both options and underlying stocks at some time (in this case, Jan. 6, 2007) at some later date. In this second experiment, I collected pricing information for some 38 stocks and options (38 was the number of MFI stocks in the top 100 stocks over $1M that had options available for either April or May). For each option, I chose a strike price that was as high as possible but still in the money. Just before the expiration I recorded the change in option price, as well as that of the underlying security. It's pretty clear that the option price amplifies the change in underlying stock price (Fig. 1). The change in stock price was 16.7%, with a standard deviation of 18.5%; the median change in stock price was 14%. By comparison, the change in option price was 59.7% on average, with a standard deviation of 105.7% and a median change of 40.9%.

In order to better simulate what I would actually do in trading options, I carried out a Monte Carlo simulation (a very simple one) in which I randomly drew 5 options from the group of 38, 44 times. The mean return of these 44 portfolios is 64.4%, with a standard deviation of 46.9%. The median return was 65.7%. The distribution of returns is skewed towards the higher end of the range (Fig. 2). How good was the randomization of my Monte Carlo simulation? Just to be clear, I took a look at the number of times each option was selected in the 44 portfolios (Fig. 3). It's not bad, but could maybe be better. But the real point is, purchasing options definitely seems to amplify the returns of underlying securities. This needs to be qualified in that the general market has been going up over this time period. I don't know whether thse results have anything to do with the fact that these are MFI stocks, only that this group of stocks went up over the course of four months, and the options went up be even more. In principle, MFI stocks should on average outperform the market, but by exactly how much is not clear. In particular, the options in this study (and my previous one) were held for either four or five months. For four month holding periods, a 16% average return is clearly quite good. Also, although I was not pleased about this with regards to my real-life portfolios, for the sake of the study it was reassuring that the slump that came about late February from the drop in the Shanghai market was barely a hiccup for the returns of this portfolio.

One last interesting piece of data, that I only thought to look at here because of comments with regards to my previous experiment. Using the data from this experiment as well as my previous one, I summarized the returns of options grouped by the change in value of the underlying security (Fig. 4). Clearly the sample size for these groups is pretty limited, but it's a start. Basically, it seems that with less than a 5% increase in stock price, the option price drops. This represents at least in part the cost of the time premium. Above a 10% change in stock value, and it seems like a pretty good chance that the option is going to be profitable. So, this leads to the question, what is the chance of at least a 10% increase in stock price within four months?

Updated Returns

2007-03-26T22:11:00.000-07:00

I realized it had been a while since the last time that I posted a listing of my actual portfolios with their returns. My overall IRR is 29.8%. By comparison, over the same period, the IRR for the Dow is 16.4%; that of the S&P is 18.2%; the Wilshire 5000 had an IRR of 18.7%; and the Russel 2000 returned 17.2%. So things are going well.

My Motley Fool portfolio is phenomenal. The current IRR is 63.7%. I've been neglecting to mention how this portfolio is doing lately, but there have been a few companies whose stock prices have really moved lately. IIVI has been climbing pretty steadily since I bought it way back in my first round of purchases last July. SDA was a real sleeper until recently, and MIDD and GIGM have been on fire. OYOG is a yoyo no more! EDU had an early drop after I bought it, but has since been bouncing around the low-$40's. Obviously, I'm really happy with the service in terms of straight-up picking of stocks. I also think that I'm learning something. With a little more work and effort, I think that I'll be able to learn a lot.

The Magic Formula Investing portfolio is also doing nicely, with an IRR of 39.7%. DECK has always been doing well, while WNR is a recent addition to my top-movers. VPHM was once my first double, but now has pulled back to the number three slot. FCX was well under the price I paid for it for a while, but has now clawed its way back to positive territory. UEPS seems to keep fighting with that $30 upper limit. It keeps making it there, and then falling back to just a little more than I bought it for.

