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Sears Holdings: A Technical Look

Sears Holdings (SHLD) is in the process of finishing the rarest and most important “technical analysis” chart pattern, the “humping bulldog.” This phenomenon began in June of last year. You will notice on the chart below the arched tail of the bulldog as SHLD dipped until it bottomed in August of 2006. Then came the share price explosion upward from August to November, which represents the “humping” back of the bulldog. Predictably, the stock leveled out and dipped a bit (From November to January 2007) at the peak of the dog’s back heading into its head.

Then, following this classic chart pattern, the dog’s arched head is represented by the January to March upward trend in the stock. This is classic technical indicators of this pattern. The drop from February to mid March is the tell tale sign of the dog’s open and panting mouth.

The euphoria the dog feels is represented by the share price appreciation both during the chart pattern and after it is completed from mid March to mid April. This bodes very well for SHLD shares in the future as the current downturn since the recent highs may just be the beginning the rarest of rare, “round 2” bulldog patterns. We will need to get confirmation of course like all chart patterns but it looks good so far.

The question that now needs to be asked is….. who bought that? If you did, why? While the name of my “chart pattern” was ridiculous, the theory behind it is not really any different than any other chart pattern out there. The thought you can anticipate stock prices based on a pattern they make is not really any different that guessing you future from the alignment of the stars or a fortune teller reading the lines in your hand. What really drives stock prices? EARNINGS, period. Both actual and anticipated earnings, in the end are what determine the price of a stock. Not a mythical pattern on a piece of paper.

Let’s break it down. If earnings are what causes stock price appreciation or depression, then the lines on the chart simply reflect that sentiment. This means they are always backward looking in nature and give you no insight into any future patterns since their future trends depend on the future earnings of the company. It does not matter what “formation” the stock trading is making because if earnings beat expectations, the stock will rise no matter what the “chart” says it should do and vice versa if earnings disappoint.

I read on another post yesterday the saying “even a stopped clock is right twice a day”. It is true. You will find occasions when the “chartist” accurately predicts price movement in a stock. You will, however, find multiples of instances in which the chartist “did not get confirmation of the pattern”. Translation? They were wrong.

Earnings drive stock prices, not fortune tellers. The next time you are inclined to believe them, remember the “humping bulldog.”

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What Leprosy Can Teach Us About Investing

Pain…

Anyone who has ever had quad tendon surgery is intimately familiar with this concept. Try doing anything without the use of a quad muscle and then consider that the movement, or any effort to move it will cause your entire body to freeze as you attempt to deal with the searing pain it induces. Pain is your body’s way of saying “hey, you are damaging me… stop it.” The pain caused by hitting your thumb with a hammer while painful at first, is useful because it is your body’s way of telling you not to do that anymore and probably saving you from losing the use of your thumb.

In their non-fiction book “The Gift of Pain”, Phillip Yancy and Dr. Paul Brand describe a world without any pain:

” A WORLD WITHOUT PAIN?

Can such a place exist? It not only can—it does. But it’s no utopia. It’s a colony for leprosy patients: a world where people literally feel no pain, and reap horrifying consequences.”

Yancy writes about Dr. Brand who ran a leper colony in Louisiana. Most people associate leprosy as a skin disease. It is not. What leprosy basically entails is the dying of nerves in the extremities. This causes the leprosy sufferer to feel no pain so a cut on a foot is not known and becomes infected, a broken ankle is not felt and heals disfigured. Those with leprosy, since they cannot feel any pain behave in ways that cause more damage to themselves. Dr. Brand descibes a young boy who reaches into a fire to grab a potato that had fallen off a grill causing third degree burns to his hand all the while feeling nothing and continuing a conversation as though it had not happened. The boy is amused by all the attention he gets from the staff and continues to do things that cause more harm to himself, eventually losing his hands to injuries he never felt. Eventually lepers become crippled due to injuries they receive or, if not medically treated, die from infections they do not know are ravaging their bodies. Brand and Yancy argue that the pain we feel from events actually protects us from far greater pain and harm.

So how does this involve investing Todd?

Investing involves some pain. Not all of our pick are winners and we all lose money from time to time. It is what we learn from that pain that matters . Why did we make the pick we did? Was it a “hot tip” from a cousin? Was is up big one day so we bought it not knowing what the company really did or what kind of financial shape they are in? Was there a stock that we sold because the talking heads on TV or the “analysts” said we should even though in our gut we knew we shouldn’t, only to watch is double or triple after we sold? Did we buy a stock recommended by those newsletters we all get in the mail and lost a bunch? For a great analysis of these picks go the Stock Gumshoe here.

Doing any of these things when investing can cause you financial pain. Repeating them with more money on the line will lead to more pain and possibly financial ruin if the bet is large enough. An investing leper is someone who does not feel the pain of financial loss and continues to repeat the same mistakes until they have no more money left to invest. They refuse to learn from or accept the pain from their actions and repeat them with increasingly dire consequences.

In order to invest with success you must have a investing strategy. I am always amazed how people will invest thousands in a stock because Uncle Leo said to yet will drive to 3 different stores to save 20 cents on a gallon of milk. Why don’t they take the same time with their investments than they do shopping for food or clothes? The strategy you begin with will not be the same you end with. Learn from the mistakes you have made (we all make them) and adjust your strategy to eliminate them in the future. Making an investing mistake is not a crime, repeating it is.

In 2003 I sold USG because I listened to analysts and talking heads who said the company would be ruined by asbestos induced bankruptcy. I then sat and watched as the stock doubled, tripled and then quadrupled. I vowed to never make that mistake again. Because of that vow I have held Altria (MO) since 2003 despite the dire predictions regarding their litigation situation and continue to hold Sears Holdings (SHLD) despite the “dying retailer” predictions on TV and both have rewarded my patience spectacularly. Had I not learned from my earlier mistake I would have sold both long ago and would have a headache from beating my head against the desk and I watched thousands in potential profits never materialize.

