Sunday, February 27, 2005

Attractively Priced Steel Industry Leaders: Mittal (MT), Posco (PKX)

At current market valuation, the largest U.S. stock exchange-listed steel companies by market capitalization and sales, Mittal and Posco, are trading at the lowest forward P/E ratios:

Company (Ticker): 2005 Est. Sales, P/S, Fwd. P/E, Profit Margin, D/E

Mittal (MT): $33.75 bil., 1.14, 6.0, 24%, 0.34
Posco (PKX): $22.5 bil., 1.12, 5.5, 11%, 0.36
Nucor (NUE): $11.4 bil., 0.86, 16.8, 10%, 0.27
Companhia Sider (SID): N/A, 4.3, 6.6, 31%, 3.3
Kubota (KUB): N/A, 0.77, 13.1, 6.5%, 0.72
U.S. Steel (X): $14.4 bil., 0.48, 11.6, 7.8%, 0.35

(Large steel companies listed only on non-U.S. stock exchanges are: Arcelor (Europe), Nippon Steel (Japan), JFE (Japan) and Baosteel (China).)

This is a curious situation, since market leaders usually trade at higher, not lower, P/E ratios. Mittal (global), Posco (Korean) and Companhia Sider (Brazil) are trading at P/E ratios in the 5 to 7 range, while Nucor (U.S.), Kubota (Japan) and U.S. Steel (U.S.) have P/Es from 11 to 17. It appears that this difference in P/Es could be due to an "established market" bias, with the companies having emerging market operations (Poland, Korea, Brazil, etc.) trading significantly cheaper than their U.S. and Japanese counterparts.

Mittal is the company resulting from the acquisition of 15 steel companies over the past decade by an Indian steel magnate, Lakshmi Mittal, and his Wharton-educated son, Aditya. International Steel Group (ISG) is their most recent acquisition and is expected to close during March. With global operations in North America, Europe, Kazakhstan and South Africa, Mittal is a low-cost producer with high profit margins (24%) and a low D/E ratio (0.34). Having mines that supply 40% of the iron ore and coke needed for their steel production, Mittal is less dependent on upstream suppliers than particularly their Japanese and Korean competitors who do not own mines. This year Mittal also is entering the Chinese market through acquisition of 37% ownership of Hunan Valin Steel. Successful integration of all of its acquisitions could keep Mittal positioned at the top of the steel industry if management is able to execute on its plan to become the world's "most admired" steel company.

Posco is a more regional player, with the majority (69% in 2003) of its production staying in the Korean market. Its primary export market is Asia, with China (taking 11% of its production) and Japan (5%) being its largest Asian customers. Among the non-Chinese steel companies, Posco is best positioned to benefit from increasing demand for steel from continuing growth of the Chinese economy. Unlike Mittal--which is about 90% owned by the Mittal family, has a public float of just 4.5%, and became one of the world's top steel producers only during the past year--Posco began as a government-owned steel company, now has 99% public float and has long been an established player in the steel industry.

As consolidation of the steel industry continues, three or four global players will likely emerge over the next few years. I expect that with consolidation will come greater resilience on the part of the largest companies to withstand the cyclical downturns that have triggered so many bankruptcies and restructurings (recall LTV, Bethlehem, Birmingham, National, others) in the industry in the past.

Mittal, with its global reach and low cost structure, and Posco, being a key supplier of steel to the rapidly growing Chinese market, are two companies to keep an eye on. Their very low P/Es and high earnings growth potential make them quite attractive at current prices. I plan to research industry fundamentals and pore over annual and quarterly reports for these companies during the next few weeks before making a buying decision. I will also be looking for a price pullback (technical short-term buying opportunity) following last week's sharp price run-up.

Friday, February 25, 2005

Searching for Value and Growth Across Industries

In my investing, I look for both good value and attractive growth prospects. I want to be able to acquire shares of high growth companies very cheaply. My investing style has a lot in common with what is called Growth At a Reasonable Price (GARP). A useful metric that captures the essence of GARP is the PEG ratio, which measures the cheapness or richness of a company's share price by taking a) its price-earnings ratio, and dividing by b) its consensus earnings growth estimate. A low PEG indicates that a company's shares are trading cheaply relative to the company's estimated growth potential. Attractive buying opportunities sometimes arise when PEG drops below 0.5.

Industry data available at provide a ranking by PEG. Below I list the industries currently trading at the lowest and highest PEG ratios:

Industry: PEG

Lowest PEG:
Iron and Steel: 0.68
Insurance (Property & Casualty): 0.90
Construction (Supplies & Fixtures): 0.90
Mobile Homes & RVs: 0.96
Airlines: 0.98

Highest PEG:
Fish/Livestock: 4.71
Gold & Silver: 3.51
Electric Utilities: 3.50
Natural Gas Utilities: 3.36
Water Utilities: 3.29

The iron and steel industry stands out from the others as having a low PEG of 0.68. The largest companies in this industry by market capitalization are:

Company (Ticker): Market Cap., PE, 5-yr. Est. Earnings Growth, PEG
Mittal Steel (MT): $27.4 bil., 5.6, N/A, N/A
Posco (PKX): $19.5 bil., 5.2, 13%, 0.42
Nucor (NUE): $10.1 bil., 16.4, N/A, N/A
Companhia Sider (SID): $7.4 bil., 7.5, 15%, 0.60
Kubota (KUB): $7.2 bil., 12.9, N/A, N/A
U.S. Steel (X): $7.2 bil., 10.9, 6%, 1.25

I have been casually surveying this industry for the past few months. Recently shares of iron and steel companies have risen dramatically but they could still be undervalued if demand for steel remains strong. I plan to examine these companies more closely in a subsequent post.

Wednesday, February 23, 2005

Assessing Buffett's Recent Performance Using His Own Measure

In the annual report of Berkshire Hathaway, Warren Buffett prominently displays his corporate performance from 1965 through 2003 by comparing the annual percentage change in book value per share of Berkshire with annual returns of the S&P 500:

Average Annual Gain for Period from 1965 to 2003:
Berkshire book value per share: 22.2%
S&P 500 including dividends: 10.4%
Difference: 11.8%

Buffett's record is particularly impressive when stated another way: $1,000 invested with Buffett in 1965 at book value would have grown to $2.5 million by the end of 2003, versus just $47,000 if invested in the S&P 500. Over this 39-year period, the end results differ by a factor of a little more than 50! This long-term track record of outperforming the market is what makes Buffett the renowned superstar investor of the 20th century.

Accolades aside, however, one aspect of Buffett's comparison that has always bothered me is that changes in book value are being compared to changes in market value. In other words, it looks like an "apples to oranges" comparison. Now, over a long enough period of time, book value and market value for a particular asset will tend to track one another, so that one can argue that the comparison is a fair one. However, over a shorter time period, wide swings in market value (typically resulting from investors' often-changing perception of the future) tend to make the comparison less meaningful.

In order to judge Buffett's performance over a shorter time horizon in an apples-to-apples framework, we can refer to book value per share data available from Using historical book value figures for the 30 components of the DJIA to create a comparative benchmark (working with all 500 stocks in the S&P 500 would be too unwieldy an exercise for me to undertake!), I find:

Annual % Change in Book Value Per Share for the 8-year period 1996-2003:
Berkshire: 17.0% (using figures from Berkshire annual report)
DJIA: 11.1% (based on historical book value per share data)

However, this is still not apples-to-apples. Since payment of dividends reduces book value, we must add the dividends back into the calculation for the DJIA to get figures to compare with Buffett's:

DJIA Annual % Change in Book Value Per Share
+ Dividends as % of Book Value
= 11.1% + 8% to 9%
= 19% to 20%

(Note: For the DJIA, the average price-to-book ratio is currently 3.8, which implies a normal dividend rate of about 2.3%, corresponding to the dividend-to-book-value rate of 8% to 9% shown above.)

