Value Investing Archives - Enterprising Investor

January 20, 2023January 20, 2023

Q4 2022 Portfolio Update

Performance Overview

For Q4 2022, the multi-asset portfolio was up 8.3%, yet down 10.8% over the full year. The Q4 starting balance was $160,358.87, and finished the quarter at $181,597.13. Contributions to the portfolio during the quarter amounted to 7,083.

As for the portfolio of individual stocks, the Q4 starting balance was $77,297.12, with an ending balance of $86,299.07. Over the quarter, there were no additions of cash into this portfolio. Performance for the stock-only portfolio was up 11.7% for Q4, and down 4.5% for the year.

Two stocks were purchased this quarter: Advanced Emission Solutions (ADES), and EMCORE (EMKR). The Sprott Physical Gold Trust (PHYS) was also added to the precious metals section of the portfolio. Several deep value stocks were sold this quarter: MI Homes (MHO), Boise Cascade (BCC), Seneca Foods (SENEA), Gray Television (GTN), and Koppers Holdings (KOP). The rolling over of tail hedge put options continued.

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio consists of discretionary value stocks, oil tankers, deep value, 401k stocks, precious metals, and cash. It can be seen that 80.9% of the portfolio is in stocks, while 19.1% is in cash and safe haven assets.

Year in Review

This year has been the most difficult year to invest in since I started buying individual stocks in 2017. The year was not so bad because of the portfolio returns, I expect some down years worse than my performance this year. Instead, the year was frustrating because inflation was elevated, so I felt like I urgently needed to put cash to work, yet I was not finding many bargain priced stocks. Sure, the major stock indices and bonds were down quite a bit this year, and speculative junk crashed, but many quality stocks were unphased. This contrasts to March 2020, where the panic was creating a once in a blue moon buying opportunity.

Another point of frustration was the slow downward grind of the market. The SPY put options I buy as my tail hedging strategy do well during market panic, which by proxy is associated with a high level in the VIX volatility index. Since there was little panic in 2021, the VIX did not reach high levels. While the tail hedging paid off mightily in 2020, it was a drag on performance throughout 2022. Despite money burned through tail hedging, I still find the strategy appealing to provide some anit-fragility to the portfolio.

Returning to the topic of bargain priced stocks, even though I did not feel like there were many undervalued stocks worth purchasing, there were many stocks that appeared cheap. During the year, there were plenty of stocks trading at earnings multiples below 10, even several large companies trading below 5x earnings. The problem is that I am not too confident these stocks are actually cheap. The vast majority of the low earnings multiple stocks were cyclical/commodity based companies in industries such as mining, steel, fertilizer, basic chemicals, poultry, homebuilding, paper products, etc. These commodity stocks have had huge run up in earnings due to inflation and supply/demand being out of whack due to COVID. Looking at years prior to COVID, these companies had much lower earnings, and often had unprofitable years. To add a cherry on top, many of the commodity companies were trading at all time high stock prices during 2022.

It is possible that we are in a period of sustained inflation and a long term commodity bull market. However, I feel like this is more of a macroeconomic call than a story of undervalued businesses. Inflation could persist for years, or we have a recession this year that would crush all these cyclical commodity stocks. I have no idea, so I do not want to load up my portfolio with these types of companies (that being said, I do own a chemical company and some other cyclical companies, so I’m not completely missing the party).

To me, value investing is about finding companies where the stock price is beat up due factors such as the industry being out of favor, the business missed short term expectations but has solid future earning prospects, or perhaps some kind of scandal that will not dramatically affect the business. At a high level, valuing businesses usually takes the form of estimating the value of the assets, or a reasonable future earnings power. I think it is more prudent to look at a normalized 5 year earnings figure when determining value, than to give weight to current earnings that are several times higher than average. We shall see if my prudence works out or if I will regret not loading up on cyclical commodity businesses during 2023.

Discretionary Summary

Discretionary value is the label I’m giving to the positions that are fairly large (~5% of the portfolio) I believe are undervalued and may have the following characteristics: quality business, competitive advantage, misunderstood by the market, or a good company in a heavily sold off industry. The current discretionary value stocks I own consist of Capital One Financial (COF), Emerson Electric (EMR), Simon Property Group (SPG), British American Tobacco (BTI), Qurate Retail (QRTEA), and Warner Bros Discovery (WBD). The table below shows the cost basis, current value, and gains/losses for these positions.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
COF	63.25	3,478.75	5,112.80	46.97%
EMR	41.00	3,485.00	8,165.10	134.29%
SPG	74.50	3,427.00	5,404.08	57.69%
BTI	37.45	7,114.91	7,596.20	6.76%
QRTEA	7.60	5,700.00	1,222.00	-78.56%
WBD	24.50	4,957.00	2,085.60	-57.93%

Most of my discretionary value picks have been humming along this year without any major news. Emerson Electric did recently announce that they were selling a majority stake of their HVAC business to Blackstone. The deal values the HVAC unit at $14B and Emerson will initially receive $9.5B for their stake. The Emerson management stated they want to focus on the higher growth automation side of their business. Between this deal, and the recent AspenTech deal, Emerson is making some big capital allocation moves. I will have to spend some time reviewing my position in Emerson with these big changes happening at the company.

Qurate Retail has been my worst investing mistake so far, with the share price constantly grinding lower not long after I made my purchase. What drew me to the business was the qualitative aspect. Qurate is the holding company for QVC and HSN shopping channels, which are popular with older women. These channels provide entertainment in a way that e-commerce does not provide, with a demographic that may be more resilient to switching to online shopping. Additionally I was lured in by the siren call of Qurate’s large special dividend.

Not long after I bought Qurate, a fire destroyed one of their distribution centers. Supply chain issues also affected the company late 2021 and through 2022. For example, Qurate was unable to have the right product mix during the 2021 holiday season, lacking consumer electronics which typically drives sales during that season. Supply chain issues and management missteps seemed to have mucked up QVC’s “daily special value” segment that draws in customers.

Despite the issues within Qurate’s control, and beyond their control, I still held onto a stock that declined 80%. I should have focused more on the company’s financials and performed a more rigorous valuation of the company before my purchase. A big reason why QRTEA stock declined so much is the high debt load. A small decline in sales can crush a heavily indebted business. I typically shy away from companies with high debt unless they have a history of steady cash flow. So with Qurate, I learned a lesson that I already knew.

Warner Bros Discovery is also a sore spot in my portfolio. Originally I owned Discovery ahead of their merger with Warner Bros, which was spun out from AT&T. I believed Discovery was undervalued due to the uncertainty of the merger, and I thought the merger would provide an opportunity as a special situation. Discovery produces cheap, but popular content should pair well with the quality content from HBO and other parts of the Warner Bros library. Once the merger gets sorted out, I think WBD can be a top tier streaming service.

The problem is that the restructuring costs from the merger are high, content is expensive, and the merger occurred right during a slump in advertising revenue. WBD also has a lot of debt from the merger, but luckily it is at low interest rates and pretty distant maturities. While it is frustrating that the stock has not performed well so far, I think if they can reduce costs and put up a mediocre level of EBITDA in 2023, then the stock will be on solid ground to revert back to a market multiple.

Deep Value

Deep value is a sub-strategy I’m employing in my portfolio. This is a quantitative strategy that buys a basket of statistically cheap stocks. The metric I use is EV/EBIT, based on the wonderful book The Acquirers Multiple. Historically, this strategy has provided excellent returns, although it has not kept up with the S&P 500 the past few years. Additionally, I am making an effort to apply this strategy to microcap companies. Microcaps are classified as having a market capitalization between $50M-300M. These small companies are more volatile, but have the potential for attractive returns.

My position sizing is smaller than the discretionary side of my portfolio because I want to own a basket of about 20 stocks. Since this is a quantitative strategy, I do not spend much time analyzing these businesses. The main idea is that these companies are trading at very cheap valuations, and the winners will (hopefully) outnumber the losers.

The new additions to this part of the portfolio were EMCORE (EMKR), and Advanced Emission Systems (ADES).

	Avg Price	Cost Basis	Current Value	Current Gain/Loss
EMKR	1.00	2,003.95	1,925.00	-3.94%
WSM	115.00	5,175.00	5,171.40	-0.07%
OMC	65.86	4,610.37	5,709.90	23.85%
BASFY	11.54	4,269.80	4,555.44	6.69%
SMTC	30.00	3,000.00	2,869.00	-4.37%
USNA	58.00	2,900.00	2,660.00	-8.28%
CHTR	360.00	3,600.00	3,391.00	-5.81%
FOSL	3.50	2,975.00	3,663.50	23.14%
ADES	2.75	3,025.00	2,673.00	-11.64%
INTC	30.00	3,000.00	2,643.00	-11.90%
SIX	20.00	3,000.00	3,487.50	16.25%
HXL	36.80	1,803.20	2,883.65	59.92%

Several companies were sold this quarter due to the one year rebalancing of the portfolio. Several of these stocks were sold for a loss, so hopefully the next batch of deep value stocks perform better.

