Sunday, August 21, 2011

2011 Portfolio Update

This is first post in four months since my write-up on CVS Caremark. Yes, I am still alive and kicking. I have been very busy in the past few months learning about the banking and insurance business, researching for new ideas, and writing new ideas at (VIC). Unfortunately, writing on the blog fell to the bottom of my list of things to do.

For those who are unfamiliar with VIC, it is an exclusive forum of only 250 value investors who share long and short ideas on the forum.  The club was started by the renowned author and hedge fund manager Joel Greenblatt. To be selected to the club, one writes up a “deeply researched” long or short position to be judged by a panel of VIC judges. I got selected to the club based on my write-up on MasterCard. I feel extremely fortunate to be part of the club – in less than 6 months I feel like I have learnt more than I ever have in my investing career by interacting with one of the smartest groups of value investors out there. One of the restrictions of VIC is that ideas posted there cannot be shared publicly. Unfortunately it means that, going forward, ideas that I post there or I learn of there will not show up in much detail on this blog.

Uncertainty and volatility has returned to markets. Correlation between asset classes has increased dramatically and almost all investing decisions today seemed to be made on increasingly short time horizons. The prevalence of algorithmic trading has reduced the already short-termed nature of a large number of market participants to holding periods of minutes, if not seconds! The only thing I know I will be doing is what I know to do – buy good businesses that are low in leverage, have low risk of obsolescence, and are offered by Mr. Market at an attractive price. Undoubtedly, this will be accompanied with a mark down in market prices of businesses we own today and will own through this environment. I will not let this bother me much since I continue to be confident that Ben Graham was right when he said “Mr. Market is a voting machine in the short-run, and a weighing scale in the long-run.”

Next, I want to talk about the portfolio’s performance. Even though portfolio’s YTD performance has beaten S&P500, it has been dissatisfactory to say the least – portfolio -6.8% YTD compared to S&P500 (with dividends reinvested) -10.39% YTD. To congratulate oneself based on comparisons with other indices is idiotic, since we do not eat from the plate of relative performance. Looking at a more longer horizon, the portfolio held up much better, +12.15% cumulative growth since 1/1/2010 relative to –0.52 cumulative growth in S&P500 (with dividends reinvested) since 1/1/2010. My longer term goal is to have the portfolio CAGR at inflation plus 10%.


Let me update you on the changes in the portfolio from the last time I reported. I sold out of four positions – three of them had reached their “intrinsic value” and the forth one, FUR,  I was wrong on and sold at a reasonable profit.


FUR is structured as a REIT – meaning it has to pay out a large portion of the FFO to the owners – causing the REIT to keep coming back to the capital market every time it wants to grow. FUR had become a 25% position in my portfolio, and the only way I could stay undiluted was to participate in the capital raise. I was super uncomfortable with a position larger than what I already had. The reason for selling out had more to do with the function of a REIT in my portfolio rather than Mr. Ashner’s skills, who is one of the smartest real estate investors I have come across. If the price becomes right, I may start a very small position again in the future.

Now, let me turn your attention to the current positions in the portfolio.


Note: Foreign holdings such as Accor and Edenred have been converted to USD on a mark to market basis. The Gains % column indicates gains in market value of the security including dividends yielded since the time of purchase of the security.

I will make a comment on my thesis on each of the holdings starting with a long comment on the ones that had the largest negative impact on the portfolio and a short one on the ones that have had the largest positive impact. I believe that we learn more from our “failures” than our “successes.” (All of the above is just mark to market – so failures and successes have limited meaning).

