Monday, April 30, 2012


Although this has been refined over the years, this is the general framework that I typically follow, and is the product of multiple years of back-testing work that I have done, combined with ideas that I have “borrowed” and weaved together from various studies published by investment guru's that have been highly influential in the formation of my investment discipline. In my opinion these collective bodies of work empirically demonstrate which metrics/factors work best in various market environments, and identify investment strategies that, when applied systemically, challenge the theory of efficient markets, and illustrate opportunities for investors to consistently “beat the market”. Most notably, Benjamin Graham’s Intelligent Investor, the Fama & French Multi-Factor Approach, the annual “Black Book Study” published by Sanford Bernstein, as well as some lesser known, but similarly convincing studies done by Jim O’Shaughnessy "What Works on Wall Street" (Multi-Factor), Mebane Faber (Momentum Approach) “Earnings Quality & the Accruals Anomaly”, (Sloan& Richardson), CSFB-HOLT (CFROI), and Joel Greenblatt’s “Magic Formula” (Value). -

I’ll try and summarize my approach which I have found to be a successful, robust starting point to identify opportunities. I generally run 3 filters:

1) Primary Universe Screen, followed by a more in-depth,
2) Fundamental Screen, and finally a
3)Technical/Momentum Overlay.

The primary universe screen I think is a very simple screen that I use across all core strategies (value, growth, dividend) and is just a very basic filter of stock characteristics that prudent investors should demand from any stock they own:

1. Market Cap minimum of $2 Billion.2. Stock trading at earnings yield > than yield earned on 10yr Investment Grade Corporate Bonds. If corporate's yield 3%, this suggests we pay a forward P/E no higher than < 33X. 3. Earnings expected to grow at a rate higher than inflation over market cycle. 
4. Company generates Return on Invested Capital exceeding cost of capital (also normalized, 5yr) (I use 6% if WACC is unavailable) 
5. Company generates cash internally – positive free cash flow. 6. Earnings Quality > Ranks above bottom quartile

Next, the most comprehensive screen is the fundamental and earnings quality screen. I will typically break out 3 Core Equity Strategies (Core Value, High Quality Dividend, and Core Growth)and if possible, break out by sector in order to make more meaningful comparisons (Financials, Cyclicals, etc.)

Core Value – More emphasis on free cash flow, EV/EBITDA, and price/earnings multiples, especially relative to its historic multiple. Less concerned about ranking within sector, more concerned about ranking vs. market averages.
1. FCF Yield > Market Average
2. EV/EBITDA < Market Average 3. Forward P/E < 1.0X Historic Relative Multiple* 4. P/EG Ratio < 2.0X 5. Historic EPS Growth > 8%
6. Historic 5YR ROIC > 10%
7. Earnings Quality > Sector Average Ranking
*(use P/B, P/S, P/CF if more appropriate)

Growth/Momentum - More emphasis on expected earnings and ROIC growth vs. sector averages. Also, demand higher EPS consistency, and top quartile rankings. Only valuation filter is P/EG
1. Expected LT EPS Growth > 12%
2. Expected LT EPS Growth > Top Quartile of Sector
3. EPS Growth Trend > Accelerating faster than Sector Average
4. EPS Consistency > Market Average
5. ROIC > 15%
7. ROIC Trend > Positive
8. Earnings Quality > Sector Average Ranking
9. P/EG Ratio < 3.0X High Quality Dividend - More focused on historic trends (indicating a willingness to pay), financial strength and consistency (indicating a capacity to pay dividend (FCF & Payout), and expected growth trends 1. Dividend Yield > 1%
2. Expected LT EPS Growth > 10%
3. FCF Yield > Market Average
4. Payout Ratio < 80% 5. EPS (DPS if Possible) Consistency > Market & Sector Average
6. ROIC > 12%
7. Earnings Quality > Market Average Ranking

The last set of screens would be technical (earnings and price momentum screens), which I use as a “trading” overlay as they can provide good insight as to the timing of stock purchase. My personal approach, is to use a somewhat contrarian strategy here, buying value when it moves and buying momentum when it is weak.

Within the value stock candidates, identify weak long term performance coupled with strong near term performance, or a relative performance reversal. Similarly, we want to identify stocks that have been taken to the "woodshed" with negative EPS revisions, and are seeing a reversal in EPS revision trends. This way we avoid “value traps”. Having followed this approach at the beginning of the year, we would have been seeing attractive entry points for homebuilding stocks, which had finally, after 5 years of price and earnings declines, were finally showing strong signs of a price reversal coupled with estimates that had been overly pessimistic. The group is now up over 80%.

Among growth, finding just the opposite, strong LT performance, with weaker short term performance, may provide attractive entry point for a high quality company taking a breather. In this way we are avoiding buying a “top”. If recent YOY EPS trends remain solid, we should be less concerned with sentiment trends, unless there is a dramatic or structural change in the company's future growth prospects. If we were to have followed this approach, high quality, high growth stocks that were in simply in a consolidation phase, such as AAPL would have looked attractive 6 months ago, penetrating its lower bollinger band, on low volume, for no particular fundamental reasons.

