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)

Conclusion

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,

Kevin


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,
Kevin

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.

Sincerely,

Kevin Graham



Have a great summer!

Kevin

Friday, July 12, 2013

Acting On Fear

Well it's been a while since I last wrote anything here so I thought I would write a few thought on a subject recently discussed among some fellow value investors and myself.  The topic was acting on fear.  More specifically the discussion centered around how the best investment ideas are often the ones you are most fearful about. 

Understanding our biology is perhaps the best place to begin to understand why this is a problem.  Over the last few years I have read a number of books relating to this topic as well have been party to a number of discussions at my workplace on this subject. 

To best understand this topic I would recommend reading about the different parts of the brain and what the different elements are responsible for.  To begin with, our limbic system is responsible for the emotional part of our mind, fear included. This part of the brain is responsible for self preservation, fight or flight tendencies, and emotional hijacking.  Questions like, "Does it eat me or do I eat it?" is what this part of the brain processes.  We should be thankful this part of the brain is located at the base of the spinal cord. This allows for a quick response when faced with a physical threat.

Today however, the most common threats are not physical threats but psychological threats and this part of the brain is unable to distinguish between the two. Think of this system as an early warning radar system, constantly looking for any and all threats. 

This part of the brain becomes fused by the age of two and stops developing. That is why you can be 2, 42, or 82 and still have an emotional meltdown. 

Now, if the fight or flight response to a threat is strong enough it will result in an emotional hijacking in which the cortex is flooded with hormones and the rational portion of our thinking is rendered useless. This process happens countless times daily in the workplace and at home whenever some one's ego becomes threatened (including our own).  Often it isn't till after the chemical response has subsided that one will be able to think rationally and reflect on how irrational their behavior was.  This is most common when people are confronted with their mistakes. 

If you would like to witness an emotional hijacking, just go tell an engineer that his design is crappy and won't work.  If you are unable to locate an engineer to perform this experiment, just go home and tell your wife she looks fat and her cooking is sub par.  I've never seen that one fail.   

Investing Implications

The consequences to investing are numerous, however patience and emotional intelligence/awareness are key.  Let's start with patience.  Never, ever make a decision on a whim or when the markets are making wild swings.  You are often not thinking rationally when you feel strongly threatened.  Personally, I have made it a practice that upon deciding to make a stock purchase to wait three days to "think it over".  Sometimes I change my mind, sometime the market corrects and the opportunity goes away, but most often the stock continues to fall and I get to purchase at an even better price. 

Secondly your should never "trust your gut" when investing.  Emotions are not tools of cognition, but they likewise shouldn't be ignored.  Emotions will be able to recognize patterns far sooner than you will be able to mentally recognize and understand them.  Learn to utilize these emotions but always utilize rational part of your brain in the analysis.  Keep in mind that rational thinking takes considerable effort, but as in life and investing... no pain no gain. 

You must also learn to trust your thinking and not your emotions when faced with conflicting signals.  There are often times when your thinking will tell to buy and your emotions will be telling you to sell.  These conflicting signals need to be properly understood and processed.   If you are unable to maintain a rational position in the face of a sharply dropping market, perhaps investing just isn't for you.  I have had stocks fall by 60+% and I can tell you my emotions were questioning my logic of doubling down and then tripling down as the continued to fall.  This leads me to my next point. 

Thirdly, learn and develop your critical thinking skills.  As Ben Graham said, "You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right."  Learn to be firmly independent in your thinking.  Write out your ideas, use checklists to find biases in your thinking, and always maintain a long term perspective.  Be willing to be wrong and actively try to prove yourself wrong.  Some people will have no idea what I mean by that last statement.

The most important aspect of being independent is taking personal responsibility.  If you are like most people you are afraid of taking personal responsibility and thus read blogs like this one and search the internet for investment ideas.  Then once you buy a stock your continually search the internet looking for validation that you are correct in your thinking.  Then when the stock goes down and you lose money you blame the writer for providing the stupid investment idea, and then continue your search for a "better" blog or site. 

While reading the last paragraph you may have felt insulted, if so great, that was exactly what I intended.  It was intended as an exercise to help you feel the tension created by your emotions and your thinking.  On the one hand, your ego was likely telling you that your need for respect was being threatened invoking an emotional response.  On the other hand, your mind may have been telling you that the statement is true (if your thinking is rational).  This is the tension I am talking about and the statement is either true or not true.  Your emotions didn't want it to be true because it threatened your esteem need while your (rational) thinking was telling you it is true. 

If you didn't feel the tension or it was short lived, I have bad news for you.  You are likely a skilled egocentric thinker who quickly told yourself some sort of lie to make the unpleasant truth go away quickly.  Self-deception is something you may not even be aware of and may want to investigate further. 

Conclusion

After reading about how the brain works, I strongly believe some people are "wired" differently and thus someone like Warren Buffett is an anomaly.  He is a strong rational thinker who properly understands and integrates his feelings (emotions) and his thinking.  The good news for the rest of us is that new neural connections can always be created and the brain is tremendously adaptive.  If you want to understand this process and change your thinking I have some recommended reading below.  Once understood it will require a lot of conscious effort and a double dose of courage.


Best Regards,

Kevin Graham


Recommended Reading

Leadership & Self-Deception - by Arbinger Institute
Your Money & Your Brain - by Jason Zwieg
Feel The Fear and Do It Anyway - by Susan Jeffers
Emotional Intelligence  - by Daniel Goleman
The Human Mind - by The Foundation for Critical Thinking
Critical Thinking - by Richard Paul & Linda Elder
Thinking, Fast and Slow - by Daniel Kahneman
Predictably Irrational, The Upside of Irrationality & The Honest Truth About Dishonesty - by Dan Ariely
My "Stroke" of Insight - by Jill Taylor
(Yes, I like to read)

Saturday, May 25, 2013

Simple & Predictable Businesses

Much has been written on Warren Buffett's circle of competence statements but I want to look at it from a slightly different point of view.  Most often it is said that Buffett prefers to buy stocks that are simple, easy to understand, and whose profitability can be predicted for several decades out. 

