Q1 Portfolio Review – Riding the Roller Coaster of Volatile Markets

By Rob Marstrand April 26, 2013

Nothing can stop the man with the right mental attitude from achieving his goal; nothing on Earth can help the man with the wrong mental attitude.

– Thomas Jefferson

Greatness be nothing, unless it be lasting.

– Napoleon Bonaparte

Public capital markets can do anything in the short term. Prices can rise quickly and fall twice as fast. Although you can invent reasons that appear to explain what’s going on, there is often little logic to these moves.

Timing these short-term price swings and making a profit is extremely difficult – even for hardened full-time professionals. I’ve known a lot of traders and fund managers over the years. Most of them do okay most of the time but then lose large amounts now and then. Overall, the performance is average at best. It is often poor.

This is why we recommend you cultivate a special type of investment discipline. It should have the following features:

  • You allocate your wealth across several different asset classes at all times. This ensures the essential diversification that massively reduces the risk of a ruinous loss of wealth.
  • You allocate wealth to investments that stand to benefit over time from strong fundamental conditions. In other words, you don’t do diversification for the sake of it. You diversify only into assets that have reasons to gain in value over time. Even cash – a loss-making proposition in the long run – has positive attributes, since it gives you the ability to buy assets at the “bargain counter” when panic selling grips the market.
  • You invest in assets when their prices are low relative to their underlying values. In other words, there’s no such thing as a good or bad asset. It’s the price you pay for an asset that counts.
  • You invest over the long term. You are happy to buy an asset when it’s selling for below its intrinsic value and wait patiently for the price to rise to fair value (or above).
  • You reduce your trading activity and, therefore, your trading costs. This is essential for private investors, since we all pay large multiples of the trading costs incurred by professional traders and fund managers. For this reason alone, we shouldn’t attempt to replicate most of their trading strategies.

I say this is a “discipline” because it requires patience. Markets can – and will – move against you and test your investment thesis. The longer it takes to realize profits, the harder it is to control your emotions and stay the course. Doubt sets in.

Right now, for instance, two of our core beta strategies, gold and emerging market stocks, are experiencing weakness. Both are out of favor. We continue to believe they should make up significant parts of our recommended “all weather” Family Wealth Portfolio.

Real estate doesn’t tend to test the nerves in the same way as highly liquid investments such as gold or stocks. This is because you can’t find quoted prices every second of every working day for real estate. Property markets move in slower cycles. (A typical time frame would be 10 years on the way up and five years on the way down.)

Also, you can use real estate that you own directly. Its tangibility is a source of reassurance. Short of a fire, war or natural disaster, it tends to stay much the same. Same numbers of bricks and tiles. Same acreage. Same changing seasons. However, it needs maintenance, which costs money. (Of course, directly owned gold is also something you can touch and feel. Nevertheless, it can be surprising how small the quantities look in relation to the dollar value.)

Of course, just because stocks and gold have easily-viewed price gyrations doesn’t make them “worse” investments than real estate. It just means they result in bigger emotional responses. You might feel you are on a roller coaster from time to time. You get the euphoria of prices suddenly rising. Sudden price plunges set off our feelings of fear, worry and self-doubt.

A Challenging First Quarter

The first quarter of this year was such a time. The MSCI Emerging Markets Index fell by -1.9%, measured in US dollars. The price of gold fell -3.2%.

The flip side of this (and there’s usually a flip side, if you’re properly diversified) is that the exchange value of the dollar strengthened. The trade-weighted US Dollar Index, which measures the exchange value of the dollar against the currencies of America’s main trading partners, rose by 4%.

Put another way, if your home currency is the dollar, those cash reserves became more valuable in the sense that you can buy more gold and emerging market stocks than at the beginning of the year.

During the first quarter, the S&P 500, which is a market we recommend you avoid in terms of any big beta allocation, rose 10%. I explained the reasons why I don’t think the current rally is sustainable in last month’s report. I believe there are serious risks to holding US stocks right now – most notably due to falling earnings and record levels of margin trading.

We have also recommend you avoid the Treasury market. Treasurys have performed well in the past couple of years despite our concerns. But in the first quarter, long-dated Treasury bonds, as measured by the iShares Barclays 20+ Year Treasury Bond ETF (NYSE:TLT), fell by -2.8%. (The average maturity of bonds held by TLT is 28 years.)

I can’t say for sure that the bull market in bonds has come to an end. As Chris has pointed out, Treasury bonds have been rallying (and yields have been falling) early in the second quarter. But yields are so low now that there is no point holding bonds for the long run. The yield on the 30-year T-bond is 2.9% as I type. The yield on the 10-year T-note is just 1.7%.

This is more than you will receive on your cash. But after current levels of inflation are factored in… and after you consider the probability of an end to the three-decade-long bull market they have just experienced… bonds remain, in our view, “return-free risk.”

The point is that it will take only a small increase in bond yields from current ultra-low levels for long-dated bond prices to collapse. (When yields rise, prices fall, and vice versa.)

