Friday, December 31, 2010

Last buys before the New Year

Bought more Vodafone (NYSE: VOD) stock.

Added Global X Lithium ETF (NYSE: LIT) to portfolio. The Fund seeks investment results that correspond to the price and yield performance of the Solactive Global Lithium Index. The index in turn consists of equities related to Lithium mining, battery production and such. I was looking at the individual companies in the index and decided to buy the index itself to hedge bets. Some of the companies look very expensive, but on the other hand Lithium is one of the key resources in the Green Race (electric cards, smart grids..).
10 largest holdings of the fund:
Symbol: Equity name: Percentage of fund: Currency

6674 GS YUASA CORP 4,48% JPY

Thursday, December 30, 2010

Beating the market - or not

Who believes in Efficient Market Hypothesis?

I don’t believe that efficient market hypothesis (EMH) completely captures what is going on in the markets. In other words, I believe that some investors can beat the market in long term and it is not just pure luck. According to EMH super investors like Warren Buffett and Charlie Munger of Berkshire Hathaway (BRK.A) are just incredible lucky. I don’t think so. Markets failed miserably in IT bubble, US housing bubble and recent EU debt crisis. The information about the risks was out there long before the crash, but market in general ignored the realities. Mr. Market failed to price assets “correctly” according to publicly available information.

Riding the bubbles with Mr. Market

Tree caricature from South Sea Bubble cards. Copyright expired. Source: "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay / Wikipedia.

The IT bubble was obvious case of pure mania, but even if I knew that I was riding a bubble I could not help to stay out (like Buffett did). On average, I got out pretty clean with a healthy net gain despite of some big losses in the aftermath of the bubble as I came back in too early. All in all, I probably was lucky that I did have only relatively small amount of money to invest back then. I was foolish enough to allocate all my money to single sector (technology/IT).

There are no mistakes or failures, only lessons. - Denis Waitley

I did not have any clue on US housing bubble, but I did start to sell off family stock positions in 2006 because I knew we needed the money for a house within 2 years and wanted to reduce risk by moving all money into short duration time deposits. Thus I completely avoided the crash, but I also lost some profits by hopping out of a very strong bull market that continued until around mid 2007.

Eruption at Eyjafjallajökull April 17, 2010. Source: Árni Friðriksson / Wikipedia. Some rights reserved. Distributed under the terms of the GNU Free Documentation License.

While I was unaware of what was happening in the US, I and plenty of others in Scandinavia suspected that there was something terribly wrong in the banking system of Iceland. Many prominent people in Finnish banking sector warned about Iceland banks that were luring people in with one year time deposit offers yielding whopping 5% or even more. Some people wrote these warnings off as jealousy, but I did not touch any of those offers. It was widely known that the Iceland banking miracle was built with good old leverage using cheap credit in the aftermath of IT bubble and low interest rates. Therefore, it was really a time bomb set to go off if interest rates raise and stock market plunges. When the perfect storm came into Europe from USA Iceland banks started to fall like dominos.

Does it make sense to try to time the market?

I came back into markets late 2008 as I simply could not believe how cheap some companies were selling. For the first time and probably last, I used borrowed money in investing as all of our savings were already spent on a house (our housing market has not crashed – at least not yet). It took a while to convince my wife to agree to this, but eventually she agreed that I can spend less than 5% of the value of the house back then. So off I went. I think I saw what every other value intestor saw back then: low valuations with healthy margin of safety.

Now, given all this bragging you might think that I believe I can time the market. No, I don’t believe I can – I don’t believe anyone can get it all right. However, I believe that a person with better than average knowledge about stock markets can spot the extremes: the lowest of lows and the highest of highs. Most of the time, timing the market is just pure waste of time. For the past two years I have tried to do that and in the process I have lost to the index due to my cash and gold positions. Also, I have deliberately built a defensive portfolio that does not behave well in bull market, but does not have a lot of downside risk either. Still, it is extremely interesting and useful to understand how ones portfolio compares to a suitable index.

How to benchmark your portfolio

First you have to select an index. I would recommend a broad index like “S&P 500” for USA, “MSCI World” for developed markets, “MSCI All Country World index” or “FTSE All World index” for developed markets combined with emerging markets. I have chosen the MSCI All Country World index for me because I am investing also outside the developed countries. It is important to study the index closely as the name does not always tell what it actually tracks (i.e. “MSCI World” really does not represent the world and “MSCI All country world index” does not actually do that to the fullest extent possible either).

