Fructivore Investments

With $787 billion in stimulus, $700 billion in TARP money, deficits projected to hit $1.8 trillion, the Federal Reserve cutting rates to effectively nothing, and Neil Barofsky, the government’s inspector general of TARP estimating a $23.7 trillion total risk exposure to the financial crisis, it is only natural to worry about inflation. Of course, that $23.7 trillion figure would require absolutely everything going wrong, but recent events have surely convinced us that betting on the modal result and ignoring the other possible outcomes is reckless, a fact that seems destined to be rediscovered every few years.

Inflation, of course, is simply an increase in the money supply that outpaces an increase in the size of the economy (actually, that’s stagflation, but stagflation is really the pernicious aspect of inflation). The purpose of money is to facilitate transactions, and as the number of transactions increases the size of the money supply should increase accordingly. Now, of course, the economy has shrunk even as all this stimulus is being thrown at the market, and we are still worrying about deflation. This implies one of two things, either that inflation is going to come later, or that the inflation has been avoided.

I fall in the inflation avoidance camp. In a modern economy, credit serves almost as well as cash, and we are now witnessing a massive evaporation of credit. The appetite for securitization products that created a pool of liquidity that so many lenders were counting on turned out to be a mile wide and an inch deep. Now that every lender in the country is reining in its operations, and many people are unwilling to borrow or incapable of borrowing against their houses, trillions of dollars of credit that used to be bouncing around the financial system no longer are. Next to this unprecedented deleveraging of America, Congress has finally managed to make a couple trillion dollars look like a small number.

Of course, it never hurts to have a backup plan in the form of inflation-protected investments. Our choices include gold, TIPS, and land. For our fructivorous purposes, however, we want an investment that produces a decent return with or without inflation. Gold or other precious metals has no baseline return, or even a negative one when counting storage, insurance, etc. TIPS pay a low rate but increase their principal value alongside inflation, which is better than gold, but I still think there are more potential opportunities in the land category.

In terms of land, obviously single family homes are far too speculative as events have indicated. In fact, using Seth Klarman’s definition that a speculation, as opposed to an investment, produces no current or potential cash flow to its owner, single family homes are not an investment at all. Rental properties are closer, but I think the ideal land for an inflation hedge is land that produces something: farmland, mines, oil fields, or timber. Any of these has advantages and disadvantages, but I’m going with timber, and with Rayonier in particular.

Rayonier owns 2.6 million acres of timberland, and also produces lumber and wood products, and wood fibers for hygiene products and also specialty fibers for industrial use running the gamut from packaging to LCD displays. Naturally the decline in demand for construction materials has hurt them, but even at this low ebb of their business, they have managed to squeeze out at least $25 million in earnings per quarter lately. Their free cash flows are approximately equal to their dividends, currently yielding 5%. This puts them at risk of a dividend cut, but for inflation hedging purposes this is not really relevant, as it is better to keep the money in the firm to buy more timberland with in that event.

The advantage of timberland is that when, as now, demand is down, producers can simply decline to harvest. Unlike farmland, and especially mines and oilfields, not harvesting for a time allows the product of the land, trees in this case, to grow and produce a greater yield when conditions return to normalcy. And given their vertically integrated fiber business, they are not wholly dependent on the construction market.

Rayonier also is getting a nice little bonus from the tax system this year from black liquor, a byproduct of the fiber refining process that contains the nonfibrous parts of the wood and the leftover chemicals used in the process. The refining of wood into wood pulp for their fiber business produces some nice long usable fibers, and a great deal of black slime. A highly toxic black slime. When dried, a highly flammable black slime. When dried and mixed with a bit of diesel fuel, a highly lucrative black slime, since the government pays a subsidy of 50 cents a gallon for its use under an alternative energy program. The program expires at the end of this year, and there is a movement in Congress to cut off the eligibility of pulp mills immediately, on the grounds that black liquor is not really an alternative fuel. (It has been used since the 30s and nearly every pulp mill uses it, meaning that it is not an “alternative” to anything.) To date this year, Rayonier has benefited $86 million from this subsidy, and there are two more quarters. Since the program will expire if not extended (which extension is not outside the realm of possibility), we cannot count on this $43 million a quarter as part of the firm’s operating income, but it is a nice little enhancement that will cushion the blow of the business slowdown for the moment.