I notice that the mid-range stocks of the MFI portfolio have had a lower return than the mid-range stocks of the MF portfolio, but the big winners have won bigger - in other words, there's a longer tail for my more moderately-performing MF portfolio (figure). Some of this effect is due to the fact that some purchases are more recent than others; however, this is not all of the effect, because both portfolios include stocks that are recent purchases as well as stocks that are older. In Marshall's study of monthly MFI portfolios, he found that they beat the Russell 3ooo most months. I wonder what the distributions of returns were within each portfolio? Is it the case that each portfolio has a small number of big winners with the majority of stocks giving moderate returns? This may be worth further study...

And finally, here's the biotech portfolio that I've been reconsidering so much lately. There is a bunch to say, though. The IRR is now -2.4%. Since my last post, Cubist found a distributor for Cubicin in Japan, the Merck subsidiary Banyu. They sold the rights for $6M. This seems somewhat low to me. Not that I've got some great insight into what that should have sold for... but it just seems low. And not just to me. A January article over at the Motley Fool predicted that they'd find a distributor, and that it would get them $10-$20M upfront. A big difference! A little good news, MEDX started another phase I trial with MedImmune. This had absolutely no effect on the share price, though. On the other hand, ARNA started a phase II trial, and the stock price dropped ~5%. ARNA and NOVC are also up for reconsideration. But I also want to consider this carefully. The idea with the biotech portfolio was that my understanding of the science would allow me to judge the science, not just base decisions on announcements like these. So, this is something that I'm still working on. Because it's also been an important lesson that the science is just a small part of the whole package with biotech companies.

A couple of notes

2007-03-21T22:37:00.000-07:00

Not long ago, I noted that CTRP had looked cheap. It had peaked at ~$74 and dropped to the mid-$50s. I picked up a few extra shares at ~$57. It's now back up to ~$67 just a few weeks later.

Similarly, PAY looks like it may be cheap right now. It peaked at ~$42, backed off to ~$35, and now has gone back up $2 to ~$37. At it's highest, it had gained 40% since I first bought LPMA, at its lowest in the last few days, it was up only 20%. Also, the chart indicators that I learned about in Phil Town's Rule #1 look quite good for PAY right now. I don't have extra cash lying around, but if I did, I'd think seriously about an extra investment in PAY.

WNR is up ~40% in the last month. It announced great earnings 1 March. It seems to me that this is probably because of higher prices for oil; they discussed better margins, but also higher operating costs. It's also due to better refinery throughput. I really liked how positive the CEO sounded about '07, especially Q1. Apparently, so did a lot of other people.

On the other hand, VPHM has plumetted since their peak mid-February. Q4 earnings were down a bit, but 2006 was a stronger year than 2005. Now they announced the sale of senior convertable notes, and the stock price gapped a little lower.

Just to update - my total IRR is 23.3%. My MFI portfolio has an IRR of 40.8%. (In a recent post, I said that it was something like 11% - I just realized that I had accidentally excluded GVHR; so the 11% IRR was wrong. It's not that the IRR jumped 30%!) The IRR of my Motley Fool portfolio is 60.8%. With PAY down a bunch from its high, the IRR of my special situations portfolio is 63%. So, the kicker from my recent post about investing in biotech is that the IRR for my biotech portfolio is -5.8%. This has put me one step closer to revising my opinion of investing in biotech at all.

Mocked by the Market

2007-03-21T21:02:00.000-07:00

Just a couple of weeks ago, I held off deciding whether to buy THE or EGY. The other day, THE was bought out at a 28% premium, and jumped ~17%. The market laughs.

Also, I had to laugh today, when the market waited for the Fed announcement before doing anything. Here's the market motion for the day (figure - red, DJIA; blue, NASDAQ; yellow, S&P). Can you guess what time the announcement was at?

Rethinking Biotech

2007-03-13T23:12:00.000-07:00

I was looking at some old posts on Fierce Biotech, when I came across one that discusses all of the recent M&A activity in the industry. It points to a BusinessWeek article that I found especially interesting. Based on the article, it sounds as though investing in Biotech is mostly a pretty bad idea.

