Author: Patrick Larkin
Covestor model: All Cap Value
My All-Cap Value Model was roughly flat in August, trailing the S&P 500′s total return of 2.25%.
My biggest losers for the month were Lojack (LOJN), down about 20%, DreamWorks (DWA), down about 12%, and Bank of Ireland (IRE), down about 7.5%. Each of these names have very solid long-term business fundamentals, and I remain confident that each of them will yield excellent returns over the next two years.
Lojack has a clear competitive advantage in its law-enforcement-preferred stolen vehicle recovery system and strong growth opportunities in both its SCI cargo tracking unit and its SafetyNet system for rescuing missing Alzheimer’s and Autism patients. I believe that Lojack is currently priced for highly adverse outcomes in its two major pending legal disputes and investors are expecting the company will just limp along with no real growth in either its core auto recovery business or in SCI or SafetyNet. While that is a plausible scenario, so are a wide range of more positive outcomes.
One can easily imagine disaster scenarios for either DreamWorks or Bank of Ireland, but I believe that these scenarios are unlikely and that the uncertainty surrounding these names has artificially depressed valuations.
Quotations on Bank of Ireland remain hyper sensitive to even the smallest pronouncements of the biggest players in the unfolding Euro zone crisis. I do hold a somewhat unusual view on Bank of Ireland: I believe that the common stock might survive and even recover its value in dollar terms in the wake of a Euro breakup.
Absent unlikely catastrophes, I expect both DreamWorks and Bank of Ireland to more than double in the next two years.
I sold out of Hewlett Packard (HPQ) on August 3rd. When I have a significant loss on a position, I try to reevaluate the position objectively. In some cases, when I determine that the fundamentals have not deteriorated and that my original thesis on the stock is still valid, I will hold the position or even average down if the opportunity is particularly compelling. If my review of the position leads me to believe that I might have made a mistake, I will typically sell.
My review of my HPQ position raised a couple of red flags. First, I was unable to convince myself that there is little merit to Jim Chano’s argument that HPQ’s free cash flow yield is a mirage. Chanos argues that measuring HPQ’s free cash flow before acquisitions in recent years has little meaning, as the acquisitions were essentially “maintenance capital expenditures,” without which HPQ would not have been able to maintain revenues and net income. Formerly, my view was that HPQ’s free cash flow showed that the company would be fine if they would just settle down and stop overpaying for acquisitions, as management has indicated they will do.
My concerns have also grown about HPQ’s competitive position in its various markets and about the continued deterioration of its balance sheet. In short, while I’m not prepared to flip to the bear side on HPQ at its current valuation, after my review of the position I concluded that the best course of action was to take the tax-loss, continue to study the situation, and to keep the stock on my watch list for possible repurchase after the one-month period required to avoid the wash sale rule and realize the tax loss.
However, I stress that my decision to sell HPQ was driven primarily by my reassessment of the fundamentals, secondarily by the tax benefit, and not at all by the recent negative price action.
Reflecting on my first year as a Covestor model manager, I have clearly made some good moves in addition to my share of mistakes.
On the plus side, my substantial investment in home health care provider Almost Family (AFAM) has turned out well, largely for the reasons that I thought it would. Also, I have managed to avoid a long-list of likely value traps, such as Research in Motion (RIMM), Best Buy (BBY), Radio Shack (RSH), and most of the for-profit education names (I am a bearish on some of these, agnostic on others).
In the minus column, in addition to HPQ, I was too quick to lose patience with Conoco Philips (COP) and especially its Philips 66 (PSX) spin-off. The misstep that I consider most serious however was my investment in Patriot Coal (PCXCQ).
It’s not that the Patriot investment was a total disaster in financial terms. I took a less than 1% position in Patriot common on May 29th for $2.59 per share, and sold on June 21st for $1.29 per share. The decision concerns me for the message it sends, and because it represents a departure from my usual investment discipline.
At the time,I recognized that the company had nothing going for it in business terms, except for the possibility that it might survive until such a time that world growth explodes again and puts severe stress on all available sources of energy. I believed that in such a scenario Patriot could increase 50-fold or more in price. I also argued that even an announcement of a financing package that could keep Patriot alive for another year would likely cause the stock to more than double.
As it turned out, I was lucky to get out when I did, as Patriot filed chapter 11 in July. While some investors might be able to be successful with a strategy based on portfolios of such “opportunities,” that isn’t what this portfolio is about. This portfolio is about seeking to buy stock in good companies when I believe they are cheap.
While I might make a mistake in the future in discerning good companies from bad, I will not be wasting valuable research time on companies that I already know do not fit the low-risk, high-reward profile that I am seeking for the All-Cap Value portfolio.
Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The investment adviser believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.