However, without counting the black liquor subsidy Rayonier’s PE ratio is hovering around 20, which is generally too high to qualify as a low-hanging fruit considering the lack of growth (not that a fructivore lays too much emphasis in growth anyway given the difficulty of predicting the future). But as an inflation hedge, timber companies like Rayonier are definitely good places to look into.

Remember what I said about the dangers of event-driven trading? USEC has been denied the loan guarantee for their centrifuge enrichment plant construction, for reasons of concerns about commercial viability (which is unusual because the technology is already in use  by other uranium enrichers) . As a result, the company seems to be making good on its vow to cancel the project, although they claim they are now investigating strategic partners or buyers. The Department of Energy has taken the unusual step of asking USEC to withdraw and resubmit the application in 12-18 months, although I’m not sure to what end.

Naturally, the stock has fallen by about a third as of this writing. I’m as surprised as anyone, but as I’ve stated, this rush for the exits is a common enough reaction to an event coming out the wrong way. I should also point out by way of shameless bragging that, since I purchased it at a low price when it was still a net-net situation, I’m actually about even on this one.

If we neglect the new construction project entirely, we are left with the existing plant, which will probably not be competitive in the marketplace once the Urenco’s centrifuge enrichment plant is finished in a projected 2013, or perhaps Areva’s Eagle Rock facility, which will be fully constructed in 2018 or 2022 but like the Urenco plant, can operate without being fully operational (one of the awesome things about centrifugal enrichment is that it’s modular), or any of the other centrifuge plants around the world. Of course, since centrifuge technology is already being used at some overseas enrichment plants, the demise of USEC’s competitiveness has already started. It is still operating at a profit, but as centrifuge technology becomes more and more common their operations will most likely be squeezed out. USEC also takes weapons-grade uranium from Russia and dilutes it to fuel grade, but that program also comes with an expiration date.

However, as I stated, without R & D on the plant, which the company may have to follow through on their promise and put on standby, the company has average earnings of $180 million a year. After this price collapse, their PE ratio is down to 3, so it might still be a hold. But I was definitely more optimistic yesterday.

How many times have we heard the above advice? Usually, it gets people to burn through their savings by starting ill-fated businesses, but that is not the only thing to love. We Fructivores love buying and selling at the right price. The right price is when a security is fairly valued, since at that point there is no longer any advantage to holding it. When a security is fairly valued, sell it off and find one that is unfairly valued. We also are familiar with stocks that went up before we had the funds to buy them, or worse, we bought them, gave up, and then they went higher.

Writing options allows us to squeeze a little extra money out of both these situations. Specifically, writing covered calls and naked puts. I know, most people would advise small investors not to write naked options, or they’ll never become large investors, but there are ways. Larry McMillan, in Options as a Strategic Investment, talks about the difference between having essentially a stock strategy and using options to augment it, and having an option-based strategy. He advises the second one, but this strategy sticks with the first.

With our value investing approach, we know what our exit target is because we had to value our holdings in order to be sure that we got a discount from that price. So, if we know when we are going to sell it, we can write a covered call at that price. If the stock exceeds that price at expiration, the stock will be called away from us and we will have made the money we were going to make anyway, and also collected option premiums while we waited. A related, but riskier proposition, is writing a naked put on a stock we like but that is at too high a price. If the stock declines below the price of the put, we are forced to buy it (make sure you have ample margin), but we would have bought it anyway at that price. It is riskier because if the company deteriorates during the life of the option, the price that we thought was low enough to make it a bargain could now be hugely overpriced. However, for a company with stable operations, like Windstream, or better still, a company like CMO that can never be worth less than the government-guaranteed securities it owns, this strategy is safe and reasonable.

For example, suppose that I think Capital One is worth at least $30 a share based on my sense of its minimal earning power after the economy and the markets get sorted out. The January 2010 $30 calls are at $3.40 now, so by writing them I take in $340 less commissions per hundred shares, and expose myself to no risk other than selling when I would have sold anyway. It also removes from me the agonizing over whether I should take my profits now or hoping it will go up (If it does go up it will do so for reasons unrelated to its bargain status and therefore this is an unfruitful waiting game). If, however I did not own Capital One but wanted to, I would consider writing puts, perhaps the January 2010 $20 puts at $1.75. This takes in $175 less commissions per hundred shares, and if the stock drops below $20 I will be forced to buy a stock I would have bought anyway at a discount I chose in advance. Of course, the choice of the January options was arbitrary; my focus is on valuation, not option pricing theory, so picking the date of the options is less important to me than the strike price.

