The rule of three

One of the most common questions that I receive from my readers is how many stocks should they own in their portfolio. Unfortunately, there is no hard and fast rule on this. It all depends on your comfort level.

However, to simplify things, I have devised a “rule of 3” strategy in allocating my funds. Instead of focusing on the number of stocks, I would group my stocks into 3 categories depending on its risk profile and expected return. So let me go through these categories and do an analogy with some popular game shows on TV. Anyway, stockmarket is one big game in itself.

Patient money – This is similar to the game show “Who wants to be a Millionaire”. You need a lot of brainpower in choosing the right stock (or the right answer). Just like the said game show, once you hit the right stock (or the right answer), you will most likely hit the jackpot. My minimum upside target for stocks that fall under this group is 100%. However, investors have to be patient and be willing to hold the stock for at least 2 years. Mostly, these are out of favored stocks that have compelling turnaround story to boot. They may not necessarily be losing companies. Here, we are looking for stocks with “paradigm shift” in its fundamentals. Stocks that I bought under this category are Philex Mining (PX-P3.80), Republic Cement (RCM – P5.10), Philippine Stock Exchange (PSE - P445.0) and PCI Leasing (PCIL – P1.60).

Long term money – Like the “Game KNB” game show of ABS-CBN (ABSP – P22.25), you need some brainpower in choosing the right stock (or the right answer) but the odds of hitting the correct answer is much better compared to my earlier analogy. My minimum upside target for stocks in this group is 25%. Usually, you have to wait at least 6 – 8 months to see the full potential of your bet. Mostly, these are stocks that are in vogue. The best indicator is to watch for a significant increase in volume activity of the sector leader. Like in 2006, the best performers in the PSEi were banking stocks led by Bank P.I. (BPI – P71.0 that rose from P40.0 to P70.0 within the year. So what is good for BPI is good for the banking sector. So there is a strong chance for other bank stocks to follow suit. The movement of the sector leader is telling you to overweight the sector. As I always mention, the writings are on the wall. For 2007, the vogue sector is obviously the energy/utility sector. The turnaround of Meralco-B (MERB – P70.50) and the strong showing of PNOC Energy Dev’t. Corp. (EDC – P4.95) IPO signal that money flow is biased towards this sector.

Speculative money – It’s simply deal or no deal. Similar to the namesake of the game show, this is purely speculative play. You need very minimal brainpower and all you have to do is to observe the money flow of the stock (and a lot of luck). The most important rule here is to sell when the news is out – no matter what “whispers” you hear. Take for instance GEO Grace (GEO – P0.80). The stock rose from P.0675 to P0.80 in 2006. When the story was announced, the stock moved within a narrow range of P0.70 to P0.80. Had you held on to GEO since the announcement, you would have missed out on other opportunities in the market. Once the news is out, the speculation is over and it is time to say “deal”.

So, the next question is how much to allocate per group? Again, there is no hard and fast rule. Currently I am maintaining a 25%-50%-25% allocation. I have allotted equal weight to speculative and patient money since the liquidity of the market is quite good. In case there is a reversal, first to go will be all my speculative bets.

In the end, it is not how much money you make but how you manage your risk that matters. That’s how you play any game.

Quote for the day: "It is better to "average up" than to "average down"

Dickson G. Watts

Quote for the day: "Like artists, the best research minds use a lot of imagination and gut feel"

Quote for the day: What's obvious is not what you see. What's obvious, is what you don't see.

Top Dog Traders

“Casino Royale”: some chips that are worth betting on; buyers beware

Today the PSEi broke past the 3,100.0 levels to close at 3,141.3. What this signifies is that the market is entering a new “run”. As mentioned in my earlier post Bull Running on 4 Legs, this is an affirmation that the bull is running on all 4 legs. The “footprints” are clearly marked in the bull’s pathway. Foreign fund managers, local institutional investors, local market players and retail punters have joined the run.

However, what’s evident today is that Empire East (ELI – P0.72) broke out of its long consolidation phase. I consider ELI as a proxy for retail money. Once, ELI moves, we should see funds flowing to the punter’s chips. So, the next leg of the market will likely see strong activity from retail money with punter’s chip taking the center stage.

Amongst the punter’s chips, my top two bets are Fil-Estate Land (LND – P0.85) and Boulevard Holdings (BHI – P0.28). There is nothing great about these two chips but as the saying goes: “Every dog has its day”.

My key argument in “speculating” on these two companies is that the worst is over for them and it seems that management have a “move forward” plan that will “likely” enhance shareholder value in the future. Besides, there is still enough upside to speculate based on their “stories”

LND recently announced that it is negotiating for a US$12.5m construction loan to complete P2.5bn worth of leisure/high-end projects. It also got LIM Asia – a real estate specialist fund in Asia Pacific to invest US$5m into the company. While the amount involved is negligible, it is a small “first” step for the company towards rehabilitation. LND also claims to have 1,000 ha. of landbank. This will be valuable in nursing the company back to full recovery.

