Friday, March 31, 2006

Value Investing with the Masters by Kirk Kazanjian :: Book review

Value Investing with the Mastersby Kirk Kazanjian sits on my bookshelf. For this book, Kirk Kazanjian interviewed 20 master value investors who run publicly traded mutual funds. The subjects include Cristopher Browne from the Graham and Dodd investment shop of Tweedy Browne, David Dreman of Dreman Value Management, to William Miller of the Legg Mason Value Trust. Each of these successful managers has a track record and a deep personal belief in the merits of a value discipline.

Each person brought their own perspective to how they determine value in the stock market. I learned the most from seeing what was common and what was different in each of the investment manager’s philosophy. Different managers can look at the same situation and see different outcomes. Understanding the thought process behind their investment choices has helped me become more aware of my thinking on what makes a good investment. Value Investing with the Masters, has helped me develop a personal framework and perspective on investment issues. This is helpful and makes the book valuable. This book complements other books on investment theory and philosophy, and I recommend it everyone who considers them self a value investor.

PEY changes over to monthly dividends.

Powershares has changed the dividend policy for their PowerShares High Yield Equity Dividend Achievers ETF (AMEX: PEY) from quarterly dividends to monthly dividends. The new distribution policy will take place on May 1, 2006.

PEY is powershares's highest yielding US dividend exchange traded fund. PEY replicates the Mergent Dividend Achievers 50 Index of the top 50 highest yielding stocks that have raised dividends for over 10 consecutive years. This index has most of it's components in the financial and utility sectors. According to Mergent the index has a yield of 3.92%.

My guess is that Powershares is making the change to differentiate PEY (the second largest dividend ETF) from DVY (The largest with over $6.7 Billion in assets).PEY is the first stock market ETF to make monthly cash distributions. The only other exchange traded funds offering monthly dividends are the iShares Bond ETFs (SHY,IEF,TLT,AGG,LQD). Treasury bond income funds have been facing competition from online high yield savings accounts which pay monthly interest at competative rates. For example VirtualBank eMoney Market pays 4.60% APR and has FDIC insurance (backed by the full faith and credit of the US government. These savings and money market accounts do not charge brokerage or redemption fees, like mutual funds do.

This change in dividend policy will remove one of the few competitive advantages of income mutual funds over ETFs, which is that most income mutual funds pay out monthly distributions. Monthly payouts help people who depend on their investments to pay living expenses, to budget for those expenses. I expect that other income oriented ETF's will also switch over to monthly distributions.

Most investors are not as single minded as John D Rockefeller who once said: "Do you know the only thing that gives me pleasure? It's to see my dividends coming in." Monthly distributions are psychologically appealing; they let shareholders enjoy the pleasure of seeing dividends coming in 12 times a year.

Board Approves Change in Distribution Policy for PowerShares High Yield Equity Dividend Achievers(TM) Portfolio

Thursday, March 30, 2006

Morningstar ETF Star Ratings

Recently Morningstar has come out with star ratings for Exchange Traded Funds. Greg Newton and Roger Nusbaum submitted articles to Seeking Alpha critiquing the idea and worth of these ratings. Broadly, I agree with Greg and Roger.

The whole concept of star ratings for ETF's is absurd. ETF’s are passive investments. The ETF sponsor cannot affect its performance in any way. The only thing that can influence an ETF’s performance is the performance of the underlying index. And past performance does not predict future results.

A simple example is the Select Sector SPDRs that cut up the S&P 500 into nine sectors. Morningstar has given the Materials SPDRs four stars while giving the Health Care SPDR two stars, based on past performance over the last three years. The reason for relative disparity between the performance of XLB and XLV has everything to do with the past performance of materials vs. healthcare, and nothing to do with the ETF's themselves. There is no ab initio reason for believing that XLB will continue to outperform XLV. And thus there is no reason for giving XLB or any fund other any number of stars.

At the moment most ETF’s are based on “benchmark” indexes that are designed to cover a certain market segment. One of the advantages of that has been the rise of very fine grained ETF's like the Palisades Water Index (PHO) or KBW Capital Markets (KCE). Only a few ETF’s are explicitly designed to beat a benchmark index [chiefly the Powershares Dynamic funds, and the Zack's Micro cap and Small cap Indices (PZI), (PZJ)]. For those types of ETF's maybe star ratings could conceivably be useful, but probably won't be.

