Your highest conviction idea for 2014 + why

[goldfinger]

BAC (common + warrants), FIATY, Altius, GNCMA, cash

[ERICOPOLY]

I find it astonishing that after the gains in 2012 and 2013, it is still conceivable (barely) to make 30% annualized returns from BAC for two more years over 2014 and 2015.

 

The stock would have to be $25.35 (including dividends) by end of 2015.  That would be 12x $1.80 per share (13% ROTE) plus $2 per share earned (using DTA) for 2014 and 2015.  It comes out to $25.60 (12x1.80 + 4).  It also assumes the $25 strike call is written (to bring the starting price down to $15).  I'm not sure it's wise to write the $25 strike call (yet), but I wanted to do it for this example just to bring the math down to stock price that's within the range of capital generation + 12x earnings.

 

That's really funny.  Another couple of years at 30% annualized (possibly).  It's not terribly unreasonable.

[james22]

Cash and precious metals equities.

 

Markets don't need a visible "catalyst" to crash.

 

They just need a minor change in sentiment.

 

http://www.businessinsider.com/catalyst-for-a-market-crash-2013-12

[original mungerville]

I know it says one idea but I have 4:

 

1) cash

2) BAC leaps or common - discussed elsewhere - fully hedged

3) Aig leaps/common - discussed  elsewhere - 20 % hedged

4) Seaspan - should grow itself and dividend at 20% per year- discussed elsewhere

 

Cash -  I am slowly raising cash into this year and throughout the year.  In the past I wouldn't have bothered but I need this money to live on for at least a couple of years starting soon. 

 

Cash - part 2 - This bull market has gone on for almost 5 years.  We have gone 1.5 years without a significant correction.  The easy ideas are gone.  Therefore one must move down the quality curve or raise cash slowly and wait it out.  Everytime I have moved down the quality curve the result has been poor.

 

I will cheat and add Pennwest - discussed elsewhere.

 

Hi Uccmal,

 

I am trying to do catch up on BAC and AIG (I have been precluded from investing in them for the last 4 years due to conflicts - which really sucked given the opportunity and the discussion on this board). 

 

Which BAC LEAPs do you hold and what did you hedge them with (ie strikes and dates for both the call and puts)?

 

Also, same question for AIG.

 

Are you hedging your deep in the money LEAPs only? or also the at, or close to, the money ones?

 

 

[bmichaud]

Wonderful year end analysis by Jeff Saut addressing all of the bears' concerns.

 

http://www.raymondjames.com/inv_strat.htm

[bmichaud]

Great article by the always hilarious Josh Brown.

 

http://www.thereformedbroker.com/2014/01/05/you-are-here-2/

[kevin4u2]

EZPW.  Here is the write up I put on my blog.  http://canadianvalueinvesting.blogspot.ca/

 

Ezcorp had an unusually bad year in fiscal 2013 for a couple of reasons. The biggest reason for this was the huge drop in the price of gold. Gold started 2013 at around $1700 per ounce and ended around $1200 per ounce. That 30% decline contributed to some really tough business conditions. In the pawn business, gold and jewelry are the two most common forms of collateral. Moreover, unless you’ve been living under a rock in recent years, the gold scrapping business has been big business. 

 

Conditions in Mexico were extremely tough for the company in the gold pawn business. On the latest conference call they discussed how competitive it has gotten down there. The industry got so competitive that everyone was posting the price of gold they were willing to pay for scrapping. That squeezed margins. This also led to the closure of 57 gold only stores in Mexico. 

 

Now to add more insult to injury, the company recorded a $43 million ($29 million after tax) impairment charge on its investment in Albemarle & Bond. The UK pawn lender had a very tough year and was delayed in releasing their financials. This wrote off the majority of their investment in the company. Albemarle is now for sale. 

 

Lastly, the company’s operating expenses have gotten way out of line. In 2011 operating expenses were 33% of revenue and in 2012 they were 34%. In 2013, operating expenses rose to 41% of revenue. This is obviously not very good performance but leaves lots of room for improvement. 

