Friday, December 14, 2007

Why I bought yet more Select Comfort

This might be a mistake. Yesterday, when I wrote the post on Select Comfort's problems, I got angry. The market is completely hammering this company and it has gotten out of hand. Every DCF model I use suggests the market is pricing in zero growth—forever! Now if we were talking about First Marblehead, I suppose I could see how that might happen. The student loan business depends on a complex web of legal, political, financial, and societal conditions. If any one of these change, the business could cease to be profitable. But Select Comfort sells mattresses. People will always need them.

Right at this moment, people aren't buying mattresses. Or to be more accurate, people aren't buying mattresses unless they are really cheap or have Tempur-Pedic on the label. I think that's for exactly the same reason that houses in Bel-Aire are selling at record prices, but aren't selling at all in other parts of Los Angeles unless the price is rock bottom. Rich people haven't been hurt by inflation, housing prices, and risky loans the way the rest of us have, so they can buy premium products. I blame Select Comfort's management for not adjusting to the current reality, but I don't think they can screw this up so badly that sales won't come back in a year or two.

While we are on the topic, management has screwed up lately, but the results of the past year ought to shake them up and get them focused on the right things. From the business update this week, I think it has. To me, it was outstanding news that they refused to give guidance for the rest of this year or next. Wall Street hates that, but if management can't be sure what is going to happen, they really ought to stay quiet. Hopefully they have permanently stepped off of the beat-the-numbers game.

My purchase at $6.50 today increased my share count by a third, but only increased my cost basis by a sixth. I intend to aggressively sell call options on my shares in order to create a synthetic dividend. Maybe this isn't rational, but I think the market is mis-valuing Select Comfort and I want to capture some of that difference. I guess another way to put it is that the market is pricing Select Comfort as if it will screw everything up from now on and I think the odds are low that will happen. So I'm adding to my position. But I'm not so sure the market is wrong that I'm willing to take on more downside risk without getting paid.

Thursday, December 13, 2007

Select Comfort not getting any better

Select Comfort gave a brief overview of 4th Quarter results and there is very little to like about them. The current advertising isn't working except for specials and sales. When a sale ends, the stores lose significant traffic. Worse, the company will be raising prices in January to cover increased materials prices. The last year and a half has been miserably poor for shareholders.

I'm listening to Winning by Jack Welch and it opened my eyes to where Select Comfort is going wrong. Traditionally, mattresses are a commodity business. According to Mr. Welch, there are only three things a commodity producer can change: a) price, b) quality, and c) service. Like the NASA mantra (cheaper, better, faster), you can only choose two. So, for instance, at Costco, you get price and quality (= value), but no service. At a traditional mattress store, you get more service, but sacrifice either quality or price. Until recently, Select Comfort was able to side-step that game because they had an innovative product that differentiated itself by being a completely separate category—adjustable mattresses.

This past year, other companies began to invade the category. I noticed that advertisers have started using phrases like "select your level of comfort" that are right out of Select Comfort's play book. Costco now sells mattress very similar to the Sleep Number bed. Further, other technologies such as memory foam are becoming mainstream. In other words, the air mattress is now a commodity.

Now there are two choices for the company: shift to a commodity strategy or find some other way to innovate. Now we don't know what direction management will take but I think we have some clues. Last month, Select Comfort hired a new Chief Marketing Office, Catherine Bur-Hall. Before that, Ms. Hall was a Vice President of Marketing at Midas Printing. Printing is even more of a commodity business than mattresses and from what I can tell, the Hong Kong company has focused on quality and service as its strategy. If it's going to be a commodity, those are the areas Select Comfort is likely to have greatest strength.

When I last bought this company, I made a mistake. I thought their product had a sustainable advantage that could be exploited for years to come. I thought they owned enough mind-share to propel the brand forward with a few tweaks to the advertising. I think management made the same mistake. The cost in terms of market value has been substantial and I think the board needs to hold management responsible.

But the market has clearly over-reacted. At $6.63, earnings would need to shrink by 5% or so over the next ten years in order to be justified. Given more reasonable growth rates, the price should be $15 to $18 a share. The market is assuming that not only will Select Comfort become a commodity business, but it will also fail to be competitive. Those are far from certain in my opinion.

Wednesday, December 12, 2007

Citizens Financial Corporation shares cashed out

My shares of Citizens Financial Corporation were cashed out at $7.25 this morning. That works out to be a 9% return and 68% annualized. This transaction took exactly 2 months and nearly a month from when the reverse split was effected. That took longer than I had planned and I'd started to worry that something had gone wrong. Today, it was as if a heavy load had been lifted from my shoulders. Intellectually, I knew this transaction would likely take a while since only rarely do they pay off quickly. But emotionally, it has been difficult to see those shares sitting and waiting to be cashed out. There is an emotional toll to investing in zero liquidity stocks.

Monday, December 10, 2007

More opinions on First Marblehead

I'm finding that many value investors are now focused on First Marblehead as a great investment. For instance, Whitney Tilson highlighted the company in his most recent Financial Times article. In general the gist of these opinions is that while student loan backed bonds might not be selling well right now, the longterm outlook of the industry is quite bright. Further, Marblehead has been tainted at least somewhat unfairly by the mortgage backed security brush.

The problem, however, is that all of us are excited about First Marblehead's value mostly because of the research done by Tom Brown. He could very well be wrong on this stock and so would all of us who have followed his analysis. So rather than having a diversity of opinion, value investors might be trapped by group think. On the other hand, Wall Street analysts seem to be trapped on the other side by Matt Snowling's research. One side is going to be shown correct and for the moment, my money is on Mr. Brown.

Friday, December 07, 2007

First Marblehead cuts its dividend

Finally some bad news from First Marblehead to justify its massive price drop. Here is the key paragraph from the press release:

"Due to uneconomic terms in the current capital markets, we have elected not to securitize private student loans this quarter. We are exploring non-securitization and securitization alternatives for future quarters to enhance our business model and provide long-term capacity to the private student loan market in a manner that benefits our shareholders. Our business volumes remain strong and we see many opportunities to facilitate and process private student loans," said Jack Kopnisky, Chief Executive Officer and President of The First Marblehead Corporation. "Our Board of Directors determined it was prudent to continue to return capital to our shareholders this quarter even during these challenging times."

Cutting the dividend is pretty close to a cardinal sin in my book, but I'm not ready to dump my shares yet. For one thing, the stock has dropped faster than the dividend, so the shares are still undervalued. For another, it isn't clear to me that this is a real cut. A year ago the dividend was 12¢ a share, which is what it will be this quarter too. Further, the press release makes the cut sound temporary and tied to the failure to securitize loans this quarter. If so, First Marblehead's earnings might be pushed into next year rather than cut off.

I don't think I've made a mistake here since I don't try to pretend to predict the market for privately placed bonds that Marblehead operates in. Clearly their raw material (student loans) are available in abundance, but customers (investors) are reluctant to buy. The good news is that these loans are probably higher quality than most others on the market so when buyers return, they will look at FMD bonds first.

Thursday, December 06, 2007

A losing year

2007 will almost certainly be a losing year for me. Here's where I stand as of this morning:

Date       S&P 500   Delta     IRA   Delta   BRK A
12/06/07      5.27% -10.95%  -5.68% -39.97%  34.28%
Total Gain   50.40%  74.55% 124.95%  20.38% 104.57%
Annualized    7.77%   8.25%  16.01%   2.00%  14.01%
Remember that I own Berkshire stock, so part of my portfolio is supported by this year's 34% gain. Berkshire is now well above the "inflation +10%" benchmark since the opening of my IRA. Select Comfort and First Marblehead have cost my portfolio the majority of the underperformance its experienced this year.

Select Comfort has not performed well in over a year in business terms. I think the company has been disproportionally impacted by the housing slump and management has made some disastrous mistakes. At this point, however, the market seriously undervalues the company even after accounting for very real degradation of fundamentals. There's no guarantee management will right the ship, but Wall Street is treating the mattress retailer as if it has no upside. I made a mistake by not selling a year ago, but I would be a buyer at this price if I didn't already own shares.

First Marblehead, which is down another 8% today, has not had any business problems to speak of and has plummeted almost from the moment I bought it. This is pretty clearly a case of Wall Street blinded by the company's association with other, more troubled financial stocks. As I've been pointing out, unless there is fraud we haven't heard about, this stock should not trade less than $30 a share. My hope now is that the low prices stick around until the next few dividends can be reinvested for me.

Wednesday, December 05, 2007

Business of charities

The end of the year is always the most important in terms of charitable giving, so I think I'll take a moment to look at what makes a charity worth giving to. First, you need to look at a charity qualitatively and then quantitatively. In other words, no matter how efficient a charity is financially, there's no point in giving to it if you don't support the cause or the way the charity pursues it. For instance, I'm fairly ambivalent about animal causes (I think we should focus on people first) so I wouldn't consider giving to one. And I don't much like PETA's tactics, so I definitely would avoid them even though they are fairly efficient about getting money to their cause.

I am interested in International Christian organizations, such as Samaritan's Purse. The link is to Charity Navigator, which rates the financial statements of charities. More about that in a minute. Two of my favorite programs are Operation Christmas Child, which let's donors give a shoe box of gifts to a poor child, and community development programs, that help people become self-sufficient. Qualitatively, it's a great organization, but what about the finances?

From a financial perspective, a charity isn't much different than a for-profit business. There are revenues, expenses, and a bottom line—only the bottom line is used to support some cause rather than owners or shareholders. The first expense, is fundraising, which corresponds to the cost of goods and services in a traditional business. Charity Navigator looks at this expense in two ways: as a percentage of expenses and as a percentage of revenues. Normally these are pretty close to the same ratio, but some charities spend more or less then they take in which causes one ratio to be higher than the other. In both cases the better charities will spend less on fundraising. Samaritan's Purse spends about 4¢ to raise a dollar of support and 6% of its expenses are related to fundraising. An excess of $67,924,383 accounts for the discrepancy.