However, what really attracts me is that at current levels, LND is trading at 75% discount to its book value of P3.45/share. This means that we are paying a mere P0.25 for every P1.0 of net asset. We are essentially coming in at the same footing as other “vulture” funds that would have paid the same valuation. I guess with the stockmarket trading at 10-year highs, there is a strong chance that real estate assets will start to appreciate. My gut feel is that near term, LND can easily trade at 50% discount to its book – equivalent to P1.72 per share.

As for BHI, I like the stock because of its relatively small market capitalization – P290m. The stock has the potential to emerge as a punter’s favorite. Beyond that, I also think that its investment in Friday’s Boracay Resort is easily worth more than P300m. Friday’s Boracay has one of the highest room rates in the region despite its so-so facilities compared to other resorts in Asia. It shows that it has retained its franchise value despite the numerous resorts that have sprouted in the area. From my estimate, Friday Boracay generates around P180m revenues and contributes roughly P40m to BHI’s bottomline.

Recently, BHI announced it would increase its capitalization to finance the construction of a second hotel in Puerto Gallera. Most likely, a capital call is in the pipeline. So we should see more market making activities on the stock in order to make the rights offering more attractive.

Finally, as I have mentioned these are speculative chips. So buyers beware and punt at your own risk.

IBD's 10 secrets to success

Investor Business Daily (IBD) – (www.investors.com) is a must read for every investor. William O’Neil – a stockbroker, entrepreneur and writer, founded the site. To know more about Mr. O’Neil, please go to http://en.wikipedia.org/wiki/William_O%27Neil

1. How you think is everything. Always be positive. Think success, not failure. Beware of negative sentiment.

2. Decide upon your true dreams and goals. Write down your specific goals and develop a plan to reach them.

3. Take action. Goals are nothing without an action. Don’t be afraid to get started. Just do it.

4. Never stop learning. Go back to school or read books. Get training and acquire skills.

5. Be persistent and work hard. Success is a marathon, not a sprint. Never give up.

6. Learn to analyze details. Get all the facts, all the input. Learn from your mistakes.

7. Focus your time and money. Don’t let other people or things distract you.

8. Don’t be afraid to innovate; be different. Following the herd is a sure way to mediocrity.

9. Deal and communicate with people effectively. No person is an island. Learn to understand and motivate others.

10. Be honest and dependable; take responsibility. Otherwise, Nos. 1-9 won’t matter.

Quote for the day : "In a bull market, even monkeys make money"

Anonymous

Quote for the day : "If you love a stock, think about when to set it free"

Anjali Cordeiro - AWSJ 01/18/07

Bull running on 4 legs

The quiet bull has matured into a raging bull running on all 4 legs. This is how I see the market in the coming months. Last Friday, the PSEi closed at 2,992.0 with value turnover increasing significantly to P3.5bn. From experience, value turnover, more than the index level is the best barometer in gauging the market. This is a powerful signal for me. As I always like to stay, the writings are (clearly) on the wall.

For the last 3 years, we have seen the PSEi bull running on “just” 2 legs. Essentially, foreign funds and local market insiders have pushed the market to the 3,000 levels. However, there are signs that the other “2 legs” – local institutional funds and retail players are beginning to enter the market.

With the bull running on 4 legs, we should expect value turnover to reach P4.5bn per day soon. As for the PSEi, this will likely push the index to 3,400 level.

The appreciating Peso and the sharp drop in T-bill rates are the key impetus in generating additional liquidity into the stockmarket.

Local institutional funds have no choice but to increase their exposure in local stocks. The continued decline in interest rates will switch liquidity into the stockmarket. Fund managers can no longer justify generating 5% return to their investors. On the other hand, retail players who have been sidelined for the last 10 years have more excuses (now) to play the market. The opportunity costs to speculate in stocks have declined considerably with 91-day T-bill rates at 3.75% and the P/$ rate hovering at 6-year highs – P49.096: US$1.0.

On the flipside, the market might be entering its last leg. The big gains have been made. The PSEi will likely be in its last 10-15% run before cooling off. Whatever it is, there still money to be made in the market. So, ride the bull and enjoy the run while it lasts.

Banco de Oro’s (BDO – P44.50) universe; why it should trade at par with Bank of Philippine Island (BPI – P67.50)

Some of the best investment ideas that I have were derived from anecdotal evidences on how companies are transforming or reinventing themselves. More than news articles, press releases and analysts’ reports, it pays to have your ears on the ground.

