Attractive Spinoff Criteria

What makes a spinoff attractive?  After picking this as a place to put my money, I need to understand what makes this type of investment valuable.  This post has the simple basic rules that make spinoffs attractive as an investment vehicle.

Institutions are motivated to dump the shares

Institutions (mostly mutual funds) are motivated to dump the shares of a spin off for a number of reasons: the size of the company is smaller than the minimum value the mutual fund can purchase or in an industry that the institution does not participate in.

Insiders are motivated to keep the shares

Management, and other wall street insiders are making sure that they get a cut of the new company’s shares.  These deals are typically disclosed in the SEC Form 10/12B.  Look for sweetheart deals that major investors are making for their interests.

The company becomes relatively cheap to purchase

The spin off provides an inexpensive company to purchase as a result of the spin off.  As institutions bail on the new company, the stock price can suffer providing a great opportunity for investment.

The company is a a great business that is only realized after the spin off

Sometimes the spin off company’s attractive investment was being dragged down by the parent.  This is particularly noticeable with spin offs created in entirely new industries.

The company provides a new leveraged risk reward situation

The new leverage is appropriate for the spin off’s industry but was inappropriate for the parent company’s industry making a new valuation model more useful and effective.  As a result, the new companies will be better valued like their peers.  This can happen when the two industries are starkly different.

Stock Predictive Analysis: Insider Trading

My wife Kayla inspired this post with a question she posed to me earlier this week.  She asked me if there was a way to determine when a stock’s price will go down.  If one truly knew the direction of an individual stock every time they moved they would probably sell the information for a lot of money.  This is one in a series of multiple posts attempting to answer the question, “can one know the direction of a stock’s price movement?”. The short answer is yes, however most of the people that can truly predict the direction of a company’s share price cannot actively trade on this information – its called insider trading.  To think that such individuals don’t do so is naive, whether they get caught is another question.  However, there are some indicators that identify where a company’s stock will go.  The biggest problem is that these are much easier to identify after the fact.  This post and others on predictive analysis will talk to some of the red flag indications that a stock price may fall.

Insider trading tells everybody at precisely the wrong time that everything is rigged – Preet Bharara

Just a fair warning, insider trading is the dark side of the stock market.  If you cannot handle a cynical perspective on the market, stop reading.  My perspective is very cynical in this area.  I personally believe that it is difficult to think that in a high performance environment to achieve better than average results the temptation to use insider information just to keep one’s job is tremendous.

An interactive Bloomberg article from 2016 talks of the largest insider trading ring bust in US history.  The SEC convicted 93 individuals total as part of this crime wave.  One can argue that this is a great job by the SEC.  However, the alternative perspective could be to think that they only have money and time to prosecute the most egregious deals-just like sports authorities only prosecute Olympians or professionals because the news value of the action has impact to show that the organization is valid.

The average rogue trade according to some professors and New York University was worth about $1.6 Million.  Quantifying this information, it was simply a study not the holy grail double blind study that shows the best statistically significant information (who is going to say, “I am an insider trader and would be more than happy to join your study for science…”).  However, they did consider over 16 years of data analyzing thousands of merger and acquisition activity as part of the study and claimed that about one in four mergers included insider trading information.

The Point

In conclusion, it is possible to get actionable information about the direction of individual stock prices this is why insider trading exists.  The individuals that participate in such activity probably can make significant gains from such activity.  However, insider trading is illegal and the SEC will prosecute anyone that they find worthy of prosecution.

Employing Cash in a Frothy Market

A few weeks ago, an article in the Wall Street Journal was titled “Stocks are Frothy but there is no Bubble”.  What does one do when the market is frothy?  In my opinion, frothy means that the market is overpriced, maybe not bubbling, but overpriced.  From that article the author identified that the forward looking price to earnings ratio for the S&P 500 rose from 12 times earnings to over 17 in the past five years.  I like to think of this simply, the price of the market is approximately 50% more expensive than it was five years ago.

The stock market might not pop, but it can still fall pretty hard. – Justin Lahart

So what does one do when they believe that the market is overpriced?  How do they participate in the stock market and preserve capital?  What can be done to continue to get returns anticipating a market drop?

My personal method is to sell puts on an Index ETF.  Remember from previous posts that selling puts allows you to gain cash on a security by providing an opportunity to another investor to sell their shares of the company at a predetermined price.  The other investor uses this as a way to preserve capital.  You get the benefit of current cash from the transaction and if things go well for you, the contract expires worthless and you pocket the cash from the transaction.  If things do not work out in your favor, you still get the opportunity to purchase the company/security at a lower price than today’s going rate.

