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.