Leucadia Update

In September 2016, I thought Leucadia was worth somewhere between $27-$32. At the  time, it was trading around $19, having bounced off of of lows in the summer. The company was still under-earning, although some of the winds had started to shift.

Earlier last month, the company put out an investor presentation (link), and I came across this well-reasoned article in SeekingAlpha, which pegs the intrinsic value around $33.

I updated my SOTP analysis, and come up with a fair value near $32.

Screenshot from 2017-11-10 07-37-11

The discount to intrinsic value has narrowed considerably from 50% ($19 versus $30 in 09/2016) to about 20% ($26/$32). The intrinsic value itself has improved marginally, mostly on the backs of improvements at National Beef and Berkadia.

The dividend has also been increased by 60% from 25c/share to 40c/share. At current prices, this implies a yield of over 1.5%.

I continue to hold.

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Portfolio Moves: Sold Apple

After 4.5 years, I finally closed my Apple position last week.

I started buying in early 2013 in the low $60s (accounting for the 7 for 1 split). In 2016, I added to the position in the low-mid $90s. For quite some time it was my largest or second-largest position.

apple

No matter how conservative I got, I couldn’t come up with a value below $120. Last fall, I wrote:

The narrative is either “its going gangbusters” or “its going down the toilet”. Right now, we seem to be closer to the latter.

The narrative shifted over the past year, as Apple racked up an impressive 80% run.

As usual, I began selling way too early ($120), and finally exited my last sliver on November 10 at $175. Overall, my cost basis was $71, and my average exit price was $130 and change.

Counting dividends, Apple returned between 18-20% CAGR. Not spectacular, but considering the size of the position, and its relative safety (in my opinion), it is my kind of long-term trade.

At current prices of $175/share, AAPL doesn’t seem to be as great a value.

Why?

Last year, Apple earned about $9/share. It has about $31/share of excess cash. Using a conservative 12x multiple on the earnings, and a 20% repatriation haircut on the excess cash, I get a valuation of about $135. If you use a 15x earnings multiple, you can justify paying up $160.

I don’t know what the right multiple is. I hesitate using a high multiple because (i) Apple relies heavily on the iPhone, which regardless of how the winds are blowing currently is subject to disruption/erosion, and (ii) earnings are starting to saturate/grow more slowly.

I don’t think AAPL is grossly overvalued. However, I prefer to sit this one out.

Apple might quite possibly march onward to become the first trillion dollar company. I’ll be happy to watch the fireworks, and cheer on from the sidelines.

Under Dog

Over the past three years, Under Armour’s (UA) market cap has fallen by nearly 80%. Just over the past year, shares have lost 2/3 of their market value.

The most recent quarterly (Q3 2017) earnings report was brutal. Everything that matters was revised downwards. A series of external pressures (North American weakness, price war etc.), and internally inflicted wounds (ERP integration mismanagement etc.) have conspired to make 2017 a year UA would like to forget.

This is what happens when a growth story goes wrong. The sentiment against the company is overwhelmingly negative. The short ratio is around 10-12%, and the days to cover based on normal volumes is now about 15.

Is UA broken for good? Or are its troubles temporary? Will the company plough through this bad patch, and return to “normal”? Is the rational behavior at this time, to fold and cut our losses, or to hold our noses and double down?

Back Story

Previously, I thought UA was worth somewhere in the high teens. That was earlier this year, when the stock was trading near $20.

UA

Since I was learning a new put-writing option strategy, I thought UA – with its high volatility – might be a good candidate to experiment with. I began writing $20 strike puts in Feb 2017, and kept rolling them until August. After Q2 results, the stock dropped to the $15-16 range, and I got assigned my first set (400) of UA shares.

At that time, I revalued UA, and thought the long-term thesis remained mostly intact, and began writing more puts. This time at $16.50 strike. I kept doing this, until Q3 earnings were declared on 10/31. The stock subsequently dropped further, and now hovers between $10-11. The puts are deep in the money, and will likely get assigned when they expire on 11/24/2017 (500 more shares).