It's important to compare apples to apples when you look at finances. For instance, every time there is a disaster in the news, the Red Cross gets a ton of free advertising. Meanwhile, my wife is the fundraising coordinator for a small pregnancy clinic that gets no government support. They hold a fundraising banquet every year that generates significant donations, but also costs a fair amount to put on. Comparing those charities by any objective measure isn't really sensible. In general, bigger charities and those with notable brands do better than others.

The next major expense is Administrative, which most correlates with operating expenses in the corporate world. As a percentage of expenses, the smaller the better. Samaritan's Purse spends about 5% on administering its programs, which means (after backing out fundraising) 89% of its expenses are directly related to programs. As a result, it has an excellent efficiency rating from Charity Navigator. I should point out that these measures of efficiency are closely tied and programs could be rated on what percentage of expenses are directly linked to programs with out losing too much information.

Besides efficiency, Charity Navigator also quantifies what it calls capacity based on revenue growth, program expenses growth, and working capital ratio. Roughly speaking, the faster a charity grows and the larger its ready reserve, the more people it will be able to help in the future. Again, its important to consider the context of a charity. Larger charities tend to have advantages in terms of growth and reserves. Samaritan's Purse's revenue has grown 24%, its programs 16% and it has about 5 months of working capital saved up for emergencies.

Personally, I like to donate to small charities that I have some personal connection to. For instance, my wife and I support several missionaries who are our friends. These small gifts have a much bigger impact than if we gave to larger organizations. We also think about how to get our contribution to the organizations we support as efficiently as possible. Usually, writing a check will help more than giving a credit card number to a telemarketer. Finally, we don't give to every charity that sounds good. Concentration helps keep costs down and increases the impact we can make.

First Marblehead just got cheaper

Well, another analyst has downgraded First Marblehead, which has caused the shares to fall once again. The downgrade hinges on a review of 16 notes by Moody's:

The ratings review is prompted by worse than expected performance of the underlying student loans. In particular, loans originated through the direct-to-consumer channel appear to default at a significantly higher rate compared to loans originated through school financial aid offices.
Also, it appears the company will not securitize any more loans this year, which pushes earnings into next.

Now there is no doubt that earnings in the short term will be hurt if the ratings of these notes are reduced and there is no further securitization this year. And I am troubled that direct-to-consumer loans, which are the most profitable for Marblehead, are the culprits. But none of these things are likely to be long-term problems for the company. As long as the dividend does not get cut (and considering cash flow, I don't see how it could), the company trades at least 2/3 of its fair value. Since I plan on reinvesting my dividends for years to come, today is actually good news.

Tuesday, December 04, 2007

Praising with faint damnation

An analyst downgraded shares of Oracle Corp. late Monday, saying a slowdown in spending on software by companies may pressure its earnings.

JMP Securities analyst Patrick Walravens downgraded the business-software maker to "Market Outperform" from "Strong Buy" and lowered his price target to $23 from $24.

"While we still believe Oracle will outperform the software industry, our due diligence suggests Oracle's business is slowing along with enterprise software spending," Walravens said in a client note.

JMP conducted a survey of 38 businesses across the economy and 61 percent said their software spending would stay the same or fall in 2008, he said.

"This survey result is the worst we have had since 2001 and is similar to the result in May 2003, which marked the beginning of a two- to three-year choppy period for Oracle's business," Walravens said.

Business in the Americas may be the slowest, he said, and should be helped by performance in Europe, the Middle East and Africa. Yet the slowing North American unit may make the company's forecast conservative, Walravens said. He lowered his 2008 earnings forecast to $1.21 per share from $1.23 per share.

From an AP story.

It's hard to get too worked up about this "downgrade". For one thing, I don't know what the difference between "Strong Buy" and "Market Outperform" might be. Second, $23 is still a pretty good premium over the current price. Third, the difference between $1.23 and $1.21 a share is well within noise, not much different from Wall Street's consensus, and nearly 20% up from this year.

Thursday, November 29, 2007

Sally's first year

Sally Beauty reported it's first year results since being spun off from Alberto-Culver. I'd say the results are very encouraging. If you recall, the massive debt load from issuing a $25 a share dividend has been partially balanced by a significant tax savings. For the year:

Year                          2007    2006    2005    2004
Net interest expense       145,972      92   2,966   2,250
Provision for income taxes  38,121  69,916  73,154  62,059
That's a pretty significant tax savings, though not enough to offset the bigger interest expense. Sally's ability to finance the debt out of cash flow has improved:
Free cash flow             138,991 126,379  63,219 107,265
Free cash flow margin        5.53%   5.33%   2.80%   5.11%
In fact, all the margins (except net earnings) have improved:
Gross margin                45.90%  45.80%  45.56%  45.33%
Operating margin             9.09%   7.59%   8.54%   8.09%
Net margin                   1.77%   4.64%   5.17%   5.02%
One of the reasons for this is that Sally has improved its inventory picture:
Inventory DIO               152.82  163.15  156.17
Receivable DSO                7.46    6.99    6.53
Payable DPO                  47.41   50.12   44.94
Cash Conversion             112.87  120.03  117.76
A large part of these gains come because same store sales increased 4.5% despite losing L'Oreal products from BSG.

Overall, Sally Beauty is doing everything they need to do in order to make the special dividend gamble pay off. I'm quite happy to hang onto my shares while the company pays down debt and exploits its leverage.

Wednesday, November 21, 2007

Only swing at soft pitches

I've been working on a model for pricing options that does not rely on volatility as an input. (I know: I might as well try to design an airplane without wings.) Testing it out on real prices, I've found that it give vastly different answers for most options. But when the stock price is fairly close to the strike price and the expiration date is only a few months in the future, my estimate doesn't stray too far from the market quote. So as a general options pricing model, this one pretty much fails.

But today I realized that I really don't care. The vast majority of options are ones I don't really care to sell in the first place. For the most part, I want to sell options with strike prices near the price I would value a company. And options longer than a few months in duration are not interesting either since it would be hard to value the underlying shares. Further, I don't really plan on selling options that are less than 50 or 60¢ because commissions eat up too much of the premium. In essence, my model pins a value on the options I'd really like to sell and I don't care what it does to options I want nothing to do with.

Now I'm interested in selling a January $22.50 option on Oracle that currently trades for 50¢. It's pretty far out of the money, so my model does a rotten job of evaluating its price. It comes up with a negative price, which obviously won't work. On the other hand, my model values the $20 option at about $1.32 while the market says the option is worth $1.50. If I were interested in selling Oracle at $20, I'd take that price, which would amount to selling Oracle at $21.50 with a 67% probability.

As it turns out, if Oracle where trading at $22.50 today, I estimate that the $22.50 option would be worth about $1.24. Now there isn't much chance that Oracle will jump from $20.21 to $22.50 in one day, but it does exist. And if it did happen, I'd gladly sell an option on my Oracle shares for that price. It would be a pitch I'd know what to do with.

Monday, November 19, 2007

Value potential energy

Recently Vitaliy Katsenelson was interviewed by Philip Durell and Bill Mann. I picked up a few ideas that apply to my investments.


In the interview, Mr. Katsenelson pointed out that international investing may actually reduce risk in an otherwise US-based portfolio. When I first bought Canon, hedging against a dollar decline factored into the decision. Since then as the dollar has strengthened from about 105 ¥ to 109.61 ¥ with a lot of fluctuation in the interim. Canon has been increasing their dividend which yields about 2.7% compared to the Japanese 30 year bond that yields 2.27%. If (when) Japan raises rates, Canon's price measured in yen will likely go up to push its yield down. At the same time, the yen dividend will likely be more valuable in terms of dollars. Since Canon has a very strong product line, the stock is very close to a sure thing.

Another point the interview touched on is that the address of corporate headquarters doesn't tell the whole story of what countries a company is exposed to. While Canon is largely a Japanese company, it sells products all over the world and has manufacturing and R&D facilities spread around Europe, the United States, and Asia.

First Marblehead

I'll just quote Mr. Katsenelson:
Another one, and I know you guys both like is First Marblehead. This stock trades at what, eight, nine times earnings? It has a phenomenal growth rate ahead of it and I think the investors still put it into the subprime mortgage category, even thought the average FICO score of its portfolio is 714, which is very high; 83% of it loans co-signed.

The part that I love about it [is] this whole speculation about major customers JPMorgan and Bank of America going away [and] you can quantify that easily. You can figure out what impact it would have on the portfolio if both Bank of America and JPMorgan dropped First Marblehead and actually I figured it out and kind of my worst case, a year after JPMorgan dropped; if JPMorgan and Bank of America leave First Marblehead, its revenues would be up 20% or 30% over where they are today. So my downside is basically none.

You could argue that the margins may become compressed, but that the JPMorgan and Bank of America business is growing so fast that it should overcompensate that. I know you guys will agree.

Potential energy

Quite a bit of the interview was actually about the importance of price when it comes to investing. I starting thinking of it like the potential energy in a spring or a hot air balloon. In Active Value Investing, Vitaliy Katsenelson suggests the QVG framework for examining investments. Quality (Q) could loosely be tied to earnings, Value (V) is related to price, and Growth (G) is how earnings (or cash flow) are likely to change in the future. (This is far too simplistic I'm sure.) To go back to the balloon analogy, price is the altitude the balloon floats at, earnings are the buoyancy of the balloon and growth is how fast that buoyancy is changing.

Now investors looking at the balloon from outside try to guess where it will be floating over some period of time. As management dumps ballast (cuts costs) or adds heat (increasing revenues), the balloon ought to rise. If it can't for some reason (investors holding the price down), the potential energy increases. The altitude (price) is fairly easy to see, but the buoyancy and its rate of change (earnings and growth) are much harder to judge. As a result, lower altitude (price) might actually be the best signal to buy assuming buoyancy (earnings potential) is increasing.

