My Returns as of Q3 2010

Well, the quarter's over so it's time to write a quick post on my returns - I started 2010 with $107,514 and finished the quarter with $104,494.  I didn't make any deposits or withdrawals, so the decrease in value was driven by a decline in aggregate of my stocks.

• On an absolute basis, my portfolio declined 2.8% during the first three quarters of 2010. Annualized, this rate of return is -3.7%.  YTD the S&P (w/ dividends reinvested) is up 3.5%.
• I've been tracking my returns for 4 years and 9 months, during which time my annual rate of return is 13.3%. Over the same period the S&P returned 1.5% annually. In other words, over 4 and half years I've been outperforming the S&P by about 11% per annum.

Unfortunately, YTD I've underperformed the S&P by a margin that can't be considered insignificant.  However, as I've mentioned before, my portfolio is quite concentrated and I'm optimistic about my holdings - so I'm not overly concerned about my recent underperformance... yet.  Anyway, you can see my current holdings below (click on the picture to zoom in).

Transaction Alert: Bought TTT

Over the weekend I posted about "uU" investing and mentioned I'd been watching TTT and MFCAF (see my previous post).  Ironically, less than 48 hours later these companies announced they'd merge, which IMHO makes them a very compelling investment.  So today I purchased 1638 shares of TTT at a price of $7.30, for a total outlay of $11,957. 

TTT/MFCAF is almost a pure "jockey" bet (at a reasonable price) - if everything works out perfectly (which there's a 99.9% chance it won't) this would be akin to buying Berkshire Hathaway in the 1960's or Leucadia in 1980's.  However, we don't need things to work out "perfectly" to make some real money here, we just need things to work out "OK". 

Both these companies are run by Michael Smith, who for the last 2+ decades has put together a case study on how to generate wealth - here's a fantastic article from SumZero on how he's done it: http://www.sumzero.com/postings/2985/guest_view.   Also, one of the Seeking Alpha contributors has put together a number of very good articles on the evolution of TTT/MFCAF, here's a link to his page: http://seekingalpha.com/author/george-fisher/articles.  Lastly, this guy has also done some excellent write-ups and owns the stock himself: http://longtermvalue.wordpress.com/.

In my previous "uU" post I said the following: 

I love it when I hear value folks talk about whipping out Excel, plugging in financial statements, explicitly projecting bull/bear cases for 7 years, trying to figure out the right cost of equity (BTW it's 12%, it's always 12%), and then passing b/c there's too much uncertainty.  Rather I'd argue, for some portion of their portfolio, investors should seek out uncertainty, try to quantify the downside (or like B. Berkowitz says, "Kill the company"), make sure you're not overpaying, and let the upside take care of itself.

In this case I'm doing just that (hopefully I won't end up with egg on my face...).

uU Investing

I just read a fascinating essay that really resonated with me, it's called "Investing in the Unknown and Unknowable," by Richard Zeckhauser. It can be found here: http://www.hks.harvard.edu/fs/rzeckhau/unknown_unknowable_PUP.pdf

Basically, the article asserts that by seeking out situations where the outcome is unknown and unknowable (uU) an investor can potentially make outsized returns. Now let's look at an example of what a uU investment is and what it isn't:

I don't know exactly what Coke's (KO) finances are going to look like in 5 years, but I know the company is still going to be selling sugar water and I can make a reasonable guess about their cash flow - this is NOT a uU investment.  IMO the large integrated banks, such as Citigroup, Bank of America, or JP Morgan, are great examples of uU investments. I have no insight into potential government regulation and capital requirements, and coming up with an estimate of their loan losses is quite difficult. In other words, these companies are "black boxes." Further, I have no idea what the economy will look like - will we be in the middle of a "lost decade" like Japan in the 90's, or will be experiencing devastating inflation, like the late 70's?