No similar correction for dividends is needed for Berkshire because Berkshire does not pay dividends.

The fair apples-to-apples comparison, then, is that the DJIA actually outperformed Berkshire by 2 to 3 percentage points (i.e., 19% to 20% for the DJIA vs. 17% for Berkshire) for the period 1996-2003, when compared using changes in book value per share. In other words, when assessed using his own measure, Buffett has been slightly underperforming the market in recent years.

Admittedly, the period 1996-2003 includes Buffett's worst and only year (2001) when the change in Berkshire's book value per share was negative (-6.2%) due to insurance reserve-related losses from General Re, the reinsurance company Berkshire had acquired in 1998. Given Buffett's otherwise consistent long-term record, it is most likely the case that 2001 was an anomaly, and that the remaining 38 out of 39 years in the period from 1965 to 2003 are much more representative of the true capabilities of the Oracle of Omaha.

Since long-term trends in a company's book value should ultimately drive market value, we should also look at market value performance over our 8-year study period:

Market Returns for 8-Year Period 1996-2003:
S&P 500: 7.5%
DJIA: 8.7%
Berkshire: 13.8%

We see that, although Berkshire's book value may have lagged the DJIA in recent years when measured by Buffett's own "weighing machine," Berkshire's market value outperformed the DJIA by a wide margin. The market's "voting machine" apparently reveals the high expectations shareholders have on Buffett's uncanny ability to continue to beat the averages.

(Disclosure: I have owned Berkshire Hathaway shares since 1996 and consider this position one of my long-term holdings.)

Monday, February 21, 2005

The Market as a Great Ocean

“I do not know what I may appear to the world. But to myself, I seem to have been only like a boy playing on the seashore, and diverting myself in now and then finding a smoother pebble or a prettier shell than ordinary whilst the great ocean of truth lay all undiscovered before me.” --Isaac Newton

The above quote has stayed with me ever since I first ran across it when I was studying physics in high school or college. I mention it here because the feeling I get when looking at the financial markets is the same as what Newton describes in this introspective quote. The markets are a vast ocean that so many of us are trying to understand. Each day at the opening bell we scurry forward into the market, encountering enticing stocks, bonds or other tradeable assets that captivate our fancy. We examine some of these close up, marvel at their profit potential and select a few of them for our portfolio. Always on the prowl for something better than what we already have, we occasionally find another stock or investment that has a more attractive risk-reward profile or is a little more promising in some way. We go about our day-to-day activities, buying and selling what the market has to offer, whilst a seemingly boundless ocean of opportunity lays undiscovered before us.

I find it fascinating to watch, examine and participate in the markets. From thousands of years ago when human society progressed to the stage where people had land, valuables or goods to trade with each other, there have been markets. Price behavior in the markets, like human emotions and beliefs, is volatile, forever evolving and difficult to predict.

Given this "mysterious" nature of the market, I wonder how far my own effort to understond the market can take me. By "understanding," what I mean is:

a) Logical Soundness: Having a consistent conceptual framework;
b) Verifiability: Being able to test the understanding;
c) Profit Potential: Having a way to profit by buying and selling.

My goal is to identify aspects of the market that can be described and tested and offer the opportunity to make a profit. I look for patterns, for some type of predictability in the way the market moves. The most promising area I have seen so far has been the long-term investing framework I have outlined in prior posts and am testing for viability in my own investing.

I imagine that there must be lots of other market trading opportunities available to those with the time and motivation to discover them. As I play on the seashore of the market's great ocean, I endeavor to understand her mysteries but will not be disappointed if all I eventually come away with is a few beautiful pebbles and seashells that I happen to stumble across during my extended journey.

Saturday, February 19, 2005

Comment On Trading Systems

Occasionally I run into people who claim to have a "system" for making consistent excess profits in the market--for example, 200% annual returns from buying and selling options on large cap tech stocks, or 40% annual returns year after year from short-term trading of a single stock on margin, or very consistent 1% monthly returns from index trading--all with extremely high Sharpe ratios.

When I ask these people to explain what they do, they generally become a little cagey, telling me that they really are not at liberty to provide detail on their methodologies, sometimes because they have signed a non-disclosure agreement with a partner or company, other times simply because they do not wish to give away "trade secrets." Usually around this point our conversation stalls, and we then go our own ways--they (presumably) back to their trading labs to continue along their paths to millions of dollars of new-found wealth, and I back to my office, wondering if such "systems" really exist at all.

I try to maintain an open mind and temper my skepticism. However, if such "systems" really exist, my guess is that these people would be a lot more wealthy than they actually are. Another odd thing is that they tend to limit the percentage of their portfolios that they allocate to their trading systems, or no longer choose to invest their money the same way, even though they "know" their systems work. I wonder why, if they really have truly reliable systems for generating excess profits, they don't proceed to put all of their money to work so that they can move into the billionaires' club a little sooner.

At this stage in my own study of and participation in the markets, I would say that I am an "agnostic" on the validity of trading systems for generating consistent excess profits. I do not deny that they exist but also, having not yet had the privilege or good fortune of encountering a systematic methodology that produces excess profits with high reliability, I have no reason to believe in them either. In my own investing, I continue to search, trying to learn a little more each day, hoping that one day my own success as a practitioner will allow me to become a believer in some system as well. (Some might say that I have the order reversed, i.e., that I need to believe first and then success will follow--but, no, thank you, I am not ready to turn my investing into a religion!)

The best analogy that I can now think of for what it takes to become a successful investor is Ichiro, the baseball player. Ichiro, through a combination of his focus, hard work and talent, is redefining what it means to be a "great" baseball player. With Ichiro's new 2004 record for the most hits in a single season, consistently high on-base percentage, speed on the bases, and close to error-free fielding, baseball fans have gained a new respect for baseball as a "base hit" game. Baseball is no longer solely a power sport worshipping home-run kings.

I think it is interesting that Ichiro, as reported by the media, is not really able (even though he seems willing) to explain clearly how he gets the hits that he does. In other words, he has no set formula, no well-defined "system" that others can follow. Instead, what Ichiro has is discipline, the ability to make "adjustments" when needed, and unwavering perseverence. Essentially, Ichiro does his work but harbors no "trade secrets" about how he does it. We all watch him and marvel at his finesse on the field, but when we try to do the same, we find that somehow we fall short--our bodies just do not work the way his does.

My guess is that investing is a lot like playing a professional sport, as Ichiro does. A combination of inherent talent and regular practice will allow just about anyone to improve and some even to excel at the game. Devotion to the game can give a dedicated investor an "edge" over others who are less focussed. In my own daily activity as an investor, I continue to keep an eye out for reliable trading systems, some methodology that will allow me to achieve consistently high excess profits. While I remain optimistic that one day I might stumble across my own "holy grail," I am at the same time very realistic, expecting that the time and effort I put into the game will most likely allow me to hone my skills and improve my investment returns incrementally over the years--just as I have found in baseball, tennis, skiing, long-distance running and other sports I engage in.

Friday, February 18, 2005

Are Equity Analysts Worthwhile Listening to?

I have often heard that discretionary equity fund managers, on average, underperform market indices. The other group of prominent Wall Street professionals is equity analysts. Does this group do any better?

One way to check is to see if the price targets of equity analysts are a good indicator of future stock price movement. To select a sizeable (i.e., statistically significant) number of stocks that are well-followed by Wall Street, I find it convenient to use the 100 components of the Nasdaq 100, which includes both technology companies such as Microsoft, Intel, Cisco, Dell and Amgen, as well as non-technology names such as Costco, Starbucks, Staples, Apollo Group and Paccar.