You will make mistakes, learn from them and avoid far greater pain.

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Short Term Thinking and Altria, A Profit Killer

I received an email this weekend from “Rich” in Weston, VA. in response to my post on Altria last Thursday. I will paraphrase the applicable portion of it:

  • “No matter how you try and spin it, they missed the quarter, missed it. All the other items in your post (spin off of PMI, buybacks) are all old news, the street has already factored them into the price of the stock. That is why it did not even participate in this weeks action.”
This email is the poster child of short term thinking. If you are a long term investor what did you take away from the post? They raised full year guidance! I have a real hard time understanding how someone can think this is a bad thing. Unless that is, your time frame for investing does not extend to the whole year. Now, it should be noted than earnings adjusted for items were up 5% from last year. They just fell short of what analyst expected. So a 5% quarterly profit increase is bad?

I said in my interveiw with Geoff Gannon for his wonderful blog Gannon on Investing my best investing decision was buying MO in 2003 (my worst was selling USG in that same year, although my not buying CHD last year is rivaling that moronic decision). Let’s see what MO has done since then:


I am averaged in at about $29 a share. Has MO beat every quarter ‘s estimates the last 4 years? Absolutely not! But, is there anyone out there, looking at this chart who would have sold this stock, OR be disappointed had they bought it? Let also not forget the 12% dividend I got in 2003 that has continued to climb along with the stock. Had some of you been “Rich” from the email and a short term thinker, I am sure you would have sold along the way after an earnings “miss” and would be kicking yourself now.

Let’s talk about the “news already factored in” comment. To a certain extent this is true. To an extent. The “hope” of these events are in the stock, not the actual event. For proof we only need look at the recent Kraft spin off from MO. The day before the actual event (well after it was first announced in Jan.), MO traded for $85 a share. For the spin, we got Kraft shares with a monetary value at just under $22 a share. The day after the spin, MO traded for $70 a share. Given our $22 Kraft windfall that means MO had a pre-spin value (for trading purposes) of $92 but traded for only $85. Why the difference? If the announced event was fully factored in, the value of it should have been realized in the stock pre-spin, but it wasn’t.

Should the actual spin of PMI be announced, the stock will jump. It will jump again after the actual event. The same can be said of a share buy-back announcement. There is a possibility these will not happen anytime soon or ever, this is why the value of them is not fully being realized in the stock now. The buyback possibility is not being factored in at all because nobody knows how much they will buy back. 1% of the shares? 10%? More? The amount is a huge determination is what happens to the price of MO shares.

More proof that a PMI spin and buybacks are not being factored in? Look at MO’s PE. It currently stands at about 13 times earnings, well within it historical range. Were these upcoming stock boosting events being factored into the stock price currently, one would expect MO to be trading at a premium to it’s it historical PE, not at the midrange of it.

In my reply to “Rich” I stated the above albeit an abbreviated version and asked him to save my response and get back to me in a year…… let’s see if he does.

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ValuePlays in Forbes.com Personal Finance

Forbes.com:

This past week my post on selling puts was picked up in Forbes.com. You can view it here. I received a ton of email on it from readers and will probably do a follow up piece soon. I seem to have people thinking about them and it did spur a bunch of additional questions the original piece may have not answered totally.

They have been featuring articles by various bloggers lately and the site is full of great info. Please visit them here.

A Good Read:

Since I am laid-up recuperating from a torn quad tendon and patella bone repair and will be for the next 6-8 weeks (If I was a horse I would have been Barbaroed’ by now), I now have a bunch of time to catch up on some reading. This weekend I read through a little known Benjamin Graham book, “The Interpretation of Financial Statements”. It is a short book , only 88 pages plus 31 pages of financial terms defined at the end. I highly advise this book to anyone who decides to take stock picking into their own hands (which you should do if you currently own mutual funds). It is written for investors of all experience levels and provides examples for each “Lesson”. Please click on the link below and pick up a copy for yourself.

Read front cover flap here:

Table of Contents here: Note: click on the arrows on the side of the page 1 to see the second page of contents, it is the good stuff!

Oh yea…………. “Who was Ben Graham”? You may be asking. None other than Warren Buffet’s teacher and mentor. Read it and you will be keeping good company!!

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SUGGESTED BLOGS AND SITES- Updated

SUGGESTED BLOGS AND WEBSITES TO VISIT:

New Titles Are In Bold

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Sherwin-Williams: Just Paint Baby!


Earning Highlights:

  • Consolidated net sales were $1.756 billion and diluted net income per common share was $.83
  • Opened 27 net new stores; 17 in Paint Stores Group and 10 in Global Group
  • Working capital ratio–accounts receivable plus inventories less accounts payable to 12 months sales–was 13.1% for the quarter compared to 13.7% last year
  • Gross margin increased 150 basis points to 45.1% of sales from 43.6% last year
  • Reaffirming EPS guidance of $4.55 to $4.65 per share for the full year


Christopher M. Connor, Chairman and Chief Executive Officer, commented

  • “In spite of the tough paint market in the first quarter, we continued to invest in new stores, opening 17 net new locations in Paint Stores Group and ten in our Global Group. We made further progress in our management of working capital, reducing our working capital ratio to 13.1% of sales from 13.7% in the first quarter last year. Our operating segment management teams continued to achieve improved gross margins as a result of hard work invested over the last few years to return our gross margins to more normal run rates after being pressured by the significant rise in raw material costs during 2004, 2005 and 2006. We created shareholder value by our practical use of cash to buy shares of our own stock and increased the dividend rate (26%), and have strategically positioned our balance sheet to be financially sound and capable of financing our business growth. “
  • “During the second quarter of 2007, we anticipate achieving a percentage increase in consolidated net sales in the low single digits over last year’s second quarter. With sales at that level, we expect diluted net income per common share for the second quarter to be in the range of $1.37 to $1.45 per share compared to $1.33 per share last year. For the full year 2007, we anticipate that the percentage increase in our consolidated net sales will be in the low single digits over 2006. With annual sales at that level, we are reaffirming our guidance that our diluted net income per common share for 2007 will be in the range of $4.55 to $4.65 per share compared to $4.19 per share earned in 2006. For the second quarter and full year 2007, we expect the effective tax rates will be slightly higher than the rates recognized in 2006.”


