The Fearful Investor

FedEx Hits Truckers While They're Down

Yesterday morning FedEx (FDX) announced a 25% reduction in fuel surcharges on its less-than-truckload (LTL) and freight services. Clearly FedEx sees this as a great opportunity to use their growing international business to grab market share by taking advantage of a weak domestic trucking market to further squeeze their competition, including Arkansas Best (ABFS), Conway (CNW), and Yellow Roadway (YRCW). With many truckers continuing to see year-over-year volume reductions, price reductions kick out another leg of the profitability stool for these companies. On many first quarter earnings calls, the saving grace for LTL truckload providers was a stable price environment despite reduced volumes. Managements trumpeted how consolidation in the LTL industry has made pricing more rational among competitors and profitability should therefore remain stable. To make matters worse for investors in these truckers, they are still trading at premium P/E multiples (while the denominator - earnings - are at risk).

As discussed in my April 27th post, one of the keys in my investment process is to invest in industries with the wind behind their back and truckers have the wind squarely in their face. For industries with the wind in their face, while the primary risk is the expected bad results, the really important secondary risk  is the unexpected even worse developments -- such as increased competition or further fundamental deterioration.

My managed account clients and I are short Arkansas Best Corp.

Buy Stock Tips Without Doing Your Own Work At Your Peril

The example I always bring up is from two years ago when everyone was saying to buy Sirius Satellite Radio because Howard Stern was coming and subscribers would skyrocket and ... you know the rest. Let's say you took the tip from a buddy, or a blog, or a newspaper/magazine and bought Sirius in May 2005 at $6/share. Without going back and reconstructing the actual news flow and the resulting stock movements, a typical run of subsequent events goes something like this:
- Great News: More subscribers that expected!- Stock goes up! What do you, the stockholder, do? Sell? Buy more? Hold? If so, why?
- Next, company reports operating numbers, showing higher than expected losses. Stock Down. What do you do? Buy more? Sell? Hold? Why?
and on and on....
Typically, a tippee who does no additional research, will base buy/sell decisions on their emotions associated with stock gains or losses. Did I make enough off this? I can't sell it here, I'm losing money? It'll definitely come back.

For the unsophisticated investor, I'm generally against taking any stock tips, but if you must, the right way to use stock tips is to, at least, have a near-term thesis and/or a target price. With Sirius, you could have said, I think they're going to have great subscriber numbers this Xmas, and when that news comes out, I'm selling, no matter what. Or, if it gets to $7, or falls to $5.50, I'm selling. Too many  tippees have old tips sitting in their accounts. They may not even remember why they bought it and don't know why they still own it.

As discussed in a previous post I love taking ideas from other investors, but before I invest I need to be able to reconstruct the investment thesis and valuation myself before I consider investing. Above all, I need to be able to understand the business so that I can interpret every data point that comes out and weigh it versus the thesis and valuation work I've done.

My Wal*Mart thesis (I and my clients own Wal*Mart) has always been: This is a highly cash generative business, which should be a great investment if some combination of the following occured, (1) The bad international businesses should be sold or turned around, (2) Domestic store construction should decelerate allowing the company to show better comps (through less cannibalization of old stores by new ones) and produce more free cash flow, (3) Turnaround domestic operations, and, (4) Sell/Spinoff Sam's Club. With this thesis I can look at all news and decide if it's relevant or not, and if it is relevant, how it affects my thesis. So, selling underperforming chains in Germany and South Korea was a good thing. Bad domestic comps are not great, but not horrible for the investment thesis. Wal*Mart's public relations problems are interesting, but only relevant inasmuch as fewer of them are better for building more urban stores and attracting more customers.

An example of a tip which I didn't take because I couldn't understand the business was Saks Inc. (Ticker: SKS) Last March (2006), I read a great interview with Jon Jacobson @ Highfields Capital where he gave a very compelling pitch on Saks as an investment, basically calling it a turnaround and as they sold off other chains and turned around the Saks chain and returned to industry margins, that the stock could go up significantly. After some cursory research, reading SEC filings and listening to an old company conference call, I realized that while I understood the thesis (turnaround and return to industry margins will make the stock go up) I did not have the skills to interpret data points relative to the thesis. So, if same store sales at Saks missed expectations for two months, I could not determine if that meant the turnaround was in trouble, or if it was irrelevant to the turnaround because they were raising prices or getting rid of bad merchandise. So, I passed on this one - even though a 15 months later the investment would have returned about 60% including two $4/share special dividends.