Using analysts' consensus 1-year price target data from, I calculate for each stock the targeted percentage price change based on today's stock price. After sorting the targeted percentage changes from high to low, I list below the stocks that equity analysts are expecting to rise the most (top 10) and the least (bottom 10). For reference I also provide the PEG ratio, whose denominator (estimated annual earnings growth rate over the next 5 years) is likewise driven by analysts' estimates:

Company (Ticker): Current Stock Price, Expected 1-Yr. % Price Change, PEG

BEST Expected Stock Performance:

JDS Uniphase (JDSU): 1.83, 47%, N/A
Sanmina-SCI (SANM): 5.97, 47%, 0.81
Career Education (CECO): 35.86, 45%, 0.85
IAC Interactive (IACI): 22.03, 44%, 1.55
Millennium Pharm. (MLNM): 8.96, 43%, N/A
ATI Technologies (ATYT): 17.69, 41%, 0.80
Juniper Networks (JNPR): 22.07, 41%, 1.75
Cisco Systems (CSCO): 17.47, 39%, 1.26
Symantec (SYMC): 22.18, 30%, 1.24
Dollar Tree Stores (DLTR): 25.58, 29%, 0.88

WORST Expected Stock Performance:

Level 3 Comm. (LVLT): 1.91, -48%, N/A
Patterson Companies (PDCO): 47.88, -17%, 1.66
Marvell Tech (MRVL): 37.23, -14%, 1.33
Pixar (PIXR): 90.11, -12%, 2.86
MCI (MCIP): 22.04, -12%, N/A
Whole Foods (WFMI): 101.82, -10%, 1.91
Apple Comp. (AAPL): 86.80, -2%, 2.10
K-Mart (KMRT): 100.50, 0%, 2.24
Electronic Arts (ERTS): 64.26, 0%, 1.69
QLogic (QLGC): 41.68, 2%, 1.90

Because it takes time for analysts to process new information and revise targets, there are certain cases (e.g., recent buyout activity driving MCI's stock price up) where this "publishing time lag" may create significant discrepancies between published consensus targets and the actual, real-time, as-yet-unpublished opinions of analysts. This adds some "noise" to our study; however, if any "edge" that analysts have through their insight into companies and stock prices is robust enough, it should shine through in the results of our study.

I will be tracking all 100 components of the Nasdaq 100 over the months ahead. As the year unfolds, our "experiment" will give us some insight into how seriously we should regard analysts' targets as we go about our investing. Should we listen to analysts or just press the ignore button? Please stay tuned as we attempt to answer this question during the upcoming year.

Wednesday, February 16, 2005

Housing Market Price Trends

Using data provided by the Office of Federal Housing Enterprise Oversight (, I took a look today at U.S. housing prices over the past 30 years. My objective is to try to understand the price behavior of real estate in my area (Seattle metro), relative to property in other geographical areas, in hopes of gaining insight into future price trends.

I downloaded the OFHEO index data into a spreadsheet, calculated year-on-year housing price changes, and graphed the resulting time series for the U.S., the Pacific region (CA, OR, WA), Washington state, and the Seattle metropolitan area. Unfortunately, I do not know how to insert my graphs into this blog; so, I'll just summarize my observations:

1. There is a strong correlation in price movement between all geographical segments.

2. The smaller the geographical segment, the greater the volatility: Seattle is more volatile than WA, WA more volatile than both CA and the Pacific region, and the Pacific region more volatile than the U.S. as a whole. (Comment: Price volatility and liquidity seem to go together--the higher the liquidity (e.g., real estate in large cities, or publicly listed stocks), the higher the volatility.)

3. Within the Pacific region, price movement in CA tends to "lead" WA and OR by about 6 to 9 months. This behavior is particularly evident in periods of rapid double-digit percentage price appreciation. (Comment: This is a "ripple" effect, with price trends beginning in highly populated areas and working their way outwards into surrounding areas.)

4. Currently, we appear to be in the middle of a two- to three-year period of accelerated double-digit percentage price appreciation, this time around being driven by low interest rates and a recovering economy. Similar periods of rapid price appreciation occurred most recently in 1977-1979 and 1988-1990:

(Table shows range of year-on-year price appreciation)

Period: U.S., Pacific Region

1976-1980: 7 to 15%, 14 to 26%
1980-1985: 2 to 7%, 0 to 11%
1986-1990: 0 to 9%, 3 to 21%
1991-1995: 1 to 4%, -3 to 3%
1996-2000: 2 to 8%, 0 to 11%
2001-2004: 7 to 13%, 8 to 23%

5. During the past 10-, 20- and 30-year periods (all looking back from end-2004), average annual price appreciation has been:

Segment: Average Annual Price Change Over 10 yrs., 20 yrs., 30 yrs.

U.S.: 6.1%, 5.2%, 6.0%
Pacific region: 8.0%, 6.8%, 8.1%
CA: 9.1%, 7.2%, 8.6%
OR: 5.8%, 6.3%, 6.4%
WA: 5.4%, 6.0%, 7.1%
Seattle: 6.3%, 6.5%, 7.7%

Generally, higher price appreciation has corresponded to higher population growth: The growth rate in the Pacific region is higher than the U.S. average, CA higher than WA and OR, and Seattle higher than the WA state average.

For comparision, I also provide a quick summary of historical stock market returns. Annual total return figures for the S&P 500 have been 9.0% over the past 10 years and 10.1% over the past 20 years. I do not have equivalent total return figures for real estate, but I believe that equity returns for stock and real estate investments with comparable risk-reward profiles should be similar over long periods of time. Using our 10- and 20-year numbers as benchmarks for comparison of these two markets:

Stock market total return
= Stock price appreciation + Dividends
= 9 to 10%

Real estate total return
= Property price appreciation + Cash flow
= 5 to 7% + Cash flow,

"Equity return equivalence" implies that operating cash flow from real estate (houses) might be expected to be around 3 to 4% per year, which is approximately the cap rate for an unleveraged investment in single-family homes. (Leverage complicates matters; however, the multiplicative effect that leverage has on equity price appreciation is approximately offset by decreased cash flow from interest payments and on debt.)

The conclusions I draw from this brief analysis are:

1. Short term: Real estate in Washington state (in particular, the Seattle metro) appears poised to continue a double-digit percentage price run-up over the next year or so, in the wake of California's 25% move (versus just 10% for Washington state) in 2004.

2. Medium term: Sometime over the next few years housing price appreciation will likely cool back down to the single-digit year-on-year percentage growth range, and prices could even drop slightly if the current market becomes speculative or the run-up prolonged.

3. Long term: Real estate prices tend to be "sticky upwards" and less volatile than stocks, with upward price momentum often continuing for years and corrections being mild. Over the long run, equity investments, whether in real estate or the stock market, should generally be expected to produce similar total returns.

In other words, it's late but probably not too late to catch a healthy chunk of the current wave. Secondary markets (e.g., WA and OR) are likely a better bet at this stage than "primary mover" markets such as California.

Tuesday, February 15, 2005

Interlude: "Behind the Scenes" Philosophy

Behind every investor is a person--a "real life" human being with experiences, emotions, desires, motivations. As we have all heard many times, the most successful investors are those who are able to match their investment style to their personality. So, as I blog on about investing, an occasional interlude taking us "behind the scenes" to see "what makes me tick" seems fitting.

For me, investing is a way to carve out a new phase in my life. Here in American society, people's lives have three basic stages: school, work and retirement. Through our schooling, we learn, largely by being spoonfed tremendous amounts of information, with the outcome being letter grades on a report card, positioning us for venturing out into the working world. In our work, the measuring stick for success quickly changes from "who's smartest?" to "who's richest?" A "good" job is synonymous with a high salary, and those who are able to earn enough in their careers to grow their bank accounts often reach retirement a little sooner.

