Options revisited

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

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

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

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

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"

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

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

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...

...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

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...

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

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

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?

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

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

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...

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

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

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

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

My Experiment in LEAPs

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

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

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

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

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

December buys, part I

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

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

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

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

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

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

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

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

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

WIld ride

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

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

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

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

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

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

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

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

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