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25% Allocation To Apple – Too Much Risk?

Summary Apple remains my largest position at 25.9%. The portfolio risk factor is not necessarily increased with position size. Reflect your knowledge or confidence in a company with your position size. After releasing the details of my Young and Cautious portfolio , one of the most frequently presented criticisms is of the very high allocation to Apple (NASDAQ: AAPL ). My current allocation is just north of 25%. Company Current p/e Current yield Annual dividends ($) Portfolio weighting (%) Apple 13 1.75 110.2 25.9 Aberdeen Asset Management ( OTCPK:ABDNF ) 10.53 5.21 130 9.6 Bank of America (NYSE: BAC ) 13.07 1.13 5.8 2 Coca-Cola (NYSE: KO ) 27.47 3.08 36.96 5 DaVita HealthCare (NYSE: DVA ) 33.16 0 0 11.6 General Motors (NYSE: GM ) 13.24 4 72 7.5 Gilead Sciences (NASDAQ: GILD ) 9.78 1.61 46.44 11.9 McDonald’s (NYSE: MCD ) 24.64 3.12 27.2 3.7 Rolls Royce ( OTCPK:RYCEY ) 8.28 4.18 62.42 7.5 Transocean (NYSE: RIG ) n/a 4 100.8 11 Wells Fargo (NYSE: WFC ) 13.51 2.7 27 4 Note: Average Yield = 2.6% The following comments sum up the main criticisms of the portfolio, which can be found in Young and Cautious – One month on and First Portfolio review – Young and Cautious , respectively. (click to enlarge) (click to enlarge) Although I respect the views of many commentators and contributors, I do not accept that the best strategy for an active investor is to just divide your capital equally among a list of companies that you think might perform well, regardless of their individual valuations and business circumstances. I will set out below why a higher allocation in a common stock does not necessarily lead to higher overall risk for your portfolio, and specifically, why I have allocated such a large percentage to Apple. Risk Risk can be split up into systematic risk and company specific risk, or non-systematic risk. However, for the purposes of this article, only company-specific risk will be analyzed. When talking solely about stocks, it is undeniable that non-systemic risk can be mitigated through splitting your capital among a variety of common stocks. This leads many investors to argue that the best way to reduce risk is to evenly distribute your capital over all your holdings. For example, 10 stocks with 10% weighting, or 20 stocks with 5% weighting. Many writers disagree on the ‘perfect number’ that provides the best risk/reward scenario for an active investor. Arguments generally range from 10 at the low end, to around 40 at the high end of the scale. Anything higher than this leads to a significant amount of money spent through transaction costs, which will impact significantly depending on how frequently positions are bought and sold. A higher number of stocks in a portfolio would most likely warrant the need to just take on a more passive approach through using a cheap index fund, such as provided by Vanguard. The risk that is not mentioned when talking about diversification Apart from individual company risk and systematic risk, one of the most prominent risks inherent in over-diversification is yourself. Your knowledge and time has to be spread over a higher number of companies, undeniably leading to the risk of gaps in your knowledge. This could be not having enough time to go through each company’s quarterly reports and individual valuations. This inefficient manner of investing has the potential to lead to sub-par returns. In addressing this view, investment icon Warren Buffett has stated: Once you decide that you are in the business of evaluating businesses, diversification is a terrible mistake to a certain degree. His reasoning is based on the idea of the mistake of omission in investing: Big opportunities in life have to be seized … Doing it on a small scale is almost as big a mistake as not doing it at all. This is not a scarcely held belief of prominent investors around the world. Below you see how frequently a large position plays a role in those investors’ portfolios: Warren Buffett Wells Fargo 19% Kraft Heinz (NASDAQ: KHC ) 18% David Einhorn Apple 20.5% Carl Icahn Icahn Enterprises (NASDAQ: IEP ) 27.5% Apple 21% Bill Ackman Valeant Pharmaceuticals (NYSE: VRX ) 25% Air Products & Chemicals (NYSE: APD ) 18.8% Chase Coleman Netflix (NASDAQ: NFLX ) 22.9% Amazon (NASDAQ: AMZN ) 20.1% Although not all of the companies have performed well over the past year, most notably Valeant Pharmaceuticals, most of them have. This high allocation in a company would classify as a ‘conviction buy’, exemplifying each investor’s confidence in these respective companies. It is what separates them from the rest of the market, allowing them the opportunity to beat the market returns. Know your strengths Every investor has their own strengths. This is