Investing

Last week, search engine giant, Google (GOOG) jumped 15% in one day.

About six weeks ago, I wrote a post stating that Google was undervalued by 33%, and worth buying at around $500 per share.

Since then it’s jumped to $600, a whopping 20% jump, more if managed to get in at the low point. Quite a strong move for a large cap stock.

I still think the story for Google is strong, but if I didn’t already own it, I wouldn’t necessarily buy it today. Instead, I’d look for another cheap stock, something a little more boring.

As I wrote about in a previous post on investing in boring stocks, I prefer unloved, boring stocks with no growth prospects over exciting, glamor stocks. Incidentally, the stock I mentioned in that post, Johnson & Johnson (JNJ), is up over 10% in the past four months.

One of the stocks I’d consider is Cisco (CSCO).

This tech giant has lost its luster, with the stock price having gone nowhere for the past ten years.

I blame the poor leadership of the CEO, John Chambers, for the stocks performance. But at today’s prices, it probably doesn’t matter how incompetent the management is.

Cisco currently trades for $15.66 with a newly introduced dividend yield of 1.50%. It trades for a P/E of 12.2 but more importantly it trades for a P/FCF of only 9.2.

FCF or free-cash-flow is one of my favorite metrics when valuing stocks. It’s the cash left over after all the expenses have been paid out, and capital expenditures have been made. Unlike earnings, free-cash-flow is very hard to manipulate. Over the past decade, even though Cisco’s share price has stagnanted, the free-cash-flow has more than doubled from $4.1 billion to $9.2 billion.

For a stable, profitable market leader like Cisco, ten times free-cash-flow is a great deal. As Warren Buffett indicated in his purchase of Lubrizol, it’s okay to pay 20 times free-cash-flow for a great company.

Cisco also has an incredibly strong balance sheet, with about $40 billion in cash or $7.80 per share in cash – that’s almost half of it’s stock value.

Even though Cisco faces increasing competition and has a penchant for wasting money on acquistions that don’t seem to make any sense, it still has a wide economic moat. Cisco makes devices that move internet traffic. And the amount of internet traffic is increasing every day.

It’s only a matter of time before Cisco becomes a $25 stock again.

Disclaimer: I’m long Cisco.

I’m cheap.

I like to buy stuff when its on sale. The same applies to stocks. I recently bought Johnson & Johnson, and Google. Both are trading at historically low P/E and Price/Free Cash Flow ratios.

But, the market for bubble stocks seems to be alive and kicking.

LinkedIn (LNKD) just went public at 1,000 times earnings. Yeah, its trailing P/E is 1,000!

Even some established companies are ridiculously expensive. Salesforce.com (CRM) is currently trading at a trailing P/E of 300 and a forward P/E of 75. I can’t imagine who’s buying the stock at this level.

The CEO and other insiders are dumping stock like its going out of style. In the past year, they’ve sold $234 million worth of stock. And they’re continuing to sell it. Reminds me of CountryWide insiders selling the stock before the real estate bubble burst in 2007.

Here’s a funny video by someone who shares my disbelief about investing in Salesforce.

I remember being in college back in 1998, when Yahoo! (NYSE: YHOO) was the leading search engine.

Around the same time, two graduate students at Stanford came up with a better way to search the internet. They started Google (NYSE: GOOG).

Now, Google is the number one internet search engine. Every day, Google processes 1 billion search requests. It’s also the leader in online advertising.

And Google’s always looking for new opportunities. Over the past decade, they’ve bought nearly 100 companies Almost every time they enter a new market, they become the dominant player.

Three things contributed to their success…

1. They buy the best company in the sector.

In 2006, they paid $1.65 billion for YouTube. It seemed like a lot of money at the time for a free service. But they’ve been able to monetize it with online advertising. YouTube also started renting movies, just like Netflix and Amazon.

2. They develop or buy the technology cheaply, and give away the service for free.

Google paid $80 million to buy internet telephone technology. They got the technology by buying Grand Central and Gizmo5. That’s 1/100th of what Microsoft recently paid to buy Skype. And they’ve already merged the technology with Gmail, and Android OS. The technology is Google Voice. It’s free for U.S. calls.

3. Google make its services easy to integrate with other software.

Microsoft, Apple and Sony don’t do this. They keep their technology secret, and it hurts them in the long run.

