2/26/2006 newsletter

*** Market
SP500 is hovering around high, 1290 (+4% YTD). My portfolio is at $12.9 (+9.6% YTD). I actually use a per-share price to track portfolio performance, just like mutual funds and stocks. I found this is the only way you can acurately track financial performance. My base is $10 at 12/1/2004. It has been 15 months. If you want to double the price in 5 years, the easiest way to remember is that you need 20% gain every 15 months (1.2^2^2 = 2, 15*2*2 = 60). This is a conservative goal to a more speculative mind, yet agressive enough compared to SP500. Some people like to hit 50% or 100% in a year. Then you can rest a couple years (you need to not lose money during those years) and prepare to hit another 100%. I do not profess to know how to do that without bearing a much larger volatility. It would be nice if that stuff can be figured out ( g=50-100% in one of X years, X > 0% for all other years). The first implication however seems to be 100% turnover rate, or a very concentrated portfolio...

The early benchmark (2 months into the year) still shows small-cap and international stocks outperform SP500 by a large margin. Gold continues to stretch amid international unrest. However, oil seems to be reaching its peak influence. Bill Miller believes all the risk around oil has been generously discounted at $70. (He is not a believer of owning energy stocks) He also thinks SP500 owes us a rally like its international counterparts. SP500 is the only underperforming asset class in last year's global rally (but 14% dollar appreciation compensated foreign owners). Of course, this is assuming the underlying uncertainties (such as interest rate, energy, Iraq/HLS spending) have to be removed (or discounted enough).

--Steve

2/18/2006 newsletter

*** Market
DJIA is pushing into new territory above 11000. Oil price is volatile battling at high level. If you have energy stocks, you must have felt it. My portfolio stands at +8.5% YTD. Hang in there okay. Latest annual reports from high profile value investors indicate that large-cap now is their nest. People have been rushing into small-cap and make that sector overvalued. Large-cap (and tech stocks) has become the baster child that nobody wants, just the opposite of 6 years ago. Therefore, value investors began to collect from the dumpster. Intel's PE ratio can well justify being a value stock, than a growth stock... The fact that Longleaf got hold of DELL implies something unusual. If large-cap is undervalued, then there is a good chance that DJIA will break into new high, this will make people quite happy...

Market news includes: Microsoft is taking on Google, iPod and BlackBerry. This is the typical large-cap strategy, waiting for smaller companies to prove the market, and then smashing them with high-power alliance and marketing. Google is a tough enemy though. On the Wall Street, following the example of asset swap between Legg Mason and Citigroup, Merrill Lynch swapped its equity assetment arm with BlackRock for 50% shares. This deal is called triple-win (the other party involved is PNC Bank) and creates one of the largest asset mgmt firms in the world, managing 1 trillion dollars of asset. For me, I made a couple thousand bucks from BLK stock. Pretty decent gain though.

*** Comment
I read an interesting article about option pricing I want to share with you. It is not about trading stock option. You know I do not play those games. It is about stock itself. A NYU professor wrote an essay that you can view most stocks as an option on its senior debt because the stock with underlying borrowing has the same property as an option: E: Net asset value, D: debt, Y: years before debt is due, sigma: Volatility of E. The value of stock at due S is then E-D if E greater than D, zero if E less than D.

What is the value of this new way of thinking? This will not help you too much to make money in stock because it is very hard to determine E and sigma (That is what the bankers do). But it explains some phenomena quantitatively. Why are some stocks more volatile than others? Why was there big price swing in the bottom of a business cycle. This model explains it very well. Basically, if a company is taking a risky business plan, sigma can be very large. This results in very large price premium to compensate that risk. The price premium does not mean the business will succeed. It only means the outcome of the business can vary a lot. It does not make sense from intuition (that is why speculator loses money), but it makes sense by viewing it in an option model. A special case is when E is much smaller than D. This is called "out-of-money" option. It is known to be a high risk play in option strategy. Unbeknown to you, when you buy a company in deep trouble and risk of being taken by the debtor, you are doing something similar to buying deeply out-of-money option. And that is why penny stocks are very volatile.