The surrounding environment contributes to the potential energy as well. A balloon will be more buoyant on cold day, while stocks have the greatest potential in markets that have low P/E ratios. The inverse of P/E ratios, earnings yields is a direct measure of potential energy. Since P/E ratios for the market as a whole are trending down, prices won't be helped as much as they once were, so it's important to have good earning yields in the individual stocks you buy and own. Canon (6.78%) and First Marblehead (13.28%) are currently have the most potential energy in my portfolio.

Friday, November 16, 2007

Why I won't be rolling my Oracle call options

The November call option I wrote will be expiring this weekend and the December option is likely to expire too (35% chance). But instead of rolling them forward, I now plan on hanging on to my Oracle shares for a bit longer. I listened to the recent OpenWorld keynotes and also the analyst meeting and I think I've ignored some significant real options that Oracle might exploit.

According to my discount cash flow models, Oracle is well within the low range of its fair value. The market is assuming 10% growth for 10 years or 14% growth for 5 years. Safra Catz, Oracle's CFO, has set 20% as the goal and hinted at 26% as a possibility. Normally, there would be reasons to be skeptical of these claims, but Oracle has some unique attributes that make this sort of growth possible and even likely.

To begin with, much of Oracle's revenues are incompressible. In other words, once a client begins to depend on HR, accounting, CRM or other software as a critical element in their business, it isn't possible to reduce the licensing stream going to Oracle without shutting down altogether. As a result, there is a floor on how much revenues can fall. Also, the natural tendency is for margins to increase over time rather than decrease. Continuing licenses are nearly cost free to Oracle because of scale.

Now assuming there is a recession this year and next, Oracle will have a harder time growing organically. But the revenue stream shouldn't fall too much and it will have an opportunity to either lower costs or buy up other companies cheaply. If the recession doesn't occur or is mild, Oracle has the option to expand its offerings organically in addition. So because of the nature of its business, Oracle has more flexibility than most companies to deal with downturns. That flexibility represents a real option that I hadn't accounted for in the past. Being able to grow earnings in the face of economic headwinds could be a huge advantage.

I know I've flip-flopped on Oracle lately. Part of the reason is that its share price has been jumping around my lower edge of my value estimates. It hasn't gotten so expensive that I feel the need to sell right away, and it isn't so cheap I'm interested in buying more.

Thursday, November 15, 2007

Did BEA's financial results make it more valuable?

One of the tough things about evaluating BEA is that they have been delinquent in their SEC filings until today. For an Oracle investor trying to see if it makes sense to acquire BEAS, the only number that really matters is total revenue. Everything else is pretty much noise, since the purpose of such a deal would be allow much better operating margins. Over the last 12 months, revenues were $1,486,713,000 compared to $1,351,967,000 the twelve months before that. Given Oracle's operating margin (~33%), that would result in $491 million in operating income. That is a significant increase from the $206 million it made in FY 2006, which was the most recent filings investors have had access to. That would indicate Oracle would need to raise its price.

But I don't think that is going to happen. For one, only $541 million of the revenues are from licenses—the rest are from far less profitable services. Also, BEA's operating income was actually negative over the last 12 months. So independent of Oracle or some other buyer, BEAS may be worth less than it was before. Further, the profitable license reviews are decreasing while Oracle's middleware sales are increasing. In any case, Oracle is in an excellent negotiating position.

Wednesday, November 07, 2007

Can First Marblehead be worth $10?

Seeking Alpha asks: First Marblehead: Worth $10 or $60? Without going into the arguments presented, which weren't particularly quantitative anyway, I don't see how you could value the stock at $10. $60 or $30 or nothing seem better guesses.

Let's take the case for the business being worthless. Basically, if management is somehow fraudulent and has stolen or wasted all of the cash in the coffers while rendering the residuals on the balance sheet valueless. Throw in a lawsuit or ten for good measure. In that case, the company is headed for bankruptcy court. Otherwise, cash and residuals are worth about $10.80 a share all by themselves. Perhaps the residuals are carried on the books at a higher price than if they were sold on the market, but First Marblehead doesn't need to sell them at market prices as long as it's still in business. And as long as the company is still in business, its value is higher than the $10.80 per share book value.

A dividend discount model prices the current $1.10 a year dividend at $33 1/2 even if the dividend never increased. To state it another way, income of $1.10 a year forever discounted to the present at 11% is worth more than $30. Forever sounds like a long time, but it's important to remember the discount model explicitly weighs income from distant years less than income in the near future. Because the dividend in 2100 is much less likely than the dividend in 2010 it also provides a much smaller portion of the present value of the dividend stream.

Ok, so if First Marblehead isn't a complete disaster or a static income stream, what other possibilities exist? Well, it could continue to grow at a healthy, though maybe not rocket-like, pace. Presumably, the dividend cannot continue to grow at 77% like it did last year nor can earnings increase by 57%, 48%, or 112% as they did in the last three years. So let's assume the dividend grows by 10% or earnings grow by 15% over the next five years. In those scenarios, I calculate First Marblehead shares are worth about $60 each. Given some growth in First Marblehead's business, I don't think many would consider these growth rates aggressive.

At this point, you could put together an expected value based on the odds of the $0, $30, and $60 scenarios panning out, but I don't think I'll bother. The $0 and $30 values are based on completely unlikely possibilities in my opinion. They might be 5% possibilities combined. I'd say my $60 scenario has a better than 5% chance of being far too conservative, but we don't need to consider that to see that at $33 1/2 FMD is a bargain.

Tuesday, November 06, 2007

Why I sold two more call options on Oracle

This morning I sold November and December $22.50 call options that cover all of my remaining shares of Oracle for 60¢ and $1.05 respectively. I've already discussed a number of reasons for trying to sell, so I won't go into too much detail. I should note, that a) my call options have captured nearly a full year of Oracle's earnings and b) I find Wall Street's estimate of 20% earnings growth seems fairly unlikely. In fact, the next few quarters may very well be disappointing because of a global slowdown. Buying BEA, even at a discount, just isn't enough to justify Oracle's current market price and make up the difference.

I should point out that by writing calls for two separate expiry dates I'm raising my costs fairly dramatically. Assuming both options are assigned, I basically have doubled my costs. But I've also doubled my opportunities. Imagine a coin-flipping offer where you earn a prize each time you flip heads and lose the coin the first time you flip tails. If you can chose between one coin that earns $2 for heads or two coins that earn a dollar each, which is a better choice? Although the expected return on the first turn is the same ($1), taking two coins gives you a 3 of 4 chance to go to a second turn as opposed to a 50% with one coin. This won't change the expected return, but it does keep you in the game longer. With two coins, you have more expected options to leave the game if the odds were to shift.

Thanks to a 3.4% increase in Oracle today, the odds the November option will be used are 63% and for the December option 66%. There isn't much short interest to propel shares higher on unexpected news and the market is already expecting good news during next week's OpenWorld conference and Q2 earnings announced in December. Therefor, I feel these options are likely to be profitable for me even if my shares are called away.

Tuesday, October 30, 2007

Earnings yield of my IRA

Currently, my IRA is flat on the year compared to an 8% or so gain for the S&P 500 and a 17% gain for Berkshire. Select Comfort (-37.5%) and First Marblehead (-28.25%) are the primary culprits, though Canon is somehow down 11% on the year too. Now I don't like the idea of seeing my portfolio stagnate, but there is a ray of hope here: my IRA's earnings yield is improving.

Here's how I calculate yield for my portfolio. Each quarter, I multiply the EPS for each company I own by the number of shares I hold at the end of the quarter. I add up those numbers and at the end of the year I have a value for "look-through" earnings. That's how much my stocks would have returned if they had paid out 100% of earnings in the form of a cash dividend. For 4th quarter earnings, I use analyst or company estimates which are decent first-order guesses. Then I divide by the total value of my portfolio to get look-through yield.

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%

Since my account value has not changed significantly since the beginning of the year, the increase in yield is entirely due to increases in my companies' earnings. This measure does not include income from cash in the numerator, but it does include cash in the denominator. That means, cash-heavy portfolios are penalized. One solution would be to subtract cash from the denominator. A better solution is to add in interest earned to the numerator. I also add in premiums from call options, profits from short-term arbitrages, and cash dividends, while subtracting commissions, fees, and option losses. This produces a sort of operating earnings yield:

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%
I know this double counts cash dividends, which are also reflected in look through earnings. Notice that my cash position has added to earnings in the last two years thanks to a number of arbitrage opportunities.

Higher yields indicate a sort of potential energy for a portfolio. Like the spring in a windup toy, increasing earnings give a portfolio a chance to run. Over a long period of time and given more or less efficient markets, an increase in earnings would represent a corresponding increase in price. Imagine what would happen to a company that earned 50¢ a share and sold for $10 were to increase earnings to $1 a share. If the yield remained at 5%, the stock would also double to $20. But until those gains are realized by selling the stock, that $10 a share increase will not be released. In order to calculate the effects of buying low and selling high, I add in realized gains and special dividends (like the one Sally Beauty distributed last year).

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%
Net          12.84% 18.31%  5.46%  3.70% 12.92%  1.74%

Unfortunately, the net yield is extremely choppy. The simplest solution is to take the geometric mean, which is the best way to get an average of rates or percentages:

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%
Net          12.84% 18.31%  5.46%  3.70% 12.92%  1.74%
Geomean       6.89%  6.08%  4.62%  4.36%  4.74%  1.74%
This smooths the data to show that net yields are also creeping up for my portfolio.

So what does all this mean? In my opinion, these yields are a rough estimate of potential. As I make good investments in companies that are cheap and have high earnings, my portfolio potential goes up. When I'm able to make money with the cash potion of the account, as I have over the last few years, I increase my portfolio's potential a bit more. When I harvest some of that potential by selling positions or receiving special distributions from a position, I have a chance to reinvest in companies with increased earnings potential. As I make good choices in allocating assets, my portfolio's yield and potential increase.