Biotech startups have no product. It takes years of VC financing before a startup can get a drug to clinical trials. Investors typically like to see at least phase II, and often even phase III clinical trial data before investing. But that's fairly late stage for a Biotech startup. So, without a product, investors (or, speculators) invest based on the probability of a product. That's based on management, on the underlying science, but mostly it seems to be based on any new developments. Cubicin is approved! The stock shoots up 20%. Indiplon is rejected at the highest treatment level! The stock plummets 40%.

The thing is, in my read of the BusinessWeek article, only suckers go through the IPO process. Big biotech and pharma are buying startups. They're interested in startups at a much earlier stage than the IPO stage; they need to make clear to investors that they have a pipeline, and one very effective way to do this is by buying companies that seem poised for success. Companies are well-remunerated for submitting to these giants - the average buyout carries an 86% premium relative to the average IPO (again, according to this same article). So if a company can be bought out, it's to both party's advantage to do so. So if the best biotech companies are being bought out, then what are the companies that are going public? They're the mid-range companies - the ones that are good enough to have products in development, but not sufficiently top-ranked to be bought out.

There are possibly exceptions. I sincerely believe that ALNY and MEDX are two, based on the science. (They're also exceptions because they were already public when this M&A-favored environment unfolded.) Sirna was bought by Merck for the sake of accessing the technology; I don't doubt that ALNY had some sort of similar opportunity. Same for MEDX - Cambridge Antibody Technologies was bought at a huge premium by Astrazeneca last year. MEDX and PDLI are in the same space that CAT used to occupy. So it seems that the management of ALNY and MEDX made decisions based on what they believe to be the future value of each respective company.

But, I've been reconsidering my investment in CBST for a little while now. Cubicin is supposed to be increasing in market share - so where are the dramatically increased profits? Why is VPHM still doing well? (At least, before the recent market turmoil - it was my biggest % gainer not too long ago.) In principle, CBST should be a good investment in the sense that they should be gaining market share with a superior product. Revenues are increasing dramatically, and earnings are growing with 06Q4 as their first official quarter in the black. (Here's a MF article about their year-end report.)

I'm trying not to be a schizophrenic trader, like I was in my earlier days with NBIX and MEDX. So, I think I'll hold on to CBST for now - at least through the Q2 results. But I'm also going to be a lot more discerning about my biotech investments. Also in the near future, I'll reconsider my investments in NOVC and ARNA as well.

The return of "Youch"

2007-03-13T22:35:00.000-07:00

OK, I thought that things might be going well after my last post, but, sheesh! My total portfolio was down about 2% today, knocking my IRR down to 21.4%. The IRR of my MFI portfolio is down to 11.2%. It's pretty amazing how things swing from one direction to another. I really don't think I can point to any one stock, either - there's variability, sure - a couple dropped as much as 6% - but others went up, so no one stock was an outlier that drove the portfolio as a whole. I checked the news for some of the companies that were at the bottom end, and there wasn't anything. So this is just the roller coaster of the market for now.

White Swan and New Picks

2007-03-06T21:46:00.000-08:00

In Fooled by Randomness, a black swan is described (more or less) as a predictable, but improbable, event that, if it occurs, has disastrous results that are not adequately planned for. I had a small white swan today.

Since last week, the market has inspired only one thought, "Youch." It had been something like 6 straight days of dramatic downturns. Yesterday was my scheduled 'buy' day. You know how they say to stay in cash during a downturn, but they also say that no one can call a bottom. In this case, I think that these sayings were giving me contradictory advice, so I went ahead with my scheduled buy. And today, the market rebounded in a big way. My portfolio did about as well as the NASDAQ, but the point is that there was more in my portfolio than there might have been otherwise. It's amazing how large an affect this had on my IRR. My total portfolio of stocks went from a 24% IRR yesterday to a 30% IRR today; my MFI portfolio was 8.4% yesterday, and 15% today.

