HP: Huh? Pardon?

I just listened to most of the HP's latest conference call, and I'm afraid I'm no wiser for the effort. They threw around the word "strategic" but didn't explain why they're paying what many consider a high price (an 80% premium!) for a software company called Autonomy. It sounded like they were reading from a script instead of trying to clearly get their points across.

I just read a book called Good Strategy, Bad Strategy by Richard Remult. Having read a number of books on strategy, philosophy, business advice, and so on, I find it better than average. (Like the author, I have an engineering degree, so maybe the way he thinks about things makes more sense to me.) For instance, Remult distinguishes between goal setting and strategy, and describes what he calls the kernel of strategy: diagnosing the problem, setting a guiding policy, and performing coherent actions. (Not earth-shattering stuff, but how many people and companies actually do this?) If HP diagnosed their problems during the call, I didn't hear it through their business jargon.

I don't understand what they're doing or why, and so I'll be looking for a different investment.

Ruger: Overvalued at $27

Ruger stock soared today with its 15% jump to around $27. Its second-quarter earnings of $.57 per share beating analyst expectations by $.15 started a buying frenzy. It led me to place a sell order.

Cyclical stocks like Ruger are hard to value. Nevertheless, I did my best with a two-stage discounted cash flow valuation model. I used Year 0 cash flow of $15 (the average over the last five years), a discount rate of 11%, a growth rate of 10%, going down incrementally to 6% at Year 10 and to 4% after that. That gives a per-share valuation of $15.98. Being a little more generous in these assumptions led me to a value of around $20 per share. At $27 per share, Ruger is overvalued by 35% to 69%. I like Ruger as a company (I wouldn't have bought its stock otherwise), but it's now an overvalued, cyclical stock. To my way of thinking, it's time to sell, not to hang on hoping for more earnings that blow away analyst predictions.

How did they beat expectations? According to today's conference call, Ruger recently introduced the 1911 handgun, which has been flying off the shelves. Some of their other new products have sold well and had better returns. Much of it has had to do with improved efficiency in their operations--and there's only so much efficiency a company can gain. On the down side, they've been able to raise their prices about 1%; a competitor seems to have started a price war. (As an aside, my favorite quote from the conference call: "About half the people who say they don't like Obama will go out and secretly vote for him." Gun enthusiasts are notoriously non-Democrat.)

A hat tip to my father for telling me what he knew about Ruger last year when it showed up on the Magic Formula stock screener--even though my phone call woke him up.

Playing to Win

Gamestop has popped up on the Magic Formula screener from time to time over the past year. I didn't buy it a year ago because it had a little too much debt, but I gave it another look last week and saw that they've been on a debt-retiring tear. Adjusted debt to shareholders' equity was 97%, 82% and 75% in 2007, 2008 and 2009, respectively. I dug deeper and found a lot to like:

• Valueline rates its financial strength B+.
• Valueline also notes that "the digital and online units are rapidly expanding, and should account for a substantial chunk of sales growth" and calls the online segment "a strong long-term growth opportunity." (Had Blockbuster taken this tack sooner with movies, it might have been a threat to Netflix. Not only were they late to the game, but they charge more than Netflix.)
• Gamestop has been aggressively repurchasing stock and retiring debt.
• They're closing some stores to save money.
• Several value mutual funds have bought this stock recently.
• Gamestop is the biggest video game retailer in the U.S.

Games are serious business. "By the age of 21, the average young American has spent...more than ten thousand hours playing computer and video games, " asserts Marc Prensky, CEO and founder of Games2train.com.(1)

With all this in mind, I purchased some shares of GME with the intent of holding them indefinitely.

(1)Richards, C. "Teach the world to twitch: An interview with Marc Prensky, CEO and founder Games2train. com." Futurelab (Dec. 2003); http://portal.acm.org/citation.cfm?id=1378719

Invest in Stock or Pay Down Debt?

I'm getting ready to refinance my mortgage. I never thought I'd take out an adjustable rate mortgage, but a 7/1 is 3.625% at ING. And since seven years is all I have left to pay off my existing loan, in my case that ridiculously low rate will be for the life of the loan.

It will also knock down my required monthly payment by two-thirds. What if I made the minimum payment and invested the rest?

On the up side, I could really get ahead if I did well in the market. Joel Greenblatt's Magic Formula has worked very well for the past few years. If it continued to do well, in just seven years I'd be ahead tens of thousands of dollars.

On the down side, those returns aren't guaranteed. If the market tanked, I could end up behind. Historically, there have been decades when stocks went nowhere. Plus, I'd only pay down my mortgage by a few thousand dollars, and still be making mortgage payments in my seventies. That's depressing. Having refinanced to a 15-year loan seven years ago, I've paid down my mortgage by almost half. That feels great.

I'll have a mortgage burning party in 2018.

I have another loan that's about to be paid off in a few months: my car loan. I'll start taking the monthly car loan payment and buy stock.