down to the fact that whatever their profession is, or if they have a strong passion for something, they will generally have a deeper knowledge of it. This gives them an advantage over the general public and can give them the edge when it comes to putting their capital to work. This can be reflected in your portfolio. For example being a student has its perks. Many trends over what is popular originate from this age group. This could be said with regards to Apple, Facebook (NASDAQ: FB ) and Nike (NYSE: NKE ). What is popular with this age group has a tendency to spread to other age groups to create the norm. Looking back at Facebook, I grew up alongside the likes of Bebo, MSN Messenger and MySpace. My age group saw a shift from these social networking sites to Facebook, because we were causing the shift. Examples such as this give investors of certain age groups, professions, or hobbies that advantage in the market. This is one of the reasons why I am still so bullish on Apple. Regardless of what some financial news websites publish about Apple losing it’s ‘shine’ or ‘cool factor’, it is evident that Apple still has the backing of its supporters. It only takes a trip to any university library to see the momentous number of Apple products being used by students, who are in effect the future. For example, the Mac lineup has been of great popularity. Many students are making use of their university discounts and either upgrading from the previous model or other brand laptops. Growing up, these students will see Apple as the norm and are more likely to continue using their products. On the contrary, there are many areas where my knowledge lacks. This could come down to being young, lack of interest in the subject matter, or just plain ignorance. This is absolutely fine. It just means I don’t invest in these areas. If I invested in these areas for the sole reason of ‘achieving diversification’, I would be opening myself up to a great deal of risk. This is just not necessary. When opportunities are present, grab them by the horns The second part of investing in your strengths is investing at the right price. There are many companies I see doing well. Nike and Starbucks (NASDAQ: SBUX ) are both companies I want to own, just not at these prices. There is too much optimism built into the stocks. On the other hand, Apple is a company I understand well. I have a strong insight into how my generation sees their products and services over their competitors, and most importantly, the valuation is cheap. Valuation The company stands at a huge discount to the overall market. Apple’s trailing P/E ratio stands at just under 13 while the forward P/E is 11. This represents a 41% discount to the current ratio of the wider market, currently standing at 22. Apple is priced for a deceleration in earnings, while it is posting ever-growing earnings. The last earnings report showed EPS growth of 38% over the previous year, with guidance showing further record earnings for the near future. An earnings growth that surpasses the wider market. In addition to this, I believe Apple has in recent years been paving the way to become a future dividend champion. It is managing to consecutively increase dividend payments to shareholders year over year, while maintaining a low payout ratio. Currently, the dividends to shareholders represent only 21% of total earnings. This gives the company a great deal of room to increase payments several years from now. On top of this, Apple stated in April of this year that the share repurchase program would be increased to $140 billion. What are my risks? Having over a quarter of my capital in one stock does mean that if the share price drops significantly, this will drag down the portfolio significantly. Bill Ackman has recently been a victim of this, as Valeant has dropped like a rock after allegations of price gouging surfaced. This has led to him suffering a severe loss of capital and significant underperformance to the market. To compare this to Apple would be unfair. Apple has many factors that give it a large margin of safety to prevent this. First of all, almost a third of the entire market capitalization is made up of cash and equivalents, and this continues to grow. This allows Apple to raise cheap cash in corporate bonds to facilitate large share repurchases. Secondly, Apple’s great P/E discount to the wider market and higher growth rate provides a safety buffer, as it is already priced for no growth. The only time I will reduce this high allocation is if either of two things happen: Earnings begin to fall, or the share price rises resulting in a P/E ratio similar to the wider market. Conclusion Everyone has their strengths in investing. This means having a high allocation of your capital in one company will carry different risks depending on who owns that particular company. When you have the opportunity to own a good company trading at a cheap valuation that you have a deep understanding of, allocate more capital to this to increase your chances of outperforming the rest of the market. Thank you for reading. If you have enjoyed reading this article, or want to follow the progress of the ‘Young and Cautious’ portfolio please hit ‘follow’ at the top of the page. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Karoon Gas – Give Me $1.00, I’ll Give You $1.20 And 2 Significant Oil Discoveries

