Diversification Myths

This article originally appeared on thinkingaboutmoney.com on June 20th, 2006.
One of the things I’ve learned in the past month is that diversification – the “holy grail” of investing, is not what it is cracked up to be. In fact, I’ve come to realize that one of my immediate investing goals should be to reduce the amount of diversification in my portfolio.

I realize that this statement will have many of you yelling and screaming, or immediately unsubscribing under the assumption I am a fool. But hear me out.

The idea of diversification is simple – it protects you from a serious loss in the event that a stock collapses. This is a real problem: I had a friend in college who was highly invested in a utility called “General Public Utilities”, dividends of which were helping pay for his college education. Unfortunately, this utility owned a nuclear power plant named “Three Mile Island”. Ouch! When the nuclear accident hit their stock crashed and my friend had some tough times.

The problem with diversification is equally simple. Once you are sufficiently diversified (say, through ownership of a selection of mutual funds), your portfolio will tend to reflect the overall market (typically underperforming it by a bit, if only because of the management fees). This means that when the market is good, your upside is typically limited to the overall behavior of the market, and when the market is down, your portfolio is pretty well guaranteed to lose value as the market declines.

Let me stress this: Most mutual fund based portfolios will decline when the market drops. Diversification through mutual funds provides no protection in down markets; rather, it virtually guaranteed losses.

In truth, diversification means two different things: protection from having all your eggs in one basket (so to speak), and matching the performance of the market. The former is obviously a good and necessary thing; the latter only good if you buy into the theory that the market will average a certain percentage gain over the long term and you should just buy and hold to get that return.

Let’s consider the first type of diversity. The overall market performance is based on a large set of companies, some of which rise dramatically in value, some of which become worthless, some of which hardly change in value, and many of which simply track overall market performance as investors add or remove money from the market following existing trends.

Let’s assume that by actually doing your homework – researching a company, reading their financial statement, and applying your own knowledge of the industry, that you can select stocks that can beat the overall market by 10%. That doesn’t mean they’ll always go up – just that if the market declines by 20%, you’re stocks will drop 10%. If the market goes up 20%, yours will go up 30%. Of course some of your choices may do better, and some worse, but let’s say you can average 10% better. Keep in mind that of that 10%, at least 1.5% and often more is “free” because you won’t be paying mutual fund management fees.

If your portfolio contains 15 stocks, one of them can become worthless and you will still beat the overall market.

So in truth, you don’t need multiple mutual funds containing dozens of stock to protect yourself from the collapse of one security. And if you learn to sell on time (see review of “Why Smart People Make Big Money Mistakes and How to Correct Them“), you wouldn’t even need to do that well.

Does that mean I’m recommending you go out, sell your mutual funds, and buy individual stocks?

NO – NO – NO!!!

Remember the name of this site: “Thinking About Money.” That means that you will never read simplistic advice, rules or guidelines here. The observations you read here are parts of a bigger picture intended to help me (and you) develop an overall financial strategy.

My point here is that there’s diversification as preached in the financial media, and there’s diversification in its true sense of preventing the loss of one asset from representing a financial disaster. My argument here depends on one being able to choose investments and manage them in a way that does better than the overall market. I believe this is possible, but I also believe it requires thought, discipline, research and strategy.

Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports – Reviewed

This post originally appeared on ThinkingAboutMoney.com on June 15th 2006

What a treat for investors or business owners! I wish I had this book when I started my first business – it would have certainly sped up my learning process at the time. And for investors who want a good solid background on reading financial statements, it’s hard to imagine a better introduction.

Financial Statements” by Thomas Ittelson does a spectacular job of introducing the three basic types of financial statements to beginners, while providing an easy to read refresher to those who might be a bit rusty on the topic.

The book begins with an in-depth review of income statements, cash flow statements and balance sheets, showing how they relate to each other. This section also includes an introduction to the basic principles of accounting.

The strongest part of the book is the second, where the author walks you through a year in the financial life of a fictional company. A wide variety of transaction types are covered from initial raising of equity, to asset purchases, to hiring, and ultimately to manufacturing and booking income. Careful attention is paid to the process of handling inventory and dealing with cost of goods (and the entire manufacturing – sales – income cycle), including the difference between fixed and variable costs. The author even discusses several approaches for determining a business’s value for possible sale (though he does discard the discounted cash flow method as being too complex).

There is enough information here for someone starting a business to handle their own bookkeeping (with practice and perhaps a bit of hand holding by a friendly CPA at first to answer specific questions). Certainly enough to understand what the bookkeeper and accountant are doing and speak with them intelligently about the state of the business.

The third part of the book is especially important to investors, covering common ratios for evaluating the health of a company and discussing techniques that can be used to “cook the books” or otherwise bias financial reports. This part of the book is all too short. It left me convinced that there was a lot more to learn in this area.