Example:

Let me share a simple example.  IJH, the S&P 400 Index ETF that I wrote about previously is selling at about 171/share,  the investor selling puts can sell a contract expiring in about four months setting the transaction price at 153 for about 1.75.  Remember that each contract represents the right to buy or sell 100 shares of a security.  Therefore, in this example, the seller gets $175 for the transaction and will purchase the underlying security for 153/share if it falls to that level.  Basically, you are locking in the opportunity to purchase at a lower rate and being compensated for maintaining the cash for such a transaction.

This strategy does offer some downside, in order to play the entire transaction out, you must maintain the value of the put in cash.  Therefore, for the example above, the seller is unable to use the $15,300 in cash for the next four months until the contract expires or is bought back.

April Fool’s Stock Terms

This post is more about wit than investing, with yesterday being the April Fool’s holiday in the United States, I thought I would have a little fun.

Why is it that the individual in charge of your money is called a broker when it seems like we are the ones broke?

Why would we call stocks and bonds securities when they are aren’t really that secure?

Why do we measure goodwill as a tangible asset only when a stock gains income but call it an impairment when the company looses money?

Why is a bull market filled with optimism, when more often than not, it is filled with BS?

Why do market leaders fear a bear market, when usually this is a bearer of good profit tidings in the next few years?

Why is debt called margin and not simply debt?

Why do the markets use the term settlements to describe a transaction occurring but don’t require attorneys for settlements?

What is another term you hear in the stock market that seems to mean something different than what it means?  Let me know what you find strange.

Accounting Landmines: Goodwill

When looking at publicly traded companies, one of the accounting landmines in modern valuation is a called goodwill.

You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission. -Warren Buffett

Definition:

Accounting principles require fair value be assigned to a company when it is purchased.  This fair value starts with the assignment of value to identifiable assets.  In today’s modern financial world, often the purchase price of a company exceeds the value of the identifiable assets of the company.   In order to keep balance sheets even, acquiring companies often must hold this excess of value as an asset.

Things to consider when valuing a company that has a lot of goodwill:

Even though such an asset has no apparent tangible value, public companies are required to account for it on the balance sheet.  Accounting principles require that such goodwill be evaluated each year and if the value of the underlying acquisition be charged to earnings if the goodwill has suffered an impairment.  Purchasing a company with a large amount of goodwill on its books is tantamount to purchasing the company’s assets and thin air (my personal opinion).

An example to consider (aka buyer beware ENDP):

Endo Pharmaceuticals (ENDP) recorded $3.5 Billion goodwill and intangible asset impairment charges in the fourth quarter of 2016.  This occurred when the company’s management completed their goodwill and in-process R&D impairment tests.  Using the estimated future cash flows for these areas, management stated that they had to revise their forecasts, Wall Street speak for “we had no idea that something could actually go wrong 12 months ago when we made our estimates.”

This caused the company to take a earnings loss of 14.96/share when the stock price for the company was about 12/share!  The management in their conference call followed this staggering number with diluted earnings per share from continued operations of 1.97.  A discussion of diluted earnings per share could merit its own post.   However, for our purposes here just think that management came to the shareholders and disclosed that in ONE QUARTER they had losses exceeding the value of the company but all is good because diluted earnings are still positive.  This resulted in the share price to drop about 17%.  Goodwill can have a real tangible effect on a company’s value in the marketplace.

As for ENDP’s management, I am reminded of the old 1980 era film with Silvester Stallone named Oscar.  After a day of trying to go straight, “Snaps” Provalone is sitting down with the bankers that are to be his new partners.  His accountant looks through the contract and finds that the contract does not allow him to have a vote on the board.  Snaps ends the session saying something to the effect of, “I’ve dealt with mobsters, bootleggers, and gonzos…but you bankers are scary”.

For another perspective on Goodwill and how it affects a company stock price consider Warren Buffet’s words on it in his 1983 letter to shareholders.  His perspective from that letter would have called ENDP’s assignment of overvalued business purchases to silliness in the goodwill account.  The lack of managerial discipline displayed by the management would be more along the lines of a “no-will” account.

Final thought

I leave you with one final thought, if you consider purchasing a company in excess of its tangible assets.  Lets use a company selling for 100/share and it has 5/share in earnings and 20/share in tangible assets.  Consider amortizing the price of the excess from the earnings over the next forty years using straight line depreciation (5-80/40=3/share).  Is the price still worth the adjusted earnings?