 

So what does all this mean? Basically EZPW was still profitable in 2013, albeit marginally. Earnings have risen every year since 2002. The company sells for 70% of book value.  Book value has grow at 17.5% over the past 10 years.  Debt is only 19% of total capital so they are not heavily financed.  Interest is well covered.  There are a few weird quirks with this small cap but I won't bother you with them here (read the 10-k and listen to the conference call for details).

 

If you exclude the one-time expenses that occurred in 2013 the company would have earned around $1.70 per share. That works out to a current P/E ratio of 6.5. Now if you, like me, assume that the gold scrapping hay-days are over (no recovery of this business) but they can reduce operating expenses by 3%, then EPS will rise to $2.35 per share (P/E = 4.7). If operating expenses can get back down to historical levels of 34% of revenue, EPS will rise to $2.95 per share (P/E = 3.7). 

 

It doesn't take an advanced degree in math to see that EZPW is worth at least double the current quote (at a minimum) and up to four times the current quote (at a maximum).  Let's call fair value roughly $30/share.  It currently sells for around $11.50, down from the $30 level a couple years ago. 

[yadayada]

Thought EZpawn was interesting , but a few buts:

 

what will FCF be like when they are not expanding like crazy? If you add Loans made, Loans paid and Recovery of pawn loan principal through sale of forfeited collateral

 

That is a negative number. Is that because of growth? Because it should be positive right? Also arent you worried about shady management? You can clearly see what happened at ABM, incompetence and non alignment with shareholders.

 

And why is revenue suddenly going down this year? Why did they over expand in mexico? They seem a bit careless, only caring about earnings that wont materialize into FCF because they have to shut down stores before they can go into harvest mode.

 

Also their rates are much higher then ABM's rates in the UK for example, almost twice as high. You could see some regulation risks here. As there is alot of room for downside pressure here before they cannot operate anymore. Seems taht all those risks kill most of the upside here.

[Aberhound]

Can anyone remember which year Prem wrote about the Austrian theory which predicts that the bigger the boom the greater the bust due to the long period of mal-investment in capital stock during the boom which causes a long period of adjustment? I think he referred specifically to Carl Menger. I was thinking why cash is my 2014 conviction investment so I want to re-read that letter.

 

I think the malinvestment is a worse problem this time than the over-leverage like we experienced in 2007. There are similarities to 1999 with dramatic overvaluations. Debt problems are similar to 2007 except that now it is a bigger problem for governments, central banks holding treasury puts and banks with interest rate derivatives. I can't think of another time with such a huge capital stock of malinvestment. The malinvestment has been made worse by the illusion of control. The illusion of control is created by massive central bank and government interventions. William White the Canadian who was the former Chief economist for BIS discusses in a recent article how the amount of interventions required to keep things stable grow ever larger. It reminds me of a paper written by an economist from the Nixon White House explaining the problems of implementing wage and price controls. Eventually they become impossible. Better to leave things to the free market because if you choose intervention the situation is far worse when you are forced to stop the interventions.

[Straddle]

Cash. Too frothy for me. if you know the train will crash in the next ten stations when do you get off?

 

I had that feeling throughout 2013 all the time but I have just hold my common stock in BAC and WFC all the same. Now in 2014 I'm also thinking about taking my gains, but I haven't sold one stock yet. Both stocks can still rise with double digits and they're  not overpriced, so I'll try to stay in stocks this year as well.

 

My bet for 2014 stays the same as in 2013: banking stocks.

[Yours Truly]

Mine is DTV.. Continued leverage share buy backs, majority of CapEX completed, World Cup in Brazil + Olympics serve as catalyst for more subscribers

[racemize]

Mine is DTV.. Continued leverage share buy backs, majority of CapEX completed, World Cup in Brazil + Olympics serve as catalyst for more subscribers

 

I thought they had hit their target debt level recently?  I was suspecting continued buybacks, but nowhere near the level over the last few years?

[no_free_lunch]

yadayada,

 

You bring up some good points.  There are definitely some warts on this one but I think overall it is a  great bargain.

