The Unknown Stock Report

I have decided to start up a paid investment newsletter focusing on individual stocks. I know the landscape is very crowded for such an endeavor, but I will truly strive to be unique and useful to my subscribers. The newsletter will focus on only one stock per issue, with an occasional update on previous stocks that have appeared. I have decided to call it "The Unknown Stock Report." I know the name sounds corny but it’s all I could think of.

What Do I Mean by an Unknown Stock?

Well, to put it simply, and at the risk of sounding a little bit like a wise ass, it's a stock that no one has heard of. There are tens of thousands of publicly traded domestic companies in the United States, yet maybe less than a thousand or so have analyst coverage. An even smaller subset of these stocks that have analyst coverage ever appear in the mainstream media in any substantial way. Most investors stampede into the same old stocks because it makes them feel warm and cuddly inside. This does not mean that these are the best stocks to own, as we all know.

Why Focus on Unknown Stocks?

I am a Value Investor, and a Value Investor is by nature a contrarian and the stocks described above tend to be underowned and therefore by definition undervalued relative to peers who trade in a more liquid and noticeable fashion.

So How Are We Different?

First, we have a strict policy of not accepting any compensation from any company that we write about. This includes compensation in the form of cash or warrants. You would be surprised just how many newsletters have buried in its disclosure statement, in as small a font as humanly possible, a small blurb about how much money the company paid to get a report written about them. We don't do that. In fact, I would open my throat with a knife before I took money from a company I am writing about. I am not a shill.

Second, I will also disclose any ownership stake that I have and at what price I paid for the shares. I put my money where my mouth is. I am also doing this for legal reasons, since I manage an investment partnership.

Third, any stock I write about will be a stock that I want you to buy. There will be no obtuse ratings system consisting of numbers from 1 to 5, or my favorite - accumulate.

Fourth, I won't insult your intelligence by telling you that you will become a millionaire by subscribing to my monthly newsletter, but I will guarantee that every month you will learn something about a new stock.

Why Am I Charging You For This?

I know what you are thinking - how dare I charge you for this, don't I know how much stuff is out there for free? Well, I enjoy writing in my other two blogs, and I appreciate the occasional "click" on my google ads, but at the end of the day, my family and I need to eat. I have four kids, with one entering college in the Fall. I think that $149 a year for 12 monthly issues is reasonable. So click on this link:

The Unknown Stock Report

and then click on the subscribe button at the top left of the page above and go to Pay Pal. I will publish the first issue in June. If you are truly dissatisfied after reading the first issue, I will refund your money.

A Threat to Value Strategy?

One of the bedrocks of Value Investing is margin of safety, which is sometimes manifested by owning a company with a large cash balance relative to its market capitalization. Most investors lump cash and short term investments into one figure, owing to the alleged safety of these investments. What if that cash wasn't really cash?

The latest hint of this problem comes from Palm Inc. (PALM) which stated during its conference call that $75 million of its cash balance has been reclassified to non current due to a "limited market" for these auction rate securities. The full quote from management, courtesy of Seeking Alpha:

"We also reclassified approximately 75 million of our investments to non-current. These are AAA and AA rated auction rate securities that currently have a limited market and are not needed to meet all liquidity needs for at least the next twelve months. As a result, they have been reclassified to non-current."

This looks to be classified on the PALM balance sheet as "other assets" which is now at $92.2 million. I am not sure what the other $17 million is.

There were no questions about this during the call.

Are We There Yet for Homebuilders? - Part IV

Another issue to grapple with when buying the Homebuilders is the number of new home sales relative to previous peaks. As you can see in the chart below, if you declare a bottom for housing at the current level, one of the assumptions that you are incorporating into your analysis is that you are comfortable with the fact that the number of new home sales will trough above the peak of the last cycle.

New Home Sales Monthly (January 1963 - August 2007)




This is an important decision because during the last three cycles, new home sales never went above a 900,000 annual rate. During this cycle, they went much higher and peaked at an annual rate of 1.389 million in July 2005. If this extra demand was real demand, due to higher population growth or a more affluent population buying second homes, then this is fine. If it is speculator demand, then we are in big trouble.

