Investment Themes

Investment themes, a way to make money in the market. Not a market timer’s methodology, but a valuation methodology. The current market has foxed many, here is one example, from a “professional money manager”;

Theme-less
by The Fly on May 2nd, 2008 at 3:50 pm

I’m sure “The Fly” is making most of you scratch your heads, thinking “what the fuck is this asshole doing”?

One day I hate stocks, the next they’re grrrreat!

Frankly, I am running, without reason. Currently, I am theme-less. I’m just walking around the forest of fucktards, with rifle in hand, picking off game.

Right now, I am long (NILE: 46.16 +2.17%), (WB: 29.62 -1.53%), (LAZ: 37.11 +4.65%), (FMCN: 39.69 -3.74%), (CTRP: 65.00 -2.72%), (NVDA: 22.23 -1.33%), (HD: 29.1019 -0.61%), (JOE: 41.0999 -1.67%), (RIG: 158.174 +0.21%), while having short exposure in (SMN: 30.524 +0.17%), (SRS: 82.90 +1.91%), (SKF: 96.01 +2.15%), (FXP: 64.72 +8.41%), (POT: 201.73 +1.52%) and (LEH: 45.81 -1.08%).

By the way, “The Fly” is Master and Commander of the putrid shares of LEH, just like (HANS: 35.90 +1.61%).

Basically, I don’t have the slightest clue, regarding the near term direction of the market. I’m just trying to be in as many plays as possible, taking gains where I can.

I’ll be utilizing my “time machine” this weekend, in order to get a better feel for the near term direction of this God forsaken market.

I highlight this individual for a couple of reasons. The first is that the “Fly” is anonymous, no-one knows who he is, save as a presence on the internet.

The second reason, is that this individual personified the “Theme investing” style. I followed various themes from his blog on a valuation basis, BWLD [fat people] MVIS [innovative tech] and a few others that escape the memory currently.

As can be ascertained from the quote, “Fly” has either lost, or given up his niche in the market. So, a post on themes.

When credit creation is the rule, and it has been for almost 100yrs now, money will flow to a sector, eventually in excess creating first a bull market, and then, eventually, a bubble.

This rule, by the Law of Opposites, dictates that other sectors will be deprived, relatively, and then absolutely, of new money flowing in, possibly exacerbated by money flowing out, creating a bear market.

Thus, we can state: When the investment community is fascinated by a major investment theme, outstanding opportunities are developing, or are already available elsewhere.

Currently, commodities of all shapes and colours are the investment theme, steel, fertlizer, grains, coffee, and cooling somewhat…Gold/Silver and other precious metals

Second, the timing thereof, will always be fraught with difficulty. The keys to successful theme investing are valuation, total returns and patience.

Here, from the flyonwallst blog site from November 2007, was my post regarding a theme. You will also note the inclusion of said security within the portfolio. I am going to purposely contradict myself, as currency, is almost impossible to value, save on one metric alone, Interest rates, so here is the article;

OPPORTUNITY
The US market and emerging markets are ranging from marginally overvalued with catalysts to the downside, to, grossly overvalued speculative time bombs.

I now offer you a quote from Horace and “Ars Poetica”, for those of you who possibly visited my blog, you will remember it;

“Multa renascentur quae iam cecidere cadentque quae nunc sunt in honore”

The moral being that bull markets invariably create bear markets, and that eventually, the bull markets revert to bear markets, while bear markets grow to bulls.

True bear markets offer very low risk entry points with huge potential upside reward potential. True bear markets are reviled by investors as they have underperformed for long periods of time, frequently teasing with cyclical bull rallies in a secular bear trend.

I have emphasized, at least for those paying attention the importance of a catalyst within investment decisions. This is not an area that I have particularly emphasized within my own investments or trading. It is however an attribute that has been on prominent display on this blog for those who were attentive.

The catalyst in this particular opportunity is particularly important as the quantitative valuation is pretty much useless. The numbers themselves provide only the merest hint and they are difficult in any case.

Thus, we are left with an almost pure qualitative play.

Japanese Yen

Japan has been in a deflationary spiral for some 20yrs now. The stock market, the real estate market, the currency have all been in a secular downtrend.

Why now?

A number of qualitative factors and one quantitative factor; I shall dispense with the quantitative factor first.

Japanese interest rates are slowly working their way upwards, from 0.25% to 0.5% currently, with further rises planned. Higher interest rates will strengthen, in time the currency.

Let’s now move to the qualitative factors; interest rates around the rest of the world have been slowly rising, faster in New Zealand, Iceland and Australia. As the world economy slows, so these rate rises will slow, freeze, or start to reverse.

