adamcz Wrote:
-------------------------------------------------------

> It's crazy how cheap this sector - long associated
> with bubbles - has become. Obviously one needs to
> do their homework in terms of evaluating the
> moats. I already own Apple, and am ready to do
> some serious thinking about ebay and Microsoft.
> Intel will probably forever remain outside my
> "circle."


You raise a good point... Tech is certainly one of the most contrarian sectors right now. This is especially true of the mega-caps and outside of the high flyers (RIMM, Apple, Amazon, etc). It's amazing to think that companies like Microsoft, Cisco, Ebay, etc, are trading at P/Es of around 10; while cyclicals such as Intel, Texas Instruments, etc are starting to post very high P/Es (high P/E is good based on the cyclical theory I follow.)

A lot of this makes sense. After huge bull markets, once-popular sectors become out of favour. I expect technology to do really well now that their valuations are seemingly low.

---------
Check out my investing blog - contrarian with a macro focus and a value investing tilt: Can Turtles Fly? A Contrarian Investing Blog.

Sivram, you like high p/es? I'm willing to sell you shares in any company you like at a sky-high PE. Maybe we could work out a deal where I buy them in the open market and then sell them to you for 10x that amount, and then you can pay me a fee for the service I provided - allowing you to get a price that works out better for your theory.

:)

buffetteer17 Wrote:
-------------------------------------------------------
> In the past several employees have been dismissed
> and some fined for trading on insider information,
> trading during blackout periods, and other
> miscellaneous infractions of company policy and
> the law. The company considers all employees to be
> insiders. I don't want to present even the
> appearance of making a recommendation about the
> stock. The PE is a little over 10 instead of its
> usual 20-30.


Well, that is certainly a powerful incentive to not name your employer!! I wasn't trying to get you to name it, just to clarify some of the metrics you used to describe it. Thanks for the clarification.

adamcz Wrote:
-------------------------------------------------------
> Sivram, you like high p/es? I'm willing to sell
> you shares in any company you like at a sky-high
> PE. Maybe we could work out a deal where I buy
> them in the open market and then sell them to you
> for 10x that amount, and then you can pay me a fee
> for the service I provided - allowing you to get a
> price that works out better for your theory.
>
> :)


Adamcz,

I see your smiley.
However, for those who may not know, it is generally recommended that cyclical companies are more of a value when the p/e ratio is high, or better yet, negative, and the best time to sell those same companies is when the p/e ratio is low (but not negative)

adamcz Wrote:
-------------------------------------------------------
> Sivram, you like high p/es? I'm willing to sell
> you shares in any company you like at a sky-high
> PE. Maybe we could work out a deal where I buy
> them in the open market and then sell them to you
> for 10x that amount, and then you can pay me a fee
> for the service I provided - allowing you to get a
> price that works out better for your theory.
>
> :)


No problem :) It's not as straightforward as saying 'buy all high p/e'...

Alanb9 answers your question but the theory I follow says to buy cyclical when their p/e is high or infinite, and sell when they are low. Benjamin Graham is also of similar opinion. If I recall, in the Intelligent Investor, he refers to Ford (I think) and points out how the best time to buy is when p/e is high (I could be mixing up Graham with someone else so correct me if I'm wrong.) However, I will note that some investors, particularly traders, momentum investors, and certain macro investors (especially those who try to identify secular trends) will disagree with this strategy.

Anyway, watch the cyclicals, especially commodities. All these commodity stocks are going to have really high P/Es soon and they would be far more attractive right now than one or two year ago when their p/e was really low. Similarly, they were much more attractive in the early 2000's when their P/E was really high. The same thing with the classic cyclicals like airlines and autos. Toyota, Honda, et al, will post higher P/Es soon (some of them will be infinite/no earnings) and I would rather buy them then than an year ago when their p/e was kind of low.

Now, this isn't a blind strategy that can be followed--nothing can be blindly followed when it comes to investing after all. There are exceptions of course. Well-run companies in cyclical industries can have stable P/Es. A good example is ExxonMobil, which does fairly well regardless of oil prices and whose p/e doesn't fluctuate as much as many other oil&gas companies.

---------
Check out my investing blog - contrarian with a macro focus and a value investing tilt: Can Turtles Fly? A Contrarian Investing Blog.

Quarterly Report for The Portfolio
March 31, 2009

For the quarter ending March 31, 2008, The Portfolio was down 0.2%, compared to the S&P 500 benchmark portfolio which was down 10.6%. Since inception in September 2004, The Portfolio compounded annual growth rate was -5.0%/year, compared to the S&P 500 benchmark portfolio return of -21.7%/year. See Note 1 for how these are calculated.