It's important to look at measures besides stock value when considering changes in investments. At the moment, First Marblehead and Select Comfort have the highest earnings yield, but are my worst performers. Oracle has the lowest yield, but is also one of the bright spots in terms of price performance. A narrow focus on recent price movement (momentum investing) would lead me to cut my losers and ride my winners. But as a contrarian investor, I'm looking to sell Oracle (low potential) and buy First Marblehead (high potential).

Is Select Comfort a "scary stock"?

This is a response to an article on the Motley Fool. I'd post it as a comment, but the site ate my post. (I think it filtered out everything after the '&' in "R&D", which is a pretty bogus behavior.)

First, operating profits are down because of increased marketing and R&D--other expense lines are down. Second, buybacks are good investments if the market is undervaluing shares, not because they raise EPS in the short-term. Third, the changes in capital structure are nearly riskless because of Select Comfort's massive and growing cash flows.

Ultimately, a lower stock price combined with a commitment to marketing, R&D, and share buybacks are very positive signs if you believe the company has a superior product. If the company's product turns out to be a fad or is overtaken by competitor copies or improvements, these moves hasten its eventual demise. The reason is that these changes are increasing the company's leverage. Small improvements will be magnified into big improvements and small declines will be magnified into big declines.

So the comparison with Tempur-Pedic is actually encouraging to Select Comfort investors. The Sleep Number bed shares more similarities to foam mattresses than traditional mattresses sold by other companies. In fact, some Sleep Number beds use similar foam to form the top layer over the air chambers. As far as price, Select Comfort offers additional features, such as firmness control, at nearly identical prices to Tempur-Pedic. (For instance, a 4000 Queen is $1,199.99 at Select Comfort and The Original Queen is $1,199 at Tempur-Pedic.) If compared to traditional beds, it's possible to buy a queen size for around $600, which is right in the sweet spot for quality mattresses.

Thursday, October 25, 2007

Dickering over the price

"Lady, you are about to be offered a bribe."
"How big? It'll take quite a chunk to keep me in style the rest of my life in Rio."
"Well . . . you can't expect me to outbid Associated Press, or Reuters. How about a hundred?"
"What do you think I am?"
"We settled that, we're dickering over the price. A hundred and fifty?"

Stranger in a Strange Land—Robert A. Heinlein

Well, BEA has responded to Oracle's Sunday deadline to take or leave a $17 a share buyout with a $21 a share counter offer. When the offer was originally announced, I estimated that $18.55 a share was a fair price, but considered the possibility of a $21 offer. The market is pricing BEAS at $17.67, which is a touch low in my opinion. The two companies have been rumored to be in merger talks for years, but only this month have the rumors been confirmed.

Here's my guess about what has happened since then: Initially, BEA rejected the Oracle offer because it hoped some other company would step in with a competing bid. When that didn't happen, management sent Oracle a letter rejecting the bid again saying it was too low. Oracle responded by setting a limit on the offer of this Sunday. Now BEA was in a bind: if it let the offer expire, it would be clear that there was no competing offer. But management needed to induce Oracle to bid more. That is why they produced the counter offer.

We know that Oracle will end up buying BEA. The only remaining question is the price.

Tuesday, October 16, 2007

Could monopolies be healthly for the software industry?

Reading commentary about Oracle's BEA offer made me wonder if monopolies really are bad for software consumers. Logically, monopolies are detrimental in every industry because a single supplier is able to control prices that customers must pay. But there are some cases where a monopolistic structure seems to be not so bad or at least a natural result in certain industries.

In software, there are only two real factors in a purchasing decision: price and features. Price isn't just the amount that goes into the software company's pocket, but also the cost to implement and maintain a system. For large systems, the cost to simply train users might dwarf all other costs combined. As Microsoft has taught us, the biggest company tends to win out when price is the primary factor if only because training costs can be minimized. Nobody bothers to mention "Microsoft Windows" or "Microsoft Office" on a resume anymore, because every halfway qualified candidate has learned to use those programs already.

The other factor is features. Since the biggest companies have a huge advantage on the price side of the equation, upstart companies must compete on features. In my experience, it's fairly difficult to justify spending more on software on the basis of "nice-to-have" features. So in order to compete with bigger competitors, a small software company needs to create functionality that is so totally different and useful that its customers start to depend on it. For instance, a few years ago I purchased a copy of Quicken that downloads all of my transactions from my bank's website. Since I've grown to depend on this feature, Intuit has locked me into their software indefinitely.

The other lesson Microsoft has taught us is that big companies have an advantage when it comes to features as well, if the big companies catch the trend soon enough to copy the feature. For instance, Excel, Word, Windows, Money, Internet Explorer, and Outlook were introduced in order to outflank Lotus 123, WordPerfect, Macintosh, Quicken, and Netscape. There are dozens of smaller examples as well. Apple and Intuit survived only because they stayed under the radar long enough to lock-in a critical mass of customers before Microsoft moved in. Other competitors, such as Google, have thrived because Microsoft didn't understand their features until it was too late to emulate. Notice that these mistakes and oversights have occurred more often as Microsoft and the software industry have grown. It's just too hard for them to see everything that is going on.

From the customer's viewpoint, the Microsoft monopoly has been surprisingly benign. Sure, personal computers are probably too expensive because of the Windows and Office taxes, but cooperate America's software training costs are probably lower than they would be with more variety. It's hard to say if we are suffering from a lack of features, but until recently Microsoft has been the leader in distributing new types of software. Where they have failed, it seems like some other company has filled in the gap fairly quickly. In either case, innovation has thrived under the Microsoft monopoly to a greater extent than is possible to imagine under the IBM monopoly of the the 1970's.

Of course, once a monopoly develops, there is a new reason to buy software from a particular company: there is no other choice. And if everyone knows the monopolistic company will simply copy any new and revolutionary product, there is little reason for startups to startup. On the other hand, if the biggest companies are willing to buy up smaller players, like Microsoft in the 1990's and Oracle in the last three years, there is an incentive to fill functional gaps. From the market leader's perspective, purchasing successful competitors when they are small is both cheaper and more certain than developing their own copy. Customers also benefit, since the original products tend to be better than the imitations, at least for a while.

So the dynamics of the software industry may produce benevolent monopolies if:

  1. Big companies drive down the total cost of software ownership.
  2. Small companies have an incentive to compete on features and are not overly afraid of their ideas being copied by larger companies.
It's like a pond with two niches: small fish (that specialize in features) and big fish (that reduce overall price). Companies like BEA are in the uncomfortable middle: too big to be truly innovative and too small to be cost effective for customers. In this case, if the big fish swallows the medium-sized one, it might be best for the entire ecosystem.

Friday, October 12, 2007

Oracle's offer to BEA

It looks like I won't sell Oracle for $22.50 this week (1 chance in 5). I plan to continue trying to write $22.50 call options on my shares because they continue to be fully-valued. I mentioned last month, that it is nice to have more than one reason to own a stock and the income from writing options is a good reason. Besides that, if the option is exercised, I feel I'm getting a fair price.

The big news for Oracle was their offer last week to buy BEA. I've learned a bit about how to evaluate mergers and I think the offer is pretty good, but is likely too be raised before all is said and done. If the premium offered is less than the expected value of the synergies produced, a transaction my be considered successful. In this case, the premium is at least $1.3 billion. Before the announcement, BEAS was priced at $13.62 a share and the offer price is $17—a premium of $3.38 a share times 392 million shares. Oracle hinted it considers the premium to be even higher: "Our proposed price is a substantial premium to an already-inflated stock price that reflected speculation of the potential sale of BEA and represents a more than 40% premium to BEA's stock price before the appearance of activist shareholders in mid-August of this year." Carl Icahn is, of course, the "activist shareholders" the letter refers to. I'm not going to factor that in, however, since the stock traded higher than $14 as recently as July 19 of this year and has been in the general range for most of the last twelve months.

Synergies are a bit harder to calculate. The market clearly thinks Oracle will need to raise its price since BEAS is trading at $18.55 a share (a $1.9 billion premium). An obvious source of synergy stems from Oracle's high operating margin (33%) compared to BEA's (14%). If Oracle simply trimmed BEA costs to match its own, it would earn an extra $205 million a year in synergies. Using an 11% cost of capital, that works out to about $1.9 billion. Further benefits, such as the ability to cross-sell products to BEA customers and technological improvements, are not included but are also less certain and harder to calculate. I'd assume they are a counter-balanced by integration costs, but they probably do exist.

I just read the chapter on Mergers and Acquisitions in Expectations Investing. One important concept it presents is Shareholder Value at Risk (SVAR), which quantifies how much of current shareholder's value the company is betting on an acquisition. For an all-cash offer, the math is pretty easy and works out to 1.2%. If the offer goes up to $18.55, as the market currently predicts, the SVAR is 1.7%. The highest offer I've seen speculated is $21 a share, which would risk 2.5% of shareholders current value. Any way you slice it, this offer will not have a huge impact on Oracle's long-term performance.

So to sum up, I like Oracle's prospects and the current offer to BEA, but I'm still trying to sell call options so that I can earn some extra income on this fairly-valued position. Got it?