A good example is BDO. Last week, I had lunch with a friend who owns a small and medium enterprise (SME). He maintains an account with BDO for his personal and business requirements. He told me that a couple of weeks ago, a BDO account representative visited him offering all sorts of non-deposit related products of the bank. My friend ended up transferring his insurance requirements to BDO and promised to sign-up for a new BDO–SM Advantage card.

After hearing this, I made some research and found out that BDO has been aggressively scoping out their client base and see what other products the banks can offer. I guess the idea is if you know the account balance, you will likely have an idea on the requirements of your clients. BDO is a universal bank that offers a whole array of financial services products from private banking to credit cards. In a way, BDO is molding itself into a Philippine version of Citibank.

I totally agree with the vision of BDO. Banks can no longer rely on plain vanilla banking services. The days of earning from interest spreads are gone. Banks will have to diversify its products to generate other fee-based income.

This makes me very “bullish” on BDO. The visit made by the BDO account representative to my friend is a microcosm of the big change happening in the bank. BDO is Tessie Coson’s gambit in expanding the empire of her father - Henry Sy. It looks like Tessie is bent on leaving her mark in the banking industry similar to the legacy of Henry Sy in the retail industry.

So, what’s the long term picture for BDO?

First, BDO is poised to become the biggest bank in the next five years. After the merger with Equitable PCI Bank (EPCI – P80.0), BDO will become the second largest bank behind BPI with P615bn in assets. I don’t think BDO will stop at number 2.

Second, BDO is well positioned to expand both its retail and enterprise business. In the retail/consumer side BDO can capitalize on the reach of SM Malls and department stores. On the enterprise side, BDO can easily tap into SM Group’s network of tenants and suppliers.

Third, BDO will realize the full benefit of the merged Equitable-PCI bank. Note that Equitable Bank has a strong niche in the Chinese market while PCI Bank is big in corporate banking.

These three factors should easily catapult BDO to the number 1 position. A bet on BDO, is a bet on Tessie. Having seen how driven she is, I guess, it is a (very) wise bet in the long run.

Against this backdrop, I do not think the market should value BDO at a discount vis-à-vis BPI. Currently, BPI is trading at 2.6x price to book value (P/BV) whilst BDO is priced at 1.7x P/BV. Investors have bid up the valuation of BPI on the back of better assets and earnings quality. However, I do think that growth should be the key consideration in valuing banks. The crisis is over. So moving forward, the market will start paying a premium on growth.

The combined market capitalization of BDO and EPCI Bank is P100bn versus BPI’s P160bn. I think the disparity is way too much. This is clearly a valuation arbitrage opportunity between BDO and BPI. Everything else equal, BDO should be trading at par with BPI. At 2.7x P/BV, BDO is easily worth P70.0/share.

Some questions from my users

Question - Sir, I have the highest regard in your views and analysis on certain stocks. May I ask you about your outlook on stock market in the first quarter of 2007 and if you have a list of stocks, companies, and industries to watch this year? Wishing you a prosperous 2007 full of great luck, blessings and good health. From Rainman

Investors should overweight utility counters. Please read my entry last week http://bigbigtrade.blogspot.com/2006/12/key-theme-for-2007-buy-utility-stocks.html . Amongst the utility counters, my number one choice is Meralco (MERB – P59.50), followed by Manila Water (MWC – P9.20) and PNOC Energy Dev’t (EDC – P4.50).

Meralco is indeed a turnaround story. Even with the recent price run-up, the stock is trading at mere 7.4x PER. So, a price target of P80.0 or 10x PER is defensible. Longer term, I do believe that Meralco should be trading close to P100.0. Added to this, there is a rumored M&A play in MERALCO. The Lopez’s have expressed their willingness to sell out of Meralco at the right price. I guess the writings are on the wall.

Manila Water has consistently been in my recommended list since early 2006, when the stock was trading at P6.30. I guess, the recent sell-down is a perfect opportunity to add to your position. MWC offers both growth and stability. Seldom do you see these two factors come together in a utility concern. Normally utility counters provide stable earnings picture. This is not the case for MWC. For 2007, the company is expected to generate healthy top-line revenue growth excluding rate hikes. This means that MWC still has a huge untapped market to grow its revenue base. The approved 13% rate hike is an added bonus. In due time, the market should pay a premium on MWC based on its quality of earnings. Easily, MWC is a P12 stock.

As for EDC, I guess the price movement speaks for itself. For a US$300m IPO to jump more than 50% tells you the level of institutional demand for the stock. Most likely, more buying orders will come in. EDC is very similar to the Petron (PCOR – P4.10) IPO in 1995. From its initial offering price of P9.0, Petron rose to as high as P25.0. Mostl likely EDC will follow the same track.