If you are comfortable creating and reading financial statements, this is not the book for you. But for everyone else, I highly recommend it. The book is clear, well written, and breaks complex topics into simple steps that are easy to understand.

See more: “Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports” by Thomas Ittelson

Up in ARMS – When is it right to use an Adjustable Rate Mortgage?

This article Orginally appeared on ThinkingAboutMoney.com
An ARM can be a huge money saver, or a time bomb. Unfortunately, there are a lot of time bombs out there.

In my previous posting, I focused on interest only mortgages and a couple of readers pointed out the risks of these mortgages – well actually, they pointed out the risks of adjustable rate mortgages, which are a different beast entirely (though they often come in the same package).

There are many variations of adjustable rate mortgages. The worst of them are those that allow for negative amortization – meaning the principal on the loan increases over time because your payments are not sufficient to cover the interest on the loan. These loans are evil and should be avoided in almost all cases (the one exception is a reverse mortgage used by some senior citizens to turn the equity of their home into income).

Adjustable rate mortgages have two separate issues that can magnify to either save you lots of money or cost you lots of money. First, they almost always start out with below market rates (either due to marketing discounts or rates bought down through points) which results in effective interest rate increases early in the life of the loan. Second, they vary with interest rates.

When are adjustable rate mortgages a wise choice?

The only ARM I’ve had was on a condo I purchased in 1985. That year conventional mortgages were over 12% – very high from a historical perspective. It was also fairly early in my career and I was still enjoying steady increases in salary (I had a real job back then). It was also a fairly slow time for real-estate – one of the periods of stable or declining prices common in the California real estate market. The combination of high interest rates, increasing income and stagnant property values is the perfect storm for getting an ARM. Over the next ten years or so, the choice turned out to be very wise. The loan was linked to T-Bills that only once during that period exceeded the rate at the start of the loan, and at one point was 4 points lower than that initial value. Most of the years I held the loan my payments actually dropped. Ultimately I paid thousands of dollars less than I would have with a conventional loan.

I honestly don’t know if I was lucky or smart at the time – but I do remember considering the risk and deciding that it was worth the chance.

Unfortunately, most people who use adjustable rate mortgages today are using them for a different reason – to purchase a more expensive home than they can really afford. All of the factors that pointed to use of ARMs in 1985 are different today.

Right now we are at a peak of housing values after a period of rapid increase (not only recent increases, but a major increase in values in the 1999-2001 period). Historically these boom periods are separated by periods of stable or declining prices – periods of a decade or more. So purchasing the most house you can afford in order to get maximum leverage is high risk choice, at least at the moment.

Despite recent rate increases, mortgage rates remain near historic lows. That means that there is a high risk that an adjustable rate mortgage will result in higher payments over time, in some cases dramatic increases.

The final factor to consider is your own income. The recent economic recovery has not resulted in widespread wage increases. With the increased levels of outsourcing and continuing shift of manufacturing to low wage countries, there is no reason to expect wages for most people to grow significantly or even necessarily to keep up with inflation.

In short, if you currently have an ARM, you may well be sitting on a time bomb. I strongly encourage you to look at the historic values for the index on which your ARM is based to get a sense of how it might move. Interest rates during the past 4 or 5 years were generally the lowest in the past 40. Betting that they will go back down is probably a long shot.

The good news is that it may not be too late for you to get out of the trap. Fixed rate loans are still relatively cheap. If your income has increased, now may be the perfect time to refinance into a fixed rate loan and protect yourself from possible rate increases.

Mortgage and interest rate statistics:

Housing booms and busts:

Coping with Disruptive Change

(This article orginally appeared on ThinkingAboutMoney on July 5th, 2006.)

One of my basic assumptions with regards to planning for the future (whether it is financial planning, or career planning, or other) is that we are in a period of disruptive change (which I’ve been calling the “Information Revolution” – as a way of indicating it is analogous to the Industrial Revolution”).

Periods of gradual change are relatively easy to deal with. Individuals can extrapolate and plan based on the past. Words of wisdom from parents and elders more or less make sense.

Disruptive change adds discontinuities to trend lines. Suddenly what worked in the past does not work anymore. Common knowledge is incorrect. What was good advice can suddenly become very bad advice.

Today a friend asked whether we were too old – a sort of generic question, but an interesting one. For example: I know some senior citizens who simply cannot cope with the change they have already experienced. I know people in their 40’s who are already very stressed about the change they are experiencing. And I know people in their 20’s who are just getting a sense of the pace of change, and teenagers who are completely oblivious to it.

I think age absolutely has an impact on how one copes with change, and that curiously enough, different ages have both advantages and disadvantages in the way they cope.

