Trembling with greed

According to Whitney Tilson, the best time to buy a stock is when you are trembling with greed. That's exactly how I was feeling last week as I set my limit order on First Marblehead each evening. Obviously, given a choice, I prefer to pay at the low end of what the market offers each day. But as the price crept up day after day during the week, I realized that I'd be willing to pay a lot more to get into a position and that my window of opportunity might be closing up. As the sub-prime lending story peeks, its negative effect on financial companies' shares could subside.

Interestingly, the sub-prime meltdown could actually help First Marblehead. In the past, consumers might be tempted to pay for college with a mortgage equity withdrawal (MEW), but that option may be less attractive in the future. Banks in the midst of tightening housing loans, might see education loans as a partial replacement for growth. Bond investors might see education loans (which can't be wiped out by bankruptcy and are backed by third-party guarantees) as a safer alternative investment. It's kinda like how pushing down on one part of a water bed causes another part to be pushed up.

One item to watch as time goes on is the trend of the "trust updates" lines in the income statement. According to the 10-K: "Trust updates reflect changes resulting from the passage of time, which results in accretion of the discounting inherent in the fair value estimates of additional structural advisory fees and residuals, as well as changes in the assumptions, if any, underlying our estimates of the fair value of these service revenue components." In 2002 (the first year I can track down those numbers), the updates represented 1.23% of the total "service receivables" line on the balance sheet, which is First Marblehead's share of the trusts. Since then, the updates have fluctuated between 4.44% and 6.25%. If I understand it correctly, this number represents the sum of all previous years' conservative accounting. If the company gets too aggressive in the coming years or if lots of borrowers prepay their loans, that number could go down or become negative.

In a sense, First Marblehead's conservative estimation of it's trust assets is akin to other under-valued assets such as real estate carried at cost or Oracle's installed base. Analysts tend to discount these assets altogether since they can't be precisely valued. The Standard & Poor's report on First Marblehead says, "Cash generated from operations totaled 21% and 68% of net income in FY 06 and FY 05, respectively. We believe the relatively low percentage of net income converted into cash stems from the large portion of FMD's revenues that are derived from residuals from securitized loans." Now these statements are true, but I'm not sure they are the negative that the report implies. If the company, can't convert earnings to cash, there's an obvious problem. But it seems like management has gone out of its way to structure the trusts so that First Marblehead gets the residuals, which makes sense because it doesn't really need cash and nobody else can value them as well as First Marblehead can. They are eating their own dog food, which must be encouraging to lenders and bond investors.

Why I bought First Marblehead

First Marblehead is an out-sourcer of private student loans. In order to understand why I believe Wall Street undervalues this company, it's important to understand what a difficult asset private student loans are to value:

1. Student loans are not backed by an asset that can be repossessed and sold as are mortgages and car loans.
2. Borrowers often have no income or even credit histories.
3. Student loans do not normally need to be repaid until after the student graduates and enters the workforce.
4. Loans do not normally carry a pre-payment penalty.
5. Loans may take 20 to 25 years to be repaid in full.
6. Private student loans are not backed by a government guarantee, but must compete (at least indirectly) with state and federal government-backed loans.
7. There is great variation in the ability and willingness of students to repay their loans upon graduation.
8. Student loans are highly regulated.
9. Securitization is required for the original lenders to transfer student loans to investors.

These "borrower-friendly" loans (as First Marblehead's CEO calls them) present many difficulties to lenders who would like to enter the market. The only way to be comfortable issuing these loans is to gather a few years (at least 10, I'd imagine) of experience and borrower data. That is exactly what First Marblehead offers. It's important to understand that the company doesn't originate or guarantee any loans, but provide outsourcing to lenders so that they can establish there own "private label" student loan programs.

Currently, First Mablehead provides these services at or near cost, and in exchange, the loan originators agree that if they sell the loans, they do it through First Marblehead. The process of selling loans to investors, called securitization, can be complicated and risky, but banks are generally eager to transfer loans to third parties so that the proceeds may be reinvested. Again, FMD has many years of experience. Once the loans are sold to investors, the originating banks are generally free of them altogether.

If you are observant, you'll notice that so far First Marblehead can't make any profit since it provides services to lenders at cost. When it structures a loan secutization, First Marblehead creates a trust where lenders deposit loans and divides the into tranches with different risks and returns. If the underlying loans are paid off as scheduled, the junior tranches will earn substantial returns on investment. If many of the loans go bad or are paid early, the junior tranches may earn less than expected or even lose principle. Setting up and administering these trusts is a difficult and complicated task, so First Marblehead is able to change substantial fees for these services.

The bulk of the fees are paid upfront by the trust. In the most recent securitization, First Marblehead claimed 13% of the trust balance upfront. It also receives ongoing fees (~1%) and residuals (~5%) of the trust. The later fees are estimates of the present value over the life of the trust, so if the loans default or get paid early, the result could be much worse. Residuals are the most junior tranche in the trust, so in theory, First Marblehead takes the greatest risk and earns the greatest return.

The beauty of the First Marblehead model is that it requires very little upfront and ongoing capital expenses. Most of its value to customers arises from its borrower database, the expertise of its employees, and the strong history of its securitizations. The market for private student loans is growing so quickly, there isn't any need to spend money to expand operations. In my opinion, this investment is a bit like buying Oracle a the start of the internet revolution. As the market increases, lenders are going to be more interested in taking advantage of the intellectual property First Marblehead already owns.

Based on explosive earnings growth, it wouldn't be too surprising to find that First Marblehead is priced to perfection. But my DCF model suggests that the shares are fairly priced even if earnings remain level for the next ten years. Part of the problem seems to be that current earnings are somewhat uncertain since a large portion are estimates of future cash flows from residuals and ongoing fees. The flip-side is that the estimates might under-value these future cash-flows. So far, the estimates seem to be on the conservative side.

One concern is the possibility that lenders will decide to hold onto loans rather than securitize them. If that happens, there's no profit for First Marblehead and the lenders might develop their own borrower databases. This (and many other) concerns are addressed by an excellent analysis from Tom Brown. (To be honest, I never would have found this company without reading his website.)

Is organic growth better?

One response to Oracle's 3^rd Quarter earnings pointed out that we don't really know how much of Oracle's recent growth has been due to acquisitions and how much is organic. All other things being equal, organic growth is the best sort of growth. For one thing, acquisitions tend to be more expensive and can mask problems in the acquiring company.

Suppose, for instance, that Coke noticed problems in its flagship product. So management decides to acquire Budweiser at a steep premium. Then they refuse to break out the portion of revenues that was beer related so that investors won't notice the slowdown in Coke sales. Another issue is that this sort of growth isn't sustainable. Who would Coke buy next?

But not all acquisition strategies are created equal. Right now, Exxon Mobil is raking in huge amounts of cash for delivering gas to American drivers. But it's clear the ride won't last forever. Eventually existing reserves will be tapped and new sources of energy will be required. Although Exxon could use it's current resources to research and develop alternative energy, it might be cheaper and less risky to wait for a smaller company to develop a winning solution and buy that company.

This, in fact, is Oracle's strategy. Actually, the database giant does one better—they supply the platform that upstart companies use to develop new products. Most modern "Enterprise" applications use some sort of relational database to store vast amounts of information about an enterprise and its connections to the outside world. Generally, the Oracle database must be at least among the target platforms that applications support. Therefore, as new companies emerge to write software for specialized purposes, they are likely to target Oracle's database. And Oracle's R&D efforts to improve the Oracle platform will encourage more startups to target it.

But small software companies have several problems that a large company, such as Oracle, can solve. Small companies are required to spend a significant portion of their revenues selling to customers, supporting customers, and providing a productive work environment for employees. These activities scale particularly well, so larger companies have an edge over smaller ones. As a result, a new product has the potential to become significantly more profitable as part of the Oracle stack then it does on its own.

Ideally, Oracle would develop new products for new markets. But it's unreasonable to demand a company grow organically when it has the opportunity to acquire growth for a lower cost and lower risk.

On a mildly related note, there's news today that Oracle is suing SAP. The complaint accuses TomorrowNow, a company SAP bought shortly after the PeopleSoft acquisition, used support login information from customers who had or were about to switch away from Oracle support to download documents, patches and software. It seems there were numerous unnamed SAP employees involved in the project who are included among the defendants. I can't imagine legal documents normally are very good reads, but Oracle lawyers seem to have a knack for producing entertaining briefs. I throughly enjoyed the anti-trust briefs from a few years ago as well.

