Saturday, December 30, 2006

2006 in review

2006 was a great year for my IRA portfolio (up 28.50%). Not only did I outperform both the S&P 500 (13.62%) and Berkshire Hathaway (24.11%), I also posted my best calendar year performance. After 4 1/2 years of out-performance, I feel confident that my results so far are not a fluke.

Date      S&P 500  Delta     IRA   Delta BRK A  S&P 500   NAV    BRK A
06/23/02                                         992.72 10.00  72,200.00
12/31/02   -11.37% 42.32%  30.95% 30.18%  0.76%  879.82 13.09  72,750.00
12/31/03    26.38% -1.49%  24.89%  9.08% 15.81% 1111.92 16.35  84,250.00
12/31/04     8.99% -2.16%   6.84%  2.49%  4.34% 1211.92 17.47  87,910.00
12/31/05     3.00%  3.23%   6.23%  5.42%  0.81% 1248.29 18.56  88,620.00
12/31/06    13.62% 14.88%  28.50%  4.39% 24.11% 1418.30 23.85 109,990.00
Total Gain  42.87% 95.63% 138.50% 86.16% 52.34%    
Annualized   8.20% 12.97%  21.17% 11.43%  9.75%    

A significant factor in my success this year was that my patience with Oracle finally paid off. I bought at a ridiculously low price and Oracle proceeded to perform quite well and account for nearly all of my IRA's gain for the second half of 2002 and all of 2003. 2004 and 2005 represented a fair amount of uncertainty for Wall Street, which refused to believe that "tech mergers" worked. This year, the various acquisitions started contributing to the bottom line and Oracle's shares followed (up 40%). The interesting thing is that Wall Street still undervalues Oracle. Too many analysts focus on new database licenses to the exclusion of higher margin renewals. Also, I think the Oracle database is under-appreciated as a platform for other businesses to develop new products on. It's nice that Oracle the company is standing in the wings to buy startups that succeed.

Canon, at 23% of my portfolio, is tied for my largest holding in large part due to its exceptional performance during 2006 (up 44%). Once again digital cameras and printer-related consumables continue to be the mainstays of Canon's business. The digital camera revolution is nearly over in my opinion—most people have a digital that meets their needs. Canon is going to have to have a new product boom in the next year or so to keep up their revenue growth. Perhaps YouTube will do for digital camcorders what Flickr did for still cameras. I think Canon's management is counting on its new flat-screen TV product to drive revenue growth.

Select Comfort endured a rocky ride this year and ended down 4.6%. Operationally, nothing much changed in my opinion. They are still the same company with the same management operating in the same business as when I first bought shares nearly two years ago. It's entirely possible that macro factors such as the slowing housing market and credit tightening will make 2007 a disappointment, but over the next ten years Select Comfort ought to do very well. After buying more shares, it is now tied for my largest holding.

Berkshire Hathaway is up 23.5% since I bought it. 2006 was a spectacular year to be a reinsurer since claims were low and premiums high. (The catastrophes of 2005 are largely to blame so its possible premiums will head down in 2007.) Auto insurance continues to be a good business since cars continue to be built safer. Berkshire's other lines of business seemed to perform well during the year. From now on, a portion of my portfolio will match Berkshire's results, which is something to keep in mind when I compare my results to it.

The year end spin-off math for Alberto-Culver is Alberto-Culver ($21.47) + Sally Beauty ($7.86) + the special dividend ($25) = $54.33. Given that I bought at a dollar-weighted average of $49.34 a share, I've made nearly $5 a share or 10% on the spin-off. Alberto-Culver and Sally Beauty together make up 15% of my portfolio, which is fairly significant. But I haven't yet decided if they will become core positions. Both companies have now released initial 10-K reports, which I hope to have a chance to read in-depth soon. But I think I'll have a better idea of how the new companies operate after a quarter or two. Also, I'd like to know what Alberto's dividend will be.

The rest of my portfolio is a smattering of going-private transactions and cash. I'm also short January 2007 options on Oracle at $20, which should expire without value. In some ways, this "short-term" portion of my portfolio is the least important. By their nature, going-private transactions are very profitable, but also very small. Last year I completed 3 and initiated 2. But if they were to make a significant impact on my portfolio, I would have had to have completed something like 10. This year, I'll need to complete even more, since my total portfolio has grown considerably. On the other hand, since they require little in the way of effort, risk or capital, I see no reason not to continue attempting to make a little profit there.

Friday, December 01, 2006

Why I bought more Select Comfort on disappointing news

Yesterday, Select Comfort reported that it was seeing a massive slow-down in sales and lowered its 2006 estimate to 80 to 87¢ a share. Since the previous guidance was 95 to 97¢, this was a huge disappointment. Last year, Select Comfort earned 76¢ a share (after adjusting for a 3/2 split), so the growth this year is between 5 and 14%. Worse Q4 earnings look to be 21 to 46% lower than 2005.

What happened?

According to the press release:

“This quarter’s sales have been disappointing, as we’ve noted a closer correlation in our business with housing industry trends. Our sales programs and promotional offers have been consistent with prior years, and we are protecting product margins,” said Bill McLaughlin, Select Comfort chairman and chief executive officer.
For a high-end furniture company, this is actually a decent excuse (though not encouraging). People moving into a new house tend to want new furniture to go with it and have access to cash from home equity lines of credit. Also, if the soft housing market foretells a recession (and it seems to be doing just that), customers might be holding off on large purchases for the moment.

But I think the specific problem for Select Comfort is the new ad campaign, which started this year. Two of the new commercials are available on the company website ("Five Senses" and "Revere"). If you aren't paying attention, you might be forgiven if you think these are drug ads (probably for sleep aids, but maybe anti-depressants or ED treatments). The bed just isn't a big part of the commercial. Sure, the message is clear if you pay attention, but you've got to figure that the people who aren't fixing themselves a snack are TiVoing through the commercials. In contrast, the previous commercials were funny and focused on the mattress itself.

