Correction Time

The S&P and Dow are both down 10%+ from their recent highs.

Despite my large cash balance, I am also down about 5%; in part this is due to my over-exposure to the energy sector.

Volatility has been resuscitated from its death bed. While there is nothing to be super-excited about yet, let’s just say, things have started getting interesting.

Here are some resources to put things into context”

  • A Field Guide to Stock Market Corrections: The base rate of a 20%+ bear market given a 10% correction is 50%. Thus, the odds of a continued decline in the market, or a recovery are about even.
  • What Past Market Declines Can Teach Us: 10% corrections are quite common; they occur about once a year. When they don’t deteriorate further, they take about 4 months to heal. 20% declines are also surprisingly common; they occur about once a leap year. On average, they take an year to climb out of.
  • Putting Pullbacks in Perspective: There have been three declines of 40% or more since 1945. They have taken about 5 years to recover from. Longer bull markets (time since last 10% correction) lead to deeper stock market losses. Based on the length of the current run (about 1.5 years), the regression line (in the linked article) suggests that we should expect a pullback of about 15%.
  • The stock market over the last 200 years: This article from Basehit Investing always provides a valuable lens with which to see any current market turmoil. Volatility is a natural part of the stock market. Patience is key.
  • Testing Times: Aswath Damodaran takes a deep breath, and takes a clinical look at the underpinnings of the current market conditions.

For some reason looking at numbers, and zooming out to see the bigger picture in times like these is helpful. It prevents my reptilian brain from retreating in panic or doubling down in hubris.

Advertisements

Switch to Interactive Brokers

One year ago I did a major housekeeping change.

I finally opened an Interactive Brokers account  (I still have accounts with TDAmeritrade and OptionsHouse – now ETrade).

I don’t particularly like IB’s web interface or the desktop GUI. But one year in, it bothers me far less than it used to. I love the speed and the quality of execution. My other brokerage accounts, while offering better UIs, force me to bid in increments of 5c, and often take forever to fill comparable orders.

The big factor, of course, is cost. Instead of shelling $5+, most of my options cost me $1 or less. IB often gets me a price better than my limit price. I understand that it could pocket the difference, and I would never know. Actions like these build trust (Costco/Amazon playbook). In 2017, almost 90% of my trades were executed on IB.

It also pays me meaningful interest on my cash balance (0.92% currently for cash balances above $10k). This is higher than the interest at my bank.

As my portfolio moved from 16% cash at the start of 2017 to nearly 35% currently, the interest I earn underwrites all my commissions and then some.

Interesting Thread on Edge

Recently, I read two superb takes on whether retail investors have any meaningful edge.

Nate Tobik did a “Drake equation” to estimate that there are about 1000 pairs of eyes following listed stocks in the US. So really, our edge is nonexistent or smaller than we think.

Geoff Gannon generalized the discussion with a broader notion of “edge”.

He argues that unlike a casino, the stock market inherently has a positive edge. If you spend infinite time in a casino, you will go bankrupt. If you spend infinite time in the stock market, you will end up extremely wealthy.

So at the base level everyone in the market has an edge over those on the outside. This is a generic edge.

Then, there is the special edge.

Since buying certain kinds of stocks (high quality businesses, cheap stocks, and stocks rising in price) works better than buying other kinds of stocks (low quality businesses, expensive stocks, and stocks falling in price) an investor who systematically bets in order to maximize certain factors (like high quality, good value, and positive momentum) has an edge over both operators who systematically bet in order to maximize other factors (low quality, poor value, and negative momentum) and operators who don’t bet systematically.

And finally there is the stock-pickers edge, which Nate talks about.

GME Update

GME recently released 2017 holiday season.

There is good news and bad news; but in aggregate the news is negative. The stock responded by falling more than 10%.

The good news is that holiday sales were better than last year. The bad news is that both preowned games (key profit driver) and technology brands (expected future growth driver) declined.

My narrative on GME has been the following: “Competent management trying to manage a cash-generative core business in secular decline, by pivoting and expanding more profitable growth businesses.

Such transitions are never smooth.

The latest report seems to suggest that the core business may be declining more slowly than expected, but some of the new businesses are not ramping up as fast as one would like. Here is a decent take on the latest news release on SeekingAlpha.

My prior bear, base, and bull cases price targets were $14, $27, and $35, resepectively. I haven’t redone a complete valuation yet (will wait for earnings release), but my feel is that all these numbers should probably be revised downwards by a couple of dollars.