I started The Portfolio in September 2004, after becoming dissatisfied with the returns from random mutual funds. I figured I could do better by actively managing the money myself. After scaling up slowly, it now represents the majority of my net worth.

Composition of The Portfolio

current
company stock fraction
Berkshire Hathaway BRK/B 2.6%
Boulder Total Return closed-end fund BTF 1.0%
bank smorgasbord 0.0%
Conoco Phillips COP 2.0%
Cisco CSCO 9.5%
Dreman/Claymore closed-end fund DCS 1.4%
Devon Energy DVN 2.8%
eBay EBAY 6.2%
General Electric GE 4.7%
Garmin GRMN 8.2%
JAKKs Pacific JAKK 6.3%
Johnson & Johnson JNJ 5.4%
3M Corp. MMM 3.3%
Microsoft MSFT 2.7%
my company myco 2.8%
Pfizer PFE 2.6%
American Freightcar RAIL 3.8%
Rio Tinto RTP 1.2%
Stryker SYK 1.8%
index puts hedge 14.3%
Walgreens WAG 0.4%
Whole Foods Market WFMI 6.2%
United Healthcare UNH 4.9%
WellPoint Healthcare WLP 4.7%
Wesco Financial WSC 0.7%
Zimmer Holdings ZMH 0.4%

previous, Q4 2008
company stock fraction
Berkshire Hathaway BRK/B 1.9%
bank smorgasbord 0.0%
Conoco Phillips COP 2.6%
CryptoLogic CRYP 1.0%
Cisco CSCO 9.0%
Dreman/Claymore closed-end fund DCS 0.3%
Devon Energy DVN 3.9%
eBay EBAY 6.4%
Freeport MacMoRan FCX 3.2%
General Electric GE 1.9%
Google GOOG 0.3%
Garmin GRMN 7.6%
Home Depot HD 2.3%
JAKKs Pacific JAKK 10.2%
Johnson & Johnson JNJ 6.5%
3M Corp. MMM 2.7%
Microsoft MSFT 2.6%
my company myco 2.2%
Pfizer PFE 1.5%
American Freightcar RAIL 4.8%
Sears Holdings SHLD 1.6%
Stryker SYK 0.8%
index puts hedge 9.8%
Toyota Motors ADR TM 0.7%
Walgreens WAG 0.2%
Whole Foods Market WFMI 5.1%
WellPoint Healthcare WLP 10.2%
Wesco Financial WSC 0.6%

The remains of bank smorgasbord, a few LEAPs for BAC and C, are now essentially worthless. I doubt they're coming back, but it is cheaper now to let the options expire than to pay the transaction fee to sell them. The hedge comprises S&P 500 index puts, described in more detail later.

Significant changes. Sold down several large holdings to decrease margin debt. Now margin debt level is about 35%. I'm allowed by my broker to go to 60%, but as a safety precaution, I never go over 50%. Switched from Freeport MacMoRan to Rio Tinto, which looks like it has better long term prospects. Exchanged half of the Wellpoint shares for United Healthcare shares. Did this because of a WSJ article about problems with Wellpoint's IT systems. Sold off the CrypoLogic position. Took a small position in another closed-end fund, Boulder Total Return, and increased position in Dreman/Claymore closed-end fund. Greatly increased the GE position. Sold off the Home Depot and Sears Holding positions. Increased the hedge.

What worked badly. JAKKs Pacific continued its downward slide. Blue chips Berkshire Hathaway, Johnson & Johnson, Cisco, and 3M finally succumbed to the market pessimism and took dives. GE fell off a cliff. Pretty much all my long term holdings except the hedge are down as nothing was immune to the general market malaise.

What worked well. There were some silly-low prices on offer this quarter. I took off my long term value investor hat and became trader for a day. I was like a kid in a candy shop with a hundred dollar bill. Unlike most traders, I had a safety net of something near a 70% margin of safety on the trades. Apple was on sale for $81 in Jan. I bought some and sold at $91 just a week later. Sprint Nextel went on sale for $2.20 in Feb. I bought some and sold for a 50% profit in a couple of weeks. GE fell off a cliff, but recovered almost 100% from its low below $6, and I was able to pick up a lot more shares under $8. When GE went below $7, I switched to buying LEAPs instead of the stock, and sold the LEAPs for a 100% profit a week later. I think I had more transactions in three weeks than in a normal year. Just to show you how crazy it was, I even owned a few shares of Google for a short time (nice profit, too). Not to worry, I'm sober now. While it was a lot of fun, I didn't have the guts to put big money into these trades. CryptoLogic rebounded from a low of around $2.30 up to $6.00, giving me an opportunity to liquidate this net-net. Whole Foods came out of its funk and went up around 80%. At the March 9 low, I sold off most of the S&P strike 800 puts for a 2000% profit, then replaced them later with more index put options in late March after the 23% jump in the S&P 500.

