SINLetter - December 2006

Welcome to edition 17 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 Exchange Traded Funds (ETFs) 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.

Is It Real?

One of the questions I get asked often by subscribers and SINLetter visitors is whether the model portfolio is real or does it just represent paper positions and profits. As I mentioned in the FAQ section, as of January 1st, ten out of the eleven stocks in the model portfolio were also in my personal portfolios. As we approach the end of the year, 11 out of the 13 stocks (not counting the two featured in this newsletter or the Gold ETF) in the model portfolio are also in my personal portfolios.

I also have a self-imposed rule to buy the stocks featured in the newsletters after the newsletter is sent out to subscribers. Hence my interests are very much aligned with the interests of subscribers. Since I do not trade very often, it is possible that I may not be able to purchase every single stock that is featured in the newsletter right away due to capital constraints. The stocks I own that are also in the model portfolio are disclosed in the "Voluntary Disclosure" section right below the model portfolio at the end of each newsletter.

Portfolio Performance:

The resilience of this market in the face of tough economic data is downright amazing. My decision to hedge the portfolio against a weak economy through put options actually ended up hurting the portfolio a little but the SINLetter model portfolio still managed to post a gain of 2.70% in November. The monthly and "since inception" performance is tabulated below.

Performance Metric Dow S&P 500 Nasdaq SINLetter
November 2006 1.17% 1.65% 2.75% 2.70%
Since Inception (Aug 2005) 15.05% 13.38% 10.77% 75.70%

 

I was also pleased to see that for the twelve month period ending October 31st, the SINLetter model portfolio outperformed every single paid newsletter tracked by Mark Hulbert of MarketWatch.com. Every edition of SINLetter is sent to Mark Hulbert at the same time it is sent out to subscribers but the Hulbert Financial Digest currently does not track the returns of the SINLetter model portfolio.

Medifast (MED), the weight management company that until a few short months ago was the top performing stock of the SINLetter model portfolio with gains in excess of 230%, reported quarterly results that came in above expectations and the stock gained 40% last month. The stock is now registering gains of 142.12% in the model portfolio and there is a good chance it will regain its top performer status from VA Software (LNUX). I wanted to post a summary of the quarterly results on the SINLetter blog like I have for the last three quarters, but was unable to do so. So here is a short summary of the third quarter results.

As you can see from the summary of the second quarter results that I posted on my blog and the comments following it, Medifast was expected to earn between 14 to 16 cents per share for the third and fourth quarter combined. Medifast actually earned $1.49 million or 11 cents per share in just the third quarter. This represents an increase of over 140% when compared to the third quarter of last year. Sales were also strong, up 79% to $19.6 million from $11 million in the third quarter of last year. The company once again left their full year earnings forecast of 38 to 40 cents per share unchanged. This means that the company only has to earn about $0.68 million in the fourth quarter to meet the high end of its full year forecast. It is important to note that the fourth quarter is traditionally the slowest quarter for Medifast and if they do not meet their full year estimates, there may be some short-term downside risk. I expect Medifast to perform well in 2007 and plan to continue holding it in the model portfolio and my personal portfolio.

SanDisk (SNDK), which was featured in last month's SINLetter, lost additional ground in November and closed the month with a loss of 7.69%. SanDisk appears to be slashing prices on its flash cards, USB drives and MP3 players based on aggressive rebates and price cuts I have seen at Office Depot and Costco over the last few days. While this might increase market share and revenue, it could hurt earnings in the fourth quarter just like it did in the third quarter. However I like the long-term prospects of SanDisk and see this current weakness as a buying opportunity. On the positive side, while Microsoft's (MSFT) new Zune MP3 player did not even make it to the top 50 Amazon.com bestsellers in the electronics category, two SanDisk Sansa MP3 players made it to the top 15. I picked up SanDisk for my personal portfolio and plan to continue holding it in the model portfolio.

Suntech Power (STP) reported another strong quarter with earnings nearly tripling to $28.7 million and revenue increasing an equally bright 188% to $163 million. Instead of reiterating some of the recent developments at Suntech, I am going to let Himanshu Pandya of FinancialNirvana.com do it for me. Suntech was up more than 15% in a single month and I expect this highly volatile stock to continue doing well.