Especially of note, I invested more in Ctrip. I first invested at $49, it went up to mid-70s, and now dropped back to about $57 when I bought it again yesterday. It was up 5% today. Also, I see that Optimal Group, my newest MFI stock prior to today, swung to profitability in Q4. It's up 16% after hours.

Oh, and my new MFI picks? WIRE, BLDR, NTRI and MTEX. After all of my complaining about evaluating companies in previous entries, I went somewhat more in depth to arrive at these four. It was still more based on hard data rather than judging things like management conference calls and CEO letters in annual reports - taking what data I could and using that. So I scanned the MFI lists (top 100 of $1M or greater market cap) for high insider ownership, recent insider purchases, increasing EBIT over several years, and a large discount relative to the 52 week high. (This last is based on the 'Blue Light Special' study that Marshall did; his data suggest that MFI stocks that have gone down by 20% tend to recover and do better than stocks that did not drop.) These criteria narrowed the list of 100 stocks to 21. Then I ranked all stocks based on these criteria as well as Earnings Yield and ROC (the MFI criteria), Piotroski F-Score, analyst coverage and market cap (less is better for these last two [arguable, but I think the Tweedy Browne study showed these to be true]). I also ranked them on corporate governance, the semi-black-box statistic on the Yahoo! Finance Profile. These four companies scored highest on these criteria, with the exception that EGY and THE were third and fourth of the top six. I was torn about buying another oil company (after WNR); also, I have been interested in EGY for a while but THE is a recent HG recommendation. In the end, I decided to wait.

I think it's worth mentioning how I looked at an increasing EBIT. I was looking for the fastest rate of growth of EBIT from 2001 to 2006. Using Randy's plug-in for Excel, I was able to easily download these numbers. Bringing them to my handy graphing program, I fit each EBIT to a linear function, and took the slope. (I think that I should have normalized the EBITs to, say, the most recent year. I'm a little upset that I didn't think of this before.) One thing that is becomes clear, especially when you compare the WIRE data with that of other companies (see figure) is that what you actually want in this analysis is an exponential increase, not a linear increase. An exponential increase in EBIT means that the company is efficiently using its resources to efficiently generate a return on capital. Conversely, a linear increase means that the company is doing less business with more cash on hand. I'm not 100% sure that this logic is correct, but I'm basing it off of the Buffett principle that % return is what's important rather than earnings.

Hopefully, today signalled a turnaround from the last few days, rather than a small bump in a continued spiral. One thing about stock investing - it's almost never boring!

ASEI in the news

2007-02-23T21:01:00.000-08:00

There was an article in the New York Times about American Science and Engineering today. It said that the ASEI SmartCheck is being tested in airports. This device takes a full-body, low-energy x-ray scan. The image generated allows security personnel to see through clothing, but not inside the body. If nothing else, this has to be great visibility for the company.

Goodbye, PW Eagle...

2007-02-20T23:11:00.000-08:00

...hello, Optimal Group.

I went ahead and sold PWEI, and replaced them with OPMR. It was nice to find OPMR on the MFI list; I first became aware of OPMR in a recent Motley Fool write-up. MF essentially said that OPMR is risky, because it's in a beaten-down industry, online gaming. OPMR also has an electronic wallet division. The MF write-up convinced me that OPMR is cheap, I mean, really cheap - cheaper than the 12% EY listed on the MFI list suggests. Essentially the e-wallet division is free, and it acounts for 1/3 of the company's business. Moreover, if the company grows at anything like historical growth, it should be worth quite a bit more than it is being sold for currently: the share price seems to imply only 7% growth. So, as they said, cheap is cheap. And that was why I bought into OPMR.

