Investing Buckets

I like categorize stocks into three buckets.

Compounders

The first bucket is compounders.

This bucket includes stocks like BRK, MKL, WFC etc. that have solid revenue growth (secular or structural advantages), high returns on capital (good business/industry), and plenty of reinvestment opportunities.

These are the best companies to own. Their intrinsic value rises steadily with time. If you stick with them long enough, your returns will mimic the return on equity (~low to mid teens). If you can add to your position when the price dips significantly below the prevailing intrinsic value, your returns will be juicer.

Ideas - 39

With compounders, you let time do all the work. These stocks let you sleep soundly at night, and require hardly any upkeep.

The relentless increase in intrinsic value is forgiving of valuation mistakes. The risk of overpaying can be mitigated by long holding periods.

So what’s the catch? Why can’t we just invest in compounders?

Turns out, you and I are not the only people in town who have this “deep insight”. Since everyone sees how desirable such companies are, the market rewards them with high valuations. Opportunities to buy these companies at substantial discounts to intrinsic value are rare.

From my experience, they encounter blips about once in year or two, when some short-term setback gets temporarily mispriced. Here I am talking about decent prices, not “back-up-the truck” type prices. Those, unfortunately, are really rare.

Our edge here patience, decisiveness, and a long horizon. There is no informational or analytical advantage.

If you are like me (someone who has fresh periodic infusions of cash to deploy), the waiting can be frustrating, if that’s your only trick. You may think that having a list of 5-10 compounders on a watchlist might help. It does. But only partially. Often when opportunities arise in such stocks, they arise all at once (like the 2008-2009 crash).

Small Caps

The second bucket is small caps and foreign stocks.

Examples of these in my current portfolio include stocks like MNDO, CODAF, and RSKIA, which are all sub $500m companies.

These are profitable companies with strong balance sheets and decent returns on equity. In the past, I have invested in companies with poor or negative earnings, so long as the company’s assets provided a sufficient margin of safety. I have now mostly abandoned this cigarbutt strategy. Time is the enemy in such asset-based investments, as intrinsic value gets eroded by mounting losses.

If you can psychologically handle such investments, then you should absolutely invest in such companies. For a small investor, the universe of such companies is far larger than the universe of small profitable companies with light debt burdens.

I have tried to fish in that pond. But I have realized that I don’t enjoy fishing there as much. Being around morbid companies makes me feel pessimistic.

So these days, I focus only on profitable small caps with decent balance sheets. Our edge here is the relative lack of competition, and tolerance for illiquidity.

Some of these stocks will go months without trading. This is both a pro and a con. The small size and illiquidity keeps the big fish and traders away. The downside is that building reasonable positions in some of these stocks takes patience.

Liquid Mid and Large Caps

Finally, the third bucket of stocks is liquid mid and large caps.

Stocks that I currently own that fall under this bucket include AAPL, LUK, IBM, and NOV. Even though they are followed and owned quite widely their stock prices can fluctuate over a large range.

Consider AAPL for instance, the largest company in the world. Over the last year and change, its stock price has fluctuated between ~$90 to ~$155. During the dip last summer, I bought my last slug of AAPL shares at $96. I sold out of most of my position between $125-$135. I hold my last 1/3 position, which I plan to dispose of shortly. AAPL may not be overvalued, but I am not as comfortable holding it at $150 as I was when it was sub-$100.

In any case, this volatility creates an opening for overlaying some options strategies. The options on these securities have a vibrant market, due to their size and liquidity. Strategies like cash-secured puts and covered calls can be used to enter and exit positions, or generate income on the side.

A current example is NOV. The stock has been trading between $30 and $40 for nearly a year. At $30, I think NOV is cheap. At $40, I think it is reasonably priced. So every time it drops to the low $30s, I begin selling puts methodically. Every time it springs back to $40, I begin ratcheting some covered calls.

Revisiting GME

I looked at GME late last year, just as the share price moved away from me. I was not able to establish a position, but have been keeping an eye on it ever since.

Recently, the stock price fell back to the $20.xx range, and I started writing cash-secured puts, with the intent of establishing a 3-4% position.

Here is a slide-deck, which summarizes my current thoughts (Revisiting GME).

Basically, in the base case, I think the stock is worth somewhere between $25-30. In the worst case, it is worth somewhere around $15, while in the best case, it could be worth nearly twice its current worth. At current prices, it seems like an interesting risk-reward bet.

