Wednesday, February 28, 2007

Look-through earnings

"Merry Christmas!" At least that's what I feel like saying every year around this time. Warren Buffett likes to publish his annual report to shareholders on a Saturday, but we get Christmas a few days early thanks to new SEC regulations. Needless to say, Berkshire's actual results were almost as good as its Chairman's commentary and advice.

This year, I thought it would be fun to present my investment's results using one of Mr. Buffett's favorite tools—look-through earnings. Essentially, I calculate my share of each companies earnings by multiplying the quarterly earnings per share by the number of shares I hold each quarter. Then I aggregate four quarters into a year and divide by the number of "shares" in my IRA. (For an explanation, see this article). This way, I can focus on the economic value the various businesses have added as if I owned each one outright. All 2007 numbers exist only in the imagination of analysts; I use them as placeholders to get an idea of what the future holds.

Earnings         2007*   2006    2005    2004    2003    2002
Oracle           0.19    0.13    0.21    0.30    0.44    0.34
Canon            0.31    0.28    0.49    0.34    0.08 
Select Comfort   0.26    0.19    0.27   
Berkshire        0.19    0.25    
Alberto-Culver   0.12    0.08    
Sally Beauty     0.04    0.00    
Look-through     1.12    0.93    0.97    0.64    0.52    0.34

* 2007 numbers are consensus analyst estimates.

The 2006 results are down in part to my purchase of Alberto-Culver and its spun-off subsidiary, Sally Beauty. I bought these shares more for the value I hoped would be unlocked by the spin-off and for the large special dividend (see below). Oracle has slowly been losing its share in my personal look-through earnings because it is a smaller part of my overall portfolio. On an absolute basis, its earnings have increased smartly.

Last year was the first in which I made more than 2 trades. Besides three new positions, I added to one of my old positions, executed three going-private, arbitrage transactions, initiated two more and sold one option. Plus I left substantial (relatively speaking) sums in cash. So my non-look-through earnings and costs were significant for the first time. In the following chart, I've included actual year-to-date results in the 2007 column.

Interest         0.01    0.16    0.01    0.03    0.02    0.00
Costs           (0.05)  (0.19)  (0.04)  (0.06)  (0.22)  (0.12)
Arbitrage        0.39    0.41    
Options          0.06     
Operating        1.47    1.32    0.94    0.61    0.32    0.23
Gain            11.28%  40.94%  52.78%  89.99%  41.50% 

My "operating" earnings are more impressive, smooth and meaningful when presented this way. The market value of my IRA is substantially more lumpy due to market fluctuations. Note that while the arbitrage earnings are quite significant for last year's results (not to mention this year's), they would be partially offset by a tax cost if this were a taxable account. I'm also batting 1.000 with a pitifully small sample size. One day I will experience a setback and the loss may very well wipe out significant gains.

Finally, if you add in my sale of Oracle a few years ago and the large special dividend from Sally Beauty, you will arrive at some very lumpy net earnings. Once again, these earnings benefit greatly from the tax-deferred status of the traditional IRA.

Realized Gain                                    1.79 
Special dividend         2.99    
Net              1.47    4.31    0.94    0.61    2.11    0.23
Gain           -65.97% 360.84%  52.78% -71.01% 827.21% 

The fun part about looking at results this way, is that it's easy to imagine being at the helm of a large conglomerate controlling an array of subsidiaries. But this approach ought to also aid an investor's thinking about the businesses he partially owns. Clearly, I will need to consider eliminating my Alberto-Culver and Sally Beauty stakes in the next few years if they do not improve performance. I might want to increase my investment in Oracle instead. Arbitrage and option activities have added considerably to my bottom line.

Thursday, February 22, 2007

Eupa International shares cashed out

My shares of Eupa International were cashed out yesterday for the expected price of 40¢ a share. My total gain was only 10.84%, but on an annualized basis the gain was 139.66%.

Tuesday, February 20, 2007

Buying Alberto-Culver (and trying to sell it too)

I can't say I know very much about Alberto-Culver. It's a consumer products company that mostly caters to women, and my wife doesn't use their products. My original thesis was that the spin-off of Sally Beauty would unlock value in Alberto-Culver. As far as I'm concerned that has already happened.

But, as it turns out, I just bought a faction of a share of ACV. Why? Because I've instructed my broker to reinvest dividends. If your broker offers dividend reinvestment as a free option on your account, there's no good reason not to buy some fractional shares of a company you already hold. Alberto-Culver's earnings yield is about 4.22% versus 4.85% that cash would earn. But remember, companies have the potential to increase earnings over time.

