Thursday, April 24, 2008

Biggest losers

I'm constantly amazed by the irrationality of the stock market. (Of course, the market seems irrational when my stocks are going down and I'm a genius when they go up!) My two biggest losers are priced far below what my DCF models predict they are worth. First Marblehead is fairly easy to figure, since the company publishes projected cash flows from its residuals. If you discount those residuals at 15%, which is greater than the rate management uses to value any of the residual tiers, the stock ought to be trading no less than $6 a share. That would imply no future business, which is a safe assumption at the moment. The current price ($3.62) implies a discount rate of 23%, which is what you might be charged for credit card debt if you had a really bad credit score. Remember, these loans can not be discharged in bankruptcy and were originally made to people with relatively good credit scores. First Marblehead will almost certainly double in price when the cash from residuals begins rolling in during 2009. Also, the shares have a built in call option on the possibility business will resume in the future.

Select Comfort, as a consumer products company that is currently out of favor with consumers, represents a tougher challenge to value. There's no way to know if the Sleep Number concept has run its course and sales will whither and die. But if we assume that the company will earn 22¢ in the next 12 months as it did the last 12 months and that earnings will increase a modest 3% forever, you get the current market value. But there are reasons to expect these assumptions are too modest. First, the company has finally stopped building new stores and buying back shares, and has cut advertising, staff and other expenses. Earnings in the future figure to be higher even if sales remain flat. Second, if the market ever turns Select Comfort would seem poised to capture quite a bit of market share. It's severely cut back advertising, which has hurt the wholesale and online portions of the business. When people start buying mattresses again, it should face fewer competitors with less capacity.

Now these companies have very little risk of becoming worthless and if things go right ought to do very well. At these prices, simply returning to profitability will provide new investors with great returns. I've already lost most of my investment in these companies and I can't afford to put more cash into them. But I will continue to hold them, which is functionally the same as considering them good buys, because the upside remains more likely and more profitable than the downside. As Mohnish Pabrai says, "Heads, I win; tails, I don’t lose that much."

Monday, April 21, 2008

Why I sold off my Oracle position

For the first time since I began buying individual stocks, I do not own Oracle outright. The call option I sold last month was exercised at expiry and was worth 80¢ since Oracle ended the week at $21.80. Although I lost a little bit on this option, my combined ratio stands at 68.04% for all options written.

The position I sold over the weekend was purchased a little over a year ago for $16.50, which works out to a 29.32% annualized gain. The S&P 500 has lost about 1% over the same time. So that particular trade has been very profitable, as has my Oracle trades in general. I still believe Oracle is misunderstood, but I believe it is trading near its fair value and I don't think its prospects look particularly good in the next few months. Eventually, companies will respond to slowing consumer demand by cutting capital spending. And we have not yet seen the end of bankruptcies even within the financial sector. Perhaps I will be able to buy back into the company if it misses earnings in the next year or two. I hope so, because I'm already starting to miss it.

Wednesday, April 09, 2008

More good news and bad news

This week, my portfolio had good news and bad news. The good news is that Canon paid their year end dividend. Since the exchange rate has fallen to about ¥100 to the dollar, the ¥60 dividend worked out to be 60¢ a share. Canon's dividend yield is about 2%, but based on my original cost basis, I'm earning closer to 3%. As long as Canon continues to raise its dividend, I will be happy to hold my shares.

The bad news was that TERI, the non-profit that First Marblehead uses to insure its loans, declared bankruptcy. Now I believe the bankruptcy is for technical, not fundamental reasons, and I think the effect on First Marblehead will be very little in the long run. But my position has been battered to a considerable degree and perhaps permanently. At the very least, the news makes an immediate recovery very difficult.

At no time have a felt that First Marblehead was a bad risk/reward proposition at the current price, so in one sense I don't feel I made a mistake. But I did ignore one of my fundamental sell signals: to get out when a dividend is cut or lowered. If I'd done that, I would have saved myself a lot of money and aggravation. Further, there will often be an opportunity to buy the shares back at a later date when I've had a chance to analyze the company independent of the dividend.

At the moment, this sell signal only applies to Canon and my token position in Alberto-Culver. Which reminds me: selling Alberto has easily been my most costly decision to date since it freed up cash to buy First Marblehead.