Weeks like this separate the men from the boys

The headline says it all. I loved to see the sell off in the market this week, such sell offs are healthy, prices come up and come down. The Valueline universe of 1800 stocks was at a p/e ratio of 19.6 when the week began. This is high, the long term average of past 15 years is somewhere around 17. Reversion to mean is a fact of life and markets are no different. Own good businesses and the stock will take care of itself.

Meanwhile Warren Buffet's annual letter came out yesterday as usual a super read, he was less scathing than usual about the excesses of Wall Street although does take on the high fees charged by hedge funds. He calls it the 2 and 20 crowd (2% management fees and 20%of the profits) . Mr. Buffet has been buying United Healthcare (NYSE : UNH) and Ingersoll-Rand (NYSE : IR), Here is the post on Industrial stocks and IR that I wrote about late last year.

Just finished reading Hedgehogging by Barton Biggs, its another great read. Talks all about hedge funds, the thing that struck me the most was the pressure that the managers feel to deliver. The fact that many funds get the 20% only if they beat an index and makes the point that 20% of zero is zero. Additionally most funds have a high water mark i.e. in the following year they have to first recoup the losses and then deliver. Another great read!!!

Performance of the 2006 picks

In this game performance is everything, if you cannot beat the market then why bother? Invest in a index fund, go home and sleep peacefully! But stockpickers inherently believe that markets are inefficient and greater than market returns can be achieved by picking stock using any number of philosophies, that is the heart of any debate between active versus passive investing. So how did we do, on the stocks we picked last year. Without further ado

We did extremely well with Sherwin Williams (NYSE : SHW) and Bausch (NYSE : BOL) both classic short term distress situations up 58% and 17% respectively. Plum Creek Timber (NYSE : PCL) was a nice winner too up 18% with a juicy 4% dividend.

On a time weighted average , to account for the in and outs and well as timing issues we came out a 17.5% in returns assuming equal weights. Lets hope for a even better 2007.

Fedex and Caterpillar were the two laggards although CAT was recommended only in Nov 2006. Although I beleive longer term (5 years +) both are keepers. My usual term for stock holdings is forever.

Top picks for 2007

Here we go with my top picks for the year and the reasons for them

Cummins Inc (NYSE : CMI) - Maker of generators and engines, low p/e around 8, cheap compared to its peers like Caterpillar. This is a gem that is trading cheap, do not get turned off by the high stock price. Price $116.75

Fedex (NYSE : FDX) - See my previous post, its trading cheaper to UPS and a great company. Price $108.86

Conoco Phillips (NYSE : COP) - Cheapest of all the oil giants, has a p/e of 6, hated by the market because of all the acquisitions and belief that they paid too much for Burlington Resources. Price $63.83

Taiwan ETF (NYSE : EWT) - Cheapest of all Asian markets, an indirect play on China. Worldclass companies like Hon Hai and TSMC. Price $14.46

Omega Healthcare Inc (NYSE : OHI) - This is a REIT that specializes in owning and financing of elder care facilities. They had some accounting issues last year but seem to have come out of it bruised but in good shape. Price $17.53

Limited Brands Inc (NYSE : LTD) - With brands like Victoria Secret, Bath and Body Works and others this company has built a strong economic moat (Warren Buffet's term). Limited trades at a p/e of 15, gives a decent dividend of 2.2%. Price $28.62

Cheers for a great 2007 - more to follow.
(Disclosure : I own OHI and plan to own all of the above, probably average into all of these during the next few months)

CAT in the doghouse?
Mea culpa for being persona non grata. I am making an early new year's resolution - a promise to update the blog regularly, atleast once a month.

The market in the meantime has been on a rip roaring ride. There are two aphorisms that come to mind, In a rising market everyone is a genius and a rising tide lifts all boats. So I suspect most stocks have done well, the key though is to beat the market and I will be doing a post mortem of all my picks and comparing them to the S&P 500 before the year ends.

Heavy machinery stocks have taken a huge beating while the market has been on a tear, mainly because these are cyclical industries and the US economy is slowing down, probably moderating is the right word.

One stock that is a fundamental value play is Caterpillar (NYSE : CAT). Caterpillar is being unfairly punished by the market it dropped almost 10% after last quarter's announcement. I believe it is a good buy based on the following
- on a strictly value analysis DCF the share price should be $68.00 (based on a Free Cash Flow growth rate of 8% for the next 10 years and 3% after that)
- the P/E ratio is 11-12x is below the historical norm of 14x
- although the residential construction is slowing down and the US economy is slowing down, this is being more than adequately compensated by international growth in mining and the China infrastructure boom, indeed today the company announced it was moving its Asia headquarters to Beijing from Tokyo. The 2008 Beijing Olympics should also give the construction boom in China a greater thrust.
- the company gives a 2% dividend

I believe that CAT will return a 12% gain over the next 12-18 months.
Since the stock is currently in Wall Street's dog house and probably will stay there for some time, it is probably wise to start buying in smaller blocks and lower your cost basis. (Disclaimer : I own CAT and plan to increase my holding)
Other industrials worth a look are Cummins (NYSE : CMI), and Ingersoll-Rand (NYSE : IR). Cummins is particularly interesting at a P/E of 9.5
All these three stocks CAT, CMI and IR are strong industrials, with great brands and economic moats, currently beaten down that are keepers. Even if you dont buy them make sure they are on your watchlist.

