SINLetter - November 2008

Welcome to edition 39 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.

Note: This is one of the busiest times of the year for me and hence this newsletter is delayed by a couple of days.


October Blog Entries:

If you do not subscribe to blog entries by email or in case you missed them, here are the blog entries for October.

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Portfolio Performance and Other Thoughts:

September felt like a terrible month, but October took the honor of becoming the most volatile month in the 80 year history of the S&P 500. Had the S&P 500 not rebounded 10.49% in the last week of October, the month would have gone down as the second worst month in the history of the S&P 500, topped only by a 29.9% drop in September 1939 as you can see from this New York Times Table. The SINLetter model portfolio suffered a similar fate dropping 18.73% for the month of October despite a small gain in our September pick Intel (INTC). Had I acted immediately after posting the "What Next?" blog entry on October 28th, the performance of our portfolio would have improved as Sterlite Industries (SLT) went on to post a gain of over 50% and Flextronics (FLEX) posted a gain of 10% in the last four trading sessions of October.

Performance Metric Dow S&P 500 Nasdaq SINLetter
October 2008 -14.06% -16.94% -17.35% -18.73%
Since Inception (Aug 2005) -12.22% -21.58% -21.61% 48.62%



The lows we hit on Monday, October 27th could very well be the low for this bear market and stocks appeared to be extremely oversold in the short-term. Consider the fact that on Tuesday, October 28th, the U.S. consumer confidence index plunged to an all-time low of 38 from September's reading of 61.4. The Dow reacted with a nearly 900 point rally, its second best point gain ever. The Dow held on to most of these gains the following day and on Thursday it posted another 190 point gain in the face of news that the U.S. GDP dropped by 0.3% in the third quarter, the sharpest contraction of the economy in seven years. However I believe that the rally we experienced in the last week of October does not mark the end of this bear market. The conditions for a sustainable move up just do not seem to be in place. Both earnings and economic news are likely be to be terrible in the next two quarters, if not longer.

My biggest worry at this point is a crisis of confidence that appears to be developing both amongst businesses and consumers. Not only are large companies like HP, Yahoo and Ebay laying off employees, profitable and promising start-ups in silicon valley are also laying off employees by taking preemptive action against a weak economy that could affect their future growth. Check out this chilling PowerPoint presentation consisting of 56 slides that one of Silicon Valley's leading venture capital firms Sequoia Capital presented at a secret meeting of its portfolio companies. Consumers who are already stretched tight are going to be wary of making purchases when faced with the specter of layoffs. No wonder car sales have dropped off a cliff and car dealership companies like Lithia Motors (LAD) and Penske Automotive Group (PAG) were trading at multi-year lows in October. With nearly 70% of the economy driven by consumer spending, this tightening in consumer spending will lead to further layoffs in other sectors such as retail and keep this vicious cycle spiraling downwards.

Why then do I continue to stay invested despite my mostly bearish outlook? Consider the following paragraphs from Mark Hulbert's recent article in The New York Times,

"As the critics of market timing often point out, the stock market tends to produce the bulk of its gains in just a few explosive sessions. Miss those days and your portfolio’s returns are likely to disappoint you.

Consider someone who was fully invested in stocks over the last decade — except for the market’s 20 best days, during which he held cash. Despite holding stocks more than 99 percent of the time, this investor would have lost 57 percent through the end of October, as judged by the Dow Jones Wilshire 5000 index, a benchmark that represents the combined value of all domestic stocks. That is 70 percentage points worse than the 13 percent gain he would have achieved had he held stocks mimicking that index for the entire 10 years, including the market’s 20 best days."

Attempting to accurately call turns in the market is very difficult, if not impossible, and hence I prefer to stay invested with some cash around to either hedge long positions or buy stocks on my watch list on days when we experience sharp drops. One such stock that has been on my radar for a long time is Suburban Propane (SPH) and I have discussed the company in detail below.

Gold took a hit in October, falling $146.3 or 4.83% to close the month of October at $723.70 per troy ounce. Gold miners like Newmont Mining (NEM) and Barrick Gold (ABX) did even worse, falling more than 30% in a single month.

Portfolio Readjustment:

I am making no changes to the model portfolio at this time. As discussed below, I am adding Suburban Propane (SPH) to our watch list.


Suburban Propane (SPH) $34.68

With the volatility in the market making it difficult even for the most experienced inventors to pick winners, I figured it would be a good idea to explore new ideas and broad investment themes. We discussed the importance of asset allocation in the previous newsletter and I would like to discuss an investment vehicle called a Master Limited Partnership (MLP) and then discuss Suburban Propane, a publicly traded MLP with a distribution yield of 9.5%. If you are familiar with MLPs, feel free to skip the next five paragraphs.