Thursday, October 11, 2007

Why I bought Citizens Financial Corporation

This morning, I bought less than 250 shares of Citizens Financial Corporation for $6.55 a share. It is a small Kentucky insurance company that announced a 1-for-250 reverse split with fractional shares cashed out at $7.25 a share. I've been burned in two straight going-private transactions, but I think this one will work out. Here are my reasons:

  • This is a reverse split with no corresponding forward split. That was how the BNS Holding transaction burned me because it only temporarily produced fractional shares. Since there is no forward split and no fractional shares will be issued, my broker will need to cash my shares out whether I'm a shareholder of record or not.
  • Over 60% of shares are owned by insiders, so the vote will go their way. Most likely, they will not back out of the transaction because the company will clearly benefit from savings from eliminating public-company costs.
  • Book value per share is about $7.90, which means even the $7.25 offer is a discount to the company's value. In fact, since many shares will be retired, the book value per share will actually increase. For an insurance company, book value is a better guess at intrinsic value than any measure based on earnings. That's because the rules for recognizing earning don't work well for the insurance business.
  • Given a 95% chance of success and the pre-announce price of $6.42 as a base, the Kelly Criterion suggests I'd be safe putting 92%+ of my portfolio into Citizens Financial. Even if the company is worth nothing, the percentage would be nearly 40%. The market currently prices the odds at 15.66%, which is far too low in my opinion.

I need to remind myself that though the results have been less than I expected recently, my process has been sound. It's easy to claim that failures are due to bad luck, but in this case I believe it to be true.

Wednesday, October 10, 2007

Why I'm selling Oracle

I'm now in the process of writing in-the-money call options on my remaining Oracle shares with the intention of closing my position soon. Today I sold a $22.50 October call for 60¢ when Oracle was selling for about $22.85. By my calculations, there is about a 63% chance the option would be exercised. Oracle ended the day at $22.92, which boosts the odds a couple of percentage points. After commission, I'll be selling Oracle for the equivalent of $23 a share in about 9 days. I'm also trying to sell November options to cover the rest of my Oracle position.

In my opinion, Oracle is no longer a good value. A conservative growth assumption of 10% a year for the next 5 years would come out to about $21 a share. Using more aggressive growth rates will produce higher estimates, of course, but we are now firmly in the range of reasonable valuations. That makes Oracle less attractive to hold and unattractive to buy. If there was a dividend, especially if there was a good chance it would be raised, I'd have more reason to hang on. But the share buybacks Oracle currently uses to return value to shareholders don't excite me at these prices.

I should note that Oracle will continue to be on my radar over the next few years because it is a business that is not well understood. Earlier this week, SAP made an offer to buy Business Objects, which was widely reported as a change in course to Oracle's acquisition strategy. The trouble with that statement is that Oracle's strategy isn't to just buy up competitors, but to get the best software even if it has to buy whole companies to do so. SAP might be doing the right thing, but only if Business Objects to improves SAP's own suite of products and doesn't cost too much. SAP's action doesn't "validate Oracle's strategy"—it merely increases the cost for Oracle to buy good businesses. So it's been odd to see Oracle's price going up this week rather than down.

Friday, October 05, 2007

The case for Select Comfort

I think the crowd is wrong about Select Comfort because market participants are focusing on short-term, rather than long-term prospects. It seems to be the usual reason the market undervalues companies. In this case, Select Comfort has swung from a hot, growth stock to a company with troubles on several fronts. They had to take a big one-time expense because of an abandoned computer system. New fire-retardant regulations reduced company earnings to an extent. But the big news is the housing slump that slowed mattress sales. Also, Select Comfort's new ad campaign failed to bring in costumers. As a result, EPS for the last quarter was down 69.41% YoY and for the last 12-months EPS is down 19.48%. Sales last quarter were down 4.84% and for the last 12-months, sales are only up 5.06%—a far cry from management's 15% goal.

But the further back you go, the harder it is to see a problem. Over the last 5 years, sales have grown 25.23% and EPS has gone from -66¢ in 2001 to 85¢ last year. Gross and operating margins have improved dramatically. Management has predicted more margin improvements this year too. The company has a negative cash conversion cycle and new stores pay for themselves within a few months. The Four Factors are moving in the right direction, so earnings yield is higher than a year ago. So the question comes down to has Select Comfort's business changed so that the next five years will be much slower than the last five.

To be certain, growth in the last five years came on the back of fixing a broken sales and marketing system, expanding into new markets and controlling costs. Those low-hanging fruit are long gone. But the market is pricing in about 8.4% growth, which is nowhere close to the 14% projected by the most pessimistic analyst. I think the disconnect is that the market is looking out only one or two years. Because of the current macro-economy, the next two quarters look like they will be flat earnings-wise. But over the next five to ten years, Select Comfort has tremendous operational advantages.

Consider they way mattresses are traditionally bought and sold. Since people rarely buy more than once every decade or so, they don't have any reason to spend a lot of time thinking about how to do it. Unlike buying a car, mattress shopping seems boring and unimportant. Consumers look for things like brand, an in-home trial, manufacturer's warranty, and price. These are shortcuts that people use so that they can get a mattress they are comfortable with and get on with their lives. It's relatively easy to manipulate people using these shortcuts. For instance, there's a mattress store here in Southern California that advertises very heavily with the slogan, "We’ll beat any advertised price, or your mattress is FREEEE!" At first glance, one would assume the store is losing money (which is the way the commercials spin it) or is working on razor thin margins to avoid giving away the store. But the fact is each chain carries slightly different models with different names so that each store can claim to offer the lowest price. The low price message must be drilled into the consumer's consciousness because you never know when they might in the market for a mattress.

Since Select Comfort offers a unique style of mattress and controls the retail experience for the most part, it can differentiate itself without resorting to product name shenanigans. The key will be a long-term, consistent focus on the unique attributes of the product. Just having a storefront in the mall that people walk past year after year improves the odds that they will buy a Sleep Number bed. When combined with advertising (especially on the radio), it should be possible to encourage most people in a market to at least consider it. Management hasn't moved into non-US markets so far because they see plenty of potential in US markets they haven't tapped so far.

Sealy cut prices in the face of slow sales, but ended with a bad quarter in terms of earnings. Tempur-Pedic, on the other hand, recently raised prices yet sales increased. The purchase cycle is very long for mattresses, so its hard to read too much into a few quarters, but it seems foam has become a legitimate substitute for traditional innerspring models. Select Comfort might benefit since newer models come with improved foam toppers.

Tuesday, October 02, 2007

Bubble pricing

Consider two stocks:

  1. Trades in a range from $5 to $15.
  2. Trades in a range from $9 to $11.
The not too difficult question is: which stock is riskier? And given no more information, A is the riskier stock. That's because the greater volatility means you could lose more money with A than trading in B—at least if you only had price information to work with.

But if you knew for certain that the actual value of each stock was $10, than A ought to be far less risky. Instead of trading randomly, an investor could begin buying once stock A is priced below its value and sell when the stock is above its value for a true arbitrage situation. This is Ben Graham's margin of safety principle. One little piece of information (the value of the stock) makes a huge difference.

Of course, we can never really be certain about anything, much less the value of a company that might have skeletons lurking in its metaphorical closet. The fact is, markets are often right. That's because of somewhat bizarre phenomenon known as the wisdom of crowds. In essence, the crowd is more likely than the individual to the answer to certain questions correctly if at least three conditions are true:

  1. There exists a diversity of thought.
  2. There exists an aggregating mechanism.
  3. There exists an incentive to individuals for being right.
If any one of them is missing, an individual has a chance to do better than the crowd. But a well-designed market has all three of these conditions most of the time. Therefore, if we want to invest in stock A, we ought to make a case not only why $10 is the right price, but also why crowd wisdom doesn't apply.

A familiar case is the asset bubble. For instance, a group of investors might decide that stock A is worth $15, not $10. So they start to buy whatever shares they can lay hands on. Then some people decide the stock might be worth more like $20 and bid up the price further. The jump from $5 to $20 attracts speculators who don't know, and may not care, how much A is worth. At this point anyone who owned A and thought it was worth $10 or even $15 has taken a profit and anyone foolish enough to be short has either covered or lost their shirt. So both sides of each trade are people who believe in the company at any price. Condition I is thoroughly violated.

But there is also a problem with conditions II and III as well. Bearish opinions on the stock are not aggregated because there is no incentive to take a position. It is difficult to make money on negative opinions in the current stock market because short trading is both difficult and dangerous. The same can be said about the housing market, except substitute impossible for difficult and dangerous. Early on, when it might help with little pain, the crowd can't apply the brakes.

I've been playing the Motley Fool CAPS game and, even though I'm doing a terrible job there, I think its a pretty useful tool. Instead of judging success on an absolute basis, picks are compared to an investment in the S&P 500 over the same time period. So, a thumbs up pick might be losing even if the stock price has gone up if the index has gone up faster. If you read a mutual fund prospectus, the concept ought to be clear. More importantly, thumbs down picks win as long as the index does better than the stock.

You accomplish the same effect by selling as stock short and using the proceeds to buy an ETF that tracks the index. It would be somewhat expensive, however, since you would need to pay twice the number of commissions and there is normally a margin requirement. Perhaps some sort of ETF or derivative could be devised to solve the problem. It's also possible to simulate a relative return on a bullish position, but this wouldn't normally make sense unless you thought the index was due for a fall.

Wednesday, September 26, 2007

Having multiple reasons to own

Looking at my overall portfolio performance, I feel pretty good, but two of my biggest positions are way down against the market (as defined by the S&P 500). First Marblehead doesn't bother me too much because I just bought shares and I can't believe how cheap they are. The first and primary reason to own a company for a value investor is that shares are worth far more than the price assigned them by the market. It's sort of the litmus test of value investing.

Select Comfort is a different story. Since I doubled-down, at the end of 2006, the price has gone down, but so has the value. Based on 85¢ EPS last year and 20% projected growth, a fair value would have been about $34 a share. But this year, 87¢ EPS seems pretty optimistic and 15% is a better guess for growth, which makes my best guess for Select Comfort's value to be $24 1/2. I wouldn't argue against a valuation as low as $20 or so. Even so, this is still less than the $18 I paid last year or the $13.30 (adjusted for a 3:2 split) I paid in 2005.

The other reason First Marblehead is easier to own is that it pays a regular dividend. I cheer for low prices since they mean I'm reinvesting at low prices. But Select Comfort doesn't pay a dividend. They do have a buyback program, which I expect is taking full advantage of the low prices the market is offering. I still prefer a dividend, however, since it is more certain and reliable. First Marblehead is buying back shares as well, so I'm doubly pleased.