Three out of the four put options and LEAPS in our portfolio were in positive territory in the beginning of November. That was until the market decided to rally strongly. We now have three options that are in negative territory, with only the put option on the mortgage REIT New Century Financial Corp (NEWQG.X) posting a gain of 13.89%. Based on a drop in consumer durable goods orders, I expect the trucking sector to remain weak and plan to let our put options ride along for now.

Gold had another strong month on account of a falling dollar and closed the month of November at $646.60 per troy ounce, a gain of $39.4 or 6.49%. The streetTRACKS Gold (GLD) ETF that we picked up for the model portfolio in October is now up 8.27% in just two months. While I would not start a new position in Gold at this time, I plan to continue holding it as a hedge against a weak dollar.

Portfolio Readjustment:

Nokia (NOK) recently revised its operating margins down to 15% from the previous forecast of 17% due to competitive pressure. Nokia's new line of high-end phones including the N Series and the E62 are uninspiring and face competition from the Motorola Q and the BlackBerry Pearl. There is also the chance that Apple (AAPL) might introduce the widely rumored iPhone. Based on these developments, I have decided to sell Nokia and book a profit of 19.47%.

The Safeway "O Organics" story played out as I expected and the stock is registering a gain of 22.65% since we added it to our portfolio 8 months ago. I am satisfied with these returns and am going to sell Safeway (SWY) to fund the purchase of our new featured stocks.

Market Commentary:

Third quarter Gross Domestic Product (GDP) growth was revised higher to 2.2% from the 1.6% reported in October. However this revised figure is still below GDP growth of 2.6% in the second quarter and 5.6% in the first quarter of 2006. Some of the other economic indicators also point to weakness in the economy. While sales of existing homes managed to post a tiny gain of 0.5% in October, they were down 11.5% when compared to October 2005. Inventory of unsold homes increased to 7.4 months, the largest supply of unsold homes since April 1993. The housing market is considered to be in dire straits when the supply of unsold homes reaches 9 months. The news was not much better on the new homes front either. New home sales dropped 3.2% in October but the median price of a new home rose an astounding 13.89% to $248,500.

The savings rate dipped further into negative territory to -1.4%, the second lowest level since the great depression.

Personal Savings Rate

U.S retail sales fell 0.2% in October after a revised drop of 0.8% in September. I would have been glad to see the "over extended" consumer who has been propping up the economy for years, scale back a little but that 0.2% drop is misleading and was driven by falling gas prices. Excluding gasoline sales, retail sales were actually up 0.4% in October.

The dollar declined further, hitting a 20 month low against the Euro and a 14 year low against the British pound. The dollar is down 50% vs. the euro during the last five years and is expected to continue losing ground. Check out this bleak outlook for the dollar by Philip Bowring in his article The Devil and the Dollar. While such a collapse of the dollar may not come to pass, it is always a good idea to have some exposure to international stocks, gold and other commodities in a portfolio.

So why is the market going up in the face of weak economic data? The fact that corporate profits were up 31% in the third quarter of 2006 when compared to the third quarter of 2005 (depressed due to hurricane Katrina) may have something to do with it. There were also some bright spots in the economy such as better than expected retail sales during the all important Thanksgiving weekend, but those sales numbers are best taken with a pinch of salt. The unemployment rate staying at a low 4.4% is another positive factor. However the majority of the data points to further weakness and sooner or later the market will align with the economic reality.

Getting back to stocks, Intel (INTC) raised its dividend 12.5% from 40 cents a year to 45 cents a year and this will be effective in the first quarter of 2007. Based on our purchase price of $19 in July, the dividend yield works out to a decent 2.37%. While there has been some recent weakness in the semiconductor sector, I continue to like Intel's prospects on account of the release of Windows Vista and the new line of desktop, server and mobile chips that Intel released in the latter half of 2006.