Exploring Spin Offs

Exploring Spin offs

Spin off companies appear to be a place where one can consistently beat the S&P 500.  This post will explore this possible investment closer than previous posts.  If you would like to see my perspective on a spin off that occurred recently you can check out the posts I wrote on the Conduent spin off that occurred earlier this year.  Full disclosure, as of this writing I currently have 100 shares of Conduent and five long term options in Conduent and Xerox set to expire in 2019.

Corporate spin off opportunity from Xerox: Conduent

“Carefully study spin offs” – Charlie Munger

Risks

The risks associated with spin offs are numerous, so before a reader immediately goes out and buys every spin off they can find, some words of caution:

  1. A Deloitte study found that 4 out of 10 spin off companies do not generate a positive return in their first 12 months of trading.
  2. The same study found that the bottom quartile returned -39% over the first year.

You can find the Deloitte study by following this link.

Rewards

The return associated with spin offs is apparent in the Bloomberg Spinoff Index which from 2003 to 2016 returned approximately 15.58% while the S&P500 returned 8.88%!

Reasons Spin offs remain a good place to look for deals

  1. In a world of increasing index investing, many spin offs will be beaten down by institutions selling the shares of the new company outright because it will not be in the index.
  2. Institutions may also find that the recent spin off does not meet their investment expectations (like size or leverage amount) and they will again immediately dump the shares without considering the value of the investment.
  3. Sometimes these smaller companies demonstrate a new, previously undiscovered business opportunity.
  4. Investors often are wary (or haven’t heard) of these companies because many of them are not followed by analysts until after a few months of independence.

Conclusion

With a consistent way to outperform the S&P500, this seems to be a place I want to be in the stock market.  Next week HPE will be spinning off a portion of its business, as a current investor in HPE I will be looking at this spin off with great interest.

Lessons from Warren Buffett’s Annual Letter to Shareholders

Last week, Warren Buffett’s letter to his shareholders was available online.  His letters are always a great read, and they provide insight into his views on investments.  This post will be dedicated to some of the wisdom and humorous quips an investor can glean from his letter.

“Today, I would rather prep for a colonoscopy than issue Berkshire shares.”

Warren Buffet, 2016 letter to shareholders, page 4

Buffett’s reason to not issue shares is a result of past experience.  The examples he cites in the letter include buying Dexter shoe and General Re by issuing Berkshire shares.  Dexter shoe is the most painful decision as Buffett notes that the company’s stock promptly went to zero.  The shares he issued to purchase the company gave the Dexter sellers $6 Billion in Berkshire shares by the end of the year.

The lesson that Warren takes from this experience is to purchase his investments in all cash.  More importantly, for an investor reading his letter it identifies that one of the best investors in the world has a long memory of his mistakes.  The Dexter fiasco happened in 1993 and he is mentioning it in his 2016 letter to shareholders as a lesson learned.

“To recap Berkshire’s own repurchase policy: I am authorized to buy large amounts of Berkshire shares at 120% or less of book value because our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders. By our estimate, a 120%-of-book price is a significant discount to Berkshire’s intrinsic value, a spread that is appropriate because calculations of intrinsic value can’t be precise.”

Letter, pg 7

After a rant against companies that repurchase their shares at an inflated price, Warren identifies Berkshire’s repurchase policy-120% of book value.  His preceding words identified that too many boards today repurchase shares of their stock with no hard numbers on which price is an appropriate price to pay.  This is ridiculous, because price would be the first thing management would consider if looking at an acquisition.

This line of thought provides two lessons that an investor can use-watch your managements and set the appropriate price in hard numbers.  Watch the management of the companies that you purchase and make sure that they are making rational decisions.  They should not be following the crowd to simply buy back shares if the company stock price is inflated.  This would be wasting shareholder funds on a poor endeavor.  Having a hard test for their numbers is a great way to find the value of a company in the market.

“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.”

“I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.”

Letter, pages 24-25

Warren identifies the best advice he can for investing-use low fee vehicles that match the market.  In my opinion, this is the simplest way to go with investing.  Match the market through a low cost index fund.  If you are not interested in looking at specific positions and digging deep – then purchase an index fund that attempts to match the S&P 500 and call it good.  Correction, if you are over 10 years from needing the money, purchase an index fund that matches the S&P 400 and call it good.  My reason is that the S&P 400 typically outperforms the S&P 500 but it will be more volatile than the S&P 500.  You can read more in the post below.

