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2014 Year End Review: Covestor Portfolio

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2014 was unique in its way; Sharp drop in oil prices, Russian annexation of Crimea, World cup soccer, Ebola epidemic, regime change in India, elections in Brazil, power shift in the congress and finally positive ending of S&P 500. Though market was started with rumble in the year 2014, it ended with humble 13.69% return beating 83 percent of large blend mutual funds.

Last year our winners in the portfolio were Southwest Airlines, Spirit Airlines and Berkshire Hathaway; Google and Holly Frontier were our laggards. As we predicted consolidation in oil refiners that has not materialized. We believe Holly Frontier has properties at strategic locations and has excellent cash flow trading at lower multiples yielding nearly 10 percent with special dividends; could be an easy acquisition target by bigger oil firms. Though Google had lackluster year in 2014; new product innovations, market leadership and lower price multiples will improve Google price in the year 2015. We are still holding both Holly Frontier and Google. Also last year our Long term value portfolio returned 15.1% net of fees versus S&P 500 realized 13.69% with dividends included.

Year 2015 is going to be very interesting year due falling commodity and oil prices, lower unemployment rate, strengthening dollar, lower trade and lower fiscal deficits and wage inflation and possible interest rate hikes. At the beginning of this year all leading economic indicators are showing positive trend. Uptrend in average weekly hours, decline in initial unemployment claims, expansion in manufacturing with new orders and steepened yield curve among the all major economies is very good beginning.

As we predicted in the last year’s review (http://investing.covestor.com/2014/01/2014-trends-watch-oil-glut-airline-oligopoly) there was so much inequilibrium between oil supply and demand. Recent oil correction is well deserved and shot in the arm for many global economies. It all started when we waged two-pronged war in the Middle East. Oil prices spiked up due to fears of supply constraints, though they never realized. Oil prices drastically moved up from $26 a barrel in January 2002 to $143 in July 2008 right before the recession. It was a startling gift to oil producers while domestic consumers were squeezed hard due to oil price spike. Oil producing countries including OPEC nations enjoyed surplus wealth due to higher oil prices. Unfortunately ones pain was others gain.

However technological innovations in shale oil extraction, slack in global oil consumption, advances in energy efficient automobiles and electric vehicles reversed the oil price trend. We have started producing more oil domestically than importing from the foreign markets. Eventually glut in the oil supply made its magic in the market. Finally we are at a stage that we don’t need to worry too much about exogenous shocks related to oil on our economy.

How low these oil prices can go?

All these boom days’ oil producing countries highly relied on oil wealth and never able to diversify their economies. They spent their excess wealth mostly on public spending, oil subsidies and wage increases. Prior to 2015, most of the energy rich nations prepared their fiscal budgets looking backwards. In order to balance their fiscal budget the price of the crude oil needs to be at above $100 for the oil rich Middle Eastern nations. As you can see in the above IMF chart the breakeven prices are ranging from $55 for Kuwait to $180 for Libya to balance their fiscal budgets. At this crude price $55, are these Oil supplying countries able to cut their oil production without dipping into their sovereign funds or cutting spending abruptly without any domestic turmoil? I seriously doubt it. The next stop for oil is below $50 or even at the $40 range?

How much impact lower gasoline prices have on the economy?

As per AAA average gas price average gas price per gallon last year was $3.301 and as of now the average gas price is $ 2.168 that is $1.133 cheaper than last year. As per BLS in 2013 average family spent $2418 on gasoline that is average family consumed 616 gallons of gasoline. Out of 126 million households we consumed 78 billion gallons of gasoline. With $1.133 gasoline price drop the impact on our economy is $90 Billion ($87,708, 611,760). If we add jet fuel and diesel from industrial consumption the impact on our economy is tremendous. Eventually all these saving this will add up on lower cost of goods and higher consumer spending and there by significant impact on out GDP growth in 2015. Some of the economists arguing that capital expenditures from energy companies will decline in 2015 due to lower profits may have negative impact. We believe overall net gains from consumer spending has lot more impact on the economy than reduction in oil industry capital expenditures due to the fact velocity of the money at consumer level is lot higher than capital spending by big firms and also oil industry expenditure is not all spent within the boundaries of the country, and third of our energy consumption is from abroad.