The satellite radio providers Sirius Satellite Radio (SIRI) and XM Satellite Radio (XMSR) both did well in November rising 11.22% and 23.84% respectively. A subscriber wrote to me in the first week of November asking about Sirius. I had invested in Sirius a few years ago when it was trading at about $2 per share and I told him that if I wanted to invest in satellite radio again, I would pick up both Sirius and XM Satellite. Perceptions of which satellite radio company will emerge a winner seem to change every year and instead of trying to pick the winner the best way to invest in these speculative stocks might be to start an equal position in both.

XM released quarterly results in the second week of November and handily beat analyst expectations when it reported an improvement in losses, an increase in the number of subscribers and also forecast becoming cash flow positive in the fourth quarter of 2006. This profitability expectation is most likely on account of the holiday season boost that satellite radio usually gets and sustained profitability may still be a few quarters away. Sirius also reported a larger than expected increase in the number of subscribers and a 150% increase in revenue. While both these satellite radio stocks remain highly speculative, they are beginning to pique my interest again.

WisdomTree Investments (WSDT.PK) $7.40

The Story:

Note: If you are familiar with ETFs, feel free to skip the first two paragraphs.

Exchange Traded Funds or ETFs are investment vehicles like mutual funds that allow you to buy a basket of investments (stocks, bonds, etc) that are administered by the company issuing the fund. However there are a few key differences between mutual funds and ETFs. The basket of stocks in a mutual fund is picked by the mutual fund manager, who has the ability to buy and sell stocks in the fund at any time. In contrast ETFs are based on an index such as the S&P 500, which contains 500 of the largest companies in America. Stocks are bought and sold in an ETF when there are changes made to the underlying index. Another important difference between mutual funds and ETFs is that ETFs are traded on a stock exchange and you can buy and sell ETFs throughout the day (not a recommended activity) just like you can buy and sell stocks. It is even possible to short ETFs.

So why would investors choose ETFs over mutual funds? It is a well known fact that the majority of mutual funds (and newsletters, I may add) underperform the S&P 500 index. You can match the returns of the S&P 500 or the Dow Jones Industrial Average or the Russell 2000 by picking the ETF (SPY, DIA or IWM) that tracks these indices and not pay the expensive management fees charged by some mutual funds. Since ETFs are not "actively managed" like mutual funds, their expense ratios are comparatively very low. ETFs also have very little turnover, are more tax efficient (barring the commodity ETFs) and provide more visibility as an investor can easily look up all the constituent stocks of a particular ETF. For example, if I wanted to look up the holdings of the PowerShares Value Line Timeliness (PIV) ETF, I can do so on the PowerShares website.

There are currently about 300 ETFs with total assets under management of $363 billion (as of September 2006) in the United States. This compares with over 8,000 mutual funds that have over $10 trillion under management in the United States. The assets under management by ETFs is no more than a drop in the bucket right now and there is still a lot of room to grow. It appears that new ETFs are being launched almost everyday covering everything from emerging markets to commodities like corn and copper.

So is it time for us to own a piece of "Utopia"? The theory of investing in companies that actually run mutual funds instead of investing in the mutual funds has been around for a while. With the explosive growth in assets under management for ETFs, why not apply this theory to the companies that are offering these ETFs? Money has been flowing out of mutual funds consistently for the last five months and instead of assuming that it is going to the sidelines, I am willing to wager that some of it is actually ending up in ETFs.

When the investment company WisdomTree was created with a star management team and launched 20 ETFs on June 16, 2006 it made quite a splash on Wall Street. However the stock of the company, which currently trades on the pink sheets, received little attention. Following the concept of investing in the companies riding the current ETF wave, I considered State Street Corp (STT) as a potential candidate for last month's SINLetter and also looked at WisdomTree after reading this blog post by the Confused Capitalist. Since WisdomTree is not traded on one of the regular exchanges it is very hard to find financial data for the company and I could not even find information about assets under management. A few weeks later, the stock popped up almost 20% when WisdomTree announced that in addition to the 30 ETFs that it already offers, it has filed to offer another 31 ETFs. You can find a list of these 31 ETFs on ETFTrends.com. Even after this pop, I remained uncertain about picking up the stock primarily on account of the aforementioned lack of data.

On November 13, WisdomTree announced that assets under management have reached $1 billion. This number lit another fire under the WisdomTree stock and it jumped up another 42% since the news came out. So is it still a good time to get into WisdomTree after it has already run up more than 60% in a single month?

