Market observations -- mid 2013

As the number of undervalued securities disappear from the US market, I can't help but observe Mr Market's antics. This isn't to trade but rather for enjoyment.

Recently when the federal reserve announced possibly reducing the pace of quantitative easing, Mr Market had a small convulsion. The impact to the equity market is well known, however I find the impact to two other markets the most intriguing.

The long treasury bond dropped in price, raising the yield. Supposedly, this response is because Mr Market expects higher inflation in the near future. However, in a classic schizophrenic fashion, the price of gold also dropped significantly, implying expectation of deflation!

Only one these two avenues must be the right one.

For those who are so inclined could investigate the economic fundamentals and determine which of these are more likely in the near future-- deflation or inflation.

In either case, insurance to protect from either of these scenarios is available for cheaper than it recently was! Gold is the classic inflation insurance; while US treasuries are the deflation insurance of choice.

Disclosure: no position.

iWent

It is incredibly rare for me that a thesis pans out within a year. In the case of iGo, it only took about 3 months.

I initiated a position in iGo at half of tangible book and below 2/3 of net current asset value. My primary motivation was the very large margin of safety being offered by Mr Market for this loss producing business.

It paid off.

On July 11, there was a tender offer announced for 44% of iGo. The premium was 71% above the day's closing price. The stock promptly started to trade high next day and I started selling into it.

Why didn't I wait to tender my units?

The complexity of the deal and other factors compelled me to sell early. The biggest holder of iGo, Adage, has offered their units for tender. This doesn't leave much room for the rest of us. Also, the business has had further impairments and will likely release a horrible Q2 report. This information was buried  in their 8-k disclosure.

I sold because I didn't want to be holding a business with significantly small margin of safety.

54% return over 3 months isn't too bad at all either.

Full Disclosure: no position in iGo at the time of this writing

Going for iGO

One of the perverse effects of being a value investor is having a portfolio full of "uglies"!

As the market price of a stock rises (and starts to look beautiful to the lay person), a value investor sells it. He then uses those proceeds to purchase another "ugly" name.

This means that at any given moment, a snapshot of a value oriented portfolio will have nothing but mostly ugly names. Hopefully, if the manager does their homework well, these uglies will have been purchased at lovely prices. That is, lovely to a value investor.

This brings me to a recent position that I have initiated in the portfolio. I came across iGO Inc. (NASDAQ:IGOI) from Saj's blog. iGO's stock price has been quite ugly over the last year-- it has lost ~77% of its value.

But let us look under the surface.

Starting from the balance sheet, I see the book value at 7.26/shr with no debt outstanding. Net current asset value (NCAV) is 6.69/shr. The liquidation value of the business is about 4.86/shr.

The price at the time of this writing is 2.28/shr, which is 53% discount to liquidation value or 66% discount to NCAV. This is a very large margin of safety being offered by Mr. Market.

Looking at the income statement it is quite obvious why this business must sell at a discount to book. They have negative net income and free cash flow over last couple years.

My investment thesis is that over the next year, this business will, at the very least, slow the cash burn rate. Even a rate reduction will be enough to make this stock sell close to the NCAV; which is a reasonable value for a chronic loss making business.


Full Disclosure: I am an owner of iGO at the time of this writing.

Leaving money on the table

As the market makes new nominal highs, I have been slowly shedding positions as they approach my estimated intrinsic value. In fact, due to various central banks' actions, I believe this market rally is not an accurate reflection of the underlying economy. Due to this concern, I have been very fearful as I saw the DOW hit the all time nominal high followed by the S&P 500.

Being fearful has prompted me to take profits early-- as in, I have been selling position(s) at a 10 to 20% discount to intrinsic value estimates.

I am knowingly leaving money on the table; but it helps me sleep better.


Full Disclosure: N/A

Walter Schloss' maxims

It has been one year since Walter Schloss passed away, aged 95, due to leukemia.

Walter had an incredible investment return record that hasn't been matched by anyone else. He managed investor's money for 47 years, on average beating the S&P 500 during that time frame by an annual average of six percent.

Walter outlined some of his best ideas in a list of 16 "Factors needed to make money in the stock market". On the anniversary of his passing, here are his 16 simple and elegant maxims.

1. Price is the most important factor to use in relation to value
2. Try to establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper.
3. Use book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity. (Capital and surplus for the common stock).
4. Have patience. Stocks don’t go up immediately.
5. Don’t buy on tips or for a quick move. Let the professionals do that, if they can. Don’t sell on bad news.
6. Don’t be afraid to be a loner but be sure that you are correct in your judgment. You can’t be 100% certain but try to look for the weaknesses in your thinking. Buy on a scale down and sell on a scale up.
7. Have the courage of your convictions once you have made a decision.
8. Have a philosophy of investment and try to follow it. The above is a way that I’ve found successful.
9. Don’t be in too much of a hurry to sell. If the stock reaches a price that you think is a fair one, then you can sell but often because a stock goes up say 50%, people say sell it and button up your profit. Before selling try to reevaluate the company again and see where the stock sells in relation to its book value. Be aware of the level of the stock market. Are yields low and P-E ratios high. If the stock market historically high. Are people very optimistic etc?
10. When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think it attractive. 3 years before the stock sold at 20 which shows that there is some vulnerability in it.
11. Try to buy assets at a discount than to buy earnings. Earning can change dramatically in a short time. Usually assets change slowly. One has to know much more about a company if one buys earnings.
12. Listen to suggestions from people you respect. This doesn’t mean you have to accept them. Remember it’s your money and generally it is harder to keep money than to make it. Once you lose a lot of money, it is hard to make it back.
13. Try not to let your emotions affect your judgment. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.
14. Remember the work compounding. For example, if you can make 12% a year and reinvest the money back, you will double your money in 6 yrs, taxes excluded. Remember the rule of 72. Your rate of return into 72 will tell you the number of years to double your money.
15. Prefer stock over bonds. Bonds will limit your gains and inflation will reduce your purchasing power.
16. Be careful of leverage. It can go against you.

Five year performance update

During the early days of 2013, I quietly updated the portfolio performance page. I didn't do the obligatory blog post with explanation of the results, until today.

End of the 2012 marked five full years I have been managing my portfolio. Five year is perhaps the earliest milestone in the long investing journey ahead. It is also a good time to look back and introspect. The annualized performance record is shown as follows.

Ironically, five years is a complete career for professionals-- going from scratch to stardom and bust before the end of the fifth year.

Is it beginner's luck? It is certainly a possibility, but I hope that there is some genuine skill involved. Only time will tell. I certainly do not expect the 30+% yearly returns to repeat very often as time goes on.

Asset allocation

As of Dec 31, 2012, the portfolio had 27.2% in cash and equivalents, which continues to earn a pittance. It continues to be a drag on the portfolio's performance-- a risk that I am willing to accept. The large allocation to US listed equities is largely due to the healthy rise of some of the US equities in the portfolio, specifically Bank of America (BAC) and Cisco (CSCO). I continue to hold these equities.

Winners

The biggest winner in the portfolio would have to be Bank of America. I started buying a significant position in BofA in mid 2011, as it was trading near 1/3 or tangible book value. During 2012, BofA rose close to 100%. I continue to view this giant bank as significantly undervalued in the market. It continues to sell at a mild discount to tangible book. I believe the market will slowly but surely realize the continuing improvement of BofA's earning power.

Other winners included Canam Group, Cisco and Markel.