Thursday, January 27, 2011

2010 Investment Commentary

Attached is my commentary on a number of stocks I own personally or own in accounts I manage for others.  It highlights a number of reason I like them as investments.  It is written for non financial types so it is accessible for everyone.  Enjoy!


Discussion of 2010 performance excluded.

The overall economy is slowly recovering but has recently eclipsed many of the previous economic measures set back in 2007 & 2008.  The best example is retail sales, which will reach a new all time high in early December 2010.  Retail Sales in an important component to GDP and I expect that GDP in the forth quarter of 2010 to rise 4 - 4.5%.  This will be the fastest growth since 2006.

What are the reasons for the increased retail spending? Well, earnings are up, private sector wages and salaries are up 4% in the past year and small business profits are up 6%. These all lead to further spending. Consumers are still paying down debt, but are doing it at a slower rate than in the past year. Also, consumers are paying less interest due to low interest rates and the reduced debt that has been paid down. Consumers’ financial obligations are now at the smallest percent of income since the mid 1990’s.  This is all information you won’t hear on TV.

I will attempt to provide some brief comments on each stock held and why they are a good investment. 

Wells Fargo – Large US Bank

Well’s Fargo has a tremendous business in the US Banking Sector.  It leads most every bank in the US in net interest margin; the difference between the interest rate it get paid and it’s cost for the loan.  Wells Fargo has greatly increased capital as the US & European governments are requiring tighter restrictions on capital requirements.  Also, it is interesting to note that according to the company total loan losses peaked back in the end of 2009 and are now on the decline.  As a result, the company is releasing funds previously set aside for loan losses.  If this trend continues the company will be recording some very strong profit growth going forward. 

Even though the company has gone up 13% since you invested the company is still undervalued by at least 40%.  This leaves tremendous upside in the stock as it moves toward its intrinsic value.  This is a company that you will want to own for a very long time.  The company has a very conservative management team.  Also, due the their recent acquisition of Wachovia Bank they have plenty of upside to grow.

Peyto Exploration and Development Corp  – Canadian Natural Gas E&P company

The first thing you will notice with Peyto is that it has changed its name and is no longer Peyto Energy Trust (as of Dec 31, 2010).  Peyto has had a very strong year as it shares gained over 50%.  Peyto’s recent transformation into horizontal drilling has greatly increased returns.  Since Peyto started drilling horizontal wells the company has increased production from 18,000 BOE/D to 31,000 BOE/D (BOE = Barrels of Oil Equivalent).  Given the capital spending plans for 2011 the company should reach over 37,000 BOE/D by the end of 2011.

Given this good news, there are some pressures facing the company.  First off, natural gas prices are still very low and will likely remain low till mid 2011.  This isn’t a huge negative for Peyto as they are still profitable at low gas prices and it really reduces competition for services like drilling rigs, etc.  If NG prices recover this year Peyto’s shares will do very well this year.  Secondly, the pipeline tariffs for NG going to the US have been going up as total Canadian gas production going down the pipeline has decreased.  It will be interesting to see how this plays out.  Peyto will be fine but this may cause other companies to have serious financial difficulties.  When the industry is in turmoil, all of the company’s are affected, it may present an interesting opportunity to purchase Peyto at lower prices. 

Lastly, it is important to note they have dropped their dividend to $0.06/month or $0.72/year.  The decrease was mainly to do with the conversion back to a corporation but also they decided to retain more cash to drill wells.  I see this as a very good move as the company is earning very good returns on capital right now.  Any increase in gas prices will magnify these returns.

Fairfax Financial – Canadian Insurance Company

Fairfax is a premier investment opportunity in Canada right now.  The shares are selling at book value and they should easily be worth much more than that.  The company has increased their book value per share by 26% for the last 24 years, giving it the best investment history of any company in Canada.  For the past 15 years they have averaged over 18% on equity investments and over 10% on their bonds investments. 

Insurance is an interesting industry for a number of reasons.  First people pay for insurance upfront and the company then pays out claims as they are incurred.  This money is called the “float” and generally it is quite stable barring any unforeseen payout events.  Assuming premiums and claims per year are the same, the company basically has the float to invest at zero cost.  This is interesting because the company can then invest the money in the meantime and keep any gains it generates.  The government keeps a close eye on the insurance industry so that it doesn’t take excessive risk with these funds they have at their disposal.

At the end of 2009, Fairfax had $1064/share of investment working for each shareholder.  The breakdown is $370/share of common equity, $115/share of debt, and $579/share of insurance float.  If the total portfolio goes up just 6% net of expenses, the book value (common equity) will increase by 17.3%. 

The company’s goal is to grow book value by 15% per year going forward.  If they can accomplish that over the next twenty-years your investment will grow 16 fold.  Considering Fairfax has grown book value by 26% for the last 24 years, it’s not hard to see why he’s called the Canadian Warren Buffett. 

Bank of America – Large US Bank

Bank of America is a decent company that has been really hurt by the mortgage mess in the US.  They are the largest originator of mortgages since they now own Countrywide Financial.  They also have a very large investment banking division since they acquired Merrill Lynch.  At the price you paid for the company you will do fine.  It was well below book value and below tangible book value.  The stock market gets irrational at times. 