Sherwin Williams (SHW) has taken a hit the past month due to it’s ties to the US housing market and the RI ruling. This ruling, while a short term negative is virtually meaningless when compared to the California Superior Court Ruling which will eventually lead to the RI case case being filed where it should be, the garbage can. This quarters numbers prove that management is adept at managing the company through these headwinds. Let’s not forget, these numbers are up against 2006 numbers that included a still booming residential housing and DIY (do it yourself) market. Two key factors contributed to offsetting the earnings decline:

  • The Company acquired 3,350,000 shares of its common stock through open market purchases at an average price of $69.27 during the quarter and had remaining authorization at March 31, 2007 to purchase 9,471,000 shares.
  • The Global Group’s net sales in the quarter increased 5.7% to $402.2 million from $380.6 million in the first quarter last year when stated in U.S. dollars. This Segment’s net sales increase of 4.8% in local currency was due primarily to a new product introduction in the U.K., architectural paint selling price increases and volume gains in South America and improved automotive and product finishes sales. Segment profit of the Global Group for the quarter improved $2.9 million, or 9.0%, to $35.4 million from $32.5 million in the first quarter of 2006 and increased as a percent to net sales to 8.8% from 8.5% last year

The growth in the global group offset the decline in the US DIY and New Residential segment and the shares buybacks did the rest as SHW was able to avoid an earning decline of a strong 2006 comparison. It should not be lost on readers that this international segment will take on further prominence and do more to insulate SHW from the US housing market due to it’s recent purchase of India’s Nitco Paints. This gives SHW a huge footprint in an paint market growing at a near double digit rate. The effects of this should be seen in the second half of 2007 and is probably the reason that despite the predicted Q2 earnings miss by the company, they still back their full year estimates. Another note: This anticipated “earnings miss,” is a miss on the current estimates that analysts have for Q2. SHW’s estimate of $1.37 to $1.45 a share is still above last years $1.33 number. I can live with that given the drastic deterioration in housing since last year.

Let’s also not forget the stock buyback. Although they do not expect to use the bulk of the authorization this year, the number of shares they are still authorized to buy represent about 7% of outstanding shares, providing another buffer for us shareholders. Gotta love it.

Lead Paint
After a brief summary of current litigation statuses, the subject was not revisited. Not one analyst on the call ask a single question about this. This is very telling as during the Altria (MO) call this morning (yesterday), several questions referenced the litigation environment surrounding tobacco, despite this being the best that environment has been in almost a decade. This has to lead one to believe that the analysts on the call (as well as yours truly) are not very concerned about the possibility of an eventual negative outcome here. While it is having a restraining effect on the stock now, when this cloud eventually evaporates, away we go..

SHW CEO, Mr. Christopher O’Connor is another wonderful example of a CEO who takes his fiduciary responsibility to us shareholders very seriously. Everything he is doing at SHW (dividend increases, buybacks, overseas expansion) are all geared at rewarding us shareholders. Sherwin is going to be not just a national leader but a global one soon. I currently own shares and will look to pick up more on weakness.

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Phillip Morris: Smokin’


MO Earnings Highlights:

— Adjusted for items, diluted earnings per share from continuing operations up 5.1% to $1.03 versus $0.98 in 2006
— Altria raises forecast for 2007 full-year diluted earnings per share from continuing operations to a range of $4.20 to $4.25, up from its previous projection of $4.15 to $4.20
— Strong operating companies income growth of 9.5% at Philip Morris International

So, another great quarter for “Big Mo”. Now, going forward, what do we expect? We would like to see the international operations spun off from the PMU (Phillip Morris USA). In the earnings release CEO Camilleri said:

  • “Strategically, the key event of the first quarter was the successful spin-off of Kraft. We now are focused on growing our tobacco businesses, while continuing to take measures to further enhance shareholder value,”…..”Philip Morris International had a strong first quarter with robust income growth, driven by higher pricing and aided by favorable currency, but faced challenges in certain markets, most notably Japan and Germany,” Mr. Camilleri said. “Philip Morris USA had a relatively weak quarter, but its retail share and volume performance improved as the quarter unfolded.”
Say what you want about tobacco and it’s evils, but as shareholders, MO has been wonderful stewards of our dollars. There is no doubt in my mind that “enhance shareholder value” means a couple of things. First, a dramatic increase in the dividend. Second, the international operations will be spun off. Third, MO will begin buying back shares on a large scale. Now, these may or may not be announced today at 9 am during the conference call but I would be very surprised that if they are not “officially” announced, they are not at least alluded to.

What will we have then? In PMU, we will have a slow growing cash machine that will most likely end up crushing the yield of every other DJIA stock. It’s cash position will allow it to buy back shares on a regular basis to enhance eps growth and reward shareholders.