MFI vs. Wilshire 5000

2007-02-19T21:11:00.000-08:00

I'm having trouble deciding whether MFI is really winning - I suspect it is, but I'm trying to figure out by how much. My MFI portfolio is up 13.43% total, compared to the Wilshire 5000 that's up 14.78% over the same period - since I started my portfolio. But my portfolio is affected by having three separate buy periods. So is it by averaging the returns since the three buy periods? In this case, it's 16.2%, compared with the average change in Wilshire 5000 of 10.67%. The IRR of my MFI portfolio is 37.0%. I think that's probably the key; and in this case, it would be compared to the IRR of the Wilshire, which is 25.1%. So, yes, MFI is winning.

The real problem is my latter two sets of stock picks - they've stunk. The first set returned 38.58%, compared to 15% of the Wilshire; the second returned 8.92%, compared to 13.4% of the Wilshire, and finally, 1.1% from MFI compared to 3.6% of the Wilshire. What did I do right in the first set of picks that I didn't do in the second and third picks? Or more likely, what did I do wrong in my later picks that I didn't do in my first picks?

The one buyout that wasn't profitable...

2007-02-16T00:19:00.000-08:00

A little while back, it was announced that PWEI was being bought out by their rivals, J-M Manufacturing, for $33.50 per share. A number of MFI stocks have been bought out, IVII, KOSP, PLAY, KMG, for example, but others as well, and generally at healthy premiums. I actually bought PWEI at $34.11, so as one might imagine, I've been a little annoyed. The general consensus seems to be to sell, and, although I've been holding off, I think that is what I'm going to do.

At this point it's an arbitrage play, with very defined values. Current price hovers in the $33 - $33.10 range, so there's little upside. In fact, because the values are so well-defined, I can calculate my upside. Today's close was $33.10. So there's $0.40 upside, or about 1.2%. The deal is expected to close sometim in Q2. That's somewhere between 1 and 4 months from now; let's say an average of 2.5 months from now. That gives an average of 0.48% per month, or 5.8% annualized.

MFI is typically expected to best the market, and this is worse than the expected average returns of the market. Clearly, there's better potential by investing the money somewhere else. I'm going to do it - I'm just sorry I didn't do it sooner.

My own annoyance aside, I'm a little surprised that PWEI convinced Pirate Capital, the private equity firm that had been buying stock like crazy over the last little while, to vote in favor of the merger. Pirate will break even or lose money on all of the shares they bought from Oct. 13 to Jan. 8. Sure, a number of their earliest purchases were in the mid-twenties, but still, a lot of their purchases are in the low-to-mid-thirties. Now they're still buying shares, doing the arbitrage for the 6% annualized return, which I guess is a little better than 5% in a savings account, but still--!! I'm not sure whether there's something I'm not seeing, that's all.

Monster

2007-02-07T20:29:00.000-08:00

Big day today. My portfolio was up 2.2%. The big movers driving this were:

ALNY, 6.75%

ARNA, 3.9%

ASPV, 8.5%

CBST, 4%

EDU, 9.5%

GIGM, 7.1%

OYOG, 10.8%

SCSS, 5%

TRLG, 7.3%

VPHM, 3.6%

(including some after-hours trading)

It's a pretty mixed bag, too. Some had earnings reports, some had no news at all. GIGM and EDU both tap the Chinese market - maybe somethin was going on there? But - no big move out of CTRP, after last weeks cashing-in, maybe it would be out o whack with the rest of the region. ALNY had good news, but VPHM, CBST and ARNA had none, so maybe there was a biotech thing - but one that skipped MEDX and NOVC. TRLG had no news, but has been climbing pretty steadily. Maybe this is the short squeeze that Marshall predicted?

