Best of Newsletter December 2016

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How to Hack Wall St. On Sale

As promised, I have set up a sale for my first book, How to Hack Wall St.  The sale will start on Tuesday, December 6.  The book will cost just 99 cents.  On December 9, the price will jump up to $1.99 and then on December 13 it will return to the current price of $2.99.  I will send a reminder email on Tuesday when the sale starts.
For more on the content of the book, jump to the break below.  Before the break I will tell the story of how the book came about.
At some point in 2014, I read a Quora answer from James Altucher on the best way to start an online business.  His answer was with eBooks.
Experts – and everyone is somewhat of an expert on something – can write a series of eBooks on a topic, start a website on that topic, use the eBook to create a mailing list and then use the mailing list to drive sales of future eBooks, affiliate products, etc.
This piqued my interest.  I had written tons of blog posts in the past and at the time was in search of a friend to send investing and economic rants to.  Why not combine these two interests?
So I used maybe 20 pages of special situations articles I had written in the past, added some case studies and some more special situations, created a portfolio and published the book.
Not a whole lot happened.
I shared the book on Facebook and LinkedIn – though I was too afraid to tell more than two or three people at work about it.
Over time I have sold maybe 40 copies of the book.  I did a paperback version and signed copies for some of my parents’ and Grandpa’s friends.
One day I went to look at the book Amazon page and two terrible reviews had appeared.  Both complaining about the lack of drilling down I did into the strategies – despite the fact that the description shows a $3 book of 40 pages. Oh well.
Going forward I will continue to manage and update the portfolio that was established in the book.  The book is still relevant and I still subscribe to the strategies in it, but I still plan to write a second version cutting out some chapters and adding more content.  So, if you end up purchasing a copy, please consider leaving a review.  Need to get that average over 1.5 :-/
Filling out the Special Situations Portfolio
In honor of this amazing sale, I decided to use some of the cash hoard that has built up in the portfolio and found three ultra exciting muni-bond closed-end funds trading at a discount.  Nice.  You can find the article about them here.
Confessions of a Teenage Investor Sample
As some subscribers know, I have been working on my next book, Confessions of a Teenage Investor, for the past several weeks.  You can find its introduction here.

The book is a traipse through old blog and message board posts I made in my teenage years as I was learning investing.  I have gone through and copy edited the posts and added footnotes in order to make fun of myself, update returns of specific stocks and highlight lessons to be learned from each of the articles.
Below is a sample post I wrote in December 2005 on American Eagle, which was my favorite clothes brand at the time.
As you’ll see, my analysis often had good intentions and a good foundation – but in the end it was almost always totally off base, simply because I was chronically too optimistic about brands that I used and loved.

WEDNESDAY, DECEMBER 21, 2005

American Eagle, like Warren Buffet

I recently finished reading How to Pick Stocks Like Warren Buffett: Profiting from the Bargain Hunting Strategies of the World’s Greatest Value Investor.

The third part of the book is about analyzing companies like Buffet, here I will analyze a company that currently interests me: American Eagle.[1]

Valuation

The first chapter is about valuation, mainly Discounted Cash Flows. I’ll use 12% as my first five years growth, 8% for the next five years, and 3.5% terminal growth. $366 million will be my cash flow number.[2]

 

> Five Years 8%

Terminal 3.5%


Discount Rate 11%
Year Cash Flow Discount Cash

1 $409.92 1.11 $369.30
2 $459.11 1.23 $372.62
3 $514.20 1.37 $375.98

4 $575.91 1.52 $379.37
5 $645.02 1.69 $382.79
6 $696.62 1.87 $372.44
7 $752.35 2.08 $362.37
8 $812.54 2.30 $352.58
9 $877.54 2.56 $343.05
10 $947.74 2.84 $333.78
First Ten Years $3,644.29


Add Terminal Value $4,606.16

Intrinsic Value (Per Share) $54

This model gives a value of $54; more than twice the current value. But the DCF is not all powerful, and sometimes ignoring is better than relying.

