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.