Friday, August 06, 2010

Newfield Exploration Company is an independent oil and gas company engaged in the exploration, development and acquisition of natural gas and crude oil properties. The Company’s domestic areas of operation include the Anadarko and Arkoma Basins of the Mid-Continent, the Rocky Mountains, onshore Texas and the Gulf of Mexico. Internationally, the Company is active in Malaysia and China. During the year ended December 31, 2007, the Company had proved reserves of 2.5 trillion cubic feet equivalents (Tcfe). Those reserves were 73% natural gas and 63% proved developed. The company has operations primarily in four regions.
Mid-Continent: The Company’s single largest investment area is the Woodford Shale play, located in the Arkoma Basin of southeast Oklahoma. Its activities in drilling led to the leasing of approximately 165,000 net acres. The Company has drilled more than 100 vertical wells and 160 horizontal wells to delineate its acreage position. The Woodford formation is a shale interval that varies in thickness from 100–200 feet throughout its acreage. During 2007, its production was 165 millions of cubic feet equivalent per day (MMcfe/d) gross. The field has thousands of drilling locations. In 2008, the company is going to drill pilots with 40 acre and 80 acre spacing.
Monument Butte: The Company’s Monument Butte oil field is located in the Uinta Basin of northeastern Utah. During 2007, the field had more than 1,100 producing oil wells and gross daily production was nearly 14,000 barrels of oil per day (BOPD).
Green River Basin: The Company has acquired interests in 8,000 gross acres (4,000 net acres) in the southeastern portion of the anticline. During 2007, the Company reached an agreement to assume operatorship of its activities in Pinedale. Approximately 13% of the reserves in its 2007, Rocky Mountain acquisition were located in the Jonah field, where Company has identified more than 40 development locations on 10- and 5-acre well spacing.
Williston Basin: Approximately 20% of the reserves associated with its 2007, Rockies acquisition were located in the Williston Basin. The Company has an interest in approximately 150,000 net acres. The Company’s net production is more than 3,200 BOPD and has benefited from a recent well re-fracture program and new drilling in the Elm Coulee field, a mature Bakken play.

Growth Catalysts
Woodford Shale: Woodford Shale is an unconventional natural gas play. It is NFX’s single largest investment in the last 2 years. It is quite similar to Barnett Shale (TX) but has more silica which means more brittle ground and more efficient drilling. Since 2003, the company has drilled 100 horizontal and 160 vertical wells in the region. For 2008 NFX plans to spend $460 million to drill about 100 horizontal wells. More than half the wells will have lateral completions in excess of 3000 feet. Longer laterals help to improve per unit finding and development costs. This has allowed NFX to reduce cost/ lateral foot by 38% since 2007.    
 At the same time NFX has been increasing production at the Woodford Shale. Company is producing 200MMcf/d in the region which is up from 165MMcf/d at the end of 2007. The company anticipates that by year end 2008, the Woodford will produce 250MMcf/d as the company ramps up its rig count in the play. The increased production and lower development costs for the wells should result in higher ROIC. Woodford Shale has estimated 2.1 to 4.2 potential reserve opportunity.

Asset base shift: As part of changes to their asset base NFX has shifted to ‘Resource’ plays that cover expansive areas, provide multi year inventories of drilling opportunities and have sustainable lower risk growth profiles. It also sold its shallow water Gulf of Mexico assets in 2007. NFX now has deepwater operations in GoM. The company therefore has longer lived assets and has been able to improve its ROIC. The longer life of its assets has also resulted in better Reserve Replacement Percentage for the company.

Competitive Dynamics

Visible growth ahead: Production is expected to increase from all of NFX’s assets. Its steady pipeline of production opportunities has caused NFX to raise its production guidance twice in FY08 and it now expects 25% organic growth in FY08. This production growth is sector leading. 

Focus on organic growth: NFX has been actively exploring and developing new assets. Growth through acquisitions is getting more and more expensive and risky. Its strategy of growth though ‘Drill bit’ vs ‘Acquire and exploit’ should therefore increase profitability. Newfield has managed to increase its production from all its assets through increased drilling activities. This gives them a competitive advantage against companies that seek to acquire potent assets as such assets are more expensive now and there is always a risk of wrongly estimating the reserves there.

1st mover advantage in Woodford Shale: NFX was the first in Woodford and it leased the best acreage for an all in cost today of about $550 per acre and drilled the most wells. NFX is at a great point in the development of this play. It has nearly all of our acreage covered by 3D seismic, substantially all of its acreage is held by production and it has thousands of wells to drill that will ultimately take production to multiples of the 250 million cubic feet a day that it will be operating by the end of this year.


Commodity price correction: NFX’s revenues, profit and future growth depend substantially on prevailing oil and gas prices. Oil and gas prices have corrected in recent weeks due to the slowing economy and strengthening USD.  

Sunday, April 25, 2010



Although Clearwater Paper's stock has been a significant outperformer and recent tax credits have provide a non-recurring benefit to their earnings, at the current $50 stock price, the shares continue to offer value to investors. We argue that although the most recent 12 months EBITDA of 173mm is an anomaly, its capacity to generate higher levels of cash flow has significantly increased and the company is attractively valued on an absolute and relative basis. The company is well positioned to continue to expand market share in a defensive consumer staple industry and has the potential to increase margins further through growth investments in its toilet paper manufacturing technology. Furthermore, the company has some cost saving opportunities and continues to optimize its investment in the slower growing paperboard business and lastly, the eventual stabilization in housing market correction will reverse the profitability headwind pressuring the lumber segment. The combination of these factors suggest investors appreciate the company's ability to expand its earning power and given industry leading returns on capital, clean balance sheet, and solid free cash flow, may once again, Mr. Market may be mispricing the shares of an underfollowed company in the "not so glamorous" toilet paper industry that could be an attractive private equity target, or a smart investment for a shareholder with long term value orientation.



company description

Clearwater Paper Corporation is a producer of tissue and paperboard products in the United States. The company operates in three segments: consumer products, pulp and paperboard, and wood products. It is the largest private label manufacturer of tissue products including toilet paper, tissue, napkins, and paper towels, sold in grocery stores in the United States. The company's paperboard is sold in the packaging industry and it is used by its customers to make packaging for products, including liquids, pharmaceuticals, consumer goods packaging, such as fast food containers and DVD packaging. The company is vertically integrated and produces most of the pulp required in its tissue and paperboard businesses. The company also manufactures wood products, including cedar and lumber products, a business that has been challenged due to the recent weakness in housing market.