I am a bit concerned that the lawsuit will backfire in the court of public opinion, since Oracle is attempting a similar support contract end-around against Red Hat. Assuming Oracle has obtained and is using its support material legally, there won't be an actual lawsuit, but there might be questions within the open source community and the media.

Why I sold Alberto-Culver

A few weeks ago, I sold a call option against Alberto-Culver and on Friday, the option was exercised. I can't think of a better way to sell my shares: I sold for $22.50, the price on Friday was $22.51, and I got paid 30¢ for the privilege. As a result, my total combined ratio (after taking a penny a share loss) is 25.92%.

I still have a few shares left, but I got out of the bulk of my position in Alberto, because my original thesis is no longer valid—Sally Beauty was spun off. As it happens, I estimate that I earned 17.47% (38.90% annualized) on the first purchase and 16.32% (46.72% annualized) on the second purchase. "New Alberto" did better than I prediced, so I'm quite pleased with the overall transaction.

I still think Alberto will outperform the market over the next 5 to 10 years, but I don't think it will be a dramatic overachiever. I'll maintain a minimal stake in the company for a long time, if only because it isn't cost-effective to sell. Based on the dividend discount model, I guesstimate the shares are worth closer to $25 apiece, but I'm happy to sell in order to free up cash for an even better opportunity that I hope to buy into within a few weeks.

Final possession on Alberto-Culver option

Today was the penultimate trading day on my Alberto option and (coincidently) the first day of the NCAA Men's Basketball Tournament. Watching my option come down to the wire is a bit like watching the final possessions of a basketball game. Early in the game, "fundamental analysis" such as per-possession offense and defense are the best ways to predict the outcome. By the end of the game, however, nearly everything that has happened to that point in the season is meaningless. Often games come down to a handful of possessions in the final minutes that determine which team will come out ahead. In other words, close games are determined by luck.

Yesterday, the odds of avoiding a "loss" on the option where roughly the same as a team up by 2 points playing defense with the shot clock turned off. Today, Alberto-Culver shares jumped 1%, which is sort of like hitting a three pointer. Tomorrow is the final possession of the game, since the option will expire if not exercised. If I'm to record a profit on the option, I need Alberto-Culver to drop by 0.22 or more in tomorrow's session.

Notice that the curve is much smoother around the zero line than the graphs I showed yesterday. That's because I corrected the issue with excess 0% gains. (Basically, I use the adjusted close from Yahoo to avoid miscalculations due to splits and dividends. But that sacrifices precision, especially early in a stock's history. Therefore, if the two adjusted prices are the same and the actual closing prices are only a few percentage points from 0%, I now use the actual closing prices.)

Writing call options is a bit like playing a slightly better team. Over a long period of time, the stock market in general goes up. This graph is the odds that the S&P 500 will advance in a particular day.

On the other hand, call options pay a premium, which is a little bit like being spotted a few points (or betting with a point spread). For the ACV option, the game is coming down to the wire. I think I made the right decision based on fundamentals, but I still might be on the wrong side of the trade tomorrow.

The odds the option will be exercised tomorrow are roughly 80%, so by Monday I should have the cash to make another purchase.

Odds of my ACV option getting exercised

As of the market close today, Alberto-Culver stands exactly at $22.50—my option's strike price. I would expect the option to be exercised if the price ends a penny or two higher on Friday. This graph shows that (if the past is any guide) there is a better-than-even chance I'll be selling my shares.

The horizontal axis shows the range of gains and losses experienced by ACV shares over any two day period. The vertical axis is the odds that the price will increase by a certain percentage or greater in two days. So for a 0% or greater increase, the odds are 56% or so. Actually due to rounding errors there are more 0% gains in my data then there ought to be. (You will notice that the curve becomes vertical on the 0% line. That's not an optical illusion, but an artifact in the data.)

If the increase is 0.89% or greater, my option will lose money compared to simply selling the underlying stock on Friday. This graph shows that the odds are roughly 34% of taking a "loss" on the transaction.

Ideally, the shares will end somewhere between $22.50 and $22.70 so that I will sell the shares at a gain (odds ~ 22%). If that happens, I am ready to roll the proceeds into a new investment. If the option is not assigned, I might sell outright or (more likely) sell another covered call for April.

Why I doubled-down on Oracle

I've been planning on buying more Oracle off and on ever since I sold a portion a few years ago. Lately, I've held off because of price or because I had better ideas for the cash. As recently as last November, I was willing to sell another portion of my holdings. But since then, the price has fallen off far (15.97%) enough for me to switch back to buy mode.

I've borrowed some key ratios from Reuters:

Ratio                    Oracle  Industry*
-----                    ------  --------
P/E (TTM)                 24.02    31.08
Price to Sales (TTM)       5.39     5.96
Price to Cash Flow (TTM)  18.54    26.05
Price/FCF (TTM)           19.70    31.53
Operating Margin (TTM)    32.40    24.49
Net Profit Margin (TTM)   23.03    19.17
Return on Equity (TTM)    26.79    22.22

* Software & Programming 

The point is, Oracle is cheap compared to other software companies. But none of these ratios consider Oracle's superior growth. Year over year, Oracle has increased sales by 24.72% compared to 18.66% for the industry as a whole. Now much of the growth has come from the purchase of Siebel systems in January 2006, so we can't expect that growth to be repeated this year. But it's also becoming clear that the acquisition strategy is working. In particular, when a customer decides to buy one portion of the Oracle Suite, there is a strong incentive to buy all of their enterprise software from Oracle. Oracle the platform company is an even better business than Oracle the database company.

I also must admit that part of the reason I bought more Oracle was to round up an odd lot. Since Oracle doesn't currently pay a dividend, I intend to sell call options against my position. Of course, that requires Oracle to increase in price to where it is overvalued. That might take a few years, however.

Odds of successful call writing

Earlier today, I wrote a call option on my ACV stake. At the time, I was more concerned about getting paid to sell than loosing out on gains. This afternoon, I took a look the odds of exceeding my break-even price at the end of the two weeks. I calculated that if miss out on any increase of beyond 1.89%. First, I grabbed all the closing prices for ACV and loaded them into an SQLite database. Then I counted the total number of two week periods in my dataset:

sqlite> select count(*)
   ...> from (select * from acv_prices a
   ...>       join acv_prices b
   ...>            on (julianday(b.date) = julianday(a.date) - 14));

5503

Next I counted the number of those periods in which the closing price increased by 1.89% or more:

sqlite> select count(*)
   ...> from (select (a.close-b.close)/b.close increase
   ...>       from acv_prices a 
   ...>       join acv_prices b
   ...>            on (julianday(b.date) = julianday(a.date) - 14))
   ...> where increase > 0.0189;

2088

Therefore, if the past is any indication of the future, there is a 38% (2088/5503) chance my option will be called for a loss.

One of my goals in writing the option was that I would like to sell my Alberto-Culver shares. It's likely that a 1% increase will result in my option being assigned, so I also took a look at the number of fortnights in which the stock increased by that percentage or more. I won't show the code, but it turns out that 2551, or 46% of the periods resulted in greater than 1% increases. And just for kicks, I looked at the odds ACV will loose value over the fortnight, which is 43%.

Overall, the odds for each scenario shakes out like this:

ACV	Option	Odds
Down	Expire	43%
Up	Expire	11%
Up	Excerised for gain	8%
Up	Excerised for loss	38%
Total		100%

Why I sold an Alberto-Culver call option

Today I sold a call option on part of my Alberto-Culver position. Between now and March 16, I may be required to sell shares at $22.50. I'd be happy with a higher price, obviously, but I'm getting eager to use that cash to pick up shares of other companies that I have more confidence in. My current combined ratio is 24.92%.

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.

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%.

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.

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.

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.

Why I bought Eupa International

Eupa is using a reverse-split, going-private transaction as a lead-in to a merger with its majority shareholder, a Taiwanese company. Normally the merger would require some fairly expensive regulatory costs, but by executing a reverse split and suspending the reporting requirements (which require no proxy vote), those costs can be avoided. It seems to me the transaction is fairly safe now that the notice has been filed with the SEC since the benefits are fairly obvious and compelling.

I bought in at 35¢ and in a few weeks, I expect to get back 40¢ a share. This isn't the best profit (someone else bought at 30¢ later in the day), but it should be a fairly quick turnaround. One nice thing is that I was able to plow in my Pegasus cash which should result in an extra $44 gain.