So it remains to be proven whether the trough of this cycle should be above or near the peak of the last three when referencing new home sales. Months supply of new homes solves this problem in some ways since it transforms the data into time. If that is the case then we may not be at the trough yet as months of inventory peaked at much higher levels at the troughs of previous down cycles. (9.4 in January 1991, and 11.6 in January 1980.)

Lennar Stock Last Cycle

One problem with Wall Street is a lack of institutional memory. It seems that no one even remembers the last big downturn in housing that occurred in the late 1980's and early 1990's. I am posting a series of charts of different Homebuilders from that era. The first up is Lennar.

Two things are clear from this chart. First, this is not the first time that Homebuilders have gone down 75%, and second if you time this right on the upside, these stocks will be the buy of a lifetime.

It's hard to see in the chart but the stock looks like it bottomed out in October 1990 at around $0.55. This is down from the peak of about $2.05 in early 1987. Also, you will notice in the chart that there was a false rally after the crash of 1987. If you bought Lennar after the crash in October 1987 at $0.78 you saw your investment almost double in two years, before the stock fell to its true trough in October 1990. It would be interesting to see when the book value of Lennar stabilized in this downturn. Unfortunately, the SEC web site only goes back on line to 1994.

Are We There Yet for Homebuilders - Part II?

Are we there yet? Are we there yet? My kids yell this in the car all the time. So are we there yet for Homebuilders? Is it time to buy? First here is the damage to some of the Homebuilder stocks since the peak, which for most of the stocks occurred in July 2005.



I am going to spend a majority of my time figuring out when to buy Homebuilders, but for now here's a quick list of what you shouldn't do.

Don't listen to anyone on the sell side. Most of them told us for years that it would be different this time. Remember that tripe? Access to capital, immigration, consolidation in the industry, better balance sheets, yada, yada, yada.

Second, don't rush out and buy because you see a "cult" investor on CNBC talking the sector up, or a rumor hits the wire that another cult investor is buying. In July, rumors hit the tape that Buffett was buying shares of Hovanian. Let's hope he didn't because the stock was at $16 then and its now at $11. Do your own work. Don't blindly follow someone else. You'll feel a lot better afterwards. This does not mean you or I will ever be as smart or as rich as Buffett, but there's nothing worse than losing money because you listened to some talking head on CNBC instead of doing your own research.

I used to be an equity analyst at a bank and my boss wanted to buy shares of Arrow Electronics (this was late 1998). I took a look at the stock and felt like the trough had not yet been reached, and I told him that. He looked back at me with a sneer and said "What do you know that Bill Miller doesn't know."

So I said to myself, "Well why don't you go out and hire Bill fucking Miller as your analyst then." Instead I just looked at him dumbfounded and swore that I would never pick stocks the way he did.

Third, do not use price to book yet as a buy signal. Book value is in flux and will continue to go down quarter after quarter. The safest thing to do is take the latest quarters book value and write off 30% and then slap a .75 multiple on it and then buy them there.

Last, think about avoiding individual stocks and buying the ETF or index that tracks Homebuilders. It is likely that a few of these homebuilders may get into enough distress that the equity becomes worthless. There is a SPDR that tracks the industry under the symbol XHB. It's not a perfect substitute since it has Home Depot and Lowe's in it but it may be a safer option to play the industry.

Why I Hate EBITDA - Part III

The street has slowly shifted over time to using Enterprise Value to EBITDA (EV/EBITDA) as a measure of valuation for a stock. The ostensible reason given is that EV/EBITDA takes into account the entire value of the firm. The real reason is that since so many companies are unprofitable, there is no "E" to put in the price to earnings formula. Wall Street had to come up with another measure to use.

So what is wrong with EV/EBITDA? It gives a false sense of cheapness – I can still hear the voice of the sell side analyst ringing in my ear

"The stock only trades at 5 times EV to EBITDA – my god that’s cheap."

But is it really cheap. Here are two companies, which one do you think is cheaper?