Bankruptcy proceedings, both business and consumer are accelerating here in New Zealand. As the US economy slows, so the exponential growth in China will start to slow. The Chinese economy is addicted to export led growth, internal consumption is anaemic.

Thus, a closing of the interest rate spread and thus the carry trade, successful for the last 20yrs will come under increasing pressure.

Further, overpriced assets, that find themselves correcting will also find themselves if purchased with cheap Yen, under pressure to reverse.

Real estate values have again started to rise in Tokyo and other cities. Goldman Sachs, Morgan Stanley and Citibank have been purchasing commercial property in the last couple of months, positioning themselves for the end of the great Japanese bear market.

Rising real estate prices, in time force a rise in the interest rate, which for the purpose of this trade is a good thing.

Currencies trend for very long periods of time and the potential for this trade due to the massive undervaluation engendered by the carry trade is large.

Who are you trading against?

In manias, the last people to get sucked in tend to be the amateurs, seduced by the idea that markets only ever move in one direction. That easy money can be made, that the leverage available via margin can make them very rich, very quickly.

Some time ago, possibly 2 months, an article appeared detailing the extraordinary story that Japanese housewives were dominating the Fx market, engaged in the carry trade. Thus, you are trading against the leveraged Japanese housewife.

It is easy to take an unleveraged position within the Japanese Yen via FXY an ETF that has previously been mentioned on this blog.

In summary, we have some quantitative data via interest rates and numerous qualitative underpinnings to catch a secular bull market in its infancy.

 

Adding on Monday

I shall be adding this security to the portfolio on Monday.

BUSINESS SUMMARY
Putnam High Income Securities Fund is a closed-ended balanced mutual fund launched and managed by Putnam Investment Management, LLC. The fund invests in the public equity and fixed income markets of the United States. It makes its investments in stocks of companies operating across diversified sectors. The fund seeks to invest in high yield convertible securities. For its fixed income portfolio, it looks for convertible, high yield, lower rated securities to make its investments. The fund benchmarks the performance of its portfolio against the Merrill Lynch All-Convert. Speculative Index and JP Morgan Dev. High yield Index. It was formerly known as Putnam High Income Bond Fund. Putnam High Income Securities Fund was formed on July 9, 1987 and is domiciled in the United States.

 

Macro-analysis for Natural Gas demand

I shall start the analysis by looking at the existing electric generating capacity, and from which source it is powered. This will illustrate the basic demand for the product that is supplied by our business [common stock] which in this case are the pipelines that transport Natural Gas.

Energy Source…………………………………………….. Number of Generators

Coal[1]………………………………………………………….. 1,493
Petroleum[2]……………………………………………………. 3,744
Natural Gas[3]………………………………………………….. 5,470
Other Gases[4]………………………………………………….. 105
Nuclear…………………………………………………………… 104
Hydroelectric Conventional[5]……………………………….. 3,988
Other Renewables[6] ………………………………………….1,823
Pumped Storage……………………………………………….. 150
Other[7] …………………………………………………………..47
Total …………………………………………………………..16,924

Natural Gas generators are the single largest suppliers of electricity.

Future expansion [planned future capacity in megawatts]

Energy Source….. 2007…….. 2008………. 2009…………. 2010 …………….2011
Coal[1]…………. 1,679………. 920 ………12,611……….. 6,839 ……………7,649
Petroleum[2]……. 255………. 1 835……… 50…………….. –
Natural Gas…….. 9,891…….. 12,896…… 11,050 ………..7,569…………… 4,622
Other Gases[3]….. — ………….580 ……….771………….. –……………….. 340
Nuclear…………… — ………….–………… –……………. — ………………….–
Hydroelectric…….13…………… 3…………. 1……………. –…………………. –
Other……………5,714………. 2,032……… 350………… 217………………… 56
Pumped………….–…………… — ………….–………….. –…………………. –
Other[5]………. –…………… — ………….– …………..– ………………….165
Total …………17,552……… 16,432…….. 25,617……. 14,675……………. 12,833

Again, Natural Gas is at the heart of near term future expansion. Thus we can safely imply, at least in the medium term, a demand for pipeline infrastructure.

