Tuesday, March 25, 2014

Thoughts on Warren Buffett's 2013 Shareholder Letter

Below are my thoughts on portions of the 2013 Berkshire Hathaway Annual Shareholder Letter.

To read the entire letter CLICK HERE.

As I’ve long told you, Berkshire’s intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That’s why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount.

The writing on the wall doesn't get any clearer than this. Buffett thinks that Berkshire (BRK) is worth much, much more than book value and he will be aggressive at buying back stock at the 120% level from any shareholder willing to sell.  This is interesting because BRK is selling at 131% of book value. It was selling for around 120% of book value earlier this year.  Do what you want with that but the implications are clear.

Over the stock market cycle between yearends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. If we fail to do so, we will not have earned our pay. After all, you could always own an index fund and be assured of S&P results.

This is an interesting comment because Buffett has laid out some guidelines in the back of the annual report on a 5 year yardstick that compares BRK's performance to that of the S&P 500.  It is true that BRK did not meet this test and that Buffett seems to have changed his yardstick to 6 years now.   

Over the past 5 years the per share book value of BRK has risen 91% while the S&P 500 index has gained 127%.  What I find interesting is that the per share book value of the S&P 500 has risen roughly only 50% over that same period.

Take from that what you want but to me the implications are clear.  Either BRK is cheap, the S&P 500 is overvalued, or some combination of the two.  My vote is BRK is cheap.

We completed two large acquisitions, spending almost $18 billion to purchase all of NV Energy and a major interest in H. J. Heinz. Both companies fit us well and will be prospering a century from now.

Going by our yearend holdings, our portion of the “Big Four’s” 2013 earnings amounted to $4.4 billion. In the earnings we report to you, however, we include only the dividends we receive – about $1.4 billion last year. But make no mistake: The $3 billion of their earnings we don’t report is every bit as valuable to us as the portion Berkshire records.

This is what I love about owning Berkshire.  They continually make good long term investments, which ensure good long term results.  BRK is a conglomerate that will be prospering a century from now... long after Buffett is dead and gone.  The market is currently willing to value the latest hot tech stock at absurd levels while BRK underperforms the broader market.  Let's be clear, BRK is built to last. 

Berkshire’s extensive insurance operation again operated at an underwriting profit in 2013 – that makes 11 years in a row – and increased its float. During that 11-year stretch, our float – money that doesn’t belong to us but that we can invest for Berkshire’s benefit – has grown from $41 billion to $77 billion. Concurrently, our underwriting profit has aggregated $22 billion pre-tax, including $3 billion realized in 2013. And all of this all began with our 1967 purchase of National Indemnity for $8.6 million.

So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund... 

If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. 

To put this is simple language, BRK has a $77 billion revolving fund (or loan).  I like to think of it as a loan but a loan that has a number of unique features.  First you never have to pay it back, so long as BRK's insurance companies are still operating.  Second, the loan has a negative interest rate.  In 2013 BRK was paid 3.9% to hold this loan.  Talk about having your cake and eating it too!

Now the lingering question in my mind is what is a loan like this worth, specifically one that has an indefinite term and a zero interest rate (assuming a long term combined ratio of 100%)? 

To give a simple answer this from a financial perspective you must turn to the perpetuity formula, where PV= C/d.  "PV" is the present value, "C" is the annual investment return, and "d" is the discount rate.  Assuming BRK can earn 10% on it's float and it doesn't grow from here, the annual investment return would be $7.7 billion. 

From here it is easy to see that choosing a discount rate of 10% gives a present value of $77 billion dollars for the float.  If we choose a 15% discount rate the present value is $51 billion.  Similarly if we choose a 5% discount rate the float is worth $154 billion. 

So what is the true value the float?  Make your own assumptions but Buffett makes it clear that the true value of this liability is dramatically less than the accounting liability.  I totally agree and in the past, given the investment returns it has generated for BRK, the liability was perhaps ZERO.

Our subsidiaries spent a record $11 billion on plant and equipment during 2013, roughly twice our depreciation charge.

In layman's terms, If BRK can earn 10% on that incremental invested capital beyond the depreciation charge, it will add approximately $550 million in annual earnings. 

In a year in which most equity managers found it impossible to outperform the S&P 500, both Todd Combs and Ted Weschler handily did so. Each now runs a portfolio exceeding $7 billion. They’ve earned it.

I must again confess that their investments outperformed mine. (Charlie says I should add “by a lot.”) If such humiliating comparisons continue, I’ll have no choice but to cease talking about them. 

Todd and Ted have also created significant value for you in several matters unrelated to their portfolio activities. Their contributions are just beginning: Both men have Berkshire blood in their veins. 