Let us use the limited amount of public information we have available for WisdomTree to arrive at a rough valuation for the company. With expense ratios for their ETFs ranging from 0.28% to 0.58% and with a majority of their ETFs sporting an expense ratio of 0.58%, I am going to assume an average expense ratio of 0.5%. To keep calculations simple and because WisdomTree does not provide this data, I am also going to assume that assets under management are equally distributed amongst the 30 ETFS that are currently offered. Based on assets under management of $1 billion over the first six months, revenue and gross profits for the company would work out to about $50 million ($1,000,000,000 X 0.05). Revenue and gross profits for small asset management companies is usually the same as you can see from the income statements of other asset management companies like Westwood Holdings Group (WHG), U.S Global Investors (GROW) and the recently tainted GAMCO Investors (GBL).

If WisdomTree were to grow assets under management over the next six months to the same extent as they did in the first six months (it is probably going to be much higher as they will have 61 ETFs instead of the current 30), they should see gross profits of about $100 million from $2 billion in assets under management. Assuming a conservative profit margin of 25%, which is about the same as the profit margin for GAMCO Investors but a little higher than the 18% margins of ETF gorillas like State Street and Barclays, we get net income of $25 million a year. With a market cap of $600 million, I arrive at a rough forward P/E of 24. Please note that it is possible that WisdomTree may not even be profitable, as many new companies tend to utilize every dollar available to grow the business at the expense of earnings. Astute investors will also realize that since WisdomTree did not start the year with $2 billion in assets under management, the actual gross profits during the first year of operations may be much lower. It should also be noted that ETFs charge their expenses on a daily basis. Based on some of the information provided here, investors should be able to build a more sophisticated model to arrive at a valuation for WisdomTree. If you do, please shoot me an email and I would happy to post it on SINLetter.

Given that WisdomTree currently trades on the pink sheets and has appreciated more than 60% in less than a month, it could be considered a highly speculative investment by some. But it is also highly unusual to find a former SEC Chairperson in the management team of a company that is trading on the pink sheets. WisdomTree may eventually end up listing its shares on one of the main exchanges or get acquired by a company like Fidelity that has oddly enough failed to launch its own ETFs. While my guesstimated P/E of 24 is not exactly inexpensive, the prospects for high double-digit growth combined with the fact that my calculations are probably conservative, lead me to believe that WisdomTree may prove to be a good investment even after this amazing run-up.

I plan to start a position in WisdomTree for my personal portfolio after this newsletter is sent to subscribers.

Competitors:

WisdomTree faces competition not only from 800 pound gorillas like State Street (STT), Barclays (BCS), and Amvescap (AVZ) that offer ETFs but also from mutual funds powerhouses like Fidelity and Vanguard that have certain funds with expense ratios so low that they would put some ETFs to shame.

The Good:

  • ETFs currently have about $363 billion in assets under management and a lot of room to grow.
  • WisdomTree is a young company with an excellent management team and a defined focus on dividend based ETFs.
  • WisdomTree already has $1 billion in assets under management and has filed to launch an additional 31 ETFs.
  • Based on my rough valuation model, WisdomTree could see further price appreciation as assets under management grow.
  • Former SEC Chairman Arthur Levitt recently joined WisdomTree as a senior advisor.

The Bad:

  • WisdomTree currently trades on the pink sheets and there is little financial data available for the company.
  • The stock has seen an astonishing 60% run-up in less than a month and is susceptible to a dramatic drop.
  • If the economy continues to weaken and the markets drop, investors may lose their appetite for newly launched ETFs.

 

Barclays Bank (BCS) $54.06

Barclays is a London based bank with a global footprint and multiple business units including investment banking, retail banking, credit card, mortgage lending and wealth management. It is the wealth management division that attracted me to Barclays as it fits in well with our ETF growth theory discussed in WisdomTree (WSDT.PK). The iShares family of ETFs offered by Barclays, has over $244 billion in assets under management and Barclays Global Investors manages 65 of the world’s top 100 largest pension plans. Barclays is growing its assets under management both by launching new ETFs as well as acquiring competitors such as Indexchange Investment, which it agreed to acquire for 240 million euros in November.