The good news it that Select Comfort has already addressed the problem by hiring a new ad agency. Poking around their website, I think Select Comfort made a pretty good choice with the one reservation that McKinney also has Southern Comfort as a client. Overall, they seem to produce polished, memorable commercials often using humor. Their Sony commercials are especially informative, because like TVs, men and women need to agree on buying the same bed.

Based on the low earning range ($42,160,000) and low growth range (20% a year), a DCF shows Select Comfort to be worth over $40 a share. $18 a share implies a growth rate of about 8%. A more conservative estimate works out to a fair value of $21. I'm concerned about a recession in the next year that could further hurt earnings, but I think the problems are likely to be temporary. In the meantime, Select Comfort will be able to buyback shares at a reasonable price, improve its advertising and find operating efficiencies.

Wednesday, November 22, 2006

Why I sold a call option on Oracle

Today I sold a January, 2007 call option on Oracle at a strike price of $20. The premium was 70¢ a share. Yesterday (when I placed the limit order for the option) Oracle closed at $19.48. After commisions and fees, I recorded 2.83% income on the transaction. On an annualized basis, that's 19.18%. If the option is assigned, I'll earn 4.47%, which is at least 24.53% annualized. For me, this is a win-win.

According to this calculator, the option was worth 62¢. I don't know if that's acurate or not, but it doesn't really matter to me. Option pricing models, such as the Black-Scholes model and the binomial options model, are interesting in the acedemic sense, but relying on them for actual options trading seems speculative. The problem with generic models is that they include volatility among their inputs. But the odds of a stock reaching a certain price are also influenced by the company's intrisic value and the probability of positive or negative news, which cannot be included in a generic model.

Writing a call option amounts to a soft sell of Oracle. I think $20 is a reasonable (though maybe low) selling price, but I'm not ready to put in a limit order. I also don't see any reason for the price to jump much higher in the next two months. Oracle Openworld, when Larry Ellison announced the company's Unbreakable Linux initiative, happened in October. There aren't many big aquisition targets on the horizon. I doubt the second quarter earnings release will be significantly better than expectations. In fact, given the persistent inverted yield curve, I suspect stocks in general will be flat at best.

Tuesday, November 21, 2006

Accounting for spin-offs

Now that the Sally Beauty spin-off has occurred, it's time to figure out how to account for it. Thankfully, Quicken has a spin-off transaction type. Unfortunately, it isn't entirely clear how it works. After fiddling with it for a while, I think I understand the accounting.

The first principle is that you received both the parent and the spun-off company (plus the dividend) on the day you bought the original shares. So on September 18, 2006 I bought Alberto-Culver plus Sally Beauty (plus the dividend) for $49.40 a share (and on October 23, 2006 for $49.24). The spin-off event has a retroactive effect on the original transactions.

Second, the cost basis for each company is determined by the market on the day of the spin-off. For the sake of simplicity, I'll use the opening prices, but I have seen the average of the day high and low used. I believe Alberto-Culver will file the official ratio to be used for tax purposes sometime soon. At any rate, New Alberto traded at $20.10 and New Sally traded at $7.35 (and the dividend was $25). For our purposes, I'm going to lump the dividend into the value of New Sally, because the dividend was paid for through the money Sally borrowed. Therefore, the ratio to use is Sally—61.68% and New Alberto—38.32%.

Third, a "Return of Capital" transaction on the date of purchase lowers the cost basis of the parent company by cost basis of the spun-off company. So for September 18, Sally Beauty was acquired for 61.68% of $49.40 or $30.47 a share. (And on October 23 for $30.37 a share.) Therefore, Alberto's cost basis is reduced by the same amount.

Fourth, the dividend is recorded as a return on the Sally Beauty investment. Currently, Sally trades for $8.51 a share, which is quite a bit lower than my original cost. But when you add in the $25 dividend, those shares have returned about $3 each so far. Meanwhile, Alberto has gained a little over a dollar a share since I bought it.

I've been able to get my Yahoo portfolio to more or less work out, but it requires more faking since it doesn't properly account for dividends. I wish someone would provide a really useful online-portfolio tracking system.

Monday, November 13, 2006

Sally Beauty (when issued)

Alberto-Culver shareholders approved the Sally spin-off on Friday and as of today Sally shares are being bought and sold on the "when issued" market. Since there is also a market for both new Alberto and old Alberto, it's now possible to find out what the market says about the breakup math: $25 (cash) + $7.50 (Sally) + $17.85 (Alberto) = $51.35

But it is still possible to buy old Alberto for around $50, so there is still time to take advantage of a market inefficiency. (Basically, index funds that track the S&P 500 need to sell Alberto before the index drops Alberto and replaces it with some other company.) Although I have a little more cash to invest, I'm holding back for when Sally Beauty trades on the open market and after I have received the $25 dividend. I still think Sally conservatively is worth 30% more than $7.50. I suspect that when the company releases financials, the conservative value will be even higher.

Many salons in the US resemble malls in the way they operate. Each beautician rents a "chair" from the salon and keeps any profit they earn above that. Besides the basic services like washing, cutting and styling hair, salons are also an outlet for high end hair and beauty products. These are products that you can't buy at Wal-Mart or drug stores, because the makers of those products (e.g. Paul Mitchell) are aiming for a "Professional" market. As a result, there is a distribution problem—how do manufacturers get their products into the hands of beauticians?

Enter Sally Beauty Supply and Beauty Systems Group. BSG sells only to beauty professionals and Sally sells both to the general public and (under the Sally ProCard program) to professionals. Wal-Mart, Target and drug stores are more or less locked out of Sally's market pretty much by definition. On the other end of the spectrum, it's difficult to imagine another company building or buying a distribution network that competes with Sally.