Looks like BRK has some top notch talent in line to take over the equity portfolio.  I find the comment in the last paragraph quite interesting.  To me it is foreshadowing a larger role in the company for either Todd or Ted.  Perhaps one will be the next CEO.

Going by our yearend holdings, our portion of the “Big Four’s” 2013 earnings amounted to $4.4 billion. In the earnings we report to you, however, we include only the dividends we receive – about $1.4 billion last year. But make no mistake: The $3 billion of their earnings we don’t report is every bit as valuable to us as the portion Berkshire records.

Buffett here is describing the "look through" earnings of the companies which BRK is a part owner of(common stock).  I wonder how many investors could actually tell you the "look through" earnings of their own portfolio?  That result might prove to be an interesting for many so called value investors. 


There is another fantastic portion of the BRK annual letter that I would highly recommend.  It is an essay entitled, "Some Thoughts About Investing".  In this essay Buffett compares buying a 400 acre farm north of Omaha and a commercial real estate investment to investing in common stocks.  The principles are exactly the same.

At the end of the annual report you will find the two page offer Buffett took over to purchase Nebraska Furniture Mart in 1983, the Financial Statement for Nebraska Furniture Mart for the yearend 1946, and a fantastic memo on the "Pitfalls of Pension Promises" by Buffett from 1975.  Click Here to read these sections.  They are located at the end of the annual report.   

Best Regards,

Kevin Graham

Disclosure - long BRK.b

Tuesday, March 4, 2014

2013 US Bank Asset Quality

Citigroup finally released their 10-K this past weekend allowing me to compare the asset quality of the four large banks in the US.  I always like to see what percentage of the assets are the so call "marked to fantasy" assets.  These assets, also called Level 3 Assets, are valued by management WITHOUT any market comparables.  Management basically values them at whatever they want so long as they can convince the auditors that the rationale is not unreasonable. 

This year Bank of America takes top honors, while JPM comes in last.  The rankings haven't changed much over the years other than BAC has overtaken WFC for top spot. 

I am amazed at how quickly Brian Moynihan has cleaned up the books at BAC.  Level 3 assets were around two and half times the current amount only two years ago.  Today, even if you discount the book value by the $32 billion of mark to fantasy assets, you can still buy the company at an $11 billion dollar discount.  I can't resist a bargain. 

I have commented on balance sheet of JPM in the past.  In particular, I noted before the London Whale incident that you could drive a truck through their balance sheet (Read Here: Bank of America & Europe).  Then after the losses from the incident were exposed, I couldn't resist and bought a whole bunch of JPM (Read Here: Why JPM Is Cheap). 

As I read the annual reports of the various banks I found the disclosure this year is better than ever.  The US financials have never been in better shape.  They are soundly capitalized and the quality of the assets have never been better.

The results of the stress tests can't come soon enough. 

Best Regards,

Disclosure: Long WFC, BAC Class A warrants and JPM warrants


Saturday, March 1, 2014

2013 Berkshire Hathaway's Shareholder Letter

Today is the day Warren Buffett releases his annual letter to shareholders.  Grab a coffee and enjoy the words of wisdom from this investment icon. 




Disclosure - Long BRK.b

Sunday, February 23, 2014

Are Profit Margins Mean Reverting?

Over the past couple of years, many readers have messaged me to ask about good blogs to read.  As I have said before most everything you read on the internet is useless and often repetitive.  Original ideas and thoughts are rare. 

That said, I stumbled upon a blog a few weeks back called Philosophical Economics and found it to offer interesting perspectives on many investment issues.  The author of the blog often challenges the status quo and provides unique thoughts that are contrary to many conventional wisdom.  Ideas are also well supported with evidence and not just conjecture. 

In a recent post the author questioned the commonly held idea that profit margins are mean reverting and bound to fall from currently elevated levels.  I thought the arguments were interesting enough to share, so here is a link:


As I've said before, unless you understand both sides of an argument you really don't understand anything.  There are intelligent people on both side of every debate and to simply write off the opposite side without thoroughly understanding their position is quite dangerous.  With that said, you still don't have to agree with one side or another but it should allow you to better defend whatever position you take. 

Best Regards,


Saturday, February 15, 2014

Bank Dividend Increases & 2014 CCAR

Historically the banks have released their capital plans mid March, so we are approximately one month away from finding out the results for 2014.  This process is often called the Comprehensive Capital Analysis and Review (CCAR).  All bank holding companies over $50 billion in assets are required to submit their capital plans for review.  I thought I provide a few details on what I am looking for from the banks as I am a shareholder in a few of them. 