Summary Karoon is a depressed stock trading 20% below cash backing due to a low oil price, and several major shareholders exiting the stock. A major selloff has resulted in Karoon being significantly undervalued. Provides fantastic long term exposure to a rising oil price with 85 mmbbls of 2C reserves from 2 recent oil discoveries. Karoon Gas is currently in the process of buying back up to 10% of stock on issue. Overview Karoon Gas (ASX: KAR, OTCPK:KRNGF , OTC:KRNGY ) is an Australia-headquartered oil and gas company with exploration opportunities focused in North-West Australia, Peru, and Brazil. With a set of great oil prospects, and no major gas prospects, they should consider changing their name to Karoon Oil. Of all the sell-offs in the oil and gas sector, this one has intrigued me the most. On a market cap of AU$450 (US$319) Million at the current share price, they sit on cash of AU$550 (US$390) Million. This cash came from their recent sale of their Browse Basin permits to Origin for the following: An upfront payment of US$600 Million (Received) A deferred cash payment of US$75 Million payable on FID A deferred cash payment of US$75 Million payable on first production A deferred cash payment of US$5 Million for every 100 BCFe of independently certified 2P reserves exceeding 3.25 TCFe Reimbursement of the costs associated with drilling its 40% held Pharos-1 well. (Received) So why are they trading so low? Apart from the oil price, I think it is primarily due to these 3 factors: Several major investors have exited the stock over the last year. IOOF Holdings, Future Fund Board of Guardians, and Paradise Investment Management all ceased to be substantial holders, selling out a major portion of the stock. The company has some corporate governance issues. There are concerns that family members of the chairman Bob Hosking are appointed on key positions at the company, as pointed out by the activist hedge fund manager Pegasus. The majority of shareholders may or may not agree with this, and I myself have questions regarding it, but none of the three candidates that Pegasus put up for election were voted in. A lot of Australian companies have corporate governance issues, and activist investment is much lower than in the US. Like any market risk, this is a risk that must be weighed against the benefits. Speculators pushed the price up to obscene levels, and then pushed the price back down in fear Despite these issues, Karoon has a great track record of increasing the long-term value of shareholders when you normalize for the boom and bust cycle. Past speculation during the boom had driven the share price as high as $12.10 – it currently sits at $1.81 at the time of writing. Karoon is, at present, up over 950% from 2004 and has managed to unlock plenty of cash for the exploration and appraisal of their major Brazil operation in the Santos Basin. (click to enlarge) ( Google Finance ) Offshore Brazil (Two Significant Oil Discoveries) The map below shows the Kangaroo and Echidna resource as well as the Bilby oil discovery dating back to 2014. (click to enlarge) ( Source – Karoon Annual Report 2015) Kangaroo went through further appraisal in 2014, production testing at rates that signaled a single vertical well could flow 6,000-8,000 bopd from a net pay of 135 meters ( Source ). It needs to be noted that Kangaroo 2 also had two side tracks as part of the appraisal that indicate that this may be a complex reservoir which would enhance the cost and difficulty of production. Despite the complexity, it remains a significant find that has a great chance of commerciality. Echidna followed up the Kangaroo discovery with a 103 meter net oil column and a facility constrained flow test 4650 bopd, further enhancing the chance of a commercial discovery for the region. (click to enlarge) ( Source ) From an operational perspective , Karoon is looking at a variety of options for producing the Echidna and Kangaroo discoveries that are less than 50km apart. The lowest capital cost method includes a Floating Production Storage and Offloading Vessel (FPSO) producing roughly 20,000 barrels of oil per day (bopd), then expanding that to 50,000 – 70,000 bopd once the field has been