Why I sold Pegasus Communications

I checked my brokerage website and it turns out I sold Pegasus Communications last Friday. Normally when I enter a going-private position like Pegasus, I initiate a limit-sell order near the cash-out price. It's sort of a safety valve in case the deal falls through later. Naturally, if the deal goes through (as this one had), I should raise the limit price to cover the commission cost which I won't have to pay when the reverse-split is paid. But the whole process is a bit silly since it's unlikely anyone will pay more than the cash-out price to purchase the shares. For some reason, someone did this time.

The final tally on the Pegasus Communications position was a 47.55% gain over 18 days. That works out to a 268,006.81% annualized return. If I had canceled or raised the limit order, I would have recorded a 111.80% gain, but my annualized return would have been much lower. Obviously, the total amount of this transaction is trivial. One nice thing about this deal is that my broker (USAA) recently lowered my commission from $19.95 to $11.95, which means I'm going to spend a lot less in the future.

Why I bought Pegasus Communications and Meritage Hospitality Group

In another going-private transaction, I bought 99 shares of Pegasus Communications. With this press release, the company announced the shareholders vote and a name change to Xanadoo Company.

I'm also waiting on the results from Meritage Hospitality Group, which will hold its meeting on January 23.

2006 in review

2006 was a great year for my IRA portfolio (up 28.50%). Not only did I outperform both the S&P 500 (13.62%) and Berkshire Hathaway (24.11%), I also posted my best calendar year performance. After 4 1/2 years of out-performance, I feel confident that my results so far are not a fluke.

Date      S&P 500  Delta     IRA   Delta BRK A  S&P 500   NAV    BRK A
06/23/02                                         992.72 10.00  72,200.00
12/31/02   -11.37% 42.32%  30.95% 30.18%  0.76%  879.82 13.09  72,750.00
12/31/03    26.38% -1.49%  24.89%  9.08% 15.81% 1111.92 16.35  84,250.00
12/31/04     8.99% -2.16%   6.84%  2.49%  4.34% 1211.92 17.47  87,910.00
12/31/05     3.00%  3.23%   6.23%  5.42%  0.81% 1248.29 18.56  88,620.00
12/31/06    13.62% 14.88%  28.50%  4.39% 24.11% 1418.30 23.85 109,990.00
Total Gain  42.87% 95.63% 138.50% 86.16% 52.34%    
Annualized   8.20% 12.97%  21.17% 11.43%  9.75%    

A significant factor in my success this year was that my patience with Oracle finally paid off. I bought at a ridiculously low price and Oracle proceeded to perform quite well and account for nearly all of my IRA's gain for the second half of 2002 and all of 2003. 2004 and 2005 represented a fair amount of uncertainty for Wall Street, which refused to believe that "tech mergers" worked. This year, the various acquisitions started contributing to the bottom line and Oracle's shares followed (up 40%). The interesting thing is that Wall Street still undervalues Oracle. Too many analysts focus on new database licenses to the exclusion of higher margin renewals. Also, I think the Oracle database is under-appreciated as a platform for other businesses to develop new products on. It's nice that Oracle the company is standing in the wings to buy startups that succeed.

Canon, at 23% of my portfolio, is tied for my largest holding in large part due to its exceptional performance during 2006 (up 44%). Once again digital cameras and printer-related consumables continue to be the mainstays of Canon's business. The digital camera revolution is nearly over in my opinion—most people have a digital that meets their needs. Canon is going to have to have a new product boom in the next year or so to keep up their revenue growth. Perhaps YouTube will do for digital camcorders what Flickr did for still cameras. I think Canon's management is counting on its new flat-screen TV product to drive revenue growth.

Select Comfort endured a rocky ride this year and ended down 4.6%. Operationally, nothing much changed in my opinion. They are still the same company with the same management operating in the same business as when I first bought shares nearly two years ago. It's entirely possible that macro factors such as the slowing housing market and credit tightening will make 2007 a disappointment, but over the next ten years Select Comfort ought to do very well. After buying more shares, it is now tied for my largest holding.

Berkshire Hathaway is up 23.5% since I bought it. 2006 was a spectacular year to be a reinsurer since claims were low and premiums high. (The catastrophes of 2005 are largely to blame so its possible premiums will head down in 2007.) Auto insurance continues to be a good business since cars continue to be built safer. Berkshire's other lines of business seemed to perform well during the year. From now on, a portion of my portfolio will match Berkshire's results, which is something to keep in mind when I compare my results to it.

The year end spin-off math for Alberto-Culver is Alberto-Culver ($21.47) + Sally Beauty ($7.86) + the special dividend ($25) = $54.33. Given that I bought at a dollar-weighted average of $49.34 a share, I've made nearly $5 a share or 10% on the spin-off. Alberto-Culver and Sally Beauty together make up 15% of my portfolio, which is fairly significant. But I haven't yet decided if they will become core positions. Both companies have now released initial 10-K reports, which I hope to have a chance to read in-depth soon. But I think I'll have a better idea of how the new companies operate after a quarter or two. Also, I'd like to know what Alberto's dividend will be.

The rest of my portfolio is a smattering of going-private transactions and cash. I'm also short January 2007 options on Oracle at $20, which should expire without value. In some ways, this "short-term" portion of my portfolio is the least important. By their nature, going-private transactions are very profitable, but also very small. Last year I completed 3 and initiated 2. But if they were to make a significant impact on my portfolio, I would have had to have completed something like 10. This year, I'll need to complete even more, since my total portfolio has grown considerably. On the other hand, since they require little in the way of effort, risk or capital, I see no reason not to continue attempting to make a little profit there.

Why I bought more Select Comfort on disappointing news

Yesterday, Select Comfort reported that it was seeing a massive slow-down in sales and lowered its 2006 estimate to 80 to 87¢ a share. Since the previous guidance was 95 to 97¢, this was a huge disappointment. Last year, Select Comfort earned 76¢ a share (after adjusting for a 3/2 split), so the growth this year is between 5 and 14%. Worse Q4 earnings look to be 21 to 46% lower than 2005.

What happened?

According to the press release:

“This quarter’s sales have been disappointing, as we’ve noted a closer correlation in our business with housing industry trends. Our sales programs and promotional offers have been consistent with prior years, and we are protecting product margins,” said Bill McLaughlin, Select Comfort chairman and chief executive officer.

For a high-end furniture company, this is actually a decent excuse (though not encouraging). People moving into a new house tend to want new furniture to go with it and have access to cash from home equity lines of credit. Also, if the soft housing market foretells a recession (and it seems to be doing just that), customers might be holding off on large purchases for the moment.

But I think the specific problem for Select Comfort is the new ad campaign, which started this year. Two of the new commercials are available on the company website ("Five Senses" and "Revere"). If you aren't paying attention, you might be forgiven if you think these are drug ads (probably for sleep aids, but maybe anti-depressants or ED treatments). The bed just isn't a big part of the commercial. Sure, the message is clear if you pay attention, but you've got to figure that the people who aren't fixing themselves a snack are TiVoing through the commercials. In contrast, the previous commercials were funny and focused on the mattress itself.

The good news it that Select Comfort has already addressed the problem by hiring a new ad agency. Poking around their website, I think Select Comfort made a pretty good choice with the one reservation that McKinney also has Southern Comfort as a client. Overall, they seem to produce polished, memorable commercials often using humor. Their Sony commercials are especially informative, because like TVs, men and women need to agree on buying the same bed.

Based on the low earning range ($42,160,000) and low growth range (20% a year), a DCF shows Select Comfort to be worth over $40 a share. $18 a share implies a growth rate of about 8%. A more conservative estimate works out to a fair value of $21. I'm concerned about a recession in the next year that could further hurt earnings, but I think the problems are likely to be temporary. In the meantime, Select Comfort will be able to buyback shares at a reasonable price, improve its advertising and find operating efficiencies.

Why I sold a call option on Oracle

Today I sold a January, 2007 call option on Oracle at a strike price of $20. The premium was 70¢ a share. Yesterday (when I placed the limit order for the option) Oracle closed at $19.48. After commisions and fees, I recorded 2.83% income on the transaction. On an annualized basis, that's 19.18%. If the option is assigned, I'll earn 4.47%, which is at least 24.53% annualized. For me, this is a win-win.

According to this calculator, the option was worth 62¢. I don't know if that's acurate or not, but it doesn't really matter to me. Option pricing models, such as the Black-Scholes model and the binomial options model, are interesting in the acedemic sense, but relying on them for actual options trading seems speculative. The problem with generic models is that they include volatility among their inputs. But the odds of a stock reaching a certain price are also influenced by the company's intrisic value and the probability of positive or negative news, which cannot be included in a generic model.

