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.

Fool Me... Once?

In my previous post I mentioned the possibility of selling GMXR, and today I did just that (at a price of $4.13). I purchased GMXR on separate occasions in February and March at an average price of $9.57, so with my 1400 shares I ended up losing about $7,600... ouch!

Basically, GMXR has been killed recently along with a lot of other natural gas companies, and since my account is taxable I decided to lock in my losses (since I have significant gains from selling SHLD, USG, WTM, and DFS earlier in the year) and simultaneously buy Jan 2012 $5.00 CALL OPTIONS (50 contracts at $1.07) in a similarly punished E&P company that I've previously owned, SandRigde Energy (SD).

SandRidge is a company in flux, and IMO there's been quite a bit of selling pressure due to it's recent transformation. In fact, apparently the only people buying SD (other than me) are the company's insiders! Check out these two articles for a great introduction to the company: http://www.gurufocus.com/news.php?id=105087 and http://www.gurufocus.com/news.php?id=103990.

Anyway, I'll try to do a separate write up on my estimate of SD's fair value if time permits, but for the time being suffice it to say that I think SandRidge MIGHT be significantly undervalued. However, because SD is highly levered and because the price of gas & oil are huge drivers of the company's results, my fair value estimate has a large degree of uncertainty - I'm going keep my fingers crossed and hope for the best!

Current Holdings and Random Musings

Well so far it's been a very tough Q3, both in absolute and relative terms. After marginally outperforming the S&P through Q2 things have taken a turn for the worse, and YTD I'm underperforming the S&P by a wide margin. However, with a highly concentrated portfolio, big swings in performance are bound to happen, and hopefully recent history isn't indicative of things to come.

For my current holdings, AHS in particular has been a thorn in my side. The company recently reported results, which weren't bad by any means. HOWEVER, the company also announced an acquisition which will be completely paid for with newly issued stock, thereby materially diluting existing shareholders. My estimate is this will destroy about $2 to $4 in value for existing shareholders. Of course, the stock has gone from $8'ish to $4'ish, which I think is an example of a typical "Mr. Market" over reatcion. All things considered, I think this stock is worth $10 to $15 per share (assuming management doesn't make a habit of diluting shareholders).

GMXR has also been a big thorn in my side. Natural gas stocks in general have been hammered, and GMXR in particular has been killed because of its high level of debt. I think the risk/reward proposition at today's price is pretty compelling, and I'm considering doing one of two things; 1) doubling down 2) trading GMXR for a similarly punished E&P company. The logic behind #2 is that my account is taxable, and with significant gains from SHLD, USG, WTM, and DFS, I'm sitting on roughly 28K of capital gains for 2010 (ouch!).

Generally I try to stay away from making broad market predictions, I figure I'm better served by trolling for pockets of opportunity. HOWEVER, I do read the predictions and observations of other smart investors, and I try to incorporate any inferences/insight when I make high-level portfolio allocation decisions. IMHO the two best sources for this are John Hussman's weekly comments (www.hussmanfunds.com) and pretty much anything published on PIMCO's website (although I'm partial to Bill Gross's monthly commentary). Again, this is just my opinion, but if you read everything they've published over the last six months (which will probably take a day or so) you'll automatically become a better investor.

Anyhow, right now I've got about 40K (or 43%) of my portfolio in cash (obviously this is a huge %), so clearly I'm worried about downside risk. This is in the realm of gut feel, but personally I'd be much more surprised if the DOW goes to 12K than if it goes to 8K. And assuming it does go to 8K it'll be nice to have some cash on the sidelines waiting to be deployed.

Why'd I sell DFS?

This was the question I got after my previous 2 posts, which was a simple disclosure that I sold my stake in DFS where I didn't really provide any rationale (my apologies)...

