Journeys of a Bumbling Investor

I haven’t been looking at the stock market for probably close to a year, but recently got involved again due to the worsening crisis (well, at least what’s reflected in the stock prices).

Just wanted to capture a couple of learning points from the current crisis:

• Stocks of asset management firms and hedge funds will get hammered more because of two reasons (see FIG and BX for examples):
  1. Customer redemptions due to the panic, forces hedge funds and mutual funds to sell at low prices into the market panic and prevents them from taking advantage of the good buying opportunities available. The exception are funds that clearly holds lots of cash that are not “callable” in preparation of buying in true market crashes (e.g. Berkshire Hathaway’s $40bn cash warchest).
  2. Market conditions affect firms that the hedge funds / mutual funds have invested in, either lowering valuations or requiring additional funds and effort to ensure that those firms survive through the crisis.

• Low liquidity stocks (e.g. Preferred stock) will get hammered more because
  1. There are fewer shares to go around, hence fewer buyers to compete for shares that are being sold, hence the bid is lower. Buyers take advantage of that to offer even lower bids. Buyers also offer lower bids to compensate for the lack of liquidity.
  2. In panic selling, sellers are forced to sell at the low bids, especially when margin calls are hit.

• Because of the reasons above, good low liquidity stocks may be bought at terrific bargains during a crash. However, do not buy into low liquidity stock until minimally the following three conditions are met:
  1. A crash has occured (refer to Cramer’s definition in my previous post, e.g. headlines of markets crashing worldwide, people ruined, blood on the streets, etc.).
     If you buy low liquidity stocks before the crash, you will find that you will be holding them all the way down. This is because the crash happens very quickly (e.g. in 2 days), the drop in the bid is huge and sudden, and buyers only bid at rock-bottom prices.
  2. You are prepared to never be able to sell the stocks until the market has recovered (which may be years later). A recovery in the general market may not cause the low liquidity stocks to recover.
  3. You do not take on ANY debt if a large portion of your portfolio is in low-liquidity stock. The huge gapping drops in the price will cause margin calls extremely easily.
     As an example, I bought NCT-PB at $9, with a buffer of $6 before hitting a margin call, and the stock tanked in 2 days to $3.

• Stock market crashes happens quickly, within 1-2 days to a week. Spread out any buying to over at least a 2-week period. Capital is the MOST important thing to have in a crisis. Use it sparingly. Do not exhaust it within a week and get slaughtered in the next.
• I cannot over-emphasize that Capital is the MOST important thing. Cash is KING.
• Do not be overly tempted by 52-week lows. It can ALWAYS go lower. Wait for the true mega plunge before committing the bulk of your capital.
• So far, this crisis have stocks trading pretty range-bound (at low prices of course), with some occasional small dips and a large plunge so far (plunged on 9-10 Oct). Some trading rules for such a market:
  1. If a company plunges due to a “structural issue inherent to that company” (e.g. AIG, WB, MER), you can put the bulk of your capital in due to the over-reaction. Be prepared to sell intra-day (i.e. on the same day) or the day after.
  2. If the overall market drops and you want to take advantage to buy positions in certain companies, spend at the most 20% of your capital. Similarly, sell off immediately when it has recovered to the average of its trading range. You should be holding all cash most of the time.
  3. If it drops further after you’ve put in the 20%, hold and wait for a few days. If the mega plunge happens, go in with the rest of your capital. If nothing happens, you may buy in a little more (max another 10% of your total capital) and hold.

• Do not do dollar-cost-averaging all the way down. That should only be done in good times. Be prepared to wait a few days (min. 3 or more) to determine if its a mega plunge before committing capital.
• PUT IN THE BULK OF YOUR CAPITAL ONLY IN A MEGA PLUNGE! There is nothing worse than running out of capital at the rock bottom of a plunge.
• Look out for “special opportunities”, e.g. 10-for-1 reverse stock split with unaware speculators selling their stock at low prices thinking that there was a jump.
• With high market volatility, dividends are not important. Do not buy a stock to capture dividends. Capital gains/losses occur much more easily and will invalidate any dividends gained anyway.
• Cramer is right – do not fight the cycle. Secular growth stocks like Walgreen (WAG) survived much better than others. Those may be safe harbours when the possibility of a market crisis is looming, and yet you don’t want to pull all out from the market.

I’ll update this post as I learn more

The points here are summarised from an interview with Howard Ward (Gabelli Funds) conducted by Kirk Kazanjian in his book Wizards of Wall Street.

Without question, 1992 and 1993 both were difficult years for you [Aside: drug stocks hammered due to health-care spending concerns + threat of federal health-care and drug-price regulation when the Clintons took office. Philip Morris in April 1993 cut the price of Marlboro cigarettes by 40% overnight. Investors clobbered not only Philip Morris, but all of the consumer staples stocks].