All said and done, I now have 900 shares at an average price of $15.50 (~$14k). My total maximum target allocation for UA is $25k (for a 5% position), which means I could more than double my ownership at current prices.

Valuation

After I factor in the disastrous Q3, and modest improvements over the next three years, followed by a return to industry averages by year 10, I get a DCF value of $15-16.I think this is a conservative estimate.

At current prices of $10-$11, the stock may be undervalued by nearly a third.

UA

Any improvement beyond the currently depressed valuations, any unexpected return to 10-20% growth rates in the near/medium term, and resulting multiple expansion could easily double the target price.

Five years from now, we might look back at this period as a good buying opportunity.

Just Do What?

Nike is a monster. It is the largest athletic apparel and footwear manufacturer in the world.

It sports mouth-watering returns on invested capital (25-30%), and has been consistently growing revenues and EBIT in the 6-9%/year range for well over 10 years now.

It is a growing, profitable, wide-moat business with an iconic brand.

Its has sales of over $34B, net-income of $4.2B, which towers over Adidas ($20B sales) and Under Armour ($5.5B) sales. Footwear and apparel account for 65% and 30% of revenues, respectively; the remaining sliver comes from equipment sales.

International sales now account for over half of Nike’s sales (~55%). About 30% of its revenues are DTC (website and company owned stores). In the medium-term both these slices are likely to continue growing.

Unlike Under Armour, Nike is a shoe company gate-crashing into the apparel market. The total addressable apparel market is $135B, almost 2x that of footwear. The size of the market and the popularity of athleisure provides a tailwind, and a new market for Nike to grow into.

It has stellar management (interview with CEO), and high insider ownership.

Essentially it is a great business. Usually such businesses are not cheap.

However, a glance at its chart reveals that it currently sits close to its 2-year low.

Screenshot from 2017-10-08 16-49-46

Might this be a good time to ease into NKE? Before we look at valuation, it might be useful to understand what the bear case might be.

Amazon. Of course.

It is killing retailers (Footlocker etc.) which still account for a majority of Nike’s sales. It is also jumping into Amazon branded apparel.

While I respect Bezos too much to dismiss Amazon, I think the actual threat posed by Amazon to Nike is far weaker than perceived.

Nike is a powerful identity brand. Like Ferrari, Harvard University, and Rayban. Unlike Gillette, Tide, or Hanes underwear, whose brands were protected through the premise of lowering search costs. Amazon (or Dollar Shave Club or Kirkland) could kill such categories with their store branded products. And they probably will.

Perhaps a bigger threat is that the apparel industry is subject to fashion trends. Nike knows how to engineer performance shoes that are sought after. The transition to a casual fashion brand may be not be easy.

The game is different. Just because someone has a black belt in karate, doesn’t mean they will do well in the boxing ring.

Currently, the North American market environment is overly promotional. This will eat into margins. However, over a few years, one would expect this latest catfight for market-share to have play out, and settle. So while this does present short-term headwinds, perhaps we should be thankful to it for allowing us to buy a great company at a reasonable price.

Which finally brings us to valuation.

Graham’s formula for growth companies, suggests a fair P/E ratio of (8.5 + 2g). In NKE’s case growth is approximately 7% for quite a few years to come. So that would suggest a reasonable P/E of 22. For FY2018, EPS is expected to be around $2.40.

This would imply a fair value of 22*$2.40 = $53, which is close to today’s share price.

One could also use a terminal value formula to come up with an alternative fair P/E, and isolate the drivers of value.

P/E = Value/NOPAT(t+1) = (1 - growth/ROC)/(COC - ROC)

If we assume Nike is a truly great company capable of growing profitably for quite some time, we might assume growth = 7%, COC = 10%, and ROC = 25%. This yields a fair P/E of 24, which after subtracting the $2.50 debt/share brings us to a fair value of $55.

