SINLetter - November 2006

Welcome to edition 16 of the 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. For those of you who are reading this and are not already subscribed, 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.

Portfolio Performance:

October proved to be a strong month for all the major indices and after a gain of almost 5.5% at one point, the SINLetter model portfolio settled down to close the month with a gain of 3.17%. The monthly and "since inception" performance is tabulated below.

Performance Metric Dow S&P 500 Nasdaq SINLetter
October 2006 3.44% 3.15% 4.79% 3.17%
Since Inception (Aug 2005) 13.72% 11.54% 7.80% 71.09%

 

Earnings season was in full swing in October and a number of SINLetter stocks reported quarterly earnings. Mattel (MAT), which was featured in last month's SINLetter, posted a gain of 14.87% in a single month after reporting results that left investors delightfully tickled and thanks to continued demand for their new T.M.X Elmo toy. The company managed to sell 250,000 Elmos on the first day of launch in September and according to Toys R Us employees I have spoken to, the T.M.X Elmo continues to fly off store shelves.

Switzerland based computer peripheral maker Logitech (LOGI) reported the "best-ever" sales and profits in the company history with sales up 19% and earnings up a whopping 36%, well above analyst estimates. The company also increased its full year forecast, which is usually a positive signal. The stock shot up $3.16 or 14.20% the day after results were announced and continued to trend higher through the rest of the month. At 25.43 times this year's earnings and 20.19 times next year's earnings, I do not find the stock grossly overvalued and plan to continue holding half our position in the SINLetter model portfolio while Bill Cara waits for a pull back.

Logitech is now registering a gain of 29.75% since we added it to our portfolio five months ago based on the stock split theory. Both the stocks that were selected on the basis of this theory, have outperformed the market by a wide margin. My decision to sell Infosys (INFY) last month to lock in a gain of 35.21% was a little premature as the company reported a 44.2% jump in quarterly profits and continued its strong upward march. I am still wary of Indian IT consulting companies based on my outlook for continued softness in the US economy and the high valuations that some of these companies currently sport.

Sify (SIFY) reported results that were in-line with analyst expectations, posting a profit of $1.49 million or 3 cents per share when compared to a loss of $1.34 million last year. Revenue rose 17.9% to $30.1 million. With expectations riding very high, the stock had run up a great deal (up 35% from our point of entry) in anticipation of Sify beating estimates. The stock gave up most of those gains after reporting in-line results and is now registering a gain of 15.78% in our model portfolio. I still find Sify attractive and some recent initiatives such as the launch of a new Massively Multi-Player Online Role Playing Game (MMORPG) called A3 India and the deal with Indian Railways to sell tickets from Sify's cybercafes should add to earnings in the current quarter. Sify also remains an excellent acquisition candidate for companies like Yahoo or Google who may be looking into expanding their presence in India. The key risk faced by Sify at this point is a correction in the Indian stock market, which has more than doubled over the last two years.

The two defensive stocks in our portfolio, Johnson & Johnson (JNJ) and Procter & Gamble (PG), also reported very strong earnings in October. Procter & Gamble's 33% rise in earnings and 27% rise in revenue is truly astounding for a company with a market cap of over $200 billion until you realize that a large part of that growth was not organic and was driven by acquisitions like P&G's acquisition of Gillette in 2005.

After swinging into positive territory in the first half of October, Teva Pharmaceutical (TEVA) reversed course and is now registering a loss of 5.93% in our model portfolio. Investors did not react kindly to news that Teva's current CEO Israel Makov plans to retire in 2007. Management changes can have a serious effect on a company but with Makov's decision to stay with the company for two more years as an advisor and the favorable conditions for generic drug manufacturers, I plan to continue holding Teva for now. Third quarter earnings are due out on November 7th for Teva.

After being down through the first half of October, Gold made a strong comeback. Gold closed the month at $607.70 per troy ounce, a gain of $9 or 1.5%, which was also reflected in the price of the streetTRACKS Gold (GLD) ETF that we added to the model portfolio last month.

Portfolio Readjustment:

The current SINLetter model portfolio is positioned well with a set of companies that span multiple sectors, market caps and geographic regions. However to fund the purchase of this month's featured pick and hedge against a slowing economy, I am going to sell half our position in Logitech and book a profit of 29.5%.