The one exception is Regis, which is consolidating the salon industry through expansion and acquisitions. As you might recall, Alberto's original plan was to spinoff Sally and merge it with Regis. That plan failed in large part because Regis suffered some operational setbacks that made the merger unlikely to succeed. Ultimately, however, product sales are likely to be merely a sideline in Regis's business. (Humberto Barreto wrote an interesting paper that uses the salon business as a modern example of Ricardian Rent Theory.)

Monday, October 23, 2006

Why I bought more Alberto-Culver

On Friday, "Prudential Equity Group analyst downgraded her rating on" Alberto-Culver. According to the AP, her reasons were "that both Alberto Culver and the new Sally Beauty Holdings face deal-related risk, and that tax obligations from the $25 special dividend may not be known until 2008." As a result, shares of Alberto-Culver dropped from $51.25 to $49.94 that day.

To address the second issue, depending on New Sally's earnings, the special dividend might be taxed as a dividend, tax-free return of capital, taxable capital gain, or a combination of the above. The dividend must be reported this tax year (assuming the proposal passes), but the final determination of how it is taxed might not be made until after New Sally's first year in operation at the end of 2007. For most people, the accounting is going to be ugly. But since I hold Alberto-Culver in my IRA, the taxes are an interesting side-note.

The other issue ("deal-related risk") is more of a concern. Without access to the complete report, it is difficult to know what that phrase represents, but I'd imagine it is a reference to the costs and difficulty of splitting a company in half. Until they have been separate for a few quarters, investors can't be sure of the extent of "one-time-charges" on or both of the new companies may incur. On the other hand, it seems to me the businesses have been more or less independent for years and ought to be up to speed quickly.

Considering why I bought shares originally, Prudential's downgrade is actually a positive sign for me. In particular, this is further evidence for point "a. Institutions don't want the spinoff (and not because of the investment merits)." The deal is complicated and it will be a few quarters, if not years, before everything settles down. Until then, institutions may not be comfortable owning shares in a company that is largely unpredictable.

In the meantime, the downgrade and resulting price drop gave me an opportunity to roll the cash I received from two going-private transactions into Alberto-Culver stock. It seems like the great value investors have a simple capital allocation strategy that I'm trying to emulate. When you have capital and an investment idea, allocate the capital to the idea.

Tuesday, October 17, 2006

Alberto-Culver breakup value

Alberto-Culver shareholders are being asked to vote on a spin-off of the company's salon products distribution business (Sally Beauty) in November. Current owners will receive one share of New Alberto, one share of 52.5% of New Sally and $25 per Alberto-Culver share. The other 47.5% of New Sally will go to a private equity fund (Clayton, Dubilier & Rice Fund VII) in exchange for $575 million, which works out to about $6.73 a share. In order to pay the special $25 dividend, New Sally will take on $1.85 billion of new debt.

Based on the current market value of Alberto-Culver and the implied purchase price of New Sally, here is a chart showing the valuation of each piece compared to some competitors:

                  Price/share Price/Sales Price/Earnings EV/EBIT
ACV               51.30       1.35        24.03          14.06 
New Alberto       19.57       1.39        25.70          17.89 
New Sally          6.73       0.50        37.21          13.68 
Cash              25.00    

Procter & Gamble  62.05       2.89        22.69          17.16 
Colgate-Palmolive 60.09       2.72        22.96          16.46 

Personal & Household Prods.   2.6         25.64 
Consumer/Non-Cyclical         2.4         22.1 
Regis             38.20       0.72        15.95          10.93 
CVS               31.25       0.69        20.96          15.56 
Walgreen          44.34       0.94        25.53          16.05 
Longs Drug        44.50       0.36        22.60          11.97 
Retail (Drugs)                0.72        24 

On this basis, New Alberto is not valued dramatically differently than current Alberto or other personal products companies. New Sally, however, looks cheap according to its P/S since it is closer related to drug stores and Regis (the salon company that tried to buy Sally last spring). Retailers, as middlemen, must carefully control profit margins in order to remain competitive, unlike consumer product companies that can nurture a brand to higher margins. The P/E ratio is less telling for Sally because it will take on so much debt. EV/EBIT, which removes the effect of leverage, puts Sally in the middle of the retail pack.

Now, let's look at how the pieces could be evaluated after the spin-off. I set New Alberto's price based on the P/E ratio of Consumer/Non-Cyclical companies and used the P/S ratio of drug retailers for New Sally's price.

                  Price/share Price/Sales Price/Earnings EV/EBIT
ACV               51.60       1.36        24.17          14.14 
New Alberto       16.83       1.20        22.10          15.38 
New Sally          9.76       0.72        38.56          13.87 
Cash              25.00

This isn't too far from the market value of Alberto-Culver, so the investment thesis is that the spin-off will allow both companies to operate more efficiently and will reveal the true value of the underlying businesses.

First, all fundamental data I've used is based on 2005 figures since only 9 months are available for 2006. So far, 2006 seems to be a fine year for the combined companies. EPS for the last 12 months is $2.37 versus $2.09 in the previous 12 months. I expect the initial financial statements from both companies will suggest a higher price per share as well.

Second, New Alberto will be debt-free and able to focus on building its portfolio of brands. The salon distribution business was a distraction and didn't provide any operating advantages since few of Alberto's products where sold in Sally stores or through Beauty Systems Group. Dumping debt on New Sally could allow New Alberto to pursue acquisitions like it recently made with Nexxus and St. Ives.