Book Value

Mr. Vick says book value is Buffet’s favorite yardstick for growth. Here’s American Eagles ten-year book value growth numbers:

 
Year Book Value Growth Earnings Growth
1996$71.10–
1997$90.8027.71%230.51%
1998$151.2066.52%177.44%
1999$264.5074.93%67.65%
2000$367.7039.02%3.42%
2001$502.1036.55%12.47%
2002$577.5015.02%-15.92%
2003$643.7011.46%-32.36%
2004$963.5049.68%255.50%
2005$1,136.3017.93%27.47%
Average37.65%80.69%[3]

American Eagle’s book value growth is extraordinary. The growth was consistent, as compared to earnings growth which was powered by four main years. However there are bad ways a company can grow book value, I will examine those now.

Issuing Shares

Companies can easily grow book value by issuing more shares. While this grows cash, it also dilutes the value of shares. American Eagle has 15% share growth during the past ten years, compared to book value which has grown a total of 1,498%; share dilution is not a problem.

Acquiring other Companies

I also don’t believe AEOS has been acquiring other companies to fuel growth.

Letting Profits Sit Gathering Interest

American Eagle has been sufficiently investing cash back into the business. Quicken estimates American Eagle has created $4.98 in market value for every dollar of retained earnings over the past five years.

Return on Capital

Return on capital shows the life-blood of a business. I will use Net Income / (Average Equity) + LT Debt. I will use a method described in the book to see what earnings growth is needed to sustain its current ROE.

American Eagle’s current ROE is 20%.

Assuming Equity will grow about 21% a year American Eagle must grow earnings 14% a year to sustain a 21% ROC. The industry’s current ROC is 15%, American Eagle is above this, but it could do better, and may have a hard time in the future maintaining a good ROC.

Hurdle Rate

The book says Buffet looks for a ten-year hurdle rate of 15% CAGR before investing. I’ll go a little further and look for 20% CAGR over 5 years.[4]

Over the last ten years American Eagle has had an average P/E of 19.6x, I will use this to project the future price for my hurdle rate calculations. I’ll also assume a twelve percent earnings growth rate, and a 15% dividend payout.


Expected 2010 price $ 54.59
>> Dividend $ 1.69
Total Dollar Amount $ 56.28
Expected 5y Return 168%
CAGR 21.79%

American Eagle passes the hurdle rate test, if it can grow earnings at a twelve percent rate for the next five years, and then trades at a P/E of ~19.6 the compound annual return should be about 22% per year – not too shabby.[5]

Putting Growth in Context

Even Buffet admits estimating growth for a company, outside short periods, is not exactly a walk in the park.[6]

Vick suggests using Quicken’s stock evaluator to judge the earnings growth necessary to justify the current stock price – inversing the DCF.

Using a 15% discount rate the stock evaluator says American Eagle must grow its earnings only 2.3% to justify its current stock price.[7]

Comparing Stocks to Bonds

Buffet won’t buy stocks unless its earnings yield (e/p) is greater than an average bond yield.

Using Morningstar’s yield comparison I see American Eagle’s earnings yield is almost double that of a 30-year T-Bill.

[1] I had an embarrassingly strong reliance on American Eagle clothes in High School.  The clothes I wear today is slightly better and almost always has a Packers logo on it.

[2] We’ll have to make-do with the numbers from the past ten years because that’s all Morningstar has.  The average growth for the first five years was -10% on 1% average revenue growth.  The second five-year period boasted stronger revenue growth at 2.5%; this did wonders for a scorching cash flow growth number of 10%.  The ten-year average was -18%.  Whoops.

[3] This growth collapsed harder than a ____, for the past ten years, book value growth averaged -3% per year.  This was due to excruciatingly bad performance.

[4] So far the main lesson to be learned from this analysis is to require 20% annual returns from teen-based retailers.

[5] American Eagle failed both goals massively.  As before shown income crashed like an asteroid that Bruce Willis was on and the current PE, at 13.5x, is almost 50% lower than expected.

[6][6] Talk about a prophetic statement following a batshit crazy one.

[7] As I have made clear, it couldn’t even achieve that easy goal.

Trade Like Warren Buffett Notes
For whatever reason self-help guru James Altucher has disavowed his older trading/investing books, including one of my favorite Buffett books: Trade Like Warren Buffett.

In a sea of bland-same-old-conservative-value-Buffett-books, Altucher’s evaluates the out of the ordinary strategies Buffett pursued and ends the book with interviews of two of my favorites hedge fund managers: Mohnish Pabrai and Zeke Ashton.