If we treat Nike like a solid (but not extraordinary) company, with growth ~ 4%, and ROC = 20%, we get estimates of value between $35-40.

Thus, despite the fall in stock price Nike is not really cheap. For $50-$55, we are, at best, buying a wonderful company for a fair price. It will probably turn out to be a fine investment. However, this is not a back-up-the-truck price, just yet.

In my opinion the $35 estimate provides a lower bound. It implies a P/E less than 15 for a company like Nike!

Given the liquidity of the stock and share price, NKE might be an ideal candidate for selling cash secured puts. I would like to try to build a sizeable long-term position in NKE, especially if I can reduce the cost basis to the lower of mid $40s.

 

 

Maintenance CapEx

Companies make money by selling stuff they make. To make stuff, they need to invest capital.

This invested capital (IC) often takes the form of PPE for traditional widget manufacturers. From a business standpoint, one can take a broader view of IC, and recategorize any expenditure that is borne in a particular period, but “pays off” over longer time periods as capital. Thus, R&D or subscriber acquisition costs (in sticky businesses) may be thought of as CapEx.

This might involve reinterpreting the CapEx that appears on the cash flow statement.

CapEx (CX from now on) has two components: maintenance capex (MCX), which a business has to reinvest just in order to stay in place, and growth capex (GCX), which is the part of CX that increases sales.

CX = MCX + GCX

MCX is a “cost”. GCX is an investment.

If you own a rental business for example, replacing a broken heater is MCX.

Buying a new rental property is GCX.

Warren Buffet’s owner’s earnings (OE) or Greenwald’s adjusted earnings try to account for this “cost” of doing business.

OE = NOPAT - MCX

Calculation

Calculating MCX is both art and science. It is not a number that is directly broken out in financial statements. However, we can develop some intuition on how to think about it broadly, and estimate it.

For a mature company with stable sales (no growth or decline), there is no GCX. Thus, all CX is MCX. For such stable businesses, MCX is approximately equal to the depreciation.

MCX = depreciation

Another popular method uses the following algorithm:

  • estimate the sales to capital ratio, SCR
  • compute the change in sales dS = S(t) – S(t-1)
  • GCX = dS/SCR
  • MCX = CX – GCX

Additional Notes

  • average SCR over several years; compare with industry averages
  • some CX may not produce sales growth immediately (ex. building a new theme park). This may involve projection, if the past doesn’t rhyme with the present.
  • if stable or meaningful SCRs cannot be extracted, then be wary of the number you produce.

References

  1. CS Investing: Calculating Capex
  2. Old School Value
  3. Seeking Wisdom
  4. Gurufocus

Valuation Updates

Here are some updates on companies I valued earlier this year

First Solar: I came up with a fair value of ~$31/share in January, and suggested huge uncertainty around that estimate. I even embarked on a put campaign when it dipped to my target buy price near $25, before it roared back to nearly $50.

Under Armour: I estimated UA to be worth about $17.50. Since then, it has simply hovered in the $15-$20 range. I’ve been trying to build a position in UA by writing puts. In August 2017, I bought 40% of my target allocation for $16.15. The recent swoon in prices has me eyeing a second slug.

VF Corp: I thought VFC was worth about $65, when it was selling in the low $50s. Since then, it has bounced back to $63 and change. I have no position in the stock currently, although I did make a decent return writing puts.

Hanesbrand: I came up with a conservative $20-25 range for HBI, when it was trading at the lower end of that range. Currently, it is trading at the higher end of that range.

Compounding Insurers: In April, I updated by valuation of BRK ($200), MKL ($1080) and Fairfax ($580). Since FFH was cheap for a large part of the year, I doubled my position. Just today, the price breached $500 on the back of a stellar Fairfax Asia deal.

