2011 in review

2011 - the year that I saw the light.

Enough games, enough allocation rules, enough mediocre companies, just pile into the best companies.

I have been in and out of Google several times over the years and made some nice profits but if I had just sat on my hands and kept my position (and added to it) my results would have been so much better.

This also seems to be the theme of the famous book "Common Stocks, Uncommon Profits" - rather than search for bargains buy great stocks and hold them.

Charlie Munger endorses buying and holding a great company that keeps on growing because "then you can just sit on your bum for years!"

The problems are that trading is fun, it is human nature to want to just do something and we have the financial media bombarding us with stock ratings and price targets.

Warren Buffet says that the fact that he lives in Omaha rather than New York has been a huge benefit as it gives him a better perspective on the market, away from all the Wall Street hype.

So less is definitely more when it comes to investing.

I have now sold the last of my mediocre holdings and am about to buy more Google and Apple. So it was farewell to BP, BHP Billiton, British Land and Barclays. This is not discrimination against the letter B! Rather I am focussing on companies that I understand, that are growing fast and have a low cost of growth. It is hard to sell stocks that are as cheap as the four above but I believe that Google and Apple are even cheaper when you factor in their growth.

So how was my 2011? Pretty decent compared to the market, largely thanks to my Apple and Google holdings. My aggressive portfolio, which ended up just consisting of Apple, was up 10% compared to a fall of 5% for the FTSE100. My "pay the mortgage" portfolio, weighed down by the British companies mentioned above, just rose 2%.

Here are the rules for 2012 and beyond:

1. Buy only beauties.
2. Keep It Simple Stupid - no allocation rules.
3. Stop trading.
4. Do something interesting with your life!

All the best in 2012.

The cost of growth

This market is ugly. Who would have thought that 3 years after the market meltdown of 2008 we are still suffering from the repercussions?

I am still waiting for the general stock market to start moving upwards in the way that all pension advisers claim that it does. In the meantime those who want a return on their investments are going to have to do more than invest in an index tracker.

My flight to quality is paying off big time. While most industrial stocks have tanked and banks remain in the doldrums some technology stocks have actually grown. Look at the chart below:



This is the 5 year chart for IBM. Here is something that you won't find in many places. Growth in the last 5 years!

The surprising thing is that companies like this are not hard to find. Here are five the come to mind instantly: Apple, Google, Microsoft, Intel, Intuitive Surgical.

What are the key qualities that separate these companies from the industrials that Warren Buffet understands and loves?

1. Large amounts of intellectual property.

These companies don't make commodities. They produce something that is hard to compete with. Banks may all copy each other's products but could you copy one of Intel's processors?

2. Cash rich with little or no debt.

These companies throw off cash in the normal course of operations. Some of them have so much cash that the idea of needing to borrow money is laughable.

3. Low cost of growth.

Producing new products for the companies above is just an ongoing process, not an extra cost. If BHP Billiton wants to grow it has to carefully weigh up the cost of building a new mine against the potential reward. The above companies have engineers that design new technology every day. Some of them have no direct competition (Intuitive Surgical.)

4. High margins.

When your product is unique you can charge a lot for it. Google can charge a lot for its marketing services as no other internet company has its reach. Apple can charge a fair price for its iPad as no other product comes close to it.

Sometimes investors are guilty of thinking too much about what they do. This results in confusion and much thrashing about. It probably explains why I ended up with large chunks of my portfolios in banks, miners and even airlines.

As a personal investor you have huge advantages over funds. You can invest in anything, there are no portfolio weighting restrictions and you do not have to show results within any particular time frame. How many of us throw away these advantages by applying restrictions to our portfolio and over diversifying?

My understanding of investing is maturing. I have still not managed to offload industrials such as BP and BHP Billiton. I still have bank holdings. It is hard to sell securities that currently look so cheap. And there will come a day when these companies will outperform the market. But long term I am going to concentrate on beauties and leave the ordinary for the funds.

Going all in with Apple

Last Friday I sold most of my Google position and bought more Apple. This makes my Apple holding my biggest position ever by quite some margin. Why did I do it? I was inspired by two facts:

1) Apple's free cash flow (FCF) per share was higher than Google's last quarter. I calculated Apple's at $11.23 and Google's at $8.07. However Google's share price is over $200 higher. This despite the fact the Apple is growing much faster. If Apple stopped growing right now it shares would still be fairly priced.

2) Charlie Munger said I could. Seriously at a recent Berkshire Hathaway shareholder meeting Charlie said that he once had over 100% of his portfolio in one stock (meaning that he used leverage.) He thinks that it is less risky to invest in one company you know really well that to diversify into a number of companies that you know less well. On the whole I agree with him so my aggressive portfolio is now 100% Apple. However I am not sure that I would recommend putting all your savings in one company. Although you may understand the company and its market you may not understand all the macro-economic factors that could affect it. Investing in a handful of promising opportunities that you really understand may be the best option.

