SINLetter - August 2008

Welcome to the third anniversary edition 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.


Looking Back At Our Third Year:

The first two years of writing this newsletter were a very exciting time with interesting experiences and a lot of interaction with fellow investors, bloggers and subscribers. As discussed in the blog entry Looking Back At Two Years, returns of 106.6% over that two-year period certainly added to the excitement. In contrast our third year was muted and delivered a loss but as you can see below, the loss was much lower than the rest of the market. I would be happy if I can continue to deliver returns like these where our profits are higher than the market on its way up and our losses are smaller on the way down.

Performance Metric Dow S&P 500 Nasdaq SINLetter
Year 1 4.83% 2.67% -6.28% 59.51%
Year 2 20.21% 15.25% 23.92% 29.54%
Year 3 -15.87% -14.39% -10.29% -4.18%
Since Inception (Aug 2, 2005) 6.62% 2.02% 5.26% 98%


The Wins:

Every trade done over the last three years can be found in the historical trades section and as you can see we greatly benefited from all the put options we had picked up in 2006 and 2007. Our LEAP puts on trucking company YRC Worldwide (YRCW) delivered returns of 200% after we held them for almost 11 months. Put options on homebuilder St Joe (JOE) delivered returns of 107.14% while put options on Monster Worldwide (MNST) returned 100% in less than 4 months. Even though I held my LEAP puts on St Joe for 14 months and sold very close to expiration, it felt like in every case I sold a little too soon.

The best example of this was our short position in Oregon based luxury RV manufacturer Monaco Coach (MNC), which we sold short (put options on this company were scarce) in September last year at $12.64. We covered the position in less than four months when the stock dropped to $8.88 and picked up a gain of 29.75%. Our hypothesis on Monaco was spot on as the demand for RVs that cost half a million dollars dried up in the face of declining home prices and $4/gallon gas. With Monaco closing plants recently due to low demand and posting a loss in the second quarter, the stock closed at $2.26 last Friday and we obviously covered too soon.

Other notable wins were closing out part of our position in Suntech Power (STP) and Irish medical research company ICON plc (ICON) for gains of 151.33% and 93.03% respectively. I still regret not selling our entire position in Suntech but then again as you can see from ICON's recent performance (the stock is now up 118.82% in the model portfolio), it is sometimes prudent to let your winners run.

I am also glad I took profits in children's clothing retailer Gymboree (GYMB) due to weakness in the retail sector and Brazilian aircraft company Embraer (ERJ) due to its plans to spend on capital intensive infrastructure projects. Both these stocks are at much lower levels now but ERJ is rebounding on strong demand for its jets and might be worth a second look. However my timing on selling SanDisk (SNDK) at $55.1 for a gain of 14.55% was either divine providence or just dumb luck. The stock how rests with the fishes at $14.36.

The Losses:

Weakness in financial stocks prompted me to close out our position in British banking giant Barclays (BCS) at $55.8 for a tiny gain of 3.22% over an 8 month holding period. I also closed our position in Indian automobile company Tata Motors (TTM) at $19.7 for a nice gain of 64.99%. The reason I list these trades under the losses section is because I picked both stocks up again when Barclays declined to $42.27 and Tata Motors dropped to $17.52. The SINLetter model portfolio now shows paper losses of 35.46% in Barclays and 45.66% in Tata Motors. I was bottom fishing in the financial sector a little too soon with Barclays and made the fatal mistake of not paying enough attention to the debt Tata Motors was taking on to finance its purchase of Jaguar and Land Rover from Ford (F).

Do I dare say that Tata Motors looks very attractive at these levels with most of the capital spending required to develop its $2,400 revolutionary Nano car behind it, its acquisition of marquee brands such as Land Rover, its plans to launch a car that runs on compressed air in 2009 and a potential partnership with Chrysler to sell Jeep Wranglers in India. The old Willys Jeeps still hold a special place in the hearts of many Indians and introducing the Wranglers in India is a brilliant idea.

We also sold our positions in WiMax equipment provider Airspan Networks (AIRN) and student travel company Ambassador Group (EPAX) for steep losses of 68.68% and 38.35% respectively. While I did not anticipate the extent of the impact a weak economy would have on Ambassador Group, which lost half its value on a single day after issuing a cautious outlook, the mistake with Airspan Networks was the classic mistake of investing in an emerging technology too soon.

