Monthly Archives: May 2012

Position sizing and cash quota

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Especially among active Value investors, there is a big debate about diversification or concentration of portfolio investments. Within the comments we were debating this already quite intensively, I also commented on Stephan’s blog why I think 30% of the portfolio in three Greek stocks is too much.

I would divide the the argument into two camps:

1. The “Buffet / Munger camp”: If you have a good idea, you should invest as much as possible into those 3-5 ideas. Reader Setla provided as proof Berkie’s balance sheet from 1995, where the top 5 investments made almost 100%.

2. The “others”, like Graham, Walter Schloss, Klarman, FPA, Tweedy etc. which usally construct portfolios with 20-50 stocks, in the case of Graham and Schloss sometimes even more.

My view on this is the following: There is no right or wrong, position sizing depends on many factors. Some of the more important ones are:

A. Type of stock

It makes a big difference in my opinion if you prefer “bufffet” style shares like Nestle, Coca Cola, Gillete etc. or small caps like SIAS, Installux, Poujoulat or Hornbach.

Nestle and Coca Cola for instance are global companies active in almost every part of the world and in different segments. If one country or even a continent doesn’t perform you still have the other 4 continents. So they are stocks which are already diversified theselves.

If I look at my portfolio, my small cap stocks are not divdersified at all on a stand alone basis. SIAS for instance only runs Northern Italian motorways or Poujoulat is highly dependent on French wod pellet heating. So those stocks are not diversified at all but have very specific risks.

The same applies for Graham/Schloss type of Net-Nets or other “deep value” stocks where on an individual basis a lot could go wrong, but within a diversified portfolio you could expect significant outperformance.

It would be therefore financial suicide to invest only into 3 or 5 of those small cap stocks as very singular events can wipe out significant amounts of the portfolio.

B) Control position

Many investors who try to invest like Warren Buffet, forget one important thing: Buffet is always in some kind of control position.

Either he is actually a direct control investor (GEICO, Iscar etc.) or he is the largest investor in a public company. You can imagine, if Warren Buffet calls Coca Cola, he will not be put into the endless phone loop but transferred directly to the CEO.

So if he has tied up a lot of money in one stock, he can influence the company to a certain degree if he doesn’t like what they are doing. And make now mistake, Warren seems to be a nice guy on the outside, but he can get quite nasty if things don’t go his way.

Other examples for less diversified control investors are for instance private equity funds which usually invest into 5-10 control investments per fund but with full control over management.

As a private investor, one is definitely no control investors. I personally do not trust ANY company management enough to put a very large amount of my hard earned money into it.

C) Personal risk tolerance

One thing: Not every investor has the same risk tolerance or risk preference. Making money in the stock market long term means that you have to be able to stay in the game.

If you are very young and run a small portfolio (say a couple of monthly salaries), you can always get back into the game by saving part of your salaries and start over again. A pensioner who relies on his portfolio to generate a large anount of his income does not have this “luxury”.

For someone too rich to bother (Warren, Charlie ?) the same applies as for the young guy. He/She can take more risk.

For me personally, the approach of investing a max of 5% of the portfolio has worked quite well in the past. I also found it helpful to start with a “half” position of 2.5% first and then increase if things go fundamentally the right way. I have no problem, letting the position grow due to performance up to 10%, by then I will decide if I take some money of the table.

Cash Quota

There are as many opinions on cash as there are investors. Interestingly Warren Buffet of course is famous for holding always cash to be prepared for crisis investments, as well as very clever investors like Seth Klarman or FPA (Bob Rodriguez) which hold large amounts of cash if they think the market is generally overvalued.

For me, a “general” target cash quota of 10% has worked quite qell in the past. Due to my investment style ( inc. Special situations ect.) I normally have continuous cashflows into the portfolio. On the other hand I have usually some stocks in my watchlist in which I want to invest at a certain price without having to sell one of my other position.

So effectively, my cash quota is “oscillating” around 5-15% depending on specific events and valuations.