	Cost Basis	Sale Proceeds	Realized Gain/Loss
KOP	2,958.18	2,042.56	-31.0%
GTN	3,105.00	2,020.88	-34.9%
SENEA	3,000.00	3,048.52	1.6%
BCC	3,025.00	3,494.65	15.5%
MHO	2,520.00	1,720.32	-31.7%

Tanker Stocks

Oil tanker stocks performed pretty well this year. I will continue to hold them, but if they start to go against me again they will be sold off.

	Avg Price	Cost Basis	Current Value	Current Gain/Loss
DHT	8.17	1,755.90	1,909.20	8.73%
TNK	23.86	1,765.88	2,279.94	29.11%

Dividends

During the quarter I received $378.35 total in dividends, which is broken down in the table below.

Ticker	Quarterly Dividend
BTI	120.75
DHT	8.60
EMR	44.20
COF	33.00
SPG	82.80
WSM	35.10
HXL	4.90
OMC	49.00
Total	378.35

401k and Precious Metals

My 401k is through my current employer and actively receives contributions. The 401k consists of a Blackrock Target Date Fund (which is no longer being funded), and the Oakmark Fund. The Oakmark Fund is a large cap value fund. Since I am actively contributing to my 401k, it will naturally have a growing influence on my portfolio.

I also have a decent allocation to precious metals that are used as a bond substitute, recession and inflation hedge. The table below shows the YTD performance for the precious metals and 401k, which includes the effects of contributions.

	12/31/21	12/31/22	YTD Gain/Loss	YTD Cont.
Precious Metals	12,854.19	15,091.98	-0.1%	2,100.00
401k	60,578.76	70,943.77	-15.3%	20,466.14

Tail Hedging

This quarter I continued a tail hedging strategy that I have used in the past. The strategy involves buying 30% out of the money SPY put options that expire in a couple of months. Each month options are sold and a new set is bought. This quarter, the options have had a cost of $2,491 and proceeds of $1,116, resulting in a net cost of $1,375. For the full year, the hedging strategy cost $8,261 with proceeds of $3,159, resulting in a net cost of $5,102.

October 20, 2022January 20, 2023

Q3 2022 Portfolio Update

Performance Overview

For Q3 2022, the multi-asset portfolio was down 5%, and down 18% YTD. The Q3 starting balance was $162,469.10, and finished the quarter at $160,358.87. Contributions to the portfolio during the quarter amounted to $6,546.

As I mentioned last quarter, I want to also report the returns of my stock picking portion of the portfolio. The Q3 starting balance was $72,164.80, with an ending balance of $77,297.12. For the return calculation, I add the proceeds from stock sales to an “internal cash” balance. Dividends received are also debited to this cash balance. Purchases of stocks are subtracted from the internal cash, unless the internal cash is depleted. This triggers a cash flow into the portfolio. Therefore the cash flow for Q3 was $10,604. Putting all of this together means the stock-only portfolio was down 6.7% for Q3, and is down 14.5% YTD.

September saw a flurry of new stock purchases: Intel (INTC), Charter Communications (CHTR), Six Flags Entertainment (SIX), Semtech Corp (SMTC), USANA Health Sciences (USNA), Fossil Group (FOSL). Stocks that were sold this quarter include Frontline (FRO), Scorpio Tankers (STNG), First Energy (FE), and Investors Title Company (ITIC). The rolling over of tail hedge put options continued.

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio consists of discretionary value stocks, oil tankers, deep value, 401k stocks, precious metals, and cash. It can be seen that 87.3% of the portfolio is in stocks, while 12.7% is in cash and safe haven assets.

During the quarter I received $401.28 total in dividends, which is broken down in the table below.

Ticker	Quarterly Dividend
FE	48.75
BTI	124.55
GTN	10.80
BCC	6.60
DHT	8.60
EMR	43.78
COF	33.00
SPG	80.5
WSM	35.10
KOP	4.70
HXL	4.90
Total	401.28

Discretionary Summary

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
COF	63.25	3,478.75	5,069.35	45.72%
EMR	41.00	3,485.00	6,223.70	78.59%
SPG	74.50	3,427.00	4,128.50	20.47%
BTI	37.45	7,114.91	6,745.00	-5.20%
QRTEA	7.60	5,700.00	1,507.50	-73.55%
WBD	24.50	4,957.00	2,530.00	-48.96%
COF	63.25	3,478.75	5,069.35	45.72%

This quarter I sold my position in First Energy. The stock has reverted to fair value now that the company is moving past its bribery scandal. I considered holding FE for the long term for its dividends, however I changed my mind. The first factor is that the company is planning large amounts of capex over the next several years, and part of that is planned to be funded by equity issuance. As a long term stockholder, I do not like to see my position diluted by issuing new stock. Secondly, I believe that utilities can pass on higher costs to users, however it is a regulated process that may take a while or not keep up with inflation. If inflation persists, then the lack of pricing power would sour the benefits of owning the stock.

	Cost Basis	Sale Proceeds	Realized Gain/Loss
FE	3,500.00	5,124.86	46.4%

Deep Value

The new additions to this part of the portfolio were Intel (INTC), Charter Communications (CHTR), Six Flags Entertainment (SIX), Semtech Corp (SMTC), USANA Health Sciences (USNA), and Fossil Group (FOSL).

	Avg Price	Cost Basis	Current Value	Current Gain/Loss
BCC	55.00	3,025.00	3,270.30	8.11%
GTN	23.00	3,105.00	1,933.20	-37.74%
HXL	36.80	1,803.20	2,534.28	40.54%
KOP	31.47	2,958.18	1,953.32	-33.97%
MHO	60.00	2,520.00	1,521.66	-39.62%
SENEA	50.00	3,000.00	3,026.40	0.88%
SMTC	30.00	3,000.00	2,941.00	-1.97%
USNA	58.00	2,900.00	2,802.50	-3.36%
CHTR	360.00	3,600.00	3,033.50	-15.74%
FOSL	3.50	2,975.00	2,907.00	-2.29%

Investors Title Company was the only company sold this quarter.

	Cost Basis	Sale Proceeds	Realized Gain/Loss
ITIC	1,974.48	1,986.56	0.6%

Tanker Stocks

The tankers are finally breaking even. I will continue to hold them, but if they start to go against me again they will be sold off.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
DHT	8.17	1,755.90	1,625.40	-7.43%
TNK	23.86	1,765.88	2,037.96	15.41%

After some progress in the share price, Scorpio and Frontline pulled back so I exited my position. In hindsight I sold too early since they have bounced back, oh well.

	Cost Basis	Sale Proceeds	Realized Gain/Loss
FRO	1,738.29	1,351.21	-22.2%
STNG	1,742.67	1,992.34	14.3%

401k and Precious Metals

	12/31/21	09/30/22	YTD Gain/Loss	YTD Contributions
Precious Metals	12,854.19	11,173.10	-13.1%	0
401k	60,578.76	60,636.83	-22.9%	16,329.14

Tail Hedging

August 10, 2022August 10, 2022

Q2 2022 Portfolio Update

Performance Overview

For Q2 2022, the portfolio was down 9.15%, and down 13.66% YTD. The Q2 starting balance was $168,049.53, and finished the quarter at $162,469.10. Contributions to the portfolio during the quarter amounted to $14,696.

This quarter I want to try something new by breaking out the results of just the individual stocks that I own. The performance of just the individual stocks will certainly have more volatility than the overall multi-asset portfolio, which can be a benefit or at times a hindrance. I may phase out of reporting my full multi-asset portfolio to just focus on the individual stocks. However, I have not made up my mind on this.

The Q2 starting balance was $76,209.80, with an ending balance of $71,930.35. For the return calculation, I am considering stocks sold during the month as negative cash flow (like a distribution), and purchasing a stock is cash flow positive (money coming in), dividends are treated as distributions as well. Therefore the net cash flow for Q2 was $6,005. Putting all of this together means the portfolio was down 13.3% for Q2, and is down 14.2% YTD.

Three new stocks were bought this quarter: Williams-Sonoma (WSM), Omnicom Group (OMC), and BASF (BASFY). I added to my position in Warner Bros Discovery by buying 50 more shares. Stocks that were sold this quarter include Quidel (QDEL), B2Gold (BTG), Madison Square Garden Entertainment (MSGE), and Biogen (BIIB). The rolling over of tail hedge put options continued.

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio consists of discretionary value stocks, oil tankers, deep value, 401k stocks, precious metals, and cash. It can be seen that 81.4% of the portfolio is in stocks, while 18.6% is in cash and safe haven assets.

During the quarter I received $486.53 total in dividends, which is broken down in the table below.

