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SINLetter – February 2007
Welcome to edition 19 of Suria Investment Newsletter (SINLetter), a free monthly investment newsletter. The objective of this newsletter is to provide you with unbiased initial research and basic facts about individual stocks and other financial instruments so that you can research them further before deciding to add them to your portfolio or not. If you are reading this and are not a subscriber, you can subscribe by going to www.sinletter.com/subscribe.aspx and you will start receiving this newsletter from next month. I have provided relevant links throughout this newsletter, but if you have any questions or comments, feel free to write to me.
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Mr. Market has a highly volatile temperament with many mood swings that reflect the hopes, fear, greed and every once in a while even the rational thoughts of investors. According to many investors, the market is also highly efficient reflecting any public information about a company immediately in the price of its stock. However there are some of us who do not believe in the efficient market hypothesis and believe that by picking individual stocks and following certain strategies, we can outperform the market. To put it in the words of the second richest man in America, Warren Buffett, “I’d be a bum on the street with a tin cup if the markets were always efficient”.
The key word in the quote above is “always” as the markets are probably efficient most of the time but not always. While looking for stocks and opportunities to feature in these newsletters, I often come across a stock or other financial instrument that looks like a great buy but before it is time to send out the next newsletter, the price has already appreciated and the opportunity is lost. An example of this was my personal purchase of Pfizer on December 12, 2005 for $21.05 as mentioned in this blog entry, which appreciated 10.78% by the time I featured it in the January 2006 edition of SINLetter.
My recent self-imposed rule of buying stocks only after they are featured in these newsletters (unless I already bought them in my personal portfolios months before they are featured on SINLetter) has also greatly restricted my ability to buy stocks at any point during the month. To address these issues, I have decided to post trades on the blog and make adjustments to the model portfolio when applicable during the month instead of waiting for the end of the month. This will be an exception to the rule rather than the norm. To notify subscribers of these changes, we will shortly have an email system in place that will send you an email when I post a blog entry. Sometimes I also discuss stocks in blog entries but do not feature them in the newsletters. A good example of this is the company Marcus mentioned in the blog entry Let’s Go To The Movies, which went on to gain over 41% in the ensuing months.
If you would like to receive changes to the model portfolio that are posted on the blog and other blog entries such as the recent merger arbitrage opportunity, you can subscribe to the blog here. As always the newsletters and the blog continue to remain free and all I ask is your help in spreading the word about SINLetter by using our Tell-A-Friend page.
A 10.16% gain in our January 2007 pick Diamond Offshore Drilling (DO) was not sufficient to help the SINLetter model portfolio post a gain in January. The portfolio ended down marginally by 0.13% due to weakness (to put it lightly) in SanDisk (SNDK) and because our put options got hammered. The monthly and “since inception” performance is tabulated below.
|Performance Metric||Dow||S&P 500||Nasdaq||SINLetter|
|Since Inception (Aug 2005)||18.81%||16.42%||12.23%||82.94%|
Diamond Offshore was helped by a rebound in crude oil prices to over $58 per barrel and an announcement by the company to declare a special dividend of $4 per share payable to shareholders of record on February 14, 2007. As mentioned last month, the price of Diamond Offshore is volatile and fluctuates with the price of crude oil. I have been trying to figure out the price point at which deep water offshore drilling becomes prohibitively expensive and I found an answer while watching the series Deep Oil on The Nightly Business Report. According to Chevron (CVX), deep water drilling is profitable if the price of crude oil stays above $30 per barrel. Since even the most pessimistic forecasters do not expect to see the price of crude oil fall below $30 per barrel, I see limited downside risk to Diamond Offshore and plan to retain it in the model portfolio. It may be prudent to wait for a day when the price of oil is down to start a new position or add to an existing position in this company.
Alvarion (ALVR), our second pick from last month, did not fare very well and lost 5.53% in January partly because of a class action lawsuit. The lawsuit appears to be frivolous and I view this drop as a buying opportunity. The stock was also upgraded by the investment bank CIBC World Markets with a 12 to 18 month price target of $8 per share. In contrast, our other WiMax pick Airspan Networks (AIRN), posted a gain of 26.49% in January, narrowing our loss in Airspan down to 16.73%.
