Heading East....Way East

I'll be heading to China today for 2 weeks on an important personal trip. You can follow our travels here if you're interested. In the meantime, with markets at close to all time highs, I won't be watching the daily ups and downs very closely from Xian, Shaanxi, PRC. I'm waiting for lower prices to add new money to the markets. I have added a little to BAC over the past 2 weeks, but overall, I'm a net seller (raising cash). However, on this trip, I'll pay close attention to what's happening in China. There is a lot of talk of a hard landing ( in an economic sense, and hopefully not my B-777's landing in Peking ) in China. I hope to visit some condo developer sales offices, as I did on my last trip, to get a sense of the status of the "property bubble". You will be the first to know.

U.S. Banks Improving

Despite all of the negative news on the U.S. banks over the past year, they continue to post good numbers.
This past week J.P Morgan (JPM) and Wells Fargo (WFC) both reported quarterly results. While I don't take quarterly results too seriously, it's always a good read to see what's happening in the business and it's industry. I'll focus on WFC since it's a portfolio holding. WFC reported a record quarter, with net income totalling $4.2 billion, on $21.6 billion in revenue. That's a 14% and 20% jump, respectively, from the previous quarter (annualized #'s). Wells is firmly back in growth mode. I won't bore you with all the nitty gritty of the numbers, but the key take-aways are:

        * improved revenue and income growth, thanks to Wachovia subsidiary taking market share
        * improved quality of loan portfolio, net charge-offs fell to 1.25% from 1.73% a year ago
        * improved tier 1 capital to 7.81 ( a measure of health for banks, under new Basel III rules )
        * BIG dividend raise (83%) to $0.22/share/quarter. $0.88/share/year. Now yielding >2.5%
        * continued reserve releases ( money set aside to cover bad loans-released back into earnings)

With this solid performance, combined with management's comfortable outlook, it's clear the U.S. economy is getting better - not worse. While WFC is not the cheapest bank out there, it is arguably one of the best. Wells deserves a premium, which will happen over time. WFC is good value at <$30. As I have noted before, the market has come quite far since the lows of last fall and is in need of a breather. It's a good time to have cash ready to deploy at lower prices - which may come sooner than you think.

In case you are wondering, here's a ranking of "cheapness" of the banks in my portfolio. The higher the rank - the cheaper the company - the more bang for your buck.

      1st place -  Bank of America
      2nd place - Citigroup
      3rd place - Wells Fargo

You'll notice that there are no Canadian banks listed. The "big 6"  banks in Canada are fine institutions, but they are not cheap.

 

The Bond Market Knows Best

There's an old saying in the markets that the bond market "knows" more and has more wisdom then the stock market. Well, something amazing occurred this week in the bond market - a run in bond yields. Say what? If you have a hobby more exciting than mine - than you might find this as boring as watching paint dry. But here we go... The yield on the U.S. 10 year Treasury Note ( 10yr Bond ) jumped over 15% from around 2.00% to 2.30% (so bond prices fell).  While that might not seem like much, in the big/deep world of bonds (32 trillion worth, in the US alone), that's a big move. It's clear that bond investors are finally anticipating growth ( and inflation ) and don't want to hold longer dated bonds. It's unclear whether this is the end of the 30 bond bull market, but I think it might be.

So what does this means for a bottom-up stock picker? Well, it means three things:
1) the bond market is telling us that the world is not coming to an end - the economy is getting better and inflation in coming. Inflation doesn't always have to be bad - owning stocks can protect you from inflation.
2) the bottom might be in on depressed life insurance stocks. You'll see in the chart below how the insurers (the chart shows Manulife, Sunlife and Great-West Life)  ran-up this week, as much as 15%, as 10 year bond yields soared. The insurers, invest the premiums you pay them in bonds, so they can generate income to pay-out claims and turn a profit. With yields so low over the last few years, the insurers have been suffering. With the pick-up in yields, the insurers will roll over capital into higher yielding bonds which means better earnings going forward. Just a 1% increase in yields can generate an additional $1 billion a year for Manulife. There is a positive correlation between bond yields and the stock market indices. So, markets could continue higher if yields continue higher. Yikes!!!
3) stay away from longer dated bonds. If you have to own bonds then you'll want to stay with maturities of less then 5 years - and hold them to maturity.



With all this talk of cheap insurers, I did sell some ( just a little) MFC this week. Say what??? It should be noted, that this transaction was a portfolio decision to raise some cash. It is not a call on the valuation or quality of MFC. I will continue to hold my remaining position. MFC is probably worth around $20/share.

If you are a Manulife customer - thanks for your business. If you aren't a customer - you should be become one.

Raising Cash

The market has been on quite a tear since the November 2011. The market has cycled from pessimism to optimism. While there is good reason for the markets to trade higher, like an improving economy and declining unemployment, I'll proceed with caution. Overall, the prices for most common stocks are no longer dirt cheap. Remember, the markets have more than doubled off the march 9th, 2009 bottom of 676 on the S&P500. Interest rates are at all-time low's and we (North American consumers and businesses) are still chugging (when we should be sipping)  from the low-interest-rate punch bowl. Who would of thought we'd see 5 year fixed money at 2.99%? I'm firmly in the camp that says it's time to raise rates ( I can hear the collective - gasp!!!). So I'm raising cash - selling into the strength. In the meantime, I'll continue to look for value opportunities that may arise. On that note, I have started a position in a large oil company, that's currently way out of favour (read cheap), but still has good prospects going forward, and plenty of oil/gas in the ground.