Google takes a different approach. For instance, Google opened up their mobile phone platform, Android OS to programmers, manufacturers and carriers. And they gave it away for free. Within 18 months, Android OS-based phones have become the largest segment of smart phones. With 33% of the market share, they’ve even overtaken the Apple iPhone.

And unlike Apple, they’re giving a third of the application revenue to the telecomm carriers. Understandably, the telecom companies are falling over each over to support Android phones.

Now Google is entering the laptop sector. It’s releasing the Chromebook, a Google OS-based laptop. It plans to rent it out to students and businesses on three year contracts.

Google has seen amazing growth. But the stock is cheaper than it’s ever been.

Google is valued at $172 billion. It has $36 billion in cash, and only $5 billion in debt. In the past twelve months it generated over $31 billion in revenue.

Over the past five years, revenue grew at an average rate of 35%, and net income at 42%. But the stock sells for less than 14 times next year’s earnings. Growth companies like these, with little debt and large cash reserves, usually sell for 20-24 times earnings.

The market is undervaluing Google’s future growth. Even at 18 times earnings, Google’s stock is worth 33% more.

I just bought two shares of Google for my Roth IRA account at $525. The only thing preventing me from buying more is the lack of dividends. But the growth is compeling at this price. If the share price drops below $500, I might pick up a few more.

I remember the good ol’ days of the Internet Bubble in late 1999, early 2000. I bought Qualcomm (QCOM) at around $300 a share and watched it skyrocket to $800 a share in less than a year. Valuations didn’t matter, only the stories behind the stocks. I had lofty ambitions of early retirement and life of luxury. Warren Buffett was widely derided (amongst my friends) as an old fool who didn’t understand the new economy – this time it was surely different.

Sadly, no one told me the party was going to end and I rode that pony all the way back down the hill.

And then my brokerage called me and informed me that not only was my investment account worth zero, I also owed them an additional thousand dollars! Yeah, leverage works both ways.

That’s when I realized that investing isn’t about excitement, it’s about buying dull, income-generating stocks and as Buffett would say, sitting on your hands for extended periods of time.

I realized that I didn’t need to be invested in growth stocks that double every year. I just need to find stocks that generate 8-12% a year in capital appreciation and dividends, and I’ll be able to beat 90% of money managers on the planet.

So why am I bringing this up today? I recently read an article about how an investor was abandoning his position in Johnson and Johnson (JNJ), citing lack of growth as the main reason.

I am not suggesting that JNJ is about to collapse or slowly fade into the background. As I said, JNJ is a strong cash flow generator and the company does generate very strong returns on capital. With such a large amount of reinvestable cash, there will always be at least the hope of better days.

The problem, though, is that JNJ just isn’t a dynamic player. If you want a company that will produce large amounts of cash, and send a fair bit of it back to shareholders in dividends and buybacks, JNJ is a fine choice. But if you really want to harness the growth potential of the healthcare market with a top-notch operator, JNJ simply does not fit the bill.

Based on the 150+ comments, it seems like the investor and numerous readers were tired of the lack of stock performance of JNJ. How anyone would mistake a humongous, global conglomerate for a growth stock is another story, but is it really a dog of a stock?

After holding it for a decade (like some of the readers claimed they did), should you sell it now in favor of a tantalizing growth stock, like maybe SalesForce (CRM) that sells for 260 times earnings?

The problem with growth stocks is that everyone knows they’re a growth stock destined for great things, and investors usually overpay for this privilege, or should I say, excitement.

Studies have shown that over the long run, growth (or glamour) stocks underperform boring, value stocks.

So are people correct in giving up on boring, no-growth JNJ?

Well, JNJ’s story sure isn’t getting any more interesting. In fact, the 100+ year-old stodgy company is so unexciting, I can’t even be bothered to read what it does on its profile page on Yahoo! Finance. I know it makes medicine and related products. It had a slew of recalls and maybe it even makes Splenda. But seriously, who cares?

I don’t need to be swayed by some BS management story. I went to business school, I know how those yarns are spun! Just show me the numbers…

JNJ has a market cap of $166B and it has zero net debt – always a good sign.

Over the past decade (2001 through 2010), income has almost doubled from $33B to $61.6B. Operating cash flow has almost doubled from $8.8B to $16.38B. And most importantly, free cash flow (or as Benjamin Graham would say, the Owners Share of Income) also nearly doubled from $7.1B to $14B.

In terms of valuation metrics, the P/E fell from 32 to 12.7 over the same time period, and the P/CF fell from 20.5 to 10.3. Which meant that it went from being grossly overvalued in 2001 to being favorably-valued in 2010.