Over the past 4 years the banks have been building fortress balance sheets.  Under the new capital rules, called Basel III, banks are require to hold more capital against risk weighted assets.  The new rules also require a surcharge for Systemically Important Financial Institutions (SIFI), or banks that are too big to fail.  This surcharge ranges from 1% to 3.5% depending on the institution.  WFC requires 1%, BAC requires 1.5%, and both C and JPM require a 2.5% buffer.

While these additional capital requirements are being phased in over time, most of the US banks have set out to meet them today.  Full requirements are not required until March 31, 2018.

So where do the banks sit today? 

Wells Fargo

WFC has met their 1% SIFI buffer, which is an additional $12.9 billion in capital.  In addition to meeting this buffer, WFC has $22.9 billion above that level.  They are generating about $22 billion in capital per year and have been paying out approximately 30% of that in dividends, or $1.20/share ($6.8 billion).  I would estimate that they raise their dividend to around $1.60-$1.80/share ($9-10 billion) and have authority to buy back $5 billion in stock. 

Bank of America

BAC is required to hold an additional 1.5% SIFI buffer.  This is an additional $19.3 billion in capital on a fully phased in basis, a 8.5% tier 1 capital requirement.  They have already met that buffer and have an additional $19.9 billion in capital above that amount (9.96% Tier 1 Basel III).  They are in decent shape among the big banks.  Currently BAC pays a $0.04/share annual dividend, or one cent per quarter ($400 million/year).  They are currently generating about $12 billion in capital per year, but are still under earning their potential.  I would estimate they return $5 billion in dividends this year, or around $0.40/share, and up to $7 billion in share buybacks.  If they leaned toward doing more buybacks verses increasing the dividend I also wouldn't be surprised. 


Citi is the next strongest bank with respect to capital.  Citi is required to hold an additional 2.5% SIFI buffer, amounting to $30.0 billion.  They have met this amount and have an additional $11.7 billion above the buffer.  Like BAC they pay almost no dividend at $0.04/share annually ($120 million).  Citi is currently generating $12 billion in capital per year and also under year earning their potential.  I would estimate they return $5 billion in dividends this year, or around $1.60/share, and another $5 billion in share buybacks.  If they leaned toward doing more buybacks verses increasing the dividend I also wouldn't be surprised given their low stock price.  It would be the intelligent thing to do.  Citi also has a pile of deferred tax assets (DTAs) that greatly reduce their Tier I capital under Basel III (to the tune of $43 billion).  This is really a huge buffer and will lead to huge capital returns in the future. 

JP Morgan Chase

Lastly, JPM requires a 2.5% SIFI buffer, which amounts to $39.8 billion.  They just barely met this fully phased in requirement  last quarter and have nothing above that buffer.  This puts them in the weakest position from a capital standpoint but keep in mind that these requirements do not need to be met for another 4 years.  JPM is currently generating around $22 billion in capital annually.  They pay $1.52/share in dividends per year ($5.8 billion), and were approved for a $6 billion buyback last year.  Look for JPM to return $7.5 billion in dividends or $2/share and buy back $6 billion in stock this year. 


I'm really looking forward to the CCAR results as the banks have rebuilt themselves and are in a position to begin returning large amounts of capital to shareholders.  This trend will continue for a number of years as the banks are over capitalized and some have significant DTA's and other capital deductions, mostly C and BAC.  This gives an additional buffer to shareholders and will allow for increasing capital returns over time.

As a shareholder I would prefer capital returns sooner than later but it doesn't really matter when it is returned since it's all money in the bank.

Best Regards,

Disclosure: Long WFC, BAC class A warrants, & JPM warrants. 