The company recently announced they have settled some outstanding claims regarding mortgages that were pooled and sold to investors (like a bond of mortgages).  It was much lower than estimated, but most everyone in the US haven’t even attempted to quantify the costs and won’t touch any financial company as a result.  This has left numerous opportunities for investors who do a little homework.  Their losses as a percent of net interest income are dropping dramatically and will be under 50% this year.  The company can and will generate very high earnings once the company has cleaned up its bad loans.  The problem is that it will take some time and as the economy improves this process will speed up.  As mentioned with Well Fargo the company’s bad loans peaked in 2009 and have been coming down nicely since. 

At current prices the company is selling at a 62% discount to my estimate of intrinsic value.  I wouldn’t be surprised if this is your best performing stock in the coming year. 

Johnson & Johnson – Large US Pharmaceutical, Medical device, and Consumer Goods Company

If you have read the newspapers or seen on TV, J&J has had some issues with quality this past year.  They recalled a number of items including Tylenol/Motrin.  This has hurt the company’s reputation, but it hasn’t from a financial standpoint yet.  Most investors don’t usually care to examine the financial standpoint.

By any investment measure the company is a premier investment.  It is selling at relative prices that haven’t been seen for over 15 years.  If you dig a little deeper into the financials statements you will see that the company is growing hand of fist in overseas markets and the North American divisions have been flat to down for the past 3 years.  Once the economy starts turning around, the North American sales will increase again and all will be back to normal slow steady growth. 

Lastly, the company has been affected by the uncertainty regarding healthcare in the US.  Many other competitors have suffered from this also.  Once American’s wake up and realize it’s not as bad as they think, they will more readily invest in companies related to the healthcare industry.  Healthcare is one industry you can guarantee will do more business in the future.

Manulife Financial – Canadian based Insurance & Financial Products Company. 

Manulife is a decent company that ran into some problems with their variable annuities that they sold to US customers.  They didn’t price them properly and along with the recession the company ran into some short-term financial problems.  They cut their dividend and raised some money by issuing new shares.  Obviously this got them into trouble with investors and many choose to dump their shares regardless of the price. 

Fortunately for you, this allowed you to buy shares in the company at a very reasonable price.  Many investors are not rational and don’t understand the underlying value of the business.  Manulife has very strong business divisions in Canada and Asia.  Their US division, John Hancock, is what has caused the problems.  Now, Manulife isn’t a company I would want to own for the long term, but it isn’t a terrible company either.  Fair value for Manulife is approx $30 per share, and they currently sell for around $17.  At your purchase price, your investment will likely double in 2-3 years depending on how well the economy rebounds.  This will yield a return on investment of 25-40% per year.  Even if I am totally wrong in my estimates, your purchase contains a very large margin of safety. 

Kraft Foods – Largest Branded Food and Beverage Company in World

Attached is a page showing the number of brands owned by Kraft Foods (Click Here).  Kraft is a very large food company that is selling for a very reasonable price.  The real value in Kraft is seen if one takes look at the big picture.  Back in 2003 Kraft had revenue per share of $18.01 and earnings per share of $2.00.  If we look at 2010 the company had revenue per share of around $28.50 and earnings will likely be around $2.05.  From this simple comparison it is easy to see that operating margins and net profit margins have decreased significantly.  Back in 2003 net profit margin was 11% and now it 7.1%.  Kraft has been working on reorganizing its operations to improve efficiency that will improve net profit margins. 

Beyond operations, the recession has hurt margins as well as people go for generic brands over the Kraft brands.  This will improve as the overall economy improves as well.  Lastly, the company has recently acquired Cadbury, which will allow for cross selling of a number of Kraft products in a number of emerging markets, particularly India.  Company wide sales growth will be slow, but overall earning should rise faster due to improved profit margins and growth in international markets. 

General Electric – Diversified Industrial Company

General Electric is a huge international industrial company with a fairly large finance division to boot.  Their finance department ran into some difficulty during the credit crisis as it heavily relied on short-term credit.  When that credit disappeared, the company was in a tight financial spot.  The US Federal Reserve provided cash and Warren Buffett invested in the company to resolve the liquidity (cash) problems. 

The company is strong internationally and can earn much higher earnings going forward.  The problem right now is that the losses in the financial division are canceling out earnings in other divisions.  Now those losses are real, but it is important to realize they will not be reoccurring and they are mainly related to the housing market.  Once the problem loans are corrected the company will once show very strong earnings growth. 

Lastly, GE is an excellent way to play emerging markets.  GE’s technology is useful in many other countries and will be in demand for several years to come.  GE will provide both the capital and consumer goods that will improve people's lives and raise the standard of living worldwide.


It appears that 2011 is shaping up to be a big rebound year in the US economy.  I would expect the US economy to grow significantly, and the unemployment rate to fall throughout the year.  While year-to-year returns are difficult to predict, 2011 could provide substantial returns once confidence and stability return. 

If you have any questions please let me know.   


Disclosure: I personally own shares in WFC, PEY, FFH, BAC (warrants), GE.

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