In PMI (Phillip Morris International) you will have a fast growing company that will begin to gobble up more tobacco companies around the world. It will also be free from US regulation since it will be headquartered abroad and have no US operations. This is a point that cannot be overlooked. The regulations that currently hamper PMI operation and the US litigation threat always present are a damper on the valuation of this segment. Once these are removed, in the word of Ralph Kramden “to the moon Alice”. In Q1 2007 PMI:

  • PMI’s market share in the first quarter of 2007 advanced in many countries, including gains in Austria, Argentina, Australia, Egypt, Finland, France, Greece, Hong Kong, Hungary, Indonesia, Italy, Korea, Mexico, Philippines, Poland, Portugal, Singapore, Serbia, Sweden, Ukraine and the United Kingdom.
  • Operating companies income increased 9.5% to $2.2 billion, due primarily to higher pricing and favorable currency of $96 million.
  • Cigarette shipment volume for Philip Morris International (PMI), Altria Group, Inc.’s international tobacco business, increased 1.5% to 213.3 billion units,
  • During the first quarter of 2007, Philip Morris International (PMI) acquired control of Lakson Tobacco Company Limited, increasing its shareholding to over 97%. Lakson Tobacco is Pakistan’s second-largest tobacco company, with cigarette volume of approximately 30 billion units in the fiscal year ending June 30, 2006.
This segment will be a gusher for shareholder once free from the US. No matter what MO shares do today hold them. Let them drop today, I do not care , it will let me buy more cheaper. Altria is the single best performer in the history of the US stock market. Just hold your shares, collect your 4 percent plus dividend (taxable at only 15% after a year by the way) and wait for Altria to treat you like a true owner and reward you for your loyalty.

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Patience Pays Off: Sears Holdings (SHLD)

Back on Feb. 27, during the 400 point sell -off on the Dow, I wrote:

“Here is the test: What you want to happen on a day like today is for your portfolio to drop less than the market. If you are a value investor this is a true test of it. Since we are buying “cheap” stocks, if they truly are, there will not be as much pain during sell-offs. The opposite is true also. During rallies, we should see percentage growth in excess of the market because our shares are so cheap others will rush to pick them up. That is how we should beat the S&P. Drop less during sell-off and jump more during rallies”

Time to put my words to the test. I am going to use my largest holding, Sears Holdings (SHLD) for this exercise since, the health of it determines the health of my portfolio as a whole (In Eddie I Trust). We are going to look at two three month charts. The first will be the S&P 500:


You will notice the huge drop on Feb 27 as all the averages plummeted. The S&P was down 3.5% on that day and eventually closed 5.5% down a couple trading days later. It took until yesterday to erase all the loses from that drop and currently stands about 1% over the pre-drop highs. As I said before, in order to check the strength of our picks we want to see a drop of less than the averages and a rise greater than them. Having picks like this will ensure that when all is said and done, we have beaten the S&P, our benchmark for the year. Now, lets look at a chart of SHLD for the same time span and see what happened:


After getting hammered along with the rest of the stock universe on Feb. 27, SHLD, like the S&P has steadily recovered. A few days after the drop, SHLD had not been hit as hard hit as hard as the S&P as it was down only 5%. The major difference is that while the S&P has realized an almost 1% gain, SHLD is sitting on an over 2% gain from its pre-drop high levels. It is important to note that the previous high prices were also 52 week highs for both the S&P and SHLD.

So, in less than 6 weeks SHLD took the hit the markets sell-off gave it and has recovered not only all of the losses from that drop, but added over 2% to the all time high set the week before the drop. Those of us who were patient and believed in our pick (and picked it for the right reasons) have been rewarded. Those who panicked (there were millions of shares dumped so a whole lotta folks did) and sold off their shares at the end of February or March are undoubtedly kicking themselves as they calculate the lost profits. They may have sold at a profit in February (if they had bought a while ago) but after the commissions they paid to sell, the taxes they will pay on the profits, and the missed appreciation of the shares since then, they are far behind us in total gains.

Sear Holdings proves, patience pays…

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ValuePlays: In the Legal News

In The News

Recently I was asked for a response to an article titled “Getting The Lead Out” that ran in The Nation magazine. Jane Genova, who runs the blog Law And More asked for a response and you can read it on her blog below. She has done the most extensive work to date on the lead paint trials in Rhode Island and for those of you interested, she actually “live blogged” from the court room in the Rhode Island lead trial. I consider her blog to be the starting point for any details you want on this litigation. You can read the response here.

Also, the legal website Legal Newsline.com did an article on the California Superior Court ruling on the contingency fee issue and picked up my post on it for reference. The article can be viewed here

A Trade:

Last Thursday we had a trade in the ValuePlays Portfolio. We sold April $45 puts in BTU. We received $90 for each put we sold. This means that is BTU closes below $45 on or before this coming Friday, We will be forced to buy 100 shares of BTU for each put we sold. As long as BTU closes above $44.10 ($45 – $.90 ) the trade is in the positive. Either way, we are pleased with the trade as BTU is a security we would have been comfortable owning at the price it was selling for last week ($45.85). The put enables us, should we end up owning it to do so at a lower cost basis. Nothing wrong with that..

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Request for Comments

I am looking to create a comments page of readers thoughts and experiences with the blog. While I have received many of them from you up until this point, I do not feel right about publishing them unless you submit them knowing they may be. So, if you have already sent one, please re-submit it so I know it has been submitted under the assumption it may be published. That being said, please email me at valueplays@gmail.com and give me your thoughts.

Please Include (some ideas):

  • Your name
  • A website or blog title if you have one (I will provide a link to it)
  • Your position if applicable, for example: fund manager, analyst etc..
  • A favorite post, pick or other notable item
  • Why you read ValuePlays
  • What makes ValuePlays different

Should there be a reason that you may not want you name published, please let me know and I will oblige. I will need to verify the authenticity of your email but will honor any special requests.

Thank you

Todd

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Selling Puts: A Great Way To Add To Your Returns

So lets do some basics. What is a “put”? Simply stated, if I buy a put. I am buying the right to sell somebody shares of a stock at a predetermined price on a certain date. You can get another definition from Investopedia here. For example, I buy a MO April $70 put. What that means is that I have purchased the right to sell 100 shares of MO to the seller of the put at $70 per shares if the price of MO drops below that during the month of April. When you buy a put, you profit when the price of the stock the put represents falls. When you sell a put, it is just the opposite.