Company 1

Mkt Cap $ 60.0
Bond Value $ 40.0
EV $100.0
EBITDA $ 13.0

EV/EBITDA 7.7

Company 2

Mkt Cap $ 60.0
Bond Value $ -
EV $ 60.0
EBITDA $ 6.0

EV/EBITDA - 10.0

Well come on Eric, you say to me, the first one is cheaper you idiot. Well look again below.

Company 1

EBITDA $ 13.0
Interest $ 8.0
Free Cash $ 5.0

Price to FC 12.0

Company 2

EBITDA $ 6.0
Interest $ -
Free Cash $ 6.0

Price to FC 10.0

It doesn’t really matter what the EBITDA is because we all know that what really matters is the cash a business produces after it reinvests to maintain its business.

Don't be fooled by EBITDA. Wall Street hates you. Don't ever forget that their job is to separate you from your money.

Why I Hate EBITDA - Part I

I said in a previous post that I was convinced that there is a special place reserved in hell for EBITDA, and that one day, God willing, it will be there. I just wanted to write a little on why I believe that.

First, for those that don’t know the term – EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is used as a measure of financial performance by much of Wall Street. So why does it belong in Hell? It has many problems that are never talked about by the financial media or those who use the term.

EBITDA is calculated before interest is paid, so it gives an artificial view of the financial strength of a company. Analysts and managements love using this number, they usually put it in the headline of a press release. After that they can't leave it alone - it has to be "adjusted." How? Usually to exclude some expense that management found inconvenient.

However, at the end of the day, bondholders do need to clip their coupon every six months and get paid. Unless, of course, they were talked into buying a covenant lite or pay in kind bond.

You can bet that Worldcom and Enron had positive EBITDA...right up until the end.

Pink Sheets - Part V

I just realized that I need to come up with a more original title than the ones I have been using in this blog. Whenever I write on the same topic, I usually just put Part II or Part III. If anyone has any suggestions let me know.

Anyway, Part V of my slog through the Pink Sheets – or maybe if I could sub title it “liquidity isn’t everything,” has produced a company called Laaco, Ltd. The symbol is LAACZ. It last traded at $1525 a share, and the current market is $1550-$1610. The company is legally a partnership and has a yield around 3%.

Laaco owns several dozen self-storage facilities out West, but its most interesting assets are the Los Angeles Athletic Club and The California Yacht Club.

This is very much a family run operation. I counted six different people with the name Hathaway in the annual report, and a family controlled entity called Stabilty, LLC owns 70% of Laaco. Clearly the family knows what they are doing and have produced shareholder value. It's hard to see it in the chart below, but the stock has tripled the last 5 years.



The lastest annual report is here and is a fairly easy read. Click on where it says filings.

Pink Sheet Page

What is Value Investing? - Part III

I think it is generally known how the word Value Investing can be interpreted many different ways by investors. I have decided to compile a list of things that I don’t consider indicative of value investing.


“The stock trades at a historical EV/EBITDA value of 8.1 and now trades at a EV/EBITDA of 7.5. Therefore, it is now undervalued.”

True value investors hate the word EBITDA. It makes their skin crawl. Many investors use the term interchangeably with cash flow, or God forbid, free cash flow. It is a word made up by Wall Street to justify deals and confuse investors. I am convinced that there is a special place in hell reserved for EBITDA, and one day it will be there.

“The stock trades at a PE of 6 while the market is at 15 times earnings.”

A low PE does not always mean that a stock is undervalued. If earnings are peaking, then a low PE actually gives a sell signal. This is why Home Builders had such a low PE for a while. As earnings come down faster than the price, then the PE will soar giving a perverse type of buy signal.

"The PE is at 15 times earnings and it usually trades at a multiple in the 20's, just look at the PE chart."

Is it possible that the earnings that you are using in your denominator are no longer accurate because the company just missed its earnings for the quarter? The new earnings numbers haven't flowed into whatever data source you are using, or maybe the market is assuming that it will be a lot worse than you do? Either way, that PE is realistic.

Festival of Stocks - #51

Check out the latest Festival of Stocks hosted this week by Dividends Matter

Average Joe has some good contributions and I urge you to take a look at:

Festival of Stocks #51

The home page of the festival is here at Festival of Stocks. If you write a related blog, and feel like hosting, then contact George and sign up.

