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.


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.


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.

1 comment:

  1. I like most of these picks. Sony I am not so sure about, they have been floundering for many years and hired a british (I think) CEO way back. He was supposed to be the outsider that would save the company but it never happened. I guess I am just dubious having casually watched it for years that this will be the year it turns around. Nevertheless there is good risk/reward with sony and I wish you well.

    I am long Wellpoint as well, I would just add that Amerigroup is not entirely negative. The medicaid is seen as a positive due to it's high growth rates with Obamacare. Given that they already have the infrastructure there should be good money to be made as you have higher utilization in a given area allowing improved efficiencies to partially offset the lower rates. There are also potential advantages in lower SG&A levels for the combined company. As far as cost-cutting and efficiencies in general they definitely lag behind but if you look at their numbers they have been taking steps over the past few years to trim costs and you will note that SG&A has slowly but steadily been improving.

    Best of luck to you, have a good 2013.