So, this fundamentals-based option strategy is a way to make other market participants pay you to take the actions you would have taken anyway, thus bringing in extra money and it also has the advantage of making decisions in advance, thus freeing up your limited investing analysis time to focus on the really important matters like valuation.

Event driven trading is never as simple as people think. The concept is simple enough: identify an event that is likely to change the price of a stock, determine the price of a stock after the event does or does not occur, determine the probability of the event occurring, and take a position accordingly. Of course, the ending price and the odds are difficult to predict, but the real problem with event driven trading is that if the event fails to occur the price of the stock will typically drop precipitously, since everyone else is watching for the same event. The typical event is a merger, but a spinoff, divestiture, or even a bankruptcy filing can create an event.

USEC Inc. has an interesting one; a loan guarantee from the Department of Energy that they applied for in order to construct a new facility. USEC is currently the only uranium refinery operating in the United States. It turns mined uranium into low enriched uranium for use in nuclear power plants, and presently employs archaic and inefficient gaseous diffusion technology. Ironically, one of the biggest inputs to producing fuel for electric plants is electricity; 65% of USU’s operating costs come from electricity, and centrifuge technology requires an impossible-seeming 95% less power. For this reason, most nuclear fuel enrichers have switched over to centrifuge technology, and USU wants to open a new plant in order to join them.

To that end, they applied for a $2 billion loan guarantee from the government, and since then they have been looking forward to it like Australia has been looking forward to rain. They have recently announced that they expect the announcement from the Department of Energy in early August, and that they may consider mothballing the entire project if they do not get their guarantee. Since there are two other centrifuge plants proposed to be built in the United States in the near future, and both of them foreign owned, their strategy is probably to embarrass the government into approving their request. Still, calling the government’s bluff like that is a dangerous strategy.

I have to admit that when I discovered USEC, it was because it was a net-net situation, not an event driven trade. At the time, they had enough cash on hand, and uranium inventory, to redeem all of their debts, repurchase all of their stock, and still have money left over. (Such a situation is the holy grail of value investing since Ben Graham started hunting them up)  Now, a couple years later, this is no longer the case because they have sunk $1.4 billion into the centrifuge project already–which, if the project is shelved, will have been wasted. In the last couple of years, the stock has produced on average $70 million in earnings ($110 million more than that if the R & D spent on the centrifuge project is capitalized). It now trades at a PE ratio of 10 without capitalizing the R & D and 4 with it capitalized and amortization of the R & D is deferred until the plant is operational. However, those figures are largely meaningless because the existing plant is going to be shut down. If they keep the same volume of business, their operating earnings (not counting R & D) goes from $180 million to $850 million, but the existing $200 million in plant is thrown away, and the $28 million they now have in depreciation and amortization is going to expand to, say, $300 million, plus the interest on the loan of $160 million at 8%, plus taxes, produces a bottom line of about $270 million, which stacks up favorably to the $70 million they reported making now, after the construction and transition periods.

So, it is easy to see the optimistic case that comes from getting the loan guarantee. (Assuming the company can keep the same margins and laser uranium enrichment, the “new” new technology, is not significantly more efficient). It is equally easy to see that cancelling the project would leave USU stuck with outdated technology against two centrifuge-using competitors in this country. So, there is the case for USU, and the basic problem that comes from trying to predict the future better than everyone else in the market. I should point out that USU is up nearly 20% since they announced that they demanded a decision by August (I hope for their sake they have a contact in the Department of Energy that gave them the date), but still has a PE ratio of about 2.6 for the company once the project is completed. So, if you like the odds, go for it.

Every financial panic needs a good person to blame. This one can be blamed on securitizers and financial derivatives engineers; the one before on deluded dot-com investors, the one before (the junk bond collapse) on frenzied, ill-advised mergers, and the one before that (the Latin American debt crisis) on the oil crisis. I’ve skipped the savings and loan crisis since at least part of it was just bad timing. However, three of these four panics can be explained by the tendency towards yield hoggery.