Third, CD&R has tremendous motivation to increase the post-spin-off value of New Sally. The private equity investment company has successfully invested in spin-off companies such as Lexmark and Hertz and only profits if the price of the highly leveraged stock appreciates significantly. It's helpful to view Sally as an LBO or the stub stock of a recapitalization.

Fourth, New Sally should be able to expand into new markets and increase current-store sales through advertising. Alberto's salon product distribution business has been hampered in the past because the parent company is a competitor with other vendors and predominately distributes through other retailers. Once free of the consumer products business, Sally should be able to promote itself more aggressively.

I see a purchase of pre-spin-off Alberto as a low risk opportunity to participate in CD&R's investment. Depending on how the market values New Alberto and New Sally, purchasing one or the other could be an even more rewarding investment.

Thursday, October 12, 2006

HyperFeed Technologies "perilous financial decline"

Talk about honest. HyperFeed Technologies, which has been trading between 60 cents and $1.05 over the last three months, announced a merger with Exegy Incorporated that will cash out shareholders at $1 a share. In the SEC filing, the company decided this was the best course of action "because of the Company’s perilous financial decline". I think I'll pass on this one.

Thursday, October 05, 2006

Advanced Nutraceuticals cashed out

Well, I don't think anyone could be as pleased as I was to lose a half-million dollars. My shares of Advanced Nutraceuticals were cashed out on Oct. 5 at $4 a share. On an anualized basis, it was 144.12% and one day short of beating Major Automotive, which was 144.21% annualized, as my best investment.

I was thinking about the comparsion with the S&P 500 and it occured to me that Berkshire Hathaway might be a reasonable benchmark to strive for:

Date      S&P 500  Delta    IRA    Delta  BRK A
12/31/02* -11.37%  42.32%  30.95%  30.18%  0.76%
12/31/03   26.38%  -1.49%  24.89%   9.08% 15.81%
12/31/04    8.99%  -2.16%   6.84%   2.49%  4.34%
12/31/05    3.00%   3.23%   6.23%   5.42%  0.81%
10/05/06    8.41%  20.51%  28.92%  17.21% 11.71%
Total Gain 36.31% 102.96% 139.27% 102.16% 37.11%
Annualized  7.49%  15.07%  22.57%  14.93%  7.64%

* First reporting date is 06/23/02
In a little over four years, I've managed to outperform both the S&P 500 and Berkshire, which astounded me. I can't imagine that will continue for the next four years however, because Berkshire is tremendously undervalued. Starting this year, some of my performance will be based on the performance of Berkshire thanks to the share I own. Also, it isn't a fair fight since Mr. Buffett and friends must allocate billions of dollars and can't invest in tiny companies like Advanced Nutraceuticals or even tinyer opportunities like going-private transactions.

Monday, October 02, 2006

Why I bought Alberto-Culver

Alberto-Culver can be divided into two lines of business—consumer products and beauty salon supply distribution. As it turns out, Alberto plans to split into two separate companies by spinning off Sally Beauty Supply and Beauty Systems Group, the distribution segment. The remaining company, New Alberto-Culver, will continue selling Alberto VO5, TRESemm√©, Consort and Nexxus hair products, St. Ives skin care products, Mrs. Dash, Molly McButter, Static Guard, and a few other random products.

Spinoffs tend to be a good place to find exceptional value. In You Can Be a Stock Market Genius, Joel Greenblatt suggests "certain characteristics [that] point to an exceptional spinoff opportunity: a. Institutions don't want the spinoff (and not because of the investment merits). b. Insiders want the spinoff. c. A previously hidden investment opportunity is uncovered be the spinoff transaction (e.g., a cheap stock, a great business, a leveraged risk/reward situation)." I believe Alberto-Culver possesses all three characteristics.

The transaction is a bit complicated, but the results are fairly straightforward: each share of pre-spinoff Alberto-Culver will be converted into a share of New Alberto, a share of New Sally and $25 cash. A private equity fund (Clayton, Dubilier & Rice Fund VII), will own 47.5% of New Sally, which will issue $1.85 billion in debt to pay for the dividend. So how does Alberto meet the criteria?

  1. I don't think institutions want any part of the spinoff. Half of the value of the spinoff is a dividend, and who doesn't like cash? Well, institutions don't like like large dividends because they are taxable events and need to be reinvested. New Alberto will have a significantly less interesting growth story without Sally and will be compared to Proctor & Gamble and Unilever. New Sally is the worst of all: high debt, single-digit stock price, not part of the S&P 500 (so must be sold by index funds), competes against Wal-Mart, Target and drug stores (but not really), and who wants to say they invested in a company called "Sally"? (To be honest, the whole thing seems a bit "feminine", doesn't it?) One other problem is the stench of failure since an attempt to spin/merge Sally into Regis Corporation, which runs a chain of salons, when sour earlier this year.
  2. Insiders will continue to be part of both surviving companies acting more or less in their current capacities. The family of Leonard H. Lavin, Alberto-Culver's founder, will continue to own a significant percentage of both companies and have agreed not to sell for at least a year in order to keep the tax-free status of the spinoff. CD&R has a history of guiding spinoffs to successful operations, such as Lexmark from IBM and Hertz from Ford. The only thing missing is option or restricted stock grants to increase insiders ownership.
  3. Generally a vertically integrated company has tremendous advantages because they have control over every step from manufacture to the final customer sale (think Starbucks). But Alberto-Culver is not integrated with Sally Beauty Shops or Beauty Systems Group, because only a fraction of New Sally's sales are Alberto products. Sally can't give, for instance, TRESemmé products preferential treatment, because Clairol, Revlon, Conair and L'Oreal would be displeased and might pull their products. Also, Sally must limit advertisement since it competes with stores that carry Alberto products. Rather than being an asset to the other, each company is a potential liability.
I had a bunch of other great insights, but managed to corrupt this post. I'm sure I'll get around to posting them later.