I think a certain cash quota is necessary to remain flexible. Howevr one should avoid increasing or reducing cash based on one’s market expecation. At least in my experience I am not able to add value consistently through this kind of “tactical” asset allocation.

Summary:

I think both, for position sizing and cash quota, there is no “one fits all” strategy. In my opinion, many value investors make the mistake trying to apply the principles of one very succesful “guru” to any situation. It might also be difficult to copy any “Guru” because the “Guru” might have a very different kind of risk tolerance and risk capacity than the ordinary investor.

I do not want to give explicit advice, but most investors should NOT try to construct 3 or 5 stock portfolios without cash reserves as the probability of NOT SURVIVING the next crisis is quite high, no matter how “safe” the stocks look like.

Weekly links

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Value investor Prem Wats (Fairfax) under fire for a murky deal in the past

Now it is official: Sino Forest was a fraud. Many interesting details provided.

csinvesting on a classic “pump and dump” scheme, Sun Peaks Ventures. Includes a good explanation how those schemes work in general.

Nate at Oddball on French (deep) value stock Nexaya

Bronte on shorting Santander US preferreds. However, I think its not only the grandmothers who are insane….

Great Sony sum-of-parts analysis from the Brooklyn investor. Great value blog by the way.

Introducing the “Boss Score” part 3 – First test with DAX 30 and own portfolio

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As already announced in the previous post, let’s have a look what results we get for the German DAX companies, sorted by the Trailing 10 year “boss score”:

Name Price Book “Boss Score”
 
RWE AG 29.72 31.38 0.89
DEUTSCHE LUFTHANSA-REG 8.43 16.57 0.65
K+S AG-REG 33.75 16.90 0.53
MERCK KGAA 77.15 48.72 0.44
FRESENIUS MEDICAL CARE AG & 53.15 28.75 0.30
METRO AG 23.99 19.74 0.24
ADIDAS AG 59.43 26.33 0.01
DEUTSCHE BOERSE AG 39.51 17.52 -0.07
BAYERISCHE MOTOREN WERKE AG 62.17 43.42 -0.10
E.ON AG 15.10 19.58 -0.13
DEUTSCHE POST AG-REG 13.02 9.45 -0.15
BASF SE 57.28 27.62 -0.19
VOLKSWAGEN AG 121.40 130.55 -0.21
SAP AG 47.28 10.95 -0.22
HEIDELBERGCEMENT AG 36.04 65.06 -0.34
MAN SE 79.59 41.25 -0.36
FRESENIUS SE & CO KGAA 75.10 37.28 -0.41
SIEMENS AG-REG 66.46 35.92 -0.53
LINDE AG 122.45 68.65 -0.54
HENKEL AG & CO KGAA VORZUG 52.98 20.76 -0.60
MUENCHENER RUECKVER AG-REG 102.85 136.28 -0.71
DAIMLER AG-REGISTERED SHARES 37.85 38.81 -0.75
BEIERSDORF AG 52.20 12.39 -0.77
DEUTSCHE BANK AG-REGISTERED 29.08 59.58 -0.81
BAYER AG-REG 50.98 24.19 -0.87
ALLIANZ SE-REG 75.81 106.62 -0.95
DEUTSCHE TELEKOM AG-REG 8.75 8.13 -1.00
INFINEON TECHNOLOGIES AG 6.33 3.15 -1.17
COMMERZBANK AG 1.42 4.22 -2.51

It is interesting to see that only 7 companies are above 0, which would indicate that they are undervalued.

Not surprisingly, financials including Insurers look relatively ugly. Also I am not surprised that we don’t see really great scores. Everything below 0.5 is not really interesting.

To a certzain extent surprising, Henkel and Beiersdorf are not performing really well. For Beiersdorf this has to do with a big drop in shareholder’s equity from 2003 to 2004 which creates volatility plus the fact that market value is already 4 times book value.