One lesson I've learned from Select Comfort over the last year is that as a stock price approaches parity with its value, there needs to be another reason to own the stock. You can't force a company to pay a dividend and share buybacks become less worthwhile, so selling becomes a reasonable option even for a company that is operating on all cylinders. As I have done with Select Comfort and Oracle, you don't have to place a sell order in order to sell a stock—writing a call option works nearly as well. I missed that chance a year ago when Select Comfort was trading near $25, but I won't miss it next time.

I've already started practicing sell discipline with Oracle. Improving, rather than worsening, financial conditions make a company easier to own. But stock prices tend to peak around the time that performance peaks. If price are getting close to value, there has to be another reason to keep the company. At the moment, Oracle is priced to grow earnings at 14.5%. Though this is possible, I'm afraid there is a real possibility Oracle's business could falter like Select Comfort's did. I don't see any reason to take that risk when there are other investments that trade well under their current value.

Monday, September 24, 2007

Why I bought more shares in First Marblehead

This is as close to a no-brainer as I've seen. Six months ago, I thought First Marblehead was cheap and now its business has improved and its price has dropped. Recently, the company raised the dividend 10% (which is on top of a 67% increase in June). Even if the dividend never goes up again, the dividend discount model suggests a value of $33 1/2 or so. A modest 10% increase for the next 5 years followed by no further increases is worth about $57 1/2 according to my model. According to the Quicken DCF model, Marblehead only needs to grow at 1.8% to justify its current price.

The only thing that has been missing for the last few months has been cash to augment my position. Thankfully, I was able to lighten up on Oracle just in time to collect a larger dividend on my shares this morning.

Update September 24:

I found another opinion of First Marblehead that echoes my feelings and assigns a range of values to the company. Even under the worst case when everything falls apart for the company, the author assigns a price per share of $42. I've found that my best investments occurred when I couldn't figure out how a company could be valued as low as the market price. For instance, when I first bought Oracle, it seemed like the market was operating under the assumption that the database business was dead. Both times I bought Canon, the market seemed to have factored in only minimal growth. If I had bought Select Comfort when I first looked into it and it was trading in single digits, that would have been the same story. In fact, the market scared me out of buying the mattress company until the price was more in line with its value.

In First Marblehead, I think the market is crazy and it thinks the same of me. One of us is right and the other will be shown wrong in the next few years. This is an ideal example of why value investing is normally contrarian investing as well.

Friday, September 21, 2007

Why I sold Oracle and how I wiped out my option profit

So the Oracle September call option I sold is going to be exercised this weekend since Oracle finished the day at $21.98 a share. Using the rules I established for accounting option gains and losses, selling the option cost me $1.98 a share. Since I only received 55¢ a share of premium and also paid a commission, I took a pretty ugly accounting loss on the transaction. In fact, this single loss would nearly wipe out all the premiums I've earned since I began selling call options this year. When adding in costs, my combined ratio is an abysmal 121.92%.

Without this single transaction, my combined ratio was an amazing 24.74%. I don't really have a large enough sample to measure myself yet, but this tells me that I'm settling for too little premium when I write call options. In fact, I was pretty surprised to see that Oracle's price had jumped from $19.36 to $20.13 on the day I sold the option. Rather than a 35% chance of losing, I sold a option that was nearly a coin-flip. If options were my full time job, I would have noticed the price change and adjusted my limit order to capture more premium. Options are so much more volatile than the underlying stock that the full-time trader has a distinct advantage.

But even if I had written the call for a reasonable price, I would certainly have lost this particular bet. Oracle's stellar earnings release, that came on Thursday, assured that the option would be exercised at a loss. The market's response to lower rates didn't help either. Now, I don't really mind too much because I still have plenty of Oracle shares that are worth more than when I sold the option. Part of the reason I sold in the first place was because Oracle was a bit overweight in my portfolio.

My letter to Congress on H.R. 1852

Senators Boxer and Feinstein,

I urge you in the strongest terms to vote no on H.R. 1852, which is titled the "Expanding American Homeownership Act of 2007". It would be a bad idea for American homeowners and a disaster for California.

The United States and particularly California are experiencing a housing crisis that is resulting in a number of families losing their homes. Lately, we've been seeing stories on the news of people who have taken a severe financial hit because they cannot pay their mortgages. But the crisis didn't begin this year or last. It started about seven years ago when the cost of buying a house began to rise faster than the income of potential home buyers.

For instance, although my family income is above the median for Los Angeles County, it would cost me well over half of my gross pay to buy the median house in this county. Despite very generous pay increases from my employer and my wife starting a part-time job, home ownership has become increasingly less obtainable for us over the last seven years. Financially and mathematically, it just doesn't make sense.

Now H.R. 1852, which was co-sponsored my own Representative Adam Schiff and recently passed the House, seems a gallant , but ultimately foolish attempt to solve the problem. This bill only addresses the problem of providing financing for expensive houses such as the L.A. County median house, and it does nothing to either lower the cost of buying a house or increase the income of prospective home buyers. That's a bit like trying to fix the Social Security system by issuing lottery tickets instead of checks--some people will be helped out, but most will be worse off.

Ultimately, we got into this mess because lenders made it easier for people to borrow money, so some people took advantage and spent more on houses then they should have. To those folks, I suppose making it easier for new buyers to take those homes off their hands seems like a pretty good deal. However, to those of us who are able to finance the purchase a house, but don't want to wreck our financial futures that way, this bill is slap in the face and an insult to our intelligence.

Thank you,
Jon Ericson

Tuesday, September 18, 2007

Why I sold BNS Holding

It turns out that my BNS Holding shares were not cashed out. While this was disappointing, it didn't surprise me too much and I was able to sell my shares at $13. On an annualized basis, I earned 23.30% on the transaction. Not a disaster by any means, but not the profit I was hoping for. At several points after it became clear the transaction was falling apart, I could have panicked and sold at a loss. But I was able to stay (relatively) calm and evaluate what I should do next.

Now I might very well have ended up with a loss anyway. Staying calm doesn't guarantee a good return. But it does give you a chance to avoid loss when the situation turns against you. When I bought BNS, I gave it a 95% chance of making $13.62 a share, which I suspect was a bit generous. I also was aware I might need to sell at $12 a share or less. I'd even considered the possibility that this position might be worth nothing. Being aware of the range of possibilities helped me remain calm and step off of the ship when the tide was high, not low.

Thursday, August 30, 2007

Why I sold a $20 September call option on Oracle

Yesterday I sold a $20 September call option part of my Oracle shares for 55¢ a share. As of this afternoon, they are selling for 65¢. Last year, I sold an option that was not exercised for these shares at 70¢, so I've created a synthetic dividend of $1.25 on a stock that earned 81¢. Now there's a risk (50.6% or so) that I will lose a percentage of that premium in accounting terms when the option expires. This option likely to be exercised, so it might be better to think of this as a sale of Oracle. I think Oracle is still undervalued, but I'm willing to sell because First Marblehead is even more undervalued.

Tuesday, August 14, 2007

Sally Beauty: The Good, the Bad and the Ugly

Last week Sally Beauty released its 3rd Quarter results. There isn't really much news here except that L'Oreal has hurt Sally by pulling products from Beauty Systems Group's (BSG). In the spring L'Oreal bought Beauty Alliance, a BSG competitor, so it no longer made sense for them to continue selling through another company. The bad news is that this has cost Sally some sales and dropped the price of Sally shares to their when-issued price.

The ugly news, which isn't really news to anyone, is Sally's rather massive debt load. On the conference call, there were some questions about how quickly the debt can be retired. Unsurprisingly, the covenants for the senior notes limit the speed Sally can pay off higher interest junior notes. So the debt may be with us for many years. Remember that the debt lowers net earnings, but also lowers taxes. Enterprise value is about $10 a share higher than the current stock price because of the debt load. A company representative on the call said something like, "We are in the beauty supply distribution business, not the bond trading business." At the moment, cash flow more than covers debt service, so the result is ugly not outright bad.

Now for the good news. I think the L'Oreal moves are a net positive for Sally Beauty in the long run. When Alberto-Culver spun off Sally, one of the primary reasons was that the association hurt the BSG business. Companies such as L'Oreal and Proctor&Gamble weren't happy about using a competitor's subsidiary to distribute their products. Since the split, it appears more brands are interested in being distributed by Sally Beauty, with the obvious exception of L'Oreal. Since L'Oreal has entered the distribution business, its competitors will have a vested interest in keeping other channels, such as BSG, open so that their products can be sold in salons.

I don't know if L'Oreal's gamble to go into the distribution business will work out, but it seems like a pretty good risk for them. Conversely, the gamble ought to be good for Sally because although they have lost a major supplier, L'Oreal has essentially taken out a major competitor. Only if fashion continues to focus on L'Oreal professional products in the next few years will Sally be in serious trouble.

Technorati Profile

I now have a Technorati Profile. They seem to have a better blog search tool than Google.

Monday, August 13, 2007

BNS update

Today, BNS executed its reverse split. Last night, I noticed that my sell order at $13.62 was canceled. This morning, the ticker for my position had changed to BNSIA*, which is an excellent sign. According to Yahoo Finance, the new BNS ticker symbol is BNSSA. Now its just a matter of waiting for the cash to find its way into my account.

Wednesday, August 08, 2007

Valuing my house

In a recent post Dr. Housing Bubble presented three ways to value a property. For a stock market investor, these valuation methods seem pretty basic. "The Cost Approach" is pretty much book value, "The Sales Comparison Approach v2.0" is a relative valuation close to P/B ratio, and "The Income Capitalization Approach" is a stable value DCF model. I'd like to take the third and try to get a value for the little guest house my family rents.