My guess is DFS is worth about $20 to $25 dollars, so I don't see a huge potential upside. Additionally, given the current state of the economy, there is a relatively large amount of uncertainty in my guess of DFS's fair value - who knows, maybe its fair value is $10, or maybe it's $30... only time will tell.

Also, the stock has basically tripled from its March 2009 lows, and this type of run-up always makes me a little nervous. This is similar to when I sold USG and SHLD after their run-ups, see my previous posts on those former holdings for details (you can click on the "zzClosed Position..." labels on the right to easily navigate there).

Anyway, someone said that when it comes to investing the science is buying and the art is selling... and someone else said there's no rule that says you have to get 100% of the upside. So maybe DFS will continue higher and I'll end up kicking myself, or maybe it'll go back down to the single digits and I'll buy more...

Transaction Alert: Sold DFS Part 2

Today I sold my remaining 475 shares of DFS at a price of $15.49.

After this transaction my cash balance has increased to almost $40K, which is a bit higher than I'd like. Hopefully some new investment opportunities will present themselves, but I also think several of my portfolio holdings are very cheap, so I could always just add to those...

Transaction Alert: Sold DFS

The portfolio churn continues...

Today I sold 475 shares of DFS at $15.25. This was only half my position, so I still have 475 remaining shares. I originally purchased DFS in late 2008 and early 2009 for an average price of $10.34.

Transaction Alert: Bought MYGN, Sold WTM

This is a two part post. Last week was a busy one for me - in addition to buying Seahawk Drilling (HAWK), I also sold White Mountain (WTM) and purchased Myriad Genetics (MYGN).

I purchased 30 shares of WTM on 2/24/2009 for $203.58 and sold on 7/9/2010 for $331.17. While the returns on this investment were good, they weren't significantly different than the broad market, so I can't really call it a win. I still think WTM is undervalued and has a top notch management team, HOWEVER I think there are better opportunities elsewhere. Despite selling my shares, I'm going to keep this one on my watch list.

I purchased 650 shares MYGN on 7/9/2010 for $15.05, and as with most purchases this position is now approximately 10% of my portfolio. MYGN hit its 5-year high in early 2009 in the low 40's, so it's really been quite a fall since then (in fact, the stock hit its 52-week low the same day I bought it). Anyway, Myriad essentially does 2 things:

• It's predictive medicine products help determine the likelihood that a patient will get breast/ovarian/colon/skin cancer.
• It's personalized medicine tests allow doctors to customize the treatment received by cancer patients for the best possible results.

This is pretty heavy stuff - predictive and personalized medicine. So why has the stock been hammered?

• It's not growing as fast as the market predicted and priced. Obviously lowering growth forecasts has a significant impact on valuation, and my guess is many "growth" investors are dumping their shares.
• There is significant uncertainty around the company's patents, and weaker patent protection could make MYGN vulnerable to increased competition.

My guess is the market is overreacting to these negatives, and as a result the stock has been punished too harshly. Here's my thesis - I think MYGN can grow in the mid-teens for at least the next 5 years, but really it has the potential to grow at this clip for next couple of decades. It's trading at less than 8x EV/EBITDA and a PE ratio of 12x for the ttm - this is VERY cheap for a company with this kind of growth profile. Also, since capital requirements are low, free cash flow is quite strong.

So what are the expected returns? Well, if MYGN grows in the mid-teens for the next 5 years before leveling off, I'd expect the stock to be worth somewhere in the high 20's. If it grows in the mid-teens for the next couple decades then the stock's worth significantly more. Finally, if I'm wrong and the market is right, then the stock is probably fairly valued at today's prices. So, I guess we'll see what happens...

On a side note, my portfolio is now about 25% cash. This feels OK, but I may look to increase my cash allocation in the near future. Afterall, there's a lot wrong with the world - municipal/state/sovereign defaults are all a possibility, deflation could be around the corner, with inflation around the corner after that... As PIMCO's Gross/El-Erian say - we're driving down a bumpy dirt road in the dark without a spare tire...