Meanwhile, I'm attempting to write a call option on the bulk of my holdings. I've got better ideas than Alberto-Culver at this point and I'm overexposed on this particular stock at roughly 11% of my IRA. But I'm not quite ready to sell outright. I like the dividend I'm getting, management seems very shareholder friendly, and I think a few acquisitions combined with cost-savings could push earnings up over the next year or two. So the middle ground for me is to write slightly out of the money call options until something drastic changes.

Tuesday, February 13, 2007

My stock option insurance business

Back in November, I wrote my very first covered call option. Since then I've been struggling to understand how I ought to evaluate these transactions—especially when the option expires worthless.

Oracle slid from $19.48 to $17, so there was no possibility that the option would be exercised. On the one hand, I certainly didn't lose any upside. On the other, if I had sold my shares instead of the call option, I would have avoided a worse than 11% loss. I'm not terribly upset about the "loss", however, since I wasn't committed to selling Oracle. $20 is at the low end of the stock's intrinsic value, and I'm interested in becoming at buyer again now that Oracle is priced under $17. From the perspective of the option buyer, the option was well worth its price. Instead of out-right buying Oracle and taking an immediate loss, the buyer has the luxury of buying at much cheaper price or taking a pass altogether. So who won and who lost in this transaction?

If you think of an option as an insurance transaction, it becomes more obvious that there don't need to be losers (though often there are). Although the option buyer lost the premium paid to me, their bigger concern was to avoid the sell-off that did, in fact, occur. And although I suffered a big, unrealized loss, I would have suffered it whether or not I'd sold a call option. So like an insurance contract, the party (me) that could afford a sudden price drop sold protection to the other party that couldn't afford it.

Insurance writing is usually evaluated with a metric called the combined ratio. It takes any losses, costs or dividends to policy holders and divides by total premiums. Ratios greater than 100% indicate underwriting loss. Insurance companies prefer to operate at the lowest possible combined ratio, but can still be profitable thanks to investment gains on the premium float, which is the money that has been paid in and has not yet been paid out in claims. Based on a single option, my combined ratio is 21.37%, so I'm currently making an underwriting profit.

The paper loss on the underlying asset (Oracle) is unfortunate, but not really relevant to the activity of writing call options. Think of the underlying asset as a reserve that is required to ensure that I can pay out a loss. When my reserve shrinks, it is the result of an investment decision to not sell not because I wrote a call option against it.

I expect that in the future, I will make a small profit on covered call options. Thankfully, USAA lowered my commissions, which will lower my cost. But I will also probably suffer some loses when options I write are exercised and I imagine I will accept smaller premiums than I did with Oracle.

Tuesday, February 06, 2007

January performance

I haven't written in a while, but my IRA portfolio turned in a spectacular January:

Date      S&P 500  Delta   IRA    Delta  BRK A  S&P 500   NAV    BRK A
01/31/07  1.41%    1.07%   2.47%  2.42%  0.05%  1,438.24  24.44  110,050.00

Here are a few highlights:

  • Sold Pegasus Communications for $3.25 a share.
  • Bought Eupa for 35¢ a share.
  • Sold Meritage Hospitality for $5.50(!) a share. (That works out to a 295.71% annualized return.)
  • My Oracle call option expired. The good news is that I was not forced to sell my Oracle shares. The bad news is that Oracle lost more than 12% of its value in that time. Fortunately, I didn't want to sell anyway.
  • Select Comfort gained nearly 6% for the month. I guess the shock of bad news in December wore off.
  • Sally Beauty gained 9% for the month. I guess the shock of bad news in December wore off.
  • Alberto-Culver gained nearly 5% for the month based, I suppose, on a 5.5¢ a share quarterly dividend.
  • Oracle and Canon had poor Januaries based on being large companies with little real news.
  • Berkshire Hathaway, as you can see above, ended flat.
  • Earned 4.85% (annualized) on any cash I had lying around.

All of this is to say that my stock prices bounced around randomly. I'd say the going-private transactions that I've participated in show true skill since they've worked exactly as I expected. My other investments have did well in January mostly due to luck. Long term, I expect to have more good months than bad ones and make more good decisions than bad, but one month isn't a big enough sample.

February is turning out to be my best month yet. My IRA balance right now is over $5 million. That easily surpasses the half million dollars I "had" back in September. But I expect my balance will return to earth shortly when my Eupa are cashed in.