Now, if you take a moment to think about it, "retirement" is an odd concept. What are we retiring from? Well, work, of course. But, doesn't that give "work" an unduly negative meaning? After all, no one would ever choose to retire from work unless retirement were somehow better than working, right? Also, what in the world are all of the so-called "retirees" trying to achieve. In school it is grades, and while working it is money. But, in retirement, what is it? Golf? Or lying on the beach? (Not that I have anything against golfers or beachgoers) It's just that I really do not like the word "retirement," since it carries images of lounging around and lazily watching the world go by. Oh, and lest I forget to mention it, the term "active retirement" is really no better, being more of an inappropriate oxymoron than anything else.

Last night, while reading a storybook with my younger son, I happened to run across a sketch of Siddhartra's life. As history tells us, Siddhartra, a prince, had a very comfortable upbringing (stage one), before going out into the world and experiencing the harshness, pain and suffering of life (stage two), and later reaching Enlightenment and becoming the Buddha (stage three). Interesting, I thought as we read, since Siddhartra's transformation into the Buddha parallels the standard life path (school-work-retirement) of American society--even though Eastern philosophy and Western consumerism couldn't be more dissimilar.

Being neither very religious nor very spiritual, I find that "enlightenment" doesn't really work for me. So, as we read, I told my son that I prefer the term "wisdom," i.e., I would just say that Siddhartra became a wise man. Later, when I told my wife about the story (which she already knew), she mentioned for comparison's sake the Shinto belief that each person's "purpose" in this world is to find his own "essence," an endeavor that really runs along the continuum from birth all the way through death, without the artificial "stages" along the way. Hmm, maybe kind of like what the French call raison d'etre?

Please allow me to mention one more view: I like to think that I will live to be 100 years old, a century being a nice round number to work with. Back to the three stages of life, if we think in terms of decades, we end up with a convenient Fibonacci 2-3-5 sequence:

20 years of schooling + 30 years of work + 50 years of . . .

. . . doing the next thing.

Investing is that "next thing" for me.

Monday, February 14, 2005

Quiz: iPod is to Apple as XD1 is to . . . ?

Answer: Cray--if their new XD1 product line is as hot as it looks.

As reflected by its sales and share price history, Apple languished over the past decade as either a decrepit dinousaur or sleeping giant (depending on the metaphorical "spin" you prefer)--until the iPod ignited sales last year:

Year: Sales, Closing Stock Price

1995: $11 bil., $16
1996: $10 bil., $10
1997: $7 bil., $7
1998: $6 bil., $20
1999: $6 bil., $51 (dotcom bubble)
2000: $8 bil., $15
2001: $5 bil., $22
2002: $6 bil., $14
2003: $6 bil., $21
2004: $8 bil., $64
2005: $13 bil. (estimate), $84 (current price)

Quarterly Sales
2004Q3: $2.4 bil.
2004Q4: $3.5 bil.
2005Q1: $3.0 bil. (estimate)
2005Q2: $3.0 bil. (estimate)

Today, Apple is on a roll, with both the iPod and, more recently, the Mini Mac driving accelerating revenue growth.

By analogy, let's have a look at Cray, the supercomputer maker, another (albeit more rarified) "household" name--well-known at least among the scientific community with high performance computing needs. (My exposure to this field came during my graduate school days when I was fortunate enough to have Prof. Ken Wilson on my dissertation committee. Prof. Wilson won the Nobel prize in physics while I was a graduate student in 1982 for his "renormalization group" theory of phase transitions, which has spawned a great deal of highly computational work across a diversity of scientific research areas.)

During the 1980s, Cray was the world's leader in supercomputing, with 40% market share. As the popularity of PCs grew throughout the 1990s, supercomputing was forced into a "back seat" position. Cray gradually fell on hard times and was acquired by Silicon Graphics Inc. (SGI). A few years later, in early 2000, SGI sold the Cray business to Terra Computing, who assumed the Cray name upon completing the acquisition.

Our sales and share price lookback for Cray, then, begins in 2000:

Year: Sales, Closing Stock Price

2000: $120 mil., $1.5
2001: $130 mil., $1.9
2002: $160 mil., $7.7
2003: $240 mil., $9.9
2004: $150 mil., $4.7
2005: $270 mil. (estimate), $3.6 (current price)

Quarterly Sales
2004Q3: $46 mil.
2004Q4: $39 mil.
2005Q1: $54 mil. (estimate)
2005Q2: $65 mil. (estimate)

Cray's sales grew and its share price rose rapidly from 2000 to 2003, but both sales and the share price fell in 2004 as the company received fewer orders from governmental organizations for its X1 "capability" line of supercomputers, which each cost $3 million and up. This sales decline appears to be due largely to the "clumpiness" of governmental funding, rather than any permanent fall-off in demand in this market segment.

Importantly, during 2004, Cray was also transitioning from a single-product company into a three-product company. Today, Cray offers supercomputers to users across a broader range of market segments, in three price ranges:

Product Line (Price to Customer): Market Segment, Addressable Market Size

X1 ($3 mil.+): Capability, $1 bil.
XT3 ($1 mil.+): Enterprise, $1 bil.
XD1 ($50k+): Divisional, $1.5 bil.; and Departmental, $2.5 bil.

(Addressable market size data from Cray's corporate website)

Following their product launches in 2004, sales of the XT3 and XD1 are beginning to rise, as evidenced by the number of press releases reporting new sales contracts:

Quarter: Number of Press Releases for X1, XT3, XD1
2004Q2: 3, 1, 1
2004Q3: 1, 2, 3
2004Q4: 1, 0, 6
2005Q1: 1, 3, 1 (year-to-date)

The new product lines give Cray an addressable market five times the size of its market for the X1. During the next few quarters, we will see just how broad the demand is for the company's more affordable products. The XD1 shows good promise, with recent benchmark tests giving it the highest overall rating among supercomputers in its class. If sales ramp up and rise even incrementally beyond analysts' consensus estimates, the stock price should rebound as well.

Since Cray is still in the early days of setting up marketing channels to reach the anticipated demand among smaller, non-governmental customers for its "bite-sized" XD1 supercomputers, investment in the stock is certainly not without its risks. However, with Cray's well-established name and niche as the only stand-alone company with a business focus solely in the supercomputer area, I believe the downside to be a lot smaller than the upside--maybe 50% downside (sag to 5-year low) vs. 250% upside (return to 5-year high), for a very attractive upside-downside ratio of 5 to 1.

Cray is tiny (market cap of just $300 mil.) compared to Apple (market cap of $34 bil.), and the XD1 will obviously never become a household name like the iPod. However, just as so many people have been racing to their local retailer to plop down a few hundred dollars for an iPod, there are probably a lot of organizations who would be very happy to pay $50k to $100k for an XD1 supercomputer. This potential "untapped demand" for affordable, fast and efficient machines is what can drive Cray's share price over the next year or two with the same explosive growth that Apple's share price saw in its 300% rise over the past year.

(Disclosure: I am long Cray (ticker: CRAY) shares. I also own an old Apple computer, but unfortunately am not enough of a music lover to have "gotten" the iPod story early enough to hop on-board for Apple's share price run-up.)

Sunday, February 13, 2005

A REIT to Watch: Affordable Residential Communities (ARC) (III)

My first exposure to Affordable Residential Communities (ARC) came when I saw an ad in the local newspaper about the auction of four manufactured home communities in Washington and Oregon. ARC was auctioning off these properties along with others across the country that do not sit within their primary markets or do not fit their core portfolio parameters. In mid-December, an investor group I cobbled together participated in the ARC auction; however, on auction day, bidding on the properties we had interest in heated up and soon escalated beyond our walkaway bid levels, and we did not end up buying any of the properties.

While I was doing my due diligence on the properties, I also found out about ARC, the REIT. I learned that ARC went public at $19 per share in Feb-2004. The stock has wilted following the IPO and closed last Friday at $12.57, a 34% discount from the IPO price. As I mentioned in my prior post, ARC looks cheap compared to other manufactured home REITs, but is the stock really a bargain at today's price?