When a bond has a yield to maturity of 3%, its price is much more sensitive to an increase in yield by 1% than a bond that starts with a yield to maturity of 5%. So bonds are risky at these low yield levels.

We prefer gold to bonds, despite the recent sell-off. As I explained here, nothing that we can see has changed fundamentally about the investment case for gold. The recent price falls had less to do with any fundamental shift in the world than with a liquidity-driven panic, as Chris wrote about here.

But what about the stocks? We continue to believe the best long-term profit growth will come from the economies that have some – you guessed it – growth! Those economies are found in the so-called “emerging markets” (which, in reality, are at different stages of economic development).

Combine that with the value-driven discipline I described above (buying things when their prices are low relative to intrinsic values) and over time, the profits will take care of themselves. In the meantime, the average dividend yield on the stock market investments in the Family Wealth Portfolio is over 4%, against just 2.1% for the US market.

Where Is the Value in Today’s Markets?

I’ve been busy recently, comparing stock markets around the world. (In particular, how they have performed so far during 2013, up to April 17.) I also looked at their P/E ratios and dividend yields. Combining this information with what we know about fundamental conditions is an excellent indicator of where the value is right now.

Below is a chart showing the year-to-date performances of selected country stock markets (at the time of writing). It shows the period from December 31, 2012, to April 17, 2013. I’ve used MSCI indexes for each country because they are all calculated in US dollars. Taking account of exchange rate movements of the local currencies ensures we’re comparing apples to apples.

The countries shown are not a particularly logical list. It’s just a group of markets that are interesting because they are large… or because they have had very strong or weak performances. But you can see right away that my favorite stock market at the moment, Russia, has been having a bad year so far. It’s down -11% in dollar terms.

Also, some of my least favorite markets, such as the US and Japan, have been doing well recently. Japanese stocks have been rallying hard, partly due to the Bank of Japan’s efforts to weaken the yen and create price inflation. The theory goes that, with a weaker yen, Japanese exporters will be able to price their goods more competitively in global markets, resulting in a big boost to profits. There is also belief that higher inflation could drive Japanese investors out of cash and bonds and into stocks.

It’s a kind of “new paradigm” moment, when a lot of analysts and investors think the world has changed dramatically, so they’re piling in. Like a minor version of the dot-com bubble.

I see several problems with this thesis. Most obvious, perhaps, is the question of how long other countries will continue to let the yen depreciate against their currencies. There have already been news reports that the Chinese are not amused. The South Koreans must be concerned, as well. Their economy also relies heavily on exports of manufactured goods.

I can also see countries such as France getting tetchy. The French car industry has been suffering lately. And foreign car imports have been a hot political topic there recently. If we get a flood of Japanese imports, spurred on by a weaker yen relative to the euro, I can see Paris pushing for a weaker euro or possibly import tariffs.

Even Germany could have a problem. The German economy is also heavily reliant on exports. And it’s hard to see the Japanese getting away with a free pass forever, with Europe in the dire state that it is in. Then there’s the US. Surely, domestic lobbying pressure would come to bear on Congress if the country sees a flood of Japanese imports.

The yen has weakened significantly recently. It’s down over -20% against the dollar since September 2012. But I am not sure other countries will let this go on for long, given domestic economic and political realities. The expected extra profits of Japanese exporters may be disappointing.

Another thing is that Japan is highly dependent on imported natural resources – specifically, energy. A weaker yen will mean higher input costs for industries that sell into the domestic Japanese market. It will also mean higher energy costs for Japanese families to heat and light their homes.

So consumers could have less money to spend at the same time that finished goods prices are rising… leading to lower sales volumes. Or Japanese companies will keep a lid on sales prices in return for lower profit margins. Either way, it points to earnings pressure for domestic businesses. This could be enough to offset any profit gains made by exporters, meaning the overall corporate profits of listed Japanese stocks don’t take off at all.

Finally, there is the thorny issue of valuations. Japanese stocks have a relatively high P/E of 17 and a relatively low dividend yield of 1.7%. That’s hardly value territory. And it will take a lot of (unproven) profit growth to justify those levels.

Why Russia Is Still My Favorite Market

I’ve also done a comparison of P/E ratios and dividend yields for the same group of country stock markets. Below is a chart that shows dividend yields on the vertical axis and P/Es on the horizontal axis. Developed markets are colored red and emerging markets are colored green.

The cheapest markets with the highest dividend yields are shown in the top left-hand corner. The most expensive markets with the lowest dividend yields are shown in the bottom right-hand corner.

This shows you why I like Russia so much. It has pretty much the lowest P/E in the world right now, at 6.1, and one of the highest dividend yields, at 4.7%. Yet corporate profits continue to grow. Last year, they grew at well over 20% per year. That rate of growth will probably slow in 2013, as Russia is not immune to the weak global economy.

Investors are concerned with Russian governance issues, often with good reason. But such a low earnings multiple makes up for a whole lot of risk. The best opportunities are found, remember, among things most people won’t do.