For example he has said that Coca-Cola and Wrigley's chewing gum are two very each companies whom he can predict will be around for hundreds of years.  The trouble is a number of companies have come and gone, so how do you predict which ones will meet the test of time? 

Buffett has also said change is the enemy of the rational investor.  He much prefers companies that are in industries that never change and never will.  So what types of companies meet that description?

I have been reflecting on this for a while and believe part of the answer is found in a simple model we discuss a lot at my workplace and most would have seen in high school.  That is Abraham Maslow's Hierarchy of Needs, shown below.

 
 
Although Maslow never formulated his hierarchy of needs in such a manner, it does make a decent representation of human needs.  As I was reflecting on this hierarchy of needs, I though how every business that ever existed has attempted to meet one of these human needs in one way or another.  What is also interesting is that attempting to meet higher level needs of Belonging and Esteem is very difficult but many companies attempt to do so.  I believe the success of Facebook is largely due to the attempt of millions of individuals trying to meet their Esteem needs (in an unhealthy way). 
 
What is interesting is that all of our wants are derived from our attempts to meet a basic need.  For example you may want to buy a new truck.  In this purchase we often use self deception to justify such a purchase by telling our self that it will meet our basic need for transportation.  The truth is we are often trying to satisfy our esteem or belonging need.  We feel that if we have that new prized possession, others will think better of us.  So whether or not we are actually trying to meet a basic or a higher level need (Esteem or Belonging), our underlying needs drive all of our wants.  This process may be conscious or unconscious. 
 
So what types of companies does Warren Buffett buy for his company, Berkshire Hathaway?  First of all Berkshire is predominately an insurance company.  Insurance has been around for hundreds of years and is in the business of risk transfer.  For an agreed upon price you can meet your SAFETY needs by paying Geico, Berkshire RE, General RE, or National Indemnity to assume your risk of loss.  Furthermore, they focus on property and casualty insurance or protecting basic PHYSIOLOGICAL needs. 
 
What else does Berkshire own?
 
Acme Brick, Benjamin Moore, Brooks Sport, Clayton Homes, Cleveland Wood Products, CORT, CTB, Dairy Queen, Fechheimer, Fruit of the Loom, HH Brown Shoe Group, HomeServices of America, Johns Manville, Jordan's Furniture, Justin Brands, Kirby, McLane Company, MiTek Inc, Nebraska Furniture Mart, The Pampered Chef, Russell, See's Candies, Shaw Industries (carpet), Star Furniture, Wayne Water Systems, Western Enterprises, and RC Willey Home Furnishings.
 
What is interesting with this list of many familiar brands is nearly all of these companies meet the basic of all needs including food, shelter and clothing.  Those needs will never, ever go away. 
 
Even some of their large equity interests meet these basic needs too, namely Coca-Cola, Walmart, Proctor & Gamble, Kraft and Costco. 
 
Under SAFETY they also own a number of banks including Wells Fargo, American Express, Bank of America, US Bankcorp, Bank of New York, and Visa.
 
Under BELONGING they own Ben Bridges Jeweler, Borsheims, & Helzberg Diamonds.  This is obviously a bet that people will continue the ageless tradition of buying an engagement ring for their significant other.  I find the tradition of handing your soon to be bride a glittering gem dug out of the earth to be a total waste of every one's time and money.  Nevertheless I doubt the tradition will change because of my point of view.  I would recommend the article "Have you every tried to sell a diamond?" for those interested in further reading.  De Beers spends millions yearly to ensure we are all brainwashed into holding on to this tradition. 
 
Also under BELONGING, Berkshire also owns a number of media companies and lately has been buying up newspapers that were formerly profitable.  Many of these business rest on the fact that we humans are relational and desire information about what is going on around the world.  What is interesting is that a number of these businesses have become disrupted because technology is transforming how this information is consumed.  I believe Buffett has made his bets in this area because the desire for information will not go away and that those producing the content will still be able to earn a decent return for their efforts. 
 
Under ESTEEM needs Berkshire doesn't own much.  I would put NetJets under this category.  Perhaps that is why Buffett calls his personal jet the "indefensible".  Often once you get to this level, the business and fads are very unpredictable.  So have been the profits.
 
Of course there are other Berkshire businesses that I haven't mentioned like it's large position in IBM.  To be honest I'm not exactly sure where to categorize that one.  My personal opinion is that Buffett bought it because businesses and government use their services to meet their SAFETY Needs.  Now in this case I don't believe that just say it meets a basic need for a business and declare it to be a stable & predictable business.  In technology, substitutionary effects are real and paradigms shift can happen quickly.  Here Buffett must also believe the switching costs are very, very high. 
 
Anyway, I hope this provides a different angle at how Buffett chooses safe and predictable businesses.  If you are every looking to open a business I would recommend ones closest to the base of Maslow's Hierarchy as you are guaranteed to have the largest number of possible customers.   
 
 
Best Regards,
 
Kevin
 
 
Disclosure:  Long BRK.b, WFC, BAC.WS.a,
 
 

Monday, April 29, 2013

Xbox 720 - IllumiRoom

The latest out of Microsoft Research.  Many believe this to be part of the new Xbox, rumoured to be called Xbox 720.  This might be one of the coolest things I have ever seen. The possibilities are endless. 



Best Regards,
Kevin

Disclosure: Long MSFT

Sunday, April 21, 2013

Fairfax Shareholder Letter Part 2: Get Defensive

As mentioned in the previous post, Fairfax has positioned themselves very defensively.  Why you might ask?  Here are some quotes for you to chew on. 

Deleveraging in the private sector has only just begun.

In our 2010 and 2011 Annual Reports, we discussed the Chinese bubble in real estate.  This past Sunday (March 3, 2013), the CBS show "60 Minutes" did a segment on the Chinese residential real estate bubble.  They showed vast empty cities with "new towers with no residents, desolate condos and vacant subdivisions uninhabited for miles and miles, and  miles and miles of empty apartments."  They called it the biggest housing bubble in history.  We agree!  The ultimate collapse of this bubble will have major consequences fro the world economy.