Who will benefit from energy savings?

Every family gets impacted from the oil price drop. On average every family saves at least $700 if the prices stays as at $2.168 a gallon, but in many parts of the country average gallon prices is below $2.00 and the trend is downwards. As you can see in this chart (compiled from BLS data), an average family spends 13% of its income on food, 18 percent on transportation. Most probably excess savings from gas

pump will be spent on consumer staples than luxury items. In our opinion excess marginal spending will benefit grocery stores like Wal-Mart, Costco, Kroger and SUPERVALU. Next level of beneficiaries are casual restaurants like Panera bread and Starbucks café. Other big winners are going to be in the transportation industry particularly corporations like FedEx and Southwest airlines.

What we see year ahead?

At recent survey at Barron’s magazine market seers on average predicted 8 percent return on S&P 500; however we believe this year we are expecting S&P 500 return will be higher than last year returns. We see lot of tail wind to our economy due to decline in energy prices and accelerated consumer spending and real wage growth which is stagnant for the long time.

European and Japanese economies may be struggle to come back to normalcy; Russian economy will end up into recession due to decline in energy prices and economic sanctions by Western countries. Yield curve in Russia is already inverted. Sorry, tough days ahead for Russia. Many Asian countries including India, China and other south eastern Asian nations also enjoy sharp decline in current account
deficit simply due to energy prices. Whereas Korea and Germany have highest percentage of their GDP tied to exports will face headwinds due to global slowdown. Other end In US our exports contribute only 14 percent of our GDP, global weakness have little impact on us in the next year. However many multi-national firms face headwinds due to stronger dollar and weaker global markets especially in Europe.

Airline industry will have another exceptional year (third in a row) due to lower competition in the domestic market and lower oil prices. However this year all airlines may not end up winners. Open air agreements with foreign carriers bringing heavy competition to major carriers in the trans-Atlantic market from gulf airlines. That will put price pressure and vigorous competition among airlines.

Almost all airlines charge for luggage and some even charge for carryon bags. All the major airlines cutting loyalty miles for economy class travelers. Only exception for all these trends is Southwest airlines. It has adopted exceptional customer service and follow egalitarian approach with single class of seating and never charge for bag fees. That is the durable competitive advantage. Southwest is also expanding its services to Caribbean and Mexican destinations and going to start direct international service from Houston Texas. Other airlines to watch is Copa airlines based in Panama. A well-run company dominant in the Latin America flies to most of the Latin America and North America has partnership with United Airlines Star Alliance trading at lowest multiple generating abundant free cash flow.

We also foresee 2015 is going to be the last year for Sears and Radio Shack companies. Their cash burn rate does not justify their existence any more. With same kind of high cash burning rate, sooner or later JC Penny may also join the cliff jumping party.

With ubiquitous cheaper internet data plans, 2015 is going to be a remarkable year for cloud players. All new personal computers, tablets and electronic devices will come with thin hard drives and heavy cloud drives. Eventually cloud storage players like Google, Apple, Amazon and IBM take major chunk of consumer business.

Finally we see Apple pay will be adopted by all mainstream retailers. If Apple can bring department of motor vehicles in their customers list, there is no need to carry our wallets because you have your driver’s license, insurance card and all electronic cash stored in the Apple phone.