proven. Discussions for the development of Kangaroo have also involved Petrobras for an integrated oil hub in the region, which could be economic as low as $43/bbl according to Citigroup ( Source ). The same article also denotes the drop in costs which could make the project economic at even lower prices “Because it’s a distressed market now worldwide, we are looking at redeployed assets, for example, a redeployed FPSO [floating production storage and offloading vessel]. The labor market is getting cheaper, the labor is getting cheaper; we see there’s a lot of cost savings for us.” One of the primary reasons for investing in Karoon is that there is almost no value attributed to the Kangaroo and Echidna discoveries. After writing off Karoon’s AU$105 (US$76) million tax liability against its cash reserves, the 2C reserves equate to a value of AU$0.41 (US$0.29) /bbl. However, investors must keep in mind that production isn’t likely oncoming until 2018 at the earliest while Karoon moves through engineering and approvals, and this may hold the share price back for the medium term. Offshore Peru and Offshore Australia After all this, Karoon still has more to offer. A possibility of more major discoveries exists offshore Peru and Australia. Nearly 27000 square kilometers of permits sit on the acreage outside of Brazil, with significant long-term potential for Karoon. They have a habit of bringing in joint venture partners to free carry them through the initial drilling stages to minimize the capital outlay from Karoon. These are likely to sit for several years during the current supply glut, however, they provide some great upside for an oil recovery. (click to enlarge) (Karoon Annual Report 2015) Share Buyback One of my favorite things to see a company do is an all-cash share buyback – specifically when their share price is trading at an all-time low. Karoon has bought back 9.4 million shares at $3.27 over the last 12 months as well as announcing plans to buy back a further 25 million shares. That comprises up to 10% of the company’s ordinary shares on issue and will further expose investors to the upside of an oil price recovery in 2-3 years. On top of all that, Karoon has a significant amount of built up exploration expense of $AU485 Million that can be written off against future cash flows. Risks and Uncertainties Karoon is in the early stages of several significant oil discoveries. There are plenty of issues that need to be sorted out, and a significant amount of cash that needs to be spent to bring these oil fields into production. Production is not likely to begin for several years, and the oil price currently sits at levels that would make these projects uneconomic. Most investors would agree that the current supply glut will not extend out to 2018, however, it is possible and poses a significant risk as Karoon spends more on the appraisal process. Karoon also has no source of cash flow, and Origins deferred payments are unlikely in the current environment. Conclusion Having several major investors exit the stock over the last 18 months has left the share price in the doldrums. While Citigroup has calculated a combined development for Kangaroo and Echidna would be economic as low as $43, I would not expect the project to go ahead unless oil moved well into the 60’s – unless the resource is found to be much larger than current estimates. There is plenty of unrealized value in this stock with hardly any value attributed to the Kangaroo and Echidna discoveries, and no value to the significant amount of exploration expense that Karoon can write off against future cash flow. Karoon’s cash reserves can be used to develop these discoveries and increase shareholder value at the same time the share buyback is increasing investors oil exposure per share. As for the remaining Australian/Peruvian blocks, Karoon will likely delay drilling as much as possible to preserve cash for the Kangaroo and Echidna discoveries. Overall, there is a significant amount of risk around Karoon going forward. They are in the early stages of appraising these reservoirs while the oil price has crashed. However, a crashed oil price means cheaper drilling, completions, procurement, and construction. Karoon would not be likely to produce oil until 2018 at the earliest, and there is plenty of time for the oil price to recover in that time period. As the Financial Review quoted from an RBC Capital Markets report “Whilst high risk, this is a freebie and success would open a significant new oil play.” I love Karoon as an asymmetric bet on an oil recovery, and I can confidently see an upside of well over 100% in the next 3-5 years in the event that the oil price recovers. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Why Are Utility Black Hills Investors Seeing Red?