Also Henkel has a much more volatile equity positions than earnings would indicate which increases volatility in the model. This might have to do with FX effects but combined with the relatively high valuation it is neither boring nor sexy.

Just as a comparison, how are the scores for some of my portfolio companies ?

Name Price Booc Value 10Y B-Score
INSTALLUX SA 140.00 178.16 3.11
OMV AG 22.91 34.59 2.36
POUJOULAT 132.00 124.66 2.00
TONNELLERIE FRANCOIS FRERES 30.05 29.46 1.88
AS CREATION TAPETEN 25.19 33.71 1.79
BUZZI UNICEM SPA-RSP 3.38 15.47 1.37
HORNBACH BAUMARKT AG 24.93 25.54 1.16
EVN AG 9.32 16.44 0.62
FORTUM OYJ 15.43 11.65 0.57

As one can see, for some of the stocks, the “Boss Scores” are much much higher.

At the moment I am building up a database and will then post from time to time interesting “Boss” stocks. But remeber: This is only one specific way to look at the stock and should be used as starting point only.

(More to follow)

Introducing the “Boss Score” part 2 – building the model

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After introducing the goal of the Scrrener / Score with the last post, let’s jump directly into the calculations:

Building the model – Step 1: Total Return on equity

Before starting to build the model, one has to define how to identify a stable, value adding business. One could use many variables, past earnings, free cashflows etc.

I personally view the long term developement of shareholders equity (including dividends and buybacks) as the best indicator if true “value” was created. This is of course not my original idea but essentially how Warren Buffet is reporting his yearly results at Berkshire.

In the times of modern IFRS accounting, one should mention that EPS (adjusted for dividends and buy backs) does not have to be equal the developement of equity from year to year. The real number usually is hidden on the second page of the P&L under “comprehensive income” which includes all kind of effects which get booked directly into equity (I.e. defined benefit pension plan valuation changes etc.)-

As comprehensive income is not very well maintained in the bloomberg historic database, I calculate “Total return on equity” with the following “basic” equation:

Total Return for (t) = Equity per share (t) – Equity per share (t-1) + Dividend paid (t)

A little bit trickier are capital increases and stock repurchases. As long as they are executed at book value, nothing changes on a per share basis. However if they are executed belw or above one will have direct impact on the per share equity and should be adjusted.

For the time being, I will stick with the “basic” formula and adjust on a case by case basis. In general I would assume that shares with significant capital increases or massive share repurchase programs don’t fit my “boring but sexy” category anyway.

The final computation than is relatively easy:

Total Return on Equity % (t) = Total return on Equity (t) / Equity (t-1)

If I do this for 10 years for example, I get TROE’s for those 10 years. With those 10 Yields, I can then calculate the average TROE in %

So the result of Step 1 is: Average Total return on Equity for period (t; t-x) where X can be 10 or 5 or any other period.

In theory the following applies: The higher the average TROE the better.

Step 2: Quantifying business volatility

The TROE average itself does not mean a lot. If we have for instance a company which has 20% TROE in one year and 0% in the next year, the average TROE will be the same as a company which shows 10% in both years.

As I am looking for “boring” companies, I have a high preference for stable TROEs. In contrast to classical CAPM, I will completely ignore stock market volatility (“Mr. Market”) and focus only on fundamental volatility.

So in order to account for fundamental volatility, I will use the standard deviation of the single period TROEs calculated above.

If we calculate the standard deviation of the TROEs, we can then in a next step calculate something similar to a Sharpe ratio which I would call the “fundamental sharpe ratio” for a company which is:

Fundamental Sharpe Ratio = Average TROE (t;t-x) / standard deviation TROE (t,t-x)

As an example, I have calculated those numbers for 4 random German DAX companies:

Avg 10 Y TROE 10 Y std. dev Fundamental sharpe
BASF SE 12.6% 8.1% 1.5
ADIDAS AG 17.7% 12.1% 1.5
BAYER AG-REG 5.4% 13.2% 0.4
BAYERISCHE MOTOREN WERKE AG 11.5% 9.7% 1.2

We see some significant differences here. On a first look, BASF and Adidas look very attractive, whereas Bayer looks rather bad. However, the fundamental Sharpe Ratio says nothing about how the volatility of the results is related to the valuation of the stock.