Saturday, September 30, 2006

American Education cashed out

My shares of American Education were cashed out this morning at 55¢ a share. Including the commision of my purchase, that's a 12.27% gain versus 0.33% if I had invested in the S&P 500. On an annualized basis, that's 78% which easily exceeds the 5% hurdle I use for these relatively safe going-private investments.

This sounds great, but I only made $30. Even if I were able to buy the 1999 shares I wanted to buy and didn't pay a commission, my grand total would have been $199.90, which isn't all that much. On the other hand, now that I've survived a few of these deals, I don't think it will take more than an hour or so to research new going-private situations. Mostly, I just need to read the proxy on the SEC's website and do a little math. If commissions continue to become a less important cost (because of inflation or my broker becomes more generous), these little investments could be even more profitable (though at no larger scale).

I've been reading Warren Buffett's Partnership letters, which provide an interesting "pre-history" to the Berkshire Hathaway letters. (Berkshire first appears in the January, 1966 letter, but Buffett has made purchases of its stock as far back as 1962.) One repeated theme in them is the categorization of investements into "general", "workout" and "control". General investments are purchased because they are cheap (either compared to their liquidation value or relative to similar companies) and tend to move in the same general direction as the market. Workout investments are purchased because some future event (not just rumored, but published in the paper) will unlock hidden value. Control investments are companies that the Partnership had influence over by reason of a large ownership stake. The last two investment types are largely uninfluenced by the general market.

Until this year, 100% of my investments have been in the general category (or cash), so my results ought to have followed the market. This year, I've been working in some special situation investments (workouts), so my results ought to be better in down markets and keep up (maybe) in up markets. (Joy and I do have "control" investments in a sense because of our careers and Joy's Pampered Chef business. It's difficult to assign a value to them, but they will provide far more earnings to us than our retirement accounts for a great many years.)

Here are my results since I opened my self-directed IRA:

Date       S&P 500   IRA    Difference   
12/31/02*  -11.37%  30.95%  42.32%
12/31/03    26.38%  24.89%  -1.49%
12/31/04     8.99%   6.84%  -2.16%
12/31/05     3.00%   6.23%   3.23%
09/29/06     7.01%  23.32%  16.30%
Total Gain  34.56% 128.88%  94.31%
Annualized   7.20%  21.39%  14.19%

* First reporting date is 06/23/02
The first "year" (actually closer to 6 months), was entirely the result of a single stock—Oracle. 2003 and 2004 were poor years as Oracle and Canon lost ground. In 2005, the addition of Select Comfort made up for the flat performance of the other two holdings. So far this year, the situation has reversed. In addition, I've purchased Berkshire, which has not done much so far, and some special situations, which have added to the account's returns. Beating the market by 14% a year isn't a realistic goal, but the wild swings are likely for a concentrated portfolio.

Friday, September 29, 2006

Canon innovations

One of the things that makes a consumer products company like Canon successful is finding ways to get the same consumers to buy new products over and over again. An example of how this can be done is found in a Fortune camera review:

Designed for serious amateur photographers but also friendly to the casual point-and-shooter, the Canon Rebel XTi also features a built-in cleaning system that reduces the chance that dust inside the camera will spoil a shot, a bugaboo that plagues most other cameras in its class. No matter how careful one is when changing lenses, dust can enter the camera body to ruin subsequent shots. The XTi literally shakes any dust off the sensor when the camera is turned on or off, using ultrasonic vibrations. The motes are then immobilized on a sticky trap. Also, the camera can "map" stubborn dust particles on the sensor and then erase them from images via software.

These seemingly minor innovations can add up to making older products completely obsolete every few years. The faster the innovation cycle, the more often consumers will want to get the latest thing and the more sales companies like Canon will make.

Friday, September 22, 2006


I just felt like crowing this morning, because my IRA has a market value over a half million dollars. Unfortunately, most of the balance is based on a single position, Advanced Neutraceuticals Inc. My 499 shares are trading at $1,025.000 for a grand total of $511,475.00. Sadly, my sell order online fails with the following message: "We are unable to process the order referenced above. This security is subject to a corporate action. Please call our Customer Service line if you need further assistance." In the crazy world of high finance, I'm bound to lose my first half million almost as quickly as I gained it.

P.S. There was a little bit of drama just before the shareholder vote. Fortunately, it seems to have worked out for me, though it wouldn't be the end of the world to have been left with a small, cash-flow positive company with manageable debt and insider-buying.

Monday, September 11, 2006

Why I bought Advanced Nutraceuticals

I've gotten a bit behind in my investment rationals, so before I forget, I better write this down. This is another going-private transaction that was initially priced at $3.20 a share for holders of fewer than 500 shares. On July 25, the offer was raised to $4 a share. Up to now, my rule has been to wait for a definative proxy before buying into these sorts of special situations, but I realized that raising the price of the offering is a similar signal that the transaction will happen. There's no particular reason a company should raise the offer unless the SEC thinks it is unfairly low, so once the offer is raised, there's a good chance the going-private transaction will be approved.

Tuesday, July 25, 2006

Why I bought American Education Corp

American Education is another going-private opportunity that I nearly screwed up. My purchase accounted for exactly half of that day's volume (500 shares). I had intended on buying 1999 shares so that the commission would be minimal, but I didn't check the "all or none" box when I entered the order on my broker's website. As a result, I initially only bought 100 shares, which would have cost me a small amount. Instead, I stand to make a small amount. My return, however should be quite satisfactory.