What did you learn during that time?

• Leading brands are valuable assets.
• All of the private label consumer-brand companies (e.g. American Safety Razor, Cott’s, Perrigo) failed to have a lasting or measurable impact on the blue chip multinationals (e.g. Gillete, P&G, Coke, Philip Morris).

How do you figure out how much you’re willing to pay for a stock?

• Developed an earnings valuatino model that tells me what the logical price for a stock is, using a five-year time horizon (don’t work well for cyclical stocks).
• Take the current year’s earnings estimate, grow the earnings by 5 years using a 5-year growth rate.
• Then look at what kind of P/E multiple the market is willing to pay for the stock in 5 years time. Typically will use a P/E number that’s 10% lower than what the market is currently paying and won’t use any multiple that exceeds 30.
• Multiply the year 5 earnings with the year 5 P/E to get the stock price 5 years later.
• Discount that number back for 5 years using the 10-year Treasury rate + 2%. The +2% part is the equity risk premium.
• The discounted present value is the fair value of the stock.

Do you sell when it reaches your target price?

• No. From experience, a stock that is rising rapidly is frequently a leading indicator of an up-side earnings surprise.
• Don’t typically start reducing a position until the stock is at least 10% overvalued.
• Won’t eliminate a position until its about 20% overvalued.

The points here are summarised from an interview with Bob Torray (Robert E. Torray & Co.) conducted by Kirk Kazanjian in his book Wizards of Wall Street.

What have you learned over the years? How has your investment approach matured?

• It is a tough way to make a living by investing in obscure companies, special situations and turnarounds, and trying to take advantage of market cycles.  My experience over several decades convinced me that I should forget about all of that.
• It wasn’t that we didn’t make money, we actually did very well. But I now believe that we could have done about the same, and certainly better after taxes, with less effort, uncertainty, and risk, by simply buying first-rate businesses run by top-notch management and hanging onto them for the long haul.
• To put it another way, early on I was playing the stock market, trying to buy low, sell high, capitalize on turnarounds, breakup values, and so on. Today, I don’t trade at all.

Some other question…

• The value of a business is related to the stream of earnings it generates. The share price will reflect those earnings but cannot alter them. We want to buy at a fair price.

The points here are summarised from an interview with Fritz Reynolds (Reynolds Funds) conducted by Kirk Kazanjian in his book Wizards of Wall Street.

• Look for companies with above-average growth characteristics, strong unit growth (>= 13%), are well managed, and enjoy good pricing power.
• Often that might be the number one or two company in the industry. It could also be economies of scale or worldwide growth.
• Many times it’s a very profitable company with high return on equity.
• It has balance sheet that’s strong, maybe no more than 30% debt.
• Use the PEG ratio (P/E divided by growth rate) as a valuation yardstick. If PEG is 1.25, and interest rates are very high, stocks are a good value. When interest rates are near a 30-year low, the average PEG is 1.5 to 2 for many of the companies ,and they are good values.

The points here are summarised from an interview with Bill Miller (Legg Mason) conducted by Kirk Kazanjian in his book Wizards of Wall Street.

How do you figure out what a company is worth?

• We use what we call a multifactor valuation methodology, i.e. we look at the value of the business every possible way we can.
• We use P/E, P/B, P/CF, but we adjust those numbers for the underlying economic reality.
• We do all the cross-sectional analyses of trying to figure out what the historic parameters have been (i.e. to correspond with the historic underlying economic reality).
• We do a scenario analysis of the business, by projecting cash flows out anywhere from 5 to 10 years under a variety of scenarios. One scenario would be where the current growth rate continues. Another, where the company does a lot worse. Another is where it does better. We then try to figure out what we call the “central tendency of busines value.” Each scenario analysis gives us a different number and then we see how those numbers cluster. If they all cluster around the same thing, then we have a pretty high confidence in the particular valuation range.

CSE is a stock that is beaten down in this mortgage crisis. Even though management affirmed that dividends will be paid as promised earlier, there are still shorts who believe that the dividend would not be paid (which was what happened in many other mortgage companies even though their managements also proclaimed great news before disasters struck).

So you would expect that when the company announced that a dividend of $0.60 will be paid this quarter, the stock should enjoy a small jump. Instead, the stock actually dropped a little. So I said, Wierd, and I went ahead to buy a bunch. Over the next few days, the stock kept tanking, all the way from $18 to $16.

1st Lesson: Don’t think that a battered stock will always jump on dividend announcement.