Really the only way to take a stock tip, is to have consistent access to the tipper, who you perceive to be the expert on the investment, so you can always bother them for interpretation of information as it comes out. In this way you're really investing in both the idea and the perceived expertise of the tipper.

Understanding Sentiment/Valuation Disconnects

On days like today, when the market is down a bunch, I usually get some client calls that go like this:
Client: Hey Chuck. What's going on with the market?
CG: It seems to be going down.
Client: Well, what do you think?
CG: I dunno. I've picked out a bunch of value-oriented investments which I think ought to do well in most market environments, are reasonably priced, and together form a conservative portfolio. I've got some nifty ideas for new investments, that I'd love to buy if the market keeps coming down like this.
Client: So you're not worried.
CG: I'm always worried. That's my job. To be worried for you, so you don't have to worry.
Client: Ok

While it's been written a million different ways, by all sorts of value investors, I try to tell clients that stock prices go up and down, but behind each ticker is a company that we can ascribe a value to. While this value is subject to change due to macro-factors (such as interest rate fluctuations and economic growth here and abroad) and micro-factors (such as competition and corporate management changes), what happens in the stock market today or tomorrow rarely effects this value.

Market movements are changes in sentiment. Does today's down market or this year's up market mean:
- that domestic trucking tonnages are rising? No.
- that Korean mobile phone churn/ARPU is changing? No.
- that Wal*Mart is suddenly reversing it's plans to reduce growth spending and buyback $15B of stock? No.
- that Chesapeake Energy is having less success drilling for Natural Gas - or, more importantly, that domestic natural gas supply/demand trends are changing? I don't think so.

Stock buying and selling opportunities are created by this disconnect between sentiment and individual company valuation/trends. Knowing how to take advantage of this discrepancy is one key to making money in stock investing.

I'm A Thief!

I admit it. I steal.

In this case, I steal investment ideas. Like the Value Investors Club and Value Investor Insight, there is a long history of investors sharing ideas and proselytizing prospective investors.

Typically, I'll troll through 13-F's of some of my favorite investors such as Fairholme Fund or Southeastern Asset Management to see if they've bought anything recently, if it's in a sector I'm currently interested in, and if the stock has moved a bunch since they've purchased. If I'm still interested, then I'll start doing the research: going through the SEC filings, listening to the conference calls, doing some basic valuation work, looking at other institutional or inside holders, etc. The vast majority of this work yields no investments as I either am not comfortable with or don't understand the investment thesis.

Last week, I attended the Ira Sohn Research Conference here in NYC to hear some of the best hedge fund, mutual fund and private equity fund investors talk about some of their favorite ideas.
I attended this conference last year and didn't invest in any of the ideas, but found the conference worthwhile nonetheless as it's great to hear how presenters discussed their ideas and get a glimpse into their thought process. More than one investor presented an idea they've been in for five years without success yet. As they would readily admit, being early sometimes means being wrong.

I haven't posted in a while as I'd expected to write about one of the investments touted in the conference that may turn into an investment for me and my clients. It is the sort of investment that usually (stress USUALLY) works, which is - proven management, good valuation, and catalyst for growth. I hope to be ready to present it in my next post.

Yes, I stole it. But, hey, all clients care about is results, not originality.

SK Telecom: Affordable Anti-Dollar & China Play

The way I look at investments are:
- start with an industry that has some positive trends working for it (wireless telecom services, are ok, add emerging markets and it gets interesting)
- have valuation at or below 10x Enterprise Value/Free Cash Flow (EV/FCF)
- try to make sure that there's little catastrophic that can happen to the story
- hopefully have good management that has a history of providing value for shareholders
- have either a trigger for positive revaluation or at least upside options

SK Telecom (US Ticker: SKM) appears to fit these criteria. Wireless telecom services continue to grow in Korea, though the market is quite mature with penetration rates at 80%. SKM has about half the market and gov't regulation seems likely to allow for continued profitability and market share at these levels. By my calculations, the company currently trades for 9-10x EV/FCF. My catastrophe possibilities include unlikely events such as worldwide recession and war with North Korea. Though I and my clients have owned SKM for about two years, I don't have above average confidence that management will always act in the best interest of shareholders, inside ownership is about 20%, so at least interests are aligned.

