The Picky Investor

With No Power, Comes No Responsibility: Efficient Market’s Role in Regulation (part 1)

2010-04-20T04:44:00.000-07:00

“With no power, comes no responsibility”. The catchphrase from the movie "Kick-Ass" seems to describe the current state of financial regulation rather well. Unfortunately, the larger Conversation on financial reform has been anything but kick ass. We have a tragedy of the commons scenario where every regulator, policy maker, academic and practitioner has joined the blame game.

No. It is not their fault. After all, people merely followed what the intellectual luminaries preached, which made the Efficient Market Hypothesis (EMH) one of the “best selling” ideas of all time. By assuming that prices reflect all known information, the EMH is convenient, user-friendly, and rationalizes laziness as an appropriate policy. It is a hypothesis that can never be wrong (cannot be disproved). The Efficient Market Hypothesis had us at hello.

The EMH truly liberated the people. It guided policy makers to pursue deregulation, freed regulators from their jobs, and saved practitioners from performing in-depth analysis. With free time on everyone’s hands, creativity reigned. Complex derivatives such as CDOⁿ proliferated and the EMH encouraged the industry to adopt a “sell first, ask later” motto. Let the market figure out how to price them, says the EMH. Financial innovation quickly transcended the industry. If the EMH were a person, the Nobel Peace prize would be its to lose.

We find ourselves in a very different world today. The EMH is now being crucified as the elegant theory that caused the financial crisis. As Krugman suggests, people mistook beauty for truth and economists everywhere climbed aboard the EMH-Titanic that was destined to hit the iceberg.

However, the fault was never with the theory per se. The EMH is silent on its ability to explain bubbles and crashes, and offers no real use to policy making. No power. No responsibility.

What we need today is a more powerful theory to guide policy and put responsibility back in the hands of the regulators. We do not need more debates on the financial reform, which have done nothing but amplify confusion. Without coherence, there is no reform. And we are running out of time.

In part two of this series, I propose a Cyclical Efficient Market Hypothesis (C-EMH) that integrates viewpoints from psychology and quantitative finance to complete the EMH. The result is a model that is useful to guide policy making and regulation.

Jim Rogers makes my head hurt too

2009-10-16T02:27:00.000-07:00

Too many long posts lately. Here's a short comic relief. Professor Krugman in his usual satirical tone, absolutely nails Jim Rogers. Krugman assigned his readers a homework to explain — in English — what’s wrong with the words that are coming out of Rogers' mouth, who said, “Well, capital has already been flowing into Asian economies, as you can see by the fact that they’re the world’s biggest creditors.”

Here's my homework solution: If somebody is the world’s biggest LENDER (creditor), by definition money is flowing AWAY from that person.

Krugman 1. Rogers 0.

p.s. I've been waiting for a long time for someone to drill Jim Rogers. Thanks Paul.

Auditing the Federal Reserve is Economic Suicide

2009-08-27T20:06:00.000-07:00

Given the potentially fatal repercussions, auditing the Federal Reserve is one of the most underreported stories by the media today. Investors today should be fearful of this development. It is shocking to see three out of four Americans supporting a bill that could lead to economic catastrophe. The passing of Ron Paul’s H.R. 1207 bill may bring serious and unintended inflationary consequences that can destroy investors’ wealth.

While it may not be the intent of the lawmakers, Ron Paul’s bill, a.k.a. Federal Reserve Transparency Act, will enable the congress to influence the outcomes of monetary policy through an audit of the Federal Reserve’s day-to-day operations, thus severely compromising the independence of the U.S. central bank from political influences.

The free market understands that auditing the fed is a very dangerous line to cross. If crossed, U.S. inflation will likely skyrocket over the next decade to unseen levels. The U.S. economy will tank under a hyperinflationary environment. Bond investors lose money as interest rates rise. Stock investors earn negative real return as equity risk premium rises and aggregate PE ratio nose dives. The US Dollar erodes due to higher domestic inflation relative to foreign inflation. Gold and commodity prices rise.

How Does Auditing the Fed Cause Inflation?

Inflation is caused by a central bank that loses control of its money supply. There are two ways that a politically compromised central bank can lose control of its money supply.

Road to Inflation #1: Repeating the Political Cycle

When the central bank is not independent, politicians have historically pumped up the money supply (for temporary economic boost) shortly before an election to buy votes with lower unemployment rate. After the election, the effects wear off, returning the economy to its natural rate of unemployment but at a higher inflation rate than before. Because it is hard to fight off inflation quickly, by the time the next election rolls around the economy has not been squeezed back to its original inflation rate. Politicians pump up the money supply again, this time from a higher base inflation. As this cycle repeats itself, the central bank loses control of the money supply.

Road to Inflation #2: Financing Government Spending

A central bank that lacks independence from politicians makes it tempting for the government to finance an inappropriately large portion of its spending through printing money. A central bank that promises to finance too much government spending also loses control of the money supply.