Therefore, we can proceed to the next stage of the analysis which is an analysis of the individual business [common stock]

 

Natural Resource Partners [NRP]

Natural Resource Partners L.P. is principally engaged in the business of owning and managing coal properties in the three major coal-producing regions of the United States: Appalachia, the Illinois Basin and the Western United States. As of December 31, 2007, the Company owned or controlled approximately 2.1 billion tons of proven and probable coal reserves in 11 states. It does not operate any mines, but leases coal reserves to mine operators under long-term leases that grant the operators the right to mine its coal reserves in exchange for royalty payments. As of December 31, 2007, its coal reserves were subject to 191 leases with 66 lessees. During the year ended December 31, 2007, its lessees produced 57.2 million tons of coal from its properties. It conducts all of its operations in a single segment: the ownership and leasing of mineral properties and related transportation and processing infrastructure.

Another potential investment opportunity.

 

National Health Investors [NHI] REIT

Medical REIT’s are an area that potentially are an interesting longer term investment based on some macro-based trends.

This macro-trend [ageing population within US] is positive for medical specialist REIT’s as an increase in the ageing population provide an increased supply and demand dynamic for the medical REIT’s.

One risk associated with REIT structures is the risk of over-supply relative to demand, viz. excessive new building or development. Therefore we should initially examine macro-trends within the industry.

Hospital spending is the strongest within this sector. Medical care and Specialist spending are lower, thus are less likely on current data to move into oversupply. Thus in our search for a potential candidate, this should be a factor taken into account. The first data set differentiates the spending into sectors, the second, while not differentiating the spending, does confirm the general data.

With a favourable macro-picture, we can now look at one potential candidate;

National Health Investors, Inc. (NHI) is a real estate investment trust that invests in healthcare properties primarily in the long-term care industry. As of December 31, 2006, NHI had ownership interests in real estate, mortgage and notes receivable investments. These investments include long-term care facilities, acute care hospitals, medical office buildings, retirement centers and assisted living facilities. As of December 31, 2006, the Company had investments in 139 healthcare facilities located in 18 states consisting of 97 long-term care facilities, one acute care hospital, four medical office buildings, 14 assisted living facilities, six retirement centers and 17 residential projects for the developmentally disabled. Of these 139 facilities, 41 are leased to National HealthCare Corporation (NHC). These 41 facilities include four centers subleased to and operated by other companies, the lease payments to NHI being guaranteed by NHC

Capitalization of this common stock has improved with a larger % coming from equity, and the long term debt declining from a 5yr average of $150.7 to currently $113.5. In the current credit environment and generally, this is a positive.

Expenses have increased. This is not really what you want to see. They are reflected primarily in two areas; Cost of Goods, which would be properties purchased, increased by 15% reflecting the high real estate prices and SG&A which is management, increased by 117%.

The increase in property costs [to purchase] is unfortunate, and definitely hurts results. The huge increase in management costs I shall look into more closely.

Cashflows have remained positive, and reflect hidden value from the reported Net Profits. This understated income has been utilized to pay down long term debt. This is a major bonus as no further Equity was required to be sold. In point of fact, common stock was reduced, also from cashflows. Cashflows have weakened, but are still showing a surplus that has not filtered through to Net Income.

Cash has increased, not unimportant with the coming problems anticipated in commercial real estate and thus impacting commercial REIT’s.

CapEx is a further cost that has been absorbed by the strong cashflows. Again, this is a little added value.

Revenues have been static. This represents the inability to raise rents. Of course the major concern would be leases renegotiated at lower rents going into the future, which would seriously impact Revenues and overall profitability. Again, leases will need to be further investigated.

All other operating ratio’s are and have been consistent, thus no immediate red flags have been thrown up.

Dividends have been consistently paid, with an approximate 6% compounded increase. Currently the dividend seems secure. This of course is the major concern. Should a serious recession strike this [healthcare] sector, can Revenues be maintained high enough to preserve at current levels the dividend? That there are some hidden cashflows that provide some cushion is positive, but, not conclusive.

Valuation: Currently, overvalued. I have an intrinsic value range from $16.50-$22.39 and with a current price circa $30, we would be paying a premium. However, current Yield is circa 7% this is not an insubstantial factor if as mentioned, this dividend is relatively secure.

NHI Increases Dividend to 55 Cents
February 5, 2008 4:31

National Health Investors, Inc., NHI announced today that it will pay a first quarter dividend of 55 cents per common share to shareholders of record on March 31, 2008 and payable on May 9, 2008. This is an increase of five cents, or 10% over last quarter’s dividend.

This 55 cent dividend reflects the company’s continued success in managing its portfolio and confidence in its future cash flow.

NHI specializes in the financing of health care real estate by purchase and leaseback and first mortgage transactions.

The long term debt is at variable rates of interest. Thus swings in the interest rate will effect a swing in cashflows due to interest paid. Thus the paying down of debt reduces the gains/losses to this variable.