Hopefully I will learn from these losses and avoid the four key mistakes of ignorance, greed, fear and hope in the years to come.


Portfolio Performance and Other Thoughts:

After a volatile month where at one point our portfolio was down more than 4%, the model portfolio and the Dow Jones Industrial Average pretty much ended the month right where they started. The S&P 500 went down by about a percentage while the Nasdaq posted a small gain of 1.42% for the month. Small-cap stocks performed much better in July, delivering a gain of almost 4% and leaving our ultrashort position on the Russell 2000 index (TWM) with a gain of just 0.96% when compared to a gain of 10.1% last month.

Performance Metric Dow S&P 500 Nasdaq SINLetter
July 2008 0.25% -0.99% 1.42% 0.03%
Since Inception (Aug 2005) 7.11% 2.59% 5.93% 96.83%


SINLetter July 2008 Portfolio Performance

"It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I've known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine--that is, they made no real money out of it. Men who can both be right and sit tight are uncommon."

-From the 1923 investment classic Reminiscences of a Stock Operator by Edwin Lefevre

Since the start of the year, I have been mostly bearish on stocks and after publishing my outlook for 2008 in January, I should have liquidated most of the portfolio. While this would have been a drastic step to take and the tax implications would not have been pleasant, sometimes it is a good idea to take a break and start afresh. Things are always much clearer in hindsight and the reason I didn't take such drastic action was because the market is unpredictable and my predictive powers are probably no better than your friendly neighborhood tarot card reader.

So what are my thoughts on the market now? I believe that the rally we experienced in mid-July was nothing more than a short bear market rally and I think there is a ways to go before we reach the bottom of this bear market. Even if stocks don't drop further, I think we are going to see a trendless market for quite some time to come as the conditions are far from ripe for a sustainable move upwards. I am yet to see anything close to the kind of capitulation or despair you would see at the end of a bear market. In fact there is still a lot of hope out there. Hope that we will get a nice gift for Christmas in the guise of a year end rally, hope that the recent uptick in unemployment claims is temporary, hope that home prices will reverse course in 2009 and a strong belief in Keynesian economics that encourages huge deficits and intervention by the state (the new housing bill for example).

As mentioned in the quote from Reminiscences of a Stock Operator above, I think that the best course of action is to sit tight, add new stocks to our watch list and act on opportunities with the highest conviction when they present themselves.

Our pick from last month, Umpqua Holdings (UMPQ), had a very volatile month with the stock dropping nearly 26% to below $9 in the first half of the month and then rebounding 51.39% to close the month with a gain of 11.95% in the model portfolio. Umpqua reported second quarter earnings of $10.2 million or 17 cents per share even after setting aside $25.1 million for loan losses. While these earnings were 49% below the earnings in the second quarter of 2007, reporting positive earnings in this challenging environment is an achievement in itself. Year-to-date the company reported earnings of $34.8 million or $0.58 per diluted share. Umpqua's acquisition of California banks in 2006 and 2007 increased the company's exposure to the Sacramento area, which is referred to by some as the epicenter of the housing crisis in California. In the second quarter earnings conference call, Umpqua's CEO Ray Davis stated that housing inventory in Sacramento fell from 17.8 months in September 2007 to 5.2 months in June 2008. On a sequential quarter basis, non-performing assets increased to $104.4 million or 1.25% of total assets but loans past due 30 to 89 days were just $18.9 million, down 72% from the $68.2 million reported for the first quarter.

The short interest in Umpqua has been very high and the short ratio was 19.87 as of July 15th. The number of shares short as of that day were 15.82 million. Dividing that by the average daily volume of 796,292 on that date gives us the short ratio of 19.87. Due to lower average daily volume, the short ratio at the end of June was 29.11. This meant it would have taken the shorts 29 days to buy back all their shares in the event of a short squeeze. The total shares of Umpqua Holdings exchanging hands between July 16th and August 1st were 11.142 million. If even half of these were short covering and no new short positions were initiated, that still leaves us with 10.25 million shares short. Using the three months average daily volume of 667,391, we get a conservative short ratio of 15.367. When compared to other regional banks like Regions Financial (RF), SunTrust Banks (STI) and Sterling Financial (STSA), which have a short ratio in the single digits, Umpqua Holdings appears to have a disproportionately high short ratio. Cascade Bancorp (CACB) based in Bend, Oregon is another regional bank with an extremely high short ratio. The bank had a short ratio of 49 as of mid-July. Based on the volume through the second half of the month, it is highly unlikely that more than 20% of the short shares have been covered. Any piece of good news would act like a powder keg on this stock provided the fundamental story does not deteriorate further (Bend, Oregon is currently experiencing a tough real estate market). The change in the naked short selling rule certainly gave a boost to the entire financial sector and one of the most dramatic bounces was in Bank of America (BAC), which shot up from $18.52 to $33.44 in a week.