You may ask. There is chance of turnaround and you will make a lot of money. Indeed you will. The very reason the stock still have residual value even when E is less than D is explained very well by an option. Out-of-money option still has value because there is still a chance it can rise above the strike price before it expires. And that chance depends on the volatility, that is the risk of the business plan. A proper accessment of the risk can make you a fortune as many value investors and traders do. But just remember you are playing a volatile option game. This is why management tends to take risky steps when a company is in trouble, to increase the likelihood of swimming above the strike price. Or he will be going to bankruptcy court.

Acutally if you think of CEO's compensation package, it is also option-like. Usually it goes like: If you turn the company around, you will get XYZ bonus (hopefully proportional to the price appreciation). If you fail, you get your base pay (which is lofty enough). So CEO takes much less downside risk than the shareholders. This often causes problem as you can see in airline industry and lately in GM (CEO salary is cut in half so that it is better aligned with shareholder's risk. But nobody mentioned how much stock option he got in exchange). If you view life through option model (figure out what are all the options available to each side under the contract), it becomes very interesting. No wonder Black and Sholes won Nobel prize.

I do not blame the union workers any more. They are just trying to protect themselves from becoming a commodity-like labor, which in an option world, will be much less valuable, if not totally of no value. People can leave their job, company can fire people. I have another essay about how to view employment contract in terms of option model. But I will spare it here.

Steve

2/11/2006 newsletter

*** Market
SP500 entered correction mode after a very bullish run in Jan. Small-cap corrects more than large-cap since it rose more in Jan. Google entered its first large amplitude correction. Growth stocks seem to catch up with value stocks (trend reversal?). It just daunts on me that Intel's PE ratio is only 15. Cisco and Microsoft is at 22. While SP500 is recovering to its all time high (SP500 is at 1260-90 now, dividend adjusted high was at 1400 in 2000), these powerful companies have come down a lot. They once commanded 60-80 PE ratio... Valuation change (future projection of value) often causes much larger price swing than the value it actually brings over the years. Is Mr Market moody or not? Something to learn from!

*** Comment
I bought Samuel two stocks that I want to comment on (very small position, $700 each). And I plan to buy more if the price comes down a little. GOL, Hung-Chin, you got to read this. GOL is a discount airline operated in Brazil and Argentine. Are you crazy to buy airline in this age of high fuel cost? Normally I won't, but this one S&P calls the most profitable airline in the world. What makes it profitable? Its business model. My God, what's new here? It just simplifies discount airline to the extreme. A single class of airplane and a single class of seat. No more 717, 727, 737, 767, and no more economic, luxury, first class. Does it make sense to you? Make a lot sense to me. It is much cheap to operate. Customer expectation is levelled (If you have money to ride first class, do not take discount airline. Go to full service, right?).Business model decides how you operate, and your cost structure! Way before how hard and efficient you have to work.

The second stock is LTM (Life Time Fitness). It is a fitness club like the close-to-bankrupt Bally. What is the big deal? I thought so too. Fitness club just have too much capital expenditure, and too much competition in a commodity like service. You can even build a gym at home if you like. But speaking of competition, how did WalMart, HomeDepot get ahead of other retailers -- Large box, one-stop shopping, high traffic. Again it is the model that differentiate itself from other run-of-the-mill. This is hard to do, but LTM did it. How big is its "box"? 11 acre of land (The most recent one is at Columbia, MD where I once lived). One-stop shop, it is a 4-in-1 site, fitness, pool/water park, spa, resort (and day care of kids). It allows a whole family to spend time in it, just like you goto the mall. High traffic, it opens 24 by 7 (Bally closes at 10pm, and pool is not always open).

I was amazed by their new ideas. So I mention to you. Hope you will come up with some great ideas too. Think big (Did someone say "Do great things for the Kingdom of God"). Good idea is also worth a lot (check out LTM CEO's holding). Lastly, however, safe harbor statement. No garantee these businesses will not fail as many of their peers. PE ratio is a bit high as they are in their expansion phase and the value of these successful ideas are more or less factored into the price. Didn't I just tell you to watch out high PE ratio... Cheers...

--Steve

2/1/2006 monthly performance

My portfolio: +28.4% since 12/1/2004

French and Fama Factor Model: [294 days, 2004-12-01]
Blend         Value         Growth
SPY    10.10
MDY    22.65
QQQQ    6.95
IWB    11.56  IWD    12.86  IWF     9.43
IWR    22.03  IWS    19.99  IWP    22.21
IWM    16.11  IWN    14.12  IWO    16.49