...today the "risk on" trade prevails everywhere, with investors reaching for yield in corporate bonds, high yield bonds and even emerging market debt... For example, Bolivia's recent $500 million 10 year bond, issued at 4-7/8% was 9 times over subscribed even though Bolivia has not issued a bond in 90 years!!  Poland did even better, issuing a 10 year bond at 3-3/4%. 

We continue to be be early - and bearish!

While commodities prices have yet to collapse (i.e. complete the down cycle)...

As we also said last year, if commodity prices come down after their parabolic increase, Canada will not be spared.  Also, Canadian house prices have gone up significantly, driven by lax policies at CMHC (Canada's equivalent to Fannie Mae and Freddie Mac).  Canadians have accessed their wealth through lines of credit easily available from the Canadian banks.  This has begun to reverse and we are watching from the sidelines. 

In 2012, Fairfax shorted the S&P/TSX 60 index to the tune of $206.1 million (notional amount) at an index value of 641.12 (as of Apr 19th, the index stood at 673.33).

We currently have 31% in cash and cash equivalents - earning us very little money. 

We did remind you last year but here it is again - cumulative deflation in Japan in the past 10 years and int he U.S. in the 1930s was approximately 14%!!  It is amazing to note that including 2012, Japan has suffered deflation in 17 of the last 18 years - beginning about 5 years after the Nikkei Index and real estate values peaked. 

In the last three years, we have had significant unrealized losses from our hedging program and from our CPI-linked derivative contracts... ($1.86 billion)

These losses are significant but we consider them unrealized and expect both of them to reverse when the "grand disconnect" disappears - perhaps sooner than you think! 

This is what I love most about Fairfax, they are very rational, stubborn and stick to their principles. 

Your company is focused on protecting you on the downside of permanent capital loss from the many potential unintended consequences that abound in the world economy. 

Bond Portfolio

The company's fixed income portfolio totals $11.4 billion dollars.  The vast majority is investment grade bonds and 68.1% is rated AA or better.  What is interesting is the comments in the annual report on U.S. state and municipal bonds.  The company owns $4 billion worth of bonds insured by Berkshire Hathaway Assurance Corp in the event of a default.  This makes the credit risk associated with 35% of the fixed income portfolio bullet proof. 

Why Defensive?

So why is Fairfax so defensive?  First they don't see the financial crisis of 2008/2009 as something that has totally corrected itself.  To answer that you have to look at what caused the financial crisis itself, namely excess debt or leverage.  While deleveraging has occurred in the private sector, the public sector has levered up.  Total debt in the system, as highlighted again the the Fairfax annual meeting, is still very high. 

Why does leverage hurt growth?  To understand leverage it is best to be understood in the context of an individual, lets call him Joe.  Lets say Joe earns a decent wage but spends all of his income and has no debt.  Then lets say Joe wants to make a bigger purchase, which is greater than his income.  He has two choices, he can either save or borrow the money.  If he saves the money he will have to under consume now in order to make his purchase in the future.  This is often the most rational approach. 

On the other hand, Joe can borrow the money.  In this case he consumes today and under consumes in the future (until the debt is payed off).  It is important to note that he has to under consume to a greater degree in this case because he not only has to repay the principle but also the interest.  If the money is borrowed on a credit card the under consumption require in the future is huge due to high interest rates. 

Now if Joe and his friends all play the same game of consume today and pay tomorrow, growth is great in the short term.  However in the long term, the economic output of a country will be artificially high because aggregate consumption today higher than it would normally be without the excessive borrowing.  This is also the reason why deflation is likely to occur as demand collapses, along with prices. 

This has been going on for years in Canada, the US and almost every western country.  However in 2008, the private sector has started to reduce debt levels in almost every country, except Canada.  Here we kept on piling on the debt.  Canada has had relative strong economic growth driven by the parabolic rise in commodity prices.

In Canada, the average household is levered to to the tune of 165% of annual income (see graph below) and is becoming heavily burdened by the debt load.  So long as you can continually add more debt you can continue to consume at a relatively high level, but make no mistake you cannot defy economic gravity.  Today many are content to pay interest in perpetuity for past economic gluttony (over consumption).  In the US the consumer had reduced debt levels but the public sector has levered up (along with quantitative easing) the consumption level has held up relatively well. 



So what difference does this make?  If commodities fall, as I expect, Canada will go through a rough process of unwinding these excesses.  If the last jobs report is any indication... the loss of 55,000 jobs that took economist by surprise, we may be in for some turbulent times here in Canada.  Secondly, the Canadian housing market is starting to turn over.  I have read reports of home being purchased in Vancouver with HELOCs so the owners can make interest only payments, can anyone say subprime?  To read more about the good, the bad, and the ugly on real estate and the Canadian economy, I suggest reading this article

Conclusion

For those with significant equity exposure in Canada, particularly banking, you may be at significant risk.  The same goes for those holding Canadian equity mutual funds in RRSPs, TFSA's, etc.  Every Canadian equity mutual fund has huge exposure to Canadian banking, thus housing and consumer credit.  A soft landing for Canada is not likely in the cards.  Now there are ways to protect yourself and perhaps profit from this mess, so buyer beware. 

Owning Fairfax common stock is a wonderful way to protect yourself from the potential issues in the market today.  They are short a number of key markets and have huge deflation protection.  If commodity prices collapse due to issues in China, the US and Canada their deflation protection will be worth billions.  Given that the stock sells for around book value it isn't even expensive.  I can also say that having read their annual report, I can say they are also very conservative in their accounting.  Just compare their assumed returns for pension assets to other companies for an example. 