China is also close to value territory. The Chinese stock market trades on a P/E of 7.7 and a dividend yield of 4.2%. But the investment case for China is a little less clear-cut. The economy continues to grow fast. But it’s now growing below its average for the last decade. Latest figures show it growing 7.7% per year. There is a debate to be had about the accuracy of these figures. But even if China is growing at only 5%, that is still way ahead of the developed economies.

The issue with China is that the stock market has a large weighting to giant banks and other financial sector companies. It’s difficult to ascertain how much bad debt these banks may be carrying – either now or in the future.

I’ve done large corporate mergers-and-acquisitions transactions in China for UBS. Bank balance sheets are difficult to decipher at the best of times. And I was working with top accountants who specialized in the banking sector! Chinese bank balance sheets are some of the hardest to really pick apart.

One concern is that a property crash could lead to Chinese banks taking huge losses. It’s an issue that is difficult to get to the bottom of… and reason to be more cautious when buying into a Chinese index, compared with a Russian one. As we found out in 2008, when leveraged banks go down, they fall with a big crash. Shareholders get whacked.

At the other end of the scale, we have places, such as the Philippines, Indonesia and Switzerland, with P/Es clustered around 20. You saw in my first chart that they’ve all been performing strongly this year. So it’s no great surprise they are trading on such high earnings multiples. Certainly, none of those markets are ones that I would dive into at these levels.

The chart also explains why I have reservations about the US and Japanese stock markets. Both are near the bottom right, meaning relatively high P/Es and low dividend yields. The US has a P/E of 17.8 and a dividend yield of 2.1%. Japan is trading with a slightly lower P/E than the US, at 17, but with a yield of just 1.7%.

There’s no hard-and-fast rule for what makes a stock market look like good value. It’s often a good starting point. But just because a P/E is low and the dividend yield is high doesn’t mean we should rush out to buy a country ETF.

Mostly, we are looking for P/Es that are below 10. As a rule of thumb, anything over 15 is unlikely to be good value. Anything in the middle has to be taken on a case-by-case basis. Within that range you need a highly convincing case for growing profits. And some sort of catalyst for that growth. None of the countries in the chart above that fall into the 10-15 P/E range jump out at me. So I’d prefer to approach them on a stock-by-stock basis – looking for individual bargains.

Our Asset Allocation Falls -1.3% for the Quarter

Our recommended asset allocation is as follows:

  • 25% in cash (of your home currency or currencies)
  • 20% in gold (split between 15% in gold coins, bullion or ETFs and 5% in gold mining stocks)
  • 20% in stock market investments, mainly in emerging markets
  • 35% in real estate and private investments.

To track the performance of our strategic asset allocations, we need to look at cash, gold bullion and the MSCI Emerging Markets Index. Once we strip out the 35% allocation to real estate and private investments, this leaves the financial part of the portfolio. This works out as having 38.46% in cash and 30.77% in each of gold and stocks.

Gold fell -3.2% for the quarter. And the MSCI Emerging Markets Index fell -1.9%. But our cash allocation worked as a hedge against any big overall losses. Our strategic asset allocation was down -1.3% for the first quarter.

This assumes an annual dividend yield on the MSCI Emerging Markets Index of just under 2% (less than half the average yield of our recommended individual fund and stock recommendations) and a 1% rate of interest on cash deposits.

I also work out a benchmark portfolio return to get a sense of how a typical investor would be doing. This is a 50-50 split of the performance of the S&P 500 and the iShares Barclays 20+ Year Treasury Bond ETF (NYSE:TLT). This benchmark rose 4.1% in the quarter as the S&P 500 rose 10% and TLT fell -2.8%, including dividends and coupons.

Value Beta Portfolio – Up 9.3% Since We Bought In

We introduced the Value Beta Portfolio at the end of last August. This is made up of nine ETFs and is an easy-to-run, low-cost emerging markets stock portfolio with a value bias. It’s ideal if you don’t want to invest in individual stocks. And because of its simplicity, it’s also a great way to get the next generation involved in managing stock market investments. You can find full details here.

The Value Beta Portfolio fell -2.8% during the first quarter – slightly more than the MSCI Emerging Markets Index, despite receiving several new dividends. But this portfolio is still up 9.3% in the seven months since we recommended it.

Two funds rose in the quarter. These were the Market Vectors Vietnam ETF (NYSE:VNM) and WisdomTree Emerging Markets SmallCap Dividend Fund (NYSE:DGS). VNM was up 7.7% at the end of December. But this jumped to a total gain of 21.9% by the end of March, including 2.2% from dividends. DGS improved from a gain of 12.6% at the end of December to 17.5% at the end of March, also including 2.2% from dividends.

In an environment in which emerging market stocks in general were weak, it was perhaps surprising to see frontier market and emerging market small caps being the biggest gainers. Usually, you would expect these to be among the weakest sectors in a sell-off, since they are often seen as the riskiest areas. Yet another illustration of why it pays to be diversified at all times.