At today’s prices, the P/FCF is currently 11.84, which is quite cheap for a blue-chip stock and it has a projected yield of 3.6%, which incidentally, puts in on par with the yield of the 10-year US Treasury.

However, JNJ has been growing its dividend around 9-10% every year since 1972. In fact, it has increased the dividend every single year for 48 years!

If you had invested in JNJ 10 years ago, your entry price (adjusted for splits and dividends) would be about $37. It’s currently trading around $60.50, so while a 64% increase over a decade may not be the dreams that growth stocks are made of, at least your initial quarterly dividend payment of 0.16 cents has more than tripled to 0.54 cents.

And even though you made the wrong decision in buying an overvalued stock a decade ago, you’re still not doing too badly. At your entry price of $37, you’re almost making a 6% yield today.

Buying this boring, no growth stock today gives me an annual yield of 3.6%. If it repeats its performance over the next decade and the dividend triples again, I’ll be making 12% annual yield from the dividends, based on my purchase price. I can live with that sort of sub-par performance!

And if the P/E expands to growth-stock levels, causing the share price to soar and the dividend yield to drop back under 1% like it did 2001, I’ll be happy to sell it to some growth-story-chasing investor.  But until then I’m happy eschewing the glamor stocks in favor of the cheap, boring, no-growth, value stocks.

Disclaimer: I bought some JNJ for my retirement account yesterday around $60.50. I’m happy to keep it for a decade, or until they cut their dividend. I also shorted CRM at the same time.

My investments are well diversified. I’m invested in foreign and domestic real estate, commodities, precious metals, domestic and international equities and foreign sovereign debt. However, I haven’t spent much time analyzing my portfolio allocation. While making money through investments is good, protecting what you have is paramount. As I grow older each year, volatility becomes a greater issue. In a few more years I”m not sure I ‘ll be able to stomach a 40% loss that the market experienced in 2008. (Luckily, I my retirement account was down only 4% that year so I didn’t have to stomach anything!)

There are tons of great books available on the subject of portfolio allocation, but I wanted something easy to understand (and thus, remember). One of the better models I can across was Harry Browne’s Permanent Portfolio.

The basic premise is to cover all possible scenarios in your porfolio:

25% of portfolio to protect against Inflation (eg. Gold)
25% of portfolio to protect against Deflation (Cash)
25% of portfolio to do well in a Bull Market (equities)
25% of portfolio to do well in a Bear Market (bonds)

Taking it a step further you can add in protection against Devaluation (eg. invest in foreign currencies and foreign bonds).  You can also add in real estate or REITs as an inflation hedge, and foreign equities. The the basic premise is simple. You try and benefit from any sort of market. 

This is pretty simple to implement. All you need is to do is buy low-cost ETFs and check your portfolio once a quarter to rebalance to the appropriate percentages.

If you like this philosophy but don’t want to implement it, you might want to take a look at the Permanent Portfolio Fund (PRPFX) which is modeled and named after Harry Browne’s  Permanent Portfolio. Over the past 27 years, it’s been down only 4 years. Maximum annual loss was 12% in 1984. In 2008, it lost less than 9%! It’s expense ratio is also reasonable at 0.82%. It’s 5-year average return is a respectable 10.3% vs say an S&P 500 index fund like (SWPPX) which had a 5-year average return of 0.99%.

 It’s portfolio consists of gold, silver, Swiss franc assets such as Swiss franc denominated deposits and bonds of the federal government of Switzerland, stocks of U.S. and foreign real estate and natural resource companies, aggressive growth stocks and dollar assets such as U.S. Treasury securities and short-term corporate bonds.

Some of the best advice is timeless. Here’re some nuggets of wisdom from the late Harry Browne.

  • Your career provides your wealth
  • Don’t assume you can replace your wealth
  • Recognise the difference between investing and speculating & speculate only with money you can afford to lose
  • No one can predict the future
  • No one can move you in and and of investments consistently with precise and profitable timing
  • No trading system will work as well in the future as it did in the past
  • Don’t use leverage
  • Don’t let anyone make your decisions
  • Don’t ever do anything you don’t understand
  • Don’t depend on any one investment, institution or person for your safety
  • Create a bulletproof portfolio for protection
  • Keep some assets outside the country in which you live
  • Beware of tax-avoidance schemes
  • When in doubt, err on the side of safety

These topics are covered in the timeless classic – Fail-safe Investing, probably the best $10 you’ll spend on personal finance and investing!