A yield hog is, simply enough, an investor who is dazzled by high yield investments. A big fat coupon impresses investors and also serves to erase a few embarrassing mistakes. In fact, an investment that produces a large cash flow that is reasonably safe is the kind of low-hanging fruit that the investor should be seeking out. The emphasis, though, is on “reasonably safe,” whereas a yield hog sees “large cash flow” and stops reading. They are willing to reach for yield, and either get it by ignoring established standards of investing safety, or worse, they make up new standards that show that what they’re doing is now safe.

The central concept in yield hoggery is that risk can be made up for with a higher interest rate. I discussed that in the Capital One context, and in theory, it works as long as the risk premium does adequately capture the default risk and pays a premium to the holder on top of that. In other words, it works until it stops working. But worse for the sleepy investor, a risk that fails to materialize seems to fall out of the view of the typical market participant, and the risk premium narrows even as the risk becomes more and more likely. If, say, a certain class of bonds has a 4% annual default rate, this does not mean that 4% of them will default every year like clockwork; it means that they will see 1% default rates for years at a time and then suddenly get hit with a 20% default rate all at once. However, the investor that invested in those bonds will, until that happens, make more money than the more conservative investor who avoids them, and will also steal all of the latter’s clients. After all, clients pride themselves on not being cowardly and very risk averse–until the risk actually happens.

This was the view held during the Latin American debt crisis, wherein according to Nassim Nicholas Taleb, American banks lost, in nominal terms, all the money they had made in the history of American banking (which makes it kind of amazing they scraped together more money to lose so quickly in the subprime crisis). Latin America was growing at a fast pace and investors were naturally attracted to the higher yields available. After all, surely a government is safer than a corporation they could be lending to, and really, what are the odds that many countries would default at the same time? I mean, it’s not like defaults are likely to be correlated or anything.

However, at the very least they were following established financial standards rather than writing new ones, which is what they did during the junk bond explosion. The priests of the junk bond religion argued that since debt financing was generally cheaper than the cost of equity, it was entirely feasible to do leveraged buyouts, saddling companies with irresponsible levels of debt.The traditional corporate financier looked at the money a corporation could spare for debt service in terms of earnings, or at least EBIT, but the new method was to expand it to EBITDA, on the theory that capital expenditures could be delayed and so depreciation and amortization were basically “free money.” Of course capital expenditures can be delayed for a time, but not indefinitely and almost certainly not for the entire term of a junk bond. The switch to EBITDA provided a justification (i.e. excuse) for all manner of crazy, ill-advised mergers, and formerly solid companies were even pushed into borrowing large sums of money and distributing it to shareholders to hold off the acquirers.

Subprime securitizers had their own version of changing standards; the CMO structure allows investors in the lower credit tranches to absorb credit losses so that the higher tranches are not likely to be invaded by losses (again, what are the odds that many borrowers would default at the same time?). Their safety also depended on the availability of refinancing and and the ability of the housing markets to continue producing the ridiculously high returns they had been, and, although it went unmentioned, they also depended on the health of the foreclosure market. At least the Latin American debt investors were honest about the risks they had taken; junk bond and subprime investors just reached for yield and rewrote the rules in order to get it. The yield hog was absent during the triple-digit-PE craze of the dot com era, since with that kind of PE it is more profitable to reinvest any earnings into the company. (Is there such a thing as an appreciation hog? I think so.).

Since I seem to be in the habit of raising problems and not solving them, I suppose I should mention a holding that a yield hog can get behind. Windstream (WIN) is a rural telecom company that as of this writing sells for a little over $8 and pays $1 per share annually in dividends, which is dramatically impressive in a time of low interest rates. Their earnings have been stable over time, true, but have been stable at just a hair under a dollar. Using the trick we learnt from Qwest (see below), we find that their depreciation exceeds their capital expenditures, which gives them some extra free cash flow. As a result, their dividend is covered by distributable earnings, but just barely. On the plus side, they have recently announced an acquisition that in the opinion of management (ha ha) will begin to enhance their bottom line by the end of the year, which will enhance the safety of their dividend. They also have a debt maturity coming up in 2011, and hopefully the financial markets will have recovered by then enough to make rolling their debt over reasonably cost effective. Obviously, the company is unlike to appreciate significantly since they are paying out every penny they earn in dividends, but given their stability in earnings it is not too likely to drop either. Of course, in the unlikely but not impossible event of a dividend cut, the company would probably would drop in price, but they would still be earning somewhere in the area of $1 a share, and that money is still the shareholders’ whether or not they have it in their hands.