The biggest quarterly losses came from our other small-cap fund, the Market Vectors India Small-Cap Index ETF (NYSE:SCIF). This was up 22.7% by the end of December but was showing a loss of -3.1% by the end of March. It is the only fund in the Value Beta Portfolio in the red.

Our other Indian fund also got hit. The WisdomTree India Earnings Fund (NYSE:EPI) dropped back from a gain of 17.5% by the end of December to a gain of 9.1% by the end of March, including 0.6% from dividends.

The weighting of the funds within the Value Beta Portfolio hasn’t changed much since we first recommended it last August. There is no need to rebalance your holdings and incur unnecessary trading costs.

Our Gold Stock Strategy Has Not Paid off So Far

Gold fell -3.2% during the first quarter, ending at $1,602 per ounce. Gold mining stocks were hit hard, as well. Miners are leveraged bets on the underlying commodity. That’s because they have a cost of production. Beat it and the profits roll in. Fail to beat it and losses rack up.

We have been wrong about gold miners over the short term. The Tocqueville Gold Fund (NASDAQ:TGLDX) fell sharply during the quarter. It went from $63.59 at the end of December to $52.70 – a drop of -17%.

Our first strategic asset allocation shift into Tocqueville Gold, in October 2011, was for a recommended 3% of total wealth. In June 2012, following further price falls for miners, we recommended you allocate a further 2% of total wealth to the fund. On a weighted basis, these investments were down -26% at the end of March, against a -2% fall in gold.

This strategy has not paid off so far. Gold has been falling. And gold miners are probably one of the most hated investments right now. But we’re only a year and a half into this position. We still have plenty of time for miners to play catch-up. It all depends on gold resuming an upward trajectory.

After the quarter ended, gold fell sharply and suddenly on April 12 and April 15. At writing, it has recovered some of those losses and stabilized. The price at writing is $1,391 per ounce. But that’s still a fall of -13.2% since the end of March… and a fall of -16% during 2013. Tocqueville Gold has fallen further, as well. At writing, it is trading at $40.05.

If you are persuaded by the case for higher gold prices in the future and have low allocations to gold and gold miners, I recommend you use this period of weaker prices to add to your positions.

A Drop in Our Russian Funds

At the end of October, I recommended you consider investing in two unlisted Russian hedge funds run by Prosperity Capital Management. This fund manager has a long track record of consistently beating the Russian stock market. And Russian stocks were selling at the bargain counter.

Prosperity Capital agreed to reduce minimum investment sizes to $100,000 for Bonner & Partners members. Usually, it accepts only much larger investments. Or it charges larger subscription fees for smaller amounts. You can find full details of this recommendation in your October Legacy Investing Report.

Russian stocks had a weak first quarter. So did our recommended funds (although they continue to outperform the Russian stock market). The Russian Prosperity Fund was up 2.4% at the end of March, having been up 4.7% at the end of December. The Prosperity Quest Fund was up 0.4% from 3.6% at the previous quarter end.

These are long-term investments that will benefit from two factors: a recovery in Russian stocks from their rock-bottom multiples and the on-going skill of the fund managers in delivering “alpha.” I remain confident that these will be highly profitable long-term investments. And if history is a guide, they could yield spectacular results.

I’ll now turn to our individual stock recommendations…

A Look Again at Our Fair-Value Estimates

I’ve been through the fair-value estimates for each of our recommended stocks this quarter end, based on the latest available information. This table summarizes how my fair-value estimates have changed.

As you can see, there have been small changes to most of the estimates, with some rising and some falling. But there have been two large increases – for Sterlite and Hess.

Estimates of fair value are subjective and constantly changing. I conduct an in-depth review every quarter, to make sure the logic of holding a position makes sense. But when there are big developments, I may change the figures more regularly.

Sterlite Industries India Ltd. (NYSE:SLT)

Sterlite is a zinc and copper miner based in India. It is 54.6% owned by Vedanta Resources Plc (LON:VED), a large and diversified natural resources group.

Vedanta is streamlining its corporate structure, and Sterlite is involved in a complicated merger with Sesa Goa and other subsidiary companies of Vedanta. The resulting company will be called Sesa Sterlite. You can find full details here.

Sesa Goa is involved mainly in iron ore mining. The share price has been slammed recently due to a court order to close its mines in the Indian states of Karnataka and Goa due to environmental concerns. Until those mines are re-opened, Sesa Goa’s earnings will not recover.

This affects the share price of Sterlite, since current holders of Sterlite stock will receive three shares in the merged business for every five shares they currently hold.

When the original deal was announced, Sesa Goa was expected to make up 27% of the profits of the merged business. So the value of the shares in the new company, Sesa Sterlite, will be affected by its ability to restart iron ore mining in the affected states.

This seems to be a regular theme in the Indian resources sector. Sterlite had to close a copper smelter at Tuticorin back in September 2010. But the Indian Supreme Court has recently overturned an earlier order by the Madras High Court to close it.