Quality of Earnings by Thornton O'glove :: Book review

Quality of Earnings is an essential book for everyone who likes value investing. First published in 1987, Quality of Earnings provides a good introduction to understanding the idea of quality of earnings. Thornton O'glove teaches you how to accurately gauge weather earnings have been created by good management or created by good accounting.

O'Glove covers common sources of low quality earnings with worked examples from 1980s.

  1. Non Operating and Non recurring Income

  2. Extraordinary increases and decreases in expenses
  3. Growth in inventory and accounts receivables that is not backed by sales
  4. Issues with recognition of debt and cashflow
  5. Changes in accounting methods and assumptions
  6. Restructuring charges

Certain aspects of this book are dated to the 1980s when it was written. The threat of hostile takeovers is constantly emphasized. Today hostile takeovers are quite rare, because of recognition that the hostile acquiring company usually ends up overpaying, and the merged companies tend to lag their undisturbed competitors.

Because the format for the statement of cash flows, was only standardized in 1988: O'glove spends only very small amount of time on the important subject of reconciling cash flows with income. Today the reconciliation of EBITDA to Net Income and reconciling Operating Cash Flow to Net Income are essential methods for evaluating earnings quality.

His chapters on quality of inventory and quality of sales are excellent. This book does not assume an accounting background. Readers without any accounting background may want to read Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reportsion by Howard M. Schilit first. "Financial Shenanigans" is a gentle introduction to world of deceptive accounting.

I highly recommend Quality of Earnings for all investors who pick individual stocks. Recognizing a company whose high quality earnings are not being appreciated by the markets is the core of my style of value investing. A reviewer on said it best "The issue of transparency in the markets is critical to assessing value. This book is an excellent introduction to the topic."

A letter from Seth Klarman -

For those in the know, Seth Klarman wrote the book. Seth's book on value investing "Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor" has been out of print since 1991. Used copies tend to go from $500 to upwards of $1000 on the used book market. It's quite a popular book with value hedge fund managers. Indeed Seth Klarman has been running hedge fund(s) for quite a while. You may be interested in his most recent letter to investors in Baupost Limited Partnerships.

Today’s Market Environment: The Bad News About Value Investing

Tip of the hat to Mr Market - Musing of a value investor

Wednesday, March 29, 2006

WPSC Wheeling Pittsburgh Steel Corporation is very cheap and a good value.

Wheeling Pittsburgh Steel Corporation, the smallest of the US integrated steelmakers, is a tough little company. Its shares have been so hurt by bad news that it barely trades about book value. WPSC shares at $20 are very cheap, when its value in M&A transaction is closer to $30 or even $40 a share.

WPSC has achieved its goal of becoming a hybrid steel producer. It has both a blast furnace (and related facilities of coke ovens and a Basic Oxygen Furnace) which can convert iron ore into steel as well as brand new electric arc furnace (EAF). This gives the company enormous operational flexibility compared to many of its competitors.

EAF's are used to melt down and refine steel scrap. EAF operations have a variable cost structure because the cost of scrap steel varies along with the cost of finished steel. However scrap steel tends have contaminants, and so most EAF-only steelmakers cannot produce the very highest quality steel which can only be made with fresh iron. Right now EAF mini-mills such as Nucor and Steel Dynamics are the darlings of Wall Street. WPSC has the same equipment as they do, as well as access to fresh iron and extensive fabrication facilities that give WPSC the ability to make value-added steel products that mini-mills cannot do.

Making steel from fresh iron with a blast furnace has a huge fixed cost of keeping the furnace running at all times, as well as exposure to variable fuel and ore costs. Because WPSC has both types of facilities, it has flexibility to exploit differences in the price of making fresh steel vs. buying scrap steel on the open market. Because WPSC's EAF can use fresh iron as feedstock, WPSC can make much higher quality steel than its EAF only competitors.

The companies 2005 results were hurt by extraordinary events that affected operations as well as extraordinary capital expenditures.

In December of 2004, ductwork collapsed at WPSC's BOF facility. This led to costs associated with the repair of the ductwork and business interruption. WPSC is currently working with its insurers to recover in excess of $40 million worth of business interruption losses. Then WPSC's supplier of metallurgical coal claimed that they could not deliver coal under an existing fixed price contract. This forced WPSC to buy coking coal on the open market at much higher prices. WPSC discovered that its supplier was selling on the open market the very coking coal that it claimed it didn't have available under the fixed contract. Hilarity (and a lawsuit) ensued.