The benchmark I selected to calculate our walkaway bids for the property auction was a 20% 5-year IRR with full expenses, capex reserves and round-trip fees accounted for. Let's perform an analogous cash flow analysis on the stock investment:

* Consensus FFO for 2005 is $1.22 per share;
* Take 5-year FFO growth to be 7% (as for peer REITs, Equity Lifestyle and Sun Communities), so that forward FFO grows to $1.71 five years from now;
* Assume that at the end of year 5 the forward P/FFO ratio is 13, in line with the current sector average, giving a final price of $22.24;
* The current dividend is $1.25 per year.

These assumptions give shareholder cash flows of:

Year 1: $1.25
Year 2: $1.25
Year 3: $1.25
Year 4: $1.25
Year 5: $1.25 + $22.24 = $23.49

Requiring a 20% IRR, I discount the above cash flows to end up with a target purchase price of $12.67 (forward P/FFO = 10.4), about where the stock is trading today.

One significant risk is that the dividend currently exceeds free cash flow (AFFO), which I take to be about $1.07 per share (assuming capex to be $100 per homesite, or $6.7 million per year, which is $0.15 per diluted share). Conservatively rounding the dividend down to $1.00 per year, I apply my 20% 5-year IRR requirement again to arrive at the lower target purchase price of $11.93 (forward P/FFO = 9.8).

Another way to gauge value is to view buying the REIT shares as a direct purchase of the portfolio of underlying properties. Annualizing ARC's financials reported for 2004Q3, we have:

Gross income: $62.5 mil. x 4 = $250 mil.
Operating expenses: ($39.5 mil.) x 4 = ($158 mil.) [63% expense ratio]
Net operating income (NOI): $92 mil.

Interest expense: ($14 mil.) x 4 = ($56 mil.)
Preferred stock dividend: ($2.5 mil.) x 4 = ($10 mil.)
Cash flow: $26 mil.
Capex: ($6 mil.) [assumed]
Adjusted cash flow: $20 mil.

(Note that $26 mil. in cash flow implies FFO per diluted share of approximately $0.58, just half of the consensus estimate of $1.22 for 2005!)

Required cap rate: 7.5%
Implied portfolio value: NOI/cap rate = $1.23 bil.

Subtracting off total debt of $1.0 billion and preferred stock of $120 mil., we end up with an implied common equity value of only $110 mil, corresponding to an implied share price of about $2.70 (using 41 mil. shares outstanding). Flipping the calculation around the other way, the current stock price of $12.57 gives a total capitalization (debt + preferred + equity) of $1.63 bil., corresponding to an implied cap rate of 5.6%. Hmm, ARC certainly looks very expensive viewed this way! No one is his right mind would ever pay $12.57 for only $2.70 of underlying value, nor would anyone buy a portfolio of manufactured home parks in today's market at a cap rate of 5.6%.

How do we reconcile the striking difference between our two valuation methods? The first method relied on Wall Street analysts' consensus FFO estimate of $1.22 per share and growth thereafter of 7% per year. This could simply be too optimistic. Alternatively, it could be that ARC really is capable of operating its properties at a much higher NOI than the recent quarter indicates. ARC's peer REITs, Equity Lifestyle and Sun Communities, have operating expense ratios around 45%, compared to ARC's 63% for 2004Q3--there should be room for substantial improvement here.

Since ARC is a new REIT and has rapidly expanded its portfolio through acquisitions over the past couple of years, visibility into earnings right now is poor. This situation is what has driven the stock down so far, creating a potential buying opportunity. With the stock currently trading well below book value (P/B = 0.87), I believe that Wall Street is just overreacting again.

I would guess that ARC will succeed in improving operating efficiency over the next year or so, and that FFO and NOI will rise very significantly. However, I think it best to wait at least until ARC reports 2005Q4 earnings (should be later this month) before buying the stock. During the upcoming conference call, I will be paying close attention to the company's outlook for 2005, occupancy trends, signs of stabilization of the recently acquired Hometown portfolio, and progress with the Hispanic marketing program. With ARC's occupancy at just 81% (compared to Equity Lifestyle's 90% and Sun Communities' 88%), there should be tremendous upside here when management gives proper focus to operations instead of only chasing acquisitions.

Saturday, February 12, 2005

Prospecting for Outliers Among REITs (II)

Because the value of a real property company derives primarily from land, buildings and other "bricks and mortar" factors (instead of brand, image and other "soft" variables), REITs are a much more homogeneous group than their counterparts in manufacturing, technology, retailing, the financial sector, etc. This tends to make the search for "outliers" (i.e., valuation misfits) among REITs a little easier.

A quick examination of simple valuation ratios can often reveal buying opportunities, resulting from a selloff (market overreaction) that makes a REIT cheap relative to its peers, even though the core business of leasing out space to tenants is basically the same. Undervaluation of a REIT's shares typically corresponds to a "disconnect" between management and Wall Street--missed targets, lack of visibility, overzealous acquisitions, operating problems, etc.--usually with only a temporary impact on reported earnings. The underlying real property that a REIT owns provides a very solid "floor" on the value of a REIT's shares. Upside for the investor comes with share price recovery when management is able to bring an underperforming real property portfolio back in line with the operating performance of properties of its peer REITs--something that is a lot easier to do with "hard" real estate assets than with "soft" intangibles.

Across the main REIT sectors, recent share performance and look-ahead valuation ratios are:

(Data from

REIT Sector: Total Return 2003, Total Return 2004; P/FFO 2005

Office and Industrial
Office: 34%, 23%; 13.0
Industrial: 33%, 34%; 15.7

Shopping Centers: 43%, 36%; 14.1
Regional Malls: 52%, 45%; 13.3
Free Standing: 36%, 33%; 14.1

Apartments: 25%, 35%; 15.9
Manufactured Homes: 30%, 6%; 13.3

Self-Storage: 38%, 29%; 15.4

In our prospecting for outliers, two sectors stand out:

1. Office: From a "quality" perspective, the office sector with its desirable Class A properties in metropolitan centers should trade "richer" than the other REIT sectors. However, with the economic recession and dotcom fallout of 2001-2002, office occupancy fell sharply to around 85% nationwide and has only recently begun to recover. Indicative of a submarket undergoing recovery, the office REIT forward P/FFO ratio of 13.0 is the lowest among the sectors displayed above, though followed closely by regional malls and manufactured homes (both 13.3). Also, the office REIT total return of 23% for 2004 was the second lowest among the REIT sectors last year;

2. Manufactured Homes: The total return of 6% for 2004 was by far the lowest among the sectors, following a 30% total return performance in line with other sectors for 2003. The sector weakness last year was largely due to a decline in occupancy rates, as low interest rates have encouraged a number of tenants to vacate manufactured home parks and "move up" into affordable stick-built homes instead.

Let's now take a quick look at particular REITs in these two sectors:

(Data from

In the office sector, the largest REITs are:

Company (Ticker): Market Capitalization, Forward P/FFO , Price/Sales, Price/Book

Equity Office (EOP): $12.3 bil., 11.8, 3.9, 1.3
Boston Properties (BXP): $6.6 bil., 14.1, 4.8, 2.3
Trizec Properties (TRZ): $2.8 bil., 11.0, 4.0, 1.5
Mack-Cali Realty (CLI): $2.7 bil., 12.2, 4.7, 1.8
Arden Realty (ARI): $2.3 bil., 13.3, 5.6, 2.0
SL Green (SLG): $2.3 bil., 13.7, 6.6, 2.3
HRPT Properties (HRP): $2.2 bil., 9.9, 3.9, 1.2

The most prominent name with the largest portfolio of prime Class A office buildings in major U.S. cities is Sam Zell's Equity Office Properties. Equity Office, Trizec and HRPT currently have attractive forward P/FFO (11.8, 11.0 and 9.9), P/S (3.9, 4.0, 3.9) and P/B (1.3, 1.5, 1.2) ratios. Though HRPT looks cheaper by these measures, I favor Equity Office and Trizec because of their larger concentration of high quality office properties in primary urban cores. As occupancy in the office market continues to recover from its nadir in 2003, I expect multiple expansion in the office sector, with the forward P/FFO ratio for office REITs rising relative to other sectors and, in particular, Equity Office and Trizec "catching up" to and outperforming their office sector peers. (Disclosure: I have owned both EOP and TRZ for a few years and continue to hold.)