Saturday, January 4, 2014

2014 Investment Commentary


Ezcorp is a short term financier, putting a positive spin on it. To put it bluntly they are a pawn broker and payday loan lender. Here is a breakdown of the operations of Ezcorp:
  • 495 U.S. pawn stores (operating primarily as EZPAWN or Value Pawn & Jewelry);
  • 7 U.S. buy/sell stores (operating as Cash Converters);
  • 239 pawn stores in Mexico (operating as Empeño Fácil);
  • 489 U.S. financial services stores (operating primarily as EZMONEY);
  • 15 buy/sell and financial services stores in Canada (operating as Cash Converters);
  • 24 financial services stores in Canada (operating as CASHMAX);
  • 19 buy/sell stores in Mexico (operating as TUYO); and
  • 54 financial services branches in Mexico (operating as Crediamigo or Adex).
  • Offer consumer loans online in the U.S. and the U.K. operating primarily as EZMONEY.com and CashGenie.com, respectively.
  • Own approximately 30% of Albemarle & Bond Holdings, PLC, one of the United Kingdom's largest pawn broking businesses with approximately 230 stores.
  • Own approximately 33% of Cash Converters International Limited, which is based in Australia and franchises and operates a worldwide network of approximately 700 locations that provide financial services and buy and sell second-hand goods. O
  • Own the Cash Converters master franchise rights in Canada and are the franchisor of eight stores there.
Ezcorp had an unusually bad year in fiscal 2013 for a couple of reasons. The biggest reason for this was the huge drop in the price of gold. Gold started 2013 at around $1700 per ounce and ended around $1200 per ounce. That 30% decline contributed to some really tough business conditions. In the pawn business, gold and jewelry are the two most common forms of collateral. Moreover, unless you’ve been living under a rock in recent years, the gold scrapping business has been big business. 
Conditions in Mexico were extremely tough for the company in the gold pawn business. On the latest conference call they discussed how competitive it has gotten down there. The industry got so competitive that everyone was posting the price of gold they were willing to pay for scrapping. That squeezed margins. This also led to the closure of 57 gold only stores in Mexico. 
Now to add more insult to injury, the company recorded a $43 million ($29 million after tax) impairment charge on its investment in Albemarle & Bond. The UK pawn lender had a very tough year and was delayed in releasing their financials. This wrote off the majority of their investment in the company. Albemarle is now for sale. 
Lastly, the company’s operating expenses have gotten way out of line. In 2011 operating expenses were 33% of revenue and in 2012 they were 34%. In 2013, operating expenses rose to 41% of revenue. This is obviously not very good performance but leaves lots of room for improvement. 
So what does all this mean for you? Basically EZPW was still profitable in 2013, albeit marginally. Earnings have risen every year since 2002. The company sells for 70% of book value.  Book value has grow at 17.5% over the past 10 years.  Debt is only 19% of total capital so they are not heavily financed.  Interest is well covered.  There are a few weird quirks with this small cap but I won't bother you with them here (read the 10-k and listen to the conference call for details).
If you exclude the one-time expenses that occurred in 2013 the company would have earned around $1.70 per share. That works out to a current P/E ratio of 6.5. Now if you, like me, assume that the gold scrapping hay-days are over (no recovery of this business) but they can reduce operating expenses by 3%, then EPS will rise to $2.35 per share (P/E = 4.7). If operating expenses can get back down to historical levels of 34% of revenue, EPS will rise to $2.95 per share (P/E = 3.7). 
It doesn't take an advanced degree in math to see that EZPW is worth at least double the current quote (at a minimum) and up to four times the current quote (at a maximum).  Let's call fair value roughly $30/share. 

"It is better to be roughly right than precisely wrong." - John Maynard Keynes
Lightstream Resources (TSE - LTS, $5.88)
This is the former PetroBakken and Petrobank, if you're familiar with those companies.  They put some lipstick on this pig by giving it a new name back in May 2013.
If you don't remember I wrote about both Petrobank and Petrobakken quite a few times back in 2010.  I even had a spirited debate with a fellow blogger called Devon Shire over the valuations of the companies.
The original article can be found here:
The back and forth can be found here:
Here is what I said about the company back then:

Lets start with Petrobakken (TSE - PBN). First, the PBN's reserves have a net present value, discounted at 10%, before tax value (NPV10-BT) of $2.46 billion for proved reserves (1P) and a NPV10-BT value of $3.65 billion for proved plus probable reserves (2P). I tend to be conservative and use proven reserves but for this analysis it won't matter much so we'll use the more optimistic value of $3.7 billion, which includes reserves that are not yet on production. The company has a convoluted debt structure of bank debt, net working capital deficiency and convertible debentures. The convertible debentures are convertible into common shares at prescribed prices so for the sake of analysis I will add them to the fully diluted shares and only consider the debt to be the sum of the bank debt and working capital deficiency. For PBN the total debt is $698 million. The fully diluted shares outstanding if you include all options and convertible debentures is 207.7 million shares. Petrobank owns 58% of PBN.

NAV10-BT 1P = ($2460 million – 698 million) / 207.7 million shares = $8.48/share

NAV10-BT 2P = ($3650 million – 698 million) / 207.7 million shares = $14.21/share

The PBN shares closed today at $22.84, a sizeable premium to the reserves. This is a 61% premium to the 2P reserve value.

Needless to say Devon Shire was wrong.  If you read the comments over at gurufocus you'll see that I struck a nerve with a number of individuals who didn't want to be shown they were wrong.

 "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." - Benjamin Graham

Anyway, fast forward to today and the picture is quite different.  The biggest change is the major drop in price.  It now sells for a fraction (1/4) of the price compared to when it was being promoted by Devon Shire.  Those who bought at those inflated prices got what they deserved. 