In other news, I've been climbing in the ranks over at the Motley Fool CAPS stock picking game. Players pick stocks to outperform or underperform the market. Players are ranked based on total difference from market performance (better than the market for outperform calls, worse than the market for underperform calls) as well as on accuracy - fraction of calls in the right direction. I've had some major swings, but I'm now in the 97th %ile, ranked 472 out of 21890 players. My accuracy is over 60%. Of course, I mention all that with the caveat that the game has been going on for too short a period to say anything that is statistically meaningful. Search for me as 'jamiemb.'

Evaluating management

2007-02-03T18:00:00.000-08:00

Just in time for my last post, this discussion came up on the MF discussion boards. It's really very rare that I read them, so it was a pretty happy coincidence that this was posted just the other day by TMFCanuck at http://boards.fool.com/Message.asp?mid=25115298

We all know that good management is critical to a companies success. How can an individual investor value management?

Currently I rely on what I can find in the TMF Boards, Newsletters, and searches of the WSJ. All of this stuff is subjective of course. I know that the Staff of TMF must have opinions on this; so... what are they?

Using Occams Razor, What is a solid, simple methodology to use to value management outside the obvious numbers found in financial statments?

This is a great question. Unfortunately, all I can offer is more subjective stuff. I often find myself arriving at an opinion of management only after reading numerous corporate filings - notably the annual proxy and the annual letter to shareholders. Probably most importantly, I rely very much on what management does, rather than what management says.

So, for example, random questions that assault me as I research a company.

* How much stock (not options) do these guys own? How did they get it? What's been their buying/selling history. Have they kept any options that they exercised (a very big positive, in my book).

* What has been the salary and bonus trend for executives? How is bonus determined? Does management disclose the criteria for bonuses? Are such criteria based on the economic returns of the business, or on easily "fudge-able" criteria. How have bonuses and other non-salary compensation been handled during periods of poor business performance?

* What's the make-up of the board? Is everyone elected annually (good), or are there entrenched multiple tranches (bad)? Are there outside connections between board members, or between board members and management? Really, look no further than Friendly Ice Cream (AMEX: FRN) write-up for an example of a really awful board.

* Has the CFO been buying stock? Talking to several academics (who, in general, seem to make lousy stockpickers - anecdotal evidence only), they've relayed some data suggesting that the CFO buying stock is the biggest indicator of outstanding future performance.

* What's the tenure of the board and senior executives? What's their background? Industry related or simply "professional board-sitters"? Have a look at the board and executive of Dawson Geophysical (Nasdaq: DWSN) for an excellent example of an experienced, tenured, and knowledgeable management.

* Are there any little side/sweetheart deals between management and the company. I generally dislike lease deals where management is leasing facilities to the company...although I'm sure the deals are at "market-appropriate rates". All-time great example was DHB back in the hey-day of David Brooks - former CEO. http://newsletters.fool.com/04/online-exclusives/updates/2006/04/06/060406xq0bluc.aspx

* Is there any deadweight on the management team/board? By deadweight, for example, look to see if the Chairman is a former CEO still getting paid a CEO's salary. This is a negative in my book. An example would be Universal Technical Institute (NYSE: UTI), where the Chairman is making mucho coin and continuing to lease facilities to the company. I consider this a black mark on a company that I otherwise like very much.

* How is the CEO compensated in aggregate? My all-time best example here is probably Garmin (Nasdaq: GRMN). The CEO takes a relatively piddling salary ($230K), and his annual bonus has been $203 (yes, you read that right....Two Hundred and Three dollars). Why $203? Well, Garmin has an annual Christmas bonus for all employees that, grossed-up to account for taxes, amounts to $203. Since the CEO is an employee - he gets it...and discloses it. A couple of years ago, his bonus spiked 12-fold (!) but it turns out that he was reporting his 15-year tenure bonus...again, an amount that all employees receive. Moreover, he takes no options and no restricted stock. He owns about 22% of the total shares though, so when the dividend gets paid, he makes a nice tidy sum. Of course, this option is open to all shareholders...want to get paid more from the company? Buy more stock!