Tuesday, July 11, 2006

Classifying investment decisions

I recently read an article by James Montier, who wrote "Behavioral Finance - Insights into Irrational Minds and Markets." He suggested classifying investment mistakes into 4 categories based on two axes:

Good outcomeBad outcome
Right reasonSkillBad luck
Wrong reasonGood luckMistake

Thinking about the decisions that I've recorded here, I can see that all of the individual stock purchases and the single sell have been very good outcomes. In fact all of my positions are beating the S&P 500 index and all but one (Berkshire Hathaway) have annualized returns better than 15%. Looking over the reasons I documented for those decisions, I think I can label my success as mostly skill. I focused on fundamentals and the fundamentals of each company have been good and improving.

The mutual fund investments I've made in my 401(k) had mostly good outcomes. I spent way too much time distrusting active funds (by stayin nearly 100% invested in an index fund) and I picked a poor time to become a bond investor. In the first case, I think I made a mistake by focusing too much on fees. In the second case, I think I've had a bit of bad luck.

But it's a lot harder to evaluate the decisions that haven't resulted in purchases or sells. It's a bit harder to analyze "sins of ommission" at least in part because they don't tend to leave traces in our memory. On the other hand, as Warren Buffett says, there are no called strikes in investing. It's entirely possible I would have made more money by purchasing my half-thought out or rejected ideas. But I'm not sure I would be as comfortable with them.

Wednesday, May 03, 2006

"Revenues are Good, Costs are Bad" and Other Business Myths

Just reading the first myth in "Revenues are Good, Costs are Bad" and Other Business Myths made me think of the struggle Oracle has with the Wall Street analysts who cover it. Oracle has two basic sources of revenue: new licenses and license renewals. New licenses are seen by Wall Street as more desirable since they represent revenue growth. But renewals are much more profitable because Oracle doesn't have to pay a salesman to drum up the bussiness.

Wall Street would also like to see more of Oracle's revenue growth come from its own products rather than from buying competators. But if Oracle can obtain customers more cheaply by buying other bussinesses, it's in the company's interest to do so. The same argument can be made about R&D spending versus buying other company's products.

Tuesday, April 25, 2006


I just want to lay claim to a word I coined in the middle of the night:

To project that the future will be less prosperous than the present.

Wednesday, April 05, 2006 Canon

So Canon Stock Has Biggest Gain in 2 Years on Digital Camera Sales according to Bloomberg. Not bad. In Tokyo, Canon ended at ¥8,300. $1 = ¥117.38 at the moment, which should mean Canon would trade at $70.67 or so in New York. It actually ended at $71.32, so there seems to be a small "Japan premium" built into the NYSE price. Perhaps that is because the market agrees with Bill Gross that the dollar is headed down—against the Yen in particular.

Naturally, it makes sense to ask if Canon is now overvalued. Quicken's DCF model suggests that the company needs to grow 6.3% over the next 10 years in order to justify its current price when discounted against the S&P 500's long term rate. Even if Canon doesn't expand into new markets, I think 6-7% growth is very likely. And if new products do succeed, 10+% growth should be possible.

Tuesday, April 04, 2006

Investment returns redux

I discovered an error with the spreadsheet I used to generate my investment returns. It turns out I hadn't adjusted the S&P 500 index price for some of my purchases. The effect was to make the Benchmark column wrong:

Stock             Opened  Price  Closed   Price Annualized Benchmark
Oracle           6/24/02   8    5/28/03   13.35     67.05%    -9.94%
Major Automotive 2/28/06   1.75 3/29/06    1.90    144.21%   -11.13% 
Oracle           6/24/02   8     4/4/06   13.84     14.99%     6.80%
Canon            12/9/03  45     4/4/06   68.56     19.04%     2.19%
Canon            12/1/04  49.66  4/4/06   68.56     26.38%     5.34%
Select Comfort    2/9/05  19.95  4/4/06   39.80     80.44%     6.60%
Berkshire (B)    1/31/06   2920  4/4/06    3001      8.29%     2.57%

Now I'm 100% both on absolute and relative terms. Obviously this was a pleasant surprize. Even better, I've been tracking my time-weighted internal rate of return and my IRA is earning about 20% annualized. Since I've held a lot of cash earning less than 4% most of that time, I feel pretty confident in my ability to make good investments over time. If anything, I ought to be making more trades.

Monday, April 03, 2006

Maxco off my watch list

It's sort of sad, but Maxco, Inc. Announces Abandonment of Proposed Transaction to Terminate SEC Registration. This was the first company I started watching for a possible going private arbitrage opportunity. The lesson is to wait for a definitive proxy.

Investment returns

After selling Major Automotive, I started to wonder how well the other positions in my IRA have faired. After cosidering commissions, my two closed positions are:

Stock            Opened   Price Closed   Price Annualized Benchmark
Oracle           6/24/02  8     5/28/03  13.35  67.05%     -9.94%
Major Automotive 2/28/06  1.75  3/29/06  1.90  144.21%    -59.70% 

And here are the open positions assuming commissions, dividends, and today's closing price:

Stock            Opened   Price Closed   Price Annualized Benchmark
Oracle           6/24/02  8     4/3/06   13.79  14.89%      6.68%
Canon            12/9/03  45    4/3/06   67.41  18.20%      2.00%
Canon            12/1/04  49.66 4/3/06   67.41  24.85%     20.25%
Select Comfort   2/9/05   19.95 4/3/06   39.73  80.41%     24.32%
Berkshire (B)    1/31/06  2920  4/3/06   3012   10.78     332.30%

As you can see, all of my investments are currently in the black and I'm 6 of 7 against the S&P 500. Obviously this won't hold up in the future.