This is very different than the “covered call” strategy most people have heard of and use when it comes to options. In the covered call scenario, you sell someone the right to “buy” your shares at a predetermined price that is usually higher than your purchase price, guaranteeing you, the seller a small profit should they get “called” the shares. This strategy is popular because if the investor gets “called” their shares, they sell them at a profit and if they aren’t, they keep the option sales price (called a premium). I personally dislike this strategy for two reason.

  • I do not like to sell the stock of a company I own unless there has been a deterioration of it’s business or fundamentals.
  • There are tax implications that are not usually considered that dramatically reduce the returns the covered call seller actually realizes.
  • Too often this covered call strategy has the effect of “capping” profits, meaning the seller of the call ends up selling their shares prematurely at a lower price than they could have gotten on the open market
As I have said before, the buying of options is a very risky strategy and I rarely if ever do it. They tend to be short term transactions and as we have discussed previously, the shorter you time frame in an investment, the greater your risk. Another reason is that if the transaction turns against you, when you own an option you must then either sell for a loss or lose everything you invested because options, when they expire, are worthless. You essentially are stuck with the decision of either losing a little or a lot. If you buy stock and it turns against you, you can at least hold it until the stock turns around. Options have a time element that stocks do not have and that makes them inherently riskier.

I quite often engage in the selling of them though. Why? If I am selling a put in the way I usually do it, I transfer this time element risk to the buyer and by doing that, have very little risk in the transaction. Let me explain.

In the ValuePlays Portfolio I currently have sold puts on 2 companies we own stock in and one we will. Let me explain why I do it and how it helps our returns. I am going to use the Altria (MO) and Peabody (BTU) puts we have recently sold as examples. First Altria:

The main parameters I use in selling puts are:

  • Only sell them in companies I want to own shares of stock in. That way, if the strategy goes against me and I am “put” the shares (forced to buy them) I at least now own stock in a company I want to own.
  • Only do this when the stock is in a price range in which I would consider buying shares in the open market at. Again, this way if the strategy turns against me and I am forced to buy the shares, I am paying a price for them I am comfortable with.
By doing it this way, I have virtually no risk in the option transaction because even if the “worse case” scenario happens and the price falls and I am put the shares, I own them at a price I was willing to buy them at on the open market anyway. The case could be made that in doing it this way, I am assuming Less risk than if I had bought them in the market in the first place. By doing it in this manner, if I end up actually owning the shares, it will be at a lower cost basis than if I had just purchased them initially. I only assume risk here if I am selling puts at prices I believe to be too high for the stock in the first place. This is an important point because this is part of an”investing strategy” not a “trading” one.

The argument could be made that I assume the risk of not owning the shares at all if the price goes up. In that case, I keep the premium price from the buyer and just miss out on owning the stock. I am fine with this because it means the riskiest part of this strategy is only making a little money. I will take this risk every day.

Examples

On 4/5 I sold an April $70 MO put with Altria shares trading at $70.45. That means that if the price of MO falls below $70 before the option expires on 4/19, the buyer of the put can sell me 100 shares of MO at $70. If the price of MO ends up above $70 at the expiration date, the option expires worthless and I keep the money the buyer paid for it. In this case, the buyer paid me $70 (70 cents a share) for each put he bought from me.

Let’s say the price of MO finishes below $70 at the expiration date of 4/19 at $69.50. I now have to buy the 100 shares from the buyer at $70 each. Bad news? NO. Why? Because I have already received 70 cents per share for the puts. This means that if I am forced to buy the shares my actual cost is $70 – $ .70 = $69.30. This means that as long as the price of MO shares do not drop below $69.30, even if I have to buy them at $70, I have profited from the transaction. If the price of MO is above $70 on 4/19, then I keep the $70 as pure profit and probably sell more puts for next month.

Yesterday (4/12) I sold BTU April $45 puts for $90 for each put. I do not own BTU yet but want to. These puts expire next Friday, April 19 (all April puts and calls expire at the same time). When I sold them, BTU was trading at $45.85 a share. In this case, the price of BTU needs to fall below $44.10 ($45 – $.90) in order for this transaction to be negative if I am put the shares. In this scenario, I am put the shares but own them at a price below what I would have bought them at today anyway. If the price settles above $45, I keep the $90 per put as profit and sell more next month (currently these sell at $145 per put). Now, let’s say that BTU closes at $46 and I do not get put the shares. At expiration I will immediately sell more puts for May. For easy math, I get $100 per put ($1 a share). BTU now needs to close below $43.10 ($45 -$1 (May put) – $ .90 (April put)) for this to become a negative transaction. If BTU closes at $44 a share and I am put the shares, I in essence enter my ownership of BTU shares already up $.90 or 2%.

How can this help our overall returns? As of my writing this Thursday afternoon The ValuePlays Portfolio is up 8.5% YTD (since inception1/18). Without the put selling strategy, it would have been up 8% YTD so in 12 weeks this strategy has added .5%. Not a huge difference but when you consider we started the portfolio 1/18, doing this can add up over the course of the year. The big take away is that this is done with very little risk.

Options can be very confusing and dangerous if you are not sure what you are doing when you do it. There are no “do overs” here. Be sure you have a good grasp of what you are doing before you push the button. Feel free to email me at valueplays@gmail.com if you have questions.

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Coal: There Is Green In It..

America has a growing demand for electricity and is currently the largest consumer of electricity in the world. In our homes, our businesses, and industries, Americans spend more than $210 billion on electricity each year. In fact, electricity and food are the two largest commodities bought and sold in America.

