Newsletter May 3, 2014

InvestorsFriend Inc. Newsletter May 3, 2014

The Ten-Bagger RRSP Account

The larger of the two Registered Retirement Savings Plan (RRSP) accounts that I manage just reached a rather impressive milestone. This RRSP is now worth ten times the amount of money that was ever contributed to it.

As of yesterday, every $1.00 contributed to it has now grown to $10. More to the point, every $10,000 contributed has now grown to $100,000.

Peter Lynch in his very popular 1989 classic book One Up On Wall Street,  talked about how he loved ten-baggers — stocks in which you’ve made ten times your money. He talked about his passion for ten-baggers and how appealing they can be.

He was perhaps too modest to mention that he had actually achieved more than a ten-bagger on the entire amount of the investment fund that he was managing. He achieved a 19 bagger in ten years.

I mentioned this same portfolio back in our June 2009 newsletter, at which time it was merely a four bagger. This portfolio was started in 1991. The weighted average length of time that the money has been invested is 14.0 years.  The compounded average return has been 17.9% per year.

How did my RRSP grow ten times?

The following describes how this RRSP did so well. I am not arguing that the approach used should be used by others. In fact most advisors would consider my approach to have been excessively risky.

This RRSP was always invested in accordance with the stock picks and thinking that I have been sharing here at since mid 1999. (Those of you that are not already customers can learn more about subscribing to our stock picks and investment analysis at this link.)

No portion of this RRSP was ever invested in bonds.

This RRSP was invested 100% in either stocks or cash at all times. The cash component was usually not large but did get as high as about 35% at times when I preferred to hold cash while waiting to identify an investment opportunity. The cash percentage tended to be higher at times when the market seemed over-valued.

A concentrated portfolio approach was used. Many times a single stock represented 10% or even sometimes 20% of this portfolio. (One cannot beat the market index by holding the market index.)

Stocks were always selected on the basis of fundamental value and never on the basis of momentum or any type of technical analysis. Stop loss orders were never used.

I never engaged in aggressive market timing in terms of getting completely out of stocks (or anything close to that) at any time.

The stocks invested in only rarely included very small cap stocks or penny stocks. They were mostly medium to larger cap companies.

Dividends were never a requirement but most of the stocks, being well established companies, did pay dividends.

Commodity stocks (oil and gas, mining, forestry) were virtually never included.

Companies that were not yet at a profitable stage (which often happens with internet and bio-technology companies) were seldom if ever included.

The performance was not because I found and bought and held individual ten-bagger stocks. I did find a few ten-baggers. I am not an active trader but I have not held many (if any) stocks continuously while they rose 10 fold.

All of this is not to suggest that there were no mistakes. A $3,354 investment, made in about 2005, in Mount Real of Montreal, which turned out to be a scam company, went to zero. A $776 investment, made in about 1999, in a tiny soft drink maker went to zero. There was an unfortunate investment in ENRON made after it had already fallen substantially. There were certainly a few other stocks that were purchased and then sold at a loss. In terms of trading it is never possible to optimize that and many times stocks were sold, or the position reduced, that should have been retained. Overall the performance of this RRSP has been extremely satisfactory despite the mistakes that were made.

I should also mention that my other investment accounts have not done quite as well although they have also done very well.

How to Think About the Cost of Stock Options to Companies

The most usual type of stock options work as follows. Executives are given the option (but not the obligation) to purchase shares for a given period of time such as five or ten years at a fixed price which is usually the price when the options are issued.

For example, imagine that an executive is awarded options to purchase 100,000 of  his company’s shares. And imagine that those shares are trading at $10.00 at the time the options are issued and that the options have a life of ten years.

The question arises as to what expense, if any, the company should book.

For many years there was no requirement to book an expense when options were issued, nor when they were exercised. In part this was due to the fact that at the issue date, the options usually had no intrinsic value. (They had no value if exercised although they would have had a market value.) And it was also due to the fact that the ultimate value to the executive could not be known in advance.

The value of the stock options to the executive depends upon the future share price. If the options were exercised in the future at a time when the share price had risen to $16, then the executive would have the right to purchase 100,000 shares for $10.00 each or $1 million. These shares would have a value of $16 each or $1.6 million. Therefore the pre-tax gain to the executive would be $600,000.

If the share price never rose above $10 even in ten years, or otherwise expired unexercised, then it could be argued that the options turned out to be of no value to the executive.

I would argue that the ultimate cost (or expense) to the company of providing the stock options cannot be known until they are exercised and that the cost is exactly the same as the value that the executive realizes upon the exercise of the options.