So you can see, there's really no "quick cut". Rather, it's digging into the filings, and gaining a broad understanding of how management does things. Are they aligned with you the outside shareholder (i.e. GRMN)? Or do they have a history of enriching themselves without respect for the shareholder (i.e. FRN). This is probably not the answer you were seeking. It is, however, the only one I can offer.

Best,

Jim

My question still remains: how is the subjective measure of management combined with the objective measures of the company? But this is a good start, and I appreciate the post very much.

How to integrate strategies?

2007-02-01T21:27:00.000-08:00

One of my ongoing goals has been to figure out how to better analyze businesses in order to make better decisions regarding buying stocks. One method was to let the Motley Fool do it for me (initially with Hidden Gems, but now I'm considering additional services of theirs). Another strategy was to try to use my understanding of biotech to pick good stocks (what I call my One Up portfolio). My thinking about biotech stocks has actually developed quite a bit, so I think that the strategy has been informative if not profitable. The third was to combine complementary strategies that each have been shown to statistically beat the market. This is primarily based on MFI, combined with insider buying, low analyst coverage and, later, with Piotroski. This has worked to a reasonable extent - my IRR is pretty good, although the time slice is too short to say anything meaningful.

Now that I'm learning about how to gain a deeper understanding of businesses, how do I integrate these statistical strategies with more subjective ones? How to I rank a moat? How much weight do I put on - for example - debt level versus improving margins versus experienced management versus owner's earnings? I suppose that this is where the science blends into art. Any advice would be appreciated.

Short but sweet

2007-01-30T22:33:00.000-08:00

VPHM closed at $17.02 today. This is my first double; I bought VPHM at $8.50 on 7-5-06.

Woohoo!

New Year's Reading

2007-01-07T12:30:00.000-08:00

I've had a few new books to read recently, my favorite of which has been The Warren Buffett Way by Robert Hagstrom, Jr. (Thanks to Steve for the book, on his own wedding day, of all times to be giving a gift!) Much of the book is an analysis of Buffett's own tenets in action. These sections did get a little repetitive. However, while these started out being very interesting and probably useful, even more helpful are the sections that summarize Buffett's tenets. These are:

Business: Is the business understandable? Does it have a consistent operating history and favorable long-term prospects?
Management: Is management rational? Candid? Does it resist the institutional imperative?
Financial: Return on equity is what's important, not EPS. Calculate "owner earnings," look for high profit margins and make sure that the company has created at least one dollar of market value.
Market: What is the value of the business? Is there a margin of safety relative to the value?

I expect that these ideas will help me a lot in thinking through businesses that I am considering investing in. My strengths are understanding probabilities of companies succeeding based on various strictly financial characteristics (PE, EY, ROIC, etc.). It is more difficult for me to think through the business aspects, and I think that these tenets will help to focus my thinking.

1. Understand how the company makes money. I remember reading somewhere that Ray Kroc insisted on owning the property of all McDonald's restaurants. He was in real estate, not in the restaurant business. I have the benefit (the 'One Up' advantage) of understanding biotech. (My most recent thinking about this, though may mean that it's a benefit that encourages me to be extremely selective. I'll probably write more about the problems that are specific to biotech at some point.)

2. What's the operating history? What does the future hold? The company doesn't have to always have been successful in every type of market, but perhaps the lows should be not so low - or should be the entry point. For the future, the best type of business to own is a franchise. The kind of company that can raise prices to keep up with inflation, for which there is no substitute, which sells something that is desired or needed, and whose profits are not regulated. In other words, it needs a moat. Most companies are somewhere in between, either a strong commodity, or a weak franchise.

Phil Town in Rule #1 describes five kinds of moats: Brand, Secret, Toll, Switching and Price. A brand is trusted or recognized, a secret involves patents or trade secrets. There is a toll when a company has exclusive control of the market (monopoly), switching is when there is a high barrier to changing providers, and price is when a company can price competitors out of the market. I suspect that price is the weakest moat: a new challenger may have a difficulty competing, but anyone who does automatically drives margins lower. In fact, Buffett prefers to avoid commodities, and a moat built solely on price essentially commoditizes what is being sold. (I think.)