The hedge comprises a number of S&P 500 index put options, with a face value (sum of strike prices) of about 2x the stock portfolio, with strike prices varying from 800 to 400, and expirations of 3-18 months. I started the hedge about 18 months ago, at a cost of about 4% of the portfolio value. I did not forsee the coming market crash. I just felt that (1) I needed a safety net in order to continue using margin debt, and (2) my returns at the time were too good to be sustainable (better than 35%/year). The hedge is doing its job fairly well. That job is to insure against margin calls and put a floor under my net worth. Without the hedge, the portfolio performance would have been worse: down 4.7% this quarter. With the hedge, I am currently market neutral. That is to say, the portfolio acts as if it were 100% cash for small movements of the market. However, since the hedge is made up of out-of-the-money puts, it protects strongly on the downside but weakly on the upside, which is what I want right now. If the S&P 500 were to drop below 800, the portfolio would make a profit. If the market unexpectedly goes up another 20% in a short time, the portfolio would go up about 12%.

Future prospects. I figure that overall, the portfolio is priced at around 50% of intrinsic value. That is in spite of some fairly large markdowns I made to intrinsic values. This bodes well for the portfolio returns for the next few years, presuming we're not at the beginning of Great Depression II. I am currently beating the S&P 500 by about 16%/year compounded long term. Naturally, this is small consolation with the S&P 500 down so much. I'm still fully hedged, but preparing for the right time to start taking off the hedge. I sold down a little in several of the larger holdings in late March to increase my cash available for new purchases. Actually what I did was reduce my margin debt substantially, so that if new bargains appear I'll have the reserve margin credit to buy them. I do not believe that the current 22% rally is the beginning of a bigger sustained move upwards. The recession continues to worsen, credit spreads are wide, the situations with the big banks and car companies are not resolved, volatility is very high, a lot of mortgages will reset to higher rates later this year, commercial real estate and credit card problems are beginning to appear, the governments are thrashing around with poor and uncoordinated responses to the credit crisis, and the consumer has pulled back spending sharply. Market action looks more fearful than hopeful. I'll stay fully hedged until some of these negatives get resolved or at least less bad. Even from a market neutral position, I can still make a profit if my portfolio outperforms the S&P 500, or if there is another large upward move in the market. I have submitted the paperwork to my broker to enable me to sell naked puts and calls on margin. I will experiment with selling naked puts to accumulate stock I want, and I will experiment with selling naked index calls as part of my hedging strategy. Weapons of financial mass destruction indeed. Oops, is my hubris showing? Warren Buffett did it, so why can't I?

My investment philosophy is to buy good companies at a deep discount and wait for them to reach fair value. I'm about 50/50 split between what I call type I and type II value investing. Type I is a great company at a reasonable price. For example JNJ and MMM. Type II is an okay company at a ridiculously low price. For example, RAIL and WFMI. In this market, my type II investments have been killed, down around 60-70%. However, I have held onto them because it seems to me they are still deeply undervalued. It is true that their intrinsic value has been damaged, but their drop in price was far worse. For example RAIL is sitting on a pile of cash awaiting orders for coal railcars. With the economy like it is, they will keep waiting for a while and future growth will be slowed for a few years. I figure the intrinsic value is down by 30%, but the price is down by 50% making it an even better bargain. My portfolio turnover is 25%/year. I expect the turnover will get even lower from here, when long term capital gains taxes increase to 20%. Lately, I've become a John Hussman/Nassim Taleb disciple, using hedging to insure against unlikely but unacceptably large losses.

Note 1. Returns are reported as compounded annual rates. These figures are net of all expenses, including margin interest and taxes. The comparable S&P 500 growth rate is based on investing the same amounts at the same times as were invested in The Portfolio, so the S&P benchmark return here may not match the S&P 500 index. Since The Portfolio has contained increasing amounts of money over time, more recent years have a greater weight in the results. Dividends are included in the S&P 500 benchmark calculation, but taxes are excluded. The reason that taxes are excluded is that I haven't much net sales, so the taxes on an index fund would be deferred. This year I will have no tax liability, since the gains from selling index puts is about equal to tax loss sales.