In the example above, the company was obliged to issue 100,000 shares for $1 million when it could have sold those same shares to someone else for $1.6 million. I would therefore argue that the cost to the company was $600,000. Or if the options had ultimately expired without being exercised then I would say that the cost was zero.

For the past number of years companies have been required to book an expense at the time that options are issued. This expense is necessarily only an approximation of what the issuance of the options will ultimately cost the company. The amount that is booked is based on the estimated market value of the options and is usually calculated using the “Black-Scholes” formula. While the expense that must be booked is only an estimate of the “true” expense, it has been said that it is better to be approximately right (book an estimate) than precisely wrong (book no expense).

Many companies are still trying to implicitly argue that there is no cost to the issuance of options because it is a non-cash expense. Many companies urge investors to “add back” this non-cash expense and any other stock-based compensation. These arguments are wrong, self-serving and ultimately irrational. Investors should be leery of managements that argue that options are not a real expense.

As an illustration, imagine that you were the sole owner of a newer and growing company that was worth $100,000. And imagine that you hired a manager for a modest salary of $50,000 and that as an incentive you granted the manger the option to purchase half of your company at any time in the next five years for $50,000. (Half the company for half its current value). And imagine that you and your manager worked very hard and that in five years your company was worth $1 million. You would now be obliged to sell half of your $1 million company for just $50,000. Clearly there would have been a cost to your issuance of the option. You were now obliged to sell something worth $500,000 for just $50,000.

Options may be a very legitimate form of compensation and incentive pay. But like other forms of compensation they do represent an expense.

It can be argued that the expense of options is borne by the other shareholders. The company never has to pay out cash when options are exercised. But the ownership position of the other shareholders is diminished when options are exercised. And not only is the ownership diminished but the company, on behalf of the other shareholders, does not receive the current market value of the new shares to be issued.

In summary, stock options most assuredly do have a cost and this cost should not be ignored in calculating the expenses of a company.

Berkshire Hathaway’s Investment Portfolio

Berkshire held its huge annual meeting today and released its Q1 earnings yesterday. It’s always useful to take a look at what Warren Buffett is invested in.

The following is the breakdown of Berkshire’s huge investment portfolio as of March 31, 2014.

Asset Class Market Value ($ billions) Percentage
Cash $50 23%
Fixed Income $29 13%
Equities $137 63%
Total $216 100%

Berkshire has a total of $495 billion in assets. Most of the assets are invested in the many businesses that it owns. $216 billion or 44% of the assets are invested in the marketable securities and cash indicated above. Of those investments, 63% are equities, 23% is cash and 13% is in fixed income. It therefore seems fair to say that Buffett is not a big fan of fixed income investments at this time. He does not view cash as an investment but rather as a parking place for funds that may be needed on short notice in the event of any huge losses in the insurance business or to buy additional businesses or stocks on short notice.

I understand that much of the cash is invested in very short term U.S. Treasury bills and not, for example, deposited in banks. It’s probably not feasible to keep anything close to $50 billion in any one bank and it is somewhat safer in Treasury bills.

Regarding equities, Buffett runs a highly concentrated portfolio.

Here is how the equity portfolio breakout looked at the end of 2013: (In the interest of quick readability, I have rounded to the nearest billion, the percentages are based on the more precise figures.)

Company Market Value ($billions) Percentage of total
Wells Fargo $22 17%
Coke $17 13%
American Express $14 11%
IBM $13 10%
Bank of America Warrants $11 8%
Wal-Mart $4 3%
Munich Re $4 3%
Proctor & Gamble $4 3%
Exxon $4 3%
U.S. Bancorp $4 3%
Sanofi $2 2%
Goldman Sachs $2 2%
Moody’s $2 2%
Tesco plc $2 1%
Phillips 66 $2 1%
All Others $20 16%
Total $128 100%

This is a concentrated equity portfolio. The top five positions account for 59% of the equity portfolio. In past years Berkshire’s equity portfolio was even more concentrated. Buffett’s two new investment managers likely account for the bulk, though not all, of the “all other” category.

The Fixed Income portion of the investments is broken out as follows:

Bond Category Market Value ($ billions) Percentage
U.S. Treasury (includes U.S. corporations and agencies) $3 10%
State and municipal $2 7%
Foreign governments  $12 42%
Corporate  $10 34%
Mortgage-backed securities $2 7%
Total $29 100%

Berkshire’s fixed income investments are concentrated in foreign bonds and corporate bonds.

Overall, Buffett does not follow conventional portfolio diversification practices. His results are also unconventional.

In a future edition of this newsletter I will take a look at the different types of insurance companies that Berkshire owns.


Shawn Allen, President
InvestorsFriend Inc.

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