Black Hills recently priced a secondary offering at a full 30% off its peak price in 2014. The acquisition of SourceGas doubles its community count in states they currently service. While Moody’s and Fitch placed Black Hills on “Negative Watch”, they are generally supportive of the company’s business profile. Black Hills Corp (NYSE: BKH ) is a small cap diversified utility whose stocks price has collapsed from $60 in June 2014 to $40 currently, with share prices down 10% on Nov 17. The answer lies in two circumstances: its business profile and the issuance of dilutive equity to fund an acquisition. The first situation is more long-term and the second more short-term. Originally founded 132 years ago in Deadwood, ND (interesting name for an investment headquarters), BKH has a long history of dividend increases, stretching back to 1970. Black Hills is a utility with regulated natural gas and electricity assets and non-regulated assets, with the non-regulated assets generating the negative issues. BKH mines coal, generates electricity with coal, and explores for oil and natural gas. These business segments are currently out of favor with most investors, and are creating financial stress. Black Hills services 680,000 customers in Colorado, Iowa, Kansas and Nebraska along with 110,000 customers in South Dakota, Wyoming and Montana. 205,000 are electric customers and 585,000 are natural gas customers. Below is a graphic of its service territory. (click to enlarge) The annual dividend is currently $1.62, for a yield of 4.0%. The company has a 45-year string of dividend increases, driven in part by strong industrial load growth in electricity. Over the previous 5 years, Black Hill’s growth has been in its regulated utility business. In 2009, regulated utility business generated $126.2 million in operating income vs. $19.9 million for non-regulated. Last year, regulated businesses generated $222.4 million vs. $39.3 million for non-regulated. At no time over the previous 5 years has the non-regulated segment generate over $45 million in operating income while operating EPS over the same time frame increased from $1.38 to $2.93. Management has forecast operating EPS of $2.90 to $3.10 for this year, midpoint $3.00, and $3.15 to $3.35 for 2016, midpoint $3.25. According to S&P Credit, the states serviced have the following regulatory environment (based on three groups of regulatory friendliness – Strong, Strong/Adequate, and Adequate): Colorado and Iowa – Strong; Kansas, Nebraska, South Dakota, Wyoming, Montana – Strong/Adequate. Pre-2014, S&P Credit offered five categories of regulatory friendliness and it seems Colorado, Wyoming and Montana improved their relative positioning. In addition, Black Hills geographic service territory includes some of the higher economic growth rates. Below is a map from the Bureau of Economic Advisors of economic growth by State for 2014. As shown, Colorado and Wyoming exceeded the national average growth rate of 2.2% while the balance of the states served fell short. In general, the Rocky Mountain States saw their economic growth rate expand from 1.4% in 2011 to 3.9% in 2014 while the Plains saw their rate of growth slashed from 2.1% to 1.3%. This underlying economic growth helps to lift energy demand. (click to enlarge) Similar to the entire oil and gas exploration and production industry, BKH has experienced large non-cash write-offs for redetermination of its natural gas reserve values. The YTD charges amount to $2.53 a share, or $110 million, reducing Trailing Twelve Months reported earnings to $0.37 vs. TTM operating earnings of $3.07. In tune with their peers, BKH has slashed its capital expenditure budget for oil and gas exploration from $242 million to a measly $27 million. From an overall observation, BKH’s future lies with its regulated business, as the non-regulated business will continuing to provide a drag on investor interest. Presently, Black Hills can provide about 50% of its natural gas delivery needs from internal production, and with commodity pass-through provisions, allows BKH to be more self-sufficient than other small natural gas utilities. While not a large attribute in these times of low gas prices, if prices were to rise over time, this could add another potential profit layer. In early summer, Black Hills announced it was buying a neighboring natural gas utility from private sources. In July, BKH announced it was buying SourceGas from an investment fund owned by Alinda Capital Partners and GE Energy Financial Services for $1.89 billion, including assumption of $720 million in debt. The expansion will add 425,000 customers and solidify its position in its existing service states as the number of community served doubles to 800. In addition to the current seven states, BKH will add Arkansas customers. However, to fund