Consumer Tissue





  • Toilet Paper
  • Paper Towels
  • Napkins
  • Procter & Gamble
  • Kimberly Clark
  • Georgia Pacific
  • Kroger's
  • Safeway
  • Albertson's
  • Idaho& Las Vegas
  • 98% pulp processing
  • 100% conversion


The Consumer segment, Clearwater's core business manufactures household private label consumer tissue products and has the highest margins and growth prospects of the three segments. Its products consist of paper towels, napkins and facial and bath tissue and its strategy to offer non-branded products that offer comparable quality & features to the "premium" and "ultra" brands. CLW is the only U.S. consumer tissue producer that manufactures solely private label products and accounts for 56% of all private label tissue products in the U.S. grocery market, and 90% of private label tissue west of the Mississippi River. There are approximately 8mm tons of tissue per year sold in the U.S., of which about 3mm are sold to industrial/commercial users such as hotels and restaurants, and the remaining 5mm are sold to the "Home" market, which is further broken down by "non-grocery-discount" stores such as Wal-Mart, which sells just over half of the "Home" market tissue. The "grocery" channel sells about 2.4mm tons, and about 1/4 of this market is private label. Clearwater holds 56% market share in this category and is significantly larger than its next largest competitor in this highly fragmented market. One risk we would highlight is a relatively high customer concentration, as its 3 largest customers (Kroger's, Safeway, and Albertson's) comprise over 50% of this division's revenue, and just over 23% of total company revenue. That said, the company has significant relationships with these companies and has been supplying them each for over 25 years (top 10 customers average 19yr relationship), and supply chain is very well integrated, making switching costs, while not insurmountable, relatively high.




Pulp & Paperboard





  • Carton & Packaging
  • Plates & Cups
  • Commercial Print
  • International Paper
  • Mead Westvaco
  • Georgia Pacific
  • Rock-Tenn
  • Paperboard Converters
  • International (20%)
  • Pulp Mills (96%)
  • Paperbrd (93%)
  • Arkansas & Idaho


Pulp and Paperboard segment manufactures and markets bleached paperboard for the high-end segment of the packaging industry and is a leading producer of solid bleach sulfate, or SBS paperboard SBS is a premium paperboard grade that is most frequently used to produce folding cartons, liquid packaging, cups and plates, and commercial printing items. SBS is used to make these products because it is manufactured using virgin fiber produced in a kraft bleaching process, which results in superior stiffness and cleanliness.  This segment also produces softwood market pulp, which is used as the basis for many paper products, and slush pulp, which it supplies to the Consumer Products segment. The company has about 13% of paperboard capacity in the United States. Interestingly, while much of the consumer tissue supplying capacity is concentrated in the Western US, Clearwater's Idaho SBS Paperboard facility is one of only two SBS processing operations in the Western US, making it one of the lowest cost SBS producers for Asian importers. Last year international exports drove about 20% of total revenue. Pricing power is somewhat more challenging in this commoditized business, and relative to the consumer business, is much more cyclical and sensitive to volatility in raw material inputs. Wood Fiber drives about 35% of the total costs of this segment, energy costs account for another 15%, and transportation is another 10% of its P&L. Combined with sluggish top-line growth, 20% higher wood fiber costs and triple digit oil prices were a significant headwind in 2008, when pulp & paperboard segment saw its EBITDA drop by 40% YOY and margins down to 6% from 12% the prior year. This business is a slower growing management is focused on cutting costs, leveraging its existing assets to optimize the business rather than investing in top-line growth. This is a cash cow business that requires minimal capital expenditure and just as its pulping operations feed other segments of the business it's free cash flow can feed growth in higher margin higher growth opportunities in the consumer division.





Perhaps the most compelling aspect of the Clearwater thesis is its attractiveness on fundamental and valuation basis. In absolute terms, as well as relative to its peer group, Clearwater offers a very conservative balance sheet, solid profitability and margins, trading at 3X its earnings and cash flow. Using its "normalized" cash flow generation (5 year average) of $125mm and a market cap of 590mm suggests a slightly higher 5X multiple, although the recent housing crisis combined with high energy and input costs have been considerable pressures on the company over the last several years. Furthermore secular trends in the private label tissue markets, moderating costs, and several company specific initiatives suggest that the last 5 years will soon represent a trough period and earning power and its multiple will expand significantly.

The most recent years cash flow generation was somewhat of an anomaly and investors should look examine the company's earning power over a multi-year period to arrive at an appropriate estimate of the company's ability to generate profit. For example, 2009 earnings should largely be considered an anomaly because the company benefited from a tax rebate that provided a cash windfall of about 175mm in 2009. A by-product of their pulp-making process known as "black liquor" has a renewable quality that enables it to be recycled in the manufacturing process and recent legislation has allowed the company to qualify for a tax rebate based on its production of this alternative fuel. It is not known whether this will be future sources of tax relief so it is not included in future forecasts, but could be a catalyst if legislative laws continue the tax benefits.



Attractive Market Fundamentals

Private Label Winning Share from Branded Players: In the United States, about 7.9mm tons of tissues are consumed annually. Of that, about 1/3 is commercial (public restrooms, hotels, restaurants, etc.) and the remaining 5mm tons define the "at home" market, which is further stratified by the discount (Costco/Wal-Mart) and grocery store channel which each sell about 2.5mm tons of tissue per year. Increasingly large supermarket chains are allocating more shelf space to Private Label goods. Retailers are pursuing this strategy because of the improved level of quality that private label goods now offer, and also the increased profitability contribution from private label. The advertising, promotion, R&D, and other expenses that branded consumer product companies incur raise the overall cost structure by 20%-30% over private label manufacturers, whose SG&A lines are not materially impacted by these items. Retailers, on average, earn 10-15% higher gross margins on these products, passing along roughly half the savings to the consumer. Since 2002, private label has won approximately 300bps of market share, growing 8% annually or twice the growth rate of branded segment(4%), and making up 26% of the grocery tissue market (or 19% of total "at-home" market, which includes discount stores, see below). The trend has been to continue to drive quality improvements from private label products, and many of which, such as Clearwater's tissue products, now offer a comparable quality profile to the premium branded products, Charmin© & Cottonelle©.