Last year Fairfax earned 6.5% on equity, a surprisingly strong result given their equity portfolio was 100% hedged.  Look for it to explode if commodity prices or equity markets fall.  If neither happen and the economy muddles along, expect similar mid single digit returns on equity.  So downside is near zero, and the upside is huge.  As I said in Fairfax Shareholder Letter Part 1, it is imperative and prudent to always obsess over the downside


Good Decisions,

Kevin Graham


Disclosure: Long FFH.

Saturday, April 13, 2013

Fairfax Shareholder Letter Part 1: Buy BlackBerry

After reading the 2012 Annual Letter to shareholders of Fairfax Financial Holding, I thought I should post their interesting and different perspective on the markets.  In short, everyone today seems to be accepting an out sized amount of risk today because of quantitative easing.  Prem Watsa (CEO of Fairfax) is having none of it and is very defensive. 

I want to use this post, and the following one, to highlight my highlights of the Fairfax Annual Letter to shareholders.  As I have said before, too many people focus on the upside when investing while value investors fret over the downside.  Anyone who has invested long enough knows that you don't have to have very large gains in your portfolio, so long as you don't suffer huge losses. 

One bad year, say a loss of 33%, means that you have lost 1/3rd of your capital and have to now earn 50% on the remaining capital just to get back to where you started.  Thus it is imperative and prudent to always obsess over the downside.  Ben Graham, the father of value investing, in his book the intelligent investor said, "Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY." (Chp. 20, emphasis mine)

With that introduction in mind let's look at Prem Watsa's Annual Letter.  I will put each quote in italics and bold and my comments will follow.  This will break up this post into two parts just so it's not so too long. 

"OdysseyRE is the jewel in the crown, accounting for almost half our business and producing an average accident year combined ratio in the last ten years (since 2003) of 92.8%."

This truly is an outstanding business and I wish they owned more.  To be honest and rational, the only other really strong business is Fairfax Asia that has a 10 year average combined ratio of 71.8% and a 26.5% compounded annual rate of growth in book value (2002-2012).  However the only problem is Fairfax Asia is writes 1/7th the amount of premiums.  That said, if Fairfax Asia keeps growing at a decent clip, it may well be the crown jewel someday.  The emerging markets have years of strong growth ahead as Prem went on later to say, "All of these (emerging) markets are growing rapidly because of the low penetration of insurance."

The only other problem is their "crown jewels" often compensate for some of less valuable insurance companies that have been running terrible combined ratios over the part couple years.  As I like to say, less is often more.  That said, unless the business is consuming capital there is little reason to sell it. 

"In 2012, we earned a total investment return of only 4.5%...mainly because of our 100% hedge of our common stock portfolio."

Given the hedges this is not a bad result, especially since the downside protection is so high.

"Markets fluctuate - and often in extreme directions... (Discussing his investment in BlackBerry) At it's low of $6-1/2 per share, it sold at 1/3rd of book value and a little above cash per share (it had no debt).  The stock price declined 95% from it's high!"

Mr Watsa then goes on to discuss his rational for the investment in BlackBerry (BB).

"The brand name, a security system second to none, a distribution network across 650 telecom carriers worldwide, a 79 million subscriber base, enterprise customers accounting for 90% of the Fortune 500, almost exclusive usage by governments in Canada, the U.S. and the U.K., a huge original patent portfolio, an outstanding new operating system developed by QNX and $2.9 billion in cash with no debt, are all formidable strengths as BlackBerry makes its comeback!"

While those are all interesting facts, what came next is even more interesting and is the missing link to the Blackberry investment.

"And please note, 1.8 billion cell phones are sold worldwide annually, and of the 6 billion cell phones in the world, only 1 billion are smart phones.  Lots of opportunity for Canada's greatest technology company!"

Boy, he just had to throw that in there... What does it mean?  Well, here is the logic as I see it. 

1) BlackBerry currently has 76 million subscribers worldwide as per their latest earnings, so BlackBerry has a little more than 7-1/2% market share of all smartphones in the world. 

2) The growth of the smartphone market is still in it's infancy since only 16% of worldwide cell phones are smartphones. 

3) Over time, a large percentage of cell phones will be upgraded to a smartphone.  Let's say over the next decade the smartphone market grows from 1 billion to 4 billion (2/3 of total cell phones).

4) If, and I say if, BlackBerry simply retains it's market share in smartphones... How many subscribers will it have?  The answer is over 300 million or over 4 times it's current subscriber base. 

Of course you can make your own assumptions and of course be conservative (everyone else is), but you easily see they have room for a lot of growth.  Even if their market share shrinks, they can still grow their business. 

Now for the ironic news of the day... Guess who has higher gross margins, Apple or BlackBerry?  That right, Blackberry's gross margin was 40.1% in Q1, while Apple's was 38.6%. 

That said Blackberry still has some room to go on the cost side.  If we keep working our way through the income statement for Q1 2013, Blackberry spent $383 million on R&D (14.3% of sales) while Apple spent $1010 million on R&D (1.9% of sales).  Next if we look at Selling, General and Administrative costs, Blackberry spent $523 million (19.5% of sales) verses Apple's $2,840 million (5.2% of sales). 

At the end of the day, the operating margin was 31.6% at Apple in Q1 compared to Blackberry's 6.3%.  Clearly Blackberry has a huge amount of opportunity, especially on the SG&A side.  They just have to work harder, grow market share and their operating margin will increase. 

To be honest about his analysis, I find it amazing how much the market hates Apple stock at this time.  Both Apple and Blackberry have solid businesses is a very fast growing segment of the world economy.  Both companies seem to be selling at distressed prices today given the above facts.  I wonder if Prem and his team shouldn't consider both investments especially given the theme of growth in the smartphone market. 

Stay tuned for part two... (Click Here for Part 2: Get Defensive)


Best Regards,
Kevin Graham


Disclosure: Long FFH.