The stock has declined substantially, has high short interest, is extremely volatile, and pays a fat dividend. The sentiment against retailers is brutal. In short, if we have adequate faith in the valuation, it is an ideal candidate for selling options on.

Ask Chuck about Schwab

Charles Schwab (SCHW) offers brokerage, banking, wealth management and financial advising services. It is one of the largest brokerage and banking firms in the US, founded in 1971, with over 330 branches, almost all of which are in the US.

Resources

Some useful reports on SCHW on the web are listed here:

  • Boyar Research put out a case study in Sep 2013 (pdf) with an estimated value of ~$32/share. At the time SCHW was trading at $14.
  • The Brooklyn Investor looked at SCHW in Aug 2015, after Lou Simpson had established in a position. At the time SCHW was trading at $30, and BI thought that it was relatively cheap (14x PE) if interest rates normalized.
  • In Feb 2017, Argus Research put out a note arguing SCHW was worth $46, when SCHW was trading in the low 40s.

Background

Like Vanguard, SCHW provides real value to its customers.

It lead the drive to lower commissions, ramped up its ETF business with Vanguard like expense ratios, proactively waived client money management fees due to low interest rates, and starting to snowball its RIA services. It is a top notch company, leverages its scale in the brokerage and banking businesses, and has a potentially long runway in front of it.

A company creates value when it grows revenues, and commands high returns on capital. SCHW checks both these boxes.

Over the past 5 years, SCHW has grown revenues at 10%, EBIT and net income by over 15%/year. Operating and net margins have been relatively stable around 35% and 20%, respectively.  Book value has also grown at 15+% rate, while the return on equity has been in the 11-14% range.

SCHW has been able to crank out this amazing performance, despite multiple headwinds. The most significant challenge is the low interest rate environment. It is possible that some of these headwinds will slowly turn into tailwinds.

One can make a reasonable case that the current EPS ($1.30+) greatly understates the true earnings power of the business.

The company lays out the key drivers of near-term value in their April 2017 “Spring Business Update” presentation.

Screenshot from 2017-04-29 23-01-08

Essentially, the company is doing what it can to grow profitably. It cannot control a few factors, like taxes and interest rates. The current climate seems to suggest that both these factors might swing in favor of SCHW. As an example, each 25bp rise in interest rates increases cash flow by about $250m.

Valuation

There are several ways of valuing a high quality company like SCHW.

IRR =ROE

The ROE for SCHW is 10-15%. If interest rates rise then hitting or even exceeding the upper end of that range is likely. If one holds SCHW for a long time, then one should expect return to match ROE.

While this exercise doesn’t give us an intrinsic value, it tells us that if the valuation doesn’t change while one holds the stock, the gravitational pull (or push) is towards this 10-15% return.

10x PTI

Now let us consider Buffet’s 10x PTI rule for high quality businesses. Last year PTI was about $2.25/share, which would put the value around $22.50/share. This is nearly half of the current market price (~$40). As stated previously, SCHW is currently a coiled spring. If interest rates go up by 2%, PTI will go up by nearly $1.60/share, resulting in a 10x PTI of $38/share.

Financial Services Company

We can value SCHW using the equity method.

BV = book value of equity = $16,421M
ROE = return on equity = 15%
COE = cost of equity = 10%
nNI = normalized net income for next year = ROE * BV = $2,463M
g = stable earnings growth into perpetuity = 5%
p = dividend payout ratio = 1 - g/ROE = 67%
Equity Value = nNI * p/(COE - g) = $32,842M
Shares Out = 1,324 M
IV/share = Equity Value/Shares Out = $25.

This gives us a value of $25 without any sudden improvement in interest rates or the tax environment. To justify the current price of $40, we need to either get to high ROEs (20%, at 5.5% growth), or sustain much higher growth rates (8% at 15% ROE).

Summary

In the long-term, there are many ways to win with SCHW, because the intrinsic value is constantly increasing. There are not too many ways to lose, although depressed interest rates can impair its underlying earnings power.

Estimates of value are all over the place. The floor seems to be somewhere around $25 (a price it was trading at not too long ago) – and can be justified essentially if nothing clicks as hoped. On the other hand, the current price of $40 seems fully priced, and assumes about a 1-2% increase in interest rates in the next year or so.

Yes, SCHW is an above average business, and probably deserves a premium. It is stock that one could hold on to for a long time, without any headaches. Perhaps, a good strategy might be to scale into a position in the $25-35 range.