I’m always in search of good books to read and a few people recommended Michael Lewis’ new bestseller The Big Short. I put off reading it because I didn’t really want to read yet another book about the subprime mortgage meltdown. However, I finally got the kindle version to read on my new iPad and was pleasantly surprised by how good it was. Actually, I wish I had read it earlier – the book was rather amazing. It was as fast paced and entertaining as his first book, Liar’s Poker.

Lewis describes the financial industry collapse induced by subprime mortgage bond derivative market from the point of view of a couple of hedge fund managers who shorted them. Not very large hedge funds either. Instead of focusing on well known managers like John Paulson, he focuses on relatively unknown and minor investors, with interesting personalities.

There’s Steve Eisman, the most pedigreed of the bunch with actual wall street experience, who’s abrasive personality insists on telling the truth even if it rubs everyone the wrong way. Running a fund that was owned by Morgan Stanley, Eisman desperately wanted to short his parent company but was prohibited by his lawyers. At one point in the book his partner asks “Who takes out a home loan and doesn’t make the the first payment?” to which Steve Eisman responds “Who the #$%^ lends money to people who can’t make the first payment?”  But that’s what happens when you lend $700,000 to a strawberry picker who makes $14,000 a year.

Dr Mark Burry, a one-eyed doctor with Aspergers syndrome,who quits his medical career to start a hedge fund with his own money and makes nearly $750 million for his investors.  And an almost comical garage-band hedge fund called Cornwall Capital that starts out with $110,000 and ends up with a whopping $135 million.

The book explains in great detail exactly how the great investment banks were creating junk bond securities with AAA ratings and selling them to institutional investors.  Companies like Bear Stearns, Lehman and Goldman Sachs blatantly lied about the quality of investment-grade bond products they were selling. The ratings agencies weren’t competent enough to properly rate these securities and they got hoodwinked like everyone else. In the end, everyone wins (except the US taxpayer) and no one goes to jail!

In all it’s a fascinating read on the excesses of wall street, the complexities of the financial derivative markets, and the crooks who run the show.

In my last post, I hinted at using QE2 to your advantage by investing in companies that benefit from a steepening yield curve. But I didn’t have time to get in to specifics. Which is what I’ll do right now, seeing that I have a couple of hours to spare at the Fort Lauderdale airport.

The Federal Reserve let the market know that it plans to keep short term interest rates at extremely low rates for the next few quarters (if not longer). Companies that can borrow short term, can do so at very low rates. So long as you have AA-rated collateral, you can borrow money at about 0.30% on a 30 day basis. If you plan to borrow for a longer term, you just need to keep “rolling” your loan every 30 days or so.

So if you can invest in a AA-rated bond that pays say 3% or 4% and borrow money at 0.30%, you’re going to profit from the spread. Do such bonds exist?

They do – they’re called Agency RMBS and they’re just large pools of single-family residential mortgages that are bundled together in to large multi-million dollar securities and guaranteed against default by a government sponsored agency such as Freddie Mac or Fannie Mae. They also yield about 3.75% or higher.

So you can borrow money at 0.30% and invest it at 3.75% and you’re guaranteed against loss of principle by a government agency! Sounds too good to be true? Well it gets better!

Companies that use this business model to make money are set up as REITs and pay out a hefty dividend to shareholders. Companies like Annaly Capital Management (NLY),  Hatteras Financial Corp (HTS), Cypress Sharpridge Investments (CYS) are mortgage REITs that are set up to do exactly this. And they all pay approximately 15% in dividends.

An RMBS is basically a bond and all bonds have 3 types of risk:

  1. Credit Risk
  2. Prepayment Risk
  3. Interest Risk

Companies which invest in Agency MBS don’t suffer from credit risk. If the borrower of the mortgage defaults, the government-sponsored agency just buys it back and you get your money back. There is no fear of loss of principle!

Prepayment risk is when the borrower pays off the loan early and returns your principle back to you. This usually happens in environments when interest rates are dropping and borrowers can refinance their mortgages at a lower rate. If you get your money back early, you need to reinvest the money, typically at a lower rate. Given that mortgage rates are so low and refinancing is much more difficult than it used to be, the risk of prepayment is limited. There are some always some prepayments though which occur as regular amortization of the loan. Some companies will calculate how much of their portfolio and try to enter forward contracts to purchase more RBMS and thus mitigate the prepayment risk. CYS is one company that does this.