References: IMF Regional Economic Outloo
Leading Economic Outlook in United States:
Oil Prices and trends:
S&P 500 performance:

Yahoo valuation after Alibaba went public

Ok Now Alibaba is started trading at around $91 and Yahoo started trading down at around $41. Being 22% share holder of Alibaba, Yahoo supposed to get all the benefits of Alibaba ownership. Why market is trading Yahoo downwards? How much Yahoo is truly worth after Alibaba IPO?
Yahoo owns 523 million Alibaba shares or 22.4% of Alibaba. At $90 Alibaba trading Yahoo’s ownership itself worth $47 billion; after paying whopping 35% tax it should be valued at $30.5 Billion. Yahoo owns 35% of Yahoo Japan. At current market value its worth is $7.7 Billion; again after paying 35% tax its worth is $5Billion. Yahoo has $2.74 Billion cash on its balance sheet; for the past twelve months Yahoo made $1.26 Billion on earnings. At twelve times past earnings estimated Yahoo value is at $14.7 Billion.
If we sum all the parts Yahoo value is way over current trading price.
Alibaba portion of Yahoo (@90) $30,595,500,000
Yahoo Japan $ 5,032,966,784
Cash on Balance sheet $ 2,744,455,000
12 times trailing earnings $14,413,572,000
Grand Total: $53, 086,493,784
Fully Diluted Yahoo shares: 1,095,000,000
Per share Yahoo value: $48.48
Let’s say if you want to ignore earnings metrics and adopt conservative 8 times trailing EBITDA ($1.28 * 8) is at $10.24 billion that puts Yahoo fair value at $ 44.40. Also every dollar change in Alibaba worth $0.34 for Yahoo on after tax basis.
Again this is conservative approach on Yahoo valuation. Yahoo can play Alibaba stake at much tax efficient way such as spinning of Alibaba stake into different entity and allocating new entity shares to shareholders. Yahoo brand itself worth lot more; if someone wants acquire entire Yahoo, Share holders demand much higher price than it is now.
Disclosure: Long on Yahoo.

What is the intrinsic value of Yahoo ?

There is lot of discussion about Yahoo and Alibaba (BABA) IPO. As of today (Sept 10th, 2014) Yahoo closed at $41.14 and has 994,600,000 outstanding shares, trading at market cap of $ 40.917 Billion. Alibaba is going to IPO at price range of $60 to $ 66, let us say $63.

Yahoo owns 22.4% of Alibaba or 523 million shares. If Alibaba stock open at $63 Yahoo share in BABA is going to be $32.949 Billion, makes it BABA market cap of $147.1 Billions

Yahoo owns 35% of Yahoo Japan. As of now Yahoo Japan Market cap is 2.363 Trillion Yens; at 106.83 yens for US dollar it is equivalent to $$22.122Billion. Yahoo’s share at 35 % rate worth $7.73 Billion.

Yahoo earned trailing twelve months $1.226 Billion. At Conservative 12 times earnings its value should be at least $14.713 Billion.

Now add all together: Estimated Alibaba value $ 32,949,000,000
Yahoo Japan $ 7,743,025,821
Yahoo 12 x Earnings $ 14,713,572,000

Total Value $ 55,405,597,821

Share price value should be $55.71. So upside potential for yahoo is approximately $14 or you can say there is big margin of safety if you own Yahoo share at this price.

Assumption here is Alibaba trades on IPO date at $63.

Again this theory, in reality there is always gap between theoretical price and actual price.

Disclosure: I own both Yahoo stock and derivatives. Do your due diligence prior to committing your hard earned money.

Year end performance report on my public portfolio at Covestor

Fed started year 2014 with tapering long term bond purchasing. Bond market has adjusted since last year with increase in long term rates and declining bond prices. As long term interest rates start going up, funds invested abroad will start coming back home. As fed stated, if short term interest rate or real interest rate starts going up that will put upward pressure on dollar relative to other currencies. This has many consequences including decline commodity prices including gold, silver and oil. On other side increase in interest rates bring funds invested abroad back to US, that has already evident in currency value drop at developing countries like Argentina, Brazil, India, Indonesia, Turkey and Venezuela.

We don’t know how much third part of the quantitative easing helped US economy but certainly did hurt the banking industry. It kept yield curve less steep; banks had no incentive to lend their deposits. By the time Fed completes bond purchase program long term rates will go up again to historical normal yield levels which are much higher than current rates; yield curve will further steepen which is generally considered boon to banking sector.

