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Final Commentary On Premium Portfolio Stocks

July 17th, 2017

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Image Credit:Mut Hardman/Shutterstock.com

On the third Monday of each month, Ill comment on the performance of the premium portfolios and provide some additional analysis related to individual stocks. In this article, I will also provide a brief commentary on all stocks in the Premium portfolios and reflect on why many stocks in the portfolios didnt perform up to expectations.

Premium Portfolio News

The performance of MoneyGeek's Premium portfolios for the month of June 2017 were as follows:

Jun 2017

Last 12 Months

Since Apr 2013

Moderately Aggressive

-4.6%

+2.5%

+37.9%

Very Aggressive

-6.7%

-2.8%

+9.1%

Extremely Aggressive

-8.9%

-8.8%

-18.0%

Because the premium portfolios consist of U.S. and Canadian stocks, it makes sense to compare the results against the S&P 500 and the TSX Composite, which are the most widely used U.S. and Canadian stock market benchmarks, respectively.

In June, a hypothetical portfolio of 50/50 Canadian and U.S. stocks would have returned -2.1%, so the premium portfolios underperformed. This is the last premium only article Ill write, so rather than highlight a select few stocks that had notable performances, I shall go through each stock in the Premium portfolios and provide some commentary.

Individual Stock Commentary

BBBY: Bed, Bath and Beyonds stock went down by 15.1% last month after reporting lower than expected earnings. Analysts had expected the company to earn more than $90 million in the three months ending in May. Instead, the company reported only $75 million.

Whether BBBY will generate strong returns going forward will depend on whether it can stabilize its revenues and profits. At current pace, the company is set to earn roughly $400 million a year. Since the company is valued at $4 billion, that means the shares should return 10% per year if the company can keep its earnings at their current level. I expect the average U.S. stock to return only 3% per year going forward, so BBBY should be a good investment if it can stabilize its profits.

Such stability, unfortunately, has so far remained elusive. The problem isnt sales. In fact, the company has been able to increase sales every year so far, albeit very slowly. Rather, the problem is the transition to digital and its impact on costs.

Contrary to popular thinking, selling online isnt necessarily cheaper than selling in brick and mortar stores. Online sales incur more transportation costs because the product is delivered to customers homes. They also require a vastly different distribution network, and transitioning the network is costly.

The key question is whether BBBY can profitably run its digital stores. If it can optimize its online distribution network to decrease delivery times and save on costs, then I believe the company will be able to stabilize its profits.

Another key question is whether consumers will stop going to brick and mortar stores altogether. I think theres a strong chance that many consumers will always prefer to go to brick and mortar stores, as we can see from the somewhat relevant domain of paper versus ebook sales. Although ebooks enjoyed high growth early on, that growth has stalled in recent years. If online retail similarly stalls, then I believe BBBY will do well.

BXE.TO: Bellatrix had another awful month in June, falling by 31.8%. I explained last week that I no longer believe oil will settle above $60/barrel over the long term. This obviously brings down my valuation of Bellatrix substantially.

However, that doesnt mean Im abandoning Bellatrix. As I also indicated last week, I believe that my method of valuing oil and gas companies is fundamentally flawed because it depends on long term assumptions that are very difficult to forecast. While I was wrong about long term oil prices, I was also wrong about long term costs, which have come down much faster than I expected. Because of that, I think its better to rely on simpler models that Ive outlined in this article.

Assuming a steady oil price of $50/bbl, there are two ways of valuing Bellatrix. One is to infer the value of the companys assets from recent transactions. Bellatrix was able to sell its non-core assets recently at a valuation of roughly $20,000/boe/d. If we apply that same metric to the rest of Bellatrixs production, then we get a value of $700 million for the companys assets. Since the company has roughly $435 million in debt, that means the companys stock in aggregate is worth $260 million, which is about twice the current price.

On the other hand, we can value Bellatrix from a cashflow perspective. At $50/barrel the company will only break even. A company that breaks even forever is not worth anything. However, this valuation is probably harsh, considering that the Alder Flats gas plant, once finished, will significantly lower the companys costs. On balance, BXE may be fairly valued in the current environment.

BTE.TO: Baytex, likewise, had an awful month, falling by 19.8%. Much of what I said about BXE also applies to BTE. I now think the fair value of the company is much lower. Judging by asset sales in similar jurisdictions, I believe Baytexs assets are worth roughly $2.8 billion in the market place. That means the company is worth roughly $900 million, which translates to $3.8/share. On the other hand, as is the case with Bellatrix, Baytex only breaks even when the price of oil is $50/barrel. The fair value of the company could be somewhere in between, which suggests that the company may be fairly valued today.