 

Tuesday, April 2, 2013

Wells Fargo Annual Report


"In 2012, we grew revenue 6 percent to $86.1 billion, mostly from noninterest income. (Imagine our earnings power when a more normal rate environment returns.) The revenue growth included double-digit growth in our capital markets, commercial real estate, corporate banking, mortgage, asset-based lending, corporate trust, and international businesses." - John Stumpf - 2012 Wells Fargo Annual Report

John Stumpf is an amazing CEO and runs a tremendously profitable company in Wells Fargo (WFC).  I too can only imagine the earnings power when a more normal interest rate environment returns.  Wells Fargo will be an earnings dynamo. 

It was just over two years ago when I woke up and realize what a ridiculously cheap price Wells Fargo was selling at.  Since then I have averaged 16.5% annually plus dividends in a sub optimal economy.  Bring on the good times.  I fully expect the dividend on my original cost to yield over 8% within two years as the economy normalizes and earnings per share reaches $4 in 2014.

I find it remarkable how nobody is interested in a boring, yet high quality bank like WFC.  Meanwhile Warren Buffett is quitely buying 1.2 billion dollars worth of their stock in 2011 and 1.8 billion dollars worth in 2012.  I have been beating the drum on them for the past two years too.  During that time frame, the earnings per share has risen 23.5% annually.  I also believe that an investor today will also realize a benefit from the low relative valuation, not just earnings growth.  Growth and value are joined at the hip.   


Best Regards,
Kevin Graham

Disclosure: Long WFC

Bank of America Annual Report


"While we are not yet where we want to be, our results reflect the underlying strength and earnings potential of the company that I believe will become even more apparent this year."  - Brian Moynihan - 2012 Bank of America Annual Report

I sure hope so Brian. 

Bank of America seems poised to greatly increase profits this year as their litigation issues are really getting behind them.  If the $8.5 billion BNY Mellon (as Trustee) settlement gets approved this summer, there will be only small pieces of litigation remaining.  Please note the funds for that settlement has already been reserved. 

The Legacy Asset Servicing (LAS) division will be mostly wound down at by the end of this year.  If I remember correctly, the company started with over 6 million delinquent mortgages in LAS and began this year with only 2.5 million remaining.  They have already sold off a large portion of those mortgages and will work though countless more this year.  By year end the company estimates they will have only 750 thousand remaining.  In other words they will be close to 90% through all of the "bad" legacy assets by year end. 

I fully expected the stock to run up after the announcement of the Federal Reserve Stress Tests announced a few weeks ago.  The good new is it hasn't and the company has just began buying back up to $5 billion worth of it's common stock.  The lower the stock price the better for those holding the stock long term.  The warrants I hold are long term and I fully intend on holding them for the long term.  The company is also buying back $5 billion of high yielding preferred securities.  Interest alone on those preferred shares equal around half a billion dollars a year. 

With every passing day the company gets more and more of its legacy issues behind them.  The earnings capability will begin to shine through once the costs come down.  I fully expect earnings this year and next to surprise many people. 


Best Regards,
Kevin Graham


Disclosure: Long BAC class A warrants. 

Monday, March 25, 2013

How do I screen for stocks?

Somebody asked, "Hey Kevin, I wanted to know if you use certain screening tools to screen out stocks? For example, p/e less than 10, debt to equity less than 0.5 and so forth. If you do, which ones to you use and what criteria do you input?"

I guess I should start by saying that I don't generally screen for stocks.  When I do I generally start with Price to Book (P/B) value.  From there I want to invest in a business that generates a high Return On Equity (ROE).   An investor needs to be especially careful with looking at ROE's because it can be easily manipulated by the leveraging the balance sheet (adding more debt).

Book Value

If you read the annual letter to shareholders by either Warren Buffett or Prem Watsa, you will find something in common.  Both legendary investors focus on book value and discuss that metric extensively in their letters.  The book value of any company acts as an anchor or financial gravity with respect to business value.  That is why both Buffet and Watsa use book value as an understated proxy for intrinsic value. 

Recently in Canada, a number of so called investors learned this lesson the hard way in Poseidon Concepts (TSE:PSN).  How a commodity type business could trade a such a high P/B ratio almost escapes logic.  The company had zero competitive advantages and no patents.  I wonder how many investors in PSN even knew what the P/B ratio for the company even was?  I would bet not that many.  Now the stock is a zero.  It would makes an interesting case study for those interested. 

Return On Equity

Now, in general, I really only want one thing when I make an investment.  I want to earn 15% on my money, preferably on day one or as close to day one as possible.  If I cannot achieve 15% on my capital then I am not interested in that investment.  By this I mean I want to see a clear, rational argument for how I can earn 15% on my purchase price. 

What I regularly observe in reading about investments is that many people do this exercise in the precisely the reverse order.  They find an investment that they think is cheap then attempt to justify the investment by "rationalizing" some non essential metric.  What they are really doing is "irrationalizing" the investment.  I am amazed how often some investments are justified, when I know full well the math doesn't add up.  PSN would be an example. 

The trouble with stocks is that valuations are nothing more than people's expectations.  Beyond that, many people look to others to determine what the value is.  This means that every time you look at a stock quote to determine what something is worth, you are really asking someone else what the value is.  It is best to determine the business value first (unbiased by the opinions of others) and then go search out the market price. 

One last thing.  If a company doesn't have any earnings it's ROE is zero.  Let me say that again.  If a company doesn't have any earnings it's ROE is zero.  That company is in the business of consuming capital and that is not a good business to be in, unless you're generous.  I find it funny how when a company's earnings are non existent (like in the oilpatch or the dotcom bubble), investors run to other metrics such as cashflow.  While the words "cash" and "flow" both have a good ring to it, if a company doesn't have any earnings, the cash is flowing in the wrong direction... out the door. 

Business Ownership

I look at businesses a little different than most others because of my experience (working in a small business) and my fundamental understanding of capitalism.  I don't really know how else to say it.  Every business lays out money (capital) in attempt to earn a return on that money (capital).  Money is just a easy way of converting one form of capital into another. 

So every company lays out capital in an attempt to earn a return on that capital.  Beyond that, I want the return on capital to be stable and easily predictable from year to year. 

From this I just want to buy at a price point that will give me a 15% return on my investment.  This means that almost every business is a potential investment, even if it is a dull boring investment, so long as the price is acceptable. 