Ticker	Quarterly Dividend
FE	48.75
BTI	129.28
GTN	10.80
STNG	6.80
BCC	114.1
DHT	4.30
ITIC	5.52
EMR	43.78
COF	33.00
SPG	75.90
KOP	9.40
HXL	4.90
Total	486.53

Discretionary Summary

Discretionary value is the label I’m giving to the positions that are fairly large (~5% of the portfolio) I believe are undervalued and may have the following characteristics: quality business, competitive advantage, misunderstood by the market, or a good company in a heavily sold off industry. The current discretionary value stocks I own consist of Capital One Financial (COF), Emerson Electric (EMR), Simon Property Group (SPG), FirstEnergy (FE), British American Tobacco (BTI), Qurate Retail (QRTEA), and Warner Bros Discovery (WBD). The table below shows the cost basis, current value, and gains/losses for these positions.

During the second quarter, Discovery Inc. finalized their merger with Warner Media, forming Warner Bros Discovery. I think WBD can use the cash generated by the linear TV advertising to transition into one of the top streaming platforms.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
COF	63.25	3,478.75	5,730.45	64.73%
EMR	41	3,485.00	6,760.90	94.00%
SPG	74.5	3,427.00	4,366.32	27.41%
FE	28	3,500.00	4,798.75	37.11%
BTI	37.45	7,114.91	8,152.90	14.59%
QRTEA	7.6	5,700.00	2,152.50	(62.24%)
WBD	22.53	4,957.00	2,952.40	(40.44%)

Deep Value

The new additions to this part of the portfolio are Williams-Sonoma, Omnicom Group, and BASF.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
BCC	55.00	3,025.00	3,271.95	8.16%
GTN	23.00	3,105.00	2,280.15	(26.57%)
HXL	36.80	1,803.20	2,563.19	42.15%
ITIC	164.54	1,974.48	1,882.68	(4.65)
KOP	31.47	2,958.18	2,128.16	(28.06%)
MHO	60.00	2,520.00	1,665.72	(33.90%)
SENEA	50.00	3,000	3,332.40	11.08%
WSM	115.00	5,175.00	4,992.75	(3.52%)
OMC	65.86	4,610.37	4,452.70	(3.42%)
BASFY	11.54	4,269.80	4033	(5.55%)

Four of the deep value positions were sold this quarter due to the one year holding period. The table below summarizes the realized gains and losses. In this case, they are all losses. Obviously this is not preferred, but I do not think this batch of losers is indicative of a flawed strategy.

	Cost Basis	Sale Proceeds	Realized Gain (Loss)
BTG	2,499.00	2,379.92	(4.8%)
BIIB	2,475.00	1,937.77	(21.7%)
MSGE	2,000.00	1,698.46	(15.1%)
QDEL	2,520.00	2,414.97	(4.2%)

Tanker Stocks

The tankers have seen a recovery lately, with Scorpio Tankers finally showing a gain.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
DHT	8.17	1,755.90	1,317.95	(24.94%)
FRO	10.66	1,738.29	1,444.18	(16.92%)
STNG	26.63	1,742.67	2,346.68	34.66%
TNK	23.86	1,765.88	1,304.62	(26.12%)

401k and Precious Metals

	12/31/21	06/31/22	YTD Gain (Loss)	YTD Contributions
Precious Metals	12,854.19	12,019.64	5.96%	0
401k	60,578.76	63,924.8	(19.62%)	3,696.00

Tail Hedging

This quarter I continued a tail hedging strategy that I have used in the past. The strategy involves buying 30% out of the money SPY put options that expire in a couple of months. Each month options are sold and a new set is bought. This quarter, the options have had a cost of $1,582.70, with proceeds of $891.81, leaving a net cost of $690.89.

January 18, 2022January 18, 2022

Q4 2021 Portfolio Update

Performance Overview

For Q4 2021, the portfolio was up 2.7%, and finished the year up 20.6%. The Q4 starting balance was $146,562.65, and finished the quarter at $159,295.45. Contributions to the portfolio during the quarter amount to $9,390. The starting balance of the portfolio at the start of 2021 was $111,461.88. Total contributions to the portfolio for the year was $23,590, where $17,590 of that was 401k contributions.

A few new positions were added this quarter in several of the portfolio categories. On the discretionary side, Discovery Inc. (DISCK), and Qurate Retail (QRTEA) was purchased. The Deep Value category saw the addition of Boise Cascade Company (BCC), Gray Television (GTN), Seneca Foods Corp (SENEA), Koppers Holdings (KOP). This quarter saw more rebalancing of the precious metal holdings with additional purchase of the SLV silver ETF.

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio consists of discretionary value stocks, oil tankers, deep value, 401k stocks, precious metals, and cash. It can be seen that 86.9% of the portfolio is in stocks, while 13.1% is in cash and safe haven assets.

During the quarter I received $1,397.62 total in dividends, which is broken down in the table below. The boost in dividends this quarter was due in large part to the special dividends paid by QRTEA, BCC, and ITIC. Total dividends received for the year amounted to $2,447.91.

Ticker	Quarterly Dividend
QRTEA	625.00
FE	48.75
BTI	137.13
GTN	10.80
BTG	19.04
STNG	6.80
BCC	171.60
DHT	4.30
ITIC	221.52
EMR	43.78
COF	33.00
SPG	75.90
Total	1,397.62

My Thoughts

One of the biggest financial stories this year was the meme stock phenomenon. AMC theaters and Gamestop were the two high profile meme stocks. In both cases, these companies were shorted by a few hedge funds. A group of amatuer speculators who gathered on Reddit were trying to create a short squeeze to cause large losses to the hedge funds, thereby sticking it to the man. Part of the motivation for the Reddit crowd was to inflict financial pain on firms involved with “payment for order flow”, and because they thought the hedge funds were intentionally trying to kill the meme stocks by shorting them. Also there was the promise of great riches if the Redditors did pull off the short squeeze.

The Reddit crowd had an arcane thesis on how to pull off the short squeeze, and to explain why the “mother of all squeezes” hasn’t happened yet, going on months, despite the hedge funds supposedly bleeding from the interest payments on their shorts. Support for this thesis included:

A get rich quick narrative
Complex financial terminology such as dark pools and naked short selling
Anecdotal evidence such as the Redditors control a large portion of the shares outstanding, and that the hedge funds interest payments are killing them
Logical fallacies such as ascribing the causation of a company going bankrupt due to short selling

Lucky for me, my investing strategy does not involve knowing what dark pools and naked shorting are. I basically try to buy boring, out of favor, maybe even hated stocks with the belief that eventually the market will forget why the company is out of favor. Most people would think it is no fun bragging to friends and family about owning shopping malls, HVAC equipment manufacturers, or electric utilities.

A key part of my investing philosophy is thinking in terms of years (sometimes decades) instead quarterly or long enough to make a quick buck. The power of compound interest is miraculous, however it takes years to appreciate its effects. It almost seems like it is a genetic mutation to be able to delay gratification, to be able to hold investments for the long term to let them compound. The simple recipe to do well financially is to live below your means, then invest your savings and not mess with it. Now I understand that it is easier said than done for some socio-economic cohorts, but the goal should be to make it practical for everyone to be able to save and invest. Unfortunately, we are all susceptible to get rich quick schemes. I am not too concerned about the person who throws a small amount of their money into this meme stock mania. What is more worrisome is the speculator who loses a substantial amount of their money, blames the system, and swears off the stock market…forgoing the tool of long term compounding.

Another big finance story this year was inflation. While pessimists have been calling for inflation for the past 10 years, now every day there is a news article discussing inflation. Much of the talk has been whether or not the price increases are “transitory”. I think the use of the word transitory is misleading, it implies that prices have risen, but will fall back to where they were. What economists and the Federal Reserve really mean is the rate of change in inflation is transitory, meaning the inflation rate goes from 2% to 7% back down to 2%. A large part of the inflation is due to the complex system that is our supply chains, where one bottleneck has massive ripple effects. Hopefully the supply chain works itself out soon, and luckily the fear mongers were wrong: we didn’t have any trouble getting our Christmas presents.

The other aspect of the inflation story is the labor shortages, which is a complicated topic. People can debate the pros and cons to the quickly rising wages, but what is certain is that the wage increases are not transitory. While I do not want to predict how long high inflation will persist, the point is that 2021 definitely experienced inflation.

Here is an example of the sting felt by this year’s 7% inflation print: I purchased British American Tobacco at an attractive 8% dividend yield, but real terms that is only a paltry 1% yield this year. Now think of the hurt from the people who own bonds that yield less than 1%. Luckily, BTI should have the ability to pass on price increases to its customers. Owning companies that have pricing power is one of the best ways to fight inflation.

In my strategy, I do not go out of my way to purchase investments to hedge inflation. However occasionally there is an overlap between a company that is undervalued and also has some degree of pricing power. These scenarios are a win-win. The investments in my portfolio that should navigate an inflationary environment reasonably well include British American Tobacco, Simon Property Group, oil tankers, precious metals, and potentially Capital One and First Energy.

In the past few years, Environment-Social-Governance (ESG) investing has increased in popularity. While I think businesses should be mindful of their ESG impact, I am not sure that there needs to be labels or a rating attached to companies. My impression is that many companies operate with short term thinking, like making sure next quarters earnings hit analyst projections. I would rather have companies focus on the long term, which should benefit the long term owners of that business. Perhaps I am being naive, but it would seem that a company needs to factor in all stakeholders to be successful over many decades, or else Karma would set them straight.