At the same time as these troubles were affecting the blast furnace operations, the company was making capital expenditures on hot steel roll changers that will increase its capacity at the Mingo Junction facility by 300,000 to 400,000 tons yearly. The company is also currently rebuilding its coke ovens in a joint venture with a Russian steel company.

Given the current consolidation in the steel industry, WPSC is a very attractive buy for a larger steelmaker. It has a state of the art EAF, a new blast furnace, and will shortly have brand new coking facilities that are collocated with Koppers Coal tar refining facilities.

In 2006, the extraordinary events of 2005 will not reoccur while the capital expenditures will begin to turn a profit. The EAF, which had been running at about 73% of capacity in 4Q2005, in January of 2006, was operating at 87% of capacity. Throughout 2006, the EAF ought to improve to be running at upwards of 90% of capacity. In 2006, company will probably resolve its disputes with insurers to recover a business interruption claim for an amount in excess of $40 million.

With shares currently, trading for slightly above the book value of $18.66 a share the stock market is assigning very little value to WPSC's going concern value. WPSC represents a fine company by itself, and would make an attractive acquisition target to others as well. By any measure, the company is very cheap at its current stock price, and is of interest to value and small cap investors.

Monday, March 27, 2006

How to pick stocks with potential for increased dividends

A critical financial ratio when evaluating a company’s strength is its ratio of cash flow from operations relative to the sum of capital expenditures and dividends. [ CFO/( CapEx + Dividends) ]. The ratio of cash generated to cash required (CGCR) measures a companies ability to sustain and increase its dividends while reinvesting in its operations. Companies with high ratios of CGCR have a margin of safety because they have more cash to spend on growth expenditures and dividend payouts.

This ratio is fairly obscure, and yet very important because it is an excellent indicator of financially strong companies with the potential to raise dividends. Increasing dividends bring good publicity and are catalyst for higher share prices. In general, companies with CGCR ratios above 2.0 have the potential to raise dividends safely. The merits of cheap stocks with the potential for dividend increases are obvious.

Sunday, March 26, 2006

Intel for value investors

Recently Intel shares have fallen so dramatically that the stock has almost become cheap. Noise traders have taken AMD's recent success and extrapolated that to Intel's complete failure. Historically the semiconductor industry has been too volatile and too overvalued to get attention from value investors. Trading below $20 a share, Intel shares are too cheap to ignore.

  1. Right now Intel is trading with a price to book ratio of 3.22-1. While capitalization of intangibles is the root of overvaluation: in the case of Intel the company's acquired knowledge and expertise is an asset. Intel's organizational knowledge is intangible, but it is also hard for Intel's competitors to replicate and a source of competitive advantage. If we assume that the value of R&D decays by 33% year (I.e. becomes worthless in 3 years), then Intel has an "R&D Asset" of [ 5.145+4.778*0.66+4.360*0.33=9.74 Billion] on the book. Recalculating P/B ratio to include accumulated R&D gives us a P/B ratio of 2.67.

  2. Cash flow return on Operating Assets. Intel is a cash machine. If we divided Cash flow from Operations by Operating Assets (Total Assets - Cash) [14823/(48314-8782)]= 37.5% Cash return on assets. Intel is returning that cash to shareholders with a dividend of $0.40 a share giving a dividend yield of 2.0%.

  3. Intel processors are everywhere, and the company has a very solid balance sheet. The long term outlook is positive. The company has international business throughout the world. The company is well positioned for solid profitable growth for many years into the future. Intel has access to more capital than its competitors, and so has much greater operational flexibility than its competitors.

  4. The technology sector is one of "Live by the puff-- Die by the puff". It is very faddish. Google's stock price is typical of the endless thirst for growth stocks at any price. Eventually Intel will return to favor. With shares of INTC trading below $19.80, Intel is cheap and merits a closer look. (FD: I do not have any shares of Intel)

Interviews with Koppers Holdings CEO Walt W. Turner

A quick roundup of several interviews that Koppers Holdings CEO Walt W. Turner made with local media in Pittsburgh after the IPO. These interviews give some perspective into the mind of the CEO. Unlike CEO's at many other companies, Mr. Turner has a significant stake in Koppers success; he owns about 1.5% of the shares outstanding.
(FD: KOP is personal holding)

Friday, March 24, 2006

Koppers spans the globe.