My favorite part of the SKM story is the upside options, which are; (1) the dollar falling, (2) anything good happening from $1 billion investment in China Unicom (CHU), and (3) upside from current money-losing investments in Vietnam and Helio MVNO joint venture with Earthlink in the USA. The fall of the dollar seems like a decent bet over the long-term -- who knows about the short-term. SKM has a billion dollar investment in China Unicom via a convertible bond which is well in the money. Commentary from SKM management implies confidence in their involvement in CDMA developments in China regardless of CHU's fate - as there have been rumors about sale or breakup of CHU. SKM is an also-ran in the Vietnam wireless market, but they have recently expanded their network nationwide (I believe) to make it a more viable competitor in this high-growth market. I've always been dubious about the prospects for Helio. Helio is a branded reseller of wireless services here in the USA aiming for the high-end user/enthusiast with fancy data-centric handsets available only through them. Last week, Helio released the Ocean handset, which has gotten positive reviews from Walt Mossberg at the Wall Street Journal and the endgaget blog.

While I don't expect positive fireworks from this investment, I'm hoping for steady positive appreciation. The stock has had a tendency to shoot up to about $27-28/share and fall back into the low-20's. Should this spike end similarly, it might be an interesting investment opportunity.

I and my clients own SKM. This is not a recommendation to buy SKM. Like all investment ideas on this blog, do your own research. I'll post again on why investing in stock tips is a dangerous game.

Chesapeake Energy: One Way To Think About Hedges

Production hedging for commodity producers should be about enabling a company to fund its value-added activity, which is exploring, developing and exploiting assets. Lot's of ink has been spilled about how Chesapeake Energy's (CHK) earnings per share fell in Q1 2007 (as compared to Q1 2006) due to mark-to-market hedge losses. I think these comments miss the point.

As a current CHK investor (both I and my clients own CHK), if management can find and bring to market an mcf of gas for $4-5 and sell it forward (hedge it) for $8-10/mcf, it would seem only prudent to do so for some percentage of their production to ensure they will have the cash flow to support further similarly-profitable development. Why should running a E&P (exploration & production) company be any different from running an oil refinery or an ethanol plant, where plant owners know exactly how much it costs to convert oil-to-gasoline (crack spread) or corn-to-ethanol (crush spread) and so long as the input commodity and the output commodity prices can be fixed beforehand, minimum budget targets can be met?

Furthermore, there's great optionality for CHK and other hedging producers. When natural gas prices fell last summer, CHK reduced gas production slightly, helping to support gas prices, and also closed some previous hedges, locking in gains. In the 1990's, when aluminum prices were below production costs, I believe Alcoa bought a boatload of aluminum futures prior to announcing a production cutback, making a fair bit of money on the trade, which helped to offset some of the operating losses.

I like to think of the mark-to-market balances, or value of the hedges, as a balance sheet item, which happens to rise/fall in value inversely with the commodity price. Typically, and correctly in my mind, the stock should react much more to the movements in gas prices, rather than the change in mark-to-market hedge value as the preponderance of company value is the gas in the ground.

Go Where The Money Is (Hint: Not Truckers!)

My investing strategy is can be summarized in two strategies: (1) 'go where the money is' -  which means find an industry poised to do well and find a cheap stock there, and, (2) 'find special situations where the world is not watching or wrong'. This post will focus on #1 by explaining an example of where the money isn't - the trucking industry, where I recently shorted a stock.

I like to read a lot of macro publications that discuss which industries are set to outperform backed by time-tested macro data. One of the recent industries to pop up as an underperformer is the trucking industry, thanks to decelerating consumer spending due to a higher percentage of income being spent on necessities such as food, gas, and rent/mortgage interest. This deceleration has caused flows of discretionary consumer items and home construction materials to decelerate as well. These results are squeezing truckers with year-over-year declines in both tonnage shipped and rates achievable for the tonnage that's left.

With most of 1st quarter's reports behind us, trucking names such as Yellow (YRCW), Con-Way (CNW), and Heartland Express (HTLD) among others are having a hard time cutting costs and holding the line on rates to generate expected returns. You don't have to run a spreadsheet to realize that the trend of economic money flows are not working to benefit truckers, and such trends will negatively affect share prices. Negative comps started for many truckers last October and is expected to continue, at least, through Q207.

The way I see it, I'm never going to be right all the time picking individual stocks, but one way to avoid destruction is to have the macro wind at my back. Interesting industries where the economic tide appears more favorable are media, energy and industrials (thanks to a strong global market).
In another post, I'll write about special situations, where it seems a lot of the big money is made. For me, the best opportunities are often when the two trends meet - a special situation in a favorable industry. Stay tuned for more.