    Private Label will continue to win market share from national brands for the following reasons:

  • Economics. Retailer earns 10-15% incremental gross margin contribution on private label
  • Negotiating Leverage. Offering non-branded alternatives with comparable quality, provide additional leverage when negotiating with national brands
  • Retailer Brand Enhancement & Customer Loyalty. Offering high-quality private label products can enhance brand recognition and consumer perceptions about their grocery retailer




Defensive Product Categories


Toilet paper is one of the most inelastic consumer products sold. For obvious reasons, tissue is usually one of the last things consumers tend to cut back on in a weak economy. Even in very weak economies as the below chart illustrates, demand for tissue continues to expand.



  • Vertical Integration and High Startup Costs: A typical tissue conversion facility and pulp processing plant with 50k ton annual capacity can cost between 50mm-10mm to build. To maintain cost competitiveness, ensure access to raw materials, and have control over sourcing, manufacturers have vertically integrated operations and most will also invest in on-site pulp processing facilities. Because there are no liquid futures markets or vehicles to hedge price risk of this input, this is an enormous competitive advantage.


  • Geography: Because tissue is a bulky, lightweight product, sold at a relatively low price, its freight costs are significant relative to the volume and dollar value of product transported. A $10 case of toilet paper usually has a freight cost of about $1 when distributed to retailers within a 200 mile radius. Delivering the same unit to a retailer over 600 miles away adds $3 in freight costs. This additional surcharge would result in a 20% higher net selling price, significantly reducing merchandise margin. Because of Clearwater's existing conversion facilities in the Midwest and its low cost access to pulp supply (295k ton pulp capacity in Arkansas) are in relative proximity to the Southeastern United States, the economics of entering that market are attractive, and barriers relatively high as new entrants without existing capacity in the region will be at a cost disadvantage (higher freight costs, higher raw material costs)


  • Consolidation within Branded Segment = Rational Price Umbrella: This is an attractive market structure for several reasons. Because the Branded producers are generally the price setters and private label producers are subject to their "price umbrella", an oligopolistic market structure promotes pricing discipline. The top three players in Branded category, P&G, Kimberly Clark, and Georgia-Pacific are unlikely to engage in a price war, and have a fiduciary duty to shareholders to maximize returns on capital. It is doubtful that Proctor & Gamble would wildly discount its premium brand "Charmin" in the hopes that they drive Kimberly Clark's "Cottonelle" out of the market. Rational pricing is good for the entire category


  • Fragmentation within Private Label Segment: While Branded Segment that makes up 70% of tissue sales is dominated by 3 players, the Private Label segment, dominated by Clearwater, is a much more fragmented market. This places Clearwater in an advantageous position for several reasons. Having more than double the market-share of the next private label producer, it has much greater economies of scale, and likely will have production cost advantage over the smaller players. Additionally, its dominance in the private label market presents many M&A opportunities, should Clearwater decide to expand its capacity in other regions of the country

Company Growth Strategy & Potential Catalysts

  • Geographic Expansion: Company exploring growth investments is the underserved southeastern US region: CLW announced it will build two tissue converting lines in the Southeast, expanding existing production capacity of 210k tons per year, by another 20k tons, or about 10% production growth. This has been announced and likely baked into earnings estimates. This region of the country is significantly underpenetrated and the private label market tends to be much more fragmented and the company believes they can take significant market share in the region by being closer to the customer. As a rule of thumb, customers located outside of 500 mile radius will see freight charges of up to $3.00 per $12.00 case (25% higher end cost), because of its shipping inefficiency (bulky & cheap). In addition to freight costs for finished products, having access to a reliable, low cost source of pulp supply is also key competitive advantage. The 295K ton capacity pulping facility in Arkansas & its relative proximity to Southeastern US, is a key competitive advantage as Clearwater expands in the region


  • Mix improvement: The company is also growing its capacity at the high end "ultra" soft market, which will contribute nicely to the segments sales mix, as high end tissue can sell at prices 2x the price per ton of single-ply budget tissue. Specifically, the company is also evaluating the purchase of a TAD paper machine (through-air-dryer technology is required to generate high end tissue) to incorporate into the southeastern expansion. This machine has a capacity of 70k tons per year, which would require an additional 5 conversion lines, in order to ensure the TAD machine is not underutilized, and the fixed costs of the investment are leveraged effectively.


Through Air Drying investments will increase capacity in higher margin "ultra" tissue products, contributing favorable to Clearwater's revenue mix. TAD Technology enhances tissue softness & absorbtion properties by air drying wet tissue rather than the traditional method of pressing & creping together tissue ply

  • Higher quality tissue: over 30% softer and fluffier
  • Better absorbtion properties (50% more liquid absorbtion)


Kimberly Clark, Proctor & Gamble and Georgia Pacific have made enormous investments in TAD technology over last decade. Procter & Gamble and Kimberly-Clark whose product lines are focused on Cottonelle© Premium Charmin© Ultra brand categories have converted 100% of their manufacturing capacity from traditional "Yankee Drum" to "Through-Air Drying"

Other Benefits

  • Input costs: increased efficiency of fiber use (less fiber per roll required)
  • Significant COGS reduction (fiber=30% COGS)
  • Lower weight/case (lower shipping weight)


  • High capital cost (40% more costly)
  • Higher energy demands (15% of COGS)
  • Yankee produces greater stretch/tensile


injecting hot air and weaving wet tissue ply


traditional method "pressing & creping" wet tissue ply






Management Integrity, Shareholder Orientation & Accounting Transparency

Business is simple to understand and accounting systems are transparent and relatively straightforward. Furthermore, management appears to be focused on creating shareholder value. In evaluating capital projects management maintains a strict policy of requiring a 9-10% investment hurdle rate, and prioritizes its capital spending in a way that maximizes ROI. Additionally, management's prudent balance sheet minimization during a period of uncertainty shows a disciplined, shareholder friendly use of cash flow during a period of credit contraction. A net cash position puts it at an extremely advantageous position relative to competitors who may now lack to the flexibility to finance growth projects, or be forced to pay much higher rates of interest to finance growth initiatives. With its financing now in order, the company is making a measured, thorough evaluation of various growth alternatives, and will soon make more calculated strategic decision about its southeastern growth initiative.