ALJ Regional Holdings: A depressed fair value estimate for the company is about $3.40. But buying ALJJ is a bet on the jockey. It could be worth more than $5 shortly. I have been buying ALJJ since June.

Others: I thought Charles Schwab was an excellent company worth somewhere between $30 and $40, and that GameStop was a struggling retailer that might still be worth about $25-30. Finally, I estimated the value of Disney to be $120.

Cash Secured Puts: An Algorithm

Here’s a rough flowchart of my current CSP strategy.

Ideas - 31

I am still actively tweaking my process; so the following only represents a snapshot of my current thinking.

Search

The first step is to search a good candidate. Usually, I have about 20-30 stocks on my radar. These are stocks I am interested in owning. Some of these are companies I already own, but want to own more of.

In any case, I have a reasonable guess of the intrinsic value, IV, for this set of companies. Some of them may be trading below IV (price p < IV). If they trade at a sufficient discount, I will consider buying them outright. Usually, I like to buy stocks for at least a 20-25% discount to IV. This represents my margin of safety (MOS).

But what do I do, if the discount is not large enough? Say,

IV - MOS < p < IV.

I use this condition as an initial filter.

At any given time, depending on the overall market, 3-5 stocks may pass this filter. Two stocks, I am looking at, that pass this filter currently are MSM (IV ~ $85-90), and WFC (IV ~ $55-60). If MSM or WFC traded around $60-65 or $40-$45, respectively, I’d buy the stocks outright.

The second important filter is liquidity. When I am buying stocks, I usually don’t care about liquidity, because my holding periods are usually long. I don’t trade positions frequently. This freedom allows me to buy small-cap and foreign stocks.

With the CSP strategy, however, I need a fair bit of liquidity, since (option) holding periods (more on this later) are usually of the order of one month, and bid-ask spreads on illiquid names can be brutal.

This restricts the universe to somewhat large cap names, say market cap greater than $5B. This number is a guide, not a strict threshold. I like to see open interest for upcoming ATM options to be greater than a few hundred. Usually, both these facts are correlated.

WFC has a market cap over $250B. MSM is much smaller, ~$4B. The open interest for the $50 WFC put expiring on Oct 20 is about 5000. The comparable number for MSM is about 10. So WFC passes the second filter; MSM doesn’t.

The third filter is stock price. I like the stock price to be around $50 or below. This seems quite arbitrary, but is a self-imposed constraint because of position sizing and tactical considerations.

Right now, I like to restrict new positions that I ease into using CSPs to a maximum of 5% of my portfolio. At my current portfolio size, this means a total outlay of between $20-25K. Unlike many options traders, my goal – my ideal outcome – is to buy with a sufficient margin of safety. CSPs are a way to reduce the effective buy price below that level.

The main reason for the $50 stock price filter is that I might embark on long CSP campaigns. Sometimes, this means committing additional capital to the position if it moves deeper in the money.

I like to have 4 slugs in my revolver ($20K outlay/4 options ~ $5K/100 shares ~ $50 price threshold). This gives me added flexibility to adapt, adjust, and exploit volatility.

The final filter is price of the option. I target a minimum return of 20% IRR. If I commit a certain amount of cash to a new CSP, I seek annualized returns on that capital of 20% or more. I will discuss this filter in more detail in a separate post, because there is a fair amount of nuance.

If a stock has fallen in the recent past, its implied volatility is often high (say >30%). These are ideal candidates to chase, since the fall in stock price may have brought them close to value territory, making the pursuit all the more fruitful.

To recap, I search for the following characteristics:

  • attractive stock, but not cheap enough,  0.75 * IV < p < IV
  • liquid options market (generally large cap >$5B)
  • p <= $50, approximately
  • initial hurdle IRR > 20% (high implied volatility helpful – but check upcoming events)

Start Campaign

Okay, once we’ve figured out we want to pursue this strategy on an attractive candidate, we write or sell ATM puts on 1/4 or 1/2 of the intended position, with a duration of about a month. Why?