I am a value investor, price is of paramount importance.  I could care less about what the market values the company at.  I want to see my own analysis make sense and have a significant margin of safety.

So today if you read the reserve report in conjunction with the financial statements you can calculate that:

NAV10-BT 1P = $9.26/share

This is the net asset value of the proven reserves using a discount rate of 10% before taxes (debt adjusted per share).  As you can see not much has happened since the 2009 reserve report.

In layman's terms this means that if you bought the entire company, stopped drilling (except remaining proven undeveloped reserves, PUDs), and put the company into blow down mode the net present value company's production stream would be worth $9.26/share discounted at 10%. 

Now this figure is strongly influenced by the commodity price forecast so if you believe oil will rise it is worth more than this, and if you believe oil will fall it would be worth less than this. 

Just for fun lets apply a 15% and 20% discount rate to the proven reserves. 

NAV15-BT 1P = $6.74/share.
NAV20-BT 1P = $4.99/share.

So when the share price got down to it's 52 week low on December 12th, 2013, you could have purchased the entire company, net of all liabilities, and made 20% on your investment (assuming oil prices match the forecast). 

The above information might explain why the CEO purchased $2.8 million in stock on December 12th, 2013 and has purchased $5.8 million of stock in the past 12 months. 


I would also note the analysis above gives no value to the probable reserves.  For a company like LTS this is a reasonable assumption because they are a terrible explorer for oil and gas. 

The only other positives are that the company slashed the dividend and canceled the DRIP program because it is highly dilutive at these prices.  The good news is that even at the new dividend rate of $0.04/month or $0.48/year, the dividend rate is 8.1%.  Whether that dividend rate is affordable or not is a discussion for another day. 

Now I am not planning on purchasing this company for a couple reasons but it should double this year barring a major collapse in oil prices.  Buying today you are getting a 15% return on your money. 

The biggest reason I wouldn't invest in this company is that it is very poorly run.  I could put some information on this blog that comes from reliable industry sources (but hasn't been confirmed as fact) but it would likely earn me a lawsuit.  The other reason I wouldn't buy this stock is because I have no idea where oil prices will be a year from now and if you think you do, I have news for you... you're self deceived. 

So for those long LTS, I applaud you.  You should make a buck here but don't stick around much past $10-12/share.  The current quote is cheap enough to offer a decent margin of safety and a decent dividend.  Management is a key criteria when I decide to make an investment and on this point they fail the test.  

Oh and one last thing... those who subscribe to the investment newsletter from Devon Shire (aka valueinvestorcanada.blogspot.com), I hope you getting your money's worth.
Bank of America (NYSE – BAC, $15.57)
I have written extensively about Bank of America over the past few years.  It is still cheap, analysts are starting to get all excited about this bank, that happens to be the largest bank by deposits.  BAC will eventually earn 1% on assets and that works out to more than $2 per share.  Beyond that they will realize significantly higher cash earnings because they have $33 billion in deferred tax assets to utilize.  This means if they report $2 per share and didn't pay taxes, actual earnings would be closer to $3/share.  Now their actual cash earnings will not be this high because the net operating losses have occurred in different businesses and in different jurisdictions.  In order to utilize these tax assets they need to realize a profit in those specific divisions. 

Furthermore, deferred tax assets are being phased out for capital requirements over the next 4 years.  Starting in 2014 they are reduced by 20% for capital requirements.  Not to worry though, BAC has already met Basil 3 capital requirements on a fully phased in basis. 

What will BAC do with the profits over the next few years?  I would bet the dividend gets increased this year and they buy back a large chunk of the outstanding shares.  This will create tremendous shareholder value over the next several years.

For the upcoming year, according to First Call, analysts estimate they will earn $1.32/share.  Factoring in the deferred tax assets, cash earnings could be up to $2/share this year. 

Look for a dividend increase in March after the capital plan/stress test results are announced (CCAR). 

Book value is just shy of $22/share.  That means the market is still discounting their capitalization by $68 billion.  Is this discount reasonable?  You can argue that they are under reserved but by $68 billion??? (Note: last year it was a $99 billion discount). 

Citigroup (NYSE – C, $52.11)

I added Citigroup simple because I wanted to have another financial stock selection for this year.  The nice thing about Citigroup is that they are a little cheaper than Bank of America on a tangible book basis.  Citigroup sells for just under tangible book value, while Bank of America sells for 1.2x tangible book.

First Call calculates the average analyst estimate to be $5.32/share for this year.  That puts them at slightly below 10 times earnings. 

Again if they earn 1% on assets that would work out to $6.10/share. 