Valuation: Wide Margin of Safety, Conservative Inputs

Our DCF Analysis assumes a sharply downward sloping growth rate from 10% to a terminal growth rate of 2% as well as a Discount rate of 11% and terminal multiple of 10X. We also used consensus estimates for 2010-2011 and management guidance for capital expenditures. Given these inputs, we arrive at an intrinsic value of $73 for the shares or about 35% premium to current trading price


In conclusion, I believe at the current stock price of around $50 per share, CLW shares offer investors a considerable upside opportunity and also some significant downside protection.






Friday, January 23, 2009

Black Swan Hunting

In my years as an investor and a professional in the financial services industry, I have not yet been able to find anyone who can accurately and consistently forecast future market events with any degree of accuracy. In my view, any and all forecasts are, at best, educated guesses. Many brokerage houses and investment banks have literally dozens of in-house economists that dedicate their careers to identifying changes in the economy before they happen, when in reality we have found that, no one truly knows what tomorrow will bring. In a survey of Wall St. economists taken one year ago, the "consensus" view was that the likelihood of recession was less that 40%. One problem with these forecasts is known as the "Black Swan Theory", popularized in a book by Nassim Nicholas Taleb, that recounts a 17th century scientific experiment as a metaphor for a deeper philosophical question about human behavior. In the book he argues that we place too much weight on the odds that past events will repeat, using statistics and the scientific method. Instead, the most impactful events are those that are rare and unpredictable. Aside from their obvious human tragedy, events occurring in the last decade such as the tech/telecom bust, 9/11, hurricanes of 2004, and the current credit crisis have been powerful examples of highly improbable events that have had a profound impact on history and our portfolios.

While I would agree with his conclusion, I would argue that there are 2 kinds of predictions that, when applied consistently, have some value to investors and should be considered in the investment process: One is opportunity-based, and the other is risk-based. Risk based forecasts are applied extensively in the asset allocation process. First and foremost, when constructing and maintaining portfolios I believe that by applying a consistent and disciplined strategy balancing growth, income, and alternative asset classes you can successfully reduce exposure to inflation, currency devaluation, credit risks, and declines in corporate and consumer spending. While we can add value by tilting these beta exposures in response to cyclical and fundamental changes, anchoring the portfolio from these risks increases the likelihood of long term success of the strategy. One tool used in determining these allocations is known as "Monte Carlo" analysis, in which a computer effectively recreates over 10,000 portfolio outcomes or "rolls of the dice" in order to effectively determine which weightings are most appropriate, Because a "black swan" can have such a large impact on our portfolios, and are so as hard to predict, we should continue to embrace diversification.

Probability assessments are typically based upon historical comparisons of prior markets with similar characteristics: The more variables that align, the higher the likelihood that a given scenario plays out in a similar fashion. While I admittedly did not anticipate the magnitude and depth of the current crisis, I have been, and continue to strategically position assets away from financial, consumer discretionary, and cyclical industries, in favor of increased weighting toward healthcare, staples, and utility stocks, which are generally a safe haven during periods of market duress. Many times these types of comparisons require going back in time, to make a thoughtful judgement about the future. A recent decision to sell a position in Schlumberger (SLB) was based on an analysis of the oil services industry and its sensitivity to economic events that happened in 1974 and 1981.

Another way to improve the likely outcome of the portfolio can be seen within the research process itself. As access to credit and free flowing spigot of the capital markets becomes sealed temporarily, I have rigorously approached each holding as "credit analyst" would, rather than simply an equity analyst. Reviewing debt covenants, credit facilities, and near-term spending needs for each company owned has become routine. I am highly confident that these actions have minimized risk, and recent additions to the portfolio like Alcon, Stryker, and Google, further improve quality of the portfolio with their pristine balance sheets and strong cash generating ability.
Probability assessments are not only used as a defensive mechanism, but also as tool used in search for opportunities within your investment universe. To illustrate this concept consider an investor with the following investment opportunities presented to him/her: Opportunity A) a $1mm investment that offers a 20% return, with an 80% likelihood of success. Opportunity B) a $1mm initial investment with a payoff of 50%, but only a 50% likelihood of success. At first glance, most people would pick opportunity A, because if its relative certainty, but a more informed investor would actually pick the second opportunity, because the probability weighted expected value is actually higher (250k vs. 160k). This type of analysis is used extensively when evaluating an E&P company with a portfolio of oil or gas reserves, with differing levels of profitability and probability of drilling project success.

When thinking about constructing your portfolio in a way that is aligned with your view of the world, it is important to have an investment paradigm or framework in place to guide decision making in a disciplined and consistent manner. Mohammed El-Erian, former manager of the Harvard Endowment, and currently a bond portfolio manager at Pimco, uses the analogy of a 6 lane highway, to illustrate how to benefit from our perceived systemic changes to the investment landscape. He believes that investors can benefit by identifying a handful of growth themes (lanes of highway) in a portfolio, that may take several years to materialize, but investor can shift vehicle to avoid traffic (risk exposures) but needs to stay within the highway barriers (investment process). Within the framework of an investment process, we can add value in a similar fashion.

In the near term I anticipate weak consumer and corporate spending environment, however, recently announced government stimulus programs around the world may offset some of this weakness. President Obama recently announced a $700B program designed much like the "New Deal" with huge investments in transportation, telecommunications, healthcare, and power grid infrastructure, are likely to benefit many of our holdings. Norfolk Southern should benefit from improvements to the nations rail network; companies like Cisco Systems, Citrix, and Google will benefit from the "networking" of America's schools and institutions, and names like ABB and ITT will surely benefit from increased spending on infrastructure and energy efficiency.
While none of us has a clear “crystal ball” to foretell the outcome of current economic situation, history tells us that it is likely to be longer and more complex than most people anticipate, and controlling risk needs to remain the top priority in your portfolio. That said, with risk comes opportunity. Many of the darkest, most uncertain times in our history, were times that presented the greatest opportunities for investors. We continue to strive to find those opportunities without taking unnecessary or excessive risk.