Quarterly Report for The Portfolio
June 30, 2009

For the quarter ending June 30, 2009, The Portfolio was down 0.1%, compared to the S&P 500 benchmark portfolio which was up 16.0%. For the year though June 30, 2009, The Portfolio was up 1.0%, compared to the S&P 500 benchmark portfolio which was up 3.8%. Since inception in September 2004, The Portfolio compounded annual growth rate was -4.6%/year, compared to the S&P 500 benchmark portfolio return of -15.1%/year. See Note 1 for how these are calculated.

I started The Portfolio in September 2004, after becoming dissatisfied with the returns from random mutual funds. I figured I could do better by actively managing the money myself. After scaling up slowly, it now represents the majority of my net worth.

Composition of The Portfolio
current
company stock fraction
Berkshire Hathaway BRK/B 3.1%
Boulder Total Return closed-end fund BTF 1.6%
bank smorgasbord 0.0% (a few thousand totally worthless BAC and C options)
Conoco Phillips COP 6.1%
Cisco CSCO 13.0%
Dreman/Claymore closed-end fund DCS 2.9%
Devon Energy DVN 4.3%
eBay EBAY 5.7%
General Electric GE 6.0%
Garmin GRMN 8.4%
JAKKs Pacific JAKK 6.8%
Johnson & Johnson JNJ 8.5%
3M Corp. MMM 4.9%
Microsoft MSFT 4.6%
my company myco 2.7%
Pfizer PFE .7%
American Freightcar RAIL 3.8%
Stryker SYK 2.6%
index puts & calls hedge -1.3%
United Healthcare UNH 5.3%
Wellcare Group WCG 1.0%
WellPoint Healthcare WLP 5.6%
Exxon-Mobil short via options XOM 0.1%

previous Q1 2009
company stock fraction
Berkshire Hathaway BRK/B 2.6%
Boulder Total Return closed-end fund BTF 1.0%
bank smorgasbord 0.0%
Conoco Phillips COP 2.0%
Cisco CSCO 9.5%
Dreman/Claymore closed-end fund DCS 1.4%
Devon Energy DVN 2.8%
eBay EBAY 6.2%
General Electric GE 4.7%
Garmin GRMN 8.2%
JAKKs Pacific JAKK 6.3%
Johnson & Johnson JNJ 5.4%
3M Corp. MMM 3.3%
Microsoft MSFT 2.7%
my company myco 2.8%
Pfizer PFE 2.6%
American Freightcar RAIL 3.8%
Rio Tinto RTP 1.2%
Stryker SYK 1.8%
index puts hedge 14.3%
Walgreens WAG 0.4%
Whole Foods Market WFMI 6.2%
United Healthcare UNH 4.9%
WellPoint Healthcare WLP 4.7%
Wesco Financial WSC 0.7%
Zimmer Holdings ZMH 0.4%

Significant changes. I was not very active this quarter. Sold down several large holdings a little to decrease margin debt from 35% to 10%. Sold out of Whole Foods when it reached 90% of my fair value estimate. Closed out the Rio Tinto position at about $145 (naturally it shortly afterwards ran up to $195). Increased the General Electric position. Started small position in Wellcare Group with call options. Restructured the hedge to be less expensive to maintain, more later.

What worked badly. Nothing really, most everything was flat to up, except the hedge, which was down a lot.

What worked well. BRK/B and BTF up about 15%. DCS up about 20%. UNH and WLP up a lot. Started two pairs trades. GE long stock/short calls. For each share of GE, I sold two out-of-the-money calls. The idea was to reduce risk and and profit by collecting the stock dividend and the time premium of the options. COP/XOM. For each COP share, shorted 0.75 XOM shares by selling a call and buying a put at same strike. This requires less margin committment and I don't have to pay the XOM dividend. The idea is that COP is too underpriced with respect to XOM, and I will profit as the gap closes. The gap is around $28 and I think it should be about $15, based on intrinsic values.