The third and major risk is interest rate risk. As the cost of borrowing increases, the spread between borrowing and invests decreases. Your profit margins drop and are no longer able to make the kind of returns you’re used to. Again some companies hedge against this event, and incur some cost in doing so. But hedging maintains long-term predictability of cash flows and may be worth the drop in potential yield. Again CYS does this and it’s net spread after hedging is 2.55%. It also uses 7.5:1 leverage to maintain a $4.5 billion portfolio against $600 million equity position. When you earn a 2.55% spread and can leverage up 7.5%, that’s a whopping 19% yield! CYS has about a 17% dividend yield.

Disclosure: I bought a 33% position in CYS on Friday and am going to be buying more under $13.50.

A UK-based chocolate manufacturer, Hotel Chocolat, has come up with a novel way to raise capital for expansion. Instead of borrowing money from banks or issuing regular corporate debt, it has decided to raise about $7.5 million USD by issuing “chocolate bonds“. Instead of a regular dividend payment (well technically it’s a coupon payment and not a dividend), these bonds will pay dividends in chocolates!

hotel-chocolat-box-of-chocolates

In order to be eligible, you need to be a member of their “Tasting Club”, which already has 100,000 members. For an investment of $2,890 USD or $5,760 USD, you can get a juicy annual dividend of 6.72% or 7.29% delivered to your doorstep every other month.

If you’ve ever been to high-end confectionery, you’ll know they charge a couple of dollars for each piece of candy.  So spending a few thousand quid might not be such a bad investment. Especially since bank yields aren’t very impressive right now. At least it guarantees you won’t have to spring for chocolate for three years, even if the rest of your portfolio tanks!

I wouldn’t be surprised a chain of British gyms are next in line to offer special “weight-loss bonds”, with special dividend rates for people who bought the chocolate bonds!

But the real question is whether Inland Revenue will be accepting their tax payment in chocolate too?

Last week the internet was buzzing with rumors of Apple coming out with an iPhone that would work on the Verizon Network. If you decide you wanted to trade this rumor what would you do? Would you buy Apple (AAPL) or would you buy Verizon Communications (VZ)? What if I told you Apple didn’t pay a dividend, while Verizon had a 6% dividend yield. Would that make a difference?

As it turns out, I decided I wanted in on this trade. I’ve been wanting to buy an iPhone for a while but the AT&T network is severely congested in major cities and the sound quality for calls is terrible. So I’ve been holding out for the iPhone until it’s available on the Verizon Network.  I did however get myself a 32GB iPod Touch that is simply amazing.

I didn’t buy either of these two companies. Instead I bought Vodafone (VOD) with a dividend yield of approximately 5.3% based on my $23.10 purchase price. It’s not widely known, but Vodafone owns 45% of Verizon Wireless. The remaining 55% of Verizon Wireless is owned by Verizon Communications.

Verizon Wireless borrowed billions of dollars from its parent company to build out its infrastructure and for the $30 billion purchase of Alltel. It’s been generating nearly $10 billion a year in free cashflow and has been paying back the loans. These loans will be completely repaid in a few months. So what will it do with all the money its generating? It’ll start paying dividends to VZ and VOD.

Verizon needs the money for its own dividend payments. In addition to the wireless division, it runs a landline division that isn’t anywhere as profitable as Verizon Wireless. And last week, Vodafone publicly asked Verizon to either spin off Verizon Wireless or to start paying dividends as soon as it was done with the loan repayments.

By itself, Vodafone generates $8 billion a year in free cashflow. It’s 5.3% dividend seems pretty safe and has the potential to see a massive increase if Verizon Wireless decides to pay out a major portion of its cash flows.  In addition to its stake in Verizon Wireless, Vodafone owns a tiny stake in China Mobile and a 44% stake in some French Telecomm company who’s name I can’t pronounce.

This way you get exposure to a global Telecomm player with exposure to the growing US wireless market and no exposure to the US landline market.  You also get a 5%+ dividend yield with exposure outside the the US and the US Dollar. If we do see inflation, this dividend is likely to keep up with it and is probably a better bet than a treasury bond (which would lose value if we saw high inflation).

For the time being, the “Can you hear me now?” dude is a little less annoying!

Disclaimer: I entered a 50% position in VOD. If the price drops from my purchase price I’ll double down.