Seeing the forest for the trees

The market seems to have embraced the old axiom "sell in may and go away". But the fact remains that its a great time for finding valuable gems in these rough times. Lets start with a Trivia question : Name an investment class that has beaten the stock market consistently over the long term? a hint: the Harvard and Yale endowments invest hundreds of millions of dollars in this investment. The answer "Timber"

So is timber really that good of an investment and how can you and me own the asset without the hassles of cutting down trees and hauling lumber to the yard?

Firstly timber as an asset class that has beaten the stock market consistently. From 1973-2002, managed timber returned roughly 15% annually as an investment, while stocks returned about 11%. Timber like most commodities is uncorrelated to stocks. Trees don't know about the rising oil prices or interest rate hikes. And ever more imprortant in today's rising inflationary environment, the price of timber has consistently beaten inflation. We should think of a timber investment as a good inflation hedge. According to legendary investor Jeremy Grantham, over the last century, timber prices have risen at 3.3% above the rate of inflation. Add 5% a year in income, and you've got a timber investment asset that has returned double digits, competing with stocks over the long run.

Large endowments and funds have the luxury of owning timberlands or holding options on the timber output on acres of forests. Large corporations like International Paper and Wayerhauser own timberlands that they use as raw materials in paper manufacture and sell timber in the open market but there are two companies that stand out in this area Plum Creek Timber (NYSE:PCL) and Rayonier (NYSE:RYN)

Plum Creek Timber (NYSE:PCL) ($34) is a Real Estate Investment Trust (REIT) and the largest private landowner in the United States. They have about eight million acres of timberland under management. The company produces lumber, plywood and fiberboard at ten facilities in the Northwest. It has a $6.5B market cap and pays a dividend of 4.5%. Currently PCL has set an aggresive $400M share buyback plan and as a REIT enjoys all the favorable tax advantages. A more attractive company on a fundamental and technical basis is Rayonier (NYSE:RYN) ($36.8) also a REIT a slightly smaller one. RYN has about 2.4M acres under timberland in the United States, Australia and New Zeland. It also has the added benefit of a diversified a performance fiber unit, these fibers are used in tires, rayon yarns, paints, ink and even diapers. RYN had a great run this year hitting $47.50 but is down almost 20% at $36.85 and yields a attractive 5%.

On a technical basis both the stocks have broken down (blame the housing slowdown) and are likely to go down south even further. Reasons as follows:
- timber is a key material in housing construction.
- these companies have in the past sold land at high prices for housing development
- the resolution of the US-Canadian timber dispute is making Canadian timber competitive again

However it may be a good time to watch these two since both these companies are long term keepers for the follwoing reasons:
-high income yielding companies
-owning a tangible asset "timber"
-inflation hedge

I think an attractive entry point may be at the stocks 52 week lows PCL ($33.60) and RYN ($34), only if you want to hold on to these for 5 years or longer.

Wall Street hates the Dow - “Dow Chemical Company”

Here is a company that had record revenues and earnings in 2005, is expected to do the same in 2006, is a Fortune 50 company, has great brands and is a well known innovator.
Trades at an incredibly low P/E of 8.5, P/S of 0.8 pays a rich dividend of 3.5%. So why is Dow Chemical (NYSE:DOW) ($39.8), the largest chemicals/plastics company being ignored by wall street, because of a few reasons:
-high costs of natural gas and oil increase the costs of production
-perceived as commodity, boring businesses no sex appeal at all

Our retorts to the above:
-Dow is in a boring business, we actually like boring.
-Not all of it is commodity businesses, they have specialty agriculture, automotive and coatings also the company is investing in performance businesses to avoid the cyclical gyrations of the bulk chemicals business.
-Dow Chemical has been one of the engines of innovation in the specialty materials sector.
-The cost of oil and gas is a concern; here are two recent articles both could be construed as positives for DOW.

According to the Barron'’s article "“Natural Gas: Lower Still"” dated April 15th by Spencer Jakab (subscription required) -"“Despite falling nearly 60% from their December peak to a recent $7.135 per million BTU'’s, gas futures may need to go below $5.50 to soak up a surplus unlike any ever seen by the industry. Total gas in underground storage at end of March, the official end of the heating season, was 1.695 trillion cubic feet, a whopping 63% above the average for the past five years and 13% more than the previous record high."