So, good luck and remember that even hogs can be eating low hanging fruit if they’re careful about it.

The deeper I get into investing, the more I find my interests are aligned with those of our corporate overlords. Thus, even though a piece of legislation is objectively progressive and fair, I also have to view it in terms of how it tilts the power away from the fat cats. Such is the case with the recent credit card legislation. Among other things, it bans universal default clauses, prohibits credit card companies from raising rates on existing balances, and requires charges and late penalties to be reasonably related to what they cost the company.

Capital One stated that, unlike mortgage lenders, credit card companies have the ability to build expected default rates into the interest they charge their customers. The ability to raise rates on existing balances may be viewed by them as an attempt by them to fine-tune this ability. In fact, universal default, a policy by which credit card companies impose large rate hikes if their customers default on other debt payments or even utilities, is an attempt to fine tune this process, since when it comes to defaults it’s hard to stop with just one. Even the legal test for insolvency is that the borrower is not paying bills as they come due. As the credit card companies probably pointed out in their meeting with President Obama before the bill passed, the alternative is serving less customers and pushing some of them into the less-regulated, less-convenient, more loan-sharky market. More likely, however, they told him it would mean higher rates for everyone, a principle that companies have certainly demonstrated by slipping in an across-the-board rate hike before the new law comes into effect. Under the new law, they can only raise rates on existing accounts after there have been two missed payments, which is probably inadequate for the companies to protect themselves, since after missing two payments it reasonably becomes more and more likely that they will miss the next four and be written off.

Even with the new legislation in place, and credit card default rates hovering around 10%, credit card companies and pretty much all corporations have short memories. Any credit manager under pressure to produce bigger numbers will eventually roll the dice on relaxing the lending standards just a little, in exchange for a higher initial rate, even if it can’t be adjusted so easily. So, with or without this legislation, when the shock of this recession is over it should be back to business as usual, apart from greater volatility in chargeoff rates. . Oh and the bit about fees and penalties being reasonably related to the actual cost to the credit card company? Who, exactly, is going to be telling the regulators what their costs are?

So, this legislation is probably not a good thing for credit card companies, but I don’t think it will be too bad of a thing either. Long live the corporate overlords.

Benjamin Graham wrote in Security Analysis that  there are few tests of management competence and none of them scientific. This was in the 1951 edition of his book, and in almost 60 years there have been few improvements.

One reasonable test, however, is management’s opportunism and understanding of the broad economic climate. Although “proactive” is viewed as a desirable quality to the point of being cliche, being reactive is also a good quality. Although there is a risk of confirmation bias (remembering what management did but forgetting what management didn’t do), developing a history of management actions is about the only way to assess their competence.

At this point it may seem unusual for me to hold up Capital One, a credit card company that is writing off its accounts at an annualized 10% rate, as an example of management competence. Well, first of all, I didn’t say they had to be a positive example, but my focus is more on the financial than the operations aspect. Yes, they overexposed themselves to a risky credit market, but short of liquidating themselves it’s not immediately clear what they could have done to avoid it (not that they deserve a free pass for it). Given that their chargeoff situation is going to dominate their earnings at least until the recession ends, I cannot say they are an unqualified buy.

In terms of their financial maneuvering, however, Capital One has not done too badly. Like all credit card companies, they rely on securitization of their credit card holdings as a source of funding, In order to diversify their funding sources, in 2006 Capital One acquired North Fork bank. In 2007 they divested the bank’s subprime mortgage origination unit, when the housing situation was still a slowdown instead of a meltdown. Their reason for doing so was that, on top of the housing situation, credit cards are capable of pricing the default rate into the interest charged to people, rather than relying on a potentially nonfunctional foreclosure market. Earlier this year they acquired Chevy Chase bank, for the same reason. Also, during the brief euphoria that accompanied the initial passing of the TARP, when their stock jumped from 30 to nearly 60, they made a secondary offering of stock at 48, which, given the current share price of $20 and change, also shows some fairly prescient timing.

As I mentioned before, the credit card situation allows the issuer to price the default risk into the interest charged. As I shall explain in my next post, this assumption may be called into question by the upcoming legislation.