First, we pay $1,200 a month or $14,400 a year to rent our 2 bedroom/1 bath house. It's about 900 square feet on what would be a relatively small lot, if it were separate from the main house. Our landlord hasn't raised rent in 5 years and is willing to pay for normal repairs. I don't know what his expenses are, but I would imagine it would be no more than the 45% of his rental income. So his cash flow is something like $7,920 a year.

In a traditional DCF model, you'd divide that number by the discount rate minus the expected stable growth rate. In the real estate model, those rates are combined to create a standard "cap rate". Nearly every home will have a stable rental growth rate that matches inflation or 2-3%. The discount rate would depend on what return you might expect to make by investing in a different property in the area or making some other equivalent investment. Stock market returns are similarly risky and will probably return 10% or so. That makes 7% a fairly reasonable cap rate. So if it were possible to buy our house on its own, $113,143 would be the fair value.

According to Rentometer, the median in our area is $1,700. That works out to a fair value of just $160,286, which I would gladly pay.

Monday, August 06, 2007's advice about my funds publishes advice on various 401(k) plans, including the one at Raytheon. A striking aspect of the suggestions is how few funds they picked—especially for the "Aggressive" portfolio. My comments on the funds I didn't pick:

  • Vanguard Windsor - 15.18/0.25/38
  • If Vanguard PRIMECAP was not offered in the Raytheon plan, Windsor would likely take its place. Compared to its Vanguard brother, Windsor has slightly underperformed with lower expenses and higher turnover. I suppose I have slightly more confidence in PRIMECAP compared to Wellington management.
  • American Century Small Cap Value - 15.89/1.05/121
  • The analogous funds I own are T. Rowe Price Small-Cap Stock and Turner Emerging Growth. American Century combines the lower performance of the former and the high expenses and turnover of the later. It's hard to get excited about that combination. Small company funds are a definite weak point of the Raytheon plan.
  • Real Estate Securities Fund - 27.55/?/?
  • This fund is a specialty REIT fund that entered the Raytheon plan on 01/01/2003, which is also the start date for the "5-year return" listed above. We have almost no other information, including expenses and turnover. The top holdings don't mean very much to me and I'm not terribly excited about adding Real Estate exposure at the moment.
  • BGI EAFE Equity Index - 20.37/0.10/7
  • I like index funds, but I already have three actively managed funds that I think do a better job than this index. The unbeatable thing about index funds is their low turnover and fees, and consistently average returns. Foreign stock funds are better candidates for actively managed funds that have the ability to out-perform the benchmark.
  • Stable Value Fixed Income - 5.09/?/?
  • I'm going to assume this is the same fund that is now called the Fixed Income fund. If not, my comments would likely still apply. Recently PIMCO made some bad guesses about the bond market that have cost investors a bit of return lately. But each month (roughly) we hear the thoughts of Bill Gross, the Total Return fund's manager. In contrast, there is nearly no information about the Fixed Income fund, which is only found in the Raytheon plan. A bond fund for me serves as a piece of a market timing strategy in which I try to avoid market losses by holding relatively stable bonds. The yield I earn in times of market risk, such as at the moment, is purely a bonus as far as I'm concerned.

I have also put into place a fund allocation scheme that I think I can follow. With 10 funds, each would have a 10% or so share in my portfolio if I were equally comfortable with their prospects. But some funds (Excelsior Value & Restructuring, Vanguard PRIMECAP, and First Eagle Overseas) deserve an extra share (15%) since they seem better bets than the others. In order to make rooms, those funds are paired with funds (Turner Emerging Growth, Fidelity Equity-Income, and Oakmark Global) that I don't have as much confidence in which will receive a half share (5%). If I were to gain greater confidence in a fund (perhaps Value & Restructuring), I could assign it a double share (20%) and pair it with either two half-share funds or eliminate a position altogether.

Note that this allocation doesn't exactly match the "batting order" I presented last week, even if the pitcher spot is given a greater role based on defense. Diversification with my IRA holdings knocks down the value of owning Oakmark Global. I'm not happy with the small company choices Raytheon offers, including the T. Rowe Price Small-Cap Stock, and that segment is well-represented in my IRA.

I've also designated PIMCO Total Return as my "gateway fund". It receives all deposits initially and diverts them to funds that are getting underweight. I had planned on using another fund for this purpose, but I just learned that the redemption fee for short-term trading is no longer going to be charged.

Thursday, August 02, 2007

Ten little mutual funds

It's been a very long time since I looked at my 401(K) options. I have a hard time talking about these funds because there isn't a lot going on with them. Unlike a stock like Canon which has more news each week than I could possibly comment on, mutual funds barely look different from one year to the next. So I thought it might be fun to look at the 10 funds I currently hold as if they were a baseball lineup. The statistics are 5-year return/expense ratio/turnover ratio. Higher is better for return (obviously) and lower is better for the other two. The lineup (with the exception of the pitcher spot) is roughly the order I feel comfortable with these funds in the future. Overseas funds belong in the outfield, small-cap funds are middle infielders, large-cap funds play corner infield, index and bond funds play catcher, and the special-situation fund is pitcher.

  1. First Eagle Overseas - 23.04/0.89/28 (CF)
  2. Jean-Marie Eveillard is once again the manager of this wide-ranging fund. He recently replaced Charles de Vaulx, who left for some reason I've never found out, but he'd had 26 years managing the fund before his premature retirement. Currently the fund is most heavily invested in cash and gold, so it ought to be able to invest in bargains as the markets head south. Some of the bigger holdings are international brands such as Nestle, Toyota, Shimano, and L'Oreal, but many more or obscure to me at least. In many ways having a fund managed by a Frenchman is more diversifying than yet another New York or U.S. based fund.
  3. T. Rowe Price Small-Cap Stock - 15.71/0.91/20 (SS)
  4. Gregory A. McCrickard has led this fund for 15 years. The five year return looks good until you compare it to the small-cap stock universe or the funds in this category. Both sport returns several percentage points higher. Unfortunately, there aren't a lot of choices for investing in small companies offered by my 401(k) plan. Small-cap investing ought to be where active management shines, so I'd like to get at least one fund in the mix even if it isn't the best in category. Both the management fee and turnover signal that the T. Rowe Price fund is a better bet than the Turner fund listed below.
  5. Vanguard PRIMECAP - 17.53/0.31/10 (1B)
  6. PRIMECAP is managed by a company of the same name based in Pasadena. Howard B. Schow, one of six credited managers, gets a cameo in the most recent revision of The Intelligent Investor discussing the idea that management ought to be held accountable for the goals they establish for themselves. It's not a good sign when a manager talks up margins until they start to contract and talks about sales growth instead. I like this fund both for its exceptional performance, but also for its very low expenses and turnover. Among its top holdings are Oracle, Adobe, FedEx, Microsoft, Sony, and Potash Corporation of Saskatchewan, Inc. There are a lot of good ideas in there, but I wish I knew more about how the companies are picked.
  7. Dodge & Cox International Stock - 24.72/0.66/9 (RF)
  8. This fund is managed by a team, which ought to help when allocating the fund's large and growing asset-base. One fairly recent addition to the portfolio is a Norwegian energy and aluminum company called Norsk Hydro ASA. There are also names like Nokia, Honda, News Corp., Shell, Bayer, and Volvo that most Americans will know. The fund seems to be widely recommended and has done exceptionally well, so it runs the risk of growing larger than its ideas. Thankfully the expense and turnover ratios bode well for the future.
  9. Oakmark Global - 22.44/1.18/41 (LF)
  10. Clyde S. McGregor has managed Oakmark Global for most of the last five years and added Robert A. Taylor as a co-manager two years ago. International funds have been a particularly easy category to make money in recently, so I have some concern this team is not as good as its record. But it is a very good record and I suspect that global funds will continue to outperform their more limited brethren. The expense ratio is pretty high, but since this is a newer fund it might creep down in time. Also, I'm happy to continue paying for exceptional performance. Oracle is one of the fund's larger holdings which makes my overweighted position in the software company overweighteder as I add to the fund.
  11. Raytheon - 15.5/0.00/0 (DH)
  12. I no longer closely follow Raytheon, but from the inside we seem to be doing fairly well. A few years ago, we were allowed to diversify away from company stock in the company 401(k), which I take full advantage of. Despite raising the dividend recently, Raytheon's yield has dropped from 2.66% in 2004 to 1.82% today.
  13. S&P 500 Index - 10.73/0.01/4 & PIMCO Total Return - 4.84/0.43/257 (C)
  14. This platoon is my basic market timing experiment. The S&P 500 index fund is the cheapest way to participate in bull markets and PIMCO is a fairly safe place to earn bond yields when there is a bear market. I've been invested in the bond portion of this position for a year and a half based on an inverted yield curve. I've missed out on some nifty gains (though only in this position), but PIMCO Total Return and Raytheon are the only two investment that have not lost money over the last month. I don't plan to switch back to stocks until the yield curve returns to a more normal configuration.
  15. Turner Emerging Growth - 19.81/1.54/78 (2B)
  16. Frank L. Sustersic and William C. McVail are closing in on 10 years running this fund and Heather McMeekin was hired five years ago. Like the T. Rowe Price fund, I've focused on Emerging Growth in order to have small companies represented in my fund portfolio. Five-year return looks great, but the expenses and turnover are a concern. Cash represents 12% of fund assets at the moment and I don't recognize many of the stock holdings. Deckers Outdoor Corporation, which makes Teva sandals and Uggs boots, stands out as a large holding I recognize. Almost a quarter of the stocks my market value are industrial materials manufacturers according to Morningstar.
  17. Fidelity Equity-Income - 13.80/0.67/24 (3B)
  18. Equity-Income has been on my radar for a very long time, but it isn't terribly exciting so I haven't started building a position until recently. Stephen R. Petersen has served as manager of this fund for 14 years, so he can certainly take credit for its current record. The current yield is 1.56%, which doesn't seem particularly high for an "Income" fund. On the other hand, expenses are reasonable and the fund has outperformed the market since the peak of the internet bubble of 2000. I won't bore you with the names of the top investments because they are exactly what you would expect this sort of fund to own. I don't plan on letting this be a large part of my 401(k), but it seems a reasonably defensive choice.
  19. Excelsior Value & Restructuring - 19.18/0.84/13 (P)
  20. This fund is actually my favorite fund in the bunch which I saved until last because I don't know what to do with it. David J. Williams, the fund's manager for 15 years, has focused on companies that are experiencing some sort of shift either internally or within their industry. For instance, he bought Tyco after the story of its extravagant CEO brought down the price and continues to hold some of the companies that spun off Tyco earlier this year. He also invested in Deluxe Corp., which dominated the paper check business and is now struggling to find new sources of revenue. These deals don't always work out, but the fund's performance is pretty exceptional. I think if I were forced to pick just one fund to hold, it would be this one. Special situation investing can be more laborious and error-prone than simply buying big companies with good earnings, so I don't mind paying the very reasonable fees.