On another note, this week 19 major U.S. banks were stress tested by the Federal Reserve. I fully expect most of the super-majors ( C, BAC, WFC, USB, JPM, GS) to pass. Some, may come closer to the line that I'd like, but remember, these are tests based on hypothetical severe economic conditions. All eyes will be on BAC, as it's my largest U.S. bank holding and >10% position in my portfolios. With these tests complete, that will likely pave the way for increased dividends and share buy-backs. The uncertainty (warranted and unwarranted) around many of these banks has started to lift and their stock prices will react accordingly over time. Several of these majors are still cheap. But if your adding new money to the banks, then wait for a pull back.

 

In case you missed it: I'm long BAC, C, WFC

The Best Investor You've Never Heard Of - God Bless

One of the finest value investors in the world passed away yesterday in New York city. Walter Schloss, was surrounded by family and passed at the age of 95. If you have not read about Walter's investing style ( and superb track record ) and about the kind of person he was, then I strongly suggest that you do. My investment strategy has been heavily influenced by Schloss' investment framework over the years. He was truly a good guy of wall street. God Bless Walter.

Slowing Down The Game

To invest successfully you need an edge, some kind of advantage over the market. While this "advantage" will not guarantee results every year, it will, if effective, produce good results over a long period of time.
Value investors are often asked what their edge is. After all, value investors don't have complicated computer trading systems, don't check stock prices every minute and many (including me) don't even use a calculator or an excel spreadsheet. So what's a value investor's edge: patience, patience, patience. Value investors understand that the value of a business fluctuates much less (generally speaking, barring some major fundamental change) then it's own stock price. This idea flies directly in the face of the Efficient Market Theorists (EMT), that postulate that a stock is always perfectly priced. It's probably fair to say the markets are pretty good at pricing stocks most of the time, but not all of the time. But there is big difference between always and most.
A picture is worth a thousand words, see below:


So value investors are willing to step when a company's share price is significantly less than the intrinsic value (IV) of the company. Then, you must be willing to wait, perhaps several years, for the market to recognize the undervalued situation and re-price the shares to reflect the company's true IV. It's the waiting period that most investors can't deal with. After all we live in a short-term world, where high frequency traders (HFT), some argue, are responsible for 70% of the volume on major exchanges. A world where mutual funds are ranked daily, and therefore can't focus long-term for fear of losing assets the next guy who "was better last week". The average holding period for these HFT's is 22 seconds. Yes, 22 seconds. Their job is to provide liquidity and capture a small ( 1/3 of a cent or so ) profit with each trade. Sounds way too stressful for me - how do they take a nap? The other one third of the market holds stocks for an average of only 7 months. The "new" long-term for most investors is one year. Consider the following (approximate numbers, source: FT):

Decade                                      Average Holding Period

1940's                                                     7.0 years
1950's                                                     7.0 years
1960's                                                     7.0 years
1970's                                                     5.0 years
1980's                                                     <2.0 years
1990's                                                     <1.0 year
2000's                                                       7 months

Owning a stock for just a couple of months presents many problems. Firstly, you will likely never capture the closure of the gap between price and value of a company. Therefore, you won't make any money, and you'll take on a lot of risk if you didn't buy cheap. Also, this approach would require you to make dozens of correct decisions a year as your portfolio turns over many times. Your trading costs could eat up much of the profit you might make from your short-term trading activities.

So investors would benefit greatly by "slowing the game down" and allocating their hard earned capital to undervalued investments that offer little risk and significant upside, but will take some time to work out. Remember, you want to be able to sleep at night (or take nap) or take a vacation without your Blackberry to check your stock quotes. Investing is a marathon not a sprint.

This discussion reminds me of  a couple of my favorite Warren Buffett quotes:

" lethargy, bordering on sloth, should be the cornerstone of any investment style"
" I'd be a bum on the street with a tin cup, if the markets were efficient all of the time"

Just in case you are wondering, my average holding period is approximately 4 years, with my largest and longest holding at 9 years. My trading cost for 2011 amounted to 0.17% of the value of all portfolios. I don't get a Christmas card from my broker.

Andre

Approaching Intrinsic Value (IV)

I have recently reduced my position in Ensco PLC (ESV) by another one third @ $55.15.  Ensco continues to perform well, but is now close to being fully priced. My conservative estimate of ESV is around $60/share ( the intrinsic value of a company is moving target and can't be calculated with precision ) and I generally like to start selling as the price reaches 90% of IV. I'll continue to hold the last 1/3 of my position for now and monitor the Pride International merger and adjust IV accordingly. Also of interest, day rates for rigs are rising and that may explain the recent run for the drillers. We'll see if that lasts....

My initial purchase of ESV was @ $38.20 in 2010.