Electricity demand has continued to increase since the 1970s. While we are more efficient in our use of energy, demand has grown largely due to the introduction of new technologies — such as the Internet — which consumes about 8 percent of U.S. energy. Between 1970 and 1999, electricity use grew by more than 130 percent, and will continue to climb: According to the U.S. Energy Information Administration (EIA), America’s energy demand is anticipated to grow over 45 percent in the next 20 years. What is the main fuel for all this electricity? Coal, it fuels about 40 percent of the world’s electricity and over half of America’s electricity (this amount continues to climb annually), which is more than all other sources combined.

Other than electricity, what are some additional uses of coal?

  • Coal liquefaction offers promise for nations that are rich in coal, yet scarce in oil. There are four plants in the United States and South Africa currently using coal as feedstock to create liquid fuels. A plant using more than 6 million tons of coal annually could produce more than 3.6 million barrels of diesel and Naptha annually, making diesel liquefaction competitive at $35 to $40 per barrel oil prices. China has earmarked $15 billion for coal-to-diesel-fuel conversion plants and has targeted replacing 10 percent of its oil imports with coal-liquified oil by 2013.
  • Partial oxidation – gasification – combines feedstock, oxygen and steam to produce a synthesis gas that is cleaned of impurities. Syngas can be used as a fuel to generate electricity and steam or as a chemical building block for the petrochemical and refining industries. The gasification process converts feedstock such as coal, crude oil, petroleum-based materials or gases into marketable fuels and products.
  • Syngas from gasification historically has been used as a feedstock for the production of chemicals, accounting for nearly one-half of syngas use worldwide in the late 1980s. World gasification capacity grew by 50 percent during the 1990s, with more than 40 plants coming on line.
  • Today, there are approximately 155 commercial gasification plants in development, construction or operation around the world in 28 countries in North and South America, Europe, Asia, Africa and Australia. When operational, these facilities will provide the energy equivalent of more than 770,000 barrels of oil per day.
How to invest and make money on coal?

Just as investing in alternative fuels begins and end with Archer -Daniels Midland (ADM), commercial roofing and insulation with Owens Corning (OC) and paint and coatings with Sherwin Williams (SHW), investing in coal begins and ends with Peabody Energy (BTU) . Since their initial public offering on May 22, 2001, at $28 per share, or $7 per share on a split-adjusted basis following the March 2005 and February 2006 two-for-one stock split, shares hit a high of $75 in May of 2006. Since then, shares have fallen steadily (40%) to their current level of $45 despite growing earnings last year 60% . The world’s largest public coal company, their products fuel approximately 10 percent of America’s and 3 percent of the world’s electricity.

So, how much coal does Peabody have? If you converted their coal into each one of the following energy sources, Peabody’s reserves would provide :

  • Enough electricity to provide all the US electricity demands for 5 years
  • More that 10 times the total US natural gas uses
  • Diesel fuel: enough to fuel the US truck fleet for 42 years
  • Hydrogen: enough to replace all oil in US transportation for 6+ years

BTU has not traded in a PE range this low since early 2003 when it’s stock traded for a split adjusted $9 a share. Since that period they have grown earnings from 25 cents a share to $1.92 last year (680%) and dividends have grown from 11 to 24 cents a share (118%). Since 2001, shipments of coal have grown from 194 million tons to 240 million tons in 2006 and in 2006, their worldwide coal sales were 38% greater than their closest competitor and in the US, Peabody’s shipments were 22% of all US coal shipments and 80% greater than the closest competitor. They clearly dominate the coal market both nationally and internationally.

The Future:

So, now that we know where we are, we need to figure out where coal and BTU is going. Let’s take a look at both worldwide demand and demand here at home in the US. The EIA estimates that 115 gigawatts of coal fueled electricity will come on line worldwide in the next 3 years and by 2030, an additional 156 gigawatts will come online in the US. These uses by themselves will require an additional 500 million tons of coal annually. This does not include additional coal demand for the other uses previously mentioned.

Currently BTU has a 1 billion ton backlog of orders with contract ranging from 1 to 19 years with the average being 5 years. All long term contract have “price re-opener” provisions in them which protects BTU from a profit squeeze should input costs rise unexpectedly.

BTU is currently is in the process of building 3,100 megawatts of electrical generation capabilities in two locations at BTU owned mining sites. This will enable BTU to become a “minimal cost” electrical producer at these locations as they would be using their own coal to produce the electricity they would then resell.

Debt grew by $1.7 billion in 2006 as this money was used to purchase Excel Coal in Australia and repay its debt. The acquisition makes BTU that largest coal producer in that country also and provides BTU a lower cost basis to export coal to Asia and China whose demand for it is surging. The Australian mines primarily produce “metallurgical coal” . This high BTU coal is primarily used for the production of steel and is highly sought after by China. Selling for about $100 a ton (vs approx. $26 a ton for all other coal), BTU estimates it will sell an additional 3 to 6 million tons of this in 2007 vs 2006 providing about $500 million in additional revenue with no added cost.

For 2007 BTU is predicting 265 to 285 million tons of coal shipments for a 10.4% to 18.7% increase over 2006.

Pricing.
From 1990 to 1999 the price of coal declined from $1.38 per million BTU’s to $ .91 per million BTU’s. Since 1999, that trend has reversed and prices have risen to $1.15 in 2005 and the EIA estimates this price will continue to rise to $1.84 by 2030.

Geopolitical Considerations
The news this week made reference to, but did a lousy job of covering the “summit” of natural gas producers. These nations are attempting to band together and create an OPEC like cartel for the sale of natural gas. The US is not one of these nations and the formation of an organization like this would only be done for one reason, to raise the price of natural gas. This event, should it come to fruition, would be monumental to the coal industry. It would create a huge demand for reliable, low cost fuel for the production of electricity and more plants and other industries would move from natural gas to coal as their main fuel source. I anticipate these nations will form this alliance and Peabody and its shareholders will be the main unintended beneficiary of it.