Another issue I have with the ESG movement is that Wall Street jumps in to create ESG funds that charge higher fees than a generic index fund. Oftentimes the holdings of the ESG fund are nearly identical to the broad index! With the rise of ESG funds, certain stocks and industries see increased buyers of their stock, while other industries are left behind. These companies left behind could present opportunities to investors. It is usually a good strategy to fish where no one else is fishing.

Discretionary Summary

Discretionary value is the label I’m giving to the positions that are fairly large (~5% of the portfolio) I believe are undervalued and may have the following characteristics: quality business, competitive advantage, misunderstood by the market, or a good company in a heavily sold off industry. The current discretionary value stocks I own consist of Capital One Financial (COF), Emerson Electric (EMR), Simon Property Group (SPG), FirstEnergy (FE), British American Tobacco (BTI), Qurate Retail (QRTEA), and Discovery Inc (DISCK). The table below shows the cost basis, current value, and gains/losses for these positions.

Emerson Electric and AspenTech Deal

The main piece of news this quarter was that Emerson announced a deal with the industrial software company AspenTech (AZPN). Emerson is providing AspenTech its industrial software subsidiaries, and $6B in order to have a 55% stake in the New AspenTech. New AspenTech will still be listed as (AZPN). After the deal, AZPN is expected to have FY 2020 revenues of $1.1B and EBITDA around $500M. The earnings of the new company will be consolidated to Emersons financials, so Emerson will directly benefit from any earnings growth the new company will experience. Usually Emerson buys entire companies, so they are mixing it up with this deal. Additionally, EMR has only been doing smaller acquisitions of late. In contrast, Emerson’s $6B outlay represents about 10% of their market cap. The deal is expected to close in the second quarter of 2022.

Discovery Inc. Purchase

The first addition to the portfolio this quarter was Discovery Inc. (DISCK). Discovery includes the cable TV station of the same name, as well as Food Network, HGTV, Animal Planet, plus others. The company has responded to declining cable viewership by introducing the Discovery+ streaming app. The bigger story is that Discovery is merging with Warner Media via a Reverse Morris Trust. Warner Media is currently a subsidiary of AT&T (T), and consists of Warner Brothers movie library and IP, HBO, and has HBO Max as a streaming option.

Warner’s movies and TV shows are big budget affairs, known for their quality. In contrast, Discovery’s main content is reality based TV shows that are cheap to make. These reality shows are nice background noise for a cable TV watcher who just wants to put on an entertaining show. Given this situation, it appears Discovery will have a tough time getting people to go out of their way to pay for their streaming content. However, Discovery’s reality based content coupled with Warner Media’s library of movies and TV shows should create a very strong package. It is possible Warner-Discovery could be in the top tier of streaming platforms in the coming years.

Despite all of this, investors seem to be quite pessimistic about Discovery, with its share price steadily decreasing ever since the merger was announced. I believe the negativity surrounding Warner-Discovery has to do with potential regulatory issues, complexity of the Reverse Morris Trust arrangement, the relatively high Debt/EBITDA the new company will have, and uncertainty in the war for streaming market share. I think the negativity is overblown, and that even if the deal did not pan out, DISCK would be undervalued. Additionally, the great capital allocator John Malone is a large shareholder of Discovery, and will be on the board of the new company. I don’t mind riding on people’s coattails…

Qurate Retail Purchase

The other large purchase this quarter is also involved in the John Malone complex of companies. This purchase was Qurate, which is a holding company that mostly consists of QVC and HSN cable TV channels. Shopping through cable TV would seem quite the melting ice cube with the trend of cord cutting and ecommerce, that is probably true. Despite these headwinds, Qurate’s sales primarily come from older women who may be slow to adapt to modern shopping. Additionally, a decent chunk of QRTEA’s sales come from “super users” who make many repeat purchases.

Even though Qurate’s bread and butter is cable TV, they are working on pivoting to the direct-to-consumer streaming model. Since the sentiment regarding Qurate is quite negative, the company trades at a price to free cash flow multiple of around 4, which is very cheap. The company’s capital allocation policy involves returning most of the cash flow back to shareholders instead of reinvesting in its low growth business. Qurate does not pay regular dividends, but pays a hefty special dividend. In my view, QRTEA will not shrink as fast as people think, and if they nail the landing with their streaming strategy then the business could be generating cash for years to come.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
COF	63.25	3,478.75	7,979.95	130.25%
EMR	41.00	3,485.00	7,902.45	126.76%
SPG	74.50	3,427.00	7,349.42	114.46%
FE	28.00	3,500.00	5,198.75	48.54%
BTI	37.45	7,114.91	7,107.90	-0.01%
QRTEA	7.60	5,700	5,700.00	0.0%
DISCK	24.50	4,165.00	3,893.00	-6.53%

Tanker Stocks

Tankers are still trading a lot lower than my purchase price. I wouldn’t be opposed to selling these stocks. In the medium term, oil tankers should recover once oil demand rebounds from the pandemic.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
DHT	8.17	1,755.90	1,115.85	-36.45%
FRO	10.66	1,738.29	1,152.41	-33.70%
STNG	26.63	1,742.67	871.08	-50.01%
TNK	23.86	1,765.88	806.60	-54.32%

Deep Value

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
BCC	55.00	3,025.00	3,916.00	29.45%
BIIB	275.00	2,475.00	3,116.43	-12.76%
BTG	5.25	2,499.00	2,003.96	-25.14%
GTN	23.00	3,105.00	2721.6	-12.35%
HXL	36.80	1,803.20	3,057.60	40.76%
ITIC	164.54	1,974.48	2,095.56	19.82%
KOP	31.47	2,958.18	2942.2	-0.54%
MHO	60.00	2,520.00	2611.56	3.63%
MSGE	95.24	2,000	1477.14	-26.14%
QDEL	120.00	2,520.00	2834.79	12.49%
SENEA	50.00	3,000	2877	-4.10%

No deep value positions were sold this quarter. Additions to this section of the portfolio include Boise Cascade Company (BCC), Gray Television (GTN), Seneca Foods Corp (SENEA), Koppers Holdings (KOP).

401k and Precious Metals

I also have a decent allocation to precious metals that are used as a bond substitute, recession and inflation hedge. This quarter, I added another 49 units of iShares Silver Trust (SLV) at a cost basis of $21.71 a unit. The table below shows the YTD performance for the precious metals and 401k, which includes the effects of contributions.

	12/31/20	12/31/21	YTD Gain (Loss)	YTD Contributions
Precious Metals	9,964.00	12,854.19	-2.91%	2,054
401k	32,252.43	60,578.76	26.96%	17,590.00

Tail Hedging

This quarter I reimplemented a tail hedging strategy that I have used in the past. The strategy involves buying 30% out of the money SPY put options that expire in a couple of months. Each month options are sold and a new set is bought. This quarter the options have had a cost of $1,652, with proceeds of $472, leaving a net cost of $1,180.

For more value investing fundamentals check out:

Q3 2021 Portfolio Update

Stock Analysis: Brown-Foreman

Book Review: Buffettology

Stock Analysis: Union Pacific

November 20, 2020December 15, 2020

Book Review: Buffettology

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Woo! My first book review. A while back, I stopped in my local used book store and saw that they had the 1999 classic: Buffettology. This book was a quick and enjoyable read, much like the Warren Buffett and the Interpretation of Financial Statements from the same authors. As a hardcore Buffett fan, most of the concepts in this book were not new for me. However, I believe this book provides an excellent foundation for new investors or those who have only participated in the speculative side of the market. While the book has a lot of good information, in this Buffettology book review I wanted to highlight my two big takeaways: thinking about stocks as a business owner and owning quality businesses.

Business Mindset

One of the key takeaways from Buffettology is that stocks are a fractional share of a business. When you own a stock, you are a partial owner of that enterprise. For example, if a company had 1 million shares outstanding, and you owned 10,000 shares, then you would own 1% of that company.

Realizing that you are a business owner when you own stock helps create a long term mindset. This is opposed to the short term, constant buying and selling commonly associated with the stock market. With a business owner mindset, would you rather own a great business that compounds at 10% a year for decades or sell a stock after six months to make a 20% profit quickly?

Another aspect of thinking of stock as owning a business is that the share price by itself is meaningless. A stock trading at $1,500 a share may be cheap, while a stock trading at $2 a share could be expensive. That is because stock prices are more than just some numbers that fluctuate on a screen. A stock price is telling you what the market currently thinks the business is worth, but that is only useful when you compare it to the profits generated by the company. The $1,500 a share company could have profits of $500 a year, while the $2 company might only generate a penny of earnings. The $2 company is not a bargain.

Since looking at giant corporations can be confusing, I like to think about this concept using a simple example. Imagine your friend is trying to sell you their ice cream stand. Probably before you even looked at the selling price, you would look at its financials. Is this ice cream stand profitable, by how much, and are the profits stable? If the ice cream stand makes $10,000 a year in profit, what would be a reasonable price to pay?