After powering up 15% in November and an additional 13.63% in December, Suntech Power (STP) once again gained 8.2% in January. This volatile stock is very susceptible to pullbacks from these levels as seen by the 3% drop on January 31, 2007 after a senior Chinese official warned of irrational exuberance (to borrow a phrase from Alan Greenspan) in the Chinese market. Even after this pullback, the stock is up 41.92% since we added it to the model portfolio six months ago and will remain a core long-term holding.
After spending a few months in the red, our generic drug company Teva Pharmaceutical (TEVA) is finally showing a small gain of 0.14%. After Pfizer (PFE) forecast no revenue growth in 2007-2008 and Indian generic drug manufacturer Dr Reddy’s Laboratories (RDY) posted a more than 200% jump in profits, investors are probably awakening to the fact that generic drug manufacturers are likely to do well in 2007 and 2008. An upgrade by Goldman Sachs and obtaining the right to exclusively market Novartis’ Focalin drug for a period of 180 days also helped the price of Teva pharmaceuticals in January. If I had to pick only one stock from our model portfolio to start a new position, it would be Teva Pharmaceutical.
SanDisk (SNDK) reported a fourth quarter loss of $35 million and offered a bleak outlook for the first quarter of 2007, causing the stock to drop 6.19% in a single day and registering a loss of 16.47% in the SINLetter model portfolio. However the news was not all bad and there were a few bright spots. Excluding charges related to the acquisition of Msystems and Matrix semiconductor, SanDisk posted a profit of $192 million, or 87 cents, well above analyst expectations of 72 cents a share. The company also reported a 55% increase in revenue and sales of MP3 players increased a very respectable 74%. I picked SanDisk because of its Sansa line of MP3 players and the ReadyBoost feature of Windows Vista but it looks like I did not anticipate the softness in NAND flash pricing. SanDisk expects demand to pick up again in the second half of 2007 and while the stock is probably not going to do much in the next couple of months, I still like its prospects.
Most of our put options got hammered in January. Given that the put options were a hedge against a falling stock market, it makes sense that they would be down in a rising market, but it still hurts. The May 2007 put option on the mortgage REIT New Century Financial Corp (NEWQG.X) is the only one that closed up with a gain of 80.56%. We may have to liquidate the March 2007 put option on the iShares Dow Jones Transportation ETF (IYTOQ.X) soon at a steep loss but I expect a rebound in the Jan 2008 put LEAPS (YBQMG.X) on YRC Worldwide especially since spot prices for trucking continue to remain weak and YRCW faces a rocky 2007. However if crude oil prices fall some more, trucking may see some of the business it lost to railroads come back and that would be positive for YRCW. Since these LEAPS have an expiry date of Jan 2008, we have plenty of time to find out which way the chips will fall.
Gold has a good month and closed the month of January at $651.90 per troy ounce, a gain of $15.90 or 2.5%.
I was considering selling the second half of our position in Logitech (LOGI) and booking the impressive 43.11% gains in 8 months but decided to hold off a little longer after learning that Logitech will become a component of the Nasdaq 100 Index on Feb 1st. I am instead going to sell our Gold ETF (GLD) and book a gain of 9.01% over a four month period. I would have liked to keep some exposure to Gold in our portfolio but I need the funds to purchase our new position. I plan to add a gold mining stock to replace this ETF sometime in the future.
Closed-End Funds and a Long/Short Strategy:
Note: If you are familiar with long/short strategies as applied to closed-end funds, feel free to skip to “the trade” section.
Instead of featuring two individual stocks, I figured I would do something different in this newsletter and discuss an interesting strategy related to closed-end funds in detail and very briefly cover one individual stock.
What are closed-end funds?
Closed-end funds are investment companies like mutual funds with a few key differences. Just like mutual funds, closed-end funds charge management fees and consist of a basket of stocks, bonds and other assets. However unlike mutual funds, closed-end funds trade on a public stock exchange and can be purchased or sold just like you would buy or sell a stock. In this way, they are more like Exchange Traded Funds (ETFs) and this might explain why the website ETFConnect.com refers to them as “closed-end ETFs”. To learn more about closed-end funds check out this description on the SEC website or this page on ETFConnect.com.