Teens and those in their 20’s have two main advantages. First, they have grown up with today’s technology. Their baseline (or starting point) is more advanced. In many cases they have a better gut awareness of current trends. Second, they have grown up with and are accustomed to a higher rate of change. Their ability to multitask (working, while watching TV, browsing the net, and engaging in a dozen simultaneous IM conversations) is well developed – arguably an advantage in today’s world (but only arguably so – some would say they have lost out on the ability to focus and perform in-depth analysis).

Their disadvantage is that they do not yet really understand change. In their minds real estate always goes up, the stock market will pretty much always rise, and interest rates will always be fairly low.

Older folks have almost diametrically opposite problems. Multitasking is much less common, and technology adoption much lower (I got a real kick out of Donald Trump bragging in his book “Think like a Billionaire” that he doesn’t use computers or handle his own Email). Also, our very experience can work against us in periods of rapid change, where our knowledge of what worked in the past (that younger folks lack) leads us in the wrong direction.

At the same time, we have an advantage that we have experienced huge change. We know that real estate can drop in value, that stock markets go down and stay down for long periods, and that interest rates can reach absurd heights.

These differences suggest strategies for both groups.

Younger people can be well served by looking back at history, not in order to forecast what is coming, but in order to realize that they are basing their judgment on a very narrow period in history.

Older folk must be careful to question their experience and knowledge of history. To try to look at trends with a clear mind an unbiased viewpoint.

Above all, every individual should strive to cultivate contacts of ages other than their own. A younger person who disregards older people as “has beens” is just as stupid as an older person who disregards those younger as “inexperienced” or “ignorant”. By working together and listening and learning from each other, individuals in both groups can dramatically improve their chances of navigating the revolutionary changes that are ongoing.

Creating a Budget You Can Live With

(This article was originally published at ThinkingAboutMoney on June 11th, 2006.)

Everybody knows that one of the first critical parts of getting your financial house in order is to create a budget. How can you know if you are living within or beyond your means without one? How can you figure out where best to cut expenses if you don’t know how you’re spending your money?

I was talking to a friend this evening who really needs a budget but doesn’t have one. Her reason – it’s just too much trouble.

You know what? She’s right. In fact, I don’t have a budget either – at least not the kind that would make a financial expert happy. What I have is, at best, a partial budget. But it turns out that’s good enough.

Budgets, at least as presented by most experts, are very much an all or nothing proposition. What good is a budget that doesn’t include all your expenses? Quite good as it turns out.

Traditional Budgeting
The main purpose of a budget is to help you live within your income (or better yet, reduce your expenses to the point where you can start saving or investing).

The common recommended approach for budgeting is to figure out everything you spend money on, to allocate a portion of your income to that expense and to avoid going over that amount each month. This approach often fails for two reasons. First, few of us have the time, patience, or interest to track our expenses that closely and maintain such detailed records. Second, a monthly budget has a tough time handling expenses that aren’t monthly – things like annual expenses or sudden surprises like car repairs or braces for the kids.

The good news is that like many things in life, you can spend a fraction of the effort to come up with a solution that is about 90% effective. That’s because most people will find that most of their expenses go to a relatively few places: housing, insurance, taxes and utilities.

A Simple (But Effective) Budget
So here’s a simple budgeting approach that shouldn’t take you more than half an hour a month to deal with – maybe less. But will serve you almost as well as a detailed budget.

Step 1. Figure out your expenses.
First, figure out your regular monthly bills. The big ones – like rent or your mortgage payment, your typical credit card payments, car loans, and so on. Be sure to include things like cable TV that have a regular monthly bill.

Next, look at those bills that come in less frequently (quarterly or annually). Insurance bills often fall into this category, as do property taxes, car registration, etc. Figure out how much they come out to on a monthly basis.

Next, look at your variable bills – like your electricity or water bill. Those vary throughout the year. See if you can track down your highest and lowest for the past year and take the average of the two, then add a bit for good luck.

Finally, and here’s the clincher – figure out how much you think you’ll need over the course of a year for major expenses. These might include a contribution to an IRA. Or money for a vacation (even if it’s still a year or two away). Maybe money to cover the deductible on your medical insurance.

You may have 20 to 30 items on the list, probably less. Even that may seem too much to keep track of, so go ahead and group them into categories, like insurance, entertainment, utilities, housing, saving, etc. You’ll probably end up with less than a dozen categories.

If the monthly amount you’ve come up with is more than your income, or close to your income – you’re probably in financial trouble. It’s a good sign that you need to invest more time to get control over your financial situation – maybe talk to a financial advisor. But if your take-home income is higher than this amount, you’re on the right track.

Step 2. Open a second bank account for your expenses.
Your next step is to open a second bank account. Every month you pay into that account the amount on your list (the best approach is to transfer the appropriate amount right after each payday). Keep track each month of how much you contributed into each category (a program like Quicken can help with this, though I personally track it on a spreadsheet).