Our second pick from last month, Towerstream Corp (TWER) also reported a small gain of 3.97% for the month. The company reports earnings on Tuesday, August 12th. Interestingly the company is also presenting at two investment conferences a few days before and right after earnings. Fellow blogger The Microcap Speculator had a totally different take on Towerstream than I did and his post is worth checking out for the bear case on Towerstream.

Gold gave up some of its June gains by closing the month of July at $913.30 per troy ounce, a loss of $10.80 or 1.17%.

Portfolio Readjustment:

I am not making any changes to the SINLetter model portfolio this month but may start a position in Flextronics in the near future or add to our ultrashort position on the Russell 2000 index (TWM). Any changes will be posted on the blog and sent by email to blog subscribers.


Flextronics International Ltd. (FLEX) $9.06

The Story:

What do competitors Lucent and Nortel, Dell and HP, Motorola and Sony Ericsson have in common? All these companies including Cisco and IBM use Singapore based contract electronics manufacturer Flextronics to manufacture components for their products or in some cases the entire product. If you are using a laptop, watching an LCD TV or using an ATM machine, there is a good chance it was manufactured by Flextronics or the company was involved in some stage of the supply chain.

Last June, Flextronics acquired its biggest competitor and industry leader Solectron for $3.6 billion resulting in massive dilution of Flextronics stock. While revenue in the second quarter of 2008 jumped to $8.35 billion from $5.16 in the second quarter of 2007, earnings have been under pressure due to the integration of the two companies. The company posted losses in the December 2007 and March 2008 quarters but during the fiscal first quarter (June 2008) earnings conference call on July 24th, Flextronics reported that all Solectron related losses have now been absorbed and the company posted earnings of $130.3 million or 16 cents per share, up 22% from the year ago period.

The stock is down 15% over a five year period and declined almost 20% over the last 12 months, giving it one of the lowest P/E ratios in the Nasdaq 100. Even with the Solectron losses out of the way the stock has shown no signs of life. Investors may have given up on Flextronics as dead money or the stock may still be depressed due to its exposure to the macroeconomic environment as a global slowdown tends to weigh heavily on contract electronics manufacturers. Oddly enough the company believes that this challenging environment will be to its benefit as manufacturers rethink their supply chains and consider using the expertise and global scale provided by a company like Flextronics that operates in 30 countries on four continents.

The Numbers:

Gross margins and operating margins are tiny at 6.1% and 3.4% respectively but 3.4% of $8.35 billion in quarterly revenue still works out to an impressive $280 million in quarterly operating profit. Flextronics sells below its book value and has a Price/Book ratio of 0.92. However with over $6 billion in Goodwill on the balance sheet, the Price/Book value in itself does not point to a bargain. The Price/Sales is 0.25 and this may once again appear to be very low until but is actually consistent with companies that have slim operating margins. The forward P/E of 6.29 and a PEG ratio of 0.36 do make the company look attractive at these levels. Did I mention that the company expects to generate $800 million in free cash flow this fiscal year ending March 2009?

The Good:

  • For a company that operates on very slim margins, both gross margins and operating margins improved 40 basis points or 0.4% year-over-year in the fiscal first quarter that ended on June 30, 2008. The company may find it hard to improve margins further because of commodity prices, energy prices and foreign exchange rates.


  • Acquisition related charge offs are finally coming to an end.


  • The company expects to generate close to $800 million in free cash flow this year and since Flextronics already has a full product portfolio through acquisitions, it is considering buying back 10% of its outstanding shares.


  • Flextronics expects to grow organic revenue by $2 to $3 billion this year without including the impact of recent acquisitions.