Koppers Holdings Inc, NYSE: (KOP) is one of my favorite stocks. Very few people know about Koppers, but it is one of the most amazing companies on the NYSE, with what I believe are some incredible possibilities for future growth.

Koppers has two main product lines. Koppers is one of the world’s largest producers and refiners of coal tar and they are main suppliers of railway crossties to the US railway industry. Coal tar has never been sexy. To make one pound of aluminum requires half a pound of coal tar. Although the aluminum industry has been trying to find a replacement for coal tar, it has been unsuccessful so far. The newest Alcoa smelters being built in Iceland and Trinidad, are all configured to use coal tar. Global aluminum production has been increasing strongly as China and India have become net importers of aluminum.

Because of higher energy costs a lot of US transportation is shifting towards railroads which are therefore increasing their capital expenditures to handle the increased loads. In 2005 CSX began giving Koppers a large amount of crossties to treat with creosote (which Koppers makes from coal tar); in 2006 CSX will be buying back the treated crossties. Higher oil prices will also increase profits forKoppers' pthalic anhydride business.

Koppers is a very recent IPO (Feb 1, 2006)but the company dates back to 1912, and was previously listed on the NYSE. In 1988 there was a very acrimonious and successful hostile takeover of the company. The management of the coal tar and wood treating operations was then sold out to the old Koppers management. Various shenanigans with private equity funding ensued, and in 2006 the company went public. In the years before the IPO, the private equity folks, saddled the company with an enormous amount of debt which was used to pay dividends to themselves. This is a sad trend among recent IPO's that companies take on debt and then use the IPO to pay that debt off.

This debt burden is something that potential investors need to be aware of. Koppers current credit rating is junk, but it should improve as the financial ratios are improving. This will probably lead to the company refinancing some of current debt which has very high interest rates on it. The IPO proceeds are being used to retire about $100 million worth of debt, which should lower interest expense by $10 million. Another issue is that Koppers is involved or will so be involved in fairly large number ofclass action lawsuits involving alleged pollution from the company’s former activities.

The management team at Koppers is very experienced, and has a very large amount of insider holdings. The company has decided to pay a dividend of $0.68 a share, which gives the shares about a 3.7% yield. Untill about two weeks ago, there was no analyst coverage of KOP, now there are five analysts covering the company, the average recommendation is hold (BSH 1/4/0) and price target is $20.60. Predicted earnings from Starmine are $1.01 for FY 2006 and $1.17 for FY2007. KOP is also recommended by Jim Cramer on his most recent Mad Money show, as being a good indirect play on railroads.

My personal price target is $25 or so, and I think that this is a stock for the longrun. Koppers products are essential to the US and world economies and the company has a leading position in its markets. It is very unlikely for any new competators to enter this market. (Full disclosure; I own shares of Koppers)

As a haiku in the Koppers corporate brochure notes:

Europe to Asia
And to North America
Koppers spans the globe

Starmine for the best earnings estimates

Starmine is a service which publishes Wall Street analyst earnings estimates and recommendations. The company has graciously created a free site for individual investors, which gives you access their data. Starmine usually has better earnings estimate/recommendation data you can get on sites like Yahoo! Finance or MSN Money.

A unique and very useful feature of Starmine are "SmartEstimates". Starmine has a secret method for coming up with especially accurate earnings estimates by taking into account the historical accuracy of each analyst and the age of each estimate. Basically Starmine gives more weight to better and fresher estimates. They also calculate a predicted surprise between their smart estimate and the consensus estimate.

With the huge effect that earnings surprises have on stock prices, having a good idea of what future earnings will be like is both important and profitable.

Thursday, March 23, 2006

High yield savings accounts

Recently several banks have started offering high yield savings accounts. These online savings accounts pay upwards of 4.25% interest rates on deposits. These are real bank accounts that are FDIC insured. As one advertisement from HSBC pointed out, these high yield savings accounts are an investment disguised as a savings account. These interest rates are competative with other risk free assets (such as treasury bonds), and offer better liquidity to boot.