White Mountains Earnings Release

I just saw this a few minutes ago but here are some quick observations:

1) Company grew book value 2% sequentially.

2) GAAP combined ratio for Esurance was up sequentially but at the analyst day in June, WTM said that this reflects requirement to amortize policy acquisition costs over 6 months rather than the economic life of 30 months.

3) Comments on Esurance business very different than comments given on analyst day. In June, management said

"Underwriting comes first in all businesses excepting Esurance – where premiums come first. This exception because it is a good business and can grow profitably."

"Combined ratio if WTM stops writing new business – 82% combined ratio. It is incredible that you can write new business at a combined ratio at that level. 2/3rds of Esurance is new business. It’s so good we are going to grow."

Compare this to the press release from this morning:

Gary Tolman, CEO of Esurance, stated, "In the second quarter, Esurance faced an increasingly challenging environment. Competition for new business increased as many of our competitors, along with Esurance, have reduced rates and continue to spend heavily on advertising. While our rate of growth remains strong, it will not be as strong as previous years. Additionally, we increased our reserves by $6 million during the quarter, primarily for bodily injury claims for prior accident years. Overall, we remain very excited about our position in the market and our performance. The current accident year loss results look good, and we have grown our policyholder base by more than 50% in the last 12 months."

4) I am still looking at the 10-Q filed this morning but WTM seemed to avoid stepping into the sub prime mess in its investment portfolio. I think if there were any impairments here it would have been mentioned in the press release.

5) I didn't see any update on the Symetra IPO.

6) Net written premiums were down in all businesses except Esurance, but this was expected due to the combination of declines in pricing and the WTM devotion to underwriting discipline.

What is a Value Stock?

I was talking to some one in the business the other day and they asked me if I owned any Energy stocks. My first instinct was to shudder in horror. Energy stocks value? At the peak of the cycle? After 5 years of unbelievable outperformance and with commodity prices higher than ever? And then I started to think about it and realized that value has a very slippery definition.

Value is one of the words like “beautiful.” Everyone has his or her own perception of what beautiful is. So just like the old cliché “beauty is in the eye of the beholder,” so to the definition of what a “value” stock is, is in the eye of the beholder. There have been times where I have looked at quarterly reports from mutual fund companies that are dedicated to value investing and just shook my head in wonder. How could that stock be a value stock? And then I would remember what a great long-term record that manager has.

Here is a theoretical argument about what value means in terms of Energy stocks. Let’s say that you are a believer in the theory of peak oil. I don’t want to get too deep on what that means so here is a good web site if you want to really get into it:

http://www.hubbertpeak.com/

It basically states that the world is at or near its peak in terms of oil production, and we will soon see declines in that production. Since demand is rising due to global industrialization, this mismatch will cause a major step up in prices, etc.

Now if this comes true, and I am not passing judgment on this argument right now, doesn’t that mean that all those oil reserves on the balance sheets of the integrated oil companies and the exploration and production companies are vastly undervalued by the market? That would make them “value" stocks then I guess. If the market is valuing these stocks based on long term prices of oil at $30-$40 but the long term price will be twice or triple that, then owning those stocks is certainly a value play.

Now the stereotype of a value stock is one that has been beaten up in price, the fundamental outlook has deteriorated and most investors generally scorn the stock, but what if that is too narrow a way to look at the issue.

I am not making a call on loading up on Energy stocks mind you. I just wanted demonstrate theoretically how a market darling group like Energy could be viewed as "value."

Focus Investing

I recently came across a website called Focus Investor run by Richard M. Rockwood. It has many good articles on Value Investing and a section where investors can download spreadsheets to calculate intrinsic value for stocks.

I want to bring attention to his article that he wrote on Pico Holdings (PICO) back in March 2000. It was selling around $12 a share back then and is now at $44. This is a fairly well known stock now but he was certainly ahead of the curve 7 years ago.

Pico Holdings

There are also solid reports on White Mountains Insurance (WTM) and Markel Insurance (MKL) in the articles section. These are a little outdated but provide good background on the stocks.