It did, however, order Sterlite to pay a fine of 1 billion rupees ($18.6 million) for pollution – just under 12% of annual profits.

As for those profits, nine-month results to the end of December 2012 were up 9.6%, measured in Indian rupees. Earnings per share were up 16.5%, also in rupees. That is the equivalent of a 14% year-on-year EPS growth, when measured in dollars. Despite share-price weakness, Sterlite continues to grow.

I’ve recalibrated my estimate of the fair value of the current Sesa Sterlite shares, taking account of the closure of the Sesa Goa mines, the share exchange ratio in the deal, the original “pro-forma” earnings estimates of the merged business, the number of shares to be issued and the number of underlying Indian shares that are embedded within a US-listed ADR (American Depository Receipt).

I’ve assumed no profit growth from the 2011 results of the combined businesses but deducted 20% for the potential loss of the Goa and Karnataka iron ore profits. This gives me an EPS for the ADRs of $1.52.

This is a conservative estimate. But I’ve also applied an equally conservative P/E ratio of 8. I got this by looking at a peer group of similar mining companies. The peer group average was closer to 10. But I’ve added in another 20% discount for indian risk and the execution risk of the merger.

This gives a value estimate for the ADRs of $12.18, versus the price of $6.98 at the end of March. This implies upside of 75% from current levels… without even taking account of future changes to commodity prices.

The merger is complex. And it’s taking longer than expected to receive all the regulatory approvals. But eventually, the series of transactions will be completed and we’ll start to get a better idea of what the final company looks like. In the meantime, I believe it is worth continuing to hold the stock.

Altria Group Inc. (NYSE:MO)

Altria makes and sells cigarettes and other tobacco products in the US market. Its most famous brand is Marlboro. Large tobacco companies have extremely stable earnings and cash flows.

Altria is probably the most stable of them all, since it’s focused on just one country. But there is always the risk that new regulations or legal settlements could hit earnings.

Altria’s share price continued to rise during the first quarter –reaching $34.39. Including dividends, it is now up over 94% since it was added to the recommended portfolio in June 2010.

Because tobacco companies have such stable earnings, management profit projections are usually highly reliable. The midpoint of Altria’s 2013 EPS projection is $2.37. I estimate fair value for this stock using a P/E of 16, which gives a price target of $37.92.

That is just over 10% above the price of $34.39 at the end of March. At time of writing, the price has risen further to $35.17, reducing the “margin of safety” to 7.8% upside.

This makes the stock price too rich to add new positions. But add in the highly attractive 5.1% dividend yield and Altria remains a “hold” recommendation.

Suntec Real Estate Investment Trust (SIN:T82U)/(PINK:SURVF)

Suntec owns prime office and retail space in the Asian trade and financial hub of Singapore. At the end of December, it had assets under management of S$8 billion (Singapore dollars). That’s equivalent to $6.5 billion at current exchange rates. It’s a substantial business.

The company is refurbishing its flagship Suntec City complex of offices and retail malls in the central business district in Singapore.

This is having a modest short-term impact on earnings, as a portion of the space has to be vacated while the work is going on. But management expects it to lead to increased earnings in the future, as Suntec will be able to charge higher rents for newly-refurbished space.

Because REITs are capital-intensive businesses – consisting mainly of real estate fixed assets – it’s appropriate to value them using the price-to-book (P/B) ratio.

Suntec’s book value per share (BVPS) was S$2.069 at the end of December. BVPS is the net assets of the company (also known as the book value or shareholders’ equity) divided by the number of shares. Net assets are the total assets less the liabilities – everything owned less everything that is owed.

Because REITs pay a future stream of fees to the asset managers that administer their properties, fair value of each share will be slightly below the BVPS. So when estimating fair value, I use a P/B ratio of 0.95. This gives me a fair value estimate for Suntec shares of S$1.97.

The share price was S$1.80 at the end of March but has now risen all the way up to S$2 at the time of writing. So essentially, we have reached fair value with this stock.

We recommended Suntec in August 2010 at a price of S$1.38. At a price of S$2, and including dividends and currency gains, the total gross dollar profit has been 77.6% so far. This is made up as follows:

The increase in share price in Singapore dollars has been 44.9%. The Singapore dollar has strengthened by 9.5% against the US dollar. This gives a total capital gain of 58.7% (144.9% times 109.5% equals 158.7%; take away the original 100% and you’re left with the gain of 58.7%). Plus, there have been dividends equivalent to 18.9% (converted from Singapore dollars to US dollars on the dates they were paid).

At writing, the dividend yield is 5.1% – still attractive in a world where the 10-year T-note yields 1.7% or thereabouts. And dividend payments are likely to increase a little in the future once Suntec City is refurbished.

I think we should hold on to Suntec for a little longer. The value of Suntec’s real estate portfolio should increase in the future, once Suntec City is finished. Also, my fair value estimate is conservative, and Singapore REITs have been known to trade above book value in the past. The dividend remains healthy. And there are plenty of investors searching for yield.