The problem with investing in the Coke's of the world is even though I can come up with a good estimate of their fair value, so can everyone else. In other words, even if I decide Coke is undervalued and therefore an attractive stock, there's someone on the opposite side of the trade who did the same analysis and decided Coke was overvalued - and she's probably smarter than me (having gone to Harvard or Wharton for her MBA).  And it's not just the Coke's of the world, there are very smart people EVERYWHERE in investing; and they're arb'ing away the pricing inefficiencies in small-caps, micro-caps, bonds, distressed debt, etc. - this is why it's so hard to beat the market consistantly and over long periods.

BUT if I decide to invest in a big bank I don't have this problem, i.e. everyone is having a huge degree of difficulty figuring out their fair value - so what type of environment does this create? Well, I think people in general have a natural aversion toward uncertainty, so a lot of current holders are dumping their stock. Additionally, our friend with her Wharton MBA isn't interested in buying these stocks - afterall if she's wrong she is subject to "Monday morning quarterback" risk, which in the investment world can get you fired.  In other words, uU investing sidesteps the normal mechanisms that generally keep securities priced efficiently.

If you already read the linked essay you'll notice the author makes a strong case for Warren Buffet being a uU investor.  You can also make the case that Mohnish Pabrai with his "low risk, high uncertainty" mantra fits in this camp.  Morningstar's fund manager of the decade Bruce Berkowitz is also a uU investor: he's investing in the banks right now, he invested in health care companies while (i.e. not after) the government was overhauling health care, he owns stocks like SHLD, JOE, LUK, and FUR - all of which are classic uU stocks.  And of course there are many other value investors who are also uU investors in disguise: David Tepper, Ian Cumming, Michael Burry, Prem Watsa, Seth Klarman, Carl Icahn, etc. etc. 

This brings me to my next point: I love it when I hear value folks talk about whipping out Excel, plugging in financial statements, explicitly projecting bull/bear cases for 7 years, trying to figure out the right cost of equity (BTW it's 12%, it's always 12%), and then passing b/c there's too much uncertainty.  Rather I'd argue, for some portion of their portfolio, investors should seek out uncertainty, try to quantify the downside (or like B. Berkowitz says, "Kill the company"), make sure you're not overpaying, and let the upside take care of itself. 

As for my portfolio, I consider LUK, SD, and HAWK to be uU stocks to one degree or another.  On my watch list I'd consider CHK, NRG, BH, FUR, SHLD, TTT, MFCAF, BAC, COF, and JPM to be uU's.  Of course it's tricky figuring out what to buy, but if you go several posts back I disguss my checklist, which is my starting point. 

My Returns?

I got a comment from a reader today with regards to my investment returns, here's what he/she had to say:

probably making a mistake somewhere...
in one place you claim a 19.5% AR as of Mar 2010 and in another place you claim 13.4% AR as of Jun 2010
- 2006-2010 19.5% beats the best of the best of the best, gurufocus shows one investors with double digit 5yr average returns (10%), you are go(o)d!
- a 6% drop in one quarter in AR could only be caused by massive losses, what happened?
regards

Well first let me say I appreciate the kind words!  Previously I've speculated that my out performance could simply be dumb luck, so for any readers who'd like to dive a little deeper the first thing you can do is go to the "My Returns So Far..." link to the right, which is under the "Pages" category.  I update this page quarterly, so it has my returns from 1/1/2006 through Q2 2010.  If you'd like to verify my calculations you can use your friendly XIRR function in Excel.  Further, under the "Labels" category there's a link called "Returns," if you click on this it will pull up all my previous posts where these have been discussed.

As this reader correctly points out, my returns fluctuate like crazy - this is simply a biproduct of having a concentrated portfolio.  If you check the "Transaction Alert" link under the "Labels" category you can see what I've bought/sold and get a feel for how I've generated my returns (or for this year, lackthereof)!

Leave a comment if you have any questions, or if you prefer you can email me at mevsemt@gmail.com

Investing Checklist

Like many people out there, investing is something I do on the side - I have a full time job, a rental property, and a 9 month old baby girl - so you could say my goal of outperforming the S&P is a bit audacious given that the vast majority of my time is spent on non-investing activities.