Every bill that falls into one of those categories gets paid out of that account, not your main account. When you pay the bill, you subtract the amount paid from the amount assigned to that category.

At first, you’ll find some adjustment is needed – you may need to move some extra money into the account to make sure a category has enough cash assigned to it, especially in cases of variable or periodic bills where you haven’t been depositing money long enough to accumulate the cash to cover a current expense. You’ll also want to reevaluate the budget at least once a year, more often if there are significant changes (like a new car loan).

After a while you’ll find that for most of your bills, there is always enough money to cover paying it in full. By the time that property tax bill comes along, you’ve already saved enough to pay it. Same for car registration, your IRA deposit, even that vacation you’ve been waiting for (trust me, a vacation is all the sweeter when paid for in advance).

And the tracking is easy – because you’re dealing with a small number of bills. What you’re not doing is tracking every penny you spend, worrying about the cash you’re carrying around and stressing over small expenses.

What about your main bank account? From a budgeting point of view you don’t have to worry about it at all. If there’s money in it, you can save it or spend it. Buy groceries or eat out, depending on what the account looks like. If it’s heading downward, try to spend less or hold off until your next payday. If it’s going up, transfer some of it to savings or an investment account. What you shouldn’t do is stress over it. This is your truly “disposable” cash.

Why This is Awesome
At this point most financial experts will be screaming. “Those small amounts of money add up” they’ll say. “It’s exactly that kind of discretionary spending where people get into trouble!” they’ll shout.

And they’re right of course. But they’re also wrong. Because we’re people, not businesses. And while many of those who read sites such as this one may have the patience, time and discipline to watch their income and expenses in the kind of detail that would make a bookkeeper happy, many don’t. And it’s those that don’t who get themselves in the most trouble because their answer to the hassle of budgeting is not to do it at all.

The approach I’ve described has the advantage of being very simple and, because it emphasizes paying yourself first and saving for periodic expenses, can help avoid the most common financial problems. And if it’s only a 90% solution, that’s a great return for 10% of the work.

Financial planning, like investing, is as much a matter of psychology as it is finance. If you can create a simple system that works for you and that you can follow consistently, go for it. It will prove infinitely more useful than a “better” and more complex system that you set up and then ignore.

Who Set The Price?

I’d like to invite you to look at a recent, not atypical, four day chart of a stock. In this particular case, it’s SiRF Technology Holdings (NASDAQ:SIRF).

SiRF Chart from Google Finance

As you can see, the stock gapped down from the $25-$26 it had been trading at to the $19-$20 range. You see this kind of thing all the time when “bad” news comes out.

The question I’d like to raise today is: who set the price?

Why did it go down to about $19? Why not $17? Why not $23?

To understand, let’s look at some of the news report headlines. Perhaps they can give us some insight as to what happened.

  • SIRF 2Q Profit fell after charges: Sales up 61%
  • SIRF Q2 EPS Declines on Higher Expenses Despite Increase in Revenues
  • SIRF shares plunge on 3Q outlook

Here’s a great company with long term growth prospects, numerous design wins, whose growth (while strong) isn’t quite what some traders would hope to see, and whose operating earnings continue to grow, but this quarter’s earnings were hit due to acquisitions and option costs. It’s a major player in the GPS space – an area that has huge short/medium term potential, as I describe in an earlier article “Thinking About Garmin“.

Logically, this is and remains a solid growth company. Yet we know that nowadays a stock can drop on any news. Even a perfect report can be followed by a drop in the share price – often explained away as investors selling because they don’t expect the next quarter’s news to be as great.

But today’s story isn’t about SIRF – that’s just the background.

Today’s question is: who set the price? Is it based on forward earnings? Some sales ratio?

Traditional marked theories would suggest that this price was set by many thousands of investors and traders, each evaluating the earnings report independently and deciding a fair value for the stock.

I would suggest that this is nonsense.

I recently proposed a new theory I call The Stupid Markets Theory that states that human stupidity is the fundamental force behind market pricing. Its main precepts are:

  • The price of a share is determined by the market, but in the long term the price will have a relationship to the value of the stock (based on the value of the company).
  • Most short term movement of a stock is a result of the decisions of a relatively few traders who are either reacting to information based on their own biases, acting illegally on inside information, or intentionally manipulating the stock. As such, a significant amount of this movement will be fundamentally stupid.
  • Most explanations for short term movement of a stock or the market are rationalizations – attempts to add reason to the inexplicable.

So, why did SIRF drop as it did?

Answer: Because the morning after the announcement when trading started, some computers woke up and had to resolve an imbalance in buy and sell orders. One or more traders out there had set up their computerized trading system to buy under about $19.50. So the exchange computers found they could match up orders at that price, and started trading. At that point, everyone else figured that was about what the stock was worth – not through their own analysis, but because a few traders had arbitrarily picked that price earlier. And so the stock sat in that range for the next 3 days while other traders tried to figure out what might happen next.