In the manufactured homes sector (which is much smaller than the office sector), the three largest REITs are:

Company (Ticker): Market Capitalization, Forward P/FFO, Price/Sales, Price/Book

Equity Lifestyle (ELS): $800 mil., 14.0, 2.9, 18.3
Sun Communities (SUI): $670 mil., 12.2, 3.4, 3.1
Affordable Residential Communities (ARC): $510 mil., 10.6, 2.5, 0.87

Equity Lifestyle (run by Sam Zell) is the largest in the sector by market capitalization. However, through a series of acquisitions completed prior to their IPO in February 2004, ARC rapidly has become the manufactured home REIT with the greatest number of manufactured home homesites (Note: Equity Lifestyle also owns RV spaces, giving it a larger number of combined MH and RV sites). ARC is the cheapest of the three when measured by forward P/FFO (10.6), P/S (2.5), and P/B (0.87). The price/book ratio below parity is particularly attractive.

A glance at the value per homesite shows:

Company: Enterprise Value; Number of Homesites; Value Per Homesite

Equity Lifestyle: $2.3 bil.; 57,000 (+ 44,000 RV spaces); $40k (MH only) to $23k (MH + RV)
Sun: $1.6 bil.; 47,000; $34k
ARC: $1.6 bil.; 67,000; $24k

Since RV spaces are worth less than manufactured home homesites, ARC is the cheapest of these three REITs by value per homesite.

Appearing undervalued by all of these quick measures--forward P/FFO, P/S, P/B and value per homesite--ARC deserves a closer look. I will examine this potential buying opportunity in my next post.

Do REITs Have Much Upside Left? (I)

Along with the rest of the real estate market, REITs have been on a tear for the past five years:

(Table shows total returns. Source: NAREIT REIT Watch, December 2004)

Year: Composite REIT Index, S&P500
1994: 1%, 1%. Even
1995: 18%, 38%. S&P500 ahead by 20%
1996: 36%, 23%. REITs ahead by 13%
1997: 19%, 33%. S&P500 ahead by 14%
1998: -19%, 29%. S&P500 ahead by 48%
1999: -6%, 21%. S&P500 ahead by 27%
2000: 26%, -9%. REITs ahead by 35%
2001: 16%, -12%. REITs ahead by 28%
2002: 5%, -22%. REITs ahead by 27%
2003: 38%, 29%. REITs ahead by 9%
2004: 30%, 11%. REITs ahead by 19%

Splitting the past decade into halves, we have total returns over five-year periods:

1995-1999: REITs +45% (8%/yr.) vs. S&P500 +251% (29%/yr.)
2000-2004: REITs +176% (23%/yr.) vs. S&P500 -11% (-2%/yr.)

The S&P 500 outperformed REITs by 21 percentage points per year during 1995-1999, but this relationship flipped around with REITs outperforming by an even wider margin (25 percentage points per year) during 2000-2004.

For the entire 10 years, REITs win out, though the comparison is more even:

1995-2004: REITs +301% (15%/yr.) vs. S&P500 +213% (12%/yr.)

Another way of looking at REIT performance is to look at the spread between the equity REIT dividend yield and the 10-year constant maturity Treasury yield. During most of the 1990s, the REIT-Treasury spread averaged about 50 bp, though it bounced around quite a bit, ranging all the way from occasional highs of 200 bp to a low of -50 bp. During 1998, around the time of the Long-Term Capital Management hedge fund crisis that drove quality spreads suddenly wider, there was an abrupt "regime change," with the REIT-Treasury spread widening from slightly negative to around 250 bp. For the ensuing five-year period, 1999-2003, the spread fluctuated around a 200 bp average (low 100 bp, high 350 bp). During 2003 and 2004, with interest rates at historical lows (10-year Treasury yield fairly stable around 4% for both years), the REIT-Treasury spread has tightened all the way from 350 bp to the 50 bp range where it sits today (REIT dividend yield 4.6% vs. 10-yr. Treasury 4.1%).

The two conclusions I draw from this historical data are:

1. S&P 500 has more upside than REITs: Since a) equities, whether stocks of "ordinary" companies (proxy: S&P 500 index) or real estate holdings (proxy: REIT index), ought to show similar returns over the long term, and b) REITs have outperformed ordinary stocks for the past five years (reversion to the mean argument), there is a greater likelihood that ordinary stocks will outperform REITs over the next five years.

2. REITs have potential downside: Today's already narrow REIT-Treasury spread is unlikely to narrow substantially more over the next five years, and instead could be driven dramatically wider (along with junk bond spreads that are also very narrow historically) in the event of any "flight to quality" crisis in the bond market. (Comment: By contrast, the stock "fair value" spread (see post dated Jan. 31, 2005) is historically wide, indicating good upside potential for stocks.)

So, aside from certain pockets of opportunity due to special situations in the REIT universe (I'll go into this in a later post), I see ordinary stocks as having a better upside-downside ratio than REITs in today's market.

Thursday, February 10, 2005

If Internet Traffic Matters . . . (an Amazon company) is a handy reference for insight into Internet usage patterns. Here are the current Global Top 15 Internet sites, ranked by average daily "Reach," which is the percentage of all worldwide users who visit the particular website:

(To compare growth, I give Rank and Reach two years ago (Jan-2003) in parentheses.)

1. (1), 30% (30%)--U.S.
2. (2), 27% (24%)--U.S.
3. (5), 17% (10%)--U.S.
4. (7), 14% (9%)--U.S.
5. (13), 5.5% (3.0%)--China
6. (150), 4.0% (0.4%)--China
7. (16), 4.0% (2.0%)--China
8. (7), 3.8% (3.8%)--Japan
9. (20), 3.5% (1.8%)--China
10. (10), 3.5% (2.5%)--U.S.
11. (9), 7% (7%)--U.S.
12. (50), 4.0% (1.5%)--China
13. (--), 2.5% (0%)--China
14. (3), 1.5% (13%)--Korea
15. (18), 2.8% (2.2%)--U.S.

Trends over the past two years are clear:

* New to the Global Top 15 during the past two years are five Chinese Internet companies: three portals (joining Sina, which itself has risen from 13th to 5th place)--Sohu, NetEase (163) and Tencent (qq)--and two search providers, Baidu and 3721 (Amazon has also moved into the Top 15);

* Search has advanced in the rankings, as evidenced by Google (moving from 5th to 3rd position), Baidu (zooming all the way from 150th to 6th) and 3721 (jumping from 50th to 12th);

* Within any country (actually categorized by language), the relative ranking of sites in the Global Top 15 has remained essentially unchanged. Two years ago the English language ranking among these sites was, and still is today, in the following order: Yahoo, MSN, Google,, eBay, Microsoft, Amazon. Similarly, among the top Chinese portals (not including the search sites, Baidu and 3721), the order today is the same as it was two years ago: Sina first, Sohu second and NetEase third (Tencent has risen rapiply from unknown status but has not surpassed the top three). In Japan, remains number one. In Korea, still occupies the number one slot.

To sum up our observations:

* Chinese Internet usage is growing by leaps and bounds;
* Search has become increasingly important;
* Market leaders tend to remain market leaders.

This simple study of Internet traffic trends points to a "sweet spot" for investment: Buy leading Chinese Internet companies, particularly those specializing in search. With Baidu being a private company (alongside a number of VCs, Google took a minority position in Baidu last year), a good alternative investment is the leading portals--Sina, Sohu and NetEase--all of which have publicly listed shares trading on Nasdaq.

