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.