2013 was one of the outstanding years for the stock market returns; our long term value portfolio returned 39.7% net of fee and most of the returns in the portfolio were unrealized and long term which is taxed at much lower rate. As far as 2014, we can predict economy is going to be healthier but we don’t know what general market is going to do next year, most probably higher than last year.

Many leading economic indicators are exhibiting very positive trends. Average weekly hours on private non-farm payroll are stable, unemployment insurance claims are lower, the trend in new orders for durable goods, non-defense capital goods are up trending. New residential construction is picking up, money supply is increasing and yield curve is steep, bottom line is all leading economic indicators are in upward trend. Will markets in 2014 follow the economic trend? We believe chances are high. We don’t know what year end S&P 50o is going to be but can certainly comment on couple of strong trends.

Year 2014 is going to be very remarkable for oil industry. This year, domestic production of oil and natural gas is going to be at remarkable level. Probably first time in long term our energy exports are going to be more than imports. That will add up big time into GDP growth. Glut of oil coming from Canadian Oil sands, Bakken shale and Marcellus shale is choking transport lanes. Crude Oil stock levels are at highest level at Cushing, Oklahoma keeping wide price margin between domestic West Texas intermediate (WTI) and Brent crude from Northern Sea. As we calculated average price gap in the fourth quarter of 2013 was $11.87, probably the trend will continue in the near future. We see the biggest beneficiaries are oil refineries in the Midwest such as Holly Frontier and lesser extent domestic refiners at gulf shore. Next year we see there will be either consolidation in refining industry or these refiners command higher valuations as their profit margins go up.

Another trend in 2014 is going to be higher travel costs as airline industry went through consolidation. Six major airlines became three big carriers created oligopoly market in domestic and international routes. Only competition to these big three is South west airlines in domestic front and Jet Blue at certain segments;whereas international market is vulnerable for high prices. Only option for price conscious travelers is South West Airlines and Jet Blue but they serve only selected cities. Recently South West airlines announced it is going to get into International markets, and the repeal of Wright amendment gives South West airlines right to fly direct routes from Dallas Love field to any other city. Despite huge run in last year South West may still have bright outlook next year.

Disclosure: Long on HFC and LUV.
References: http://www.sreenimeka.com/econ.php

My October Monthly letter to Covestor.com

The following letter to covestor wriiten on October 4th and published on October 27th.

Here is the publisher link http://investing.covestor.com/2012/10/we-bought-wal-mart-on-the-strength-of-its-global-push

 

We bought Wal-Mart on the strength of its global push

 by Sreeni Meka

 

Recently, the Fed announced a new monetary policy (QE3) in which the central bank will buy mortgage backed securities and start pumping money into economy. This aggressive monetary policy keeps long-term rates low and may spur activity in housing sector. But with sagging unemployment levels, I doubt how quickly housing sector can bounce back. Once bitten, twice shy.

With recent bad memories, bankruptcies and foreclosures, I suspect the public will respond very slowly to the housing sector even though there are hundreds of houses on the market at rock bottom prices. So will the banks, as they are still cleaning their balance sheets from a glut of unwanted properties. I would rather credit the foreclosed property investors for the recent uptick in the housing sales than the general public.

There is a wonderful book “The Wall Street Waltz” written by Ken Fisher (Forbes Columnist) on real estate cycles. In one of the chapters in his book he concludes from 150 years of data, that real estate prices go through cycles like any other economic cycles. According Fisher, from the peak of the real estate cycle to trough is around nine years and from trough to peak is nearly nine years. Let us assume if the real estate peak was in early 2007, then the bottom of the real estate market may not be until 2016.

If you think this time is different and the Fed is easing its monetary policy, there may still be few more years to go to reach the bottom of the real estate market.  There may be pockets of strength in real estate, but I won’t rush to invest in home builders and other real estate related companies. Caveat Emptor.

