Saturday, January 4, 2014

2014 Investment Commentary


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

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

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

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

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

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

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

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

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

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

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

NAV10-BT 1P = $9.26/share

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Citigroup (NYSE – C, $52.11)

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

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

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

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

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

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

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

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

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

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

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

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

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

PKX is a solid long term holding. 

Good luck in 2014!

Best Regards,

Kevin Graham

Disclosure - Long EZPW & BAC class A warrants. 

Wednesday, January 1, 2014

Top Investments for 2014

2013 Year in Review

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

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

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

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

Nat Gas

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

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

2013 Stock Recommendations

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

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

Here is the graphical performance.

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

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

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

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

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

2013 Other Recommendations

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

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

Top Investments for 2014

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


Lightstream Resources (TSE - LTS,  $5.88)

Bank of America (NYSE – BAC, $15.57)

Citigroup (NYSE – C, $52.11)

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

For Investment Commentary Click Here

Safe and Very Cheap

IBM (NYSE – IBM, $187.57)

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

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

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

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

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

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

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

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

Cheers to another great year!

Best Regards,


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