Will the Bill Pass?

Although Obama and his economic team oppose this bill, it may not matter much. The risk of the bill passing is increasing every day. Ron Paul is using the recent economic recession as an opportunity to sway angry politicians to advance his personal agenda of ending the fed. The table below shows that government officials are embracing the Federal Reserve audit. In fact, support is so overwhelming that we are dangerously close to reaching the veto-proof status. Once reached, the President will have little say in the outcome. Deadline for voting of this bill has been set to December 2010.

In sum, auditing the Fed’s daily operations will cause it to succumb to political pressure, lose control of the money supply, and create sticky inflation that could be much worse than the 1970’s. America is an angry nation right now. When it comes time to vote on the bill, it remains to be seen if cooler heads will prevail or if America will swallow the economic suicide pill.

*Related links: Reactions from 6 economists, Bernanke, Bernanke (2), Geithner, Washington Post, and general public.

The Efficient Market, Debugged

2009-02-07T08:02:00.000-08:00

What is the link between the price discovery process and fixing software bugs? In a debugging process, one can never eliminate all the bugs*. This is because fixing a known bug can potentially create more unknown bugs, implying that there exists a point of diminishing returns where fixing more bugs will not yield any more benefits.

The stock market shares the same essential characteristics as open source software: anyone can participate. In the stock market, anyone can buy and sell securities. Likewise, any programmer can participate in an open source project. When a stock market participant discovers the “solution” to a price (i.e. fixes a bug) based on certain information that he’d gathered, he will simultaneously affect the price (i.e. creates a bug). This newly arrived at price becomes a new piece of information that acts as a signal to other traders who cause the price to change again (i.e. creates more bugs). And because not all bugs can be fixed, prices at any time cannot be correct and never will be.

How much money should one devote to “fixing bugs” in the stock market at most? The answer is: spend money up to the point of diminishing returns! This point is defined simply by the Kelly Criterion.

Where E(r) is the expected return, r_fis the risk-free rate of borrowing and lending, and s² is the variance of the expected return. Wealth is destroyed when more resources are allocated than necessary (Kelly Criterion’s f). This is exactly what caused the current boom/bust cycle of the finance industry – there was simply too much finance. The society had overspent its resources (beyond the point of diminishing returns) to making the markets more efficient. Isn’t it ironic that in the pursuit of more efficiency, we have made it more inefficient, and destroyed our own wealth?

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*In theory, it is possible for a software to be completely bug-free. However, in practice, the more complex the system, the higher than probability of a buggy system. In the same token, the efficient market hypothesis is correct in theory, but the complexity of the market system causes prices to tend toward equilibrium, but never quite get there.

Stimulating the Economy: The Great Debate

2009-01-29T23:46:00.000-08:00

The debate on the fiscal stimulus plan is all the rage these days. Prominent economists are killing each other over this topic. The arguments from the pro-stimulus camp can be found from Krugman (1), Krugman (2), Stiglitz, Mankiw, Summers, Feldstein. The anti-stimulus camp include the usual Chicago-school suspects such as Fama (1), Fama (2), Barro, Cochrane, Murphy, and Chinn (Chinn is not Chicago). You can click on the names to view their arguments.

Where do the disagreements come from? The whole thing centers around three key issues:

Is government intervention worth the costs?

Keynesians believe that an economy can become stuck in a recession when its natural recovery forces operate far too slowly, creating prolonged periods of high unemployment. They further believe that the government is able to move the economy out of a recession through fiscal policy and it should.

Chicago-school economists believe that the government has no business interfering in the economy, and that government intervention, however well-intentioned, too often makes things worse, not better.

What extent of the role should government play?

People on the left of the political spectrum – liberals, socialists, and Democrats – believe that more control by the government over resource allocation in the economy is a good thing. Those on the right – conservatives and Republicans – believe the government is an inefficient allocator of resources, and that individuals, through spending financed by tax cuts, can cause the market to produce and distribute more desirable outputs in a more efficient fashion.

How should the government finance an increase in spending?

An increase in government spending can be financed in three ways:

Raising taxes
Selling bonds to the public
Printing money (selling bonds to the central bank)

Chicago-school economists, such as Fama, essentially ignore printing money as a method of financing. As a result, stimulus plans can never work because raising taxes or selling bonds to the public lead to a phenomenon called “crowding out”, that is, financing offset the impact a stimulus plan is supposed to have on aggregate demand.

In contrast, financing by selling bonds to the central bank increases the money supply. When buying a government bond, the central bank writes a check against itself and thereby creates money out of thin air (printing money). In this case, there are no crowding-out effects. This is where Krugman thinks Fama made his mistake.

Recently, China proposed to increase government spending by a massive 4 trillion Yuan, or about 16% of GDP. This dwarfs the proposed stimulus package in the United States, a mere 5% of GDP. However, the U.S. has expanded its monetary base by 100% from last year. Clearly China favours the use of fiscal policy while the U.S. favours monetary policy. Why is it so? I will blog about this interesting phenomenon in the near future.