 

Regarding the cash flow, they have been growing the business for years using a combination of share issuance (with accretive earnings) and cash so I personally don't think that is an issue.  I still need to dive deeper into the numbers but I just don't see a problem with cash flow when they have been able to grow so much without jacking up their debt levels.

 

Revenue actually went up this year so they are still growing but yes earnings did go down.  This was due to gold prices falling and some poorly performing stores which were closed as well as a loss on the ABM equity.  It is just a question of whether this is indicative of long-term performance or not.  I think it's just a bump in the road as in the past you haven't seen this confluence of events.  They are still profitable even with that.

 

The remaining mexican operations are payroll deductions loans.  They are only set-up for public sector companies where there is low likelihood of the employer not making payment.  It actually seems like a great business with plenty of room for growth.

 

There is a chance for regulation changes but I am not too worried about that.  I remember in 07, there was talk about interest rate caps and what-not, I think some legislation might have gone through but somehow these companies just adapt.  The government isn't really interested in stopping the practice but rather putting through legislation that gives the appearance of them (the government) having taken action.  The industry responds by shifting increasingly to fee-based costs rather than true interest charges.

 

Running the numbers and even looking at analyst expectations, it is not hard to see them earning $2+ in the next year or two.  It really could be higher even, if they return to growth.  The industry is VERY fragmented so plenty of opportunity to grow still.  You also have downside protection from a relative lack of debt, not that it couldn't go lower but one less thing to worry about.  Weighing it out it just seems there is incredible upside on it and it is essentially priced for the past year earnings, with all of it's one-time hits, repeating indefinitely.

[jay21]

Mine is DTV.. Continued leverage share buy backs, majority of CapEX completed, World Cup in Brazil + Olympics serve as catalyst for more subscribers

 

I thought they had hit their target debt level recently?  I was suspecting continued buybacks, but nowhere near the level over the last few years?

 

I am not an expert on DTV but they can de-lever via growing EBITDA and then lever up again. 

 

I'm thinking about creating a Malone type basket with LMCA, Global and DTV because they are so good at deal making and capital structure optimization.  I never get fully comfortable with the assets though (specifically SIRI).  I'll keep digging.

[racemize]

Mine is DTV.. Continued leverage share buy backs, majority of CapEX completed, World Cup in Brazil + Olympics serve as catalyst for more subscribers

 

I thought they had hit their target debt level recently?  I was suspecting continued buybacks, but nowhere near the level over the last few years?

 

I am not an expert on DTV but they can de-lever via growing EBITDA and then lever up again. 

 

I'm thinking about creating a Malone type basket with LMCA, Global and DTV because they are so good at deal making and capital structure optimization.  I never get fully comfortable with the assets though (specifically SIRI).  I'll keep digging.

 

that makes a lot of sense to me--I've had similar thoughts/lack of comfort.

[no_thanks]

KCG holdings. Largest market maker, growing brokerage. Selling close to book value. costs are going down, earning power is going up, debt is being paid down. 2014 should be good.

 

I bought some a few days ago.  Would love to see any research if you come across it.  Do you see the banks moving away from market making, and that helping KCG? 

 

Thanks.

[bennycx]

Risk of KCG is very high, no..? One wrong code and another Knight Capital event might happen...

[no_thanks]

Risk of KCG is very high, no..? One wrong code and another Knight Capital event might happen...

 

I actually am kinda attracted to these situations because I believe a lot of time people are giving to much weight to recent issues.  Yes, it may happen again, but does that risk justify the discount it trades at to it's peers?  And the company, if they are sane, is liking devoting a ton of resources to making sure that the same problem doesn't happen again, so in my opinion it is less risky that it was before the initial incident, but that is in hindsight of course.

 

Welcome any more feedback though. 

[constructive]

I would be less worried about another trading glitch and more worried about the erosion of the market making business model over the last decade. A lot of it is driven by HFT hedge funds (a superior business model). Some is also driven by more efficient brokers. How low will their ROE go? If they can only earn 5% ROE going forward, it's not worth book value.