So, all this now has us considering buying shares of a company that is the world leader in its industry, with increasing demand and pricing power for its products selling at historically low levels….

ValuePlay anyone?

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DOW CEO Liveris: No Deal


DOW Chemical CEO Andrew Liveris appeared on CNBC on Tuesday to attempt to “put to bed once and for all” the rumors of an LBO. Appearing on David Faber’s segment he reiterated the companies stance that they have had “no talks with any private equity group regarding an LBO”. If they had, he said “we would be the first to tell people”. He went on to state that the true value of DOW is in it integration of both upstream and downstream operations and that integration is “total.” This level of integration is shared by only two chemical companies in the world, DOW and BASF. An LBO, he said that would break up the pieces of DOW and sell them off would destroy that value for shareholders. In this instance, an LBO would lead to “value destruction, not creation”. Other notables from the conversation:

Liveris:
“We are currently involved in over 60 deals flows, one of which we announced this morning with Chevron Phillips Chemical”

From The Press Release:

  • Dow Chemical Co. (NYSE:DOW – News) and Chevron Phillips Chemical Co. (NYSE:CVX – News; NYSE:COP – News) said on Tuesday they planned to form a joint venture of their plastics and plastic feedstock operations in the Americas.
  • The 50-50 joint venture, which would link the companies’ polystyrene and styrene monomer assets, is expected to close in the second half of the year and yield significant synergies in manufacturing, commercial and feedstocks.
  • No financial details were released from the planned link-up under the nonbinding memorandum of understanding signed by the companies.
  • The new partnership is expected to combine Dow’s styrene monomer plant in Camacari, Brazil, and six polystyrene plants in the United States, Colombia and Brazil, with Chevron Phillips’ Louisiana styrene monomer plant and Ohio polystyrene plant.

In this joint venture, the refining capabilities of Chevron Phillips upstream operations (which Dow does not do), compliment perfectly the downstream plastics operations of DOW (which Chevron Phillips does not do). In essence, Dow is receiving guaranteed feedstock at more than competitive prices in exchange some of the profits from the sale of the final product. A win- win for both companies. This is a vital change in the business strategy of Dow.

When asked about using the growing cash balance at DOW and its now “de-levered” balance sheet for acquisitions, Liveris gave tremendous insight as to what DOW may be looking at. He said:

“We have put the company back in charge of its own future which includes, acquisitions. Now, acquisitions of what companies or what businesses? You’ve read the strategy I am sure and you just implied it when you referred to GE plastics, we are looking for downstream businesses that provide earnings growth and earnings momentum that compliment our own businesses…..”

“…. I won’t comment on any specific deal (after being asked about his interest in GE Plastics) but with over 60 deals in the works, we are looking at everything. It is the deals we haven’t done that are the most instructive. This is a company that financial discipline and making sure that the deals we do do, fit our strategy and we are not just going to come around and buy whatever is available. Now, having said that, look at the profiles, look at the downstream businesses, we are not interested in more commodities, we are interested in technology rich downstream businesses.”

In the past I have pleaded on this blog with CEO Liveris not to give in to the temptation of the easy LBO money. It would seem, based on this mornings interview that those fears should be put to rest. It is also apparent that Liveris is in this thing for the long term. When I reviewed his annual letter to shareholders last week I said a sale of the company was not in the works for 2007. So far so good on that one. Liveras did say that 2007 was going to be a “significant year”. As I have said before, nothing he has done up until this point has lead me to doubt anything he says, no reason to start now…

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Sears Holdings (SHLD) Securitizes Main Brands


Eddie Lampert, Chairman of Sears Holdings has created $1.8 billion worth of securities based on the brand names Kenmore, Craftsman, and DieHard. What that means is he essentially transferred ownership of the brands to another entity, which it then pays for the right to use the brands. The deal, carried off last May, was the biggest “securitization” of intellectual property in history, according to Eric Hedman, an analyst at Standard & Poor’s. The story hasn’t gotten out until now because the bonds haven’t actually changed hands, Sears is holding them in its Bermuda-based insurance subsidiary and because Sears has never disclosed them, nor has it had to do so. That would change if Sears were to decide to sell them to outside investors and collect the cash.

How does It work?
Sears has disclosed that it has created a “separate, wholly owned, bankruptcy-remote subsidiary”. This is essentially a company within a company. It is called KCD IP (for Kenmore Craftsman DieHard intellectual property) and it has issued $1.8 billion worth of bonds backed by the intellectual property of Sears’ three biggest brands, according to filings with the Patent & Trademark Office.

Sears has in effect now created licensing income from it’s most known brands. First it transferred ownership of the brand names into KCD. Now, KCD charges Sears royalty fees to license those brands and uses the royalties to pay the interest on the bonds. It has sold the bonds to the insurance subsidiary, where, like any other security on an insurer’s books, it serves as protection against future loss. The insurer, meanwhile, protects Sears from financial trouble and because it’s a subsidiary of Sears, it does so at a lower cost than they could get from an outside party. Essentially, the deal at its current level allows SHLD to save money on insurance.

The question you are most likely asking is: Who is making money off the transaction? The answer? As it is set up, nobody. The payments net out to zero because Sears owns every piece.

Why Do It Then?
It seems like a whole lot of work to do for no profit. Why do it and how then can Sears turn these bonds into money?

1- Sell the bonds to outsiders. Then, Sears would be holding up to $1.8 billion in cash, and investors would be holding the bonds.

2- License the brands: Many people (me included) feel there is a huge revenue stream for Sears in the value of these brands. Allowing outside manufacturers to make products and use the Craftsman, Kenmore and Diehard brand names in return for royalty payments is an easy way to increase profits without any additional expense. These payments would be virtually 100% profit for Sears. More importantly, by licensing these brands they would be expanding the availability of them. I feel that especially with the Craftsman tool line, this could really have a compounding effect. Tool buyers are a brand conscious lot. If their favorite brand came out with a Craftsman line, given Craftsman’s reputation for quality, it would sell.