Now from this I would add that there are a number of other variables that are at play.  Every company has different investment merits.  Each balance sheet has to be analyzed individually for the assets and what those assets can earn for the business owner.  Sometimes there are hidden assets or undervalued assets that may potentially be very valuable. 

So my golden rule of thumb is this: How can I earn 15% on my money.  I don't care if it's an apartment, a bond, a piece of land, or a stock (part ownership in a business).  I just want to earn 15% on my capital. 

This may sound simplistic because it really is simplistic.  Staying disciplined (rational) and actually finding investments that meet the above criteria is the hard part. 


Best Regards,

Kevin Graham


P.S. - I have been extremely busy lately and thus haven't been able to write on this blog.  Early this year I was given more responsibilities at work that required more of my attention.  Beyond that, I was away on vacation for the first two weeks of February and then was in Ireland for the first 10 days of March (for work).  Only recently have I gotten back into my normal routine. 

Monday, January 28, 2013

Richard Ivey - Pershing Square Event

Since I have started blogging I have been pleasantly surprised to meet many people who share my passion of value investing.  Recently, I was asked by one follower of this blog to both attend and promote an event being put on by the Investment Club of The Richard Ivey School of Business.  I said I would be honored and would gladly post the detail here. 

Event Details (Click Here for the Event Brochure):
--------------------------------------------------------------------------------------------------------------------------

The Investment Club of The Richard Ivey School of Business cordially invites you to The CPR Activist Campaign and the Implications for the Canadian Establishment 
 
Featuring iconic author Peter C. Newman and Pershing Square Capital Management, L.P. Partner and Canadian Pacific Director Paul Hilal. 
 
Date & Time:
February 27th, 2013, 6:00 pm - 9:00 pm 
 
Location: 
Ivey ING Direct Leadership Centre 130 King St West, Toronto 
 
*Admission is free
 
Program: 
6:00 pm – 7:00 pm
Networking and Cocktails 
 
7:00 pm – 8:00 pm 
Keynote Address: 
"The Eclipse and Rebirth of Canada's Business Elite: From Aristocracy to Meritocracy" by Peter C. Newman
 
8:00 pm – 9:00 pm
Q&A with Peter C. Newman and Paul Hilal (30 min)
with Audience (30 min) 
 
(Moderated by Wes Hall of Kingsdale Shareholder Services) 
 
Please RSVP to iveyinvestmentclub@gmail.com by February 8th, 2013. 
 
*This event is open to MBA and Law students, Richard Ivey Alumni and distinguished members of the Ivey business network. The event is not open to the press and will be conducted off the record. 
 
The Richard Ivey School of Business would like to thank the Pershing Square Capital Management, L.P. for their generous sponsorship of this event.

--------------------------------------------------------------------------------------------------------------------------

When I first heard Pershing Square was involved with this event, I immediately said I was not interest in attending.  I don't have a huge amount of respect for Bill Ackman, especially in like how how he's handled himself with the whole Herbalife fiasco.  I was relieved to hear that Paul Hilal would be attending instead of Mr. Ackman. 

While I would have loved to attend this event I unfortunately will not be able to.  I am on vacation for the first couple of weeks in February and as soon as I return I am heading down to our USA operations for a week.

Now this event should be quite interesting.  As some may be aware the CPR railway played a monumental role in the founding, development and industrialized of the nation and its board of directors has always been composed of the most eminent, and 'untouchable' members of the business/financial/political elite in Canada.

The fact that a foreign hedge fund (Pershing Square) was able to successfully win shareholder support (particularly from other establishment players like Canada Pension Plan, Teachers pension plans, etc) to depose the CPR board members proved to be a watershed event in the history of Canadian business and will have implications for many other organization and investors. 

Peter Newman has been advancing the idea that the Canadian Establishment, an old boys club that rules many Canadian corporate boards, is dying.  The CPR event may well be he last nail in the coffin, marking the rise of a new class of businessmen and entrepreneurs. His keynote address will be centered on this.  The Q&A session will allow the ideas to be explored in greater detail. 

It promises to be a great event.


Best Regards,
Kevin



Sunday, January 20, 2013

Arkansas Best

At the beginning of 2012 I recommended Arkansas Best (ABFS), a trucking company.  I noticed a fellow blogger has also picked up on the idea. So to save time I thought I would share a link. 

You can read his commentary here:

http://reminiscencesofastockblogger.com/2013/01/02/arkansas-best-the-upside-of-union-negotiations/

It's a good analysis and hits on the cost side of their business.  ABFS has huge upside if they get costs get under control and the economy picks up.  They have been floundering since 2008 but they will get things figured out. 


Best Regards,
Kevin

Disclosure - None

Wednesday, January 9, 2013

2013 Investment Commentary

Bank of America (NYSE – BAC, $11.61)

BAC was a huge percentage gainer last year but don’t let that fool you. As I pointed out in the post on comparing Canadian & US banks, BAC sells for 1/3 of a comparable Canadian bank on an apples to apples basis. Some of that valuation gap has narrowed, but don’t kid yourself there is still a lot of money on the table.

To begin, BAC has a tangible book value of $13.48/shr at the end of Q3 2012. The company still sells for below that level despite the fact the bank is soundly capitalized. At the end of the Q3 2012 the capital level was 8.97% on a Basel 3 basis. The bank only requires 8.5% so it is now over capitalized and Q4 should add further to this capital buffer.

The bank has been drastically shedding assets during 2012. Now that it has taken care of business they are now in great shape to start growing again and the CEO has stated he has finally instructed bankers to aggressively lend to both mortgages and business segments.

To me the biggest news in Q3 for those who listened to the conference call was that the legacy asset servicing (LAS) group will see expenses fall by $10 billion over the next 5 quarter. That is huge and will greatly add to the bottom line in 2012. Here is part of the Q3 conference call: 

Brennan Hawkins - UBS

"Okay. Just to make sure I understood, Brian I think you had said that, as far as the trajectory of the decline in expenses overall when you’re looking at the entire thing at LAS taking a step back, moderate improvements in 2013, but the big lever there is 2014. Is that right or are we reading too much in to it?"