Premiums and Discounts
Once formed, closed-end funds do not issue any more shares and investors who want to buy into the fund must do so by purchasing it on a public stock exchange. Hence the price of these funds depends more on supply and demand instead of the value of underlying assets. This creates situations where some closed-end funds sell at a discount to its underlying basket of stocks (or other assets), while others sell at a premium to its net asset value (NAV).
A good example of funds selling at a premium are the closed-end funds India Fund (IFN) and India Investment Fund (IIF), which were the only options for investors who wanted to invest in India but did not want to purchase individual ADRs like Wipro (WIT) and Tata Motors (TTM). Over the last two years both IFN and IIF have traded at a premium to their underlying assets with the premium ballooning to more than 30% for the India Fund in the second quarter of 2006. After the May 2006 crash in emerging markets that probably reduced investor’s appetite for India and a rights offering that increased the number of shares, the premium of the India Fund has shrunk to its current level of just 2.16%.
Similarly some closed-end funds that are not in as much demand as the India fund often trade at a discount to their underlying assets or NAV. While uncommon, there have been instances where certain closed-end funds have traded at premiums of as much as 100%. For such a fund, you would be paying $2 per dollar of underlying assets held by the fund. On the flip side, if a fund traded at a discount of 50%, you would be paying 50 cents per dollar of assets held by the fund.
How Do I Figure Out These Premiums and Discounts:
The website ETFConnect.com has made it extremely easy to figure out not only the premium and discounts of individual closed-end funds, but it also has a very handy tool to display the funds that are selling at the largest discounts and premiums. For example if you want to see the premium or discount of the India Fund, you can go to ETFConnect.com and enter the symbol IFN in its search box. To figure out the funds selling at the largest premiums or discounts, you can use their Fund Sorter tool.
So I understand what closed-end funds are and how to look up their premiums or discounts. Now what do I do with this information?
Applying this information to the principle of “reversion to the mean” or in other words “what goes up must come down”, could create some interesting opportunities for investors. Funds that trade at a large discount to NAV are likely to narrow that discount at some point, leading to an increase in price of that fund assuming the price of the underlying assets remains unchanged. Similarly funds that trade at a large premium are likely to narrow that premium at some point, leading to a drop in the price of that fund assuming the price of the underlying assets remains unchanged. In the case of the India Fund, while the Indian stock market and individual ADRs like Wipro and Tata Motors appreciated a lot over the last seven months, the India Fund lost money because the premium narrowed from 28% to 2% as you can see from this chart.
Investors could use this information in combination with a various long/short strategies to create some very interesting hedged (low risk) or profit maximization opportunities. Long/Short strategies are discussed below.
Long/short strategies involve going long (purchasing) a stock or financial instrument (options, ETFs, etc… ) while simultaneously going short another stock or financial instrument to create a paired trade. This is sometimes done to reduce risk and in some instances to increase profit. For example, if you believe that Intel (INTC) is likely to do well in 2007 with its new line of processors and take away market share from AMD (AMD), in a regular scenario you would buy Intel stock but not AMD. Now if you are convinced that Intel will do well and AMD will do very badly in 2007, you can try to increase your profit potential by buying Intel and simultaneously shorting AMD so that you benefit from the price of Intel increasing and the price of AMD falling. Unfortunately you have also increased your risk with this “directional bet”.
Long/short strategies can also be used to reduce risk as illustrated in the following example. Let us still assume that you like the prospects of Intel in 2007. However you realize that a dropping tide brings down all boats and that the price of Intel is highly correlated to that of the semiconductor index (SOXX). So even if Intel is likely to do well in the long-term, there is a risk the stock might go down if the semiconductor index is dragged down by its other components like AMD. To hedge against this risk, you could go long Intel while simultaneously going short the semiconductor ETF XSD. This way even if the semiconductor index were to fall and drag down Intel with it, your losses in Intel would be offset by your short position in XSD.