The above materials are based on Peter Kennedy’s Macroeconomic Essentials, a wonderful book written by my favourite university professor.

Buy Physical Oil, Not Energy Stocks

2008-12-11T11:52:00.000-08:00

Enjoying the lower gas prices lately? Well, now's the the time to fill up your tank some more because oil prices may be on its way up again. The chart on the right shows the ratio between energy stocks and crude oil prices, and in the background is oil price. Notice that high points in the ratio are associated with a bottom in oil prices. If you subscribe to the commodities supercycle theory, this may be your chance to stockpile on oil again. Looks like this is exactly what Jim Rogers is doing.

As a commodities bear, I personally do not believe this is a long-term buying opportunity for oil. There are three conditions that need to be met for me to consider commodities.

1. Currencies of commodities producing countries bottom
2. Real assets become undervalued to financial assets
3. US dollar about to enter a long-term bear market

Currently, none of the three conditions are met, which means any bounces in oil are merely bear market rallies within a long-term commodities bear market.

This is a Mid-cap Rally

2008-11-28T00:05:00.000-08:00

So is this the Santa clause/year-end/super-bear rally we've been waiting for? The S&P 500 has just gained 18% in the past five trading days. "Does it have legs," ask fund managers everywhere who are suffering from performance-anxiety attacks.

Well, we're currently in what I call a mid-cap rally, where mid-cap stocks outperform small-cap and large-cap stocks. Last time the mid-caps led the market we had a 70-day rally from March to May 2008.

Some say that the March rally had legs because it kicked off with a Lowry's 90-90 day on March 19th. However, the October rally had two 90-90 days on Oct 13th and Oct 28th; that rally turned out to be short-lived, lasting only 3 weeks. Clearly, 90-90 day was not the answer.

I recorded all the bear market rallies lasting longer than 1 day from both the 2000-2002 bear and the current bear.

Start	End	Length (days)	Leadership (overall)
10/10/2008	10/13/2008	3	Large-cap
7/23/2002	8/23/2002	31	Large-cap
2/6/2008	2/26/2008	20	Mid-cap
11/26/2007	12/10/2007	14	Mid-cap
3/10/2008	5/19/2008	70	Mid-cap
4/6/2001	5/18/2001	42	Mid-cap
10/27/2008	11/4/2008	8	Small-cap
1/22/2008	2/1/2008	10	Small-cap
7/15/2008	8/11/2008	27	Small-cap
10/17/2008	10/20/2008	3	Small-cap
12/17/2007	12/26/2007	9	Small-cap

Average large-cap bear market rally = 17 days
Average mid-cap bear market rally = 36.5 days
Average small-cap bear market rally = 11.4 days

It appears that the average mid-cap rally lasts longer than the average large-cap or small-cap rally. Does someone have an explanation for why mid-cap rallies last longer? Otherwise, it could simply be a case of curve fitting.

Canadian Stocks: A Large Decline Is Brewing

2008-06-25T14:30:00.000-07:00

There are five major divergences occurring on the Canadian TSX stock index. These conditions have led to steep declines in the past. Consider it a heads up warning. If you hold Canadian stocks, you should buy some insurance via XIU puts.

I will be posting a more detailed analysis within the next week.

U.S. Market at an Imminent Top

2008-04-29T01:41:00.000-07:00

Market Timing Signals
Short-term Signal: Sell
Long-term Strategy: Sell the rallies

All signs are pointing to an imminent market top. Sentiment indicators are as bullish as ever since the start of the bear market in October 2007. Technical indicators are also reaching extremely overbought levels. Worse yet, there are widespread disillusions among money managers -- only 10% of all managers believe the stock market is overvalued (Barron's big money poll, March 28). The biggest opportunities are created when market prices no longer reflect true fundamentals and technical signs are pointing to a reversal. Right now is the perfect opportunity to short the market.

When Did The Recession Start?

2008-03-28T23:05:00.001-07:00

Hugh Cleland made an interesting observation about recession and the stock market. He noted that the NBER start date of the recession in 1990 coincided with the top in the S&P 500. Using this relationship, he conjectured that the market top in October 2007 may be the start date of the recession.

However, data from the past 7 US recessions reveal that this relationship was not repeated in any of the other 6 recessions and therefore, is a mere coincidence. So when did the recession actually start?

Below are ECRI’s official recession calls in the past:
Feb. 6, 1990 by Geoffrey Moore. Lead time = 6 months.
Mar. 26, 2001 by Anirvan Banerji. Lead time = 0 months.
Mar. 21, 2008 by Lakshman Achuthan. Lead time = ?

My own speculation is that ECRI’s recession call is late this time around. There was solid evidence for a recession call in January 2008. Unfortunately, ECRI was hoping that rapid rate cuts by the Fed could help avert a recession. They did not realize that this particular recession, driven by a deflating credit bubble, would increase the time needed for monetary stimulus to work itself into the economy.