the acquisition, this week management priced a 5.5 million share secondary offering at $40.50 a share, for a dilution of about 12%, based on 44.5 million shares outstanding before and 50 million after. The company will also offer equity units comprising of an interest in a 2028 subordinated debt and a collar contract to buy additional common shares between $40 and $47. When exercised, the equity units will further dilute share count by 10% and the equity unit is expected to yield 7.5%. Net proceeds from these two are expected to total $465 to $535 million on their close at the end of Nov. The original acquisition funding estimates called for $575 to $675 million in new equity. This still leaves new debt issuance of between $590 and $660 million, and is higher than the original estimate of $450 to $550 million. In connection with the acquisition, Moody’s and Fitch credit rating agencies lowered BKH’s outlook to “negative”. The added concern mainly focuses on higher debt levels BKH will take on. Moody’s comments : However, the decline in financial metrics is slightly offset by the anticipated improvement in the company’s business risk profile. The transaction brings increased scale and diversity as well as additional opportunity to grow rate base in the constructive regulatory environments that SourceGas operates in. It improves Black Hill’s overall risk profile as it adds low-risk LDC utility operations and reduces the proportional size of its higher risk E&P operations. The rating affirmations and stable outlooks on Black Hills Power and SourceGas reflect the companies’ stable utility operations with visible growth opportunities. Because Black Hills already operates in three of SourceGas’ four states, we expect Black Hills to improve efficiency by combining utility operations and to be better positioned in these states through the increased scale. Arkansas is the only state where Black Hills currently does not have any operations. In recent years, SourceGas has experienced improvements in its regulatory environment in Arkansas, including a reasonable outcome in its rate case in 2014. Fitch’s comments : BKH operates regulated electric and natural gas utilities in seven states, all of which allow for pass-through of commodity and/or purchased power costs and many feature other riders or recovery mechanisms that enhance timely recovery of expenses and invested capital. Transmission investments are regulated by the Federal Energy Regulatory Commission (FERC) or state regulatory commissions with most capital expenditures eligible for rider recovery. The diversity by regulated jurisdiction further enhances the predictability of cash flows and minimizes the effects of exogenous factors. Non-regulated investments consist of a legacy upstream energy exploration and development business. Fitch considers BKH’s coal and competitive generation businesses, which are largely contracted to BKH’s utilities, as possessing relatively low risk. BKH’s utilities, coal, and merchant generation businesses have a large degree of operational and financial integration, with jointly owned or contracted generation and common call centers. BKH has interests in the Mancos shale play and is committing relatively large capital investments in order to further assess and prove its potential reserves in the area. BKH’s proposal to place a portion of its natural gas assets into a nonregulated exploration and production subsidiary, which would supply its utilities with up to 50% of annual gas consumption through long-term contracts, if successful would reduce the inherent risks and volatility of the non-regulated oil and gas business segment and would be viewed positively by Fitch. BKH has traditionally managed this business in a conservative manner and uses swaps and other instruments up to two years in duration to hedge pricing risk. Black Hills has earned a disappointing S&P Equity Quality Below Average Rating of “B”. Fastgraph outlines the current valuation for BKH in the chart below, along with a historic review of return on invested capital ROIC. ROIC between 2006 and 2011 were at sector average of 4% to 5%., but has improved since 2011. (click to enlarge) Source: fastgraph.com (click to enlarge) Source: fastgraph.com Since 2014, investors have punished BKH with a substantial stock price haircut, but the barber may not yet be done. By all accounts, the acquisition of SourceGas will reduce the company’s risk profile by increasing its regulated footprint in states where they have a good PUC relationships. Black Hills would be more enticing with a further dip in price to generate a higher yield, but nibbling here could offer interesting opportunities as a small-cap portfolio diversifier serving the Rocky Mountain and Plains geographic area. Author’s Note: Please review disclosure in Author’s profile.