Reasonably Thinking

 I initiated a new long position today: 30 shares of Exelon Corporation (EXC) at $46.14.  Exelon is (I believe) America’s largest utility company; it’s primary markets are Chicago (ComEd) and Philadelphia (PECO).  Being a utility company, some of you may view this as a rather bland play, and to some degree, it is.  However I see this as an appropriate tactical maneuver in a strategy that allows for an open minded approach to investment success.

This story begins late last year.  In December, Bill Gross (of PIMCO) opined in favor of purchasing utility stocks.  His argument is that over the next several years, “Diminished growth, deleveraging, and increased government involvement will temper profits and their eventual distribution to investors.”  In such an environment, utility stocks will adequately perform.  I agree.

In last week’s issue of Forbes, Exelon was named one of America’s Best Companies (only three were highlighted).  The article mentioned that Exelon runs 17 nuclear reactors, “by far the largest nuclear fleet in the nation and the third biggest in the world.”  With its nuclear advantage, Exelon can produce low cost, carbon free energy, something that other utilities cannot do.  “Exelon’s nukes turn out 130 billion kilowatt-hours of electricity every year and not a single metric ton of carbon dioxide.”  In my view, Exelon is a company that will be able to generate solid returns without having to worry about competition.

Since I belive that Exelon will be an overachiever for years, all I needed was a reasonable entry point for the stock.  Since Gross’s article was published, utility stocks and the market have been slightly positive, whereas Exelon has fallen about 4%.  I’m happier to buy the dip now, than to have chased earlier only to watch the stock fall.

The remaining question is, why has Exelon underperformed recently?  Perhaps an unlikely passage of a cap-and-trade bill hurt the stock.  Such legislation would have hindered carbon producing utilities, but not Exelon.  Another explanation could be that investors and analysts were disappointed with Exelon’s earnings on Friday.  To me, this can be disregarded since the fundamental earnings power of Exelon are unchanged over the upcoming years.

Pricecheck!

In contrast to some other utility companies’ price metrics (as I calculate), Exelon’s metrics look fairly consistent and stable.  Cash return, return on invested capital, and earnings’ returns all tell similar stories even though they use different inputs.  A juicy dividend every quarter is also reassuring.

I sold my position of Chesapeake Natural Gas (CHK) today.  My orignal thesis is no longer valid, and the stock is probably fairly valued.  The main fear is that the supply of natural gas will become (or already is) excessive relative to the demand for natural gas.  This would move the price of natural gas lower, which would hamper producers like CHK.

Previously, I had written a call option (covered call position) that expired last Friday, and I considered writing another call.  However, I view the risk of principal loss as too great and am happy to walk away with a profit.  Further, since I held this position for a year, this gain is taxed at a long term capital gains rate.

Having sold CHK, I still desire a broad exposure to commodities.  Even though commodities have risen, and are likely to pull back, I purchased the Deutsche Bank Commodity Index (DBC), 50 shares at $24.50.    This purchase uses less than half of my funds from CHK, and I intend to increase my allocation to commodities on price weakness.

Taking the two trades together, I am now less exposed to natural gas and more broadly exposed to commodities.  I have less money on the table and am in position to increase my stake on price weakness.

Here is my history for CHK.  As you can see, I stumbled out of the gate on this, but catching the bottom and writing two covered call positions turned out to be great tactical manuevers.

I have been bearish on housing for about a year now.  Evidence of this can be seen here, when I first shorted ITB (betting against US Homebuilders) back on Feb 6, 2009.  I remain bearish on homebuilder stocks because I am skeptical of an economic recovery, question the supply/demand of the market, and believe valuations are expensive.  Let’s take these one at a time.

I hesisitate to believe a bounce-back economy is upon us.  The all-inclusive unemployment is 17.3%.  Even worse, manufacturing jobs are slipping while service jobs, like government positions are holding steady.  Further, with the decline in credit, I can’t imagine many companies are expanding their capacity to produce (via more factories/machines).  With fewer manufacturing jobs and without investments in production capabilities, how can an economy produce more to enable a recovery?  I have read that even if the data somehow shows a recovery, it will be not only a jobless recovery, but a job-loss recovery.

To get a sense on how unemployment affects the housing outlook, consider this from Mark Zandi, chief economist at Moody’s Economy.com:

A soft job market, especially one this soft, means potential buyers don’t have money to pour into new homes or the confidence that they’ll be able to hang on to their jobs and pay the mortgage on their existing home.

Combine the weak consumer with massive mortgage rate resets (most of which are unlikely to have been modified), and it’s easy to see that supply is likely to outstrip demand.  Reasonably thinking, if consumers are unable and unwilling to purchase houses, homebuilders will have difficulty profiting from not selling houses.

To further strengthen my argument, Pending Home Sales increased in response to the government’s tax credit for first time homebuyers through October.  Then, when the tax credit was originally set to expire in November, Pending Home Sales dropped.  Now that the tax credit has been extended to April, prices have again mitigated.  This means that the deciding factor in home sales has been the tax credit.  All this is doing is pulling forward demand.  May I kindly remind the audience what happened to car sales following the end of the cash-for-clunkers program:  demand dropped to below where it had been before the program started.  I believe that since the tax credit has existed for a longer duration, the drop in home sales will be more severe.

On to valuation… Yahoo shows the P/E of ITB at 23.7; given my thoughts above, I think this is absurdly high.  Perhaps earnings are depressed, which could warrant a high multiple.  However,  I argue that earnings will continue to be depressed, at least through the first half of 2010.

As far as execution goes, I would have liked to have shorted an additional 100 shares of ITB, but there were none left to borrow at my brokerage.  So, I purchased 3 put contracts at the July $17.50 strike, for $4.70 each.  Considering ITB is trading at about $13 per share, I am quite content with a $12.80 break-even price.  I’m hardly paying a premium–only paying $0.20 for six months of time decay.  (For the options gurus, the volatility was 30, which is what I consider an inexpensive option contract).

A final note…  One of the neat things about trading options that are deep-in-the-money is that sometimes you can see your volume.  If you look up the .ITBSW option, you can see three contracts traded today; those would be mine.  I have displayed this below in the red circle.  To the left of it, you can also see the $4.70 that I paid for each of them.

Since there has been a large increase in visitors this week, here is a 10 second table-of-contents:

1>  To read my most recent article, click here.  For the article that made a name for myself, click here.

2>  For my portfolio performance in 2009, click here.  For my 4th quarter performance in 2009, click here.

3>  I publish all of my stock trades; to view them, click here.

Hussman’s article is a little lengthy, but a good refresher.  Reading his point of view continually strengthens my confidence in the ‘open minded approach’ perspective.  Here are a few highlights:

“The best way to destroy the capitalist system is to debauch the currency.”

Vladimir Lenin, leader of the 1917 Russian Revolution

“My impression is that investors underestimate the risk of assuming that those problems are solved because we are riding a wave of deceptively “costless” government bailouts.”

http://www.hussmanfunds.com/wmc/wmc100104.htm

…I will have 4Q09 Performance data up on the site soon!