Brian Moynihan - CEO

"No, I think I was saying, that you’ll get the improvement sort of on a quarterly basis all though ’13 and in ’14 you’ll have the run rate of all that accumulated and for you, in year-over-year comparisons, but it’s going to come all during ’13.

We can debate about moderate when we are that [expense base]. The other question was discussing but it will come every single quarters, so it’s not going to be held up and wait, it’ll come as fast as it can.

So the word we’re getting out this quarter has to do with the clients and the 60 plus day in the second quarter into the third quarter came out in the third, and the third quarter comes out in the fourth, it will take just little time, because you actually have to finish the work, reassign accounts and go on. 

So it will come, it’s not in quarter-by-quarter, it will come month-by-month, week-by-week all to the ‘13."

Enough said.

The company has a huge low cost deposit base and the huge earnings power of this bank will appear once the LAS expenses come down and interest rates normalize.

The economy is improving and the improvement in the housing market will be a huge tailwind for BAC. Fair value is closer to $20/shr.

***Recent update: The recent legal settlements, particularly with Fannie Mae, settle a large portion of the legacy issues related to Countrywide.  While the company still faces some legal issues they have settled $45 billion dollars worth of issues over the past 2 years. 

A person I know recently put it this way...  BAC is selling for $99 billion below book value.  You can argue that they are under reserved but come on now, that is valuation gap is ridiculous. 

Investing only requires grade 5 math and rational thinking.  The problem is the rational thinking. 


Berkshire Hathaway (NYSE - BRK.b, $89.70)

This is perhaps the easiest investment decision a rational person with reasonable expectations can make. Warren Buffett, the CEO, has made it clear the stock was undervalued when he first bought back shares at 110% of book value (BV). He has always treated his shareholders as partners so he doesn’t buy back shares without first letting them know that he feels it's a cheap price.

Since then Buffett, along with the blessing of the board of directors, has bought back 1.2 billion in stock.   He also raised the price he is willing to pay to 120% of BV.

Now anyone with half a brain should realize:

1)  Buffett believe the shares are cheap and represent great value at 120% of BV.

2)  The shares have a type of “floor” underneath them at that level. That doesn’t mean the stock can’t go lower but it does mean there will be a big buyer below 120% of BV.  Buffett has over $40 Billion in cash and is looking for somewhere to invest it. 

3)  Berkshire has huge exposure to the housing market

4)  Buying today at historic low valuation will ensure you benefit from both the growth in earnings and the valuation adjustment as the stock moves higher.

An investor really only has two levers from which to make returns. The first is growth in earnings and the second is an increase in valuations. Some people include dividends but I don't since dividends are merely a percentage of earnings. So with Berkshire you will benefit from increasing earnings power and possibly a higher valuation.  Over the past decade the valuation has hovered around 170% of BV.

Lastly Berkshire will also greatly benefit from the improvement in the economy, particularly in housing. Berkshire also does not pay a dividend so all of its earnings are plowed back into the company. They also own a number of outstanding companies that can generate very high returns on capital.

If you put all your money in one stock, Berkshire would provide adequate diversification in one security while generating acceptable returns.

The reason most people won’t buy BRK is because they “think” they can generate a higher return than what Berkshire can generate.  For those who hold that belief may I suggest two words, “good luck.”


Sony Corporation (NYSE - SNE (ADR), $11.20) 

Sony is an interesting company I initially looked at last summer but I was too stupid to connect the dots at that time. I know, I know at times I am a little slow.

Examining the 2011 annual report for a second time I noticed a couple things? First of all of you took the cash on the balance sheet ($19.2 billion) and subtract the long term debt ($9.3 billion) you were left with just shy of $10 billion in cash. Then if you look at the market capitalization of the company, you could purchase the entire thing for around $12 billion. Now assigning $2 billion for all of Sony is quite ridiculous.

Now to be fair the company lost quite a bit of money in fiscal 2011 year and they are still losing money in 2012. Secondly, the company has never earned very high return on equity which is a reoccurring theme for Japanese companies.

So what do I like. First the new CEO just stated they are going to right size their operations in an attempt to achieve a 10% ROE in 2014. Second, they have a very strong brand name and have strong ties into a number of markets. I realized this after my wife started looking for a stereo with a docking station for her iPod touch. I then realized I had two other Sony stereos in my own house. I also notice Sony speakers in a friend’s new Ford pickup truck. Then I realized that the Sony Playstation and handheld Playstation Vita are popular video game systems.

Then upon investigation, I discovered Sony Pictures Entertainment owns Columbia Tristar and Metro-Goldwyn Mayer.   On top of that, Sony Music is the second largest music recording company in the world and owns full rights to Michael Jackson & The Beatles, among others.

It should be clear that Sony owns some very valuable and unique assets. I would bet with some American style management Sony could be worth 5x of the current quote. As Peter Lynch once said, “Go for a company that any idiot can run – because sooner or later any idiot probably is going to run it.” Well, Sony has been run by idiots for a while now and with some decent management they would be worth much, much more.


Wellpoint (NYSE - WLP, $60.92)

Wellpoint is a company I have been watching for a while and finally got around to reading the annual report.  For my Canadian readers, Wellpoint is one of the largest US healthcare organizations with 33.5 million members at the end of Q3.  They are an independent licensee of Blue Cross and Blue Shield in a number of US states.

Let’s begin by looking at the positives and the negatives.

Negatives

WLP is a very interesting investment candidate because they aren’t the most efficient operator in the sector. They seem to constantly have among the higher medical loss ratios compared to competitors. The medical loss ratio, or sometimes referred to as the benefit expense ratio, is the benefits expense as a percentage of revenue.

They also appear to be floundering as they don’t have a CEO. They have also just purchased Amerigoup which will increase exposure the Medicaid customer base. The downfall here is a lower margin business.  I would have preferred them to buyback more shares.