The price has good momentum behind it and could get carried higher. Finally, the Singapore dollar is likely to remain strong, given the strong financial fundamentals of the country and its key role in the Asian region.

So for now, I recommend that you continue to hold Suntec stock. I don’t want us to take our profits too early. We’ll keep a close eye on developments. If Suntec reaches S$2.30, it could be time to sell and look for new value opportunities.

Chaoda Modern Agriculture (Holdings) Ltd. (HK:682)/(PINK:CMGHF)

Chaoda is a large producer of fruit and vegetables in China. The stock remains suspended from trading following accusations of fraud back in September 2011.

These accusations are unsubstantiated. But it falls to the company to produce a full set of audited accounts before it can resume trading. As yet, these have not been forthcoming, although the management says that it is continuing to work to clear its name.

I’ve written extensively about Chaoda in previous quarterly portfolio reviews. There is no significant update to share with you this time.

Lippo Malls Indonesia Retail Trust (SIN:D5IU)/(PINK:LPDMF)

LMIRT owns retail malls and other retail space in Indonesia. It had assets of S$1.75 billion at the end of December, equivalent to $1.4 billion at current exchange rates. Since we recommended you buy this stock in October 2010, it has gained 30.1%.

Dissecting these profits is more complex than for Suntec. That’s because LMIRT raised capital via a rights issue in late 2011. (During a rights issue, a company issues new shares to existing shareholders at a discounted price.)

After a rights issue, the share price is lower than before, but the apparent loss is made up to you in one of two ways.

First, you could sell your rights to receive the new shares – called the “nil-paid rights” – for cash before the new shares are issued.

Or you can subscribe to the new shares at the discounted issue price, which is below the new trading level. The unrealized profit on the newly bought shares offsets the loss on the previously owned shares.

Whether or not investors sell their nil-paid rights or buy new shares, the net profit outcome should be zero or close to zero at that point in time. You can find full details of the transaction and how rights issues work (health warning: they’re complicated!) here and here.

When calculating gains on this position, I assume you sold your nil-paid rights for cash. To repeat: This should give the same or a very similar outcome to buying new shares. Investors who sell their nil-paid rights end up with positions that have smaller sizes but more cash. Buyers of new shares end up with bigger positions from the extra cash injection they give to the company.

Assuming you sold your nil-paid rights for cash, your total profit of 30.1% breaks down like this:The buy price when we first recommended this stock was S$0.535 against S$0.52 today, meaning a -3.7% fall (in price, not profit). At the same time, the Singapore dollar has risen 4.3%. So this gives a net capital gain of 0.4% (96.3% times 104.3% is 100.4%).

Then there is 29.1% on top of cash disbursements. This is made up of 12.1% from the one-off payment for the sale of the rights and 17.6% for dividends received so far.

I estimate LMIRT’s fair value using the same method as for Suntec – with a P/B ratio of 0.95. The book-value-per-share was S$0.56 at the end of December. So this gives a fair-value estimate of S$0.53.

That leaves just 3.3% upside from the price of S$0.52. But as with Suntec, the stock could rise above fair value. The dividend yield is 5.7%, and the stock remains a “hold” for now.

Vietnam Opportunity Fund (LON:VOF)/(PINK:VCVOF)

VOF is a company, or “closed end fund,” that invests in real estate, listed stocks and unlisted companies in Vietnam. It’s best thought of as a country fund for “little China.”

As I reported in the last quarterly portfolio review, VOF was a slow starter for us, despite its huge discount to book value. But Vietnamese stocks have been having a decent run recently. And VOF continued to rise during the latest quarter.

It is now up 13.6% since we first recommended it in November 2010. This is still not a stellar performance. But at least we’re showing a profit. The share price remains significantly underpriced against its intrinsic value.

VOF doesn’t pay dividends. But it has been running a share buyback program to reduce the gap between the (lower) share price and the (higher) book value per share (BVPS). At the end of March, the price was $2.11, and BVPS was $2.70. This is one of the rare and clear-cut cases in which returning cash to shareholders via buybacks makes perfect sense. The stock offers good value at current prices.

According to fund manager VinaCapital, VOF had bought back a total of 13.5% of its shares by April 8 this year. I use BVPS as the fair value of VOF. Using this measure, there remains 28% upside between the price and the fair value.

For this reason, VOF remains a “buy” recommendation for now.

Petroleo Brasileiro Preferred Stock (NYSE:PBR-A)

Petrobras is the Brazilian state-owned oil company with massive offshore oil reserves.

The preferred stock pays the same variable dividend as the common stock (ordinary shares). But it has a minimum dividend payout in the event that Petrobras reports a loss. This means it should trade at a premium to the common stock. The preferred ADRs are not well understood and usually trade at a discount to the common ADRs.