What are MLPs?

The reason I used the word distribution instead of dividend is on account of the fact that MLPs are not like regular corporations and do not get taxed on income. Instead they tend to return most of their income (typically 85 to 90%) to investors or partners through quarterly distributions. This shifts the tax responsibility to the partners, who are taxed at their ordinary income rates. Since ordinary income rates of investors are typically lower than the income tax rates of corporations, this proves to be advantageous to the MLPs and hence their investors. One of our portfolio companies, Marcus (MCS), paid 39.21% of its fiscal 2008 income in taxes. When you compare that rate against the rate you paid for your 2007 personal income, the tax advantages of MLPs are laid out in sharp relief.

Tax Consequences:

Since distribution income from MLPs is treated differently from dividend income from most stocks, at the end of the tax year, MLPs issue a Schedule K-1 to their investors. If the MLP pays out distributions in excess of the income it generates, the distribution is classified as a "return of capital" and tax deferred until you sell your shares or units. Please note that income from MLPs is often taxable even in retirement accounts like 401Ks and IRAs if the income exceeds $1,000. Hence investors tend to shy away from MLPs in retirement accounts and they are also not preferred by institutions.

Indirect methods to own MLPs:

There are certain indirect methods of investing in MLPs and avoiding the tax complications. The MLP Kinder Morgan Energy Partners (KMP) also has a counterpart called Kinder Morgan Management (KMR) that holds units of KMP and whose quarterly payout is treated like a regular dividend instead of a partnership distribution. Another alternative is closed-end funds like Kayne Anderson MLP (KYN) and BlackRock Global Energy and Resources Trust (BGR). KYN is currently trading at a 15.22% premium to net asset value (NAV) and a yield of 9.17%. In contrast BGR is trading at a 13.16% discount to NAV and a yield of 8.61%.

Most MLPs tend to be concentrated in the energy sector but there are always exceptions such as the private equity firms The Blackstone Group (BX) and Fortress Investment Group (FIG), which also happen to be set up as MLPs.

Analyzing MLPs using yield spreads:

One method of analyzing MLPs is to look at the spread between the average yield of the MLPs and the 10 year treasury note. A big spread when compared to historical averages could be construed as a favorable factor. The current yield on 10 year treasury notes is 3.81%. The yield of the Alerian MLP Select Index, which consists of the 50 most prominent energy master limited partnerships, was 9.78% as of October 30. The current spread between the two is 5.97% give or take a few basis points. Looking at the data going back to 2000, with the exception of last month, the spread between the two has never been this high, making this a great time to consider adding MLPs to your portfolio.

Suburban Propane:

Propane, a clean burning and non-toxic gas, is created as a byproduct of oil and natural gas processing and is used to heat homes, cooking and sometimes to power vehicles as Liquefied Petroleum Gas (LPG). According to the National Propane Gas Association, about 8.1 million households in the United States use propane to heat their homes as an inexpensive alternative to electricity. New Jersey based Suburban Propane services over 1 million residential and commercial customers in 30 states. Suburban Propane also provides customers the option to rent large propane tanks from them and since these tanks are often buried underground, switching to a different provider is not an easy option, giving Suburban Propane a "lock" on certain customers.

Suburban Propane has been on my radar for over two years since it showed up on a stock screen I ran in 2005. The stock lost nearly a third of its value in the second half of 2005 to $24.51 when the price of propane spiked and the company was not able to immediately pass on this increase to customers. The stock went on to nearly double from those levels to $48.83 by 2007 but lost a lot a ground over the last two months. At one point on October 6, 2008, Suburban Propane traded as low as $22.64. Since propane is a byproduct of oil refining, wholesale propane prices generally tend to follow oil prices. The important difference between the drop in Suburban's stock in 2005 and right now is that propane prices were rising back in 2005 but are actually dropping right now along with the price of oil.

The company hedges part of the propane it has in physical inventory by going short propane futures. When propane prices rose earlier this year, the company had to take a $14.5 million loss against its hedges in the fiscal third quarter ended June 28, 2008. This was right before oil hit its peak of $147 in July. If the company continued its hedging activity in its fiscal fourth quarter, which ended September 2008, the sharp decline in oil and propane prices during the quarter should prove beneficial to the company. Even if the company suspended its hedging program, the decline in propane prices should benefit the company as I do not see a significant drop in retail propane prices that Suburban Propane charges its customers. This is one of the key reasons why I find Suburban Propane attractive ahead of its fourth quarter conference call scheduled on Friday, November 14th.