Thursday, November 13, 2008

While the consensus thinking is that MLP’s may have difficulty accessing capital to fund future growth projects, I believe the valuation adequately discounts these risks, and in general, MLP’s are an attractive investment vehicle for the following reasons:

-Historically very low correlation to traditional equity and fixed income asset classes, and surprisingly low correlation to price of oil (co-variances of 10-30% to equity and fixed income) making them a great portfolio diversifier during times of uncertainty

-Attractive source of relatively stable income (yields ranging from 7-10%), particularly during periods of declining interest rates and volatile equity markets. With 10 year treasury yielding 3.9% nominally, and much less in real inflation adjusted terms, the value proposition of an 8% dividend is compelling

-Annuity like cash flows, similar to utility or infrastructure plays, due to inelasticity of demand provide dividend visibility. Whether the price of oil/gas falls, it still needs to be transported to the end user. A majority of an MLP’s cash flow is fee based on the volume of oil/gas that is distributed.

My analysis suggests that Oneok is one of the most well positioned MLP’s, trading at a reasonable valuation, and is therefore poised to outperform its peer group (Alerian MLP index is most comprehensive) over the next several years

On a relative basis, Oneok generates a greater % of its EBITDA through the storage and refining of natural gas, vs. other pure play pipeline/distribution business models. Just as Valero (a refinery company that we owned in 2006-2007) earns excess returns by running complex refining system capable of converting abundant & inexpensive heavy-sour crudes in to higher value grades of distillates and gasoline, Oneok benefits from similar dynamics as it converts domestically produced natural gas into LNG (liquid natural gas) used in many commercial applications, and increasing as an alternative to gasoline and diesel. The energy content ratio of 6X, is largely “out of whack”with the $6:$70 NYMEX (Nat. Gas) vs. WTI (Light Sweet Crude Oil) relationship. This increases the value proposition of the conversion & refining process, and leads to higher margins for Oneok (about 40% of cash flow) (40% pipeline, 40% refining, 20% storage). In simple terms, there is a wide price differential between raw inputs & prices paid by the consumer.

Well positioned infrastructure near high growth gas areas like the Barnett Shale, the Anadarko Basin, and Fayetteville Shale in Oklahoma. High levels of asset turnover(revenue growth/asset growth) are indicative of highly productive and improving asset base. Management has exercised capital discipline in acquiring these assets. One new area of investment has been the Woodford Shale, a resource we are very familiar with given our investment in Newfield Energy. As the chart below indicates, you can see the secular growth in production that these unconventional, mid-continental shales are experiencing.

The company has a relatively high ratio of unregulated “intra-state” pipelines, vs. “inter-state” pipelines, which are regulated by FERC who typically allows no more than a CPI-linked price increases, and generate regulated utility-like ROE’s of about 10-12%. Essentially this is a volume story, not a pricing story, but the prolific nature of the mid-continental shales (Barnett & Woodford) with their low decline rates and the application of more sophisticated technology like horizontal drilling techniques are increasing the daily output from these areas.

Most importantly, the company looks healthy than most of its peers from a financial perspective:

-Strong balance sheet – The company has industry leading interest coverage ratio, low debt/EBITDA, and has relatively minimal capital needs to fund near term growth

-Distribution coverage ratio – cash flow generation ability vs. expected dividend payouts. The company is believed to have one of the most secure dividends because of its strong cash flow coverage and consistent growth in payouts.

-Capital Spending budget analysis We believe that OKS has lower risk of missing its growth targets over the next 2-3 years because the bulk of its capital investments have been made in 2007 & 2008, and on a relative basis, should be much less reliant on re-accessing the capital markets to fund its growth promises and maintain its dividend growth rate.

Investment Risks

We remain bullish on the MLP investment thesis presented last week but will continue to be vigilant of the following risks

1. potential conflicts between limited and general partners – to date, this has not been an issue, but voting control does lie in the more leveraged and less profitable GP structure

2. Access to capital markets & post 2009 capital budget needs – in late 1970’s there was a boom in MLP development, followed by a huge bust in the mid-1980’s as energy prices collapsed & access to credit became more difficult. While we have extensively reviewed the companies capital needs over the next 2-3 years, should the company need to greater than expected amounts of capital that it has communicated to investors, and credit conditions remain tight, this could hamper growth.

3. Regulation risk - any changes to their laissez-faire approach regulation during times of consumer and economic contraction. Does new democratic administration have any tax law changes that would jeopordize MLP’s tax status?

4. Natural disasters – While the company does have insurance for these types of events a major hurricane outage could put near term revenues at risk until pipelines are replaced

Given the volatility and poor returns in the market lately, investors should continue to look for new alternative sources of growth in their portfolios, and I believe that MLP’s offer investors a great opportunity at these prices

Thursday, June 19, 2008

ABB: Well Positioned to Create Value in "Energy Efficiency" 
One exciting investment opportunity identified through a fundamental/earnings quality screen that I run periodically is ABB Ltd. ABB is a Swiss conglomerate that provides a wide range of products and services to the power and automation markets. A recent earnings warning from Siemens, another European conglomerate that competes in similar markets, dragged the stock down in sympathy, and now trades at an earnings multiple slightly less than its long term growth rate. I felt the problems at Siemens were company specific, and the market reaction of ABB was unwarranted, creating an opportunity for long term investors to own a great business at a reasonable price.

The investment thesis on ABB is relatively straightforward. ABB has smartly positioned itself as an “energy efficiency” solution provider. Its products & services can be found at every node of the energy value spectrum, resource production, transportation, por generation, por transmission & distribution, and even consumption. Here is a sampling of the types of solutions that ABB offers:

  • motors that efficiently por deep-sea drilling rigs
  • marine propulsion systems that transport the oil
  • substations, circuit breakers, capacitors used in electricity generation
  • high, medium, low voltage transformers used to transmit and distribute energy across
  • power grid automation, robotics, and variable speed drives/motors that drastically reduce industrial consumption
ABB is well positioned competitively to maintain its leadership status in most of the markets it serves. An enormous installed base, economies of scale, and a core competency in efficiency solutions provides the company with an enviable competitive moat. It's industry leading R&D budget that has generated a voluminous portfolio of intellectual property and innovative new products has galvanized this edge over the competition. Lastly its global footprint positions ABB favorably to benefit from rapidly growing emerging markets. Only 15% of revenues are generated in the US, and almost 40% from fast growing emerging markets. Interestingly, its leading market share in Asia is likely remain firm, as customers in that part of the world place greater emphasis on business relationships, and are more likely to award new contracts to their existing network of suppliers, a Chinese social custom known as Guanxi.