COH: Coach more or less tracked the overall stock market last month, going down by 1.6%. So far this fiscal year, Coach has been able to increase its net income by about 15% compared to last year. The company has worked hard over the last few years to upgrade its image from a cheap luxury brand to a more medium grade luxury brand. Such effort was necessary because the company faced aggressive challenges in the cheap luxury space from competitors such as Michael Kors. Today, the pain of making that transition is probably over, and growth lies ahead.

Furthermore, Coach is using its sizable cash flow in order to acquire competitors, who themselves are decently profitable. The company acquired shoemaker Stuart Weitzman in 2015, and it more recently acquired Kate Spade. All indications are that Coach will continue to acquire other brands.

Whenever a company goes on a buying spree, the worry is that the company will overpay for acquisitions. Fortunately, it looks as if Coach has been disciplined with regards to the prices paid so far. I think Coach will do well as long as it can keep this discipline, but we will need to monitor this aspect.

ET.TO: Evertz Technologies has done well over the past couple of years, and that momentum continued into June with the stock gaining 7%. However, the stock appreciation came despite reporting stagnant results. For the year ending in April, Evertz reported only a 1% increase in its revenues and a 1% decline in its net income as costs increased faster than revenues.

Going forward, Evertz needs to show some earnings growth in order to maintain its price momentum. If not, I believe itll do about as well as the rest of the Canadian stock market.

FSLR: First Solar shares declined by 0.5% last month. There was no significant news pertaining to the company. The future of the company will depend on how well it can execute its upcoming Series 6 solar modules, which they hope to sell by the end of 2018. If they can cut costs significantly with these new modules, I believe FSLR will do very well going forward as renewable energy demand will only go up from here.

INTC: Shares of Intel fell by 10.2% in June. There was no obvious reason for the decline, but theres definitely a pessimistic narrative forming around Intel, and that narrative may have begun to gain popularity.

Intel currently dominates two markets: PC CPUs and server CPUs. While the server market continues to grow, the PC market has begun to decline in recent years. While that hasnt translated into lower revenues for Intel yet, many perceive that the writing's on the wall. Furthermore, long time competitor AMD released a new PC CPU that appears to be very promising. Some investors have begun to worry that AMD will take away significant market share, though that hasnt happened so far.

Furthermore, I believe investors are worried that Intel will miss out on the next big market for processors - namely, machine learning. Currently, most serious machine learning practitioners employ GPUs (graphical processing units) instead of CPUs to train their algorithms. For reasons beyond the scope of this article, GPUs are several times faster than CPUs for this task.

Machine learning has been becoming very popular in recent years, and that has led to a large increase in demand for GPUs. Nvidia, the leading manufacturer of GPUs, has seen its stock triple in the past year.

Unfortunately, Intel doesnt manufacture high end GPUs, so investors are worried that Intel wont participate in this market at all. To address this issue, the company acquired a leading artificial intelligence firm called Mobileye for $15 billion. Still, many investors are skeptical about Intels ability to compete in this market, and some are also worried that Intel paid too high a price for Mobileye.

Fortunately, Intel doesnt have to increase its profits each year to justify its valuation today. But neither can it afford to let profits fall. I think Intel will be able to keep profits level, but I admit thats hard to predict in the rapidly changing tech sector.

LNF.TO: Shares of Leons went up by 2.0% in June. The company reported its most recent earnings in May. The results so far have been encouraging - the company has been able to increase revenues while cutting costs. If the company can keep doing this, the stock will do well in the coming years.

The big question for Leons, or any other traditional furnitures store, will be whether online stores will disrupt their business models. Furniture is harder for online stores to disrupt because its big and heavy, which requires higher delivery costs. Consumers are also generally reluctant to buy furniture before they can see and touch it with their own hands, though the success of Ikea shows that this is perhaps not that big of an issue.

If Amazon or other online retailers can disrupt the furniture market, then I believe Leons could be in trouble. Its very hard for a traditional retailer to successfully transition to digital, and that especially applies to smaller retailers like Leons.

MAL.TO: Magellan Aerospace declined by 3.8% in June. There wasnt any significant news to speak of during the month. The latest report earnings show an increase in Magellans net income compared to the same period a year ago. However, that was only due to a one time gain resulting from the companys sale of a real estate property. Excluding the gain, Magellans profit would have gone down.

Its much too early to say whether the recent low earnings marks the beginning of a trend. My bet is that it does not, given the rude health of the airline industry. Magellan should do well as long as its end customers do well.