Step 3: Valuation model

In order to determine if a stock is attractively valued compared to the volatility of its business model, we have to build a simplified valuation model.

For the Boss Score I assume the following:

– the company will earn constantly its average past TROE going forward (without any growth) based on its current book value

So for Adidas for example: Adidas had a book value of 26.33 EUR and a average TROE of 17.7%, I will assume (26.33*17.7%)= 4.66 EUR per share for every year in the future, howver on a constant basis without any growth. This is somehow a similar perspective to the “EPV” from Greenwald.

In order to come up with a real value, I have to discount the future cashflows with somthing. And here comes the trick:

I use the CAPM formula to determine the discount rate, but intead of the market based “Beta” factor, I use the “fundamental Sharpe ratio” to determine the final equity ratio. I am not sure if this is mathematically correct in any way, but the intuitive idea is that the better the relationship between TROE and volatility of the TROE, the lower the discount rate.

As we all (hopefully) now, the CAPM calculates teh discount rates in the following way:

Discount rate (x) = risk free rate + Beta x (Equity market premium)

For the “Boss Score”, this changes into

Discount rate (x) = risk free rate + (1/fundamental sharpe ratio) x (Equity market premium)

With the discoutn rate we can then easily calculate the “intrinsic value” of any share under our model which is:

Intrinsic value = Assumed constant Profit / Model discount rate

As a final step, in order to have a direct relation to the current market Price, the “Boss Score” is then calculated the following way:

Boss Score = (Intrinsic Value / Market price) – 1

The final Boss Score can be interpreted the following way:

Boss Score > 0: Stock is based on the model undervalued

Boss Score < 0: Stock is based on the model overvalued, does not earn its cost of capital

The higher the Boss Score the better.

Before actually applying the screen to “live” data, it might make sense to define expectations in order to be able to “test” the outcomes of the “Boss Sore”. I would expect that (among others)

– companies with high leverage and / or cyclical business models will score relatively badly
– banks should score badly
– companies which a lot of one off write offs should score badly
– companies which earn below their cost of capital or which are in terminal decline should score badly
– “boring” comanies with stable returns and low P/B should score well
– the screen should bring up companies which might not show up in other screens

In the next post I will test the “Boss Score” first with the German DAX companies to see if the results make sense.

Introducing the “Boss score” (Boring sexy stocks) – part 1

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Introduction:

As I have discussed a couple of times, in value investing screeners can be a helpful tool if you use them right. In theory one has two possibilities: One can use screeners in order to create a more or less automatic investing strategy or one could use a screener for idea generation.

Screeners for automatic investment strategies

In order to come up with a screen for an automatic investing strategy, you have to do a lot of number crunching and backtesting. Mostly you end up with something which combines a few single attributes (P/E, P/B, past perfomeance) which have performed best in the past. Usually there is a periodic requirement (for instance every year on June 30th) to redo the analysis and adjust the portfolio.

Many people, especially with a mathematical background, like this kind of investing, because it doesn’t really require to know anything about the companies. To be fair, it requires a lot of discipline to hold through this aproach especially if the startegy doesn#t work for a subsequent number of years

The most famous startegies of this kind are strategies like “Dogs of the Dow”, Greenblatt’s Magic Formula and the results from O’Shaughnessi’s epic book (which still is on my pile to read).

In a very interesting article Joel Greenblatt is comparing the performance of “fully automatic” accounts versus accounts where peple manually followed the Magic Formula. Not surprisingly, the auotmatic system outperformed by a wide margin. The reasons for this underperformance seems to be relatively clearly market and/or strategy timing. People buy more after good performence and sell after bad performance.