3- Swap bonds for debt. Lampert acquired K Mart through its debt. These new “brand” bonds allow him a vehicle to do a similar deal. How? Lampert could swap these bonds or a portion of them for the debt of another company. One morning shareholders of BJ’s could wake up and find that Sears Holdings owns all their debt. The beauty of this scenario is that it would require none of the cash Sears has in the bank ($4 billion) to be used. Having these bonds as leverage also allows for the possibility of a much larger acquisition.

4- Insurance. In the past I have speculated on the possibility of Sears getting into the insurance business. Now we have an insurance subsidiary of Sears sitting there holding $1.8 billion in bonds that could be used for an acquisition. As I stated in the past, I think there are few acquisitions that would make the stock price of SHLD explode to the upside than the purchasing of an insurer.

The creation of these bonds opens up a plethora of situations in which they can be used to add value to Sears Holdings for shareholders.

At the end of the day, what Lampert will do with this is a mystery. It is great fun for us to speculate though. If we do it enough, eventually one of us are going to be correct. What I do know is that given his past track record, we shareholders will benefit greatly.

Things are getting exciting here.

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Curt Schilling & Starbucks: Same Problem


As I watched Curt Schilling’s opening day debacle for my beloved Boston Red Sox against the hapless Kansas City Royals, I immediately began thinking once again about Starbucks (SBUX) because the comparisons between the two are striking (baseball pun intended). Really they are, read on and I will explain. A note: I have penned (typed?) several pieces on Starbucks in the past and will not regurgitate them again. For those interested, you can read them here, here and here.

First a bit about Mr. Schilling.
He came to Boston in 2004 with a singular goal in mind: To win the World Series and by the time the 2004 season ended, he was a hero. Anybody who saw the blood filled sock (now in the Baseball Hall of Fame) and his gusty performance in the playoffs as he lead the Sox to their first World Series title in 86 years can understand why he was then elevated to royalty in Boston.

This spring Curt who, after an poor 2006 season, apparently took the off season so seriously that he showed up to spring training almost 30 pounds overweight. Now, at 20 that weight can be worked off in spring training. At 40? Not so much. To compound this he:

  • Asked for a contract extension for two more years
  • When denied, he then spent the spring talking about “not talking” about his contract
  • When “not talking” about his contract, he spent time talking about his online game company which, in a snit had a name change from “Green Monster Group” (in reference the Fenway Park’s famed left field wall) to 38 Studios which….
  • Mirrors the name of his website “baseball” blog that spend very little time talking about baseball
  • Seemed to be distracted with all the attention new arrival and pitcher Mr. Matzusake is getting in Boston with his vast array of pitches. In response he….
  • Decided he was going to expand his and start working on a change-up.

Now, Starbucks
The Starbucks concept as we know it today began with Howard Schultz in 1987. The singular premise was to mirror the Italian coffee houses he visited during a trip to Italy in 1984 and for the better part of two decades they did exactly that. They single handedly invented the coffee experience we enjoy today. Their growth exploded in the 90’s and made investors gobs of money all the while staying true to what made them great, their singular focus on great coffee in an intimate, relaxed setting. This growth lead to them needing to squeeze more sales from each location to finance new ones. The formerly intimate setting became cluttered with items for sale that covered the spectrum of coffee makers, coffee mugs to CD’s and almost everything in between. The rapidly expanding drink menu became complicated to both order and execute and led to longer, much longer, wait times at the counter. The peak of this came in the summer of 2006 when execution difficulties with a new frozen drink led to people choosing other options for coffee rather than waiting in line an obscene amount of time in the hot sun for one. In response to rising customer complaints and negative media reports Starbucks:

  • Decided to give away 10,000 custom made t-shirts from a designer no one has heard of
  • Introduced more drinks to further complicate an already burdensome process
  • Seemingly distracted by the incredible success McDonald’s (MCD ) was having with their Newman’s Own Premium coffee and the new and very popular McCafe‘ concept, decided to copy them with a breakfast menu. It should be noted that the same production problems that hamper the coffee experience are being exacerbated and compounded by this new wrinkle. It just is not worth the time or the $4 for an egg and cheese sandwich guys.
  • Jumped at the opportunity to finance Paul McCartney’s upcoming divorce by creating a record company and signing him to a deal. I wonder if the brass at corporate realized that Mr. McCartney’s last #1 hit was with Wing’s in the 70’s. When you sign a new act to your label and the first reaction of your core customer is “He is still alive?”, it is not a good sign
  • Decided that despite centuries of drinking tea, the Chinese ought to switch to coffee
  • Are considering a Starbucks themed clothing line
  • These action now have them financing their growth with debt which has exploded from $4 million to over $700 million in just two years

Greatness requires a singular focus on the intended outcome that is desired. In Schilling’s case it was being a great pitcher, a leader, and winning a World Series. In the case of Starbucks, it was the coffee, period. By focusing on those items and only those items, both accomplished those goals and received the accolades that accompany that success. Sadly, both have strayed far away from what have made them great in the past. It appears Red Sox fans will feel this pain this year again as Schilling seems to have picked up where he left off the second half of last year, focusing on everything but baseball. It also seems that Starbucks shareholders and customers will also feel the pain of distraction as Starbucks makes them wait longer in more and more crowded locations (not with people) for coffee while they try to sell them sandwiches, records and clothes.

Here is hoping Schilling at least gets his act together first….

PS. A note to Mr. Schilling: We Red Sox fans have no patience or sympathy to someone making $15 million a year who complains about not making more and then gets his head handed to him by the worst team in baseball. You have not pitched well in almost a year now. Do you want to feel our wrath? Keep it up because it is brewing out there. Just keep your mouth shut and win, you do that and we will do your talking for you.

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