Question – Sir Jack, what are your criteria in choosing a sector or a stock? I notice that you have very different calls on the market. Btw, it seems that you are not been bullish on the property stocks. – From theblackmagic

My key criterion for liking a sector (or a stock) is if there is a significant change in paradigm. For 2007, I like the utility sector since the government has shifted from “anti-utility” to “pro-utility” policy in regulating the sector. With the move, we should expect a re-rating in the coming months. Note that the Price Earnings Ratio (PER) is an indirect pricing for risk. Lower risk translates to higher PER and vice versa.

For 2006, my best picks were RCBC (RCB – P24.50) and Republic Cement (RCM – P4.20).

For RCBC, my argument then was that the company has moved from being “inadequately capitalized” to “adequately capitalized” after the successful P2.0bn “Tier 2 equity” offering. Thus we saw the valuation moved from 0.8x Price to Book (P/BV) to 1.6x PBV.

On the other hand, RCM moved from being a “distressed” cement company to a “cash flow positive” cement company. The change in paradigm saw the stock zoom from P0.85 to P4.20 in less than a year.

Finally, I am not too keen on the property sector. The series of equity calls from Megaworld (MEG – P1.82) and Filinvest Land (P1.66) indicate that the sector is still in the negative investment cycle. This means that property companies are running on negative cash flows and thus, they have to resort to borrowings and equity calls. Note that these fund raising activities have a negative impact on the value of the existing shares. It dilutes the equity value.

So, until the sector starts showing signs of turning around its cash flow position, returns will likely lag the rest of the market. Between 1994-1996, property companies outperformed the market simply because they are generating positive cash flow. Recall that during that time, property buyers were scrambling to purchase properties upfront or even pre-pay the units during the pre-selling phase. Unfortunately, this is not happening right now.

Hidden Gems: PCI Leasing (PCIL – P1.40) Philippine Stock Exchange (PSE – P280.0)

Hidden gems are hard to find in this market. Majority of the stocks with good fundamentals have “glittered” to reach prices not seen in 5-10 years. However, amidst the shimmer, there are still some stocks that looks “dull” on the outside but is definitely worth more once its “polished”. I guess it is a matter of time before the market sees these gems. I am referring to PCI Leasing and Philippine Stock Exchange – yes, the stock exchange where we trade Philippine stocks.

Let me start with PCI Leasing or PCIL.

PCIL is a leasing company that is 85% owned by Equitable-PCI Bank. There is nothing spectacular about the leasing business. Leasing companies do quasi-banking functions but it cannot take deposits. It mainly serves as a conduit between the banks and the SMEs, which might be too “expensive” for the banks to service. However, despite the boring nature of its business, PCIL still manages to generate stellar earnings numbers. For 2006, the company is on track to generate 21% earnings growth.

What attracts me is that despite the good numbers, PCIL continue to trade at “distressed” valuations. This means that investors have generally ignored this gem (of a stock).

At current levels, PCIL is trading at 7.7x PER to 12/07 earnings and a “mere” 0.77x Price to Book Value (P/BV). I do not think valuations will continue to stay this low. The only time you value financial companies below book value is when the company is teetering on bankruptcy. PCIL is nowhere in that league. In fact, in 2005 PCIL paid out P0.20 cash dividend to its shareholders. The company is on track to do the same this year, I think.

At the least, PCIL should trade at par with its book value of P1.84. This should give us a 31.0% upside from current levels. Not bad considering that the market has already risen by 42.0% in 2006.

Philippine Stocks Exchange or PSE is another gem waiting to be discovered. From how the market has performed in the last 12 months, it seems that the market has more room to grow. What’s good for the market; is also good for the PSE. My gut feel is that the PSE can easily double its net income in 2007 to around P450m.

PSE derives its income mainly from listing fees and service revenues form clearing operations. In 2006, companies raised P57.2bn from the market. On the other hand, average daily turnover reached P2.9bn.

For 2007, I expect the market to double the amount raised in 2006. In January alone, Megaworld (MEG – P2.40) and Filinvest Land (FLI – P1.80) are expected to raise P20bn from the market. This is already equivalent to 40% of what was raised in 2006. So, we can easily surmise that listing fee for 2007 can potentially double.

On the other hand, revenue from clearing operations will likely increase on the back of higher value turnover of the market. Again, my “gut feel” is for the market to generate US$100m or P4.9bn in daily turnover equivalent to what was achieved before 1997.

So based on these assumptions, a P500m net income target is doable. Note that the PSE do not have to incur additional cost to grow its revenue. Almost 90% of the incremental revenue will likely go straight to its bottom-line.

At P280.0 PSE is trading at mere 9x PER to 12/07 earnings. I believe that similar to exchanges around the region, PSE ought to trade at a premium. On the average, regional exchanges trade at 15x PER. Assuming, we use that as a “back of envelope” target, PSE should be trading at P500 per share.

The only drawback in owning these stocks is the lack liquidity. However, the potential reward is worth the wait.