Now if you thought BAC had significant deferred tax assets (DTAs) you were right, but Citi has $53 billion.  The kicker is that $47.5 billion of that is US Federal, $4.5 billion is US State and the rest is foreign. 

So actual Citi cash earnings could be in the $8-9/share range going forward.  They did utilize 1.8 billion in their DTAs in 2013 YTD. 

Look for the dividend to rise substantially in March when the capital plan/stress test (CCAR) results are announced. 

Citigroup could easily double and still be fairly valued.  Look for it to gain 30-50% this year. 
POSCO (NYSE - PKX (ADR), $78.00)

POSCO was a selection from last year and was carried over.  Here is what I said a year ago:

POSCO is the third largest steel producer in the world. So what is so great about POSCO? Well to start with, they are selling for about 60% of book value.  Why is that so important? It means you’re paying about the same valuation that Warren Buffett paid for his POSCO shares back in 2005.

Why would you want to own POSCO?  As I've said before, in any commodity business you want to own the low cost producer.  POSCO is likely among the lowest cost steel producers in the world and are much more efficient than US competitors.   Their operating margins are double that of American steel companies.  Lastly, the company has been constantly profitable for the past decade unlike many other steel producers. 

POSCO will also benefit as the world’s economy improves.  I would expect ROE and net profits to improve by a couple percentage points.  You’re definitely not buying the company at a time when they are generating peak returns.  At 6.5 times normal earnings, your getting over a 15% earnings yield.

Nothing has changed except book value grew to around $135/ADR last year.  While that is lower than their 15% annual increase in book value over the last ten years, look for it to continue to grow.

Now earnings will likely come in at around $7.25/ADR in 2013, so you might be asking what's so fantastic about that.  Well, PKX did earn much more than that amount over the past decade.  Typically net profit margins have been in 10-12% range, and up to 15% at times.  Last year they were 7.3%.  That means if they return to past profitability levels earnings will rise to around $11-13/ADR or up 40-80%. 

PKX is a solid long term holding. 

Good luck in 2014!

Best Regards,

Kevin Graham

Disclosure - Long EZPW & BAC class A warrants. 

Wednesday, January 1, 2014

Top Investments for 2014

2013 Year in Review

Well 2013 turned out to be a very interesting year with returns for the broader market that surprised nearly everyone.  Concerns over QE, tapering, Obamacare, and other government interventions were popular news but they didn't stop capitalism from unleashing human potential.  Gold and other commodities got slammed in 2013.  This shouldn't take readers of this blog by surprise as I wrote about this twice in 2012 (Canada - Headed for a Crash & Canada: A Storm Brewing in China?). 

The most surprising thing was the rally in the markets that just wouldn't stop. The S&P 500 was up 29.6% and the Dow Jones Industrial Average was up 26.5% for the year.

While many might think that a 20%+ move in the equity markets is rare, JPMorgan notes that such a move is not all that unusual.  The table below groups the annual returns of the S&P 500 (and Dow prior to 1928) since 1897.  What is remarkable is that one out of every three years has been up 20%, and the markets are 3x more likely to be up double digits. This years return was strong but it's not unusual.

Here in Canada, the TSX Composite index was up 9.6% for the year.  As already mentioned commodities got slammed this year and below is a list of the damage.

Nat Gas

I found it remarkable how oil prices have held up in 2013.  US oil production has been off the charts, going up in a parabolic curve.  US dependence on foreign oil fell to a 27 year low (Click Here).  In 2005 the US imported 60.5% of their oil requirements and last year that fell to only 34%.  This is a result of the shale oil revolution in the US where oil production is up 46.5% or 2.36 million barrels a day since 2007.  If oil prices fall in 2014 that will be another significant headwind for the Canadian economy.

Fellow Canadians could have benefited from the fall in commodities by not owning Canadian Dollars.  Canadians who invested in the US not only realized out sized gains this year, they also realized foreign currency gains that contributed an additional 7% to their returns. 

2013 Stock Recommendations

So how did the stock recommendations for 2013 turn out?  Well this is the third consecutive year (ever year since I started this blog) that my stock recommendations outperformed the S&P 500.  On average for 2013, they outperformed the S&P and Dow by 5-10%.  They outperformed the Canadian markets by 25%. 

Company Ticker
Total Return
Bank of AmericaBAC
Berkshire HathawayBRK.b
Sony CorporationSNE
Average Gain

Here is the graphical performance.

Looking at the graph, these picks were up 40% in August, double the market returns at that point.  Of course I pick these stocks for fun and use the year end as arbitrary start and end points but much higher gains can be had for those who sell once a stock returns to its intrinsic value. 