Depending on the bank you have different methods of depositing and withdrawing money from these accounts. Typically you would use the ACH system (electronic check) to make deposits and withdrawals from your main checking account. HSBCdirect is unique in offering withdrawals and deposits from their ATM network. The most interesting of these accounts are Emigrant Direct and VirtualBank, which offer the highest normal interest rates, and HSBC direct which offers ATM withdrawals and a lucrative promotion.

Powershares International Dividend: Buy now or be priced out for ever !!!

PID is the Powershares International Dividend Achievers ETF. It is based on Mergent's international dividend achievers index of companies that have raised dividends for at least five years running. In my opinion this ETF, or a similar international dividend ETF, is a central part of any long term investment strategy.

Dividends from foreign companies are great way to profit from the eventual weakening of the US Dollar. As the dollar weakens over time, the value of foreign currency dividends will increase. At the same time strong profitable companies that make up the international dividend achievers index are poised to profit from the ever widening US trade deficit and gradual diffusion of economic activity away from the US.

PID is mostly concentrated on financial companies with somewhat smaller holdings in financial, energy, and utilities companies. Most of the stocks from English speaking countries, such as Canada and England which are best poised to absorb business from the US in the future. The index has recently expanded to include 60 companies, and thus provides pretty good coverage of the EFA world, with a fairly strong tilt to value stocks.

One thing to be aware of is the funds 0.50% expense ratio, which is a bit high for an ETF, but not excessive compared to other ETF's targeting foreign assets. After expenses the fund yields around 2.9% based on the last dividend of $0.11 per share

Jim Cramer's stock picks, Six years later

I present for your enjoyment an infamous article from February 29, 2000, where Jim Cramer listed his personal choices for ten stocks that everyone should sink all their money into. Six years later, nearly all of those stocks have either gone bankrupt or fallen 95%.

PHO -- Water ETF as a liquid asset.

PHO, the Powershares water index ETF, based on the Palisades Water Index (ZWI), is one of my core portfolio holdings. I think the macroeconomic arguments for investing in water are enormous.

There is a great and growing shortage of drinkable fresh water thought the world, which has created great demand for water improvement technologies. Unlike energy, demand for water is inelastic and not subject to economic cycles. Because water service is a capital goods/natural resource industry it is resistant to inflation. Historically water and water technologies were very unsexy and have not attracted a great deal of market attention. But that is changing rapidly. 2006 may be the ground floor for a long term bull market for the water sector.

There are several drivers for this bull market:

  1. Population growth -- people need water.

  2. There is increasing acceptance of the idea of privatizing or outsourcing of government owned water operations to publicly owned utility companies.

  3. Many industrial companies are shifting to "green chemistry" by replacing toxic solvents with water. Those companies now have sophisticated needs and requirements for water that they use in industrial processes.

  4. More marginal sources of fresh water will need to be exploited in the future, creating a demand for treatment technologies that can improve and reclaim contaminated water.

  5. The US water and world infrastructure is aging, the last major round of public spending on water infrastructure in the US was the 1960s before that during the New Deal of the 1930s. Many cities and towns must upgrade or replace older water systems.

The water sector as a whole is becoming somewhat “frothy”, valuations for many of the more speculative companies have become quite high. PHO has had a massive growth in market cap over the past few months. This is certainly been the case for PBW, Powershares Clean energy ETF. However I think the macro element for PBW and PHO remains very compelling even if these funds don’t meet strict value criteria.

PHO/PBW are also a good way to add small cap exposure to a portfolio, but beware that most of their stocks are classified as small cap growth, especially in PBW. The majority of the PHO assets are in industrials and utilities. Both ETF's have the typical powershares expense ratio of 0.60%.

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Inflation or Insolvency

Howdy, this blog will cover thoughts and ideas about the future of capital markets and investment opportunities. Readers are reminded to do their own research and not to breathe asbestos dust.

My views on long term trends for the US economy is based on the currently unsustainable high levels of capital outflows from the US as represented by the foreign held public debt and massive trade deficits. At some point the only solution to the debt crisis will be inflation or insolvency. I believe that I can predict which choice “Helicopter” Ben Bernanke will choose.

For the individual investor, the best investment choices will be those investments that can return real income, those that bring capital back into the US via exports, and those that will profit from the tend of capital outflows from the US. Given the increasing levels of indebtedness at all levels of society, businesses involved in the origination and servicing and collection of debt will also prosper.