This also means the preferred stock is different than the kind of preferred stock usually issued by companies in the US and most developed countries. “Normal” preferred stock pays a fixed dividend. Petrobras preferred stock dividends will vary with profits (down to the minimum), making them much more like common stock. In fact, prices of the common and preferred stock move in a similar way over time for this reason.

We first recommended you buy Petrobras preferreds in December 2010 at a price of $31.01. This is another investment that, so far, has not worked out as we hoped. By the end of March, the share price had fallen to $16.73 – for a loss of -46%. Add back 5.9% of the dividends, and the net loss was -40%.

One of the reasons for this fall has been losses in Petrobras’s refining and distribution business. This was due to a combination of government-imposed price caps for fuel and the inability to refine enough fuel to keep up with local demand. This has meant Petrobras has been importing fuel and selling it at a loss in the local market. The effect has been to reduce profits overall.

But the Brazilian government is now raising the price caps. And Petrobras is working to increase its refining capacity. But for now, it is difficult to estimate a “normalized” level of profits. So I’m using price to book instead to work out fair value.

Petrobras’s BVPS was $25.74 at the end of December – giving a P/B ratio of just 0.75. Put another way, shares are trading at a 25% discount to liquidation value. You could sell all the assets and pay off all the liabilities and you’d end up with a 33% profit (1 divided by 0.75 equals 133%).

I’ve estimated fair value by looking at comparable big oil companies. I calculated P/B ratios for Exxon Mobil, BP, CNOOC, PetroChina, Chevron, Royal Dutch Shell, Total and Eni SpA. These have a sizeable range of values, but the mean and median P/B figures are close to 1.4.

Once it has sorted out its refining issues… and market sentiment picks up again (all things Brazilian have been having a rough 2013)… I expect Petrobras’s P/B to come back in line with those of its peers. Using a P/B of 1.4 applied to the BVPS figure of $25.74 gives a fair-value estimate of $36.04.

Since this is 115% above the end of March share price and the dividend yield is a healthy 3.1%, Petrobras preferred stock remains a “buy” for now.

Gazprom OAO (PINK:OGZPY)

Gazprom is the Russian state-owned natural gas giant. Its main markets are Russia, former Soviet Union states and Europe. There are also plans to construct a new pipeline to China to help satisfy the energy needs of Russia’s giant, energy-hungry neighbor.

Gazprom stock is deeply unloved right now. At the end of March, it had a price of $8.50, and it traded on a P/E of just 2.7. It also has a P/B ratio of just 0.37. By either measure, this is ridiculously cheap.

Investors remain concerned about governance issues in Russia and about the effect US and other shale gas could have on Gazprom’s profits. But the ultra low P/E of Gazprom makes it an incredible bargain, in my opinion – along with most of the Russian stock market.

I’ve estimated fair value by calculating a price using first a P/E of 8 and then a P/B of 1.51 and taking the average. Both of these include a 20% “Russia discount” to what I believe is the real fair value, just to be on the conservative side.

This gives me a fair value of $30.09, which is a stunning 254% above the March end price. It’s also 105% above the original buy price of $14.69 – still a huge margin of safety.

Add in the estimated dividend yield of 6.4%, and Gazprom is a strong “buy” recommendation. I expect patient investors will be richly rewarded.

AFP Provida (NYSE:PVD)

AFP Provida is the leading pension fund administrator in Chile – where all employees make compulsory pension contributions each month.

As outlined here, US insurance company MetLife is acquiring Provida from Spanish bank BBVA. MetLife will buy BBVA’s controlling stake and then launch a tender offer to try to buy all remaining shares traded in the public markets. Before that happens, Provida will sell stakes in various businesses outside Chile and distribute cash to shareholders. Exact details of the tender offer and the cash distributions are not yet available.

Provida is a successful business and an extremely attractive investment. Its cash earnings in 2012 grew by 15.5%. This was the result of fee income rising at 9.3%, which outstripped cost growth of 4.6%. Also, costs are a low 47% of fee income. This means fat profit margins.

Because Provida uses little capital in its business, most of those cash profits are distributed to shareholders as dividends. The stated company policy is to pay out 75% of profits as dividends. But in practice, the ratio is usually higher. I estimate the current dividend yield to be 7.6%.

When we first recommended Provida in May 2011, it was trading at a substantial discount to fair value. So it’s no surprise that it has delivered strong profits. This company ticks a lot of the boxes we look for in our legacy investments: market leadership, fat profit margins, highly cash generative, low debt, high “margin of safety,” strong profit growth and a large dividend yield.

This has added up to a gross profit up to the end of March of 50%, made up of 37% of capital gains (price rise) and 13% of dividends. That’s a great return in 22 months, especially given that emerging market stocks have been out of favour.

There is still plenty of upside potential. I’ve recalculated my estimate of fair value using a blend of a P/E-based approach and a P/B-based approach. For the P/E estimate, I’ve taken 2012 cash earnings after tax and applied a fair-value P/E ratio of 15.3. This is the same P/E ratio used in my original Legacy Investment Report. The cash earnings assume no growth in 2013, so this is conservative.