Hence, until NBER announces the official recession dates for this cycle, I will assume that it began in January 2008.
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Edit: NBER's Business Cycle Dating Committee announced on December 11, 2008 that the recession officially began in December 2007. My speculations have been proven correct and ECRI was late by 3 months in calling the recession.

Taiwan Election Trade

2008-03-19T14:58:00.000-07:00

Take note that the Taiwan presidential election takes place this Saturday (Mar. 22). Taiwan's prediction market (http://nccu.swarchy.org/contract_groups?tag=75) is placing an 89% chance that Ma Ying-jeou will win the election. This may serve as a huge catalyst for a rally in Taiwanese stocks in the next few weeks or months.

I've entered a 30% position in the EWT June 12.50 call option. Expect EWT to hit at least $16 if the election goes as expected. That means a gain of about 20% for the call option. Any further gains will be icing on the cake. Below is the calculations for determining position size. Kelly criterion says putting 34% of the portfolio into this trade will maximize return (and volatility).

Expected return: .11x(-100%) + .89x20% = 6.8% gain
Kelly criterion: 6.8% / 20% = 34% weighting

Since markets are closed this Friday, tomorrow will be the last chance to enter this trade.

Growth vs Value: A Short Reversal?

2008-01-10T22:12:00.000-08:00

Growth stocks have been trouncing value stocks since last summer. The financial-heavy value indices have been lagging severely behind value indices during the current housing recession. This has benefited growth stocks as the VIX set new highs and risk aversion picked up.

Could value stocks make a temporary come back here after 6 months? I think so. Plotting growth vs value, we see the enormous outperformance of the Rydex Pure Growth index relative to the Value index. But the negative divergence on the daily and weekly RSI, the channel throwover, as well as the extremely overbought MACD seems to suggest a short-term comeback for value stocks is due. Previous periods where growth lagged value during the current advance has lasted half a month on average. Bottom line: overweighting the value stocks for the next 2-3 weeks should generate some decent alpha.

Strategy: Buy financial stocks with above average short % of float to benefit from the shortsqueeze. Aggressive investors should buy some January call options.

Chicken Soup for Investors

2007-07-05T16:39:00.000-07:00

In the past two years, I've learned a great deal about the practice of stock market investing. Below is an investment framework that I've distilled down to from giants such as Warren Buffett, Chuck Royce, John Templeton, Bill Miller, Francis Chou, Peter Cundill and Tom Stanley.

But first, before getting ahead of ourselves, let's make sure we are clear on the definition of an investment. Ben Graham defines it as follows:

Definition

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

Now, here is the chicken soup recipe for the ultimate investor:

Philosophy

Must thoroughly analyze a company, and the soundness of its underlying businesses
Must deliberately protect against serious losses
Must aspire to adequate, not extraordinary, performance
Be a Long Term Investor
Have a Flexible Approach
Actively Look for Ideas
Only buy the best ideas
Be Skeptical
Filter out the noise
Stay humble
Invest differently from the crowd (be a contrarian)
Be fearful when others are greedy. Be greedy when others are fearful.
Understand the intrinsic value of a business
Seek valuation discrepancies, not just statistically inexpensive stocks
Set buy and sell target for all positions
Always follow where reason leads rather than fall victim to passion and emotions
Always keep the diagram below in mind

... and below are the buy/sell criteria I set for myself when it comes time to make a buy/sell decision:

Buy Criteria

Odds are stacked up in my favour
The business is understandable
The company has good corporate governance (i.e. not run by crooks)
People are overly pessimistic (i.e. hardly any bullish analyst)
There is a margin of safety
Catalysts exist

Sell Criteria

The original thesis to purchase the stock is wrong
The stock price has reached my target
People are overly optimistic
The portfolio requires rebalancing
A better opportunity exists elsewhere

Finally, all of my investments fall into one or more of these categories:

New Links and Portfolio Performance

2007-07-05T12:12:00.000-07:00

Just a small update today. I've added a more comprehensive list of links that I frequently peruse over. I've also added the performance of my real-life portfolio as well as the virtual portfolio at Marketocracy.

Real Life Portfolio - As of Jun 30, 07

YTD: +616.9%
2006: -2.0%
2005: +7.8%
Since inception*: +304.8%

*Annualized return since Oct 11, 05

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Marketocracy Virtual Portfolio

Ranked #1 overall for 1-year ending March 31, 07

Bill Miller Interview: How to Outperform Market with Brain Damage

2007-04-11T14:16:00.000-07:00

Consuelo Mack interviews Bill Miller on Wealth Track. In this insightful and funny video, Miller talks about the relationships between psychology, biology, and the stock market.

Miller is the portfolio manager of Legg Mason Value Trust. He has been the only mutual fund manager who has beaten the S&P 500 for the last 14 straight years. Over the last ten years, he has achieved an average annual total return of 16.8%.