The largest customer [NHC] who lease 41 properties, reached agreement to extend the leases through 2021

Increased diversification through customer base; this is important as when this REIT was started in 1991, NHC was the sole customer and constituted 100%. Currently NHC constitutes 14.1% of the portfolio.

Hidden value. When the assets were purchased [transferred via non-taxable exchange] the properties were valued at net depreciation book value, after 20+yrs of depreciation. Thus the actual values [land] will have appreciated at 4% compounded to provide increased [undervalued] assets.
No figures were provided, so feel free to speculate a little and add your own figures.

In summary, this REIT provides potential for conservative investment returns based on three main factors;

*Initial purchase price is reasonable
*Provides high dividend yield that is both secure and likely to grow
*Provides opportunity for capital growth over a period of time

Therefore, investors who are interested by income producing investments, should take a close look at this candidate.

 

The Dividend advantage

The following table makes a compelling case for including solid dividend paying stocks within your investment portfolio. This is especially true in an inflationary environment.

Does a high dividend yield translate on average to high total return? In the February 2008 version of their paper entitled “Dividend Yield Strategy in the British Stock Market: 1994-2007″, Janusz Brzeszczynski, Kathryn Archibald, Jerzy Gajdka and Joanna Brzeszczynska examine the recent performance of an equally-weighted portfolio of UK stocks with the highest dividend yields. Using total dividend-reinvested return data for portfolios of the Top Ten highest dividend yield stocks in the FTSE 100, reformed annually on the first trading day in March, and for the index itself over the period 1994-2007 (13 years), they conclude that:

The average annual return of the Top Ten portfolios over the entire sample period is more than four times higher than that of the market index, significant both statistically and economically (considering transaction costs, taxes and risk).

The arithmetic mean annual return for the Top Ten portfolios (FTSE 100 index) is 15.7% (6.3%).

The geometric mean annual return for the Top Ten portfolios (FTSE 100 index), compounded monthly, is 13.5% (5.8%).

The standard deviation of returns for the Top Ten portfolios (FTSE 100 index) is 28.7% (17.2%).

Commonly used risk adjustments ((Sharpe ratio, Treynor ratio and Jensen’s alpha) also indicate that the high-yield portfolios have mostly outperformed the broad market.
The Top Ten portfolios outperform the FTSE 100 index in seven of 13 years and seven of nine five-year subperiods within the overall sample period (see the table below).
The following table, extracted from the paper, compares the returns by year and the compound annual return during five-year subperiods for the Top Ten highest dividend portfolios and the FTSE 100 index over the entire sample period of 1994-2007. As noted, the Top Ten portfolios beat the index in seven of 13 years and seven of nine five-year subperiods. Over the entire sample period, the compound annual return of the Top Ten portfolios (FTSE 100 index) is 28.2% (6.7%).

 

Thesis behind PIV purchase

PIV is an ETF that tracks the analytical model behind the Value Line methodology. Being an ETF it provides you with diversified exposure to the “Growth Stock” universe.

Growth stocks are very difficult to value accurately, and tend to have the need to be actively managed, thus having the Value Line analysts do this for you, and rebalance the portfolio seems an easy and lower risk way to access the Growth stock universe.

This chart details their track record;

 

PNW potential investment candidate.

Pinnacle West Capital Corporation (Pinnacle West) owns all of the outstanding equity securities of Arizona Public Service Company (APS), its major subsidiary. APS is an electric utility that provides either retail or wholesale electric service to most of the state of Arizona. Pinnacle WestGÇÖs other principal subsidiary is SunCor Development Company (SunCor), which is engaged in real estate development activities in the western United States. Pinnacle West has two principal business segments: the regulated electricity segment (accounting for 83% of operating revenues during the year ended December 31, 2007), which consists of traditional regulated retail and wholesale electricity businesses (primarily electric service to Native Load customers) and related activities and includes electricity generation, transmission and distribution, and the real estate segment (accounting for 6% of operating revenues in 2007), which consists of SunCorGÇÖs real estate development and investment activities.

I’ll be starting an overall analysis over the weekend and running through next week.

 

Some Market valuations

I haven’t done a valuation for a little while on the market, so lets take a look at how we compare in January 2008 to previous market lows. All are January numbers.