Using the P/B method, I’ve taken BVPS at the end of December and multiplied it by a P/B ratio of 4.1 – again taken from the original legacy report. This assumes no retained profits, so it is conservative.

Averaging these two approaches gives me a fair-value estimate of $123.46 – 16.2% above the price of $106.50 at the end of March.

Because of the on-going tender offer… and despite the still substantial upside to fair value… Provida is a “hold” for now.

If you own the shares, based on current information, I recommend that you reject any tender offer that is made below $140 per share. Acquiring companies are usually expected to pay a premium price to gain full control of companies. Don’t give a free gift to MetLife.

Hess Corp. (NYSE:HES)

Hess is an integrated oil company that produces internationally and is expanding in the US. It has come under pressure from Elliott Management, an activist hedge fund, in recent months.

The Hess management team is implementing a transformation strategy that will lead to asset sales of $3.4 billion and leave Hess as a pure-play exploration and production company.

Most of the proceeds from asset sales – which include international assets and low-return US fuel retailing businesses – will be used to pay off debt. But there are also plans to increase dividends and start share buybacks.

Hess’s board of directors has already increased the annual dividend from 40 cents to $1. But this still leaves the dividend yield at a relatively low 1.4%. The company proposes to spend $4 billion on share buybacks, which is 17.5% of the market capitalization of $22.9 billion at the time of writing. But it is still unclear when this will happen.

Hess’s return on tangible equity (RoTE) was 10.8% in 2012. “Tangible equity” refers to shareholders’ equity (also called “net assets” or “book value”) less goodwill assets. RoTE allows a fair comparison of companies that have done acquisitions in the past with companies that haven’t.

(Goodwill is an accounting oddity that is created when companies acquire other companies. Company managements like it because it means the total cost of acquisitions doesn’t have to hit their balance sheets, as cash is paid out in return for the new business. Goodwill is the difference between the price paid and the net assets acquired. It’s a sort of mirage accounting entry that prevents acquisitive companies from taking hits to their book values. For this reason, investment bankers like it, as well, because its creation makes it easier to sell deal ideas to corporate management teams.)

Hess’s RoTE is likely to increase in future. Its profits have suffered from various asset write-downs in recent years, as it has exited businesses and joint ventures. Also, the company is divesting low-return businesses to concentrate on exploration and production. And as it pays down debt, its interest costs will also fall.

Cash flow should also improve. Hess went through a period of intense capital expenditure, as it intensively invested in developing its Bakken shale reserves in the US. This level of investment is expected to fall in the future.

I’ve upgraded my estimate of fair value for Hess shares using an average of P/E- and P/B-based methods.

For the P/E method I’ve used 2012 EPS and added 10% to reflect the expected removal of asset write-downs in future years. Then I’ve applied a P/E of 12, which is slightly higher than Exxon Mobil’s P/E of 11.3, reflecting the fact that Hess is aiming to become a pure-play exploration and production company.

For the P/B method, I’ve used tangible book value, excluding goodwill. I’ve started with the base of tangible book value per share of $55.29 at the end of 2012. This will increase in future as the company retains new profits. It will also fall as cash is paid out for share buybacks. The two effects will offset each other. But with the absence of better information, I’ll use the end-of-2012 figures.

I’ve then applied a P/B ratio of 1.59, which assumes improved RoTE once the low-return businesses have been sold. Also, this is not far off the P/B of 1.4 used to value Petrobras (see above).

Taking the average gives me a revised fair-value estimate per share of $83.28.

This was 16.3% above the price of $71.61 at the end of March. At the time of writing, the price has fallen to $66.78 as the oil price has come under pressure in the short term. But I don’t expect that to last long.

That leaves 25% upside to my fair-value estimate. That means Hess is now a “buy” again.

 PT PP London Sumatra Indonesia (Jakarta:LSIP)/(Frankfurt:PS9A)

The name of this one is a bit of a mouthful. So most people shorten it to “Lonsum.” The company owns oil palm plantations in Indonesia and produces palm oil and palm kernel oil. We first recommended you buy shares in Lonsum last December.

Palm oil prices have been flat since the recommendation. But the Lonsum share price has fallen -16.5%. There is no specific reason for this that I have found, except that the stock prices of palm oil producers in general have been under pressure. Also, they are listed in emerging markets, where indexes have seen selling pressure.

Lonsum’s profitability remains strong, delivering a return on equity of 18% in 2012. This is a long-term play on increased demand for edible oils – specifically, low-priced palm oil – meeting limited supply. Oil palms can be grown only in a narrow band around the equator, with the plantations concentrated in Indonesia and Malaysia.

Ultimately, Lonsum is a leveraged play on the palm oil price. If it goes up in the future, Lonsum’s profits will go up faster, as income from sales accelerates faster than costs. These are still very early days for this investment. Lonsum remains a “buy” for now.

Until next time,

Rob