Guns, Numbers and a Late-night Phone Call

"Risk comes from not knowing what you're doing." -Warren Buffett

About a year ago, a familiar name popped up on the Magic Formula stock filter: Ruger (RGR). In the house I grew up in, this name was as well-known as Smith & Wesson and Colt Firearms are to others. My father used to be a hunter and gun collector, he checkered the grips on some of his guns, reloaded his own ammo, and even made bullets on the stove top. When I saw Ruger on the list, I immediately called him.

Dad: "Hello?"

Me: "Hi, Dad."

Dad: "Hi, Lori."

Me: "Are you in bed?"

Dad: "Yes."

Me: "I'm sorry. As long as you're awake, though, I wanted to ask you about something."

Dad: "What is it?"

Me: "Ruger stock is selling at a bargain price. Is that a good brand of guns?"

Dad: "That's one of the best there is."

Dad went on to tell me about other brands whose ownership and quality had changed back and forth, and another who had turned to using poor quality steel. But Ruger was one who made the good stuff. And their financials looked good to me. According to the spreadsheet I made then, for 2009, Ruger had no long-term debt, a return on equity of 22%, gross profit margin of 32%, adjusted debt to shareholders' equity* of 37%. Results for 2008 and 2007 were more or less similar. It looked like a company with a durable competitive advantage selling at a good price.

I bought Ruger at $12.29 on April 5, 2010, and at $13.14 on October 1, 2010. It last traded at $17.51, a gain of 42% since April 5 and 33% since October. That doesn't include dividends. In comparison, the S&P 500 (no dividends) has gained 11.15% since April 5 and 15.15% since October 1.

*Total debt / (shareholders' equity + treasury stock)

The Future is in Plastic

As I scanned the Magic Formula stock screener for a stock I'd want to hold indefinitely, one company stood out: Visa (V). It's not a credit card company, but a global financial network that allows credit, debit, and prepaid cards to work. What I like about Visa:

• Name brand recognition and reputation
• International growth
• Low debt
• Stock buy-backs
• Increasing dividends

A few other stocks I considered and rejected:

Microsoft (MSFT): a little too much debt, a little too much competition from others. Their Mickey Mouse Word and Excel 2007 don't endear them to me, either. I use different word processing and spreadsheet software that I downloaded legally for free. It kind of reminds me of what Internet Explorer did to Netscape.

Altria (MO): Revenue has been going down for years. Maybe word has gotten out that cigarettes are unhealthy; maybe the taxes are too high; maybe they've been banned in too many places; maybe the recession has made a lot of people kick the habit. I'm not going to make it my problem.

Full House Resorts (FLL): They're going $30 million into debt to buy another casino. If it doesn't work out, the company will have a hard time absorbing that loss. Someone once said that change and profits usually don't go together. But good luck to them!

Coach: to Sell or Hold?

Back in 2008, Coach (COH) showed up on the Magic Formula stock screener. I researched it and liked what I found: low debt, lots of growth, and a high-quality product. A coworker remarked that everyone and her sister carried a $500 Coach bag, and looking around downtown Denver where I worked, I saw he was right. As I recall, Coach was busy establishing a beachhead in China and closing some lower-earning stores.

It didn't matter that I didn't understand why anyone would pay $500 for a purse. Two of my purses, a fabric Sack and a no-name raffia, cost $3 at thrift stores. A few months ago, I went wild and spent $50 on a gently used nylon Kenneth Cole handbag that I carry every day now. (The store owner called it "handsome.") I don't buy Coach purses--that's why I have money to spend on Coach stock.

I paid around $30 a share for Coach in 2008 and now it's trading in the high $50s. In my IRAs, I put a big bet on it and held it for two years, even though that wasn't according to the Magic Formula. It was just such a good company. I also have Coach in my non-IRA account, and wondered whether I should sell it or hold it. On the one hand, the Magic Formula has worked well for me. OTOH, Coach is still a great company with growth, low debt and a popular product. If I sold it, I'd have to pay tax on the earnings and find a better investment for my money.

Someone recommended selling enough of the stock to get back what I paid for it, but it seems to me that if it's time to sell, I should sell it all. I looked elsewhere for wisdom.

My handsome new handbag held a book called The Little Book of Value Investing by Christopher H. Browne of Tweedy, Browne & Co. LLC. The company used to be down the hall from Benjamin Graham (a client), and Walter Schloss had a desk in their office. Christopher Browne worked there for about 40 years. Here was just the person to turn to.

In the chapter "Watch the Guys in the Know," Browne says,

There are a lot of reasons insiders may sell shares in their company. They may wish to diversify their holdings, plan their estate, buy a dream house, or pay off a soon-to-be ex-spouse. They may sell shares obtained by exercising stock options. For these reasons, sales by insiders are not as strong an indicator as their buys.

I saw that a lot of insiders were selling Coach (there were several exercises too) but nobody was buying it in the $50s.

In the chapter "Buy and Hold? Really?" Browne says,

Long-term capital gains earned on stocks held for at least a year are taxed at 15%....And that is before any state or local taxes.

Turnover is the enemy of compounding and the friend of the Internal Revenue Service.

Many investors think they should be proactive and keep looking for ways to tweak their investment portfolio when just sitting tight, if they made the correct choices in the first place, often would be the better course.