Writing a call option amounts to a soft sell of Oracle. I think $20 is a reasonable (though maybe low) selling price, but I'm not ready to put in a limit order. I also don't see any reason for the price to jump much higher in the next two months. Oracle Openworld, when Larry Ellison announced the company's Unbreakable Linux initiative, happened in October. There aren't many big aquisition targets on the horizon. I doubt the second quarter earnings release will be significantly better than expectations. In fact, given the persistent inverted yield curve, I suspect stocks in general will be flat at best.

Accounting for spin-offs

Now that the Sally Beauty spin-off has occurred, it's time to figure out how to account for it. Thankfully, Quicken has a spin-off transaction type. Unfortunately, it isn't entirely clear how it works. After fiddling with it for a while, I think I understand the accounting.

The first principle is that you received both the parent and the spun-off company (plus the dividend) on the day you bought the original shares. So on September 18, 2006 I bought Alberto-Culver plus Sally Beauty (plus the dividend) for $49.40 a share (and on October 23, 2006 for $49.24). The spin-off event has a retroactive effect on the original transactions.

Second, the cost basis for each company is determined by the market on the day of the spin-off. For the sake of simplicity, I'll use the opening prices, but I have seen the average of the day high and low used. I believe Alberto-Culver will file the official ratio to be used for tax purposes sometime soon. At any rate, New Alberto traded at $20.10 and New Sally traded at $7.35 (and the dividend was $25). For our purposes, I'm going to lump the dividend into the value of New Sally, because the dividend was paid for through the money Sally borrowed. Therefore, the ratio to use is Sally—61.68% and New Alberto—38.32%.

Third, a "Return of Capital" transaction on the date of purchase lowers the cost basis of the parent company by cost basis of the spun-off company. So for September 18, Sally Beauty was acquired for 61.68% of $49.40 or $30.47 a share. (And on October 23 for $30.37 a share.) Therefore, Alberto's cost basis is reduced by the same amount.

Fourth, the dividend is recorded as a return on the Sally Beauty investment. Currently, Sally trades for $8.51 a share, which is quite a bit lower than my original cost. But when you add in the $25 dividend, those shares have returned about $3 each so far. Meanwhile, Alberto has gained a little over a dollar a share since I bought it.

I've been able to get my Yahoo portfolio to more or less work out, but it requires more faking since it doesn't properly account for dividends. I wish someone would provide a really useful online-portfolio tracking system.

Sally Beauty (when issued)

Alberto-Culver shareholders approved the Sally spin-off on Friday and as of today Sally shares are being bought and sold on the "when issued" market. Since there is also a market for both new Alberto and old Alberto, it's now possible to find out what the market says about the breakup math: $25 (cash) + $7.50 (Sally) + $17.85 (Alberto) = $51.35

But it is still possible to buy old Alberto for around $50, so there is still time to take advantage of a market inefficiency. (Basically, index funds that track the S&P 500 need to sell Alberto before the index drops Alberto and replaces it with some other company.) Although I have a little more cash to invest, I'm holding back for when Sally Beauty trades on the open market and after I have received the $25 dividend. I still think Sally conservatively is worth 30% more than $7.50. I suspect that when the company releases financials, the conservative value will be even higher.

Many salons in the US resemble malls in the way they operate. Each beautician rents a "chair" from the salon and keeps any profit they earn above that. Besides the basic services like washing, cutting and styling hair, salons are also an outlet for high end hair and beauty products. These are products that you can't buy at Wal-Mart or drug stores, because the makers of those products (e.g. Paul Mitchell) are aiming for a "Professional" market. As a result, there is a distribution problem—how do manufacturers get their products into the hands of beauticians?

Enter Sally Beauty Supply and Beauty Systems Group. BSG sells only to beauty professionals and Sally sells both to the general public and (under the Sally ProCard program) to professionals. Wal-Mart, Target and drug stores are more or less locked out of Sally's market pretty much by definition. On the other end of the spectrum, it's difficult to imagine another company building or buying a distribution network that competes with Sally.

The one exception is Regis, which is consolidating the salon industry through expansion and acquisitions. As you might recall, Alberto's original plan was to spinoff Sally and merge it with Regis. That plan failed in large part because Regis suffered some operational setbacks that made the merger unlikely to succeed. Ultimately, however, product sales are likely to be merely a sideline in Regis's business. (Humberto Barreto wrote an interesting paper that uses the salon business as a modern example of Ricardian Rent Theory.)

Why I bought more Alberto-Culver

On Friday, "Prudential Equity Group analyst downgraded her rating on" Alberto-Culver. According to the AP, her reasons were "that both Alberto Culver and the new Sally Beauty Holdings face deal-related risk, and that tax obligations from the $25 special dividend may not be known until 2008." As a result, shares of Alberto-Culver dropped from $51.25 to $49.94 that day.

To address the second issue, depending on New Sally's earnings, the special dividend might be taxed as a dividend, tax-free return of capital, taxable capital gain, or a combination of the above. The dividend must be reported this tax year (assuming the proposal passes), but the final determination of how it is taxed might not be made until after New Sally's first year in operation at the end of 2007. For most people, the accounting is going to be ugly. But since I hold Alberto-Culver in my IRA, the taxes are an interesting side-note.

The other issue ("deal-related risk") is more of a concern. Without access to the complete report, it is difficult to know what that phrase represents, but I'd imagine it is a reference to the costs and difficulty of splitting a company in half. Until they have been separate for a few quarters, investors can't be sure of the extent of "one-time-charges" on or both of the new companies may incur. On the other hand, it seems to me the businesses have been more or less independent for years and ought to be up to speed quickly.

Considering why I bought shares originally, Prudential's downgrade is actually a positive sign for me. In particular, this is further evidence for point "a. Institutions don't want the spinoff (and not because of the investment merits)." The deal is complicated and it will be a few quarters, if not years, before everything settles down. Until then, institutions may not be comfortable owning shares in a company that is largely unpredictable.

In the meantime, the downgrade and resulting price drop gave me an opportunity to roll the cash I received from two going-private transactions into Alberto-Culver stock. It seems like the great value investors have a simple capital allocation strategy that I'm trying to emulate. When you have capital and an investment idea, allocate the capital to the idea.

Alberto-Culver breakup value

Alberto-Culver shareholders are being asked to vote on a spin-off of the company's salon products distribution business (Sally Beauty) in November. Current owners will receive one share of New Alberto, one share of 52.5% of New Sally and $25 per Alberto-Culver share. The other 47.5% of New Sally will go to a private equity fund (Clayton, Dubilier & Rice Fund VII) in exchange for $575 million, which works out to about $6.73 a share. In order to pay the special $25 dividend, New Sally will take on $1.85 billion of new debt.

Based on the current market value of Alberto-Culver and the implied purchase price of New Sally, here is a chart showing the valuation of each piece compared to some competitors:

                  Price/share Price/Sales Price/Earnings EV/EBIT
ACV               51.30       1.35        24.03          14.06 
New Alberto       19.57       1.39        25.70          17.89 
New Sally          6.73       0.50        37.21          13.68 
Cash              25.00    

Procter & Gamble  62.05       2.89        22.69          17.16 
Colgate-Palmolive 60.09       2.72        22.96          16.46 

Personal & Household Prods.   2.6         25.64 
Consumer/Non-Cyclical         2.4         22.1 
    
Regis             38.20       0.72        15.95          10.93 
CVS               31.25       0.69        20.96          15.56 
Walgreen          44.34       0.94        25.53          16.05 
Longs Drug        44.50       0.36        22.60          11.97 
    
Retail (Drugs)                0.72        24 

On this basis, New Alberto is not valued dramatically differently than current Alberto or other personal products companies. New Sally, however, looks cheap according to its P/S since it is closer related to drug stores and Regis (the salon company that tried to buy Sally last spring). Retailers, as middlemen, must carefully control profit margins in order to remain competitive, unlike consumer product companies that can nurture a brand to higher margins. The P/E ratio is less telling for Sally because it will take on so much debt. EV/EBIT, which removes the effect of leverage, puts Sally in the middle of the retail pack.

Now, let's look at how the pieces could be evaluated after the spin-off. I set New Alberto's price based on the P/E ratio of Consumer/Non-Cyclical companies and used the P/S ratio of drug retailers for New Sally's price.