Buffettology explains that the price you pay for a business determines your rate of return. Let’s say you paid $100,000 for this ice cream stand, which would generate a 10% return. Not bad. Alternatively, if you paid $1 million for this ice cream stand because they have this new flavor that is the best thing since Rocky Road, well, you would likely earn about 1% a year. When you can see how much earnings the business has, you can determine the price you are willing to pay for that stock by determining your desired rate of return (there is more to business valuation than this, but it’s a good basic concept).

Thinking about stocks as partial ownership in a business is a key aspect of my investing philosophy. One of my favorite Buffett quotes is, “Investing is most intelligent when it is most business like.” I think for someone new to investing, or someone who trades the market in a speculative manner, Buffettology does a good job introducing investing from a business owner perspective.

Quality Companies

Now that Buffettology has laid down the foundation for how Warren Buffett thinks about stocks, the book spends some time defining what a good business is. Most businesses are mediocre, or just plain bad. Searching for quality companies is like a process of elimination. It can make your life easier because you filter out all the mediocre businesses in order to focus on researching the gems.

The book introduces the concept of “consumer monopolies”. These are businesses that have a popular brand name, patents, or secret formula. Think of companies like Coke-Cola or Nike that have products that are “must have” for some people. Another example was when newspapers existed, a city with a single newspaper had a monopoly on all newspaper ad revenue.

A thought experiment described in Buffettology used to test if a company has a consumer monopoly is to think about what it would take to create a better competitor from scratch. If you had access to billions of dollars and top managers, could you overtake Coke? Probably not.

There are many benefits to consumer monopolies that attract Buffett’s interest. These businesses are typically very profitable. Even better, these profits are consistently increasing. Poor quality businesses have erratic earnings that make it difficult to predict your rate of return. Consumer monopolies are often low tech, and often have products that are easy to make. This differs from companies that must constantly invest in R&D or build complex factories to stay competitive. Finally, consumer monopolies typically have low debt, since they’re business grows just fine without it. Low debt is a major factor I look at when analyzing companies. It’s hard for a company to go bankrupt with no debt.

Warren Buffett often talks about business having a “wide moat” to defend itself from competitors. These moats are the consumer monopolies as described in Buffettology. For my discretionary stock picks like Capital One, or Emerson Electric, I am definitely thinking about whether these are quality companies with consumer monopoly.

Conclusion

Buffettology is now my go-to book recommendation for anyone who wants to be introduced to the value investing philosophy. As a value investing nerd, I have a few nit picks such as the valuation method used, and the implications of low interest rates (the book is talking about 5-7% rates!). Towards the back of the book, there is a list of companies the authors believed are consumer monopolies. One of these days I want to go through this list to see how these consumer monopolies did 20 years after the book was published! Hope you enjoyed my Buffettology book review

For more value investing content check out:

Q3 2020 Portfolio Update

Intro to DCF Analysis Part 1

The Many Flavors of Value Investing

October 14, 2020October 24, 2020

Valuation: Intel vs TSMC vs AMD

Recently, Intel announced the delay of its 7-nanometer integrated circuit process. Affected by the news of Intel’s delay, Intel stock moderately sold off. At the same time, Intel’s competitors AMD (Advanced Micro Devices) and Taiwan Semiconductor Manufacturing (TSMC) have seen their stock prices rise sharply. Given the recent hype in technology stocks, AMD and TSMC stocks have been very hot recently. I think Intel’s sell-off has been exaggerated, while the valuations of AMD and TSMC suggest unrealistic growth. The purpose of this article is to perform a fundamental DCF analysis of Intel and compare it with the valuations of AMD and TSMC.

Background

The narrative is that Intel’s latest chips will be delayed, their rival AMD will gain the lead by selling 7nm devices. AMD does not produce its chips. Instead, AMD signed a contract to produce its circuits with Taiwan Semiconductor Manufacturing Co (TSMC), the largest IC contract manufacturer. As another twist, Intel has stated that if they need a backup plan, they will have TSMC produce some of their chips. The market is interpreting this announcement as Intel is doomed and that AMD and TSMC will grow like crazy. This is reflected in the share price of these stocks, which is shown below.

Both AMD and TSMC stock prices have gone parabolic lately. Part of this is from Intel’s news, while a lot of it is their gains are from the recent tech stock mania.

By doing a rough DCF valuation on these companies, I believe Intel is reasonably valued. As for AMD and TSMC, I believe the market is pricing in unrealistic growth. The narrative may be true, that Intel loses market share. Maybe Intel becomes the next IBM, being less relevant than its glory days. On the flip side, I believe overpaying for a stock is far riskier than scary headlines. Value investors look for times when negative news is overblown, and the stock can be bought at a discount.

Intel DCF

First, let’s estimate the value of Intel using a discounted cash flow model. Intel’s free cash flows for the last few years, plus trailing-twelve-month, are shown in the table below. I’ll use the average of these FCF figures in my model by using $15B as the input. Over the last five years, Intel has grown revenue at 7% a year. I will handicap this a bit by using a 5% growth rate for the next ten years. For the growth rate beyond year 10, I will use a value of 2%. The last input to the model is the discount rate, which I will set to 10%. These values estimate the value of Intel at $51.20 a share. Currently, Intel is trading for around $50 a share.

2017	2018	2019	TTM
10.33B	14.24B	16.93B	21.9B

Intel Free Cash Flow

Based on this analysis, Intel appears to be fairly valued. It may not be a screaming bargain, but it is trading at a reasonable business valuation. I believe the market’s narrative is exaggerating Intel’s troubles. It is quite possible that you could buy Intel, and the business produces a 10% average return. As we will see, I do not believe that is the case with AMD or TSMC.

TSMC DCF

Next, we will perform the same calculation on TSMC. The table below shows TSMC’s recent free cash flow figures. An average free cash flow value of $7.3B seems reasonable, so that will be input into the model. In the last five years, the income growth rate is 8%, so we assume that the cash flow in the next ten years can grow at this rate. The terminal growth rate and discount rate are the same as the Intel example. These DCF inputs yield an estimated value of $27.25, while TSMC currently trades around $79 a share.

2017	2018	2019	TTM
8.56B	8.41B	5.16B	5.16B

TSMC Free Cash Flow

As you can see, there is a significant discrepancy between my estimate of what TSMC’s business is worth compared to what the market thinks. Perhaps I underrated TSMC’s growth rate since the narrative is that it will gain market share on Intel. Let’s try redoing the calculation by using a 15% free cash flow growth rate instead of 8%. This produces a value of $42.80 per share. Ok, how about we try an even more optimistic growth rate of 20%. The DCF outputs a value of $59.15 per share for TSMC, still significantly below what it currently trades at.

Another technique I like using when looking at stocks is performing a reverse DCF. This is done by specifying the current cash flow, discount rate, and current stock price. Then address the growth rate instead of the business value. This can help investors understand what kind of growth the market is pricing in stocks. Through this exercise, based on TSMC’s current prices, the market estimates a ten-year growth rate of 25%.

I believe a 25% growth rate for TSMC is rather optimistic. Many companies can grow at high rates for short bursts, but it is difficult to sustain greater than 20% growth for ten years. It is possible TSMC could pull it off, but I assign a pretty low probability to this.

AMD DCF

Finally, in our Intel 3-way show off, we will calculate the value of AMD. The recent cash flows are shown below, and we can see 2017 and 2018 cash flows are negative. The 2019 FCF figure is slightly positive, and the TTM number is the highest in this series of data. To be generous, we use the round number of $600M. In this example, I will use a 7% growth rate, which is why AMD’s revenue has been growing in the last five years. With these inputs, the DCF produces a whopping $9.70 for AMD’s shares…AMD currently trades at $78.

2017	2018	2019	TTM
-101M	-129M	276M	611M

AMD Free Cash Flow

To give AMD the benefit of the doubt, let’s recalculate its value using higher growth rates. Using a 15% growth rate produces a value of $15.95, while a 20% growth rate yields $21.90 a share. Both of these are well below what AMD currently trades at.

Using the reverse DCF, we can see how much growth the market is pricing in. This technique shows that AMD would have to grow at 40% per year for ten years straight to justify its value. This growth rate is completely unrealistic. Sure, the stock price of AMD has skyrocketed lately, but the business hardly makes any money. The price of AMD makes no sense when looking at it as a business. Instead, the market is valuing AMD based on its narratives, making increased profits from AI, self-driving cars, cryptocurrency mining, and, most recently, gaining market share from Intel. These could all come true, but an investor must pay a reasonable price for growth.

Conclusion

As a value investor, I try to find situations where the market hates a stock or industry. Usually, these narratives are exaggerated, which creates opportunities. The market has also exaggerated potential growth, which has resulted in stock transactions that are much higher than actual growth rates. With this post, I tried to show that the market is pessimistic towards Intel. Still, it is trading at a decent business valuation. Intel’s competitors, however, are trading at values that imply unrealistic growth. AMD and TSMC may continue to do well in the short term, but valuations matter over the long term.