After selecting the index, I recommend to find an ETF that tracks the index and reinvests the dividends. Then all you have to do is to compare performance of your portfolio to that of a single ETF. I wasn’t able to find one for my purposes, so then I looked for an ETF that distributes dividends and tracks index similar to “MSCI All Country World”. I found three candidates: “iShares MSCI ACWI Index ETF” (ACWI) tracking “MSCI All Country World Index”, “Vanguard Total World Stock Idx Fd ETF” (VT) tracking “FTSE All World index” and “WisdomTree Global Equity Income Fund” (DEW). However, I find it a bit hard to convert back and forth from USD to EUR and then also to track the dividends. Therefore, I chose to track the index itself and compile own benchmark index “fund”.

How to construct own benchmark index “fund”

It is actually not at all hard. First you need to find the index data. You can download MSCI index data from their web site in Excel format. Before doing so, make sure that you have selected the right index, currency and index level. I used the “Net” as in “With Net Dividends” that takes into account taxes that you would have to pay before you can reinvest back into the fund. “Gross” option reinvests dividends wholly.

Then you should get data from your brokers about your investments, cash position etc. The additions in cash to the brokerage accounts are a bit problematic. I chose track these as if I had purchased my imaginary benchmark index fund on the very same date. By dividing the money with the index, you get “shares in index”. Be sure to take into account the usual expenses in purchasing and owning an ETF. I decided to use 0.5% for yearly expenses and 0.5% for purchase cost and spread. The rest is then just a matter of “small” Excel exercise.

In nutshell: you are comparing your actual investment performance to passive index investing. You don’t have to track the individual trades, dividends or such. You only have to look at cash and stock balances at year end and take into account any additions or removals to/from brokerage accounts. This may sound easy, but actually is not. It may take a while to get hang of it. But believe me, it will be worth the time and next year you have got a template ready!

Sunday, December 19, 2010

BYD: Build Your Dreams

“The companies that succeed are often the ones who just improve better and faster than the competition and just keep doing that. And that is the essence of BYD.” This how Berkshire Hathaway Vice Chairman Charlie Munger described BYD in an interview with Fox Business back in May 2010. Berkshire Hathaway (BRK.A, BRK.B) owns 9.9 percent of BYD (BYDDF.PK, BYDDY.PK) through its MidAmerican Energy Holdings subsidiary. Charlie Munger introduced Buffett to the company that he had discovered via Li Lu, a hedge fund manager that also happens to have a large stake in BYD.

“Build Your Dreams” or “BYD” is in the business of making cars: conventional, hybrids and electric ones. It is also a major battery and electronics manufacturer that supplies components to major cell phone manufacturers. Despite that the fact that the car division of BYD didn’t even exist until 2003 it is now brining in the most revenues. In 2009, over half of the revenues came from auto division while handset components and assembly services contributed 37% and battery division 10%. So far, the growth has been mostly due to home market as over 80% of revenues come from China. Therefore, the potential of this company is huge if it succeeds also in other markets.

BYD e6 shown at 2009 North American Auto Show, Detroit, Michigan, US. Source: Wikipedia.

Wang Chuan-Fu founded BYD back in 1995 in Shenzhen, China. By 2000, BYD had become one of the world's largest manufacturers of cellphone batteries. Both Buffett and Munger sing high praises for the CEO of BYD. "This guy," Munger told Fortune in April 2009, "is a combination of Thomas Edison and Jack Welch - something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it." Buffett actually wanted to buy 25% of BYD, but Wang Chuan-Fu only wanted to let go of 10%, which Buffett took as a good sign.

Looking at the owners of the company, one can immediately see that majority of the stock is controlled by insiders and a few investment companies.

*) owned 89.5% by Mr. Lu Xiang-yang
**) via MidAmerican Energy Holdings Company

***) controlled by Mr. Li Lu

The market capitalization of BYD is about USD 13 billion when valuing the company using all outstanding shares and the price of H shares listed in Hong Kong and available for foreigners to buy. P/E 2009 is roughly 21 and P/E for 2010 can be estimated to be in the same ball park given that the profitability that fell drastically in Q3 will pick up. Otherwise the P/E 2010 might be closer to 30. Therefore, by no means the company can be considered cheap.

The revenue growth has been very good and gross margin has stayed in range of 19-22 for more than five years. The problem with BYD seems to be that the net profit swings quite wildly. Apparently in Q3 2010 BYD was barely making profit while first half of 2010 seemed to go better than ever. Despite of this, earnings per share has gone up consistently over long run and is likely to do so also in future if gross profit margin stays in the same ballpark as now.