Why did that handful of traders pick $19-$20?

We don’t know. But we do know one thing about those traders: They are human (and, if the price was set by computer, its programmers are human – so it’s an indirect variation on the same theme).

That means there is a strong chance that decision was a stupid one. This is based on the Dilbert Principle and Peter Principle. We are all idiots some of the time. People do get promoted to their level of incompetence. Traders and financial advisors are no wiser than politicians, lawyers, or anyone else for that matter.

The Stupid Market Theory would argue that the choice of $19-$20 for the price of SIRF over those three days was completely arbitrary. Like any short term pricing, it had no relationship to the company’s value, or to news about the company, and that any explanations for that price are rationalizations after the fact (as Heinlein said – human beings are rationalizing creatures, not rational).

What does that mean for SIRF? In the short term, I have no idea. In the long term it will depend on how the company does – a topic for another day.

What does the Stupid Market Theory mean in terms of an investment philosophy? This is something I am continuing to work on and will be writing more about in weeks to come. Accepting that the market is fundamentally irrational (stupid) is contrary to most of what I’ve seen and read. Remember though, this is just a theory. I have not proved it, nor do I entirely believe it. Yet it is interesting enough to be worth studying and taking to its logical conclusions just to see where it might lead.

Mr. Market has no love for Garmin (GRMN)

Mr. Market is an Idiot. On June 21st, I posted an article “Thinking About Garmin” in which I proposed that Garmin is uniquely positioned as the leader in a technology that is “crossing the chasm” from early adopter to mainstream. I was expecting a stellar earning report this week, which is exactly what Garmin delivered. Only to see the stock go down.

So I took another look at my analysis.

In my analysis I suggested that if, in fact, auto GPS units were on that kind of growth curve, we should at the very least see growth rates continue, and I suggested that conservatively, we should see quarter revenues for April 2007 (9 months from now) at $453 million with an operating income of about $140 million on 1.25 million units. Let me stress – this was my forecast for conservative numbers based on my take on the state of the GPS market.

This quarter Garmin delivered revenues of $432 million with operating income of $134 million on 1.28 million units. In other words – they are already within 5% of my prediction for 9 months from now!

Now, let me throw some more facts into the mix:

  • On Amazon.com, the top 7 products in GPS and navigation were Garmin, 17 of the top 20 were Garmin. The top GPS is ranked #13 overall in electronics (that’s the entire category).
  • Garmin announced surprising growth in Europe. In my forecast I had written off Europe as “owned” by Tom-Tom, but they’ve had supplier troubles. You have to go to #6 on Amazon.co.uk to find a Garmin unit, but they do have 5 of the top 15. They are investing in Europe, so it looks like they’re not going to give up that market without a fight.
  • Garmin has opened a second assembly line and seems very focused on switching to “mass market” mode on GPS’s. Shaving costs might help them keep margins from dropping too quickly.
  • Garmin’s stock is splitting this month.

In short, my “blue sky” estimates in June are looking increasingly conservative.

So why has the stock gone down?

Two possibilities come to mind:

  • I am missing something in my analysis. Some hidden flaw in the company or market that the market sees that I don’t.
  • Mr. Market is an idiot.

I’ll be honest, I’m usually pretty skeptical of my own ability to analyze these situations. Yet no matter how I look at this one, everything I see supports my fundamental theory: that auto GPS sales are skyrocketing, and will continue to do so for some time because market penetration is still very low. I believe GPS units are going to be among the most popular gifts this holiday season, and that Garmin is going to have a virtual lock in the U.S. – with their increased marketing and existing mindshare there isn’t time for anybody who can make a dent in this timeframe – retailers are probably already placing their holiday season orders. Garmin is going to own the shelf space.

Every rental company is going to be offering GPS units, and Garmin just signed Avis and Budget (Magellan has Hertz but failed terribly to capitalize on it).

I recently proposed “The Stupid Markets Theory” that suggests that the driving force in market prices in human stupidity, and I think Garmin is going to prove the point. Because sometime in the next six months their numbers are going to be so obscenely good that whoever it is whose been selling (and thus keeping prices down) is going to be kicking themselves in a big way.

Heat Wave Investing: Consider Fedders (FJC)

It’s hot here in San Jose. With a record streak of record temperatures (many over 100 degrees), newspapers are reporting that every local store selling air conditioners has been cleaned out. Similar stories are being heard around the country.

Naturally, that led me to think again about companies selling air conditioners. I already wrote about Lennox which, while down from when I originally looked at it, still looks like a good medium term play. Their plan on building up an extra large inventory this season looks like it will pay off big time, though it may not be until their next quarter report that we’ll really know the results.