For more value investing content check out:

Q2 2020 Portfolio Update

Intro to DCF Analysis Part 1

Intro to DCF Analysis Part 2

The Many Flavors of Value Investing

September 26, 2020September 26, 2020

Intro to DCF Analysis Part 2: How to Calculate a DCF

In part 1 of this series, I introduced the discounted cash flow model and its four input variables. These variables were cash flow of the business, short term growth rate, terminal growth rate, and investors discount rate. In this post, I will show how to calculate a DCF by running the numbers on Emerson Electric (EMR). Emerson is an established business that is not rapidly growing, and is not overly cyclical. Using a DCF is more suitable for a business with these characteristics.

PV of Future Cash Flows

Performing DCF analysis consists of three parts. The first part is looking at the company’s financials to determine the values we should use to plug into the model. Next is the calculation of the present value of future cash flows from the business. This means we have a black box that produces a certain amount of cash flows far into the future. The DCF equation allows us to place a value on this stream of cash flows. The last step is to make some adjustments so that we get the value of the company on a per share basis.

Determining Cash Flow

The first step is to determine what cash flow value to use. In this example I am using EMRs free cash flow (FCF). The FCF for the last few years, plus the trailing-twelve-month figure is shown in the table. Typically I average the last few years of FCF to use as the input to the model. In this instance, let’s use $2.5B as our starting cash flow.

Choosing a Short Term Growth Rate

Next, we have to determine a reasonable growth rate. Emerson is a diversified industrial company that sells HVAC units, tools, and the InSinkErator brand. These products are going to produce a low sales growth rate. Probably increasing a few percent a year at the rate of inflation. EMR also has an industrial automation division that could have a bit higher sales growth going into the future. For this example, let’s assume EMR can grow their free cash flow at a rate of 3.5% a year.

The Terminal Growth Rate

As described in part one of this series, I discussed the difference between short term growth rate and terminal growth rate. Terminal growth rate assumes the business will decline to a steady state growth rate that is about the rate of inflation. In my DCF models, I typically use a terminal rate of 2%.

Specifying a Discount Rate

The last piece to the DCF model is the discount rate. As a refresher, the discount rate is the investors desired rate of return. This desired rate of return affects the future cash flows of the business. One dollar is worth more today than it does 10 years from now. Because of inflation and because we can invest that dollar. Mathematically, the discount rate has an interesting effect on the future cash flows. However, I’m trying to keep light on the math in this series so that can be a tale for another day. For my models, I use a discount rate of 10%. Don’t forget that a higher discount rate will mean the stock needs to trade cheaper. And a low discount rate means you could pay up for that stock (you’d be getting less of a return).

Performing the Calculation

Bringing it all together, we are now ready to do the DCF calculation. I use the calculator from Old School Value, which is a paid service, to do my DCF analysis. However, there are many online DCF calculators, or you can do it in Excel. Inputting the four variables described above, the DCF spits out a present value of EMRs future cash flows equating to $27B.

What this means is that we have a black box that is throwing out $2B in cash that is growing at a rate of 3.5% a year. If we paid $27B for this black box, we would expect a 10% return on investment. In order to arrive at a per share value of EMRs future cash flows, we need to do a few adjustments to this $27B.

Converting to Equity

The last step in showing how to calculate a DCF is to convert the DCF output into a value per share. The number that the DCF calculation produces is really the value of the entire enterprise. The enterprise is commonly made up of equity (the stockholders) and debt (bond holders). Since we are buying the stock, we need to adjust the $27B enterprise value of Emerson to reflect the equity holders’ share of the pie. To illustrate this, let’s say the enterprise was made up of 50% equity and 50% debt. It is not fair to say that the equity holders get 100% of the cash generated by the enterprise. You have to make debt interest payments, and pay off the bonds when they come due.

To arrive at the equity value, you take the enterprise value and subtract the value of the long term debt the company has. In some cases, it is applicable to also subtract capital lease. Emerson has $7B in debt, so we subtract that from the $27B. The next step is to add back the current amount of cash the company has. This means we can add $2.5B to our $20B. This resulting figure of $22.5B is the value of Emerson’s equity.

From here, we can obtain the value of EMR at a per share basis by dividing the $22.5B equity value by the amount of shares outstanding. Currently, Emerson has 600 million shares outstanding. This results in a per share value of $49.90 for Emerson’s stock.

DCF Example Summary

To summarize, if we could buy EMR stock at $49.90, and our DCF assumptions held true, we could expect a 10% average rate of return. Now that we have determined a back of the envelope value for EMR, we can check what it’s trading for in the market. When I entered my position in EMR, I paid $41 a share. Currently, Emerson is trading for about $70 a share, so you probably would expect a lower return if purchased at that price. Buying below the value calculated from the DCF provides some margin of safety in case our assumptions on Emerson’s cash flows or growth rates are wrong.

Conclusion

With this two part series on discounted cash flow analysis, I hope to provide a foundation for business valuation by showing how to calculate a DCF. Understanding that a stock is really a business that produces a stream of growing cash flows instead of a price that fluctuates is key to being a successful investor. Even though DCF valuations are not perfect, they do capture the growth of the business where a simple P/E ratio does not. Going forward, I want to occasionally highlight examples stocks are overhyped and trade at valuations that do not make sense, even if they can produce a high rate of growth.

For more value investing fundamentals check out:

What is Value Investing Anyway?

The Many Flavors of Value Investing

July 24, 2020September 8, 2020

The Many Flavors of Value Investing

One of my favorite things about value investing is that it is a broad church. A lot of people typically talk about value in generic terms, comparing value stocks to growth stocks. The reality is there are many strategies under the value investing umbrella.In this post, I’ll outline several of the main value investing strategies, give some examples, and discuss which ones I focus on.

Growth at a Reasonable Price (GARP)

GARP investors try to balance buying high growth companies while still maintaining an anchor to business fundamentals. Companies like Tesla, Beyond Meat, Uber, pot stocks, tech companies, are growing their sales at very high rates. Oftentimes, the narrative of their growth is driving the stock price to valuations that would imply unrealistic growth. Additionally many of these companies are not profitable. GARP investors would find high growth stocks that still had a profitable business trading at a reasonable price.

One of the main metrics used to find GARP stocks is the Price to Earnings Growth ratio (PEG). The PEG ratio was made popular by the famous fund manager Peter Lynch. Examples of GARP stocks are Apple (AAPL), Microsoft (MSFT), and Lowe’s (LOW). I don’t utilize this strategy in my investing since I typically focus on more modest growth, and more emphasis on being undervalued.

Quality

Warren Buffet says to “buy great companies at fair prices”, which is the definition of this value strategy. Quality stocks have strong brand names, competitive advantages, constantly growing profits, little debt, high returns on equity, low growth. These are companies like Coca-Cola (KO), Procter & Gamble (PG), and Johnson & Johnson (JNJ). It makes sense to want to invest in high quality stocks, however these companies are typically very expensive. With their predictable earnings, and often recession proof businesses, they are almost treated like bonds. ETFs such as QUAL contain these types of companies, but they appear overvalued for my liking. I would love to own a handful of quality companies at a good price. In reality, the only time you can find remotely cheap quality companies is during a market panic.

Compounders

Compounders are quality businesses with competitive advantages, good return on equity, and modest to high growth. The idea is that these companies will continue reinvesting earnings into their business in order to compound at attractive rates for 10 years or more. In many ways these are similar to GARP and quality stocks. Compounders will have high return on equity and consistently growing earnings. Finding an attractively priced compounder is an investors dream, but difficult to do so in a bull market.

This value investing strategy gets a bad rap from “Compounder Bro’s”. These investors buy companies like TransDigm (TDG), Roper Technologies (ROP), or software-as-a-service (SaaS) stocks, which are great businesses. Compounder Bro’s stereotypically over pay for these stocks, or may have over-optimistic projections of future growth. Additionally, Compounder Bro’s brag about how great their stock picks have done since these types of companies have greatly outperformed typical value stocks lately.

Traditional Value

What I consider traditional value stocks are good or decent companies that are temporarily undervalued. Reasons for their cheapness could be bad news, law suits, sector headwinds, being misunderstood, or the business is out of favor. Usually if the financial media is saying a sector or business is “dead”, then it’s time to sift through the depressed industry and find any hidden gems. These types of stocks are one of my main areas of focus. I typically look for solid businesses with low debt, then try to understand the narrative and decide if the consensus is overreacting.

In my current portfolio, Capital One, Emerson Electric, and Simon Property Group fall into this category. Emerson was simply sold off because of the dramatic March sell off. Capital One has to navigate this low rate environment, which means it’s cheap along with a bunch of other financial stocks. SPG has high quality malls in major metros which I think will do fine, while crappy malls in crappy cities will die.