One problem with having only one stock in a portfolio is that it makes for painful viewing when the stock is having a bad week or month. However I have other portfolios I can look at and I am not one to panic.

When the next iPhone is announced the stock should get a modest boost and iPhone and iPad should sell like hotcakes in the 2011 Christmas season.

Now that I have a big position it is time to hold on and enjoy the ride.

Is Apple fully ripe?

Another blow-out quarter from Apple, another market under-reaction.

Here is one key statistic: Free cash flow for the last quarter was over $10 per share. If you annualise that to $40 Apple has a Price/FCF ratio of under 10! And yet earnings growth was over 100%!

The reason Apple is so cheap is clear - its market cap. of $358B. How can a company that big grow fast in the future?

To get the market cap. in perspective, Research In Motion (the Blackberry maker) has a market cap. of $15B and Nokia has a market cap. of $22B. Microsoft has a market cap. of $228B

In order to continue growing at stellar rates Apple is going to have to grow its markets and enter new markets. For example the iPhone has grown the overall smartphone market as well as stolen market share from Nokia and others. The iPad has virtually single handedly resurrected the table market.

There are rumours that Apple is going to enter the TV market - probably by combining its Apple TV box with a flat screen. While this could be lucrative it is not going to be the next iPad - it would be for consumers rather than business and consumers do not change TVs as often as computers.

Could Apple double its earnings in the next couple of years? Quite easily and without entering any new markets. Apple has less than 10% of the global mobile phone market and less than 10% of the global PC market so there is plenty of room for growth there. Apple also makes bigger margins on its products than competitors as they are all at the premium end of the market.

So here is the problem. The numbers say that Apple is amazingly cheap. The market cap. says that Apples growth must slow.

But here is the odd thing: Apple is cheap even if the growth slows to 10%.

The risk - reward ratio is phenomenal for this one - still a screaming buy.

My smartphone position

When you have a significant idea take a significant position.

My idea is that Apple (AAPL) and Google (GOOG) are cheap - very cheap. Here are my recent purchases to build up a position:

05 Jan 2010 - Buy 3 GOOG @ $624
13 Jan 2010 - Buy 4 GOOG @ $572
09 Apr 2010 - Buy 9 AAPL @ $251
12 Jul 2010 - Buy 4 GOOG @ $507
26 Jul 2010 - Buy 6 AAPL @ $273
19 Jan 2011 - Buy 8 AAPL @ $342
10 Jun 2011 - Buy 5 GOOG @ $512
07 Jul 2011 - Buy 6 AAPL @ $358

My GOOG position is showing a slight gain and AAPL is showing a significant gain.

I thought I would plug some numbers into Benjamin Graham's stock valuation formula to see if they are still cheap.

Here are the figures I am going to use:

AAPL EPS = 21
AAPL Growth = 20%

Using the simple formula (see here)

Value = 21 * (8.5 + (20 * 2)) = $1018

This takes no account of the amount of cash per share AAPL has and uses the GAAP figures and a conservative growth estimate!

Now lets try the more complicated formula that takes into account current bond yields:

Value = ((21 * (8.5 + (20 * 2))) * 4.4) / 2.67 = $1678

So AAPL looks pretty cheap at its current price of $357!

Now I'll plug in GOOG's figures:

EPS = 26
Growth = 15

Value = 26 * (8.5 + (15 * 2)) = $1001

And the more complex formula gives a value of $1649

I wonder if any analyst would be brave enough to publish these figures as a target price? The answer is no as they have to save their face.

Of course the risk is that the companies will not keep growing over the next 10 years. However even if the companies only grow at a rate of 10% over the next 10 years they are still undervalued.

I have seen several articles on how to play the smartphone revolution by investing in component manufacturers like Qualcomm and Samsung. Well you could but why not just invest in the players at the top of the value chain? They have the brand and the momentum whereas a component manufacturer can be silently replaced without the public caring.

GOOG and AAPL are cheap - very cheap. This is my position on smartphones.

Sorting the wheat from the chaff

I have mentioned previously that I want to eliminate mediocre stocks from my main portfolio this year, especially as growth companies like Google and Apple are so cheap at the moment.

I am going to do a quick comparison of four companies that I own with a view to selling some of them to invest in Google.