Kirkland’s (KIRK) – I initiated my position in KIRK, a specialty retailer, in Nov 2010 when it got really cheap (2x EV/EBITDA) due a couple of factors – gross margin compression due to higher than expected discounting and promotional activity, and operating margin compression due to deleverage caused by falling same-store-sales. The closest comp, Pier 1 (PIR) was trading at 5x EV/EBITDA. My wife and I have been shopping at KIRK since the time we bought our home a few years ago, so I was familiar with their concept. I viewed their problems more short term in nature and viewed this as a 2x given that KIRK had a long runway in front of it as it expanded its store count. KIRK has about 300 stores whereas Pier 1 has about 1200 stores, so it wasn’t unreasonable to assume that KIRK could get to 400-500 stores by 2015, as long as the economy remained somewhat stable. KIRK moved up by 30% in less than a few months, but I didn’t sell out, because I viewed it as a compounder over the next 5 years. Mistake #1 – valuation is not an exact science, hence the need to invest using a margin of safety. I should have taken 30% gains and got out. KIRK was back to where I started my position by the time it reported next quarterly results. Old issues (which I viewed as temporary) were still a concern but no new issues came up on the call other than a slow down in growth of new stores due to difficulty in finding new locations. KIRK management was now projecting growth of 20 net new stores in 2011 rather than 40. 20 new stores still got you 100 new stores in 5 years. My thesis remained intact, so I doubled up on my position. Mistake #2 – I should have nibbled at it, rather than doubling up. A small store like KIRK has massive operating leverage at work, so a lot of little issues can cause major swings in their margins (even though they may be temporary) causing volatility in the stock price as the street is focused on those little things. The volatility meant that I could have added to my position as it went down, and if it didn’t go down I still had a reasonable sized position to get a good enough upside. There was no reason to double up on one shot. A few weeks later, KIRK was down 25% primarily due to macro concerns. Today, KIRK is insanely cheap – EV of 85M, fortress balance sheet with no debt, and a EBITDA ranging from 30-60M in 2008-2010. KIRK reported its quarterly results on Aug 19, 2011 and nothing much has changed business wise. They are working through their issues – by changing merchandise mix to help lower the promotional activity and stabilize same-store-sales. They also announced that they will be using 40M of excess cash on balance sheet for buybacks in the next 18 months. When the stock is so cheap and the issues are temporary, use of excess cash to do buybacks is highly accretive to the shareholder. 40M of cash at today’s price will buyback 25% of their outstanding stock! Even if net income does not grow from 2011E of 20M, EPS grows from by 33% from $1 to $1.33. If they fix their issues in the next 18 months, Mr. Market will come back and award KIRK with the multiple it deserves of 10x – $13. In addition they will have generated another 30M or $2 of cash by then. So, conservatively we should see it go back to $13-$15 in 18 months – an IRR of 16% from my cost basis, or if you are starting a new position an IRR of 40% from today.

POSCO (PKX) is a one of the lowest cost producers of steel in the world based in Korea. It is the third largest in terms of production, and among the most profitable, if not the most. In an industry that is highly cyclical, it has achieved the rarity – consistently earned returns above the cost of capital for over a decade. In 2010, it reported one of the lowest margins in the last decade due to weakness in steel prices and increase in raw material costs. POSCO is taking the right steps to lower its raw material costs, so I am expecting that margins will eventually revert to mean. In my estimate, POSCO (ADR) is worth about $150 – 40% higher than my cost basis and 70% higher than today. Not baked into this valuation is a free option on India growth. POSCO has in-plans the largest foreign direct investment of 12B USD in India to create a FINEX plant with 12M capacity in the state of Orissa. FINEX is POSCO’s proprietary technology of steel making that can operate at 15% lower operating costs and 20% lower capex than traditional blast furnace.

With the new macro concerns surfacing, if we do double dip into a global recession, steel demand will continue to stay weak putting pressure on margins. Margin reversion-to-mean will take longer than I originally thought (five years instead of three) lowering my IRR in POSCO from 11% to 7%. My mistake on this position was one of incorrect sizing – even before the dip of 17% - at my cost basis, I was expecting a low double digit IRR which clearly did not justify a 8% position in the portfolio. I wonder now what I was thinking when I picked such a large position size! If POSCO goes back to my cost basis, I will reduce my position size. I will add to this position only if it goes below $50 (to bring my cost basis to $75 and an expected IRR of 15%).

Look for the second part of this post for comments on the next 4-5 positions, hopefully by the next weekend.

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