Another example is in 2017, when all the headlines were saying Amazon is killing retail. Sure, Amazon will destroy companies like Sears and JC Penny who sell undifferentiated products. But retailers like Tractor Supply and Williams-Sonoma got caught up in the industry selloff. I thought these businesses were higher quality, niche retailers that would not immediately be impacted by Amazon. These companies had strong fundamentals but were selling at a discount. I bought both of these companies and sold them a year later for a 40-50% gain.

Quantitative Value

This strategy involves buying a basket of statistically cheap stocks. Out of this basket, some of the stocks will do poorly but hopefully a subset mean-revert to a typical valuation. The valuation metrics used to screen for these stocks could be price-to-book value (P/B), price-to-earnings (P/E), price-to- free cash flow (P/FCF), enterprise value over earnings before interest and tax (EV/EBIT) among others.

Buying low P/B stocks is a classic implementation, is often used in academic value investing papers, and often is used in value indices. Supposedly accounting standards don’t accurately account for book value with tech companies, or businesses with a great brand name. P/B seems to work better for financials or old economy businesses with little R&D or other intangible assets. Given these apparent limitations, I do not screen specifically for low P/B stocks.I like looking at P/FCF in general as a shortcut valuation, however I don’t screen strictly for low P/FCF stocks.

Deep Value

Deep value falls under the quantitative value strategy. The book “Deep Value” by Tobias Carlisle wonderfully discusses this strategy. I wanted to particularly highlight this strategy since I am interested in implementing it in my portfolio. This metric is also known as the acquirer’s multiple because instead of using the stocks market cap (the price), it uses enterprise value.

Enterprise value is the market cap of the equity, plus any outstanding debt, minus cash on the balance sheet. This reflects the price someone would have to pay to buy the entire business since they would have to retire the debt and could use the cash to offset the purchase price. EBIT is basically operating income, which is higher up the income statement than net income (earnings). Net income takes into account a companies interest payment on debt, but this metric factors in debt with the enterprise value.

Studies have shown that EV/EBIT is one of the most robust quantitative valuation metrics. This strategy has historically outperformed the S&P 500. Lately all quant value strategies have underperformed, with value investing in general having a hard time keeping up with the frothy market. I plan on incorporating the acquirers multiple strategy in my portfolio because of its long term track record of outperforming. Another reason I am drawn to this strategy is because it can be rare to find quality stocks at cheap valuations. Low EV/EBIT stocks can fill up my portfolio until opportunity arises.

Asset Plays

Asset plays are similar to buying low P/B stocks, but with a twist. The difference between asset plays, and simply buying cheap P/B stocks, is that the value of the company is based on a physical asset. Occasionally an investor can buy into these assets at attractive prices. If you really dig for treasure, you can find companies where the assets are under reported on the balance sheet, which creates value. An example would be a Maui Land and Pineapple (MLP), that has real estate recorded on its books at the price paid decades ago. Of course Maui real estate has greatly appreciated, but this value is not showing up in the accounting. Another example could be a timber company, or quarry, that owns natural resources. Additionally, these hard assets will probably do well during inflationary periods.

Net-Nets

This is the original value investing strategy devised by Benjamin Graham. While there are a couple of ways to implement this strategy, the most common is to buy companies that are trading below their net current asset value. Current assets are things such as cash, inventory, and accounts receivables. Current liabilities consists of short term debt coming due, and account payables. The net current asset value is arrived by subtracting the current liabilities from the current assets. When the market cap of a stock is below this figure, it is really freaking cheap. You are paying less than the cash on hand and the inventories of the business.

Warren Buffett cut his teeth on net-nets back in the 1950’s, helping him create a great early track record. The problem with net-nets is that everyone knows they are awesome, so it is very rare to find any. Right now there are only a few net-nets that may be worth buying. However, during big market selloffs, net-nets make a reappearance. Finding a handful of net-nets is something I am always on the lookout for.

Special Situations

Special situations, or “work outs” as Buffett called them back in the day, are corporate spinoffs, mergers, or emerging bankruptcies. I think this is one of the coolest value investing strategies. The unfortunately titled book “You Can Be a Stock Market Genius”, by Joel Greenblatt, explains special situations in great detail.

Occasionally companies spinoff operations into a new company in order to simplify the core business, among other reasons. Institutional investors are typically more interested in the parent company, so they indiscriminately sell off their shares of the spinoff. This selling can create tremendous value. Companies emerging from bankruptcy (not going into it like Hertz) can be dirt cheap, and ridden of their burdensome debt. These stocks, under the right circumstances, can provide great returns. I would love to invest more into special situations, however it is time consuming to research these opportunities.

Conclusion

There are probably a few variations of value investing that I missed, but the strategies outlined here are the most commonly discussed. I personally utilize a blend of value strategies. The most desired types of value stocks are probably cheap, quality stocks, and net-nets. In the meantime, I will continue searching for good companies that are misunderstood and share more reliable value investing strategies. Finally, I will use quantitative deep value to round out the portfolio.

Check out my other posts on the fundamentals of value investing:

What Is Value Investing Anyway?

Intro to Discounted Cash Flow Analysis, Part 1

July 18, 2020July 18, 2020

What is Value Investing Anyway?

So far on this blog, I’ve written about my current stock positions and have casually mentioned that I use the value investing strategy. In this post I want to define what value investing means to me. Value investing was pioneered by Benjamin Graham, who was Warren Buffett’s professor and for a short period, boss. Buffett took value investing to new levels. He built the juggernaut of Berkshire Hathaway and teaching his investing philosophy along the way. Other well known value investors include Charlie Munger, Walter Schloss, Lou Simpson, Bill Miller, Peter Lynch, Bill Nygren.

Value investing is the process of buying an undervalued asset and selling it if it becomes overvalued. This sounds like the age old “buy low sell high” mantra, which is what everyone is trying to do right?

The difference is that for a company to be undervalued, you must know what is a fair value…what the business is worth. There are many ways to value a business, which I’ll save for a different post. All valuation techniques involve some analysis of the earning power and growth of those earnings. Value investors believe each business has some intrinsic value, or a reasonable valuation, based on its earnings power. The price that a stock trades at reflects to some degree the performance and economic environment of the business. However, a large degree of a stock price is based on psychology and other market forces. This means that a stock can trade at a discount to its intrinsic value if the market is pessimistic on the company’s outlook. On the other hand, a stock can trade at a premium if the market is overly rosy on the business.

How Does Value Investing Make Money

Investing in a company at its fair value can be a reasonable proposition. The real money is made by buying below intrinsic value, and waiting for the company to appreciate back to its fair price. It may sound silly that businesses trade at a discount, then revert back to a reasonable price, but opportunities like these exist. The goal is to buy $0.50 dollars and wait for them to go back to being a dollar. This sounds simple…but it is not easy.

The Philosophy

Value investing to me is more than just another strategy like growth, momentum, trend following, technical analysis, risk parity, etc. It is a philosophy. Most people think stocks are a piece of paper that gets traded bank and forth, numbers on a screen that go up and down, a spin of the roulette wheel, some get rich quick scheme, or some amazing story of how this company is going to be the next Microsoft.

I saw the light when I read Warren Buffett’s shareholder letters. In these letters he described stocks as owning a fractional share of a business. Owning stocks means you are a business owner. Therefore you should only be buying good businesses that you understand. Businesses sell things, pay employees and incur other costs, produce a profit, reinvest those profits back into the business to grow, pay out some profits to the business owners (stockholders). Value investing is estimating what this business is worth, and opportunistically buying it when the market does not agree with you.

A write up of my Q2 2020 results can be found here

Check out my summary of my March Stock purchases

May 6, 2020June 6, 2020

Investing in Oil Tanker Stocks

Weird things are happening in the economy now amidst this COVID19 crisis. Stocks sold off sharply, then largely recovered. Unemployment is rocketing higher and the oil market is in shambles. The chaos in the oil market appears to be offering an interesting opportunity. The oil tanker thesis has been floating around Financial Twitter, and appeared on Real Vision. This trade seemed interesting, but out of my comfort zone. I decided to investigate the opportunities from investing in oil tanker stocks, and share my findings in this post.

Current Oil Conditions

While I am by no means an expert in the oil market, there are a few interesting things going on that create this oil tanker trade. Right now there is an extreme imbalance between supply and demand in oil. Below is a chart from EIA showing global oil production and consumption. From the chart, it can be seen demand for crude has had a very sudden drop with the onset of the COVID19 crisis, where most economies around the world are shutting down or limiting travel. This type of sudden decrease in demand is unheard of.

With this drop in oil demand, you would think that producers would massively cut their production? Wrong, at the start of this pandemic, Saudia Arabia and Russia had a spat, and decided to go full steam ahead producing oil. To make matters worse, it is not trivial to reduce oil production, it is a slow process. The EIA data suggests there is an estimated 10 million barrel a day surplus of oil.

The oversupply in oil has created a bizarre reaction in the futures market. We recently saw the front month crude futures price go negative. The simple explanation of this is that there is so much oil that producers are paying people to take the crude from them because they are running out places to store it. Further out on the futures curve, the price slopes up, which is a scenario called contango. Contango means you can buy oil cheap now (or free?), store it, and sell it at a future date for a profit. Profiting from storing oil is where oil tanker stocks come in.