I have a tiny position (~1%) in GME at an average price of approximately $17.50. I will probably wait another quarter to see if my base case thesis has broken fundamentally. For the moment I continue to hold because:

  • tax bill will help lower tax rate (~35% in the past, and assumed for the future in my valuation); this will increase IV about 10-20%.
  • short interest is high; more than 35% of the float has been shorted. Based on the average trading volume, the days to cover are 15. The chance that it takes off to $25 on a good break is quite high (for example if the latest report had TechBrands neutral to positive, instead of down double digits)
  • the impairment charge is better to assume in 2017, when the tax rate is high, compared to next year, when it would be “worth” less. The most charitable interpretation of the writeoff might point to management’s willingness to acknowledge mistakes early, and monetize them opportunistically.
  • GME remains volatile and “interesting”. Option premiums are fat.
  • The stock pays a generous dividend, which makes it easy to hold on. There are no foreseeable liquidity issues. The debt is well-covered by cashflows.

I continue to believe GME is a modestly undervalued, but risky turnaround story.

A Quick Look at Western Digital

Western Digital (WDC) does storage; it designs, makes, and sells hard disk and flash drives. These are used from PCs/notebooks, consumer electronic products, all the way to enterprise servers.

The company’s 2016 investor presentation, and this 2017 update provide a good overview of the business and opportunities.

WD has a history of bolstering its storage offerings by arguably decent acquisitions. It has morphed from a pure HDD play to a more general storage play over the past 10 years.

acq

The company’s presentation also lays out positive and negative factors.

headtail

Headwinds

  • secular decline in PC and notebook industries; but the company expects the storage portion of this market to work out better
  • HDD industry is essentially a duopoly (with Seagate); but overall storage industry (particularly HDD) is cyclical
  • commodity product; no durable competitive advantages

Tailwinds

  • in the near term, HDD to remain dominant fraction of total stored data
  • decent management, good acquisition and capital allocation record
  • increased demand due to “big data”, more digitalization
  • datacenters, cloud computing

Valuation

The company lays out numbers to anchor a valuation.

finmodel

  • TTM revenues are ~$19.5B (up from $8B in 2008); EBIT is $2.6B (up from $1B in 2008). EPS numbers are noisy, but FCF is indicative of a cash generating business.
  • Share count has increased from 226M to 301M over the past 10 years.
  • Historical tax rate has been 7-12%, in line with future expectations. Probably should not expect tax bill to help much.
  • Total debt is $13.1B (about 2.75x EBITDA), peaked at $17B in 2016. WDC is develering. Interest expenses are currently ~$800M (compared with EBIT of $2.6B). Debt looks manageable, especially when compared to competition like Seagate, which has a much more levered balance sheet.

The adjusted FCF/sales has been 13-14% (in line with target). Sales growth is expected to be low single digits.

If we use FCF/sales = 13%, sales growth = 3%, then FCFF/share = $9.05. Subtracting the $2.75 of interest payments/share, we get FCFE for the next year of $6.30. Using the Gordon growth model with a hurdle rate of 10%, we get a target price of $85.

If we use less conservative numbers (FCF/sales = 13.5%; sales growth = 3.5%, and interest payments of $2.50 from continued delevering), we get a target a target price of $115.

Thus, the range of values is probably between $85-$115. Currently, it is trading below the lower end of this range.

 

 

 

Learning the Wrong Lessons

2017 was my first full year of “mindful investing”. As expected, I made many mistakes. These can be classified into two buckets.

Selling Winners Early

I sold WTW around $18. It soared to nearly $50 over the next few months.

I sold AAPL at an average price ~$130-140. It kept rising to $175.

Peter Lynch said, “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.”

I should hold my winners longer.

Historically my worst mistakes have been “successful investments”.

I sold MSFT and EBIX for 80% and 300% gains, only to see both stocks double from there. And don’t even get me started about Priceline. I sold it only because I had made 10x on the stock. There was no fundamental reason for selling. It was agonizing to watch it soar 10x from that point, over the past 7-8 years.

Sucking my Thumb too Long

I dabbled with a few stocks, hoping to buy them at more attractive prices, only to watch them fly away. I watched FSLR go from $25 to $60, MSM from $70 to $95, FAST from $40 to $55, VFC from $50 to $75, WFC and NKE from $50 to $60+, and on and on.

So perhaps, the lesson is don’t be too picky. But is that the right lesson to draw?

I began the year with a certain view of the overall market: I expected it to return somewhere between -25% to +15%.

One can ask two questions: (i)  was the view correct, and (ii) was the strategy (of being patient with buying) correct, given the view?