As I said last year, Bank of America has been like shooting fish in a barrel.  After being up 110% in 2012, it came in with another respectable 34% return, and the kicker... it's still recommended for 2014.  Financials were left for dead after the financial crisis and rightly so.  Nobody wanted to touch them because they didn't trust them.  Today the major US financial companies are soundly capitalized and are in great shape. 

Berkshire Hathaway was very safe and very cheap, and remains that way.  Most investors think Berkshire is too large to produce out sized returns.  I disagree.  Their exposure to home building is large and they their equity portfolio is poised for strong gains over the next few years.  Their insurance businesses, which includes GEICO, are best in class.  They consistently report underwriting profits.  Berkshire is still modestly undervalued, I would estimate by 25%.

Sony had some hedge fund activism that got the stock price moving.  This wasn't surprising given the assets Sony owns.  Similarly, Wellpoint turned in a strong result this year as well. 

The outlier was POSCO, which is still cheap and recommended for this year.  POSCO had a tough year as steel demand was not as robust as expected.  The company still sells for well under book value and is profitable because they are a low cost supplier.  Demand for steel will return. 

2013 Other Recommendations

For 2013 I recommended both Well Fargo and Microsoft in the Safe and Cheap category.  They were indeed cheap and both outperformed the market indices last year.  Downside was also very well protected.  I also has some honorable mentions that should have been my top recommendations.  As I mentioned all these companies had wide appreciation potential.  The small energy company I didn't disclose was Rock Energy.  This was because family members were purchasing this stock.  It turned out to be a home run.   

Company Ticker
Total Return
Wells FargoWFC
Teva PhamaceuticalsTEVA
Prudential FinancialPRU
Arkansas Best ABFS
Rock EnergyRE
Average Gain

Top Investments for 2014

The markets have become slim pickings over the past year, but I still believe I have some decent ideas for this year.  The first two have significant upside potential.  US financials are still cheap and I'm selecting two of them for this year.  Finally, POSCO, a holdover from last year is still on the list.  POSCO is still profitable and growing but operationally is under performing due to slack steel demand.  Demand will return and perhaps 2014 will be the year. 


Lightstream Resources (TSE - LTS,  $5.88)

Bank of America (NYSE – BAC, $15.57)

Citigroup (NYSE – C, $52.11)

POSCO (NYSE - PKX (ADR), $78.00)

For Investment Commentary Click Here

Safe and Very Cheap

IBM (NYSE – IBM, $187.57)

IBM is the safe and very cheap pick for this year.  Last year I included this quote from the 2011 Berkshire Hathaway annual letter to shareholders. 

"...Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%.  Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us.  Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares.  Our quiz for the day: What should a long-term shareholder (in IBM stock), such as Berkshire, cheer for during that period? 

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years...

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon.  Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply. 

Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life."

I couldn't agree more.  The stock has languished, investors are fearful about a lack of revenue growth and cloud computing competition.  IBM is one of the best run companies in the world, especially from a financial perspective.  The two thirds of their revenue from Software and Services is annuity like.  Earnings per share has grown by 12% annually for the past 10 years and 16% annually for the past 5 years.  They generate close to $20 billion in free cash flow per year and have reduced the shares outstanding by nearly half over the past 15 years.  You can call that financial engineering, heck you can call it whatever you want, but the effects are real... Revenue & earnings continue to grow on a per share basis.

If you think of each share of IBM as a separate business, those businesses are doing really well at IBM.  The consolidated noise is only a distraction.   

As I mentioned last year, be sure to do your homework on any investment.  The markets are at all time highs and while that shouldn't alarm you, it should invite caution.  All of these companies have wide appreciation potential but results will depend on the operating results.  All of the recommended companies have short term headwinds that will clear over time.  These issues and problems make for poor short term visibility.  That is why they are avoided, but think like a long term owner and remember fear is your friend. 

Cheers to another great year!

Best Regards,


Disclosure – I own BAC Class A warrants, BRK.b, WFC, MSFT, EZPW, & IBM. 

Saturday, December 7, 2013

Where Is The Economy Headed In 2014?

I know it's been a while since posting but given the general level of the markets there really isn't much to discuss.  I have had an exceptionally tough year finding anything to buy. 

I made it my goal to find three solid value investments this year and so far I have only been able to find one.  The ironic thing is I was able to find it only a few weeks ago while the market was making new highs.  This stock is another of what I call value in plain sight but most people won't touch it.  It is making a yearly lows while the rest of the markets are making new highs. 

Given the level of the markets and the lack of easy investment candidates I though I would post some macro comments on the overall health of the economy.  I choose the October Housing Permits number because I believe it is an excellent long term indicator of the overall health of the economy.