If the market undergoes a correction (as it certainly will sometime in the future), I might have to keep an eye out for SCHW. But right now, it is a pass.

The Allure of Cash Secured Puts

Recently, I wrote an example of a CSP campaign on VFC.

The ideal layup for CSPs is the following:

  • you are interested in a liquid large cap stock,
  • options on the stock are available and liquid,
  • you have done a valuation and price is below the intrinsic value,
  • however, (intrinsic value – price) > margin of safety,
  • the stock has fallen in the recent past (greater implied volatility),
  • you have tons more cash than ideas.

Let’s consider my campaign on VFC, and how it ticks many of the conditions above.

Liquidity

VFC is a large liquid large cap stock. Its market cap is ~$21B, and nearly 3M shares trade every day. Monthly options are available on VFC, and the ATM calls have a daily volume of a few thousand. Bid-ask spreads on such options are usually between 5-20c. While this is not as liquid as a megacap like Wells Fargo or Apple, it is sufficient.

Valuation

I did a valuation of VFC, and determined that it was worth somewhere between $55-$70. Lets pick $65 as a point estimate of the intrinsic value. I like to buy stocks with at least a 20% margin of safety.

Thus, I would be interested in VFC at 80% * $65 ~ $52. Since VFC is a reasonably safe, unexciting, range-bound stock, which pays a 3% dividend – I really don’t mind buying it around that price – although I would really like to buy it under $50.

Environment

Two years ago, VFC used to trade over $70. In the past year, its range has been $48-$65. Thus, it has had a somewhat rough time.

At the same time, the overall market is going gangbusters. I haven’t found too many new opportunities. My cash balance is over 35% of my portfolio. The only stocks I have bought in the past six months are OAK, FFH.TO, and ALJJ. I have liquidated a lot more. I don’t mind diverting a small part (say 25%) of my cash balance towards CSPs.

Advantages

CSPs open up the universe of investable ideas. For ideas where there is insufficient margin of safety, it provides a method to work out a reasonable cushion by embarking on a campaign that can last several months. It lets you lower the effective buy price below what the market offers over that time period.

It also helps psychologically.

I know we are all supposed to be patient and wait for the really fat pitches. But the wait can be really hard and exasperating. It gets harder as you continue selling positions that have risen above your estimate of fair value, and the cash keeps building up. Furthermore, if you are adding external cash to your portfolio like me, it just compounds the aggravation. All that cash has nowhere to go.

CSPs help alleviate frustration, by keeping you productive and busy. They increase the size of the available opportunity set. They prod you to keep looking. If done carefully, they either lower your effective buy price, or help you collect some income on the side, while you wait for the market to swoon and offer better opportunities.

Either way they prevent you from splurging on something overpriced, or going crazy.

Cash Secured Puts: VFC Example

The most valuable skill I’ve learnt this year has been using cash secured puts (CSPs) more effectively. While I’ve used CSPs before, these resources at the “Great Option Trading Strategies”, especially on opportunistically rolling out options, greatly clarified the philosophy and mechanics of adjusting a trade for me. (Thanks, Brad Castro!)

The best part of a CSP is that it is completely congruent with a long-term value investing focus. It lets you buy securities on the cheap, or generate an income stream.

Let me illustrate its use with a real-life example.

Earlier this year, I looked at VFC, and guessed that it was probably worth around $65. At that time, VFC was trading around $53, having bounced back from a multiyear low of $48. I believed that there wasn’t much downside left.

So on 2/23, when the stock was trading at $52.55, I wrote 2 $52.50 Mar17 puts and collected about $205 in premiums. The stock hovered in the range $52.50-54 in the lead up to expiration, and the option died worthless (~$54 at expiry).

Screenshot from 2017-06-02 15-46-41

Five days later, the stock fell back to $53.09. I again wrote 2 $52.50 Apr 2017 puts for about $245 in premium. I closed the position 12 days before expiry on 4/10 for $35, after the stock jumped to $55. This allowed me to book nearly $210 in profits.

After that VFC continued to rise to nearly $58, and I lost interest in it. On 4/28, the stock fell back to $54.75, and I wrote 2 $55 May17 puts for $205.

After reporting lackluster earnings a few days later, the stock fell down to $52, and I learnt my first options lesson: be cautious of earnings announcements.