We can use long/short strategies with closed-end funds to maximize profits or to create an arbitrage opportunity. Using the Fund Sorter tool on ETFConnect, we can see that the two funds with the largest premiums are Herzfeld Caribbean Basin Fund (CUBA) with a premium of 87.15% and the Cornerstone Total Return Fund (CRF). The premium on CUBA is probably a little lower as the data on ETFConnect is from 1/30/2007 and not from 1/31/2007 like the rest of the funds.
Similarly we can also get the two funds with the largest discounts and they are Equus Total Return (EQS) and Canadian World Fund Limited (T.CWF) with discounts of 26.59% and 16.69%. A simple profit maximizing strategy would be to go long EQS and T.CWF while simultaneously shorting CUBA and CRF. Please note that if you short a stock or fund, you are then responsible for all dividend or distribution payments. CRF pays out monthly distributions of 17.8 cents and its annual distribution rate is 11.45%. Could this be the reason this fund is trading at such a high premium?
According to Herb Greenberg of MarketWatch.com, these high distributions are a red flag. In the comments section of Herb’s blog, investors also discuss how hard it has been to short either CUBA or CRF. A big institutional investor may still be able to pull off such a trade but since this trade may not be accessible to all investors, I will not add it to the SINLetter model portfolio.
One part of the arbitrage (or low risk) trade would be to short CUBA, which has gone up on speculation that with Fidel Castro out of the picture, the trade embargo on Cuba (the country) would be lifted and companies based in the Caribbean would benefit greatly. However when you look at the holdings of the CUBA fund, you will notice that nearly 60% of assets are in U.S based companies like Royal Caribbean Cruises (RCL), Carnival Corp (CCL) and Garmin (GRMN). In fact 20% of assets are concentrated in a single railroad company called Florida East Coast Industries (FLA). So the second part of the arbitrage trade would be to go long on the top 10 holdings that constitute more than 60% of assets.
Whew! That felt more like writing a book or a lengthy article instead of an investment newsletter. It is almost 5 AM and the caffeine is beginning to wear off.
ICON plc (ICLR) $37.30
As mentioned in the closed-end funds section above, I am going to keep this very brief.
As one of my long-term IT contracts switches into a maintenance phase, I started looking for opportunities and noticed that a company called Icon was hiring very actively. Even though this was not a technology company, their hiring activity piqued my interest as an investor and I looked it up. This Irish company that does research for the pharmaceutical, biotech and medical devices industries was not only hiring but also came out with a press release on Dec 15th raising 2006 guidance and predicting 29% earnings growth in 2007. This stock seems to be so far from investor’s radar that it barely reacted to this news on that day and only in the following week did the stock post moderate gains.
The stock has almost doubled over the last year, rising from $20.795 per share on Feb 1, 2006 to its current $37.30. Paying approximately 28.91 times 2006 earnings and 22.07 times 2007 earnings for a company that is expected to grow earnings by 394% in 2006 (I am using $1.29 earnings per share, which is the mid point of their forecast) and 29% in 2007 is not unreasonable. Is there a possibility this company is actually this cheap because its balance sheet is debt laden? That is hardly the case with the balance sheet sporting more than three times the number of assets as liabilities. As of 2005, Icon had more than $82 million in cash and short-term investments and only a little over $6 million in short and long term debt. The fourth quarter 2006 and annual results will be announced on February 13th and investors should be able to get the full year 2006 numbers then. The key unknown is whether ICON can conitnue a high rate of earnings growth beyond 2007.
Every month we add the two featured stocks into a model portfolio started with a cash position of $100,000 on August 2, 2005. To keep calculations simple, trading costs and regular dividends are not included. Prices reflect the closing price as of the last trading day of the previous month (January 31, 2007 for the February 2007 newsletter).
|Stock||Number of Shares||Cost||Current Value||Difference($)||Difference(%)|
|Option||Number of Units||Cost||Current Value||Difference($)||Difference(%)|
Voluntary Disclosure: I currently own shares of Airspan Networks (AIRN), Medifast (MED), Tata Motors (TTM), Logitech (LOGI), Intel (INTC), VA Software (LNUX), Suntech Power (STP), Sify (SIFY), Teva (TEVA), Mattel (MAT), SanDisk (SNDK) and Alvarion (ALVR).
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