Barclays also provides international diversification and a hedge against the falling dollar, which is now at a 14 year low against the pound sterling. Barclays has business operations in 37 countries outside the United Kingdom and a strong presence in Africa through acquisitions. There is speculation that Barclays itself might get acquired by Bank of America (BAC). Bank of America currently holds 9.2% of U.S deposits and has been attempting to expand without breaching the 10% regulatory ceiling.

So why would I want to invest in Barclays instead of Bank of America or Citigroup (C)? Apart from international diversification, the dollar hedge and the ETF growth theory, Barclays also sports better revenue and earnings growth than either Bank of America or Citigroup. It is astounding to see a company with a market cap of almost $88 billion exhibit quarterly revenue growth of 35% and earnings growth of 45.1%. Barclays does not face the mortgage default and weak housing risks that Bank of America is facing as the British housing and mortgage industries are very strong right now. But that could change overnight.

The stock has a decent dividend yield of 3.8% and an attractive valuation with a current P/E of 12.57 and a forward P/E of 9.94. Barclays may prove to be a better and possibly safer alternative to either State Street or WisdomTree as a play on the burgeoning growth in ETFs.

The Good:

  • Barclays is a globally diversified bank with strong revenue and earnings growth.
  • Barclays through its iShares family of ETFs is the 800 pound gorilla amongst ETF providers.
  • Barclays sports an attractive valuation with a forward P/E of just 9.94 and P/S of 2.28.

The Bad:

  • Barclays profit margin of 18.34% is well below the margins of either Citigroup or Bank of America.
  • Barclays could be hit by a slowdown in the British housing market.
  • The dollar may rebound from its low, leading to a drop in the price of Barclays ADR shares.

 

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 (November 30, 2006 for the December 2006 newsletter).

Model Portfolio - December 1, 2006

Stocks

Stock Number of Shares Cost Current Value Difference($) Difference(%)
WSDT.PK 1000@7.40/share $7,400 $7,400 $0 0%
BCS 200@54.06/share $10,812 $10,812 $0 0%
SNDK 200@48.10/share $9,620 $8,880 -$740 -7.69%
MAT 600@19.70/share $11,820 $13,170 $1,350 11.42%
GLD 150@59.47/ETF $8,921 $9,658 $738 8.27%
TEVA 300@35.05/share $10,515 $9,618 -$897 -8.53%
STP 400@25.93/share $10,372 $11,972 $1,600 15.43%
SIFY 1000@7.92/share $7,920 $9,910 $1,990 25.13%
PG 180@55.60/share $10,008 $11,302 $1,294 12.93%
INTC 550@19.00/share $10,450 $11,767 $1,317 12.61%
LOGI 240@20.385/share $4,893 $7,094 $2,202 45.01%
JNJ 200@57.65/share $11,530 $13,182 $1,652 14.33%
LNUX 2000@1.83/share $3,660 $9,120 $5,460 149.18%
MED 500@5.39/share $2,695 $6,525 $3,830 142.12%
TTM 900@11.94/share $10,746 $16,254 $5,508 51.26%
AIRN 1700@5.62/share $9,554 $4,845 -$4,709 -49.29%


Options

Option Number of Units Cost Current Value Difference($) Difference(%)
IYTOQ.X 5@3.90/contract $1,950 $1,700 -$250 -12.82%
YBQMG.X 8@2.60/contract $2,080 $1,960 -$120 -5.77%
LRXMJ.X 3@7.00/contract $2,100 $1,710 -$390 -18.57%
NEWQG.X 5@3.60/contract $1,800 $2,050 $250 $13.89
Cash     $6,775.2    
Total     $175,705 $75,705 75.7%

 

Voluntary Disclosure: I currently own shares of Airspan Networks (AIRN), Royal Philips (PHG), Nokia (NOK), Medifast (MED), Tata Motors (TTM), Logitech (LOGI), Intel (INTC), VA Software (LNUX), Suntech Power (STP), Sify (SIFY), Teva (TEVA), Mattel (MAT) and SanDisk (SNDK).

 


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