In retrospect, the S&P clearly overshot the optimistic end of my expected range. The pendulum had swung more than I thought. My view was wrong.

However, given a view that is negatively biased, the strategy of waiting for more attractive prices was not necessarily wrong. Or at least, a single year (esp. one like 2017) may not be sufficient to draw that conclusion.

 

Portfolio Review 2017

As 2017 winds down, here is a review of my top holdings.

Cash

I started the year with 16% of my portfolio in cash. As the year wore on, I added new capital, and sold off more positions than I bought.

As a result, I ended the year with an uncharacteristically high cash position of 38%. I am starting to get uncomfortable, and hope not to get trigger-happy.

I disposed off significant stakes in Apple, Cisco, and Cullen-Frost as the positions reached my estimates of fair value. I also began cleaning house by eliminating several small positions that had accumulated over the years (Staples, Hanover Foods, and SPE). I did not have much conviction, or meaningful exposure in these names.

I also sold Weight Watchers for an approximately 40% loss ($15-18) just before it blasted off to nearly $50.

I added to Fairfax Financial and Oaktree Capital, and opened (small, but potentially growing) new positions in ALJ Regional Holdings, Under Armour, and GameStop.

Berkshire Hathaway

BRK.B started the year at $163, climbed to $190 in mid-October, before slouching down to the low $180s in early December. Since then it has whipsawed to nearly $200. It represents over 10% of my portfolio. I did not add or subtract from my holdings during the year. I believe the intrinsic value of BRK is probably a little north of $200.

Fairfax Financial

FFH was a 4.5% holding at the end of last year. For much of the first half of 2017 FFH traded between $420 and $460. I took the opportunity to raise my position to nearly 6% of my portfolio. Currently the stock price is in the $520-$540 range. I believe its intrinsic value is at least 10-15% higher ($580-$600).

Leucadia National

LUK is a 6% position. It has been tossed around between a “support” of $22-23 and a “resistance”  of $26-27 for much of the year. The operational performance, especially at National Beef, has improved considerably.

My latest estimate of IV pegs LUK at $32. It also raised its dividend yield to about 1.5% during the year.

Oaktree Financial

OAK started the year at $40, dipped to $37.50 in the first quarter, and subsequently spent the bulk of the year in the upper 40s. I added to my position at $39 and sold a similar-sized chunk at $47 a few months later, thus lowering my cost basis.

Recently, I updated my valuation notes, and figured OAK was worth $55-$60. I started writing puts and ended up buying a slug in the low 40s, recently. It is a 5.5% position.

IBM

IBM started the year at $170. Since I had assessed its IV to be around $165, I began writing $175 covered calls on 2/3 of my position, which eventually got called away, when the stock rose to $180 in February. Then the news of Buffett paring down his position became public, and IBM drifted down to $140 by mid-August.

Unfortunately, I bought back the position I had sold a little too early (around $165), and rode the roller-coaster all the way down to the 52 week lows. It looks like things have started to turn. The stock is currently in the low $150s, and pays a nearly 4% dividend. It is currently a 4.4% position.

Wells Fargo

WFC started the year at $55, and oscillated between $50 and $60 throughout the year. While I did not add to my 4% position, I wrote plenty of cash-secured puts in the low 50s, with the intent of adding to my position. I earned well over $1000 in premiums, almost twice what I earned from its nearly 3% dividend yield. I believe that WFC is a buy in the low $50s or below, since its IV is probably somewhere around $60.

 

Other

Other ~3% positions, which I did not touch over the year include:

  • MKL: 3.7% position, trading nears its IV of $1080.
  • XOM: 3.1% position, trading in the low 80s, after starting the year strong in the low $90s (IV ~ $90).
  • CFX: ~3% position, spent the year between $35 and $43. I collected nearly $2700
    ($6.75/share) in covered call premiums by offering to sell around $40.
  • MNDO: 3.1% position, trading above $2.50 for much of the year (IV ~ $3)

New Positions

I initiated positions in ALJJ (2.8%), UA (2.0%), and GME (1%) this year. I plan to build these positions up on price weakness. I believe all three stocks are materially undervalued.

In 3-5 years, it is easy to visualize a scenario where ALJJ could be worth >$5.0, UA > $30, and GME ~ $30.

GameStop is something of a wildcard. It has healthy current cash-flows and pays a fat dividend (>8%), but its core business is seriously impaired. I don’t plan on allocating more than 2% to GME.

With ALJJ and UA, I can see myself taking on a full 5% position if prices remain or become more attractive.