With slowing growth in the consumer electronics segment at Philips, I am also going to sell our position in Royal Philips (PHG) and book a profit of 7.1%.

Other Interesting Events:

Gross Domestic Product (GDP) growth, a number everyone was watching to gauge the strength of the economy, grew only 1.6% in the third quarter following growth of 2.6% in the second quarter and 5.6% in the first quarter of 2006. Estimates for third quarter growth had been 2%. As mentioned in previous editions of SINLetter, I have been forecasting a continued slowdown in the economy or a recession in 2007. The signs pointing to a slowdown already existed even before the third quarter GDP number came out and I mentioned some of these signs in the "Portfolio Readjustment" section of last month's SINLetter. To provide further confirmation, the consumer confidence index dipped unexpectedly in October.

It is important to note that with so many economic indicators out there, different people can come to wildly different conclusions about the economy and if Bernard Baumohl, the Director of the Economic Outlook Group, were to be believed, the economy is still sound and may even pick up speed next year. I for one, beg to differ and will continue to take defensive steps to hedge the portfolio against a further slowdown in the economy.

The toy company JAKK Pacific (JAKK), which was mentioned in the October 2006 edition of SINLetter as a competitor of Mattel (MAT) reported spectacular third quarter results with sales jumping 27% to $295.8 million and earnings increasing 24% to $40.5 million. Investors were clearly very pleased with these numbers, "jakking" the stock up an astonishing 20.88% in a single day. It looks like the toy companies are as hot as the toys they make, if not hotter, this holiday season.

A new Exchange Traded Fund (ETF) called PowerShares Listed Private Equity Portfolio (PSP) was launched in October, which includes more than 30 U.S. public companies with investments in more than 1,000 private businesses. Based on the price movement of two companies that I am watching closely, CMGI (CMGI) and nanotech venture capital company Harris & Harris (TINY), I wondered if these companies were part of the PSP portfolio and my hunch was confirmed when I looked at its holdings. The current popularity of ETFs as an asset management and diversification tool is clearly driving up the price of some of their index constituents. A relatively simple strategy that investors could use would be to follow the filings of ETFs at the SEC and start investing in some of the underlying constituents of the ETF right before its launch. While some investors are already aware of this strategy, the price movements of CMGI and TINY lead me to believe that it is not yet widely utilized and could still provide a window of opportunity to nimble investors.

SanDisk (SNDK) $48.10

The Story:

I am sure most of you have either used or seen others use flash cards in digital cameras over the last few years. The explosive growth in the use of digital cameras and MP3 players combined with the demise of the floppy drive has been a boon for companies that make flash cards and Universal Serial Bus (USB) drives. Milpitas, California based SanDisk makes flash memory cards for digital cameras, MP3 players, the Cruzer line of USB drives and gaming cards for use in Sony's PlayStation Portable (PSP).

So what attracted me to this well known company that I felt was overvalued just a few months ago? While the stock has retreated from a high of almost $80 in January to the current $48.10, the company has released an exciting new line of MP3 players, acquired a key competitor and is well positioned to benefit from the launch of Microsoft's new operating system Windows Vista in 2007.

While Apple's iPods remain the clear leader in the MP3 market, competitors like Sandisk and Singapore based Creative Technology (CREAF) have been nipping at Apple's heels for years. Sandisk's Sansa line of players have been a great alternative to iPods for music lovers who use a subscription based music service like RealNetwork's (RNWK) Rhapsody To Go, Yahoo Music Unlimited To Go or Napster To Go.

I personally bought a couple of Sansa's over the last two years and could not be happier with my player. However no player on the market has managed to capture the "cool factor" that has propelled the iPods to their status as a market leader. Until now. With the release of the sleek and highly attractive e200 series of MP3 players, Sandisk stands a good chance of capturing market share in this highly profitable and competitive segment this holiday season.