My favorite funds are those that open up the black box just enough for investors to take a peek inside. My 401(k) doesn't have many funds that are as open as Pimco has been over the years, so I need to search a bit more than I'd like to get to know the managers and their styles. Ten funds seems like a lot when compared to the more compact portfolio of my IRA and much of that is due to the sparse information available. I don't want to assign strict 10% allocations to these funds, since they vary in quality and likelihood to outperform. I think this post will help me sort out what the final allocation ought to be.

Tuesday, July 31, 2007

My miserable July

This is the portion of the show where I normally discuss my exceptional portfolio return and modestly claim the results were the result of "good luck" or some one-time event that can never be repeated. My IRA was down 5.20% in July, which was on top of a -1.92% return for June. So which stocks ought I to have sold to avoid this calamity? Oracle, my largest holding, was down a modest 2.99%. Canon clocked down 9.48%. Select Comfort only lost 1.73% in July but for the last 3 months it has lost 14.02%. Berkshire nearly held steady at -0.66%. First Marblehead was the biggest loser: trimming 14.7%. Sally Beauty lost 10.78% and its brother, Alberto-Culver, lost 0.84%. So it was a clean sweep—everything lost market capitalization in July. Here's how I compared to my benchmarks so far this year:

Date     S&P 500 Delta   IRA   Delta  BRK A
07/31/07   2.61% -3.32% -0.71% -0.72% 0.01%

To be honest, I don't feel that holding onto these positions was a mistake. Each of these companies have performed well in my opinion and will likely rebound when the market starts to calm down a bit. First Marblehead in particular is wildly undervalued because of its perceived connection to mortgage bonds and other asset backed securities.

Update on BNS Holding

BNSIA has dropped to $10.50 a share from $12.75 just before the new reverse split procedure was announced last Friday. My guess is that 100% of the price cut is panic selling from people like me who bought shares for a quick cash-out. Most of us will probably not be cashed out unless the procedure is based on beneficial owners not shareholders of record.

Now my broker sent a message indicating that my shares will be cashed out sometime after the record date on August 2. Until then, I can't be sure that my shares won't be aggregated. So I'm pursuing another tact.

The letter I sent to BNS Holding on Friday resulted in a fairly quick response on Monday from one of the company's directors. This morning I was able to return his phone call and we talked about the situation for a few minutes. One of the good things about investing in very small companies is that you might actually have a chance to talk to principle people. Imagine trying to talk with a director of Oracle, for instance. At any rate, we had a good chat and the upshot is that I plan on sitting tight.

One thing this director mentioned is that the proxy that was mailed to shareholders was different than the one published by EDGAR. I don't really know how that happened, but since the proxy that was actually voted on contained language that allowed the company to aggregate shares, the SEC probably won't have a problem with the company's actions and disclosure. That's the bad news. The good news is that BNS Holding is aware of the issue and the director I talked to seemed willing to work on straightening it out. The bottom line seems to be that it's more trouble than it is worth to them to have a small disgruntled shareholder such as myself. (I can't decide if my letter was overly threatening or if that was one of the reasons it got noticed. If this situation happens with a different company, I plan to go easy for the initial contact at least.)

I should also mention, that holding on to the company wouldn't be a terrible bet. I haven't done a valuation, but company presentation at the annual meeting seemed very promising. This week represents the best and final opportunity to buy shares for a very long time. I'm mildly temped though I think it's just the lure of scarcity talking.

Once again, I think the key here is to not panic. I took a few moments to get my strategy in order and I acted in a way that kept my options open. I'm still 95% sure my shares will be cashed out sooner or later, but I would certainly have lost money if I'd immediately sold on Friday.

Friday, July 27, 2007

BNS Holding changes the rules in mid-stream

Here is the text of a complaint I just filed with the SEC:

BNS announced a 1-for-200 reverse split that was intended to result in fewer then 300 shareholders of record. This would allow the company to "go private". Shareholders of fewer than 200 shares would receive $13.62 in exchange for surrendering their shares.

According to the proxy statement (DEF 14A), the company would not be required by law to cash out holders of shares in street name. But the company did promise to instruct brokers to treat those shareholders in the same manner as shareholders of record:

"If your shares are held in street name, under Delaware law the proposed Reverse/Forward Stock Split would not impact your shares. However, we plan to work with brokers and nominees to offer to treat shareholders holding shares in street name in substantially the same manner as shareholders whose shares are registered in their names. To determine the transaction's effect on any shares you hold in street name, you should contact your broker, bank or other nominee."

According to the press release dated a week after the proposal passed a shareholder vote, stockholders holding their shares in street name would NOT be cashed out after all. The relevant passage is:

"MIDDLETOWN, R.I., July 27 /PRNewswire-FirstCall/ -- BNS Holding, Inc. (OTC Bulletin Board: BNSIA - News; the "Company") confirms that the Company has elected to require banks, brokers or other nominee to aggregate any fractional shares within the Depository Trust Company totals upon the consummation of the Company's proposed 200-for-1 reverse stock split immediately followed by a 1-for-200 forward stock split (the "Reverse/Forward Stock Split") scheduled to take effect on August 2, 2007. As a result, the Company need not provide for cash payout to any stockholders holding shares of Common Stock in street name (such as a bank, broker or other nominee). In addition, stockholders holding their shares in street name would retain the same number of shares they held immediately prior to the Reverse/Forward Stock Split. Following the consummation of the Reverse/Forward Stock Split, the Company intends to cease the listing and trading of the Company's Class A Common Stock, $.01 par value per share and Preferred Stock Purchase Rights on the Boston Stock Exchange and cease to be a reporting company pursuant to Sections 12(b) and 12(g) of the Securities and Exchange Act of 1934, as amended."

As a result, investors who bought shares in street name with the intention of being cashed out in the reverse split acted using false information from the company.

Meanwhile, shareholders who wished to remain shareholders may have performed unneeded transactions. Here is the advice from the company's proxy:

" If you would otherwise be a Cashed Out Shareholder as a result of your owning fewer than 200 shares of Common Stock, but you would rather continue to hold Common Stock after the Reverse/Forward Stock Split and not be cashed out, you may do so by taking either of the following actions:

o Purchase a sufficient number of additional shares of Common Stock on the open market and have them registered in your name and consolidated with your current record account, if you are a record holder, or have them entered in your account with a nominee (such as your broker or bank) in which you hold your current shares so that you hold at least 200 shares of Common Stock in your record account immediately before the Effective Date of the Reverse/Forward Stock Split; or

o If applicable, consolidate your accounts so that together you hold at least 200 shares of Common Stock in one record account immediately before the Effective Date of the Reverse/Forward Stock Split.

You will have to act far enough in advance so that the purchase of any Common Stock and/or consolidation of your accounts containing Common Stock is completed by the close of business prior to the Effective Date of the Reverse/Forward Stock Split. The Effective Date is the date upon which the Certificates of Amendment to our Certificate of Incorporation become effective and may not be prior to the date of the Annual Meeting."

If BNS intended for shares held in street name to not be cashed out, the company ought to have stated that in the proxy. Many companies follow that procedure and I don't see anything wrong with that. But there something wrong with announcing one procedure before a shareholder vote and announcing another after the proposal has already passed. It is a form of bait and switch.

I believe that BNS should be required to honor the earlier statement and work with brokers to cash out all shareholders of fewer than 200 shares whether those shares are registered in street name or not.

Thank you,

My next step is to talk to my broker about what is likely to happen to my shares. I don't believe it will be possible to register them in my name.


The company has more information about the shareholder meeting at their website. Besides recording the results of the vote, the only thing I've found pertaining to this issue is the following:
It is the Company’s intent that following the reverse/forward split that the Company will initiate the steps necessary to terminate the registration of our shares of Common Stock under Section 12(b) of the Securities and Exchange Act as last amended. As such, our obligations to file Form 10-K, and Form 10-Q, and the like will be immediately suspended within 10 days of the consummation of the reverse/forward split. This will be an advantage to the Company for a variety of reasons, inclusive of controlling the dissemination of certain business information, elimination of costs associated with the requirements of the Exchange Act, and elimination of the initial and continuing costs of compliance with Sarbanes-Oxley and related regulations. The Company intends that future financial information will be made available to our stockholders regularly and on a timely basis via our websites and

The second website isn't currently live.

Update #2:

I just sent a fax to the company's investor relations that included the text of my SEC complaint and the following:
I don't know if the SEC will be able to take action on my complaint between now and August 2, but there is still time to correct this unfair procedure, or to cancel or delay the Reverse/Forward Stock Split. As can be seen in today's trading (share price is down by over 10%), this mornings press release has had an averse effect on the market value of this company. Further, the procedure revealed this morning may permanently harm the rights of minority owners without proper compensation.

According to Hoover's, the fax number is 401-848-6444. Depending on what my broker recommends, I may also try calling the phone number that is listed (401-848-6300).