Well, it’s official. Bernie Madoff is to be locked up for 150 years. Although it’s not exactly investing related, the largest fraud in history cannot pass without comment.

Madoff’s attorney must have been dreaming when he offered 12 years; Madoff’s fraud lasted longer than that, and it makes no sense to me that he should be punished for less time than he was a criminal. It should be recalled that at any time during his fraud, Madoff could have said “Enough” and turned himself in, but in fact it seems that he was raising money to shore up his scheme right up until the end. And, even if he can’t live out his sentence he can’t pay off all of his investors either and that didn’t stop them from seizing his assets.

So, what else is there to say, apart from some old advice involving eggs and baskets? (It’s hard for a crooked hedge fund manager to steal all your life savings if you don’t give them all to him.) The sad fact is that investors are generally powerless against fraud. Investing is hard enough without worrying about data quality, and so any remedy for fraud has to come from outside the investment world. That is why we have auditors and that is why Enron took Arthur Andersen with it. Madoff had an auditor (who has also been charged with securities fraud), but apparently his auditor avoided the peer review process among accountants by publicly denying to the AICPA that his firm does any audits. Again, this might have been a red flag, but a typical investor has enough demands on his time, and fraud on a scale big enough to be worth guarding against is so rare, that it would be more productive to invest in a straightforward manner and leave the fraud prevention to the existing system of accountants and regulators. Trouble is, sometimes that system has a Madoff-sized hole in it.

Shorting stocks is widely considered dangerous. The old adage is that “Stocks can only fall to zero, but they can rise to infinity.” I’ve always been unsatisfied with this explanation, because I’ve never seen a stock actually rise to infinity, and if I did see one I would short it.

The problem with shorting is that it is impossible to open a position and forget it. Unlike a long position in a solid and stable company, no one opens a short position without planning to close it. No one ever inherited a short position from a distant great-aunt, and if a brokerage needs the shares back it can close the position without the shorter’s consent. Furthermore, the best candidates for shorts are those that the market is most optimistic about. If their exuberance continues, the price can stay high and climb higher, giving the shorter a great deal of stress. And generally, shorting a situation of excessive optimism is the only way to do it; if everyone already knows that the stock is a losing proposition the share price will indicate this by being very low and there is really no profit left in shorting it.

Short selling may also be inconsistent with the low-hanging fruit approach. Purchasing an underpriced investment with strong present or potential cash flow gives investors assurance that, if they did their research correctly, the investment’s apparent underpricing will resolve itself. After all, cash is always worth cash. Short sellers have no similar assurances. They are reduced to waiting for the rest of the investment community to wake up to the fact that the company is nowhere near as good as the “story” they bought indicated (Ideally this process would be accelerated by accounting scandals, but you can’t have everything). The waking-up process, since it doesn’t involve cash piling up, has no time pressure to occur, and in the meantime, as Mohnish Pabrai indicated, the company can turn that fake value into real value by issuing new stock for cash, acquiring a real company with its overpriced stock, or allowing itself to be bought out.

On the plus side, shorting stocks, if you have a knack for it, is a way to find a use for unused margin (a margin account is nearly always required, and don’t use up all your margin because optimism has a tendency to feed on itself) and to reduce your market exposure in the face of a broad-based downturn. There definitely are times when optimism is clearly unjustified, and if, after seeing the downside of shorting we still want to short, finding excessive optimism is definitely the place to do it.

Coinstar presents such a situation. It has a market cap of $782 million as of this writing, made only $2 million last quarter, and $14 million the year before, which is an improvement from the previous year in which it lost money. That works out to a P/E ratio of 55, which strikes me as just the tiniest bit high.

I have to admit that when Coinstar came out, I was optimistic. Rolling coins is not most people’s idea of fun and any company that is in a position to exploit the laziness of the average person should have a bright future. However, the execution proved not to be as bright as the idea; the business proved itself to be high in capital requirements and expenses and I never really found an entry point I liked. But when such a company reaches a P/E ratio of 50 what could be more natural than looking for an entry point on the other side?