                  Price/share Price/Sales Price/Earnings EV/EBIT
ACV               51.60       1.36        24.17          14.14 
New Alberto       16.83       1.20        22.10          15.38 
New Sally          9.76       0.72        38.56          13.87 
Cash              25.00

This isn't too far from the market value of Alberto-Culver, so the investment thesis is that the spin-off will allow both companies to operate more efficiently and will reveal the true value of the underlying businesses.

First, all fundamental data I've used is based on 2005 figures since only 9 months are available for 2006. So far, 2006 seems to be a fine year for the combined companies. EPS for the last 12 months is $2.37 versus $2.09 in the previous 12 months. I expect the initial financial statements from both companies will suggest a higher price per share as well.

Second, New Alberto will be debt-free and able to focus on building its portfolio of brands. The salon distribution business was a distraction and didn't provide any operating advantages since few of Alberto's products where sold in Sally stores or through Beauty Systems Group. Dumping debt on New Sally could allow New Alberto to pursue acquisitions like it recently made with Nexxus and St. Ives.

Third, CD&R has tremendous motivation to increase the post-spin-off value of New Sally. The private equity investment company has successfully invested in spin-off companies such as Lexmark and Hertz and only profits if the price of the highly leveraged stock appreciates significantly. It's helpful to view Sally as an LBO or the stub stock of a recapitalization.

Fourth, New Sally should be able to expand into new markets and increase current-store sales through advertising. Alberto's salon product distribution business has been hampered in the past because the parent company is a competitor with other vendors and predominately distributes through other retailers. Once free of the consumer products business, Sally should be able to promote itself more aggressively.

I see a purchase of pre-spin-off Alberto as a low risk opportunity to participate in CD&R's investment. Depending on how the market values New Alberto and New Sally, purchasing one or the other could be an even more rewarding investment.

HyperFeed Technologies "perilous financial decline"

Talk about honest. HyperFeed Technologies, which has been trading between 60 cents and $1.05 over the last three months, announced a merger with Exegy Incorporated that will cash out shareholders at $1 a share. In the SEC filing, the company decided this was the best course of action "because of the Company’s perilous financial decline". I think I'll pass on this one.

Advanced Nutraceuticals cashed out

Well, I don't think anyone could be as pleased as I was to lose a half-million dollars. My shares of Advanced Nutraceuticals were cashed out on Oct. 5 at $4 a share. On an anualized basis, it was 144.12% and one day short of beating Major Automotive, which was 144.21% annualized, as my best investment.

I was thinking about the comparsion with the S&P 500 and it occured to me that Berkshire Hathaway might be a reasonable benchmark to strive for:

Date      S&P 500  Delta    IRA    Delta  BRK A
12/31/02* -11.37%  42.32%  30.95%  30.18%  0.76%
12/31/03   26.38%  -1.49%  24.89%   9.08% 15.81%
12/31/04    8.99%  -2.16%   6.84%   2.49%  4.34%
12/31/05    3.00%   3.23%   6.23%   5.42%  0.81%
10/05/06    8.41%  20.51%  28.92%  17.21% 11.71%
Total Gain 36.31% 102.96% 139.27% 102.16% 37.11%
Annualized  7.49%  15.07%  22.57%  14.93%  7.64%

* First reporting date is 06/23/02

In a little over four years, I've managed to outperform both the S&P 500 and Berkshire, which astounded me. I can't imagine that will continue for the next four years however, because Berkshire is tremendously undervalued. Starting this year, some of my performance will be based on the performance of Berkshire thanks to the share I own. Also, it isn't a fair fight since Mr. Buffett and friends must allocate billions of dollars and can't invest in tiny companies like Advanced Nutraceuticals or even tinyer opportunities like going-private transactions.

Why I bought Alberto-Culver

Alberto-Culver can be divided into two lines of business—consumer products and beauty salon supply distribution. As it turns out, Alberto plans to split into two separate companies by spinning off Sally Beauty Supply and Beauty Systems Group, the distribution segment. The remaining company, New Alberto-Culver, will continue selling Alberto VO5, TRESemmé, Consort and Nexxus hair products, St. Ives skin care products, Mrs. Dash, Molly McButter, Static Guard, and a few other random products.

Spinoffs tend to be a good place to find exceptional value. In You Can Be a Stock Market Genius, Joel Greenblatt suggests "certain characteristics [that] point to an exceptional spinoff opportunity: a. Institutions don't want the spinoff (and not because of the investment merits). b. Insiders want the spinoff. c. A previously hidden investment opportunity is uncovered be the spinoff transaction (e.g., a cheap stock, a great business, a leveraged risk/reward situation)." I believe Alberto-Culver possesses all three characteristics.

The transaction is a bit complicated, but the results are fairly straightforward: each share of pre-spinoff Alberto-Culver will be converted into a share of New Alberto, a share of New Sally and $25 cash. A private equity fund (Clayton, Dubilier & Rice Fund VII), will own 47.5% of New Sally, which will issue $1.85 billion in debt to pay for the dividend. So how does Alberto meet the criteria?

1. I don't think institutions want any part of the spinoff. Half of the value of the spinoff is a dividend, and who doesn't like cash? Well, institutions don't like like large dividends because they are taxable events and need to be reinvested. New Alberto will have a significantly less interesting growth story without Sally and will be compared to Proctor & Gamble and Unilever. New Sally is the worst of all: high debt, single-digit stock price, not part of the S&P 500 (so must be sold by index funds), competes against Wal-Mart, Target and drug stores (but not really), and who wants to say they invested in a company called "Sally"? (To be honest, the whole thing seems a bit "feminine", doesn't it?) One other problem is the stench of failure since an attempt to spin/merge Sally into Regis Corporation, which runs a chain of salons, when sour earlier this year.
2. Insiders will continue to be part of both surviving companies acting more or less in their current capacities. The family of Leonard H. Lavin, Alberto-Culver's founder, will continue to own a significant percentage of both companies and have agreed not to sell for at least a year in order to keep the tax-free status of the spinoff. CD&R has a history of guiding spinoffs to successful operations, such as Lexmark from IBM and Hertz from Ford. The only thing missing is option or restricted stock grants to increase insiders ownership.
3. Generally a vertically integrated company has tremendous advantages because they have control over every step from manufacture to the final customer sale (think Starbucks). But Alberto-Culver is not integrated with Sally Beauty Shops or Beauty Systems Group, because only a fraction of New Sally's sales are Alberto products. Sally can't give, for instance, TRESemmé products preferential treatment, because Clairol, Revlon, Conair and L'Oreal would be displeased and might pull their products. Also, Sally must limit advertisement since it competes with stores that carry Alberto products. Rather than being an asset to the other, each company is a potential liability.

I had a bunch of other great insights, but Blogger.com managed to corrupt this post. I'm sure I'll get around to posting them later.

American Education cashed out

My shares of American Education were cashed out this morning at 55¢ a share. Including the commision of my purchase, that's a 12.27% gain versus 0.33% if I had invested in the S&P 500. On an annualized basis, that's 78% which easily exceeds the 5% hurdle I use for these relatively safe going-private investments.

This sounds great, but I only made $30. Even if I were able to buy the 1999 shares I wanted to buy and didn't pay a commission, my grand total would have been $199.90, which isn't all that much. On the other hand, now that I've survived a few of these deals, I don't think it will take more than an hour or so to research new going-private situations. Mostly, I just need to read the proxy on the SEC's website and do a little math. If commissions continue to become a less important cost (because of inflation or my broker becomes more generous), these little investments could be even more profitable (though at no larger scale).

I've been reading Warren Buffett's Partnership letters, which provide an interesting "pre-history" to the Berkshire Hathaway letters. (Berkshire first appears in the January, 1966 letter, but Buffett has made purchases of its stock as far back as 1962.) One repeated theme in them is the categorization of investements into "general", "workout" and "control". General investments are purchased because they are cheap (either compared to their liquidation value or relative to similar companies) and tend to move in the same general direction as the market. Workout investments are purchased because some future event (not just rumored, but published in the paper) will unlock hidden value. Control investments are companies that the Partnership had influence over by reason of a large ownership stake. The last two investment types are largely uninfluenced by the general market.

Until this year, 100% of my investments have been in the general category (or cash), so my results ought to have followed the market. This year, I've been working in some special situation investments (workouts), so my results ought to be better in down markets and keep up (maybe) in up markets. (Joy and I do have "control" investments in a sense because of our careers and Joy's Pampered Chef business. It's difficult to assign a value to them, but they will provide far more earnings to us than our retirement accounts for a great many years.)