Using current price for H share ($5.42 for BYDDF.PK) the P/B of the company is 4.5. Therefore, it can hardly be referenced as a value investment. It is clearly a growth play. So far the growth has been phenomenal and more importantly – profitable! It is quite intriguing to find Buffett and Munger still so committed to BYD at these valuation levels. They have stated that BYD might become one of the biggest auto manufacturers in the world. Bold statement, but not at all hard to believe given what they have managed to achieve so far.

I recently bought BYD via Frankfurt Xetra (BY6).

Friday, December 10, 2010

Is Western Digital a bargain?

The company

Western Digital (WDC) is one of the world’s largest makers of data storage products. Specifically, it is a global leader in the development and manufacture of hard drives and solid state drives for internal, external, portable and shared storage applications. The products Western Digital offers are used in computers of all kinds ranging from a notebook to high end servers. They are also used in other applications such as mobile devices and home entertainment equipment.

Picture. Inner view of a Seagate 3.5 inches hard disk drive Medalist ST33232A model manufactured in Malaysia in 1998. Copyright: Eric Gaba (Wikimedia Commons user: Sting).

Hard Disk Markets
The data storage industry is expected to ship some 660 million hard drives this year. Western Digital and Seagate (STX) compete neck to neck for the number one position in this market. Western Digital is number one in terms of shipped units, but Seagate gets more revenue as it serves the high-end enterprise sector. Western Digital employs a low-cost business model and gets lower average selling price. Combined they ship over 60% of all hard drives. Hitachi (HIT) has third largest market share (18%). The other significant players are Toshiba and Samsung.

The market is still growing. Industry observers foresee a compound annual unit growth rate of 5.6 percent for the years through 2013. The driver of this growth is simply the amount of data that needs to be stored and backed up in the world.

Threats to hard disk sales: Solid-state disks and Tablets

Picture. Mtron solid state drive. Source: Wikipedia user 76coolio.

Solid-state disks do not have moving parts like hard disks do. Therefore, they are faster in seeking data, immune to vibration and shock and also more reliable. Solid-state disks are superior to hard disks in many respects except what comes to storage capacity and price. Therefore, it will take years for solid-state disks to have significant share of the overall storage market in terms of terabits sold.
Tablets that use solid-state disks are feared to cannibalize PC and notebook sales. While this might be true to some extent, the tablets are also complementary to PCs and notebooks so the overall storage market grows leaving plenty of room for hard disks still far into the future.

Increased capital spending

According to iSuppli the hard disk companies will spend considerable amount of money in the near future on their manufacturing plants. Western Digital will spend $1.2 billion during the next five years on its plants in Malaysia. Likewise, increased capital expenditures have been announced by the likes of Toshiba, Samsung and Hitachi.

Western Digital vs. Seagate

Data source:

Seagate has higher long term debt / equity – ratio and price per book than Western Digital, but on the other hand it has higher margins and lower P/E and P/S valuations. Looking at these values, both companies look like good picks. However, I started leaning towards Western Digital as I followed the buyout talks regarding Seagate in which Western Digital seemed to have an upper hand. Also, Western Digital products populate five positions in Top 10 list of most sold hard drives in my favourite local computer dealer whereas Seagate has only two (WDC #2,3,6,7,8: STX #4,9). This fact and the fact that Western Digital is volume & cost efficiency champ, I place my bets on it at this point of time.

A closer look at Western Digital

Western Digital has very strong balance sheet. There is only tiny amount of long term debt compared to cash and cash equivalents. Subtracting long term debt from cash leaves net cash position of $2596 million or $11.30 per share.

The valuations of the company also look very attractive if the net cash is taken into account. Also, the growth rate has been phenomenal so far. Even if it reduces to 10% p.a. the company looks cheap. estimates price per free cash flow at 7.09. My own back-of-the-envelope questimate is that FCF for ongoing fiscal year will be at least $800 million (or $3.48 a share). Taking into account net cash position, I arrive to conclusion that the price of the business divided by free cash flow is 6.8. Not awfully cheap, but given the growth prospects, I think it’s a buy.

Tuesday, December 7, 2010

Inflation tax

Mr. Taxman collects payments in many forms ranging from income tax to sales tax. The most unjust form of taxation in my opinion is capital gains tax that does not take into account inflation. Atleast in my country capital gains are taxed in nominal terms, not in real terms. Only certain holdings like your own house where you live are exempt.