MEG.TO: As with other oil and gas stocks, MEG Energy had a terrible month, dropping by 26.2%. As with the other oil and gas companies, I now judge the fair value of MEG to be much lower than before.

Applying the different valuation methods leads us to the same conclusions we saw with BXE and BTE. Judging by recent transactions on similar assets, I believe the companys main Christina Lake asset is worth roughly $4.5 billion. If we add the value of some of its other assets and subtract its liabilities, then we get a value of roughly $2 billion. This suggests that the company is somewhat undervalued.

Unfortunately, MEGs break even point appears to be higher than the other companies, at roughly $55/barrel judging by its latest financials. If the company cant cut costs significantly, then the company may not actually be worth much. Fortunately, the companys CEO claims that the company can now generate a profit at $45/barrel oil. If this is true, MEG could also be undervalued from a cashflow perspective.

OGC.TO: Shares of OceanaGold declined by 14.1% in June due to declining gold prices. Going forward, Oceanas share prices will also depend on the outcome of the Philippines governments review of its mining ban. So far, the government has sent out favourable indications, but the matter is still far from settled.

PJC-A.TO: Jean Coutus shares declined by 10.3% in June, as the Quebec government made a final decision to adopt a tendering process for generic drugs. Ive commented on this matter in this Q&A. I think Jean Coutus shares are fairly valued today.

TOT.TO: Shares of Total Energy Services went down by 5.0% in June, as investors anticipated that the current low oil and gas prices will depress drilling activity again. However, I expect drilling activity to bounce back once oil climbs over $50/barrel again.

Owning TOT acts as a hedge to owning other oil and gas companies to some extent. If drilling activity doesnt ramp up despite higher oil prices, then oil prices will go higher as there will be a lack of new supply, which will benefit oil and gas stocks. If activity does ramp up, then its good for TOT.

TOU.TO: Alone among all oil and gas stocks, Tourmaline Oils shares climbed in June, by 3.2%. Tourmalines shares had tracked oil prices for the past couple of years, despite the fact that the company mostly produces natural gas. The price of natural gas is currently at a point that allows TOU to generate healthy profits. The company should do well as long as natural gas prices hold.

VSEC: VSE Corporations shares increased by 3.3% in June. There werent any noteworthy developments during the month. VSEs future is still largely tied to the U.S. governments spending, particularly the military. Revenues from the military climbed significantly over the past year, and with the Republicans in charge, I dont see that spending decreasing.

I continue to see VSEC as an option on geopolitical conflict. If the U.S. gets involved in a war, VSEs revenues will skyrocket. If not, then I expect the company to continue to earn what it does currently, and I believe the company will look fairly valued.

WFC: Shares of Wells Fargo increased by 4.1% in June. There werent any noteworthy developments surrounding the bank that Im aware of. The profitability of the bank will depend on long term interest rates. If the rate goes up, then it will make more profit, and vice versa.

Long term rates rose in the aftermath of Trumps election as many investors expected higher inflation. But as it became apparent that inflation wont go much higher, long term rates have largely stood still. Its very hard to predict where rates will go in the future, but even if rates fail to rise, the bank looks somewhat undervalued today.

Closing Thoughts

This is the final Premium article, and Id like to close with some reflection.

While some stocks in the Premium portfolios worked out as I had expected, the majority of them, unfortunately, havent. Its not just oil and gas companies that failed to work out - I misjudged the value of IBM for example.

To arrive at the decision to recommend a stock, I followed the valuation framework I laid out in this article. Over time, I came to realize that though the valuation framework is solid, its very hard to make correct assumptions that feed into the model. Among the assumptions, none of them mattered as much as the assumption around a companys growth.

As I explained in this article, even a slight change in a companys growth outlook can produce large swings in a companys fair value. Previously, I had largely based my growth projections on the companys long term results. However, it turns out that such simple observations dont work in practice. Companies with stellar long term records can start to fall on their faces within a couple of years if business environments shift.

Thus, I now think its important to take a more sophisticated approach to project a companys outlook. I plan on doing this through the combination of machine learning and alternative data. But instead of publishing the results behind a paywall, I plan on making them public so that it can reach a wider audience.

In summary, this experience has taught me both the importance of getting a companys growth prospects correct, and the fallacy of simply relying on history to guide a companys outlook. I apologize for any ill effects that my faulty analysis may have caused, and I will strive to do a better job going forward.

Disclosure: I hold COH, FSLR, WFC, TOT.TO, LNF.TO, BBBY, BTE.TO, TOU.TO, MEG.TO, PJC-A.TO, MAL.TO and BXE.TO shares.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.