Investment Plans, Part 3: ETF example

In conclusion, Warren Buffett’s letters are great for anyone aspiring to be a successful investor.  If you would like to read his whole letter in its entirety you can find it here.  I leave you with my personal favorite quote from his letter, it is an adage he used when talking about how Wall Street managers separate their customers from money:

“When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”

-Letter, pg 25

Review of a few Positions

This week’s post will review the performance of a few positions I currently have interests in.  Unless explicitly stated, this is not an endorsement of getting into these positions at this time. This is because the reasons for purchasing them may have changed.

Conduent

In January after the spinnoff, I purchased 100 shares of CNDT at $14.38, today the price is near $15.02, representing over a 4% return in a month.  As stated in the original post, the holding period for this stock is closer to 2-4 years.  I expect that this company’s actual share value is closer to $22/share, so such a move is simply confirmatory. TDAmeritrade indicates that the institutional investor commitment is a mere 16.75%.  One of the things I am looking for is an increase from the institutional investments to closer to 50% before selling this security.

Mylan

This week, Pharmaceuticals jumped on bullish call options for Mylan.  This appears to have something to do with David Tepper who reduced his position in Apple in favor of increased or new positions in Mylan, Pfizer, and Allergan.  Tepper is one of the few hedge fund managers that has performed well since the financial crisis according to Forbes magazine.  Tepper’s positions were revealed on Valentines Day and rose almost 5% that day and the next-solidly placing the price just over $42/share.  Consequently those call options seem to be indicating that the market movers expect a move beyond $42.5/share because many of them were placed at that price.  The open interest in $42.50 call options expiring on March 17 exceeds 7,800 contracts showing an extremely bullish sentiment for this company.

Market overall

I still think the market is in for some volatile days ahead.  The Trump trade we have discussed in several posts is still showing exuberance that seems to think nothing could go wrong.  Donald Trump seems to be a shoot from the hip type of president which could cause some uncertainty-Wall Street traders are fickle and seem to hate uncertainty.  They could respond quickly to some unfavorable policy and send the market down as quickly as they pushed it up during the election.  I may be wrong, and hope that I am because this would indicate a better economy for the coming years, but the skeptic in me keeps me from a full commitment of funds due to such a possibility.

Dow over 20,000 and overpriced

The last two weeks we experienced the Dow Jones Industrial Average (DJIA) topping 20,000 for the first time in history.  This milestone was inevitable, but at the current time and price multiple it is too high.  This week’s post will look at it from a different perspective, what are people saying about this historic rise in DJIA prices?

Say what you will about the ultimate importance of the Dow reaching this big round number, but it certainly got there in a hurry. The 9% the Dow has added since Election Day is the sort of move that is usually reserved for market rebounds after big tumbles as opposed to when it was already in reach of its record high. – Justin Lahart, Dow 20000 Means Stocks are Pricey, WSJ.com

Even if I understood quantum mechanics, this (rally) wouldn’t make sense but oh well. Rally on!! – Heath Anderson WSJ.com forum

So what’s the alternative to stocks? Bonds, paying zilch if they’re solid and a few percent if they’re not (do you really want to lend to Chicago?) Real estate? REITs seem to be taking it on the chin with more mall defaults on the way according to an article today. Individual property? That’s more sunk illiquid capital for a long-term spec bet than most investors can stomach.

I guess there’s always unicorn farms.” – John Rogitz, WSJ.com forum

Yes. P:E’s are above the levels pre dot.bomb and pre derivative/housing crash. And the Dow is jiggered by removing losers and inserting winners. Celebrating a single index is like sacrificing goats to make it rain. – Marty Anderson, WSJ.com forum

It’s really disappointing how the markets can react to perceived opportunities/disappointments in the future without knowing any specifics. Premature ejaculations never really result in material benefits. Can’t we wait until specifics are delivered? Does business award bonuses for ideas that never see the light of day? – Bob Schafer, WSJ.com forum commenting on the fast run up of financial stocks since the election (up between 15-36% in the last few months).

The Trump trade seems to be an excuse to overprice the companies in the stock market.  When the DJIA passed 10,000 for the first time, the phrase irrational exuberance was used to describe the market.  The metric then passed the 10,000 mark over 30 times before crossing 20,000.  The Trump trade is all focused on what he is planning to do, and very little on what he will actually do.  The market seems to think that his policies will be very one-sided and only include upside opportunities.  For over three months, the market appears to only be considering the upside potential.  Several articles this week indicated that Wall Street is taking its cues from Washington.  Until earnings and more importantly cash flows begin to catch up, I think that the markets will be more volatile.  Therefore, I am currently maintaining 50% of my investment accounts in cash and cash equivalents.  Consider Warren Buffett:

Be fearful when others are greedy and greedy when others are fearful

Conduent Continued

Last week’s post looked at the spinoff from Xerox called Conduent.  The new company trades as CNDT.  Since last week’s post, CNDT rose 48 cents representing a 3.4% increase in value over the week.  If you want to see the first post look here.  This week’s post will look at the cash flows for the company and consider some of the motivations of those in charge of the company.  This post will attempt to determine the appropriate value of the company per share.