We sell at ATM options, because they have the thickest time value premiums. Ideally, we want to maximize these as we are going in. Later, we may be have to be content with ITM puts, which are less juicy, but we aim high to begin with!

How to size the initial position? This depends on how large the margin of safety is at the current price. If it is reasonably large, then I’d go with half. If it is not large enough, then I go with a quarter. This usually ties up $5-10K in the first round.

Finally, I usually try to sell options about one month out. You can get higher IRRs by using weekly options if they are available. This involves more frequent trading (potentially higher commissions), and careful upkeep. A frequency of one month is short enough to capture a fair chunk of the fastest decay in time value, and long enough to suit my temperament and schedule.

To summarize, we start a CSP campaign by,

  • writing ATM or slightly OTM puts,
  • on 1/4 – 1/2 the intended final position (depending on MOS),
  • with a duration of about a month.

Then we collect the premium and wait.

Quick Validation

Several things can happen. One outcome is that the underlying stock shoots up, and moves far away from the strike price of the puts we wrote. If that happens, it may be worthwhile to close the position prematurely. Suppose,

G = initial premium collected = maximum gain
T = initial duration of the put (in days)
t = current time to expiry 
g = gain on the position at current time (g < G)

Currently, I use a rough rule of thumb.

If the gain on the position exceeds 75% of the maximum possible gain, within the first half of the intended holding period, then I close position. Mathematically, this condition can be expressed as.

t < T/2 and g >= 0.75 G

The reason for not continuing to hold on to the position is that it frees up capital.

Thus, if the stock spikes, and then falls down again, you may be able to exploit the volatility by collecting twice on the same stock. In reality, things can work out even better. When the price of the security rises, its implied volatility falls. That, and the moneyness of the position make it cheap to buy it back. If the stock falls back, generally implied volatility increases, and you can juice out more time value from an ATM option.

Expiration

At expiry, you encounter one of three possibilities. Let’s dispose of the easy ones first.

If the stock prices exceeds the strike (p > S), you let the position expire. Depending on the price, you may consider reestablishing a new position at a later time.

If the stock prices hovers around the strike (p ~ S), or slightly below, you can roll out the position. This means you close the current put, and write a new put one month out. This lets you collect additional premium, or lower the effective buy price.

If the stock price has gone substantially below the original strike, things get interesting. This is where experience may be invaluable. I haven’t been doing CSPs systematically for long, but think that I have already gotten better at a few things.

In any case, you have several options; you could,

  1. take delivery – if you have reduced your effective buy price to a point where it is sufficiently below the intrinsic value, then it might be a good idea to take possession. Remember the overarching goal of the strategy is to buy good companies at a cheap price.
  2. roll out  – If you aren’t still happy with the effective buy price and have no new capital to commit, you can roll out the position. Note that the premium for ITM or deep ITM options may not be terribly attractive. Increasing the duration beyond one month might help add a little meat on the bone, but it will hurt your overall IRR. That said, it is a fine default strategy.
  3.  add position: if you have dry powder left (this is why I like four slugs in my revolver), you have more flexibility. There are multiple flavors, you could (i) keep the strike the same, (ii) lower it, or (iii) lower it and add extra duration. The first option (keep strike same) usually gives you the fattest premiums – it works best, when you think the stock has gotten really cheap and you want to lock in this cheapness. You fully expect the stock to rebound before the next expiry. The second or third options (lower strike/add duration) are worth considering, when you think the stock is headed even lower. You may take an IRR hit extending your position this way, but you are playing the long game. This way you reduce your effective buy price, and set yourself up to write future options that are less ITM (and collect fatter time premiums).
  4. use a wheel strategy: this involves some combination of the alternatives laid out above, and requires additional dry powder. You take delivery of the ITM options, write slightly OTM covered calls on these options, and use your dry powder to simultaneously write ATM or slighly OTM puts.

In future posts, I will highlight specific examples using this template.