Next they have been experiencing flat to declining enrollment for several years.

Lastly they are facing increasing regulation which should make the sector much more competitive and limits medical loss ratios and restricts how much they can increase premiums.

Positives

The company is an absolute cash cow. They currently sell for 8 times earnings and just over 7 times free cashflow.

Since 2005 the company has reduced the shares outstanding from 660 million to roughly 310 million at the end of October 2012. You don’t need a calculator to figure out that these share buybacks have been huge. It is interesting to note that revenue and earnings have gone up 200% and 100% since then but the stock price has declined.  P/E ratio has fallen from 17 times to 8 times.

Now if your math is any good you would have also notice that this is not a very good operating performance. Earnings per share (EPS) should naturally double when you buy back half your shares.  What this really tells you is that their net profit margin has declined by 50%, not good.

While many would use this to criticize the company I see it as an opportunity. At the current pace of share buybacks, EPS should grow at 10% and if they improve the operating performance of the company they could grow earnings at a much faster clip.

Now this is not some pie in the sky estimate. If their expenses were comparable to say Unitedhealth (NYSE:UNH), earnings would rise by 50%. That is huge opportunity and no revenue growth is required.

Next some of the headwinds facing the company should shortly become tailwinds. First enrollment should begin to rise as the economy improves and companies add to their payrolls. The high unemployment rate over the past several years has hurt the company.

Lastly, the recent regulatory changes (due to Obamacare) has increased costs as company sorts out the changes. Some of these costs are here to stay but some should taper off over time.

If you add it all up you a have a company that is selling well below book value and can earn decent returns on equity. Recent headwinds should shortly turn into tailwinds and they have huge opportunities cut expenses. If the company can find a decent CEO who can get costs under control and the economy picks up a little, watch out, this stock is going to double in very short order.


POSCO (NYSE - PKX (ADR), $82.15)

I’m getting tired so this one is going to be short and sweet.   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.

Good luck and may 2013 be as profitable as 2012.


Best Regards,

Kevin Graham


Disclosure:  I own BAC class A warrants & BRK.b.

Tuesday, January 1, 2013

Top Investments for 2013

2012 Year in Review

Well 2012 was a fairly strong year for negative news yet surprisingly the markets were strong.  If this year taught me anything it was to avoid the headline news and just buy cheap stocks.  There was negative news regarding Europe most of the year and China has been a major drag on commodities. Interestingly enough, despite the negativity, the S&P 500 was up just over 13% and the Dow Jones Industrial Average was up just over 7% for the year. Here in Canada the TSX Composite index was up 2% for the year.  

So how did this compare to the stock recommended for 2012?  On average, they strongly outperformed the broader markets.  Due to my overweight in financials (stated at the beginning of 2012) contributed to very strong returns in my personal portfolio. 


Company  Ticker Return Return (w/Div)
Bank of America BAC 109% 110%
Goldman Sachs GS 41% 43%
First Niagara Financial Group FNFG -8% -4%
Sears Canada SCC -4% 6%
Speedway Motorsports TRK 16% 20%
Average Gain 31% 35%

Here is the graphical performance (click on image to see it better).



Now these five stocks soundly trounced the market as a whole.  It doesn't surprise me that the financials led the way with BAC powering ahead.  It was so cheap at the beginning of 2012 it was like shooting fish in a barrel.  Goldman Sachs performed much as expected but surprisingly it is still very cheap on a Net working capital basis (current assets less all liabilities including long term debt and preferred stock). 

I found the First Niagara results quite interesting but not overly surprising.  I find it amazing how many stocks sell on a price to earnings (P/E) basis while the underlying earnings capability is much higher.  For First Niagara, it's earnings are masked by large integration costs due to acquisition of the HSBC assets earlier in the year.  This reduced HSBC's profitability by 135 million in 2012.  I still consider FNFG to be cheap. 

Sears Canada's result was also interesting.  It was up strongly early in the year but ended flat.  They did pay a special $1/share dividend from it's cash hoard, so the return was still satisfactory. 

Speedway Motorsports benefited from the improvement in the economy.  This trend should benefit the company in 2013 as well.

Top Investments for 2013

Bank of America (NYSE – BAC, $11.61)

Berkshire Hathaway (NYSE - BRK.b, $89.70)

Sony Corporation (NYSE - SNE (ADR), $11.20)

Wellpoint (NYSE - WLP, $60.92)

POSCO (NYSE - PKX (ADR), $82.15)

Click Here for Investment Commentary 

Safe and Very Cheap (New Category)

Wells Fargo (NYSE –WFC, $34.18) & Microsoft (NYSE - MSFT, $26.71)

Wells Fargo was in the Safe and Cheap last year and it stays there again for this year.  I also decided to add MSFT this year because of the recent price decline.  To me the recent price decline make the investment even more safer.  As a shareholder I am very thankful that the shares are low and I hope they stay there.  Why you might ask?  So they can repurchase more shares at a cheaper price. 

Warren Buffett explained this well in his 2011 letter to shareholders.  While discussing his investment in IBM & share buybacks this is what he had to say. 

"...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.   

Some Honorable Mentions – Research in Motion (TSE - RIM, $11.80), Hewlett Packard (NYSE - HPQ, $14.25), Teva Pharmaceuticals (NYSE - TEVA (ADR), $37.34), Prudential Financial (NYSE - PRU, $53.33), Arkansas Best (NASDAQ - ABFS, $9.55) & a small Canadian energy company which I cannot disclose at this time (but perhaps in the near future)

Again for these stocks you will have to do your own homework. All I will say is that they all have wide appreciation potential but results will depend on the operating results of each company. Many of these companies have their own issues or problems that make the near future cloudy. That is why people avoid them but without uncertainty they wouldn't be cheap. Remember fear is your friend.

Cheers to another great year!


Best Regards,

Kevin

Disclosure – I own BAC Class A warrants, WFC, GS, BRK.b,  and MSFT.