Year……………………………1982……………2003……………..2008
Index value……………………117.30…………895.84…………..1378.76
Dividends……………………..$6.66…………..$16.12…………..$27.77
Earnings………………………$15.18…………$28.50…………..$70.98
Dividend Yield………………..5.68%………….1.80%……………2.01%
Price/Earnings………………..7.73……………31.43……………19.42

Inflation rate…………………3.90%………….2.53%……………6.11%
Earnings on capital………….12.9%………….3.1%……………..5.15%
10yr Bond Yield………………14.59%………..4.05%……………3.52%
Dividend/Bond ratio…………..0.38……………0.44……………..0.57
Earnings/Bond ratio………….0.88……………0.76………………1.46

Obviously, in isolation, the figures have little context. The trend in inflation and interest rates are key pieces of information that would be required to make a more informed judgement.

In 1982, inflation was trending down, interest rates were at near all-time highs, thus, stocks represented a lifetime buying opportunity based on previous P/E levels. Earnings were coming out of a recessionary period, thus were set to rise.

In 2003, interest rates had fallen, and actually fell a little further. This artificially boosted the market. Earnings were again at cyclical lows, from the recessionary period. Valuations were far from bargains, yet, the market rose.

2008, earnings are falling from cyclical highs, inflation is trending up from cyclical lows, interest rates had to be dropped precipitiously to save the Banking system. Valuations are not low, yet, they are lower than in 2003.

Will inflation, eventually force a rise in interest rates? I think yes, after the Banks are salvaged once again, which now looks probable. Interest rates will again, be raised gradually.

I’m interested in buying the market via an ETF [SPY] if and when valuations become compelling. They are nowhere near compelling currently.

 

Letter from Annual Report, Berkshire Hathaway.

1. When you know you’re the best, you can afford to tell it like it is. Buffett says: “Our insurance business had an excellent year… that party is over. It’s a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. So be prepared for lower insurance earnings during the next few years.”

2. Only four things really count when making an investment (or buying whole companies if, like Buffett, you have $141bn to spend) - “a business you understand, favourable long-term economics, able and trustworthy management, and a sensible price tag”. That’s investment, everything else is speculation.

3. Invest this way and you don’t need to constantly look for the next “new” thing, with all the risk that necessarily entails.

Buffett’s biggest investments (companies he doesn’t own in their entirety) include American Express, Wells Fargo, Procter & Gamble and Coca-Cola.

These four businesses, he notes, were founded in 1850, 1852, 1837 and 1886 respectively. “Start-ups are not our game”.

4. Businesses are run by people and the best people are not necessarily the ones with the flashiest CVs. Buffett singles out Susan Jacques, chief executive of his jewellery retailer Borsheims. “Susan came to Borsheims 25 years ago as a $4-an-hour saleswoman. She’s smart, she loves the business and she loves her associates. That beats having an MBA degree any time.”

5. Even for a super-long-term investor like Buffett, there’s always a time to sell. Berkshire Hathaway bought 1.3pc of PetroChina in 2002 and 2003 for $488m, valuing the Chinese oil company at $37bn when Buffett thought it was probably worth $100bn.

When the China share bubble took its value to $275bn last year, way above its fundamental value, Buffett cashed in his holding for $4bn, an eightfold rise in five years.

6. Buffett believes incentivisation of managers on the basis of earnings per share encourages disingenuous, if not downright dishonest, behaviour.

Take the assumptions about future investment returns in corporate pension schemes. The average in America is 8pc, despite the fact that a quarter of pension funds are in bonds and cash (for which a 5pc return would be a reasonable expectation) and the rest in equities, which rose by just 5.3pc a year on average over the 20th century as a whole (a remarkable period of growth for the US economy).

Managers don’t really believe they’ll get 8pc, but pretending they will means they can contribute less and so boost their reported profits. “If they are wrong, the chickens won’t come home to roost until long after they retire.”

7. Between 2002 and 2007, Buffett notes, the euro appreciated from 95 cents to $1.37, yet the US’s trade deficit with Germany widened from $36bn to $45bn, the reverse of what should have happened.

As long as these imbalances continue, foreigners will continue to buy up America on the cheap. “This is our doing, not some nefarious plot by foreign governments.”

8. Buffett has not lost his eye for witty one-liners which, as usual, make his letters a joy to read. Here he quotes John Stumpf, chief executive of Wells Fargo, on the behaviour of lenders: “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.”

9. He can see the joke, but Buffett also knows that there is something profoundly wrong at the heart of corporate America.

“As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out - and what we are witnessing at some of our largest financial institutions is an ugly sight.”

10. Investors should be realists but the best are optimists too. Buffett has taken premiums worth $4.5bn from investors buying insurance from him against four major stock markets being lower in 15 to 20 years than they are today.