Here are my results since I opened my self-directed IRA:

Date       S&P 500   IRA    Difference   
12/31/02*  -11.37%  30.95%  42.32%
12/31/03    26.38%  24.89%  -1.49%
12/31/04     8.99%   6.84%  -2.16%
12/31/05     3.00%   6.23%   3.23%
09/29/06     7.01%  23.32%  16.30%
Total Gain  34.56% 128.88%  94.31%
Annualized   7.20%  21.39%  14.19%

* First reporting date is 06/23/02

The first "year" (actually closer to 6 months), was entirely the result of a single stock—Oracle. 2003 and 2004 were poor years as Oracle and Canon lost ground. In 2005, the addition of Select Comfort made up for the flat performance of the other two holdings. So far this year, the situation has reversed. In addition, I've purchased Berkshire, which has not done much so far, and some special situations, which have added to the account's returns. Beating the market by 14% a year isn't a realistic goal, but the wild swings are likely for a concentrated portfolio.

Canon innovations

One of the things that makes a consumer products company like Canon successful is finding ways to get the same consumers to buy new products over and over again. An example of how this can be done is found in a Fortune camera review:

Designed for serious amateur photographers but also friendly to the casual point-and-shooter, the Canon Rebel XTi also features a built-in cleaning system that reduces the chance that dust inside the camera will spoil a shot, a bugaboo that plagues most other cameras in its class. No matter how careful one is when changing lenses, dust can enter the camera body to ruin subsequent shots. The XTi literally shakes any dust off the sensor when the camera is turned on or off, using ultrasonic vibrations. The motes are then immobilized on a sticky trap. Also, the camera can "map" stubborn dust particles on the sensor and then erase them from images via software.

These seemingly minor innovations can add up to making older products completely obsolete every few years. The faster the innovation cycle, the more often consumers will want to get the latest thing and the more sales companies like Canon will make.

Half-millionaire

I just felt like crowing this morning, because my IRA has a market value over a half million dollars. Unfortunately, most of the balance is based on a single position, Advanced Neutraceuticals Inc. My 499 shares are trading at $1,025.000 for a grand total of $511,475.00. Sadly, my sell order online fails with the following message: "We are unable to process the order referenced above. This security is subject to a corporate action. Please call our Customer Service line if you need further assistance." In the crazy world of high finance, I'm bound to lose my first half million almost as quickly as I gained it.

P.S. There was a little bit of drama just before the shareholder vote. Fortunately, it seems to have worked out for me, though it wouldn't be the end of the world to have been left with a small, cash-flow positive company with manageable debt and insider-buying.

Why I bought Advanced Nutraceuticals

I've gotten a bit behind in my investment rationals, so before I forget, I better write this down. This is another going-private transaction that was initially priced at $3.20 a share for holders of fewer than 500 shares. On July 25, the offer was raised to $4 a share. Up to now, my rule has been to wait for a definative proxy before buying into these sorts of special situations, but I realized that raising the price of the offering is a similar signal that the transaction will happen. There's no particular reason a company should raise the offer unless the SEC thinks it is unfairly low, so once the offer is raised, there's a good chance the going-private transaction will be approved.

Why I bought American Education Corp

American Education is another going-private opportunity that I nearly screwed up. My purchase accounted for exactly half of that day's volume (500 shares). I had intended on buying 1999 shares so that the commission would be minimal, but I didn't check the "all or none" box when I entered the order on my broker's website. As a result, I initially only bought 100 shares, which would have cost me a small amount. Instead, I stand to make a small amount. My return, however should be quite satisfactory.

Classifying investment decisions

I recently read an article by James Montier, who wrote "Behavioral Finance - Insights into Irrational Minds and Markets." He suggested classifying investment mistakes into 4 categories based on two axes:

	Good outcome	Bad outcome
Right reason	Skill	Bad luck
Wrong reason	Good luck	Mistake

Thinking about the decisions that I've recorded here, I can see that all of the individual stock purchases and the single sell have been very good outcomes. In fact all of my positions are beating the S&P 500 index and all but one (Berkshire Hathaway) have annualized returns better than 15%. Looking over the reasons I documented for those decisions, I think I can label my success as mostly skill. I focused on fundamentals and the fundamentals of each company have been good and improving.

The mutual fund investments I've made in my 401(k) had mostly good outcomes. I spent way too much time distrusting active funds (by stayin nearly 100% invested in an index fund) and I picked a poor time to become a bond investor. In the first case, I think I made a mistake by focusing too much on fees. In the second case, I think I've had a bit of bad luck.

But it's a lot harder to evaluate the decisions that haven't resulted in purchases or sells. It's a bit harder to analyze "sins of ommission" at least in part because they don't tend to leave traces in our memory. On the other hand, as Warren Buffett says, there are no called strikes in investing. It's entirely possible I would have made more money by purchasing my half-thought out or rejected ideas. But I'm not sure I would be as comfortable with them.

"Revenues are Good, Costs are Bad" and Other Business Myths

Just reading the first myth in "Revenues are Good, Costs are Bad" and Other Business Myths made me think of the struggle Oracle has with the Wall Street analysts who cover it. Oracle has two basic sources of revenue: new licenses and license renewals. New licenses are seen by Wall Street as more desirable since they represent revenue growth. But renewals are much more profitable because Oracle doesn't have to pay a salesman to drum up the bussiness.

Wall Street would also like to see more of Oracle's revenue growth come from its own products rather than from buying competators. But if Oracle can obtain customers more cheaply by buying other bussinesses, it's in the company's interest to do so. The same argument can be made about R&D spending versus buying other company's products.

Poorcasting

I just want to lay claim to a word I coined in the middle of the night:

Poorcast

To project that the future will be less prosperous than the present.

Bloomberg.com: Canon

So Canon Stock Has Biggest Gain in 2 Years on Digital Camera Sales according to Bloomberg. Not bad. In Tokyo, Canon ended at ¥8,300. $1 = ¥117.38 at the moment, which should mean Canon would trade at $70.67 or so in New York. It actually ended at $71.32, so there seems to be a small "Japan premium" built into the NYSE price. Perhaps that is because the market agrees with Bill Gross that the dollar is headed down—against the Yen in particular.

Naturally, it makes sense to ask if Canon is now overvalued. Quicken's DCF model suggests that the company needs to grow 6.3% over the next 10 years in order to justify its current price when discounted against the S&P 500's long term rate. Even if Canon doesn't expand into new markets, I think 6-7% growth is very likely. And if new products do succeed, 10+% growth should be possible.

Investment returns redux

I discovered an error with the spreadsheet I used to generate my investment returns. It turns out I hadn't adjusted the S&P 500 index price for some of my purchases. The effect was to make the Benchmark column wrong:

Stock             Opened  Price  Closed   Price Annualized Benchmark
Oracle           6/24/02   8    5/28/03   13.35     67.05%    -9.94%
Major Automotive 2/28/06   1.75 3/29/06    1.90    144.21%   -11.13% 
Oracle           6/24/02   8     4/4/06   13.84     14.99%     6.80%
Canon            12/9/03  45     4/4/06   68.56     19.04%     2.19%
Canon            12/1/04  49.66  4/4/06   68.56     26.38%     5.34%
Select Comfort    2/9/05  19.95  4/4/06   39.80     80.44%     6.60%
Berkshire (B)    1/31/06   2920  4/4/06    3001      8.29%     2.57%

Now I'm 100% both on absolute and relative terms. Obviously this was a pleasant surprize. Even better, I've been tracking my time-weighted internal rate of return and my IRA is earning about 20% annualized. Since I've held a lot of cash earning less than 4% most of that time, I feel pretty confident in my ability to make good investments over time. If anything, I ought to be making more trades.

Maxco off my watch list

It's sort of sad, but Maxco, Inc. Announces Abandonment of Proposed Transaction to Terminate SEC Registration. This was the first company I started watching for a possible going private arbitrage opportunity. The lesson is to wait for a definitive proxy.

Investment returns

After selling Major Automotive, I started to wonder how well the other positions in my IRA have faired. After cosidering commissions, my two closed positions are:

Stock            Opened   Price Closed   Price Annualized Benchmark
Oracle           6/24/02  8     5/28/03  13.35  67.05%     -9.94%
Major Automotive 2/28/06  1.75  3/29/06  1.90  144.21%    -59.70% 

And here are the open positions assuming commissions, dividends, and today's closing price:

Stock            Opened   Price Closed   Price Annualized Benchmark
Oracle           6/24/02  8     4/3/06   13.79  14.89%      6.68%
Canon            12/9/03  45    4/3/06   67.41  18.20%      2.00%
Canon            12/1/04  49.66 4/3/06   67.41  24.85%     20.25%
Select Comfort   2/9/05   19.95 4/3/06   39.73  80.41%     24.32%
Berkshire (B)    1/31/06  2920  4/3/06   3012   10.78     332.30%

As you can see, all of my investments are currently in the black and I'm 6 of 7 against the S&P 500. Obviously this won't hold up in the future.