But Lennox mostly sells larger units. Today I went looking for companies that sell the portable and window units that have been selling like crazy, and I found Fedders Corporation (FJC).

Fedders is at best a turn around story. They’ve certainly had a couple of tough years. 2005 sales dropped considerably due to an unseasonably cool summer in the U.S. in 2004. Note the one year lag time – a cool summer in 2004 builds up inventory that sells in 2005, so it reduces 2005 sales. All the 12 month numbers and ratios are based on 2005 and thus actually reflect the summer of 2004. Do you see where I’m going with this?

2005 was a hot summer, which led to a significant sales increase in early 2006. Given what we’ve seen this summer, an empty inventory pipeline should result in significant sales through the next two quarters, maybe more.

Earnings were depressed earlier because material costs rose beyond what they could pass through due to existing sales contracts. This should be mitigated going forward as sales prices increase.

Fedders has also consolidated several manufacturing plants which might produce savings. They’ve started addressing problems in their financial controls. And they’ve started diversifying into some less cyclical areas to expand their product line beyond air conditioners.

Normally I don’t like buying into companies that are losing money – even if they are cyclical (where they lose money some quarters and run a profit on others). And while the story seems like a potentially good turn-around play, it still strikes me as a fairly high risk proposition. At least it did until I noticed another possibility.

Fedders previously paid a dividend. A small dividend (about 3 cents) on the common stock and a fixed dividend of $2.15 on their series A preferred stock which represented about a 9.0% yield on the $23.75 original buy-in. Not a bad yield even by today’s standards. But, they haven’t paid the dividend recently (though it continues to accumulate). And today the stock can be bought for $12.10.

This represents an interesting opportunity. Should the company become profitable and start paying dividends again, the yield will be 17.7%, which is certainly nothing to complain about. But it’s even better, because if they recover to the point that shareholders feel confident in their ability to continue to pay dividends, the shares will probably quickly return to their actual value, which is currently $27.15 ($25 liquidation price plus $2.15 in deferred dividends).

The nice thing about preferred stock is that it is somewhat less risky than common stock. If the company is bought or liquidated, the preferred shareholders get paid first. So even if the company collapses (which does not seem likely at all), chances are you’ll recover something (unlike the poor common stock shareholders). Plus, for every quarter Fedder doesn’t pay a dividend, the potential value of the shares increases further.

And don’t forget – those dividends get the favorable dividend tax rate!

Also, if Fedders does recover, the share price on the preferred stock is likely to increase before the common stock does. Why? Because it depends on the ability of the company to pay the dividend, not on the net earnings (remember, those dividend payments reduce net earnings).

It’s unclear how Fedders is going to do. It does have the potential to return to profitability – and if it can’t do so given the sales rates it’s going to see, then all bets are off. , but if you do see it as a turnaround, the preferred shares just might be the way to play it.

(See disclaimer)

Cendant: Breaking up is hard to do

In his book You Can Be a Stock Market Genius (review at ThinkingAboutMoney.com), Joel Greenblatt discusses the investment opportunities that come from investing in special situations – such as corporate breakups and mergers.

Over the next few weeks, Cendant is breaking itself up into four companies. You may not have heard of Cendant, but you’ve certainly heard about the companies it owns. In a few weeks Cendant will turn into the following:

  • Travelport – about to be sold for $4.3 billion, the best known brands of this travel services company are Orbitz and cheaptickets.com.
  • Reology – One share of this new company will be distributed for every 4 shares owned by current Cendant stockholders. The best known brands of this real estate services company are Coldwell Banker, ERA and Century 21.
  • Wyndham – One share of this new company will be distributed for every 5 shares owned by current Cendant stockholders. The best known brands of this hotel and timeshare company are Ramada, Howard Johnson, Days Inn, Super 8, Travelodge, AmeriHost Inn, RCI and a so on.
  • The remaining company will be changing its name to closer correspond to the rental car business it keeps – Avis and Budget.

Joel’s book suggests that these kinds of breakups present unique investment opportunities. First, the market tends to give the individual companies a higher value as separate companies than as one. Second, there are often parts of the deal that are missed by the market until well after the breakup. Finally, after a breakup like this the mutual funds and hedge funds that own shares in the parent stock often rearrange their portfolio (i.e. sell shares that were disbursed) because they no longer match the fund category or goals.

I decided it might be an interesting challenge to dig further into this rather complex deal.

Before going further, let me remind you that I am not an accountant, and certainly did not have the time to read the hundreds of pages of documentation filed with the SEC on these various deals. So what you are about to read is guesswork. Intelligent guesswork I hope, but guesswork nonetheless.