SanDisk Sansa e200

Beyond MP3 players, SanDisk also stands to benefit from other emerging areas of growth. Samsung unveiled a 32GB flash-disk based laptop earlier this year, which has distinct advantages over hard drives but remains prohibitively expensive. While the possibility of flash based laptops is a few years out, hybrid hard drives (HDD) that combine a regular hard drive with a 1 GB flash chip to improve performance and conserve power are right around the corner with the release of Windows Vista. Instead of a hybrid hard drive, Windows Vista users can also use a feature called ReadyBoost that can improve the performance of the system by attaching an external flash memory device like a USB Key. The ability to increase the memory of a computer without having to open it up and adding more RAM will certainly appeal to many users and is likely to increase the sales of large USB key drives.

Sandisk has been attempting to increase market share by significantly dropping prices on its USB Key drives and the flash chips it supplies to computer manufacturers. This quest for market share along with increased R&D costs has indeed caused a drop in margins, clearly spooking Wall Street in the process and leading to a drop of $12.58 a share or more than 20% on October 20th after Sandisk reported third quarter results. While income dropped 4% to $103.3 million from $107.4 million, revenue actually increased a healthy 27% to $1.85 billion, providing the perfect opportunity to get into this growth stock in a moment of weakness. With a solid balance sheet and a forward P/E of 17.24, SanDisk could prove to be an attractive long-term investment.

Competitors:

SanDisk faces stiff competition from Samsung, Hynix, Micron Technology (MU) and Intel (INTC) in the flash memory segment as well as Creative Technology (CREAF) and Apple (APPL) in the MP3 segment.

The Good:

  • SanDisk continues to benefit from the explosive growth in the use of digital cameras, MP3 players and USB key drives.
  • SanDisk recently launched a highly attractive line of MP3 players that work well with subscription music services like Rhapsody.
  • Windows Vista with its ReadyBoost feature and the launch of hybrid hard drives should fuel growth in the flash memory segment.
  • SanDisk has a solid balance sheet with almost three times the total assets to total liabilities.
  • The recent 20% drop in price after the release of third quarter results could provide an attractive point of entry.

The Bad:

  • Net income dropped 4% in the recent quarter due to a drop in gross margins from 37% to 32%.
  • The MP3 player segment is highly competitive and despite attempts by a large number of rivals, Apple continues to maintain its leadership position.
  • SanDisk faces strong competition from Samsung, a company that continues to find new and innovative uses for flash.

The Numbers:


P/S 3.32 Cash $1.318 billion
P/E 26.33 Long Term Debt $1.15 billion

Hedging The Economy Through LEAP Puts

Preservation of capital and risk management are two key aspects of portfolio management as it can take many years to recover financially and psychologically from a large loss. Risk management can be achieved through various strategies such as diversification across various sectors like healthcare, industrials, technology and retail; geographical diversification by investing in different countries and diversification through investing in non-correlated assets (when one asset moves up, the other is likely to move down) such as stocks, gold, real estate and bonds. We have used some of these strategies in the SINLetter model portfolio but with 90% of the portfolio dedicated to long stocks, it still remains vulnerable to the threat of an economic slowdown or recession.

To hedge against a sluggish economy, I have decided to add some naked put options to the portfolio. I usually tend to avoid options as I am not very fond of the time factor associated with options and the possibility of a 100% loss. However if they are used wisely, they can prove to be a useful risk management tool. If you are familiar with options and LEAPS, feel free to skip the next three paragraphs.

Stock options are financial instruments that give you the right (but not the obligation) to buy or sell an underlying stock at a pre-determined price until the expiration date of the option is reached. For example, if you bought Google (GOOG) at $100 a share back in 2004 and are still holding on to the stock after it has appreciated more than 375%, you are most likely a very happy investor but probably a nervous one too. To protect against a drop in Google's stock price, you could buy an option to sell Google for it current price of $476.39 until December 2006. This is called a "Put" option and for a small premium you have the right to sell Google for $476.39 even if it drops to $200 before the option expiration date. You can either chose to exercise the option to sell your shares at $476.39 or just sell the option and retain the underlying stock (if you are convinced the drop was temporary).

The opposite of a "Put" option is a "Call" option, which gives you the right to buy the underlying stock at a pre-determined price until the expiration date of the option. For example if you think SanDisk (SNDK) is underpriced at about $48 a share right now but would rather not invest almost $10,000 for 200 shares, you could consider buying a call option for SanDisk with an expiry date of April 2007 and a strike price of $47.50 for little over $2. So even if SanDisk appreciates to $60 in January 2007, you will have the right to exercise your call option and buy SanDisk for $47.50, making a tidy profit in the process. You could also just sell the call option which would have appreciated by a few hundred percent. For a better understanding of options beyond this basic introduction, check out the excellent options tutorials on the Chicago Board Options Exchange website.