We are still in the very early days of the Internet, especially in China. As have Yahoo, Microsoft, Google, eBay and Amazon before them, the Chinese Internet companies will almost certainly find a way to convert their increasingly heavy user traffic into much more profitable enterprises. Chinese demographics (population of 1.3 billion) and economic growth (GDP still growing at 9% annually) indicate a very promising future. More users will drive more revenue and profit and, in turn, higher market capitalizations and share prices for the market leaders. In my opinion, Chinese Internet usage trends are so strong that, even with the recent regulatory setbacks in the Middle Kingdom (e.g., revoking of Sohu's mobile content license, halting of Sina's radio and TV advertising over fortune-telling concerns, and lower revenue sharing percentages in contracts with China Mobile), these young companies will most likely find a way to prevail--and enhance shareholder value.

I think it very likely that the valuation gap between the leading U.S. Internet companies (Yahoo, Google and eBay all have current market caps around $50 billion) and their Chinese counterparts (Sina and NetEase have market caps around $1.2 billion, while Sohu's is about $550 million) will narrow over the years ahead. I would not at all be surprised to see the leading Chinese Internet portal a few decades from now attain a market cap surpassing Yahoo Japan's (which today is around $40 billion--and keep in mind that Japan, while of course considerably more affluent than China, has only about one-tenth the population of China).

In the short run, the share price of any Internet company is likely to experience considerable volatility. However, in the long run, it seems to me, market cap should approximately follow user traffic.

(Disclosure: Among the companies mentioned, I am long Yahoo, Sina, eBay and Amazon.)

Wednesday, February 09, 2005

An Alternative to Gold

Gold is a commodity, like oil, lumber and steel. As a commodity, it derives at least part of its value from its useability in the industrial process. However, as gold bugs point out, gold serves an additional function: It is a "store of value" that is non-perishable, easily transportable, rare, hard to find, costly to unearth, universally recognized and of historical importance. No other stores of value (U.S. dollar, foreign currencies, etc.) nor any assets (stocks, bonds, real estate, collectibles, etc.) have all of the special properties that make gold such an ideal store of value . . . as the gold story goes.

Based on this type of reasoning, financial pundits have been recommending buying gold coins and gold mining stocks, in anticipation a continued run-up in price, from $410 per ounce today to as high as $3000 (!) per ounce over the next few years. The argument is that throughout history governments have had a very bad track record of managing their budgets, leaving us all exposed to risk of rapid currency depreciation, as indicated by recently weakening U.S. dollar. In times of crisis, gold should retain value while currencies become worthless. So, buy up all the gold you can, before the crisis strikes, right?

Well, not so fast, please. In my opinion, the gold pundits are overlooking two very important character traits of the human species--survival instinct and innovation. One of the conclusions George Soros reached through his trading experiment documented in Alchemy of Finance is that the financial markets are always "on the brink," just about to be engulfed in a crisis when, at the eleventh hour, something changes to dissipate the economic stress. What is happening here is that the key players in our economy (i.e., government officials and businessmen) make policy revisions to alter the rules of the system so that the impending crises never really occur. Basically, people use their survival instinct and a little innovation to prevent our economic system from collapsing.

In my opinion, gold as a store of value is overrated. Times have changed. The world's leading multinational corporations do business in all of the major currencies. Information flows instantaneously across borders. The world's financial systems are interconnnected to such a degree that an economic crisis in any major economy would quickly spread to encompass the entire world. Trying to run to safety with your stash of gold tucked under your belt when crisis strikes would be a futile move when, in fact, there will be no safe place to run to (or, equivalently, no place will be safer than where you already are!).

With our greater interconnectedness across international boundaries comes a clearer realization among governments, private enterprise and citizens alike, that we should cooperate for the common good of all of us. I personally have high confidence in our ability as a society to steer our world economy ahead, avoiding large-scale calamity along the way. Having "faith" in our system, I am quite happy to own a portfolio of stocks of companies leading the world economy towards a better future. My bet is that these multinational companies will grow faster and generate more profit for me as a shareholder, than would hoarding a pile of gold under my pillow.

Tuesday, February 08, 2005

Asset Allocation and Portfolio Management: An 80-20 Super-Rule

Back to our example of how to allocate $1 million, here are some basic asset allocation and porfolio management rules I use:

1. Diversification: Invest about 5% of the portfolio in each of 20 assets (stocks or properties), but not many more than this number, for that would not allow the degree of focus needed to manage the individual positions well. When very bullish about long-term fundamentals of a company and timing, double the exposure to 10%. When prospects are sound but timing is less certain, start with half exposure of 2.5%, leaving open the possibility of buying more later.

2. Concentration: Allow winners to run but cap exposure to any one asset at 20% (4 x 5%) of the portfolio. Also, give losers time to recover but, if the value of an asset drops to 1.25% (1/4 x 5%) of the portfolio, either buy more if still bullish or sell the position and move on. Furthermore, to avoid having too many highly correlated assets, limit exposure within a single industry to about 30% or 40% of the portfolio.

3. Fundamental Soundness: Invest only in companies that are very likely to be around in 10 years. Typically this means market leaders with strong balance sheets (little to no debt, making them effectively bankruptcy-proof), top (revenue) and bottom (profit) lines that have been growing consistently for at least five years, strong profit margins, and positive cash flow generation. Instead of buying IPOs, allow at least a year of public market trading history to develop post-IPO before buying into any newbie company.

4. Familiarity: Invest in "familiar" industries and companies, i.e., those that you normally tend to follow in your everyday walk of life, through work, hobbies, friends, or whatever information source. Frequent exposure to relevant information gives you a slight edge over people who are further removed from the news and events affecting an industry or company.

5. Equities: To take advantage of long-run secular trends pointing to outperformance of equities, aim to stay fully invested. Generally, regardless of the condition of the overall market, it is possible to find 20 assets (stocks or properties) that have very attractive upside-downside ratios and warrant deployment of investment capital.

6. Relative Value: Make buy and sell decisions based on relative value analysis, trading out of positions with diminished upside and into new positions with better upside-downside ratios. "Reversion to the mean"-style thinking comes into play here, with statistical outliers often showing tell-tale signs of undervalued and overvalued assets. I find PEG to be a very useful indicator for identifying good relative value.

7. Portfolio Turnover: Buy with the intention of holding any particular asset for 10 years; however, be prepared to sell if fundamentals turn negative. This leads to an expected average turnover rate of 10% annually. Allow turnover to fluctuate in a range from about 5% to 20%, depending on opportunities that present themselves.

8. Target Returns: Target a 20% annual return, buying assets that might deliver 40% with flawless execution on the part of management and a little good luck, and that truly can be expected to return 10% even with a few hiccups and some bad luck along the way.

9. Hope and Safety: Make sure that within the portfolio there is a good mixture of assets, some of which should safely deliver 10% returns and others which hopefully might even double in a year. In investing, as in life, we all need a healthy balance of hope and safety.

10. Simplicity: As an investor, spend the bulk of your time gathering information to give yourself an edge over others. Avoid holding assets that require large amounts of time and effort to be spent on day-to-day management duties (after all, that's what we do as workers, not as investors!). Keep transactions simple (e.g., through stock investing) to allow more time to be focussed where it can be utilized most productively, i.e., in making the most informed and best possible buy-sell decisions.

These basic rules are aimed at creating a "perpetual portfolio" with high (20% annual) and consistent (80% confidence) returns. Taken together, the individual rules comprise an "80-20 super-rule" for optimizing investment performance and allowing our hypothetical $1 million portfolio to grow indefinitely.

Monday, February 07, 2005

Negative Feedback and Relative Value Investing

If I buy a stock based on long-term fundamentals and the stock goes down in the short run, my tendency is to want to buy more at the new "bargain" price, so long as the fundamentals remain intact. The drop in price diminishes the value of the stock in my portfolio, allowing me to buy more without giving me an undue amount of exposure to the stock.