Part of the problem is that for all the hundreds of pages of documentation available on this deal, they mostly consist of guesswork on the part of the company (so my own analysis becomes guesswork on top of guesswork – not a great formula for accuracy). Also, remember that during a breakup of this sort, many of the numbers you read are in a sense made up – Cendant has pretty much total control over how assets and liabilities are allocated to the various companies, and can shift value among them in the form of separation adjustments.

As tough as that is, this particular deal is made more complex by the fact that Travelport is being sold. All we really know is that it’s being sold for $4.3 billion – it’s not at all clear how that sale ultimately impacts the current financial statement. Unlike the corporate spin-offs, where Cendant generates pro-forma financial statements that estimate what the individual company’s financial status would have looked like if it had been a separate company during the past reporting periods, similar information does not (yet) exists for the Travelport sale.

Finally, the most recent financial statements available to work with are the year end 2005 statements. The first quarter statement is available, however the revenues of the different companies are seasonal, so I decided it’s better to use the last annual report and give up on some currency than to use the later quarterly report.

Looking for Surprises

Despite the complexity of the Travelport deal, I did not find anything remarkable in the overall structure of the deal. The only thing I found somewhat puzzling was the allocation of income across the four companies.

Cendant showed $869 million income last year (excluding discontinued operations). Unfortunately, the annual report provided no way to divide that number among the individual divisions. It did indicate the division of income on an EBITDA basis. Normally I ignore this figure, but it’s all I had to work with in this case, so I used those percentages to get these income figures for the various segments:

Reology: $451 million, Wyndham: $281 million, Avis/Budget: $167 million, Travelport: $38 million.

Now here’s where it got interesting. In the United Pro-Forma Combined Condensed Statement of Income for 2005 (what a mouthful!), that proposes what the income would have been had Reology been a separate company, the income after adjustments is as follows:

Reology: $492 million, Wyndham, $341 million.

Hmmm… Perhaps Cendant believes income would have been higher had the companies been separate? I think it’s more likely we’re seeing the effect of depreciation. My guess is that the Travelport income is probably close to the EBITDA value (not much in the way of assets to depreciate or huge debt in an airline reservation business); whereas the rental car business has very high depreciation (all those new cars depreciate considerably as soon as they go into service).

In other words, it seems like Cendant is moving income into the Reology and Wyndham chains. By these numbers Avis/Budget will show basically no earnings after the breakup. This has an impact on what comes next.

Pricing the Pieces

With no hidden treasures found, there remain two questions. 1 – Is the sum of the values of the individual companies likely to immediately be worth more than the current value of Cendant? If so, it might make sense to buy Cendant now and take the distributions. 2 – What are likely fair stock prices for the individual companies once they start trading?

This becomes an exercise in company valuation. Again, it’s tough to decide the best way to do this, so I tried several different ways. For Reology and Wyndham I looked at earnings and likely P/E ratios. For Avis/Budget, I assumed little or no earnings, so explored Price/Book or shareholders equity and Price/Sales (I checked these rations for Reology and Wyndham as well). Then I looked at ratios among competitors. I also examined the results both with and without the Travelport sale (part of the $4.3 billion cash will be distributed to Reology and Wyndham as well).

Here are the likely share prices I came up with:

P/E = 15 – Reology 27, Wyndham 24
P/E = 20 – Reology 37, Wyndham 32

(Numbers are without/with Travelport)

Price/Equity = 1.5 – Reology = 8.8/17
  1.5 – Avis = 37/68.4
  3 – Wyndham = 39/48
Price/Sales = 1 – Reology = 27
  2 – Wyndham = 33
  0.7 – Avis = 35

Again, the ratio I used was that of comparable companies in the business. Note: the Avis/Budget numbers assume Cendant goes through with a planned 10:1 reverse stock split.

Assuming the Travelport sales happens; take a look at the market cap of the sum of the companies using the lowest valuation:

Reology @ 17 + Wyndham @ 32 + Avis @ 35 = $15 billion

$15 billion is the current market cap of Cendant.

Coincidence? Probably. The most this tells me is that my guesses are probably somewhere in the ballpark (at least when taken as a whole – I may be wildly off on the proportions).

This does, however, also tell me that there is no incentive to buy Cendant at this time unless you really want to own these four companies.


The Cendant story is an interesting one and bears watching. But right now I’d take a wait and see attitude. I don’t see any reason to buy Cendant shares at this time in order to take part in the distribution. Instead, I plan on waiting until the companies start trading independently.

I would probably avoid Reology. Though it’s been hugely profitable, I believe we are going into a period of declining real estate transactions (See “The Realtor Bubble” ) which is likely to severely impact real estate agencies.

Both Wyndham and Avis/Budget are interesting. Higher gas prices may impact both however. In this respect, Wyndham is a safer bet. With lodging scattered all over the world, any shift from distant vacations to vacationing closer to home will leave their revenue stream largely intact. Strength in lower cost chains could lead to growth as people try to cut costs when traveling.