The Storage Problem

The massive oil glut creates a new problem: where does all this oil go? Data from the EIA states that there is about 650 million barrels of land storage in the US, with 1.2B barrels of storage globally. Below is a chart from EIA data showing the capacity utilization of US crude storage, where it can be seen storage 61% full at the latest data point.

With land storage rapidly filling up, and contango in the futures market, a scenario is created where oil tankers are being used for floating storage. As tankers are being utilized as storage, instead of transporting oil, the supply tankers available to transport crude decreases. This causes the price tanker companies charge to transport oil (called spot rate) rate to increase. Typical spot rates in 2019 were about $15,000 per day. Recently tanker companies have been charging over $200,000 a day to transport oil. Rates these high have been seen a few times in the past, but for very brief periods of time.

How Long Will the Rates Last?

It is difficult to predict how long these extremely elevated rates last. While $200k spot rates may not last for weeks or months, it seems very likely that rates will continue to surpass 2019 rates for some time. Even more difficult to predict is what magnitude these temporary increases in tanker rates factor into the full year earnings for these companies.

I believe the consensus among investors is that tanker rates settle back down to normal levels once oil production is cut, or demand rebounds. The counter to this argument is that oil producers can not flip a switch and cease production (why not). On the demand side, I’m not convinced global economies are going to immediately rebound from the COVID19 shutdowns. Basically everyone thinks oil production cuts will be swift, and we will have a V-shaped recovery in the economy. In my view, the mismatch of oil supply and demand will persist, although slowly improve throughout most of 2020.

Tankers: An Example of Operating Leverage

Now that I’ve covered the background information, let’s analyze the tanker business. Oil tanker companies are characteristically capital intensive because in order to expand, you must acquire more ships. The ships are purchased with debt, so tanker companies have high debt loads and interest expenses. Finally, tankers have high operating leverage, which can be beneficial but also pose a vulnerability.

A business with high operating leverage has a large amount of fixed costs, such as employee wages, fuel, ship maintenance, and insurance. These costs do not change much year to year. The leverage comes in when the business experiences higher revenues, while maintaining about the same operating expenses. This causes the operating income of the business to massively increase.

Oil Tanker Financial Analysis

Let’s dig deeper into the financial statements to better understand the operating leverage and estimate how much profit these tanker companies can generate. The table below shows rounded figures from Scorpio Tankers last annual report. While I’m using STNG as an example, the same analysis can be done to other tanker stocks. Between 2018 and 2019, Scorpio Tankers increased its revenue by 30%. Despite this increase in sales, the main expenses were pretty consistent year over year. This means the increase in revenue went straight to operating profits, which translated into a 12x increase from the previous year.

(Thousands of dollars)	12/31/2019	12/31/2018
Vessel Revenue	704,325	585,047
Vessel Operating Costs	(294,531)	(280,460)
Voyage Expenses	(6,160)	(5,146)
Depreciation	(180,052)	(176,723)
G&A	(62,295)	(52,272)
Total operating Expenses	(574,353)	(574,505)
Operating income	129,972	10,542

A Note on TCE

Additional concepts that need to be described are revenue days and Time Charter Equivalent (TCE). Revenue days is the total time the fleet has spent generating revenue throughout the year. Scorpio Tankers has about 115 ships in their fleet that spend most of their time generating revenue, but there are some periods where they are dry docked for maintenance. Time Charter Equivalent is a way to compare revenues from time chartering vs operating in the spot market, and is an industry standard way to measure operating results. Without going into the differences between time chartering and the spot market, the important piece is that TCE is vessel revenue minus voyage expenses. Another way to put this is that the tanker spot minus voyage expenses is the TCE rate. This is important since we want to see how the high spot rates affect the operating results of the business.

Income Statement Analysis

Using the simplified income statement in the table below, the operating income can be constructed from the revenue days and TCE. We can figure out the TCE revenue for the year by multiplying revenue days (42,000) by the TCE rate (17,000) to arrive at a TCE revenue of $714M. Voyage expenses amounting to $6M are added back to get the total revenue of $720M.

Revenue Days	42,000
TCE	$17,000
TCE Revenue	$714,000,000
Voyage Expense	$6,000,000
Total Revenue	$720,000,000
Operating Expenses	$575,000,000
Operating Income	$145,000,000

By working our way up to the total revenue, now we can go down the income statement to calculate the operating income. Operating expenses mainly consist of vessel operating costs, depreciation, and G&A. These add up to $575M, which means the operating income is $145M.

Estimated 2020 TCE Rates

The above calculations are based on 2019 figures where the spot rate/TCE are in the neighborhood of $20,000 per day. By adjusting the TCE to reflect the elevated 2020 spot rates, we can recalculate the operating income. For this analysis I’ll use an estimated yearly average TCE of $40,000 per day. This number seems modest given the spot rates of $200,000 per day, but it is hard to predict how spot rates will hold through the year. I would rather be conservative on my estimates even though there is a good chance of average TCE being significantly higher than $40,000 per day.

Income Statement Analysis Round 2

An updated income statement, with the new TCE rate, is shown in the table below. Even though we increased the TCE, the revenue days, voyage expenses, and operating expenses will stay the same since they do not vary much year to year. Multiplying the new TCE by revenue days arrives at a TCE revenue of $1.68B. Subtracting voyage and operating expenses shows an operating of 1.01B, which is almost seven times greater than the 2019 example. That’s the benefit of operating leverage when it works in your favor!

Revenue Days	42,000
TCE	$40,000
TCE Revenue	$1,680,000,000
Voyage expense	$6,000,000
Total Revenue	$1,674,000,000
Operating Expenses	$575,000,000
Operating Income	$1,099,000,000

Going further down the income statement, we can estimate the net income using the $40,000 per day TCE. The main expense after operating income is the interest expense on all the ships. This amounts to about $185M. Subtracting the interest expense from the operating income equates to a net income of $920M. The current shares outstanding for Scorpio is about 49.85M, so the earnings per share is $18.45. Compare this earnings per share to the current price of around $20, which creates a price to earnings ratio of 1.08. A price to earnings ratio this low is ridiculously cheap, therefore we should expect investors to buy up the stock to reach a more reasonable P/E ratio. Additionally, the management at the tanker companies could reward shareholders with a generous special dividend or share buyback.

Interest Expense	$185,000,000
Net Income	$920,000,000
Shares Outstanding	49.85M
EPS	$18.45
Current Price	~$20

The Trade

Since the high spot rates affect all oil tanker companies, I think the best method for investing in oil tanker stocks is to buy a handful of them. The four companies I have bought are Teekay Tankers (TNK), Frontline Ltd. (FRO), DHT Holdings (DHT), and Scorpio Tankers (STNG). These companies have a variety of fleets sizes, and composition of the fleet. Ships ranging from the largest VLCC to medium sized Suzemax tankers are represented. Since this is an industry play, where each stock should benefit equally from the higher rates, I am not looking to do in depth valuations on each business. Each one of these stocks I have allocated about $1750, which combined makes up about 8% of my portfolio.

Lack of Price Movement

While the spot rates have been elevated for over a month, and this trade has become somewhat popular on FinTwit, the stock prices for tankers have yet to respond. One reason for the lack of price movement is that oil tanker companies are mediocre, cyclical, capital intensive businesses, which means they have booms and busts. Furthermore, tanker companies are notorious for being poor stewards of shareholder capital. These factors have turned off many people from buying into these companies.

My other theory for the lack of price action is that a lot of people are watching from the sidelines, waiting for the latest quarterly earnings to come out in order to validate that these companies are raking in some cash. All four of the tanker companies I own announce Q1 earnings in May, so hopefully the catalyst will begin soon.

Plan Going Forward

My game plan is to see if these stocks readjust to a normal P/E ratio after the Q1 earnings are released. From there, I will assess the likelihood of the high earnings persisting through the year. I am not interested in holding these stocks for a long period of time, and I do not want to try to perfectly time the top of this trade. It is possible that I’ll hold these companies for a couple of quarters, but if they significantly run up during Q1 earnings then I may quit while I’m ahead.

Besides seeing what these companies are earning with these elevated spot rates, there are some other factors that I’m considering with regards to the timeline of this trade. The crude storage capacity is the key driver to this thesis, so I will be watching for drawdowns on capacity utilization. The cause of these drawdowns would stem from the supply and demand imbalance to normalize. Finally, as the country opens back up, it is possible the consumption of oil will return closer to normal.

Conclusion

Hopefully this post provides a sufficient overview of investing in oil tanker stocks, with simplified analysis of the current situation in the oil tanker industry. While trades like this are out of my comfort zone, I feel supported by the fact that the high spot rates are public knowledge, and the high profitability of these companies is not caught up in hope and dreams. However, this position could prove to be a lesson in sticking with my circle of competence, we shall see!

You can check out my latest stock buys here.