However, by using an investment checklist I save a ton of time. Basically, it enables me to pass on the majority of investments without doing any heavy lifting, and I can dedicate serious time to only what I perceive are the best opportunities. Anyway, here's the checklist:

1. Insider buying (http://www.gurufocus.com/) or insider ownership (http://www.morningstar.com/)
2. Near 52-week low
3. Significant discount to Morningstar's fair value estimate (yes, I subscribe to Morningstar)
4. "Guru" buying (http://www.gurufocus.com/)
5. For options only: high degree of leverage
6. Significant discount to my fair value estimate
7. Downside protection - i.e. low risk / high uncertainty profile
8. Asymmetric payoff

Items 1 to 5 can be done in less than 5 minutes, and based on the results I either pass on the investment or start working on 6 to 8, which take quite a bit of time. The nice thing about having a checklist is it really narrows my universe of possible investments - at any given time there are usually less than 10 stocks that meet enough of the criteria to be considered (right now there's less than 5) - and with so few stocks to pick from investing becomes a much simpler process.

All or Nothing...

Today I placed an order to purchase Jan 2011 $2.00 call options (the contract price is $0.05, my order is for 175 contracts but as of now only 92 have gone through) for Jackson Hewitt Tax Services (JTX). Assuming I get all 175 contracts, my total purchase price should be about $994 including commissions.

JTX is a company in a TON of trouble and is drowning in debt - there is a very real chance they could be bankrupt before the end of the year. The situation is complicated, and I'll try to elaborate in a future post, but ultimately I think there's about a 50/50 chance they'll survive. IF they do make it they're probably worth $3 to $5 per share - which means the options I purchase today could be worth quite a lot.

IMO I'm essentially betting on a coin flip - but I'm only paying $1 for a chance of winning $10.

Backing up the truck...

Given the precipitous decline in the stock price of AHS I thought now would be a good time for a second look. To recap, AHS reported decent results last quarter, BUT they also announced an acquisition which they’re completely funding with stock (thereby massively diluting existing shareholders). They’re also assuming 136 MM in additional debt in conjunction with the acquisition. IMHO it’s the dilution and debt burden that has caused the sell off, which may in turn be an opportunity to buy more shares.

So now that AHS has new operations, new cash flows, and a new capital structure, (and a new stock price!) let’s do a quick and dirty valuation analysis. Assuming a stock price of $5, the company has an EV of about 400MM and a market cap of 206MM. IF we also take management at their word and model 30MM in additional EBITDA from the acquisition, then we’ve got pro forma EBITDA of 71MM on revenue of 904MM – this means AHS is trading at an EV/EBITDA of 5.6x.

Now let’s run through a hypothetical (but very reasonable) 5-year scenario. First, we’ll assume that EBITDA will grow steadily to 90MM by the fifth year (btw this is a pretty conservative assumption given that EBITDA before the acquisition in 2008 was 95MM). Second, we’ll assume all EBITDA during our 5 year analysis goes toward paying down debt, paying interest, rebuilding working capital, and capex. Because AHS has low ongoing capital requirements, it’s not unreasonable to assume they can pay off all their debt within our 5 year window.

So, in our hypothetical situation, at year 5 AHS as a pretty simple company – it’s essentially cash free / debt free, it has EBITDA of 90MM (which we can assume is growing at a low single digit % going forward), and the majority of EBITDA converts to FCF. The question is, how much would you pay for this asset?

The answer, of course, is “it depends,” but I think it’s reasonable to assume the company could trade somewhere between 4x (very conservative) and 8x EV/EBITDA, giving us a market cap somewhere between 360MM and 720MM (or a stock price between $8.75 and $17.50). Now obviously I have no idea if this is how things will play out, but it feels like a high risk/high reward situation. Remember, AHS does have a lot of leverage and if the economy falls off a cliff AHS could be in real trouble. However, I think this is a risk worth taking, so I purchased an additional 550 shares (giving me a total of 1750) today at a price of $4.68.