Let's assume that Mr. X won in lottery and bought a property worth of 1.000.000 FIM back in 1980 for investment (not for living primarily). This translates to 168.188 euros and change in nominal terms.
Fast forward to 2009 when the property is now valued at three times the original purchase price: 504.564 euros. He decides to sell. Does he make a profit in real terms? No.
Picture. A tax collector at work – from an illustration by Henry Holiday in Lewis Carroll's „The Hunting of the Snark“ (1876). Copyright expired. Source: Wikipedia.

See that lizard in the picture? Look left. Lower ... There it is reaching for the pocket of the man sitting (and presumably working despite of all the strange creatures wondering around). At any rate, that's Mr. Taxman collecting money from Mr.X.

Mr.X actually makes a loss of 36.721 euros in real terms. This is because Mr. Lizard (alias the tax man) collects 28% tax from nominal gain - not from real gain.

The nominal gain in this example is 336.376 euros. Therefore, Mr. taxman collects 94.185 euros from Mr. X. That leaves 410.379 euros for Mr.X to reinvest.

In real terms, one million finnish marks in 1980 translates to 447.100 euros in 2009. The real profit Mr.X made is 57.464 euros. However, because he is taxed on the nominal gain, he loses money in real terms. This is what I would call "inflation tax" or "stealth tax". Bummer!!

Saturday, December 4, 2010

What drives gold upwards?

While I typically ignore all predictions on the price of gold at certain time (because of very high volatility of gold prices), I highly recommend this excellent article on gold:
Four Reasons Why Gold Will Hit $1,900 in 2011

In his arcticle Peter Krauth summarizes his bullish case for gold:
  • Ongoing global stimulus initiatives figure to ignite inflation, which is highly bullish for gold.
  • The so-called concept of "peak gold" is real, and that even in the face of record gold prices, miners can't seem to crank out enough of the "yellow metal."
  • Global demand is burgeoning as wages rise in such newly emergent markets as China and India - a trend that's not going to quit.
  • Global investors remain dramatically under-invested in gold.
I could not agree more!

Here is a couple of recent articles from Seeking Alpha regarding exploding Chinese demand:

I am a gold bull

Having gold in portfolio seems crazy to many. However, to me it has been increasingly easy to add to my gold and gold stock positions even though the price of gold has skyrocketed. I am no gold bug. I don't believe that we should return to gold standard (i.e. that paper money in circulation should be convertible to gold at a fixed exchange rate). Instead, I am a gold bull. I not only believe that it's good to own gold as portfolio diversifier, but I believe that it is quite possible that it will be the best performing part of my portfolio. So far, it hasn't been. I have paid a price from my gold bullishness and also from my overally defensive stock portfolio. I probably have lost to most indexes. So far.

It is sobering to read economics 101 books. Equally so, it is sobering to study how central banks and fiat money work. Ever wonder why we have inflation? ....It's not some "law" as in gravity or second law of thermodynamics. It's created by the central bank in control of the fiat money in question. They add money to the system via banks as long as they get the inflation rate they are targeting. Why it's important to have inflation?  ... So that you spend your money and don't sit on it like Uncle Scrooge. Because sitting on money (i.e. saving) causes deflation (i.e. negative growth - job losses etc.) if everybody does it. And that's not good. Therefore, we have to have some of it. Not too much, not too little. Just "right" amount.

The fact that central banks cause deliberately inflation leads to the fact that economies have to grow atleast at the inflation rate. Otherwise, economy will be actually declining in real terms. And that's why we just gotta have always growth. Not necessarily real at all. But people are lot happier that way. They get salary increases and they think that they are getting more wealthier. It is just the perfect scheme.

You really can fool most of the people ALL THE TIME. But you can't fool all of the people all of the time. I was long fooled, but I am no more. For me gold is money. When I don't keep all of my savings in stocks and property, I invest some of it to gold. I also have to keep paper money: dollars, euros, swedish krona and so on for practical reasons and to hedge my cash positions. The reason I hold gold and cash should be obvious to anyone following the financial news. The situation does not need much more sparks to get the fire really going. I really hope it does not happen, but who knows. Anything might happen. You got basically a currency war brewing: the mighty race to bottom. When US devalues, other have to follow. Not just because they want to keep their currency "cheap", but because that's the ultimate way to get the debt load reduced.  And it might work, if just most of the people have faith.

It's all about faith. What we really have is a faith-based monetary system. And right now, the gold charts tell me that more and more people understand where we are headed ultimately and try to protect atleast part of their wealth from the doom day scenario. I really hope we don't eventually get hyperinflation, but inflation we will have. Because the central banks make everything to get the inflation started. The big risk here is that they really don't understand how global economy works. Nobody does. So they might overdo it. Then it's the 70s all over again.