Investment Activity Review - July 2013

It was a rough July as several stocks I owned crossed my 20% loss threshold so I had to make some hard decisions to sell or hold on. These types of decisions are even harder to make than deciding what to buy.

Sold 1/2 position in S&P500 Short ETF (HSD)
When Ben Bernanke and the Federal Reserve signalled for the umpteenth time they don’t plan on increasing interest rates anytime soon even though interest rates have remained artificially low for such a long period of time which has been increasing prices of companies who really haven’t been generating sufficient growth in revenues and profits to justify their stock prices. It appears the program of Quantitative Easing will continue for the foreseeable future and so stock prices will continue to not fight the Fed and resume their ascension. So I decided to take some money off the table and reduce my short position by half. I still think the current trends are unsustainable and that at some point we will see a pretty rough pullback and so to hedge my portfolio, I decided to still keep a portion of assets in a short position. At some point, the stock market will need to start recognizing fundamentals and what’s going on the company’s income statement. I just see a lot of companies that have questionable business models (Best Buy), governance (HP), and businesses that are OK but not performing to the extent to justify rapid increases in stock prices. I booked a loss of 20% on HSD which is at my loss threshold.

Added to Broadcom position (BRCM)

 

In its latest quarterly report, Broadcom reported earnings that disappointed analysts and the stock sharply sold off and now has been languishing in the $27 range. There have been wave of downgrades on the stock. Right now anything that doesn’t cut it with Wall Street estimates is getting smashed. In a sense Broadcom plays second fiddle to Qualcomm in the mobile chip market much the same way AMD is the David to Intel’s Goliath in the PC chip space. It has a higher hill to climb. Despite this I decided to add to my position and average down (our cost base is now $31/share. I did so because the company is still generating strong excess returns on invested capital. It has a pretty strong balance sheet with minimal debt. It also operates in a sector where there is rapid growth (mobile technology). The main thing for Broadcom is that most of their business is in North America. They really don’t have much of a foothold globally so there is an opportunity to grow. As far as I can tell their products are pretty solid and well received. The stock after the sell-off crossed our 20% loss threshold . In this case we decided to average down and see what happens. As long as the company continues to generate tangible wealth, the stock could be oversold and primed pop back up on any positive events in the business.

Sold Potash Corporation for a -24% Loss

This was a very hard decision that challenged my emotions. One of my long term investing themes revolves around food. As the world population grows and more people from the developing world get pulled out of low income to high income, they will want to eat better. We will need to produce more food. Potash as a material plays a key role in nurturing our soil so we can grow more food. Traditionally it is the one material that has been controlled by a few companies around the world, and Potash was one of them. They were able to effectively control prices and supply much like OPEC does with oil. They were a cartel. Now one of the members of the cartel Urakali decided it wanted to go out on its own and sell its potash in the open market, the impact being more supply in the market leading to lower prices. All the potash companies got killed, with Potash Corp falling by more than 20 percent.

A 20 percent drop is pretty drastic but when the news came out, I first thought that perhaps this could be a buying opportunity as the markets are overreacting. The more I delved into the story, the more it became obvious to me that we might be witnessing the Game Changer moment. where a shock to the market occurs that can negatively or positively change the long-term fundamentals of the business. In this case the breaking of the cartel was a shock to the potash market and the transition from a controlled market to a market driven market will normally create disruption and uncertainty which is not good for stocks. The other item that jumped out at me were some comments from the CEO of Potash Corp a few weeks before the cartel shock news, where he said the should the potash market change in the future, the company will continue to be run from a cartel/price control perspective rather than an open market perspective. What struck me was that management was telling us they don’t possess the competencies to adapt the business for future changes. Is the current management team which has been trained to work in an oligopoly environment, capable of competing in a volume driven world? Their comments did not inspire confidence with me that they can. Putting these two elements together in addition to the fact the stock had crossed my loss threshold of 20 percent, led me to decide to sell my position. I liked the company. I liked the business. It met many of my criteria for investment, but the world of potash changed and I have to take my emotion out of it. A 24 percent loss would require the stock have to go up 33 percent just to break even, which is a pretty high return to generate. So I decided to bank the loss and move on. I am still going to keep an eye on the company to see how it responds to the shock and if it can demonstrate that it can compete effectively under the new paradigm, it might be worth jumping back in. Another possibility is that the Russia and Belarus work out their issues and re-form the cartel. Stranger things have happened over there.

What’s interesting is that even though I had three stocks in a losing position that challenged my 20% loss comfort zone, I made different types of decisions. I sold Potash because of a Game Changer moment that I feel will impact the long-term fundamentals of their business model. I bought more Broadcom because I still believed in the fundamentals are still intact to the point where I decided buy more to average down the cost. And finally I sold 1/2 my short position on the S&P500 because I still believe as some point, the market will focus on tepid earnings growth and less on Gentle Ben’s money printing ways. This is what makes investing more of an art than a science. You can have all the formulas and scenarios mapped out and follow them to a T but at the end, we’re humans and we all carry a human trait called “belief” that can challenge these rules we try to implement. It’s an emotional trait and as you can see it is not hard to take you away from your core strategy.