Length of video: 25 minutes
http://www.leggmason.com/about/wt_video.asp

Dendreon - Dancing with the 'Swann'?

2007-04-11T00:07:00.000-07:00

Dendreon will be having a conference call on Wednesday Apr. 11 at 12pm ET with investment bank, Leerink Swann. Detail or purpose of the meeting is unknown to me. Though often times company meetings with investment banks are usually the first sign of a potential buyout. Expect an extra volatile trading day for DNDN during the day.

300% Return In Two Weeks - Is Dendreon a Bubble?

2007-04-07T22:52:00.000-07:00

Of Friends and Lucky Tips

I first heard about Dendreon three weeks ago from a friend at University of Victoria. He is the best special-situations investor that I know of and so naturally when he told me about Dendreon I digged deep into what has now become an amazing story. I came to the conclusion that Dendreon's prostate cancer therapeutic vaccine, Provenge, was very promising and would likely be approved by the FDA.

Boosting Returns with Call Options

On the day before the FDA advisor panel review, I bought some May $12.50 call option as well as some shares. Those May $12.50 call options are now with $7.60, up from $0.40 when I first bought them. 1800% gain in two weeks – not bad at all. The shares of Dendreon returned 246% in the same time period, which is still spectacular but pales in comparison to the power of leverage that the call options provided. So should I sell these options now? Should you sell the stock?

Buy, Sell, or hold Dendreon?

Well, anytime when a stock rises this much in such a short amount of time, investors instinctively want to lock in some gains. However, as a value investor, I never make buy/sell decisions based on how much the stock has gone up or down. A value investor's motto is blindingly simple: buy when a stock is below what it should be worth; sell when a stock is at or above what it should be worth.

In order to know when to sell Dendreon, let's see how a value investor like Warren Buffett might value the company using a discounted cash flow (DCF) analysis.

Will Provenge Get Approved?

Of course, any valuations would only be useful if Provenge gets approved on May 15. So first, let me say this: Provenge will be approved. The following excerpt outlines how the FDA makes decisions on approvals:

At the heart of all FDA's medical product evaluation decisions is a judgment about whether a new product's benefits to users will outweigh its risks. No regulated product is totally risk-free, so these judgments are important. FDA will allow a product to present more of a risk when its potential benefit is great — especially for products used to treat serious, life-threatening conditions. (FDA's official website)

The above statement was one of the key reasons I invested in Dendreon because not only is Provenge safe, it is also a drug that's used to treat a life-threatening disease (end-stage hormone refractory prostate cancer) and I decided that Provenge would be approved even if the advisory panel's votes were split on its efficacy. Now that the panel has voted overwhelmingly in favour of Provenge (17-0 for safety and 13-4 for efficacy), the final approval should not be a mental block in your decisions to invest in Dendreon.

Dendreon's Price Tag: $20, $30, $70?

So let's see how much Dendreon is worth using the discounted cash flow (DCF) analysis. The DCF is a more robust valuation method than merely multiplying the price/sales ratio by the discounted peak sales. The idea of a DCF is to discount each year's free cash flow that a company generates in the future back to today's value and then add them up. Here's an article from Investopedia on using DCF in biotech valuation.

I will be using the sales revenue as estimated by Adam Feuerstein from Thestreet.com as a basis for my calculations. Therefore, my DCF analysis is only as reliable as Adam's sales revenue numbers.

To double-check Adam's numbers, I looked at an interview conducted by the Wall Street Journal with Simon Hall, director of the Deane Prostate Health and Research center at the Mount Sinai School of Medicine in New York, and an investigator on a trial of Provenge. Dr. Hall estimates that there are “between 29,000 to 40,000 men” eligible to use Provenge.

Adam's revenue model No. 1 estimates that there will be 49,823 men eligible for Provenge growing at 1.5% each year for an aging population. This estimate is clearly much higher than Dr. Hall's estimate and so it would be unreliable to perform a DCF analysis based on this model.

Adam's revenue model No. 2 estimates 34,123 men eligible for Provenge. This number falls nicely in the middle of Dr. Hall's estimates.

Adam's revenue model No. 3 estimates 6,885 patients eligible for Provenge in 2007 growing to 27,366 in the year 2012. He then applies a much higher Provenge penetration rate for these patients in comparison to the previous two models. Still, these numbers are much lower than Dr. Hall's estimates – model three is overly conservative.

I am going to use the average sales revenue as derived from the three models (table 1) for my DCF analysis.

Table 1

To get the free cash flow I take the above sales revenues and subtract from each one the costs of bringing Provenge to the market. The costs include operating costs (eg. manufacturing, research & development, sales & marketing and administration), taxes, as well as any capital investments in laboratory equipments and facilities.