I have devoured this book at least seven separate times and much of it led to the techniques I wrote about in my first book.

The strategies that Altucher describes include: Merger Arbitrage, Relative Value arbitrage, Junk Bonds, Closed-end fund arbitrage, PE ratios and market timing and disasters.

Portfolio Review
As I repeat endlessly in these emails and tell myself during lazy Sunday nights when I would prefer to lie down and watch football, the creation and consistent following of several portfolios is the backbone of this site. Followed closely by run-on sentences.
My goal is to establish strategies that combine passive and active elements, and I have several along that fit that description. The most passive is the asset allocation portfolio, which gets re-balanced once per year (and we’re doing that today!) The most active is my personal portfolio, in which I have several long-term names and several trades (and we have a new trade today, what a deal!).
To find all the portfolios, visit the portfolio page on the website.
Note: we will not update the Hack Wall St. Portfolio today – we just went over it last week and I’m sure the twelve people who read that have had enough Wall St. Hacking for the month.  If you’re really into Wall St. Hacking, here’s the article that I wrote last week.
Asset Allocation
We’ll start with the fun one.  Our asset allocation portfolio is an attempt to diversify away asset class and geographic risk, while also earning a consistently strong return over time.
The strategy includes an annual re-balancing – taking money out of potentially overpriced asset classes and putting it into undervalued ones.
Here is the what we had to do (the portfolio had an original fake value of $100,000):
Junk Bonds -$79.76
Emerging Mkt Bonds $148.81
Gold & Silver $1,541.30
Commodities $15.37
Oil Stocks -$304.55
REITs $466.34
Int REITS $742.58
Dividend Stocks -$274.12
Global Momentum -$84.19
Shareholder Yield -$1,367.60
Global Value -$664.65
CASH -$139.55
Positions with positive values had more shares purchased, which were funded by the sales of positions with negative numbers.
The Shareholder Yield and Global Value ETFs, which both had positive gains (Shareholder Yield was up 11%), are doing the most work in the portfolio. They make-up for the piss poor performance in Gold & Silver and the REITs.
Market Timing
We debuted the Market Timing portfolio in the last exciting portfolio review letterand it has since taken off like a rocket.  I should quit my job and start timing the market tbh.
An 18% gain in our Uranium minor, Cameco, and a 12.4% gain in the Russia stock market ETF has pushed the portfolio return to 3.5% – blazing past the S&P 500 return of just 3%.
Investors were pleased with Cameco’s third quarter results and I can only assume formerly scared investors charged into Russian stocks following the incessant articles about its government influencing the US election. If you can hack the DNC’s emails, why can’t you run a profitable oil company?
My Portfolio
There’s only one new trade this month (new readers can find my trading strategy here).  I’ve made hay in the past buying oversold story stocks and this trade should follow that same path.
Fitbit has fallen 70% this year and even more from its 2015 IPO price.  My fiancee and I have each loved tracking our steps and hated tracking our calories with the app and have become somewhat addicted to the weekly step challenges with friends and family.  I seem to diverge from the typical market thinking in believing that the company is building a strong network effect in its challenges, calorie tracking and scale integration.
So when I determined the stock was oversold (I spared you the pain of loading a bunch of stock charts in this email by putting them all in a post on the site) I lunged at the opportunity to build a position.
For the value guys, the stock trades for just 0.8x sales and 14.5x forward earnings, despite 585% revenue growth over the past two years.
I purchased one call with a Jan 2018 date and $5 strike for $3.40.  This is a $340 outlay.  At Fitbit’s current price, the intrinsic value of the call is $2.48.
If Fitbit manages to get to its 50 day moving average of $10.39, the intrinsic value of the call would be $5.39, if you add the same time premium/implied volatility that it has now, you get an option price of $6.31 which is an 86% gain on a 39% move in the stock.  If it gets back to its 200 day moving average, the option gain would be 180%.
I’ll use a 35% trailing stop loss on the position.
Christmas Presents
In a completely transparent attempt to earn some affiliate cash, I have pulled together a bunch of recommendations for Christmas presents to get for people who want to be rich.  And, really, outside of Jill Stein supporters, who doesn’t?  I’ve suggested four books (one for each of the site’s pillars) and two courses.  If you enjoy the site, try to buy the expensive courses; if not, still buy all of the books.  Read more here. 






 

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