Wyndham stock will be very interesting at anything under $30. Avis/Budget will be interesting anywhere under $35 (after the reverse split). Wyndham over $40 and Avis/Budget over $45 is probably overpriced (keep in mind again that these are based on guesses that may be way off).

Watch for a possible impact in price when the Travelport sale closes in mid August (however, whether it drops on failure, or rises on success will depend on which way the market factors the chances of success into the initial trading price).

Watch for a possible major adjustment after 3-6 months of independent operation when we start getting real numbers for the individual companies.

A Buck, A Yen, A Mark or A Pound

Devaluation of currency is not uncommon in other countries, but so far has been moderate in the U.S (in part because the dollar is the world’s currency). I recently discussed this in an article titled Speculating on the Future of the Dollar. But given our massive debt, budget deficit and trade deficit, a significant drop of the dollar against other world currencies (and corresponding increase in inflation as all types of imports become more expensive) becomes a possibility.

How can you protect your portfolio from a significant slide in the dollar?
This is indeed a tough question, and I won’t claim to know the answer. However, based on what we’ve seen in other countries, when the value of a currency drops, the value of tangible assets remains roughly the same. In other words, devaluation and inflation go hand in hand.

The consequences for traditional investment vehicles are tough to predict. A value investor might say that stock prices would rise, especially for multinational companies that have significant non-dollar assets. But the stock market is.. a market. And if people are withdrawing money from their mutual funds to cover increased expenses, stock prices will drop regardless of the valuation of individual companies. The same applies at least in part to real estate, though again there are many other factors involved.

In short, you can’t count on stocks, real estate, mutual funds, or certainly dollar denominated or corporate bond funds to protect you from inflation.

So what are your options?

One is TIPS (Treasury Inflation Protected Bonds), that pay a base interest rate and a correction value based on the consumer price index (CPI). Not a bad approach, though there are risks involved for those who are more on the paranoid side – namely, you are trusting the government to accurately calculate the CPI and meet it’s payment commitments on the bonds.

Another traditional approach is gold. Gold is easier to invest in than ever now that you can purchase gold funds (one popular one is GLD). There are two problems with investing in gold. First, it really is a speculative investment – in other words, the price of gold seems more dependent on the action of speculators and governments than on currency values. Second, gold is a rather poor hedge against inflation. If you bought gold at $130/oz in 1975 and sold it at $600 last month, your overall return would be 5.06%, vs. an inflation rate of 4.63% for the same period. Gold might still be a good protective choice (especially if you are concerned about a worldwide depression including a collapse of all currencies, not just the dollar), but as an investment it’s not a particularly good long term play. Gold is also generally taxed as a commodity, not an investment – so you get to pay taxes at the regular rate – which wipes out much of the protection it offers.

You can trade in currency futures. This is just like trading option on the stock market – a technique for more sophisticated investors. I’ve actually done a bit of this, but more as a hedge to prevent a sudden increase of costs when traveling abroad. Currency futures suffer from the same problem as options – they expire. If you’re concerned about a drop in the dollar in the next few months, futures are a great deal. But if you’re concerned about a drop in the dollar over the next 20 years, they are an expensive form of insurance.

A newer approach involves currency ETFs (Exchange Traded Funds). These are funds that hold other currencies. You can now buy ETFs in Euros, Pounds and other major currencies (and a few relatively minor ones). These are especially nice if you’re in the U.S. where it’s typically difficult to trade in other currencies. Their disadvantage is that they really are a pure currency play. The currency in the funds is typically held in accounts that pay little or no interest, so you’re lucky if the fund’s income pays for the fund’s expenses. Another disadvantage is that the IRS considers these a form of commodity trading, and any gains are again taxed as regular income.

Finally, you can invest in an international bond fund. This is my personal favorite. Because the fund’s holdings are generally not in dollars, the fund will tend to do better when the dollar is weakening. At the same time, the fund holds bonds that actually do pay interest – so the fund has income that offsets both expenses and loss in value due to fluctuating interest and currency exchange rates. As a result, you have potentially the best of both worlds – an income fund that at the same time provides protection from a significant drop in the dollar. More important, depending on the individual fund, some of its return will be in the form of long term capital gains (with its more favorable tax rate). Plus, if you hold the fund for over a year and it increases in value, your profits will be taxed at the long term rate when you sell. There is risk – bond values drop as interest rates rise, so I would definitely stick with a short or intermediate term fund if you go that route.

Currency and gold ETF’s are the latest cool investment toy on the block, but frankly, I’m not impressed. Consider using a currency ETF if you’re planning a trip abroad and want to protect yourself from currency fluctuations. Consider a gold ETF for your IRA where the taxation rate isn’t a key factor. But at this time, for a good balance of income and security from a drop in the dollar, a short or intermediate term international bond fund might be just the ticket.