To estimate the costs, I looked at several biotech companies and took note of their capital expenditure as a percentage of operating cash flow. What I found was a typical range between 20%-40%. However, simply subtracting 20%-40% from the sales revenue would be an overestimation of the free cash flow because Provenge requires a higher cost to produce than the typical drug – Dr. Hall states that Provenge is “custom made for each individual patient with their own cells.” Hence, I am going to subtract 50% from the sales revenue to account for the higher costs.

What I end up with is the 10-year free cash flow available for use at Dendreon's discretion in the figure below.

Figure 1

Finally, I discount each year's free cash flow back to the present value and add them up to get a total present value of $2,063,182,242. Subtract long-term debt of $17,027,000 and divide by the total number of shares outstanding gives me a price tag of $24.82 for Dendreon. Remember that this price tag is derived from 50% costs of sales and the average of the three sales revenue models.

Table 2 below shows the rest of the price tags for Dendreon if I had used different costs percentages and sales models.

Table 2

As a word of caution, when performing a long-term analysis like the DCF, always remember Murphy's Law, which states: anything that can go wrong will go wrong. Frankly speaking, perfect execution is not possible no matter how good a company is. Therefore, when given a range of values or estimates, it's prudent to stick with the lower ones. With that said, the DCF I performed on Dendreon comes with several assumptions:

The company is only able to generate free cash flow for ten years.
Provenge is the company's only source of revenue for the next ten years.
Sales revenue of Provenge only comes from the U.S.

In conclusion, the intrinsic value of Dendreon would be significantly higher if the company exceeds any of the above expectations. Dendreon remains undervalued even after the tripling of its stock price since the FDA panel vote on Mar. 29.

Disclosure: I own shares and call options of Dendreon.

Slate: Long Live the CD!

2007-03-28T23:31:00.000-07:00

The market is way too pessimistic about the music industry. After recent news broke out about the demise of the music industry, shares of Handleman is once again trading near its 5-year low of $6.50. I for one do not agree with the view that the CD is dead and have written at length about it in a previous post.

Daniel Gross from Slate.com wrote about the future of CD's yesterday. Aptly titled The CD is Dead! LONG LIVE THE CD! Gross gave a balanced and realistic view on the CD as a commercial product. "Is the CD dying as a commercial product? Sure. But it's got a lot of dying left to do," Gross concludes.

For your entertainment, here are the most recent discussions on this issue:

CDs are not dead -- yet [from Encore]

Are CDs Obsolete because of iTune? [from Yahoo! Answers]

Music's New Gatekeeper [from The Wall Street Journal]

As CD Sales Drop, Pirates Continue to Board Music Industry's Ship [from 24/7 Wall St.]

Words From Value Investors: Buffett, Bill Miller, Charles Brandes

2007-03-28T21:36:00.000-07:00

Buffett videos from CNBC.

Legg Mason's Bill Miller's optimistic outlook on the stock market.

Brandes Investment Partners says you should catch a falling knife.

Words of Wisdom: Letters from Superinvestors

2007-03-20T00:30:00.000-07:00

I like to learn investing by reading about how successful investors think. The best access to the brains of these superinvestors is through their letters. Here are a few that’s been recently released this quarter.

Warren Buffett expresses his interest in hiring a young protégé in his 2006 Letter to Shareholders.

Francis Chou gives 7 reasons to why the market is euphoric right now in his 2006 Chou Funds Annual Report.

Martin Whitman thinks that Hong Kong Stock Exchange is relatively inefficient in his 2007 Q1 Shareholder Letter.

Ken Fisher: Bull Market Not Over

2007-03-16T20:00:00.000-07:00

If you're getting nervous about a coming bear market. Stop worrying. Ken Fisher, the most accurate market forecaster in the world according to an independent study done by the CXO Advisory, says, "Four and a half years and still going strong. The bull market that began in late 2002 is far from over." He reasons that:

The driver is the relationship between earnings yield (the inverse of a price/earnings ratio) and bond yields. When earnings yields are bigger than bond yields, institutional investors can make a profit by using borrowed money to acquire shares of stock. The process can continue for years, until equity prices are bid higher or the cost of money gets higher.

Here's the full article from Forbes (available after free registration).

News Picks: Falling market, China manipulation, Buffett holdings

2007-03-14T13:11:00.000-07:00

I am currently subscribed to over 40 different investment and financial news feeds. And indeed there are a lot of noise out there for the average investor. Here are some recent news picks from The Picky Investor.

The stock market has more room to fall according to BCA Research.

China is manipulating its own stock exchange: InvestorInsight.

Morningstar cherry picks 6 stocks from Warren Buffett's 39 holdings. (Editor's note: Wal-Mart, on top of getting a Morningstar 5-star and being in Buffett's holding, is also held by Joel Greenblatt and makes up 45% of Joel's total holdings. Greenblatt has a 10-year annualized return of 50% at Gotham Capital. Buffett's 42-year investment record at Berkshire Hathaway is 21.4%. Stay tuned for an analysis of Wal-Mart.)