The stock recovered above $55, before falling to nearly $51.50 around expiry. My puts were now deep ITM.

In such a situation, there are a few options. Since I thought $51.50 was a great price, I increased my position, and on 5/17 rolled out the previous put, and committed more capital. Effectively, I closed the old puts, and wrote 3 new $55 Jun17 puts, for a net inflow of $452. The table below summarizes my actions so far.

Screenshot from 2017-06-02 16-04-10

Currently (June 2, on the day of writing) there are two weeks left before expiry. VFC is trading near $54. I don’t know what the stock will do between now and then.

Even if I decide to take delivery, I will have reduced the effective buy price to $51.50. I may be able to reduce it further if the stock remains range bound. If it jumps well beyond $55, I will happily walk away with over $1000 in earned premiums, and a solid return on capital employed.

Update on CSCO

CSCO was the first stock I valued on this blog. I came up with a $30-$35 valuation band.

At one point in time CSCO was my largest holding. Today, it is a 4.5% position. It’s stock price fell nearly 10% recently, and I thought I’d value it again in light of these developments. Unlike the previous valuation, I also capitalized R&D expenditures this time around.

Here are the assumptions I made in my valuation. I used a 10-year explicit forecast, based on the notion that CSCO remains a solid, profitable company experiencing some temporary hiccups. I assume operating margins will decline somewhat from 24% currently to 18% in year 10. I also assume that tax reform will happen, reducing CSCO’s tax rate marginally. It will also be able to repatriate its cash hoard – but I assume a 20% hair cut [PS: I have a python program to automate DCF analysis, which I plan to share on this blog after I clean it up, and apply some make-up.]

I can model some uncertainty in the margins and growth. I come up with the following range of estimates.

figure_1The median is $34. At today’s price of $31 and change, CSCO looks mildly undervalued. There is clearly a lot more upside than downside.

I continue to hold, and opportunistically write (and roll) covered calls.

Capitalizing R&D

Industrial companies reinvest in plant, property, and equipment to grow revenues. Technology companies grow by investing in research and development. However, on an income statement, these R&D investments are treated as an operating expense (instead of a capital investment).

One can reorganize financial statements of such companies by capitalizing R&D expenditures. You can check out this video, and this spreadsheet (look for R&DConv.xls) from Aswath Damodaran to understand the logic and mechanics of this reclassification.

The R&D asset you create goes to the asset side of the balance sheet.

Since assets = equity + liabilities, this increase in assets leads to an increase in the book value of equity, and hence the invested capital.

Similarly, we adjust the operating earnings by adding back the R&D expense and subtracting the depreciation of this asset in the current year.

When we capitalize R&D, we get a more authentic view of the earnings, reinvestment, and returns on capital. This alters the fundamental inputs that go into a discounted cash flow valuation, including earnings, growth and reinvestment rates (sales to capital ratio), and operating margins.

Process

To begin the process of capitalizing, we need the following inputs

  • An amortization period, N years, over which R&D is expected to deliver results (software ~ 2 years, hardware ~ 3-5 years, pharma ~ 10 years; Damodaran’s spreadsheet has some numbers for guidance)
  • Collect R&D expenses for the prior N (or N+1) years from the income statement. You can get these from company filings or a data service like Morningstar.
  • Create a table (see spreadsheet) to determine (i) the net value of the R&D asset on the balance sheet, and (ii) the current year amortization number.
  • Recompute operating earnings, net income, invested capital, and reinvestment rate.
  • Use these numbers to inform inputs in the DCF analysis

Example

I took Damodaran’s spreadsheet, and modified it slightly to account for partial year data. I did this to understand the spreadsheet better; not necessarily because I think such an adjustment is important. Of course, it uses the latest numbers, so it has that thing going for it.

For prior years, I assumed that R&D expenditures were distributed evenly throughout the year. Thus, if $100M were spent over an year, I assume $25M were spent each quarter. This spares me the burden of having to deal with quarterly filings.

I used this modified spreadsheet to analyze CSCO after two quarters of fiscal 2017.

1

Cells in yellow are inputs, while those in green are computed. This yields the following calculation for the value of the R&D asset and the amortization.

2

It also yields some summary statistics. In CSCO’s case, capitalizing R&D did not have a big effect on (i) operating income/margin and (ii) net income/margin. It had a modest effect on the reinvestment rate, which increased. The amount of capex, invested capital, and depreciation increased dramatically, while the return on capital went down modestly.