I sit on a lot of boards…I don’t have to watch Saturday Night Live anymore, I just sit at the board meetings. I will tell you it’s a sad commentary that we have an inability to compete. You can blame unions to some extent. But the real problem is that boards – there’s a symbiotic relationship between boards and CEOs today. And as a result, there is no way to hold these guys accountable except when someone like myself comes along or some other person who is really well to challenge them. But you have to go through contortions. There is no corporate democracy. –Carl Icahn

According to ValueLine, the business represented in CNDT for the spinoff is the growth business for Xerox (XRX).  Icahn is one of the main shareholders at XRX, and as a result, he cares that the company makes its shareholders money.  Icahn and another major shareholder Darwin Deason are the main beneficiaries of the CNDT spinoff.  Before looking at the price, let us see what kind of deals Icahn and Deason received from this spinoff.

Icahn’s Interests

Vincent Intrieri, Courtney Mather, and Michael Nevin are all connected to the Icahn Group.  This means that on the eleven member board, Icahn has three individuals placed in order to protect his interests.  The Form 10 filing also notes that Icahn will maintain one seat on the board at XRX post spinoff.  His interests represented 9.8% of XRX pre-spinoff.  In the Form 10 filing, he required XRX to spinoff CNDT no later than March 2017.  He also requires special benefits to individuals holding more than

Darwin Deason

Deason, like Icahn is a self made billionaire.  In October, he filed a complaint with the courts alleging that the spinoff would violate certain provisions of Xerox’s Certificate of Incorporation.  His stake in XRX represented 6.1% pre-spinoff.  Deason dropped his charges against XRX with an exchange agreement where he relinquishes 300,000 shares of preferred stock in XRX for 180,000 shares of XRX preferred and 120,000 shares of CNDT preferred after the spinoff. The payout of these shares is 8%.  These preferred shares have a conversion right at any time to get 44.9438 common shares per one preferred share of CNDT.  This reflects a conversion price of approximately $22.25.  Mr Deason has given himself a beautiful golden parachute in this spinoff. He is probably trying to protect his cash flow from the preferred shares that he had with the XRX preferred investment.  His actions indicate that the real value is in CNDT’s business, not XRX.  Why else would he insist on a 40% stake in his preferred holdings when everyone else gets 20%?  It is possible that he wants to use the conversion rate which is much higher than the current price-considerably higher, like almost 50%.

Deason and Icahn both appear to be jumping on the CNDT bandwagon.  It appears that this is where the money is to be made.  This, coupled with the statement by ValueLine that the company represents the growth segment of XRX’s business pre-spinoff, does make it that much more attractive.

Value?

There are many places to look for value on a stock.  Price to earnings ratios are one.  Personally, the best pulse on a company comes from operating cash flows.  This is typically an erratic number, but it has less to do with taxes and more to do with actual cash coming into a company.  In the case of CNDT, the company’s net income according to Form 10 was (414)M in 2015, (81)M in 2014, and 182M.  The company therefore has started its life with a negative earnings track record.  However, the company’s operating cash flows over the past three years has been 493M, 665M, and 379M-all positive numbers even with a 216M charge for recent litigation in 2015.  On a per share (anticipated number of 202.8M shares) basis this means CNDT’s current price to past cash flow was between 4.4 and 7.7 over the past three years.  CNDT’s most recent price to cash flow is 5.9.  Even at the high end of this range, the company trades in the bottom 10% of the market on a per share valuation with the average valuation over 16 times cash flow.

Reasons for Buying

The market’s reaction to CNDT is weak, it appears to have little interest in this next generation growth stock.  The thing that makes me interested is that 9.77% of its shares are owned by institutional investors however Darwin Deason, Carl Icahn, and the CEO Ashok Vemuri all have vested interest in its success.  When the institutions begin purchasing the company’s shares it should rise dramatically.  After this analysis, I plan on investing in CNDT.  I am looking at about 1/8th of my portfolio to be exposed to this stock at less than $15/share.  This is with an expected 2-4 year holding time.