The hedge comprises a number of S&P 500 long index put and short index call options, with a face value (sum of strike prices) of about 2x the stock portfolio, with strike prices varying from 850 to 400, and expirations of 3-18 months. Coming into the quarter the hedge comprised only long puts. I switched to long puts and short calls partway through the quarter. This changes the shape of the portfolio risk curve (a curve with the S&P 500 level on the X-axis and the portfolio value on the Y-axis). With pure puts, the curve is an inverted parabola. If the S&P index goes up or down from the low point, the total portfolio makes money. However, there is a time decay issue, the puts get less valuable over time. By selling some calls, I get to profit from the option time decay, which makes the hedge a lot cheaper to maintain. But the risk curve flattens out so I don't stand to profit very much if the market goes up or down. I'm actually being paid money now to maintain the hedge, note that it is -1.3% of the portfolio! Of course when the hedge expires, I'll have to pay that money back, since either the puts or calls will be in the money. Meantime, it is handy to hold the money to zero out my margin loan, so I don't have to pay any monthly margin interest on my 10% of margin.

Without the hedge, the portfolio would have been up 22% this quarter. Effectively the hedge cost me 22%, so hedging isn't always a good idea. Much of this was time decay and much was a great reduction in overall market volatility. But I'm not a market timer, so I don't have the option to turn the hedge on and off short term. However, looking at the whole year of 2008 to date, the S&P has gone approximately nowhere and neither has the portfolio. While I missed the Q2 run up, I also missed the Q1 drop. Without the hedge the portfolio would have been up 15% for the first half of 2008. So 15% of my returns was the true cost of the hedge. Realizing that is what prompted me to restructure the hedge. The new hedge doesn't offer much upside due to large market moves, but it costs very little to maintain. In hindsight it was a mistake to structure the hedge to make money if the market moved up a lot (even though it did in Q2). I was hopeful of a marvelous market recovery to 1500 but now, I'm convinced the market is roughly fairly valued, so I am not betting on it one way or the other. Instead, I hope to profit because my stock picks outperform the market.

Future prospects. I figure that overall, the portfolio is priced at around 60% of intrinsic value. That is in spite of some fairly large markdowns I made to intrinsic values. This bodes well for the portfolio returns for the next few years, presuming we're not at the beginning of Great Depression II. I am currently beating the S&P 500 by about 10%/year compounded long term. Naturally, this is small consolation with the S&P 500 down so much. I'm still fully hedged, but preparing for the right time to start taking off the hedge. I think the economy and market are on shakey grounds, so I will maintain the hedge until conditions change.

My investment philosophy is to buy good companies at a deep discount and wait for them to reach fair value. I'm about 50/50 split between what I call type I and type II value investing. Type I is a great company at a reasonable price. For example JNJ and MMM. Type II is an okay company at a ridiculously low price. For example, RAIL and WFMI. In this market, my type II investments have been killed, down around 60-70%. However, I have held onto them because it seems to me they are still deeply undervalued. It is true that their intrinsic value has been damaged, but their drop in price was far worse. For example RAIL is sitting on a pile of cash awaiting orders for coal railcars. With the economy like it is, they will keep waiting for a while and future growth will be slowed for a few years. I figure the intrinsic value is down by 30%, but the price is down by 40% making it an even better bargain. My portfolio turnover is about 25%/year. I expect the turnover will get even lower from here, when long term capital gains taxes increase to 20%. Lately, I've become a John Hussman/Nassim Taleb disciple, using hedging to insure against unlikely but unacceptably large losses.

Note 1. Returns are reported as compounded annual rates. These figures are net of all expenses, including margin interest and taxes. The comparable S&P 500 growth rate is based on investing the same amounts at the same times as were invested in The Portfolio, so the S&P benchmark return here may not match the S&P 500 index. Since The Portfolio has contained increasing amounts of money over time, more recent years have a greater weight in the results (unfortunately). Dividends are included in the S&P 500 benchmark calculation, but taxes are excluded. The reason that taxes are excluded is that I haven't much net sales, so the taxes on an index fund would be deferred. This year I will have no tax liability on the portfolio. In fact, I actually have a rather large tax loss carry forward, so I probably won't be paying any capital gains taxes for some time. The tax loss carry forward is hard to value exactly, but I estimate it is worth around 6% of the total portfolio. If I engaged in shady accounting, I would have added that 6% to my total return (some companies do just that).

If you're using 'compound annual rate' for your own figures you should use it for the S&P 500 as well.

It did 3.8% in just six months- not one year.

[www.BeatingBuffett.com]

"The comparable S&P 500 growth rate is based on investing the same amounts at the same times as were invested inThe Portfolio, so the S&P benchmark return here may not match the S&P 500 index."

Thanks for pointing out the mistake, doc. I meant to say "For all of 2008 through June 30, The Portfolio was up 1.0%, compared to the S&P 500 benchmark portfolio which was up 3.8%. "