The company also has a consistent history of raising quarterly distributions and has done so 19 times since 1999. Distributions in the recent past have been financed entirely through operating income and the company has built up its cash position to $118.6 million, while holding long-term debt steady at $548 million over the last three years.

If Obama wins the election (which appears very likely as I write this) and raises the long-term capital gains rate and dividend taxation to 20% (for families earning over $250,000), the tax deferred status of MLPs is going to make them even more attractive to high net worth or high earning families. Check out the following links for additional reading about MLPs and related investments.

Due to the tax implications of MLPs and the fact that the SINLetter model portfolio does not take dividends into account, I am going to add Suburban Propane to our watchlist instead and most likely leave it there for some time to come.


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.

Model Portfolio - October 31, 2008

Long Stocks

Stock Symbol Number of Shares* Cost Current Value Diff ($) Diff (%) Date Added
Intel INTC 500@$15.60 $7,800 $8,015 $215 2.76% 8/29/2008
Activision ATVI 600@$16.41 $9,846 $7,476 $-2,370 -24.07% 8/29/2008
Towerstream TWER 10,000@$1.27 $12,700 $9,000 $-3,000 -29.13% 6/0/2008
Textron TXT 150@62.55/share $9,382.5 $2,655 $-6,728 -71.7% 5/31/2008
Companhia Siderurgica Nacional SID 200@43.15/share $8,630 $2,720 -$5,910 -68.48% 4/30/2008
Lionsgate Entertainment LGF 1,000@9.41/share $9,410 $7,000 $-2,410 -25.61% 2/29/2008
Tata Motors TTM 500@17.52/share $8,760 $2,925 $-5,835 -66.61% 2/29/2008
Barclays PLC BCS 400@32.435/share $12,974 $4,292 $-8,682 -66.92% 11/20/2007
Powershares Water Resources PHO 400@22.10/share $8,840 $5,496 $-3,344 -37.83% 10/31/2007
Marcus MCS 500@19.94/share $9,970 $7,015 $-2,955 -29.64% 9/14/2007
Blockbuster BBI 3,000@3.925/share $11,775 $4,560 $-7,215 -61.27% 7/9/2007
Unilever Plc UL 200@32.53/share $6,506 $4,512 $-1,994 -30.65% 5/11/2007
EMC Corp EMC 600@13.85/share $8,310 $7,068 $-1,242 -14.95% 3/31/2007
ICON Plc ICLR 300@18.65/share $5,595 $7,611 $2,016 36.03% 1/31/2007
Diamond Offshore Drilling DO 80@76.65/share $6,132 $7,104 $972 15.85% 1/3/2007
Alvarion ALVR 1000@6.87/share $6,870 $3,470 $-3,400 -49.49% 1/3/2007
WisdomTree Investments WSDT.PK 1000@7.40/share $7,400 $1,450 $-5,950 -80.41% 11/30/2006
Teva Pharmaceutical TEVA 300@35.05/share $10,515 $12,864 $2,349 22.34% 9/1/2006
Suntech Power STP 250@25.93/share $6,483 $4,375 $-2,108 -32.51% 7/31/2006
Procter & Gamble PG 180@55.60/share $10,008 $11,617 $1,609 16.08% 6/30/2006
Johnson & Johnson JNJ 200@57.65/share $11,530 $12,268 $738 6.4% 2/28/2006


Options

Option Number of Units Cost Current Value Diff ($) Diff (%) Date Added
IBNAZ.X 5@2.6/contract $1,300 $1,000 $-300 -23.08% 9/7/2007
IBNMV.X 5@2.05/contract $1,025 $1,500 $475 46.34% 10/31/2006
Cash     $12,627      
Total     $148,619 $48,619 48.62%  

 

* Price and number of shares adjusted for Activision Blizzard (ATVI) and ICON plc (ICLR) to reflect splits on September 8, 2008 and August 13, 2008 respectively.

Voluntary Disclosure: From the stocks that are currently in the model portfolio, I own shares of Intel (INTC), Activision Blizzard (ATVI), Towerstream (TWER), Lionsgate Entertainment (LGF), Tata Motors (TTM), PowerShares Water Resources (PHO), Barclays (BCS), Suntech Power (STP), Teva (TEVA), Alvarion (ALVR), WisdomTree (WSDT.PK), Unilever (UL), BlockBuster (BBI) and Marcus (MCS). I also own $20 Jan 2009 IBN calls (IBNAZ.X)

 


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