Handleman (HDL) is Still a Bargain

2007-03-11T23:00:00.000-07:00

This is a follow-up post to Handleman (HDL), A Turnaround Candidate. With the release of Handleman’s latest quarterly report and conference call, I will give you an update on this company to see if it remains a legitimate undervalued turnaround stock.

Stock Category: Turnaround
Ticker: HDL
Share Price: $6.95 (Mar. 9, 2007)
Intrinsic Value: $14.76
Suggested Buy Range (66% of IV): Below $9.74
Market Cap: $141 million

Suspending Dividends to Pay Off Debt
For the quarterly period ended January 31, 2007 Handleman reported in its 10Q filing:

Handleman announced that it has suspended its quarterly cash dividends of $.08 per share on common stock in connection with amending its credit agreement. The Company will redirect its cash flow to reduce outstanding debt, which increased as a result of several investments to diversify the Company’s products and customer base.

Short-term debt increased from $4 million to $88.9 million. The debt is incurred from the acquisition of Crave, distributor of video games.

Shareholders should not be discouraged by the dividend suspension. With Handleman’s current ratio at 1.37, this is a wise decision made by management to pay off debt in order to avoid running into liquidity problems later on. This is the correct way use the company’s free cash flow.

Expanding Customer Base
In the annual report for the fiscal year ended Apr. 29, 2006, Handleman reported:

During the fourth quarter of fiscal 2006, the Company announced that it will provide distribution, in-store merchandising and category management support for music, video and video games to Tesco PLC beginning in April 2007. Tesco, the largest supermarket and general merchandise retailer in the United Kingdom, is also one of the world’s leading international retailers. This agreement allows Handleman Company to extend its core services to over 700 Tesco stores in the United Kingdom and is expected to generate approximately $50 million in annual revenue for the Company.

Tesco will become Handleman’s 3rd largest customer, behind Wal-Mart and Kmart. Tesco is expected to make up about 4% of Handleman’s total revenue. I see this move as a step in the right direction as diversifying and expanding Handleman’s customer base acts to reduce business risks in a deteriorating business environment.

On an unrelated note, Warren Buffett has been accumulating shares in Tesco.

Company’s View on the Music Industry
A decline of revenues from music sales is currently around 9%. Stephen Strome, CEO, described the music industry as currently in a “long-tail”, when asked by a caller to express his view of the music industry at the conference call. Strome went on to say that the sharpest music sales decline is likely to happen in 2007 and reach a plateau before a slower and steadier long term decline. Strome also expressed that the greatest impact on traditional CD music sales is not due to the downloading of music; he believes that the ease of pirating and sharing songs with friends remains the primary cause of declining CD sales. Lastly, Strome said that in addition to unit declines there are also the effects of dollar declines – many albums are being priced at $9.99 or $11.99 nowadays.

Interestingly, large merchants such as Wal-Mart and Tesco (Handleman’s two biggest customers in North America and the UK) are fairing better than specialty music stores in the face of declining music sales. Strome’s explanation is that shoppers are more likely to purchase a CD while doing every-day shopping at large merchants.

Although technology is changing fast, I maintain that the physical sales of music will be around and this demand should keep category managers such as Handleman in business for a long time to come. This is because the sound quality of downloaded music today is inferior to physically purchased music. Audiophiles have long criticized lossy compression formats such as MP3 and WMA for their poor sound quality. Only until the summer of 2006 have there been talks of Apple selling high-quality music at the iTunes Music Store (iTMS). For this purpose, Apple is planning to use its own Apple Lossless Encoder (ALE), which as its name suggests, compresses music with no loss in quality.

As you can imagine, music compressed with the new Apple Lossless Encoder takes up considerably more space than its MP3 counterpart -- typically 10 times or more. So that means a 40GB iPod is essentially reduced down to a 4GB given that you store every song in ALE format. Furthermore, Apple will be pricing ALE formatted music at a premium to MP3’s. Lastly, the ALE has neither received FairPlay nor DRM support yet. I see Audiophiles continue buying CD’s for the foreseeable future.

In a few years, CD’s and DVD’s will start to be phased out by new mediums such as NAND flash drives. The bottom line is that there will always be demand for high-quality, uncompressed music in the physical form, whether that is in a CD, DVD, or flash drive medium is irrelevant and Handleman will remain a key player in the music distribution business for many years to come.

Valuations & Other Metrics
Price/Book: 0.51
Price/NCAV: 1.30
Price/Cash flow: 1.34
ROA: -3.5%
ROE: -7.8%

Handleman’s valuation stays attractive. Asset-wise, it is trading at half of book value, and is only selling at 1.3 times its net current asset value. The stock is even cheaper when measured in terms of cash flow, trading at a price per cash flow of 1.34 (bargain basement level). To put it into context, companies that trade below a price per cash flow of 10 often are bought out or go private, richly rewarding shareholders when such events take place. There is very little downside to Handleman’s stock price based on current valuations. However, in the case that the annual cash flow suddenly becomes negative and triggers another sell-off, the stock’s net current asset value of $5.47/share will act as a floor for the stock.