The Bad:

  • Flextronics derived 55% of its revenue from its top 10 customers and Sony Ericsson is their only customer that accounts for more than 10% of revenue. Sony (SNE) came out with bad results last week and the stock is now trading at levels last seen in December 2005.


  • Inventory has been steadily rising and Flextronics now has $4.456 billion in inventory on its balance sheet. The company has more than $3 billion in long-term debt but also has enough cash on hand to cover notes that come due in 2009 and 2010.

FLEX 1 year chart


Conclusion:

It remains to be seen if a slowdown in demand for electronics and other consumer discretionary items has an adverse impact on Flextronics or if the company will benefit from increased outsourcing. While the company is attractive at these levels, general market conditions do not warrant any additional purchases on the long side. Hence I plan to add Flextronics to our watch list and may start a position in case the stock drops further due to general market weakness.


Every month we add 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 (July 31, 2008 for the August 2008 newsletter).

Model Portfolio - July 31, 2008

Long Stocks

Stock Symbol Number of Shares Cost Current Value Diff ($) Diff (%) Date Added
Towerstream TWER 10,000@$1.27 $12,700 $13,200 $500 3.94% 6/0/2008
Umpqua UMPQ 500@12.13/share $6,065 $6,790 $725 11.95% 6/30/2008
Textron TXT 150@62.55/share $9,382.5 $6,520 $-2,862 -30.5% 5/31/2008
Companhia Siderurgica Nacional SID 200@43.15/share $8,630 $7,838 -$792 -9.18% 4/30/2008
Lionsgate Entertainment LGF 1,000@9.41/share $9,410 $9,850 $440 4.68% 2/29/2008
Tata Motors TTM 500@17.52/share $8,760 $4,675 $-4,085 -46.63% 2/29/2008
Barclays PLC BCS 200@42.27/share $8,454 $5,440 $-3,014 -35.65% 11/20/2007
Powershares Water Resources PHO 400@22.10/share $8,840 $8,660 $-180 -2.04% 10/31/2007
Marcus MCS 500@19.94/share $9,970 $7,955 $-2,015 -20.21% 9/14/2007
Ultrashort Russell 2000 TWM 50@71.00/share $3,550 $3,584 $34 0.96% 9/7/2007
Blockbuster BBI 3,000@3.925/share $11,775 $8,370 $-3,405 -28.92% 7/9/2007
Unilever Plc UL 200@32.53/share $6,506 $5,478 $-1,028 -15.8% 5/11/2007
EMC Corp EMC 600@13.85/share $8,310 $9,006 $696 8.38% 3/31/2007
ICON Plc ICLR 150@37.30/share $5,595 $12,051 $6,456 115.39% 1/31/2007
Diamond Offshore Drilling DO 80@76.65/share $6,132 $9,544 $3,412 55.64% 1/3/2007
Alvarion ALVR 1000@6.87/share $6,870 $6,440 $-430 -6.26% 1/3/2007
WisdomTree Investments WSDT.PK 1000@7.40/share $7,400 $2,490 $-4,910 -66.35% 11/30/2006
Teva Pharmaceutical TEVA 300@35.05/share $10,515 $13,452 $2,937 27.93% 9/1/2006
Suntech Power STP 250@25.93/share $6,483 $8,365 $1,882 29.04% 7/31/2006
Procter & Gamble PG 180@55.60/share $10,008 $11,786 $1,778 17.77% 6/30/2006
Johnson & Johnson JNJ 200@57.65/share $11,530 $13,694 $2,164 18.77% 2/28/2006
Medifast MED 1000@6.955/share $6,955 $5,430 $-1,525 -21.93% 11/30/2005
  Cash     $16,206.5      
  Total     $196,824 $96,824 96.82%  

 

Voluntary Disclosure: From the stocks that are currently in the model portfolio, I own shares of Towerstream (TWER), Umpqua (UMPQ), Lionsgate Entertainment (LGF), Tata Motors (TTM), PowerShares Water Resources (PHO), Barclays (BCS), Medifast (MED), Suntech Power (STP), Teva (TEVA), Alvarion (ALVR), WisdomTree (WSDT.PK), Unilever (UL), BlockBuster (BBI) and Marcus (MCS).

 


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