Well, I averaged down during the tanking, though I was thinking if there was some impending news that I was not privy to – that’s a very scary thought =). Anyway, what happened was that 1-2 days before ex-dividend, the stock started to jump up. There was very significant short covering by short sellers who do not want to end up paying the dividend (to the guy whom they borrowed the stock from). The stock jumped back up above $18. At that time, I was considering if I should sell into the short squeeze. The idea being that the short squeeze was artificial demand, so I should take advantage of that temporary dislocation, else the stock might drop back down significantly on ex-dividend date after the artificial demand has disappeared. This coupled with the possibility that the short sellers might resume shorting the stock again.

But I ended up not selling the stock. On ex-dividend date, the stock opened at $18 (the previous close would be $17.67 when adjusted for the dividend). The stock pretty much stayed above $17.67 during the session and thereafter. The fear of a price tank due to i) lack of artificial demand, and ii) resumed short-selling, did not materialise.

2nd lesson: It may not always be wise to sell into a short squeeze.

The first two lessons illustrate that in the stock market, anything can happen. That’s why its extremely hard to make money from short-term trading. I think the Value Investing is still the sure of making consistent profits in the stock market.

On a related note, NCT announced dividends a few days after CSE’s ex-dividend date. Well, unlike CSE, NCT soared when the dividend announcement was released. Again highlighting the fact that, you can never predict with certainty what would happen in the short-term.

Well, I made a costly mistake this week: I betted that the Fed would not cut rates on 18 Sep 07.

Apparantly, the futures market had a 100% expectation of a 25 basis point cut, and many news articles were clamoring for a 50 basis point cut. The reason that the market gave was that with the credit/liquidity turmoil currently, a recession could potentially develop, hence the Fed should cut rates. However, I felt that the Fed would not bow down to the market pressures and would instead only cut rates when there are definite signs of a slowdown/recession. In fact, with the oil prices making new highs this week and other indicators showing signs of inflation, I felt that that inflation is still a potential problem, so it would be unthinkable to cut rates.

As it turns out: I was wrong. Bernanke bowed down to market pressures and cut rates by 50 basis points.

As a bet against a rate cut, I had liquidated most of my positions, and ended up missing a 15% rally on my positions over two days. With my stocks now at a short-term high, I’m very cautious of going back in for fear that the price level would drop significantly back to pre-rally levels, even though the stock is still clearly undervalued. It made me realised how much a good thing it was to buy a large position when the stock was trading ridiculously low. The psychological comfort and safety of buying in at an extremely low price was wonderful. I should not have let go of that and should have held my position.

On hindsight too, I realised that I was making a call based on a wild guess. I had no idea of Bernanke’s personality, no idea of what kind of pressures/influences the FOMC was subjected to, and no idea of many other factors that would impact the Fed’s decision. I was literally speculating, in the purest sense of the word. Hence my lesson: Never speculate on Fed decisions ever again.

Interestingly, I saw this article about an interview with Warren Buffett on the Fed rate cut (link here). The important quote from Buffett:

“The important thing in stocks is to buy a stock in a good business at a reasonable price. Anybody that is buying or selling stocks based on what the Fed is doing, or what they think they’re going to do at their next meeting, I think is destined to not having a great financial future. It really doesn’t have anything to do with the value of good companies 3, 5 years from now. People who think they can dance in and out based on Fed signals, I think, they’re going to make their brokers rich, but they’re not going to make themselves rich.“

I was doing a very quick compilation of the effects of the liquidity crunch on the financing of some of the mortgage companies that I’m looking at. To set the background, the average interest rate for traditional 30-year fixed-rate mortgages is 6.25%, and the average interest rate for one-year adjustable rate mortgages is 6.34% (from Mortgage Bankers Association’s weekly applications survey for the week ending Sep 7).

You can see that many of the companies’ financing cost jumped up significantly and is way above the residential mortgage rates. The “better and larger” the company, the lower the financing cost relative to others (though still high in the absolute sense).

CapitalSource (CSE)
CSE announced on 11 Sep 07 that they have secured $1.07bn of term financing with commercial real estate loans. The interest paid is the floating commercial paper rate + 1.5% , which at the time of writing this is 6.15% + 1.5% = 7.65%.

Thornburg Mortgage (TMA)
TMA announced on 30 Aug 07 that they issued 20 million special shares and raised $500m (i.e. $25 per special share). The special shares carry a dividend yield = Max(10%, common stock dividend yield), and are convertible to common stock for $11.50 each. TMA is basically diluting the company at a time when their stock is hammered.

Countrywide Financial (CFC)
CFC announced on 22 Aug 07 that Bank of America (BAC) acquired $2 billion in the form of nonvoting, convertible preferred stock yielding 7.25 percent annually. The shares can be converted into common shares of Countrywide at $18 per share, with certain restrictions. That was at a time when CFC was trading at about $22. Again a very significant dilution with the addition of a more ’senior’ security, given away at a low price.