New Infrastructure needs to be built to support electricity demand in emerging markets-
As a provider of infrastructure & energy efficiency, ABB finds itself in a “perfect storm” of end-market demand. Emerging market electricity demand is expected to grow from 8B kilowatts per hour to 16B kw/h over the next 20 years. As population and GDP grows in these parts of the world, new infrastructure will be required to provide the energy to fuel that growth.

Existing Infrastructure in developed markets needs to be replaced -
Wall St. as ll as the entire northeastern US remember the summer of 2005 por outage in that left more than 20% of the US population in the dark for nearly 24 hours. A huge capital investment cycle in the 1960’s and 1970’s follod by a long period of neglect has left the US por grid in brittle condition, and as the head of the EIA describes, “one or two heat waves” away from crisis. The average US transformer is over 40 years old, ll beyond the average life expectancy for that type of equipment.

Energy Efficiency – The low hanging fruit of the green movement. While less “sexy” than other green investment opportunities, efficiency improvements are the low hanging fruit of the energy problem. 65% of energy use and CO2 pollution can be attributed to motors and engines. ABB’s variable speed drives and motors can significantly lor energy consumption and pollutants, yet in the US are used marginally (only 5% penetration). For perspective, consider that the installed base of these drives/motors in Europe has reduced annual consumption of energy to a level equivalent to 32mm households (1/3 US households!) and reduced yearly CO2 tonnage by the amount that the entire country of Ireland emits on an annual basis. Throughout the energy value chain, ABB believes it can reduce waste by about 20%, generating low-risk, high return on investment opportunities that businesses and governments will find hard to walk away from.

Renewable Momentum – Remote energy sources (solar/wind) will require transmission
Renewables – Public & legislative momentum as ll economic parity with traditional coal, gas, & nuclear fired por plants, is stimulating demand for renewable energy sources around the globe. While wind and solar por have become a meaningful part of the European por grid, the US still only generates about 2% of its electricity needs from such sources. Because renewable por sources are often great distances from the population centers that they serve (think Arizona!), infrastructure such as high voltage transformers must be used to effectively distribute the energy. ABB is the #1 player in this type of equipment.

Catalysts & Low Expectations may drive upside surprise for investors
In addition to these growth drivers, ABB has a great balance sheet, which could be a catalyst for the stock. The company has paid off most of its debt and now boasts a net cash position of over $6B, which can be used as competitive ammunition, for strategic M&A, or simply can be returned to shareholders through dividend or share buybacks. Expectations are modest relative to recent results, and believe the 10% earnings growth that Wall St. is anticipating will be easily surpassed. A closer look at the company backlog reveals a visible stream of high margin revenue yet to be realized.

Fundamentals & Valuation very attractive – Price target of $43
Returns for the company have been strong. Margins have grown from 5% to almost 12%, and the company sees 18% margins down the road as internal goals are met. Return on invested capital is ll over 20% highlighting quality management and focus on creating shareholder value.

Valuation is reasonable. For a company growing earnings at a 20% rate over the long term, a P/E of 18 represents a fair value in our opinion. This is a 20% premium to the market, but would argue growth prospects and profitability deserve an even greater premium. I am also comforted by the free cash flow yield of just over 4%, and annual free cash flow generation of about $4B. Using relatively modest assumptions (about 10% long term growth) and a 8% discount rate, I arrived at an intrinsic value of about $43 for the shares.  In conclusion, I found it difficult to poke holes in this investment case. While the world adjusts to $130 oil, terrorism, and a rapidly growing population, ABB’s products and services address some very real problems. We may not be able to find more energy, and it may take several years to find alternatives, ABB offers solutions to get much more out of what have, today.

Saturday, February 16, 2008

How Mother Nature Can Grow Your Portfolio

If a tree falls in the woods, does Wall Street hear it? Clearly not, judging by the wide discounts to intrinsic value being awarded to names in the Timber REIT sector. Based on my analysis of private market value, the three largest timber REITs, Plum Creek, Rayonier, and particularly Potlatch Corp. offer investors a wide margin of safety, relatively stable cash flows, and a healthy dividend yield.

Perhaps the most compelling argument for an investment in timber lies in the risk reduction benefits that timber can add to a growth focused portfolio. Backtesting 20 years of data from the NAREIT Timberland Index, in addition to a portfolio of US stocks, intl developed, emerging markets, and bonds reveals remarkably low correlation, while generating long term returns of almost 14%. The correlation with equities was less than 10%, providing "bond-like" diversification, with returns that would be expected from smallcap or emerging markets. As these risk/return characteristics continue to improve the opportunities along the
efficient frontier, the optimization models that institutional investors base their asset allocation on will continue to overweight this asset class. Many highly regarded asset allocation gurus, such as David Swensen, who manages the Yale endowment, have been long time proponents of adding real assets, such as timber, to a well diversified portfolio. That said, as of this past Decemeber, the average institutional portfolio only held about 1% of their assets in timber, a far lower allocation than the efficient frontier would suggest as optimal.

Within the Timber REIT sector, one of the more attractive companies is Potlatch Indstries. Potlatch owns about 1.7mm acres of timberland in Arkansas, Minnesota, and Idaho. The company is vertically integrated with higher margin businesses such as resources (timber harvesting) and real estate sales, offset by its lower margin, downstream businesses such as wood products (lumber), pulp/paperboard manufacturing, and consumer products (off-label tissues). This provides the company with numerous growth levers and allows
them to more effectively manage volatility in its business. For example if timber pricing is weak, the company may delay its harvesting activities, choosing instead to generate cash with its manufacturing operations and real estate sales. Importantly, there is minimal opportunity cost when the company delays its timber harvest as trees continue to grow biologically. On average, trees grow between 3-6% per year.