And then today'’s New York Times article "“Chemical Companies Look to Coal as an Oil Substitute"” by Claudia Deutsch has a quote from Dow'’s CEO Andrew N. Liveris "We want to be economically feasible in the United States, and coal enables us to do that," The article further goes on to say Dow Chemical, has tripled its research into coal-based ingredients. – I will grant that this is perhaps a pipe dream or a long term soultion. Also I do not expect oil prices to fall but then chemicals and speciality derivatives are a part and parcel of our lives and eventually DOW will be able to pass the costs down to the consumer.

So we took a detailed look using Valueline data at DOW Chemicals


As seen on the left Free cash flow to Equity DCF value stands at $44, The stock trades at $39.8 close to its 52 week low and a 10% discount to the DCF value of $44. This is a classic Buffet/Graham situation where a gem is out of favor with the street, on basis of exagerated pessimism regarding high oil and gas prices. This company will deliver rich gains to investors in the next 5 years, and while you wait for it a 3.5% dividend is icing on the cake. (Disclaimer : I will take a position in DOW soon)

Eye of the Storm
Bausch and Lomb (NYSE:BOL) ($45.6) the eyecare maker has been in a lot of news more so since the story of the fungal infection broke two weeks ago. The infection has afflicted 109 patients using its ReNu with MoistureLoc solution. However the company has been in trouble since a few months ago. Here is the chronology with closing prices

23 December 2005 - BOL moved to restate financial results back to 2000 because of accounting shenanigans at its Brazilian unit. Stock price falls from $79 to $72.

26 January 2006 - BOL says it will postpone its earnings filing to investigate improper booking of sales at its South Korean subsidiary. ($68.56)

2 March 2006 - declares dividend $0.13

31 March 2006 - First reports of fungal infections surface ($63.70)

10 April 2006 - BOL suspends shipments of ReNu ($57.44)

11 April 2006 - Company defends ReNu, says all tests are negative, Walgreen pulls entire line of ReNu, WalMart pulls the specific product. ($45.60)

These events usually qualify as one time opportunistic buys in my book, the previous call we made in a similar situation with Sherwin Williams on Feb 24 has paid us handsomely with a 25% gain in five weeks. However this is one is much harder to call. Here are the facts:

According to the 10Q filling dated 28 July 2005 (last filling on record). The six month revenues were broken out as follows:
Contact Lenses $359 M
Lens Care $269 M
Pharmaceuticals $ 278 M
Cataract & Vitreoretinal $ 185 M
Refractive $ 72 M
Total (6 months) $1163 M

Lens care generated about 23% of the company's revenue. 2005 Revenues from ReNu are estimated at $45 M about 2.25% of the total $2.3B. In the US there are reportedly 109 cases of "Fusarium" fungal infection reported by the CDC and according to a Business Week article about 36 million Americans wear contact lenses. Of the 30 cases investigated to date by the Food & Drug Administration, 28 wore contact lenses, and 26 of those patients used Bausch's popular ReNu products to clean and store their lenses. To date no direct link has been found to the usage of ReNu and the fungal infections. From the numbers and the facts it seems like this may not be a big deal.

The key here though is the statement from Walgreens released today -"There's a lot of customer confusion out there, which is why we decided to remove the entire ReNu line, - a Walgreen spokesman told Reuters." What is it that first comes to mind when you hear the words Baush & Lomb? Eyes, eyecare, contacts!!!! right. So calling this a Tylenol scare like situation that J&J was in is incorrect - afterall J&J is a very well diversified company selling Cordis heart stents, baby lotions and Band-Aids.

Although ReNu may be only 2% of revenue as the Walgreen statement implies Bausch &Lomb means eyecare to most customers and spillover effetcs are bound to affect sales in general. Moreover according to the 10Q "Growth for the first six months of 2005 was driven by share gains attributable to the Comapny's ReNu with MoistureLoc brand, the ReNu franchise gained 2% market share in Q2 05" So this was a major growth engine for the company.

Back to the fundamentals before the fungus story broke but after the accounting irregularities were uncovered the company traded around $65 a share - market cap of $3.5 B on sales of $2.3B a P/S ratio of 1.52

Lets look at the most pessimistic scenario for this company, assume that the company loses all of its share of lens care of about $ 500M and spillover into other areas, legal liabilities causes loss of another 15% of revenues $300M. This would imply a 2006 revenue number of about $1.5B (assuming no growth in other areas).

Now at today's price $45.6 (Market cap $2.45B) this gives the company a P/S of 1.63, still higher than the 1.52 it sported on March 30th. At $42.5 the stock should reflect its pre infection value.

So in conclusion, the company is in deep trouble has a great brand & franchise but its entire identity is associated with this franchise "eyecare" something people take very seriously. I believe that the company will recover and thrive but I want the classic "Margin of safety" before I play this one, I'll assign a 20% margin of safety and using $42.5 as my benchmark I would be a buyer at anything south of $34 a share. Speaking of J&J, once the air on this issue clears up they may just swoop in and buy BOL.