Friday, March 31, 2006

SC 13E3 filings

Here are my notes on some recent SC 13E3 filings:

Pegasus Solutions, Inc.
Merger valued at $9.50 a share. Currently trading at $9.39.
Yadkin Valley Company
1-for-50 reverse stock split valued at $78.00. Currently trading at $97.50 a share.
Asconi Corporation
1-for-30 Reverse Stock Split valued at $1 a share. Currently trading at 30 cents a share.
Badger State Ethanol, LLC
Reclassification of Class A member units to Class A-1 member unit for holders of fewer than 20 units. I can't find any trading information on the units.
The Sports Authority, Inc.
Merger valued at $37.25 a share. Currently trading at $36.98.
Foodarama Supermarkets, Inc.
Merger valued at $53 a share. Currently trading at $52.
Masonite International Corporation
Went private in the spring of 2005. I think this is a bug in the SEC's script.
Obsidian Enterprises, Inc.
Went private on March 17. (Timothy S. Durham is also related to this transaction.)
Scheid Vineyards Inc.
1-for-5 Reverse Stock Split valued at $9.25. Currently trading at $6.64.
Stratford American Corporation
Merger valued at $0.80 a share. Currently trading at 78 cents.
Instrumentation Laboratory S.p.A.
Tender offer valued at U.S.$0.98 per ADS. Currently trading at 50 cents.
Lafarge North America Inc.
Tender offer valued at $75.00 per share. Currently trading at $83.86.
Cruzan International, Inc.
Went private on March 22.
Rogers Wireless Communications Inc.
Went private in 2004. Another bug, I think.
William Lyon Homes
Tender offer valued at $93.00. Currently trading at $97.30.
Chiron Corp.
Tender offer valued at $45 a share. Currently trading at $45.70. This is an interesting case. Novartis is trying to by Chiron, which made news recently because it is major supplier of flu vaccine. But it isn't clear how shareholders will vote, since two proxy advisory services covering the deal are split.

These notes cover March 20 to March 30, and as you can see, there aren't any real prospects here. Most of these filings cover tender offers and mergers, which are too competitive. Anyone can make money if they guess the outcome correctly. Yadkin Valley Company is trading (very thinly) above the offer price. Asconi Corporation would be only be worth $29 if someone gave you 29 shares, so the commission would kill me. Scheid Vineyards pays out only $37. So far, I don't see any worthwhile deals.

Thursday, March 30, 2006

Raytheon raises its dividend

Raytheon announced that it is raising the quarterly dividend to 24 cents a share. Last year it was 22 cents and for several years before that it was 20 cents per share per quarter. The new rate pushes the dividend yield over 2% at current prices, which isn't great on its own. But the new trend toward increasing the dividend is very encouraging. One the reasons I feel good about Canon, is that every 6 months management raises the dividend a notch. Giving out cash is not only very good for shareholders, it signals that management is comfortable with the future of the business.

SEC webpage hack

First, I'm using definition 3. a., not 3. b.

Easily the most difficult part of investing in reserve split cashout situations is finding the SEC filing. Companies that intend to "go private" initially file a SC 13E3 ("Going private transaction by certain issuers"). Later they might file a SC 13E3/A (" [Amend]Going private transaction by certain issuers"). Often those filings refer to either a SC TO-T ("Tender offer statement by Third Party") or a PRER14A ("Preliminary Proxy Soliciting materials") which contain the details of the transaction. Normally, companies that are merging or buying out all outstanding shares are less interesting than reverse splits. All of this takes some digging.

Fortunately, the SEC offers an interface to recent filings, but the menu only goes back five business days. But if you change the URL, you can see filings any number of days old. Today's 13E3 filings are: The ones filed two weeks ago are:

The next step is to search through the filings for good or potentially good deals. Since the same companies might amend their 13E3 filings dozens of times, it's good to take notes so that you don't duplicate research.

Wednesday, March 29, 2006

Major Automotive transaction completed

I bought Major Automotive on February 28 for $1.75 a share and received $1.90 a share this morning. After accounting for commission (on the purchase), I made $129.90 in 29 days. If I could make this transaction on a continual basis, I'd earn 144% a year.

Of course, the problem is that there aren't enough of these situations and they aren't big enough to constantly do them on a large scale. Which is just as well for me, since if they were, the opportunities would disappear.

Wednesday, March 08, 2006

Major Automotive goes private

I'm one step closer to collecting a quick $128 profit according to this 8-K filing.

Friday, March 03, 2006 - Oracle? Buy, sell or snooze?

I think Oracle might be undervalued again. As you can guess from the title - Oracle? Buy, sell or snooze? suggests that Oracle is sleepy stock that isn't worth pursuing. That may be (certainly it has been true for last year or so). Let's go over Matt Krantz's arguments step by step.

"Step 1: Measure the stock's risk and reward."

Beta is the measure of how a stock's price moves in comparision with the overall market. According to Oracle's beta, the stock is extremely risky. (It also suggests that Oracle isn't a sleepy stock.) This chart illistrates the risk.

I think most people would be happy with this sort of risk, but it's obvious that if you bought at the wrong time (during 2000) you would have lost a ton of money. On the other hand, if you bought at some of the right times (not during 2000), odds are good you would have come out ok. (I originally bought in 2002, so I'm feeling pretty good about Oracle right now.) If you know how to evaluate Oracle, high beta is actually a plus.

"Step 2: Examine the stock's earnings multiple."

According to the article, Oracle looks pretty good from the P/E ratio standpoint. "But even this should give investors pause, because it shows that Oracle's profitability (defined by return on equity) also has been declining sharply. This is not an encouraging sign." As a matter of fact, since its peak in 2000, ROE has fallen from 97.5% to 26.6%. For comparision, Microsoft's ROE peaked in 1997 at 35.3% and fell to 10.9% for 2004. It's now at 25.5%—a bit less than Oracle. Let's just say, I'm not discouraged.

"Step 3: Calculate the company's value using forecasted future cash flows."