1. eBay

eBay is one of my oldest holdings and I have learnt some valuable lessons while holding it. For example, just because a company recently had a trailing PE of 100 doesn't mean that it must be cheap when it has a trailing PE of 40. By buying eBay when it had a PE of 40 I had little margin of safety when the growth slowed and the fall in the share price was painful. eBay has recovered somewhat and I am now sitting on a 30% loss.

eBay is forecast to earn about $2 non-GAAP this year giving it a 2011 PE of 15 or about 13 if you subtract the cash per share from the share price.

Here is the scorecard:

Growth Potential: 6
Risk: 6 (low score means high risk.)
Valuation: 7

This give eBay a score of 19 out of 30.

Barclays

Barclays is one of the few British banks that emerged from the Credit Crunch of 2008 with its pride intact. It accepted a large investment from a Middle Eastern fund rather than use government assistance and as a result is still in control of its own destiny. However it is currently a low yielder, still has a lot of bad debt and operates in a very competitive marketplace.

Barclays could earn about 45 pence this year giving a 2011 PE of about 6!

Here is the scorecard:

Growth Potential: 5
Risk: 6
Valuation: 10

So Barclays scores 21 out of 30.

BP

Everyone knows that 2010 was not a good year for BP. However the oil spill in the Gulf of Mexico may end up costing less than analysts feared and the current price of oil means that BP is still making a very sizable profit.

BP could make 70 pence this year giving a 2011 PE of 6.5!

So the scores are:

Growth Potential: 5
Risk: 5
Valuation: 10

Giving BP a score of 20.

And finally the big one:

Google

I have recently written about the monster that is Google. It is huge and it is still growing at 30%. Android is taking off and with the Chromebook Google is trying to access the enormous PC market. There is plenty of growth left for Google.

Google could earn $40 in 2011 giving it a 2011 PE of 13 or 10 if you subtract the cash per share from the share price.

Here are the scores:


Growth Potential: 8
Risk: 7
Valuation: 8

Google gets a score of 23.

Conclusion

Barclays and BP are very cheap and highly profitable. Across the pond Google is cheaper the eBay and growing much faster.

It looks like I should hold on to the British pair for now but consider offloading eBay for Google. Does Google's better score justify the trading cost of changing position? Probably. Google is a growth machine and is much more central to the internet economy than eBay. I have some and I want some more.

Get switched on

Hello again!

I have been keeping a low profile, letting my investments look after themselves. It is now time to do a health check on a couple of my stocks, checking that they are still as attractive as when I first bought them.

Here are my thoughts:

Apple - ridiculously cheap. Maybe people think it is too big to grow but it has an enormous PC market to eat up and enormous populations like India and China to sell phones to. Once people get used to the iOs platform it will be inconvenient for them to switch to Android or Phone 7. This means hundreds of millions of people will be buying Apple products as long as Apple keeps on making them desirable. That is the risk - what if a competitor releases a hit product? Well the Android smartphone is that product but this world is big enough for both of them. Blackberry and Nokia will have to feed off the remaining scraps.

Google - cheap and plenty of growth left. If you think that Google is too big to grow then you are wrong. Google has an ability to innovate that Microsoft can only dream of. Take the upcoming Chromebook. This is a cheap netbook that stores all your data online (in the cloud) rather than locally. Most of us have had an experience of losing data because of a hard disk failure or accidental deletion. With the Chromebook this will become a thing of the past. What about when you cannot access the internet? I suspect that there will be a way of caching your work locally and working offline for a time. However if you get a 3G Chromebook it is unlikely that both your broadband and mobile operator will be unavailable at the same time.

How hard would it have been for Microsoft to produce a product like this? Not very hard actually but Microsoft seems to be stuck in an eternal cycle of endless iterations and incremental improvements rather than innovation. The world is changing and Microsoft is being left behind. Unless it accepts that it needs to get involved in the hardware side and produce products that look and feel good as well as having good software it is going to get beaten by Apple and Google.

Microsoft has finally realised this with its Phone 7 product and so is collaborating with Nokia. It had better do the same with PCs or it will be toast.

One other big advantage of the Chromebook is that it updates itself. Can you remember giving up a weekend to re-install the latest version of Windows? This will also be a thing of the past as the Chromebook quietly updates itself in the background.

Google seem to realise that people don't want to think about the operating system - they just want it to work and quietly let them get on with surfing the Web or listening to music.

Google realise this with their Chrome browser. People don't want to think about a browser, they just want to surf the Net as fast as possible with as much screen real estate as possible. People don't want to spend an hour upgrading to the latest browser version so Chrome quietly does this for you in the background. And the better people's internet experience the more time they will spend online potentially clicking on Google's sponsored links.

There will come a time when Google and Apple are the giants of the consumer PC world and Microsoft will be able to play the role of innovative competitor. The path to that situation should be a fun one for Google and Apple investors.

So there you have it. Leave your boring, low-yielding savings accounts behind and invest in the future!