[bennycx]

I've worked in this area before but what I mean is not that it will happen again soon

 

It is more of when it happens it might just go to 0, and there is almost no way a ton of resources can prevent that happening. It is not really like risk management inside a bank that can cut trading losses by reducing leverage

[NomadicRiley]

I would be less worried about another trading glitch and more worried about the erosion of the market making business model over the last decade. A lot of it is driven by HFT hedge funds (a superior business model). Some is also driven by more efficient brokers. How low will their ROE go? If they can only earn 5% ROE going forward, it's not worth book value.

 

I also work in the industry and agree with constructive.  The market maker space is incredibly competitive and provides no sustainable moats.  There are often price wars when new entrants enter the market which drives down returns for all participants.

[no_thanks]

I would be less worried about another trading glitch and more worried about the erosion of the market making business model over the last decade. A lot of it is driven by HFT hedge funds (a superior business model). Some is also driven by more efficient brokers. How low will their ROE go? If they can only earn 5% ROE going forward, it's not worth book value.

 

I also work in the industry and agree with constructive.  The market maker space is incredibly competitive and provides no sustainable moats.  There are often price wars when new entrants enter the market which drives down returns for all participants.

 

Thanks for the feedback.  So you don't think that the technological infrastructure, know-how, and regulatory system will keep others from taking market share from Knight?  It seems like others would see the trading glitch as a good reason to stay away as it is an easy business to shoot yourself in the foot in.  Since there are some people in the industry here, are GETCO and Knight going to offer a better product than the other market makers?  Why are competitors trading at over 3x TBV while KCG is just a little over 1x TBV? 

[ItsAValueTrap]

In my opinion regulators should regulate the market making industry away.  The futures exchanges don't have market makers with special trading advantages.  Those markets work fine without market makers and haven't had any flash crashes.

 

What market makers do is valueless.  They pay exchanges for special trading advantages.  Sometimes they own a piece of the exchange.  With these special trading advantages, they skim from investors.  Stealing from investors is a broken business model and regulators should rightfully curb the abuses that occur.

On the retail side, most retail orders get routed to companies like Knight, ATD, and tens of other companies involved in order internalization.  These trades don't occur on an exchange but the same thing happens: market makers skim from investors.  The retail brokerage receives higher rebates when they route an order to Knight (or any number of Knight's other competitors).

 

The retail side has also gotten incredibly competitive.  I believe the number of competitors has exploded.  When a brokerage routes an order that takes liquidity, it polls a huge number of venues looking for the best price/negative rebate.  This is not good for Knight.

 

2- I wouldn't want to own any market maker, but wouldn't you rather own IBKR over Knight?

 

*I'm a Thomas Peterrfy fan.  He has some good commentary on the current market structure.  Peterffy's career has been about creating value.  He was a pioneer in automating market making via computers.  And on the brokerage side, he is definitely creating value.  Interactive Brokers is clearly more efficient than other retail brokerages.  For example, they don't call you with a human being whenever there is a corporate action; everything is done online.  And they send you very little mail.

[boilermaker75]

 

 

2- I wouldn't want to own any market maker, but wouldn't you rather own IBKR over Knight?

 

*I'm a Thomas Peterrfy fan.  He has some good commentary on the current market structure.  Peterffy's career has been about creating value.  He was a pioneer in automating market making via computers.  And on the brokerage side, he is definitely creating value.  Interactive Brokers is clearly more efficient than other retail brokerages.  For example, they don't call you with a human being whenever there is a corporate action; everything is done online.  And they send you very little mail.

 

I concur about IB. I don't believe I have ever received actual mail from IB. Maybe I am just not remembering something coming when I first opened my account. But definitely nothing for years.

[constructive]

Why are competitors trading at over 3x TBV while KCG is just a little over 1x TBV?

 

I'm not an expert but I think this is because those competitors are more efficient and more differentiated away from pure market making. Some operate dark market pools (which Knight also does), some specialize in less liquid securities, some offer more client service as opposed to trading for the firm's own account. KCG and the other large market makers may also be behind the curve in hiring computer scientists, mathematicians, physicists, etc. who have innovative ideas to push the business forward as opposed to S&T oriented MBAs.

 

If I remember correctly KCG was trading around 1.3x TBV and 8% ROE before they blew up. So the upside might not be higher than that.