Using the discount cash flow tool at I find that is worth somewhere between $11.50 (if you take beta into account) and $13.18. The key assumption is a 12.2% growth rate over the next five years. I think this growth rate is possible, even likely, but I'll talk about why in a moment. Since Oracle is currently priced around $12.80, I'd say it's overpriced if you think beta is a good proxy for risk and fairly priced if you don't.

"Step 4: Check the USA TODAY Stock Meter score."

To be honest, I don't have any idea what this adds to the argument. I tried out a few other stocks to see what their "USA TODAY Stock Meter score" might be, and most companies seem to be in the 3.0 region. I guess I'm not sure what it tries to measure.

So the real question is will the aquistions of PeopleSoft and Siebel provide enough extra earnings to make Oracle's current price a bargain? I think Oracle paid too much for that to happen from cost-cutting alone. As a shareholder, I'm betting that there will be more opportunities for Oracle to sell expensive bundles to companies as a result of these aquisitions. I see Oracle in much the same situation that Microsoft was in around 10 years ago.

Tuesday, February 28, 2006

Why I bought Major Automotive

Today I bought 999 shares of Major Automotive at $1.75 a share. Nearly 100% of the reason may be found in a recent SEC filing. I haven't had many good ideas for long-term investments, so I thought I'd try out an idea for a short-term investment I'd recently read about. The basic idea is to invest in shares that will be cashed out in order for the company to go private.

My hurdle rate for short-term investments is the 4-5% that I will be getting from the money market account my cash will be invested in over the next few months. If I don't expect to earn that rate, I'm better off staying in cash. The Major Automotive proxy says that anyone holding fewer than 1,000 shares will receive $1.90 in cash if the deal is approved. So I stand to receive $1,890.10 for my 999 shares. Including commission ($19.95), I spent $1768.20 to buy my shares, which works out to a $129.90 gain. Obviously, this isn't going to be a huge investment in absolute terms, but it is a little over 7% rate of return.

The one thing I don't know, however, is how long it will be before I get the cash. If the deal is approved at the annual meeting on March 3, and the paperwork takes until the end of the month, I'll be holding the shares for about 1/12 of the year. On an annualized basis, my return (130%) blows away the hurdle rate. Of course, it could take longer than that. But as long as it doesn't become a long-term investment, I'm in good shape.

Monday, February 06, 2006

Why I bought Berkshire Hathaway

Actually the question might be why I didn't buy Berkshire Hathaway earlier. After all Mr. Buffett's annual letters taught me how to value businesses and inspired me to try my hand at investing in individual stocks. The basic insurance business is one of the all-time great business models. Shortly after my wife started her Pampered Chef business, Berkshire bought the company. I've known about GEICO since long before it advertised in earnest. And of course, I'm a big fan of Dairy Queen and See's Candy.

But the strange array of assets that make up the company is a bit hard to value. Thankfully other people are interested in that question as well. A little while ago, I discovered the Berkshire Hathaway Intrinsivaluator. Of course, I've substituted a complicated set of models that I don't completely understand for a business that was complicated, but explained in relatively simple terms by Mr. Buffett. But the nice thing about the models is that we have an objective judgment that extends back through the years.

Currently, the models suggest that the shares are fairly cheap, but not at "cigar butt" level. And going back in time, the intrinsic value for the various models seems to grow by fits and starts. But the price jumps all over the place—far too cheap in 1981, over valued in 1996, and everywhere in between. Lots of times, the market seems to have a handle on the value as calculated by the models.

The real problem with an accurate evaluation, is the nature of the insurance contracts Berkshire writes. Someday there will be one or more super-catastrophes that could threaten the solvency of Berkshire Hathaway if it became undisciplined. In his 2002 letter, Mr. Buffett said, "Had Gen Re remained independent, the World Trade Center attack alone would have threatened the company's existence," in reference to a recently acquired reinsurance subsidiary. But unless and until such a disaster occurs, an insurance company can use the premiums it hasn't yet needed to pay claims (called float) to invest as it sees fit.

In some ways, investing in Berkshire Hathaway is like investing in a large and sucessful mutual fund. On the one hand, the past returns look outstanding. On the other, it becomes harder and harder to find good investments for the cash that keeps rolling in. Unlike a fund manager, Warren Buffett isn't restricted by investment style or SEC restrictions on funds. He may buy whole companies—even privately held companies. And so far, he's managed to get a good return.

Monday, January 09, 2006

The purpose of R&D

The companies I invest in tend to have a high rate of R&D expenses. I suppose some of that is rub-off from where I work. I'd like to have a part in developing cool new technology like fuel cells.

But creating new products is only part of what I look for in a company's R&D. I also would like to see research that makes existing products better and cheaper to manufacture. Not only is it lower risk, it also is harder for other companies to copy. This sort of research can lead to long-term competative advantages.

Why I'm buying the PIMCO Total Return bond fund

For the past year or so, I've been concerned about my original strategy of investing heavily in an S&P 500 index fund. For one thing, I've been investing in active funds that beat their index over the course of several years. Also, it seems like the index is biased toward expensive stocks. I still like the low fees, but I'm concerned that the indexing strategy will be costly if there is a recession—especially since P/E ratios are so high.

Recently, the yield curve inverted slightly. So I decided to move about half my index fund "ballast" into a bond fund.

I only considered funds with expense ratios < 0.5% and manager tenure of 10 years or more. Here are the returns for all candidates in my 401(k) plan:

Investment Name   1 Yr 3 Yr 5 Yr 10 Yr LOF
PIMCO Total Return Inst CL 2.58% 4.89% 6.84% 6.98% 8.54%

PIMCO Total Return is the largest of all bond funds in terms of net assets. For a stock fund, that would be a huge negative, but a bond fund should scale better. Costs are everything in bond funds, since there is little room to differentiate on the basis of picking individual bonds. Unlike stock funds, size doesn't lock bond funds out of the best investments.