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.