Management
Success in corporate turnarounds largely depends on the company’s management. Having a motivated management will tie together all of the other important factors in turning around a business such as having a viable core business, healthy balance sheet, transparent and clean accounting, as well as a strong free cash flow. I have learned much about turnaround situations from Robert Olstein, who has managed the Olstein All Cap Value Fund since 1995 with an annualized return of 15.4%.

To determine management’s quality, I look for three things:

Executive’s compensation
Recognition of problems
Actions

I learned the first tip from Warren Buffett and the second and third from Robert Olstein.

As I discussed in this post as well as the first Handleman post, I believe management fully recognizes the problems that the company is facing and has taken the corrective actions to help solve those issues.

As for executive’s compensation, I will firstly point you to the company’s Corporate Governance Quotient (CGQ) and then show you the executives’ stock options compensations.

The CGQ is an excellent way to quickly see a company’s overall quality in terms of its corporate structure and quality of management. The following categories are used by CGQ to evaluate companies:

Board of directors
Audit
Charter and bylaw provisions
Anti-takeover provisions
Executive and director compensation
Progressive practices
Ownership
Director education

As you can see, part of the CGQ rating is derived from the company’s executive and director compensation.

According to Yahoo! Finance, as of Mar. 1, 2007 Handleman’s CGQ is better than 97.5% of Russell 3000 companies and 94.6% of Retailing companies. This is a very high rating for Handleman. My typical criteria are for companies to score in the top quartile or at least 75% above its peers.

Lastly, let’s take a look at Handleman’s exercisable stock options for its employees.

Table 1 shows the company’s outstanding and exercisable stock options as of April 29, 2006.

What we see here is that the majority of the options granted in the previous years have been at prices significantly above the current market price. Exercise price ranges from $10 to $22.95. Given Handleman’s recent share price in the single-digits, management’s options are worth a lot less if they decide to exercise it today. And indeed, during the fiscal year ended Dec. 31, 2006, with the exception of Sr. VP of HR & Organizational Development who has exercised $11,000 worth of options, all of the other five executives, including the CEO and CFO have exercised no stock options.

By hanging onto their stock options, the executives are showing that they still have faith in the company’s business and are waiting for a recovery in the share price.

Going forward, shareholders of Handleman should pay close attention to the amount of stock options being exercised. If executives across the board are exercising their stock options without the company’s share prices improving that would be the first warning signal for shareholders to sell their shares.

Finding the Intrinsic Value
Table 2 shows the data used to perform a discounted cash flow analysis based on Handleman’s latest reported financial data as of Jan. 31, 2007.

The numbers are based on Handleman’s financial statements, management’s articulation at the conference call, as well as my own estimations. You will immediately notice that the growth rates used in the table are very conservative, even for the aggressive column. Since the future is unpredictable, when performing a long-term analysis such as the discounted cash flow model, conservatism should always be exercised. I am using $14.76 as my sell target until the next quarterly results are released.

Conclusion
Handleman is an understandable business with a wide margin of safety, quality management and rock-bottom valuations. For these reasons it qualifies as a stock pick from The Picky Investor.

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Guru disclosure: Franklin Templeton, Third Avenue, Arnold Van Den Berg, Renaissance Technologies own shares in Handleman as of Dec. 31, 2006.

My Disclosure: I, as well as a client, own shares in Handleman (HDL) and Wal-Mart (WMT). I do not own shares in Apple (AAPL) or Tesco PLC (TSCDY).

Handleman (HDL), a Turnaround Candidate

2006-12-13T23:06:00.000-08:00

5-year low.

Stephen Strome, the company's Chairman and CEO is doing the following:

Acquired Crave Entertainment Group, a distributor of console video game hardware, software and accessories.
Added greeting cards to product category in UK.
Hired President/COO Robert Kirby, previously the president of Personal Products Co. at Johnson & Johnson, to replace the recently resigned John Beeder.
Reducing selling, general and administrative (SG&A) expenses, which will save $20 million annually, or 9% of total annual SG&A.

Percentage of total revenues:

Music revenue 77%
Video games 14%
Greeting cards and DVDs 9%

Valuation & Financial health ratios:
- P/S: 0.1
- P/B: 0.45
- P/E: 12
- Debt/Equity: 0.3

There’s no doubt that the revenue derived from selling music will continue to fall at retail stores as customers go online to shop for music. This trend is reflected in the continued decline of Handleman’s stock price in the last two years. The big question is: whether the cost-cutting and diversifying into the video games & greeting cards businesses are able to offset the decline in music sales?

At today’s bargain-basement price level, the answer won’t matter. A discounted cash flow analysis, which I’m projecting a negative 15% growth over the next 5 years and zero growth afterwards with a discount rate of 8%, shows that Handleman is about 45% undervalued. The company also yields a 4.8% dividend. Handleman is solid undervalued turnaround play.