If you are like me and do not like the short expiration dates of options (an investment could easily go down from my purchase point in the short-term even if my long-term hypothesis is correct), Long-Term Equity AnticiPation Securities or LEAPS could prove to be the right instrument as they are options with expiry dates well into the future. You would obviously pay a bigger premium for LEAPS but you also have more time to determine if your investment hypothesis was correct or not. Just like Put and Call options, you can buy Put and Call LEAPS.

While some defensive sectors like healthcare tend to perform well in a slow economy or recession, stocks in sectors such as retail, travel and transportation can be adversely affected. To hedge our model portfolio I am going to purchase options and LEAPS in a transportation ETF, a trucking company, a homebuilder and a mortgage lender.

At first I decided to just buy LEAPS Puts in the iShares Dow Jones Transportation Average Index Fund (IYT) as a negative call on the trucking industry but noticed that FedEx and UPS were 11.36% and 7.3% of its holdings. Since both FedEx and UPS have large international operations, they may not be as adversely affected by an economic slowdown in the US as the trucking industry. So I also decided to buy a put option on the trucking company YRC Worldwide (YRCW). While investors have been dazzled by the gains in real estate and commodities over the last couple of years, trucking companies like JB Hunt Transport Services (JBHT) and Landstar Systems (LSTR) have quietly appreciated more than 700% and 500% respectively over the last five years. However both JB Hunt and Landstar have excellent balance sheets and I decided to pick the highly leveraged YRC Worldwide instead.

To round up our put options, I picked the Florida based homebuilder St Joe (JOE), a company that I made a negative call on in September 2005 and that eventually decided to exit the home building business altogether. I also decided to pick the home mortgage lender New Century Financial Corp (NEW), a real estate investment trust (REIT) that engages in sub-prime lending. This is an area that is likely to face the most mortgage defaults as the housing bubble deflates.

Please note that options are highly risky investments with the possibility of losing your entire investment. I could also be spectacularly wrong about the economy. Hence the amount I have invested in these four options is relatively small. Each options contract represents 100 shares of the underlying stock.

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 (October 31, 2006 for the November 2006 newsletter).

Model Portfolio - November 1, 2006

Stock/Option Number of Units Cost Current Value Difference($) Difference(%)
SNDK 200@48.10/share $9,620 $9,620 $0 $0
IYTOQ.X 5@3.90/contract $1,950 $1,950 $0 $0
YBQMG.X 8@2.60/contract $2,080 $2,080 $0 $0
LRXMJ.X 3@7.00/contract $2,100 $2,100 $0 $0
NEWQG.X 5@3.60/contract $1,800 $1,800 $0 $0
MAT 600@19.70/share $11,820 $13,578 $1,758 14.87%
GLD 150@59.47/ETF $8,921 $9,036 $116 1.29%
TEVA 300@35.05/share $10,515 $9,891 -$624 -5.93%
STP 400@25.93/share $10,372 $10,400 $28 0.27%
SIFY 1000@7.92/share $7,920 $9,170 $1,250 15.78%
PG 180@55.60/share $10,008 $11,410 $1,402 14.01%
INTC 550@19.00/share $10,450 $11,737 $1,287 12.32%
LOGI 120@40.77/share $4,893 $6,348 $1,455 29.75%
SWY 300@25.12/share $7,536 $8,808 $1,272 16.88%
JNJ 200@57.65/share $11,530 $13,480 $1,950 16.91%
LNUX 2000@1.83/share $3,660 $8,100 $4,440 121.31%
MED 500@5.39/share $2,695 $4,660 $1,965 72.91%
TTM 900@11.94/share $10,746 $16,362 $5,616 52.56%
NOK 600@16.91/share $10,146 $11,928 $1,782 17.56%
AIRN 1700@5.62/share $9,554 $5,015 -$4,539 -47.51%
Cash     $3,612.2    
Total     $171,086 $71,086 71.09%

 

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) and Mattel (MAT).

 


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