SC 13E3 filings

Here are my notes on some recent SC 13E3 filings:

Pegasus Solutions, Inc.

Merger valued at $9.50 a share. Currently trading at $9.39.

Yadkin Valley Company

1-for-50 reverse stock split valued at $78.00. Currently trading at $97.50 a share.

Asconi Corporation

1-for-30 Reverse Stock Split valued at $1 a share. Currently trading at 30 cents a share.

Badger State Ethanol, LLC

Reclassification of Class A member units to Class A-1 member unit for holders of fewer than 20 units. I can't find any trading information on the units.

The Sports Authority, Inc.

Merger valued at $37.25 a share. Currently trading at $36.98.

Foodarama Supermarkets, Inc.

Merger valued at $53 a share. Currently trading at $52.

Masonite International Corporation

Went private in the spring of 2005. I think this is a bug in the SEC's script.

Obsidian Enterprises, Inc.

Went private on March 17. (Timothy S. Durham is also related to this transaction.)

Scheid Vineyards Inc.

1-for-5 Reverse Stock Split valued at $9.25. Currently trading at $6.64.

Stratford American Corporation

Merger valued at $0.80 a share. Currently trading at 78 cents.

Instrumentation Laboratory S.p.A.

Tender offer valued at U.S.$0.98 per ADS. Currently trading at 50 cents.

Lafarge North America Inc.

Tender offer valued at $75.00 per share. Currently trading at $83.86.

Cruzan International, Inc.

Went private on March 22.

Rogers Wireless Communications Inc.

Went private in 2004. Another bug, I think.

William Lyon Homes

Tender offer valued at $93.00. Currently trading at $97.30.

Chiron Corp.

Tender offer valued at $45 a share. Currently trading at $45.70. This is an interesting case. Novartis is trying to by Chiron, which made news recently because it is major supplier of flu vaccine. But it isn't clear how shareholders will vote, since two proxy advisory services covering the deal are split.

These notes cover March 20 to March 30, and as you can see, there aren't any real prospects here. Most of these filings cover tender offers and mergers, which are too competitive. Anyone can make money if they guess the outcome correctly. Yadkin Valley Company is trading (very thinly) above the offer price. Asconi Corporation would be only be worth $29 if someone gave you 29 shares, so the commission would kill me. Scheid Vineyards pays out only $37. So far, I don't see any worthwhile deals.

Raytheon raises its dividend

Raytheon announced that it is raising the quarterly dividend to 24 cents a share. Last year it was 22 cents and for several years before that it was 20 cents per share per quarter. The new rate pushes the dividend yield over 2% at current prices, which isn't great on its own. But the new trend toward increasing the dividend is very encouraging. One the reasons I feel good about Canon, is that every 6 months management raises the dividend a notch. Giving out cash is not only very good for shareholders, it signals that management is comfortable with the future of the business.

SEC webpage hack

First, I'm using definition 3. a., not 3. b.

Easily the most difficult part of investing in reserve split cashout situations is finding the SEC filing. Companies that intend to "go private" initially file a SC 13E3 ("Going private transaction by certain issuers"). Later they might file a SC 13E3/A (" [Amend]Going private transaction by certain issuers"). Often those filings refer to either a SC TO-T ("Tender offer statement by Third Party") or a PRER14A ("Preliminary Proxy Soliciting materials") which contain the details of the transaction. Normally, companies that are merging or buying out all outstanding shares are less interesting than reverse splits. All of this takes some digging.

Fortunately, the SEC offers an interface to recent filings, but the menu only goes back five business days. But if you change the URL, you can see filings any number of days old. Today's 13E3 filings are: http://sec.gov/cgi-bin/current.pl?q1=0&q2=0&q3=SC+13E3. The ones filed two weeks ago are: http://sec.gov/cgi-bin/current.pl?q1=9&q2=0&q3=SC+13E3.

The next step is to search through the filings for good or potentially good deals. Since the same companies might amend their 13E3 filings dozens of times, it's good to take notes so that you don't duplicate research.

Major Automotive transaction completed

I bought Major Automotive on February 28 for $1.75 a share and received $1.90 a share this morning. After accounting for commission (on the purchase), I made $129.90 in 29 days. If I could make this transaction on a continual basis, I'd earn 144% a year.

Of course, the problem is that there aren't enough of these situations and they aren't big enough to constantly do them on a large scale. Which is just as well for me, since if they were, the opportunities would disappear.

Major Automotive goes private

I'm one step closer to collecting a quick $128 profit according to this 8-K filing.

USATODAY.com - Oracle? Buy, sell or snooze?

I think Oracle might be undervalued again. As you can guess from the title USATODAY.com - Oracle? Buy, sell or snooze? suggests that Oracle is sleepy stock that isn't worth pursuing. That may be (certainly it has been true for last year or so). Let's go over Matt Krantz's arguments step by step.

"Step 1: Measure the stock's risk and reward."

Beta is the measure of how a stock's price moves in comparision with the overall market. According to Oracle's beta, the stock is extremely risky. (It also suggests that Oracle isn't a sleepy stock.) This chart illistrates the risk.

I think most people would be happy with this sort of risk, but it's obvious that if you bought at the wrong time (during 2000) you would have lost a ton of money. On the other hand, if you bought at some of the right times (not during 2000), odds are good you would have come out ok. (I originally bought in 2002, so I'm feeling pretty good about Oracle right now.) If you know how to evaluate Oracle, high beta is actually a plus.

"Step 2: Examine the stock's earnings multiple."

According to the article, Oracle looks pretty good from the P/E ratio standpoint. "But even this should give investors pause, because it shows that Oracle's profitability (defined by return on equity) also has been declining sharply. This is not an encouraging sign." As a matter of fact, since its peak in 2000, ROE has fallen from 97.5% to 26.6%. For comparision, Microsoft's ROE peaked in 1997 at 35.3% and fell to 10.9% for 2004. It's now at 25.5%—a bit less than Oracle. Let's just say, I'm not discouraged.

"Step 3: Calculate the company's value using forecasted future cash flows."

Using the discount cash flow tool at Smartmoney.com I find that is worth somewhere between $11.50 (if you take beta into account) and $13.18. The key assumption is a 12.2% growth rate over the next five years. I think this growth rate is possible, even likely, but I'll talk about why in a moment. Since Oracle is currently priced around $12.80, I'd say it's overpriced if you think beta is a good proxy for risk and fairly priced if you don't.

"Step 4: Check the USA TODAY Stock Meter score."

To be honest, I don't have any idea what this adds to the argument. I tried out a few other stocks to see what their "USA TODAY Stock Meter score" might be, and most companies seem to be in the 3.0 region. I guess I'm not sure what it tries to measure.

So the real question is will the aquistions of PeopleSoft and Siebel provide enough extra earnings to make Oracle's current price a bargain? I think Oracle paid too much for that to happen from cost-cutting alone. As a shareholder, I'm betting that there will be more opportunities for Oracle to sell expensive bundles to companies as a result of these aquisitions. I see Oracle in much the same situation that Microsoft was in around 10 years ago.

Why I bought Major Automotive

Today I bought 999 shares of Major Automotive at $1.75 a share. Nearly 100% of the reason may be found in a recent SEC filing. I haven't had many good ideas for long-term investments, so I thought I'd try out an idea for a short-term investment I'd recently read about. The basic idea is to invest in shares that will be cashed out in order for the company to go private.

My hurdle rate for short-term investments is the 4-5% that I will be getting from the money market account my cash will be invested in over the next few months. If I don't expect to earn that rate, I'm better off staying in cash. The Major Automotive proxy says that anyone holding fewer than 1,000 shares will receive $1.90 in cash if the deal is approved. So I stand to receive $1,890.10 for my 999 shares. Including commission ($19.95), I spent $1768.20 to buy my shares, which works out to a $129.90 gain. Obviously, this isn't going to be a huge investment in absolute terms, but it is a little over 7% rate of return.

The one thing I don't know, however, is how long it will be before I get the cash. If the deal is approved at the annual meeting on March 3, and the paperwork takes until the end of the month, I'll be holding the shares for about 1/12 of the year. On an annualized basis, my return (130%) blows away the hurdle rate. Of course, it could take longer than that. But as long as it doesn't become a long-term investment, I'm in good shape.