October Housing Permits

Here is a graph of Housing Permits going back to the 1960s (Recessions are highlighted in grey).

Source: Federal Reserve Bank of St. Louis (click for larger image)

As you can see in the above graph, every recession in the past 63 years occurred 1-2 years after a severe drop in housing permits.  Moreover, housing permits tended to bottom at around 800k per year. 

This makes sense when you think about it because once a permit gets issued, a house gets built.  The new homeowner then spend money on new appliances, televisions, window coverings, decorations, furniture, landscaping and builds a fence.  All this crap comes from Home Depot, Costco or Pier 1 Imports.  These effects spill over for a couple of years after the permit is issued.  An increase in housing permits means an increase in overall economic activity that touches nearly all areas. 

Perhaps this is why Buffett has bet big on housing and housing related companies. 

Given the relative level of housing permits, and the fact that October reached a pre-recession high means that their is a low likelihood of a recession in the coming year.  Once this indicator starts to roll over, watch out. 

Probability of Recession Predicted by Treasury Spreads

For reinforce the above graph, we can look at forward treasury spreads to see if it is predicting a recession.  The graph below compares the 10 year treasury with the 3 month treasury looking 12 months ahead.  As you can see in the graph below, nothing to report at this time. 

Source: Federal Reserve Bank of New York (click for larger image)


So what can we expect in 2014?  Likely more slow and steady growth as we've seen for the past few years.  What will the markets do?  Who knows.  One report I read (Click here) showed that whenever the market is up 30% year over year, as it was in November, the market was up 18 out of 18 times in the following 12 months. Will that happen again?  Don't know and don't care...  All I worry about is finding cheap stocks... and if I do that the results will take care of themselves. 

Best Regards,


Disclosure: none

Sunday, September 8, 2013

Saudi America

The American energy landscape has gotten decidedly better over the past five years.  Consider the following US energy facts:

1)  US oil production average 7.62 million barrels at the end of August.  This is the highest level since October 1989 (24 years ago) and most of the increase has come over the past 2-3 years.  For those not familiar, the US was in terminal decline since 1973 but this changed around 2008.  Since then oil production has gone up in a parabolic curve.  So much for peak oil...

2)  Since last November the US has been the #1 petroleum producer in the world, surpassing Saudi Arabia (#2). 

3)  The US now produces 90% of its energy consumption, up from around 70% back in 2005-2006.  The last time the US was this "energy self-sufficient" was back in September 1987, almost 26 years ago. 

Source: EIA

It was only a few years ago it appeared that the US would never reach energy self-sufficiency but with the unlocking of shale oil and gas reserves, that appears to have changed. 

The only remaining question is what is why are oil prices so stubbornly high and natural gas prices so low?  On an energy basis natural gas is 82% cheaper than oil.  Oil is not as scarce as it once was.  This gap will close, it simply has to, but the question is will natural gas prices rise or will oil prices fall?  I would bet on a combination of both. 

Best Regards,

Sunday, July 28, 2013

Gasoline Prices

I thought I would provide some weekend entertainment here since there is little to write about in the markets.  I believe the stock market is fairly valued, however there are limited value opportunities out there but you must turn over enough rocks. 

Anyway... Every summer the price of gasoline rises and the complaints over gasoline prices begin to appear almost everywhere.  The victim mentality is common in our society.  Well, three years ago I read one such victim complaining in the editorial section of a local newspaper.   I instantly went to my computer and typed up my response.  This was my first letter to the editor.

I would note that this letter was very pointed to drive home the point.  For many people this message will not sit well because it challenges a number of beliefs.  So next time you hear someone complaining about gasoline prices, here is some ammunition.  If this does not sit well with you I would like to know why and what you consider to be false. 

(Please note I removed the name and location to protect the individual I was responding to.)

Dear Mr. Rodger _________. 

If you would like to see the person responsible for setting the gas prices, please go look in the mirror. Nobody forces you or your neighbors to purchase gasoline at any price. Nobody forces you to drive a vehicle. In fact, if you feel that they are making obscene profits you have the economic liberty to open your own gas station and to drive down the prices.  

The simple truth is our free market system works quite well at setting prices. The company that best meets the needs of the customer gets the sale. We ourselves collectively vote on prices every day in what we choose to purchase. The companies that charge excessive prices for goods will lose business through competition until the market reaches a fair price.  

I find it utterly ridiculous when people blame “greedy” oil companies for high fuel prices. A few years ago the price of gasoline was much higher than it is now. I haven’t seen any letters to the editor thanking “generous” oil companies who have now dropped the price to the current level. Perhaps this will be the first.


Kevin Graham

Have a great summer!