The biggest event in the fourth quarter is presidential elections. And by end of the year, the Bush tax cuts are going to expire. Long term capital gains tax rates are going to go up from 15% to 20%, and if your annual income is above $250,000 there will be 3.8% surcharge on capital gains. Dividends will be considered as ordinary income.

Market participants may not wait until the election results. Some of them may adjust their portfolios and realize capital gains this year rather than waiting until the last minute. Some companies may even declare one-time cash dividends before the end of the year.

In my opinion fiscal policies, including reduction of fiscal deficits, may do more to dictate future economic recovery than just changes in taxation or relying on monetary policy when interest rates are at zero percent. Oversupply of money into the market may benefit in short run, but will have painful consequences in the long run once inflation picks up speed.

For years Amazon.com (AMZN) has enjoyed a tax exemption on its online sales. From September 15th onwards the state of California joined Texas, New York and other five states in imposing sales taxes on Amazon online sales. The combined population from all these eight states is more than third of the national population. Next year New Jersey and few other states start collecting taxes from online sales. The well anticipated tax change can keep companies like Wal-Mart (WMT) is competitive edge with online retailers like Amazon, and may give second life to lone brick and mortar book companies like Barnes and Nobles and electronics retailers like Best Buy (BBY). But it certainly helps many big retailers like Wal-Mart. If the unfair tax advantage is eliminated people may tend to buy at brick and mortar retailers like Wal-Mart due to free shipping to nearest retail location for pickup and for convenience of sales returns.

Last month the Indian government eased restrictions on foreign retailers; Wal-Mart is now spreading its wings into the Indian market through joint ventures. Twenty nine percent of Wal-Mart’s revenue comes from international sales and revenues at international segment and are growing at a 15% rate, according to a recent earnings statement.

Wal-Mart has about 5,800 international retail stores; out of that Wal-Mart has only fifteen stores in India. The potential to serve more than billion customers in Indian market is tremendous.  Wal-Mart financials look impressive and can weather both tough and good times. Recently I included Wal-Mart into my portfolio.

I am a long term investor and most of my funds tied to assets are held for long term; however last quarter I have made few quick runs when short term opportunities with relatively less risk have arrived. Also I adjusted last few days of the September to protect the capital and to address my perceived volatility of the fourth quarter of this year.

Finally, as of October 4th, I have completed two years of managing the Long-Term Value (LTV) portfolio. In two years the cumulative portfolio return was 45.2% (net of advisory fees) versus 27.6% return of S&P 500 (excluding dividends), that is annualized returns of 20.4% (net of advisory fees) versus 12.8% on S&P 500 return. Year to date, LTV portfolio returns were 26% (net of advisory fees) versus 15% on S&P 500.

 

Recent Trades: Power One Inc (PWER)

 

 

Here is  my recent investment PWER (Power One); one of the old dogs from California. Power-One, Inc. engages in sale, and service of power supply products for the renewable energy (RE), servers, storage and networking, telecommunications, industrials, and network power systems industries worldwide. Predominantly focusing its energy into solar invertors . Invertors are used to store the power for future usage similar to batteries.

This stock is currently under performing due to decrease in sales growth and concerns about German and Italian government support to solar projects. Recently they have entered into emerging markets like India where Solar power projects picking up speed.

Apart from the market conditions, PWER balance sheet looks very attractive. PWER is trading at six times earnings and has $2.00 in cash with no debt priced at $4.60 (as of now) . The price to book ratio is 1.25, and has generated $148 million in free cash , that is equivalent to $1.21 per share ( Trading just four times free cash flow).

Market is treating this company as if there is no hope in the future, but based on the numbers it should trade lot higher ( 15 time free cash is nominal for US stocks). Bottom line, in my opinion it has little downside risk and can be bought over by its rival firms or private equity firms .

For more financial details , check Reuters web site, here at http://www.reuters.com/finance/stocks/financialHighlights?symbol=PWER.O

Disclosure: I purchased this stock for long term at my Covestor portfolio. Please do your due diligence prior to purchasing any of my trades I discuss here.