The cause for the latest round of optimism is Redbox, the DVD rental kiosks in grocery stores and some McDonald’s. They are certainly the driver of Coinstar’s recent sales growth; in the last reported quarter they produced $150 million in sales and $27 million in operating income.It is obviously difficult to value a fast growing entity, but Coinstar’s own latest 10-Q gives us a hint. Redbox used to be a joint venture with Coinstar and several other investors, but last February they acquired GetAMovie’s 44.4% interest in Redbox, plus a note for $10 million from Redbox, for $10 million plus a lot of stock. The company has already paid about $115  million in stock and expects to pay up to $20.8 million more. Taking out the cash and the note, we get at most $135.8 million for 44.4% of Redbox, which suggests that the whole of Redbox is worth no more than $305  million. This price was negotiated between two sophisticated buyers, each in possession of all the inside information they could want. Of course, Coinstar intends to expand this business, and presumably hopes to realize a decent return on capital by doing so, but presumably GetAMovie considered the same course of action and thought it was better to get out. Take away $305 million for Redbox, and that leaves a valuation of $477 million for the rest of Coinstar’s operations, which as I’ve said have not been at all impressive over the years. When Coinstar’s investors wake up to this fact the price should drop accordingly.

So, having heard the drawbacks and benefits of shorting stocks, if you want a stock to short I suggest this one.

On a forum I visit regularly there was a post when a novice investor asked if there was a good beginner stock that he could learn the ropes with. The general consensus was that there is no such thing as a beginner stock; all stocks were viewed as extremely complex generators of investment returns, full of capital issues, economic outlook situations, regulatory environments, etc.

The advice was to find a company in an area that interests you. However, most of the stocks on parade to the investing public are likely to be large, diverse, and to present a more complicated analytical situation than some of the smaller issues. The perennial advice is to invest in companies you understand, but there are different levels of understanding. “Of course I understand what Enron does. It trades energy derivatives.” “Of course I understand what AIG does. It’s an insurance company.” “Of course I understand what Citigroup does. Everything.”

So, even though the onus is on the investor to do his homework, some stocks are more amenable to valuation than others, and although complicated situations are more likely to have hidden value to unlock (or to have hidden traps), there is an argument to be said for finding a simple and understandable situation that allows the investor just to leap on it whenever the price is right.

Capstead Mortgage (CMO) probably qualifies as such a situation. It’s more of a fund than a company; it produces no products and has no customers. Their business plan is to purchase adjustable-rate mortgage passthroughs from federal mortgage agencies (Fannie, Freddie, and Ginnie) and to finance these purchases through short term borrowing, thus profiting on the spread the adjustable rate mortgage charges over the cost of financing. Also, since they are dealing with agency securities, and the federal government is now explicitly guaranteeing them (just as investors always thought they would), the risk of default is off the table.  Stock investors nowadays are often asking themselves “Where’s my bailout,” and here it is.

So, given these advantages, how can Capstead Mortgage lose money? Or, to be precise, Capstead Mortgage has lost money in the past and here’s how. First off, many of their holdings were until recently in the “teaser rate” phase, so their interest payments were lower than they would be once the teaser rate expires. Second, the company’s short term financing runs for a term of 30 days, while the reset period for many adjustable rate mortgages is a year or six months, and they have a “soft cap” where interest rates cannot rise beyond a certain limit per reset period. For this reason, it is possible that the interest on the mortgage will not always keep pace with rising interest rates. Capstead claims to use fixed/floating interest rate swaps to handle this, which allows them to receive the prevailing short term interest rate in exchange for them paying fixed interest payments. If their hedging is sufficient investors have nothing to worry about from rising interest rates. And when interest rates are low and declining, as they have been, the company has produced returns of about 15% on equity, which is not bad for a situation with theoretically so little risk.

So, what prevents Capstead Mortgage from being a screaming buy? The price. I mentioned the return on equity, but the investor cannot buy the equity for the same price the company paid for it. Net of the liquidation preference of its preferred stock, Capstead has a book value per share of about $10.40, and its current price is about $13. Although in theory a high cash flow producer like this is entitled to a premium, the economic situation of mortgage investing counsels against buying into a high premium situation. A mortgage borrower can refinance his mortgage at any time, and mortgage defaults also result in principal being returned to the holder of the mortgage passthrough. Therefore, a mortgage security that the market currently values at $13 will be paid back at $10.40, and the premium paid vanishes into thin air. The annualized prepayment rate was 16.6% last quarter. It is possible that even at current prices the high cash flows produced will justify the premium, and at a lower share price they definitely will. So, a significant price drop will turn Capstead Mortgage into the low-hanging fruit we all know and love.