3. Is management rational? Watch how management reinvests cash: does it earn more than you could earn elsewhere? Cash should either earn a high return or be returned to shareholders as a dividend or through share buybacks. Is management cadid? How do they discuss failures and problems? Listen to the conference calls for this. Do they avoid the institutional imperative? Will they take solutions to problems that cause short-term loss of profitability in exchange for long-term solutions and profitability?

4. ROE is more important that EPS, because increases in EPS don't take into account the company's (hopefully) growing cash base.

5. Calculate "owner earnings," which is Net Income + Depreciation/Depletion + Amortization - Capital Expenditures. Use this to determine the value of the business: Estimate the future cash flows of the business. How? Do the owner earnings show a consistent rate of growth? Use that rate. Then discount that rate by the rate of bonds. This gives the current value of the company. I'm not sure that I've completely grasped this; it's something to come back to. In particular, I know that Motley Fool is a proponent of free cash flow and owners' earnings, so I'll look into it there.

6. High profit margins are a sign of a strong business and of management that controls costs. Look at the margin over the years. I suspect that looking at the SG&A over time will also be informative.

7. Make sure that the company creates more than a dollar of market value for every dollar retained. It's apparently a simple calculation: Determine the retained earnings by subtracting the dividends paid from the net income. Sum the retained earnings over the last ten years. Compare this value to the change in market value over the last ten years. If more market value has been created than earnings retained, then the market has valued the company more highly than its earnings.

8. Insist on a margin of safety. Buffett insists on 25%. Phil Town stresses 50%. The difference between these is that Phil Town knows that he's teaching beginners who have a higher probability of having made a mistake somewhere along the way; Buffett has a better chance of correctly valuing a company that someone following Rule #1.

It is one of my major goals for the year to carry out more thorough analyses of purchases. I'm going to be looking for moats and good management more than anything else (MFI automatically finds companies selling cheaply relative to most recent earnings, although more complicated analyses could almost certainly refine the margin of safety.) I also like the idea of ensuring that the company creates more than a dollar of value per dollar retained.

UEPS rises! And other news...

2006-12-12T20:04:00.000-08:00

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

2006-12-10T13:37:00.000-08:00

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

2006-12-08T21:04:00.000-08:00

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

2006-12-08T20:01:00.000-08:00

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?

2006-11-30T23:55:00.000-08:00

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

2006-11-26T15:24:00.000-08:00

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...

2006-11-25T15:29:00.000-08:00

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

2006-11-18T20:13:00.000-08:00

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

2006-11-18T20:12:00.000-08:00

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

2006-10-31T20:04:00.000-08:00

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

2006-10-23T20:15:00.000-07:00

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

2006-10-17T20:34:00.000-07:00

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

2006-09-17T18:22:00.000-07:00

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

2006-09-17T15:52:00.000-07:00

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?

2006-09-10T21:41:00.000-07:00

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

2006-09-10T19:52:00.000-07:00

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

2006-08-31T22:17:00.000-07:00

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

2006-08-29T22:56:00.000-07:00

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

2006-08-29T21:37:00.000-07:00

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?

2006-08-24T22:42:00.000-07:00

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

2006-08-24T21:25:00.000-07:00

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

2006-08-07T22:50:00.000-07:00

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

2006-08-07T22:08:00.000-07:00

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

2006-08-07T17:34:00.000-07:00

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

2006-08-07T00:09:00.000-07:00

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

2006-08-05T15:38:00.000-07:00

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

2006-08-05T15:16:00.000-07:00

(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

2006-08-05T15:14:00.000-07:00

(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

2006-08-05T15:11:00.000-07:00

(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

2006-08-05T14:59:00.000-07:00

(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.