Insiders are Buying

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?

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

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

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

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

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

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

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

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...