On the other hand, when a stock I own rises dramatically, I tend not to want to buy more, because the stock begins to look expensive. The high price encourages me to sell some shares and thereby reduce the overexposure the rising price has given me to the stock.

In this sense, my relative value-oriented, long-term mindset towards investing has a negative feedback mechanism naturally built in. Short-term price volatility presents opportunities to buy more shares at depressed prices (good relative value) and to sell shares at rich prices (bad relative value). This mechanism adjusts exposure to individual companies in a portfolio, preventing me from becoming overexposed to any one company.

Contrast this with the positive feedback mechanism inherent in trend-following investing. If a stock rises, a trend-follower should buy more, thereby giving him more and more exposure to a single company. Stocks with losses will be sold early on. The end result is a portfolio holding just a single company, which from an asset management point of view is certainly a very precarious position to be in.

Investing strategies with built-in negative feedback provide an investor with some degree of natural diversification, thereby giving the portfolio a higher survival rate. This is one of the benefits of taking a relative value approach to buy and sell decisions, rather than being a trend-follower.

Sunday, February 06, 2005

Subjective Risk

Traditional economists, in the spirit of the natural sciences, measure investment risk by calculating the volatility (standard deviation) of returns. What all economics and business students are taught is that the higher the risk of an investment, the higher the expected return. In practice, we are told, investors seeking higher returns should be prepared to take on higher risk. I find this "objective" view to be misleading and not very useful in practice.

Admittedly, it is convenient to use historical price data (time series) to derive volatility and analyze investment returns. However, as we all know, history is the past, and what really matters in investing is not the past but the future. Traditional analysis uses past data to construct probability distributions describing where future prices might end up. In actuality, though, only one price path occurs--asset prices only follow a single path, whether it be up or down or roundabout. Those investors, who by luck or foresight are on the correct side of the market, profit from this actual price movement.

It often happens that successful investors, in hindsight, will say that they "knew" or at least felt very strongly that a stock would rise, and that's why they bought when they did and how they made the money that they did, while others sat on the sidelines, unwilling to risk their money on such an what was in their view an uncertain outcome. What is going on here is that investors have different vantage points and really are effectively NOT all working with the same information. Sure, basically the same information is available to all investors but, as a matter of fact, different people access and process information in different ways and end up with different assessments of the risk involved in any particular investment.

In other words, perception of risk is subjective. What one investor may see as very risky, another investor may see as having a very different risk profile. Like a tightrope walker who is able to perform on the highwire, while the average man would quickly lose his balance and fall, the investor with special insight into a particular situation or company is the one who climbs on board when others won't and ends up reaping the excess profit.

To sum up: High risk investments for the majority can actually be low risk investments for individuals with special insight into the particular situation. Successful investors are those who walk on tightropes familiar to them, staying on the highwire while others fall off.

Friday, February 04, 2005

Do the "Experts" Know Better?

Interest rates are at a 40-year low and may be headed even lower, despite the government's massive budget deficit, the U.S. trade deficit, military spending in Iraq, etc. The 10-year Treasury rallied 10 b.p. today to yield 4.06% on news that employment is weaker than expected, making it less likely that the Fed will continue to raise rates. This also led to a rally in the stock market, defying conventional logic that bad news about the economy is also bad for the stock market.

Everyone I know tells me that interest rates will probably head up this year. A measure of just how skewed market opinion on interest rates is comes from an article I saw recently, citing results of a survey of financial market professionals who watch, analyze and forecast interest rates. Some 46 out of 47 of these so-called "experts" indicate that interest rates will rise this year. The article also mentioned that these experts as a group have a very poor track record over the past 20 years, being right far less than half the time.

From a contrarian point of view, when such an overwhelming consensus develops in one direction, the best thing to do is to run the opposite way: When consensus says interest rates are rising, they will most likely fall. I am not necessarily a contrarian but I think that there is some merit to reversion-to-the-mean theories of human behavior. When investors and traders all sell Treasuries based on predictions of rising interest rates, there comes a point when there is nobody left to sell. At such a time, the markets rise and interest rates fall.

Interestingly, we may be in this situation today. In my opinion, the stock market looks oversold and interest rates could have further to fall.

Thursday, February 03, 2005

Investor Overreaction

I have thought for a long time that investors overreact to news, moving stock prices higher and lower than warranted. A recent example of this is eBay's stock price dropping 25% upon reporting quarterly earnings below analysts' estimates by a penny in January. With Amazon's earnings announcement coming Feb. 2, I thought that I would do a paper-based experiment to see if there might be a short-term way to make money off this type of investor behavior.

My strategy (all on paper--no real trading) was to go long both a call and put (straddle) struck at-the-money (Feb. 18 expiry), just before the earnings announcement. I had done my homework and observed that over the past eight quarters in 2003 and 2004, the 1-day changes in Amazon's stock price from pre- to post-announcement were: 1%, 15%, 15%, -9%, -7%, -5%, -13%, -12%. The average change is -2%, but the average change in absolute value terms (i.e., without regard to direction) is 10%. A long straddle position would allow me to profit from a large move either way, up or down.

With the stock price at 41.8 and a strike of 42.5, the call cost 2.0 and the put 2.6, giving a total option premium of 4.6, with implied volatility about 55%. After close of market, Amazon announced earnings. They missed by $0.04 and the stock dived 16% in after-hours trading, positioning me for a nice profit when closing out my straddle in the morning.

This morning (Feb. 3), with the stock price having dropped overnight from 41.8 to 35, I found that the call became worthless but I could sell the put for 7.40, giving me a "cool" 1-day profit of 61%. Clearly, had I actually done the trade, I would have profited like a bandit.

To see how I would have done under other possible outcomes, I run a few sensitivities, using pricing from the post-announcement market, with implied volatility now lower at 35% (less demand for options, less uncertainty since the news is out):

Change in Stock Price, Proceeds from Options Sale, Profit or Loss:
Down 20%, 9.05, profit of 97%
Down 10%, 5.05, profit of 10%
Unchanged, 2.80, loss of 39%
Up 10%, 4.15, loss of 10%
Up 20%, 7.75, profit of 68%

Like with most real-world distributions, the outcomes in the middle are more likely, meaning in this case that a lossy outcome is more likely than a profitable one. However, if the frequent losses are small and the occasional profits are large (like the movie industry with its few blockbusters that make up for all the duds), the expected outcome can be a profit. With the past two years as a guide, I construct a simple probability distribution,

Probability (stock price down 20%, down 10%, unchanged, up 10%, up 20%)
= (5%, 30%, 30%, 30%, 5%),

which gives an expected loss of 3%. Sure, there is big profit for the big moves, but the more frequent losses tenaciously eat all the way through the gains!

If the volatility had stayed high at 55%, the expected outcome would have been a gain of 20% using the same probability distribution. Going into my paper trade, I had expected the volatility to drop following the earnings announcement, but I was hoping that the drop would be small enough to permit some "excess profits" for even a retail investor like me. Unfortunately, it appears that the professionals (statistical arb boutiques like O'Connor, equity trading desks of investment banks, hedge funds and the like) have already arbitraged away any margins in this type of trade. I suspect that there may be small excess profits but that they can only consistently be realized by market-makers who do not have a bid-offer spread to contend with and who do not pay trading commissions.

Conclusion: The simple options trade I mention, while it can be highly profitable on days when a stock flies or plunges (as Amazon did after announcing earnings), should not be relied on for consistent profit. For investors with a long-term view, a better way to take advantage of sell-offs (investor overreaction) like we have seen for eBay and Amazon--situations when nothing fundamentally changes--would be simply to buy a few shares and patiently wait for the companies to execute on their business plans. (Disclosure: I own a few shares of both EBAY and AMZN and am in for the long haul.)