Why I bought Berkshire Hathaway

Actually the question might be why I didn't buy Berkshire Hathaway earlier. After all Mr. Buffett's annual letters taught me how to value businesses and inspired me to try my hand at investing in individual stocks. The basic insurance business is one of the all-time great business models. Shortly after my wife started her Pampered Chef business, Berkshire bought the company. I've known about GEICO since long before it advertised in earnest. And of course, I'm a big fan of Dairy Queen and See's Candy.

But the strange array of assets that make up the company is a bit hard to value. Thankfully other people are interested in that question as well. A little while ago, I discovered the Berkshire Hathaway Intrinsivaluator. Of course, I've substituted a complicated set of models that I don't completely understand for a business that was complicated, but explained in relatively simple terms by Mr. Buffett. But the nice thing about the models is that we have an objective judgment that extends back through the years.

Currently, the models suggest that the shares are fairly cheap, but not at "cigar butt" level. And going back in time, the intrinsic value for the various models seems to grow by fits and starts. But the price jumps all over the place—far too cheap in 1981, over valued in 1996, and everywhere in between. Lots of times, the market seems to have a handle on the value as calculated by the models.

The real problem with an accurate evaluation, is the nature of the insurance contracts Berkshire writes. Someday there will be one or more super-catastrophes that could threaten the solvency of Berkshire Hathaway if it became undisciplined. In his 2002 letter, Mr. Buffett said, "Had Gen Re remained independent, the World Trade Center attack alone would have threatened the company's existence," in reference to a recently acquired reinsurance subsidiary. But unless and until such a disaster occurs, an insurance company can use the premiums it hasn't yet needed to pay claims (called float) to invest as it sees fit.

In some ways, investing in Berkshire Hathaway is like investing in a large and sucessful mutual fund. On the one hand, the past returns look outstanding. On the other, it becomes harder and harder to find good investments for the cash that keeps rolling in. Unlike a fund manager, Warren Buffett isn't restricted by investment style or SEC restrictions on funds. He may buy whole companies—even privately held companies. And so far, he's managed to get a good return.

The purpose of R&D

The companies I invest in tend to have a high rate of R&D expenses. I suppose some of that is rub-off from where I work. I'd like to have a part in developing cool new technology like fuel cells.

But creating new products is only part of what I look for in a company's R&D. I also would like to see research that makes existing products better and cheaper to manufacture. Not only is it lower risk, it also is harder for other companies to copy. This sort of research can lead to long-term competative advantages.

Why I'm buying the PIMCO Total Return bond fund

For the past year or so, I've been concerned about my original strategy of investing heavily in an S&P 500 index fund. For one thing, I've been investing in active funds that beat their index over the course of several years. Also, it seems like the index is biased toward expensive stocks. I still like the low fees, but I'm concerned that the indexing strategy will be costly if there is a recession—especially since P/E ratios are so high.

Recently, the yield curve inverted slightly. So I decided to move about half my index fund "ballast" into a bond fund.

I only considered funds with expense ratios < 0.5% and manager tenure of 10 years or more. Here are the returns for all candidates in my 401(k) plan:

Investment Name   1 Yr 3 Yr 5 Yr 10 Yr LOF
PIMCO Total Return Inst CL 2.58% 4.89% 6.84% 6.98% 8.54%

PIMCO Total Return is the largest of all bond funds in terms of net assets. For a stock fund, that would be a huge negative, but a bond fund should scale better. Costs are everything in bond funds, since there is little room to differentiate on the basis of picking individual bonds. Unlike stock funds, size doesn't lock bond funds out of the best investments.

Syntax versus semantics

Recently I had someone contribute some coding changes for my project at work. I had made it clear that I wanted to know all of the things he had changed. He didn't seem willing to do that and for mostly political reasons, I didn't feel I could compel him to give a complete report. So I settled on a compromise: he'd give me a list of "interface" changes.

My idea behind that suggestion was that if he fixed a bug or reformatted some code, I really didn't care too much. But if he changed the way a part of the system operates, I'd like to know the general reasons why. A couple of weeks later, he checked in his code and reported the changes in the interface as he saw it and I started to test the code.

Not surprisingly, something broke. He's an outstanding programmer, but with a large system it isn't easy to make a large number of changes that work right out of the gate in every situation. After digging around for a few hours, I finally discovered the offending code. He had replaced an entire source file with a check-in comment something like, "Replaced with working version." His version changed the semantics of a function call in a way that broke a program in a non-obvious way.

Now, that sort of change is exactly the sort of thing I was fishing for when I asked about "interface" changes. His response was that since the function signature hadn't changed, the interface hadn't changed. And he's correct if we had been talking about syntax. But I don't care about the syntax interface. A compiler can tell me if that changed. I needed to know about semantic changes, which are much more difficult to discover.

The price of foam

On of the more obscure problems Katrina caused is a shortage of foam used in upholstered furniture. Thankfully, Select Comfort's business model allows them to sell beds now and ship them later, so with careful management it should be possible to avoid lower sales if not fewer deliveries. If the average delivery time goes up only a few days, consumers might not even notice or care.

The principle of supply and demand might cause problems in the long term, however. If foam is in short supply over the next few months, companies that need it will bid up the price in order to ensure they have enough to finish their own products. Until the supply problem is fixed, Select Comfort is at risk of lower profit margins.

Company-specific risks like this are hard to predict unless you have a detailed understanding of the micro-economics of an industry. Even then, the unexpected happens more often the we think. But good companies with solid capital structures and competent management will survive.

Capital allocation

The central idea of capitalism is that money is the score-keeper of economic activity. Most people would feel that there are numerous other criteria to judge human endeavors than whether or not it makes money. For instance, artists take pride in creating works that are not commercial, environmentalists oppose companies that pollute, and most people would trade salary for doing what they really enjoy. And if money didn't somehow represent all of those things, capitalism wouldn't work.

Consider labor unions. They demand higher pay and better working conditions for workers at the expense of company profit. Auto workers over the years have virtually guaranteed that US manufacturers will produce more cars than they can profitably sell. In essence the unions have won the battle, since it is Ford, GM and Chrysler who are paying the price, and not the workers. But the war isn't over, and if those companies can't stay in business while paying their wages, all sides will lose.

In other words, money gets converted into what we really value. For organized labor, it gets converted into job security at all costs. Consumers don't particularly care about job security (except their own, of course), but they do care about how much money their car costs. If paying for job security lowers the cost (unlikely) or raises the quality of cars sufficiently, it could be a good use of capital and the companies will thrive.

The problem with the communist systems in Eastern Europe and Russia, was that workers where theoretically valued, but poitical influence was valuable. Over time, the disconnect became unsustainable.

More on Canon

This Business Week article includes a quote from the S&P 500 analyst who recently downgraded Canon: "'Canon has been one of the few electronics companies able to maintain double-digit margins, but [Canon's second-quarter operating profit] shows that even Canon isn't immune to price pressure,' says John Yang". The other concern seems to be who might replace CEO Fujio Mitarai, who is 69.

According to SmartMoney.com's DCF calculator, Canon's current price assumes about 1.5% earnings growth. The article suggests 6 to 7% growth which works out to about $60 an ADR. Given more productivity gains and a return on the company's R&D investment, I think Canon is a good value.

Writing good error messages

A good error message should say:

1. What the program was trying to do.
2. What it expected to have happen.
3. What actually happened.

This is the same requirements of a good bug report, except that there is no need to show the code used. And actually, the location of the code (source file and line number) should also be included in an error message unless it's completely obvious. This is such a common requirement, many systems include source location automatically:

$ perl -e 'die' Died at -e line 1.

The more difficult thing, surprisingly, is knowing what errors to report. Most system errors should be reported, but not if the code tries to work around the problem.

Bad error messages

Error: can not locate file....

What am I supposed to gain from reading that message? Any information at all would help. What file? I know the program must know what file it tried. Why the ellipsis and the "Error: " string? This error resulted from a failed stat call, which normally means the file doesn't exist. But what if it were a permissions problem or a self-reference symlink or the path argument exceeded PATH_MAX? That's why we have errno and strerror.

Fortunately I had access to the source and changed it to:

Can not stat /path/to/file: No such file or directory

The orignal code made this more difficult by using this custom function:

int error_msg(char *error)

I know varags is a pain, but it really does have a place. There is no reason error messages can't provide more than enough information to debug any problem.