After recently filling the CFO post with Eric Cremers, who recently orchestrated the splitup of Albertsons, it is clear that the company is focused on creating value for shareholders. Based on my analysis, there is plenty of value that can be monetized. Using data from 30 of the largest private market transactions over the last 5 years, US timberlands have been sold at roughly $800 per acre. The most recent data, published by industry journal, Timber Mart South, indicates timberland transactions have been averaging $1400 per acre. Lets be conservative, and use the 5 year average. The company also has 225k acres of HBU land (or higher or better
use land) that the company conservatively believes can be sold at $2000 to $4000. After conferring with industry sources, and considering that competitors Plum Creek and Rayonier value their comparable HBU land at $4000 to $10000, using $2000 per acre as a base-case scenario should provide a margin a safety in the analysis. Assigning these values to the 1.5mm timberland acres and the 225k HBU acres, subtracting debt, and applying a trough 6x EBITDA multiple to the the manufacturing businesses implies a total enterprise value of about $56 per share for Potlatch. At its current $40 stock price, the risk reward is quite favorable. Furthermore, a dividend yield of 5% should offer investors a healthy stream of income as we
patiently await for catalyst to develop and the intrinsic value to be realized.

Thursday, November 29, 2007

Adobe Corp: Riding the Wave of Web 2.0
Given the recent volatility in the market, I have slightly modified my screening process placing a slightly greater emphasis on strong topline growth, earnings consistency & clean balance sheets, the qualities of companies that tend to trade well during times of economic uncertainty. Obviously, I am not the only investor seeking a safe haven in this market, and the redirection of money flow into these stocks has driven their prices and P/E ratios up. Stocks like Proctor & Gamble and Microsoft are at their 52 week highs and trade at P/E multiples much higher than historical averages. Although my investment approach is rooted in value investing, I am willing to pay a premium for stability in this environment. After all, the great Warren Buffet has even been known to pay up for quality during times of turmoil, as evidenced by Berkshire's late 1980's purchases Coca Cola and Gillette.

My search has led me to Adobe Corp. Most everyone that owns a computer in the developed world has at one time or another used Adobe Acrobat(900mm installed base). Adobe utilizes a "reverse razor blade" strategy by distributing free copies of its reader product to PC manufacturers, and generating its profits on sales of its writers, or applications used to create communications in PDF. format. This creates enormous competitive moat for the company and allows it to generate strong returns on its invested capital.

Not only does the company have strong competitive position, but several growth catalysts are emerging that should increase the visibility of earnings growth and likelihood of upward revisions. From an industry perspective, the outlook is bright. Enterprise roll-outs of Vista (Microsoft) and insatiable consumer demand for notebooks is expected to support PC/Notebook shipment growth of over 11%-13% according to Gartner and IDC forecasts. Most of these machines will come pre-installed with Acrobat software. Furthermore, the popularity of web-communities such as myspace and youtube is resulting in exponential growth in the number of websites and the need for creative content solutions.

Internally, the company is intently focused on its recent launch of CS3 (Creative Suite 3), a suite of tools used by creative professionals and consumers that want to use computers to create their own websites, blogs, and share media with family and friends. With the recent acquisition on Macro-media, known for their popular flashplayer technology, the new product offers much greater video functionality for web-developers and should generate significantly higher per unit margins than previous rollouts. Since 2003 the average selling price of ADBE's product mix has grown from about $250 to $400. This trend should continue. Going back 20 years, I found a strong correlation between product launches and accelerating sales trends. Given that CS3 is anticipated to be the most successful launch ever for the company, revenues are poised to follow the historical pattern of post-launch growth. On its most recent conference call Adobe management pointed out that penetration rates among creative professionals are 40% higher than previous releases at this point in the product roll-out cycle (launch + 6 months), due to the products growing popularity and enhanced functionality.

Additionally, new product launches in mobile applications should gain traction in 2008. The number of of "flash enabled" devices sold per year has grown from about 50mm to 250mm in just the last 3 years. Interestingly, most of the developing world (and over 60% of the worlds population) will access the internet for the first time via a mobile device, so the enormous opportunity here is clear. There are indications that the company will launch a mobile product in 2008.

Lastly, the company is making significant strides within the enterprise marketplace through a recently announced partnership with SAP which should dramatically increase the Adobe value proposition within large organizations. Longer term, the company has been beta testing a new html-based architecture known as AIR that will make web content creation much more accessible to the masses. As the operating system continues to look more and more like a home-page, applications such as AIR will be at sweet spot of this technological evolution. At a recent conference management indicated that internally, they think AIR has the potential to do for internet content development what Acrobat did for document management. The company expects numerous product launches based on the AIR technology, as this next generation "razor blade" gains mass acceptance.

Fundamentals & Valuation
The company should earn about $1.85 next year, which means it trades at about 22x earnings at the current price of 42. They do have over $6B in cash & equivalents on the balance sheet, so adjusting for cash we are paying about 19X, not cheap, but not ridiculous either for a company that generates ROE's of 25% and is expected to grow at 16% over next several years. I also like to look at free cash flow, and as expected with any software company, Adobe is a cash machine. The company has well over $1B in cash flow earning power, which is healthy for a company with an net enterprise value of about $18B. Based on my DCF analysis, which assumes consensus growth rates, a discount factor of 10%, and a terminal multiple of 18X, the stock is intrinsically worth about $50 per share, a modest margin of safety.

This isnt a classic value stock, and any execution missteps with the new management team do pose a real risk to the thesis given the premium we are paying. I have met the new management team, and they have been well groomed internally, and largely seem to be thoughtful, shareholder friendly managers. Not a risk free story, but when the market gyrations have you reaching for the Pepto, a stock like Adobe, might let you sleep a little better.