Delta Financial Corporation (DFC)
DFC announced on 14 Aug 07 that it obtained a $60m repurchase financing facility from Angelo, Gordon & Co, with the following conditions:

1. Angelo, Gordon & Co. will receive warrants to purchase 10 million shares of commons stock with exercise price of $5 per share, with the warrants expiring Feb 2009.
2. The repurchase facility is collaterized by all currently existing securitization cashflow certificates (Class P, Class BIO, owner trust certs).
3. Interest rate charged is 6% over one-month LIBOR (at the time of writing, that would be 6% + 5.8% = 11.8%), payable monthly.
4. If the warrants are exercised for at least 5.0 million shares, and thereafter, the holdings of the Angelo Gordon do not decrease beneath that amount, then Angelo Gordon will be entitled to appoint up to two members of the Registrant’s Board of Directors.
5. For so long as the Angelo Gordon Entities own 5.0 million shares of the Registrant’s common stock (or the warrants to purchase those shares), the Angelo Gordon Entities will have preemptive rights to purchase up to one-half of the Registrant’s equity securities that may be offered in certain types of offerings.
6. Under the terms of the warrants, the exercise price will be reduced if DFC issues shares of its common stock (or certain convertible securities) at a price that is less than the exercise price of the warrants.
7. The exercise price of the warrants may also be paid by reducing an equal portion of the principal amount of the Repurchase Facility.
8. The repurchase facility matures in 12 months, if not sooner repaid.

Enough conditions for you?

DFC also issued $10m convertible notes to Mohnish Pabrai, convertible to 2 million shares of common stock at a $5/share. The convertible notes mature in August 2008, if not converted or redeemed earlier, and bear interest at the rate of 6% per annum for the first 90 days, and thereafter at the rate of 12% per annum, until converted or redeemed.

Came across this web page by Damodaran which highlighted some good points on the stable growth rate (link here):

1. The stable growth rate cannot be greater than the overall growth rate of the economy, since if a firm grows forever at a rate higher than the growth rate of the economy, it will be bigger than the entire economy.
2. Make sure you know whether you are choosing to use nominal growth rates or real growth rates.
3. The stable growth rate can be negative.

Rating: OK

Background: Came across this book by Gary Marks. Picked this up because I saw that the Foreward was written by John Mauldin, and I like the weekly newsletters that John Mauldin puts out.

Key points:

1. The nice thing about this book is that it puts out its main point very early on =) Basically, the book defines the “End Game” as the point where individuals and their families no longer have to be concerned about money (e.g. enough principal invested safely for your after-tax income to match or exceed your annual expenses on an ongoing basis). Once you have accumulated enough wealth for you and your family to stop, you should stop putting your wealth at risk. Stop risk-taking with investments of any kind, walk away from the investing game and spend the rest of your life doing something else.
2. To summarize the main point, you want to succeed at your own personal life. Once you have accumulated enough wealth, switch to choosing only risk-averse investments and spend your time enjoying life.
3. How to hedge your investments
   • You have a full position in a bubble period, you don’t know whether the market will continue to go up or tank. Do you sell all and hope to buy in the crash? or do you continue to hold and hope for more speculative gains? Neither. Sell half position – “win some” either way.
   • Diversify the ideas, asset classes and strategies.
   • Always have sell stops in mind before you make an investment.
4. Don’t be afraid to pay your taxes.
5. Real estate investment is bad: tenant problems, lost monthly income when tents leave, lost monthly rent when tenants don’t pay you, hassle of possible evictions, repairs on the house, property tax, property insurance, liability insurance, being responsible for a second and third mortgage to a bank. Not the way you want to spend your time.
6. A family office is an office dedicated to the investments of a multi-generational family (i.e. continuation of legacy wealth). A chief advisor to a family office once said, only 3-5% of the assets maximum are in the stock market. The rest are in extremely conservative hedge funds, hedged accounts, real estate bought and overseen by a development corporation that the family owns (develop from raw land, hence not dependent on price of real estate rising).
7. How to invest
   1. If you have net worth of less than $1.5 million, you should perform dollar cost averaging (in periods of 6 months to a year) on a few broad indexes, or a basket of ETFs (e.g. S&P500 Index, Wilshire 5000 index, some international index, Russell 2000 index, QQQQ, Wilshire REIT index). Make sure you are well diversified in sectors and capitalization sizes.
   2. For people with net worth more than $1.5 million, find a group of hedged funds of funds with consistent levels of good performance net of their fees, and net of your taxes, including tolerable performances under strained market conditions. You want to do growth-oriented, risk-averse, passive investing. Minimum of 3 funds of funds that correlate as little as possible.
8. At the Appendix of the book, Gary gives a nice Fund of Funds questionnaire that an investor can use to ask the General Partner of a fund of funds.