Without having proof for that, I would nevertheless assume the follwoing: In my opinion many of the strategies work in the long term, but only few people are actually “mentally equipped” to follow them through.

For me personally, it wouldb e really hard to invest in companies I don’t really like so i guess I would not hold through the magic Formula for instance.

Screens for idea generation

Another type of screener would be a screener, which, based on certain pre defined attributes, tries to identify interesting companies to be analysed further. Those screens are not back tested but rather rely on subjective assumtions what could make a stock intersting.

The “Magix Sixes Screen” I often use for instance is a good possibility to find potential “fallen angels”. The only stock out of this screen where I really invested, Autstrada, didn’t work out, so why bother further with those screens ?

As I discussed several times, I have certain ideas what risk characteristics my portfolio should have. For instance I prefer below market volatility because this helps me avoid any market timing actions even in the worst times. As I have only a limited amount of time per day to work on analysis (maybe 1-2 hours) and I want to have at least 20-25 different investments, one has to think about how to distribute the capacity best.

My “special situation” investments are usually rather “high maintenance”, so I prefer for the rest of the portfolio more “low maintenance” stocks. Low maintenance for me means the following primary characteristics:

1. company has a stable unexciting business with respective results over a long period in the past

2. company is cheap compared to “intrinsic value” to limit downside

3. company has shown historically that it adds value above cost of capital

So in the end, I am looking for companies which have a boring (non-volatile) business model and a sexy (cheap) valueation..

I think additionally it makes sense to define what I am not necessarily looking for in the first place

– deep value turnaround situations (too risky)
– net nets (usually no ongoing value creation)
– “moat” stocks (too crowded)
– growth stocks (too risky)

In the next post I will follow up how I actually calculate the “Boss” Score.

CS Euroreal closed as well

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Already yesterday’s news but here ist the link (German).

So not really a surprise, the price chart showed already clearly the outcome:

In the wake of this process, also the other funds lost further, which kind of makes sense as now even more real estate is hitting the market:

For instance the Axa fund lost even more:

As I have mentioned before, I think at some point in time, the funds could become interesting again, but there is no need to hurry now.

Edit: According to this article, business for the remaining open funds seems to be really good. So at some point in time we might see some selling activity from the closed funds.

David Einhorn’s “Go Ups” – a first look (Microsoft Example)

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David Einhorn is a guy which is clearly moving the markets these days. When he spoke at the famous Ira Sohn hedge fund conference last week, he even managed to move a stock by not speaking about it (Herbalife).

However, the second part of his presentation which I linked to in the “Weekly links” did not get so much attention but for me, as a Corporate Finance/ capital structure guy is much more interesting:

The “Greenlight Opportunistic Use of Preferreds” – Short Go Up.

First thing to notice: If you want to promote something, make sure you have a great acronym for it…….

Those “Go Ups” should work as follows:

1) A company creates a new class of preferred shares which have a liqidation preference and carry a 4-6% coupon hich only has to be paid at full discretion by the issuing company (although he mentions unpaid coupons are “cumulative”)

2) Those pref shares then get distributed “for free” to the shareholders like with a normal stock split

His basic argument to support is very simple and sounds convincing enough:

There are many great companies with great balance sheets that suffer from low valuation multiples in the current environment, when market participants have enormous appetite to pay for yield, but little appetite to pay for earnings. The traditional advice to such companies is to offer a dividend, but dividends often don’t work. A stock with a low P/E multiple often just becomes a stock with a low P/E and an attractive dividend.

He then adds a spreadsheet which shows his assumption for a couple of cash rich companies like Apple, Microsoft, Dell, Marvel and GM.

To take Microsoft as an example, he calculates the following way:

Microsoft has now a share price of USD 30.21 USD and a market cap of 255 bn USD. With 6.56 USD cash per share and an estimated 2.84 USD Earnings for 2012, you get an P/E of 10.6 including cash and 8.3 excluding cash.

In the next step, he assumes that Microsoft will issue 250 bn of “Go Ups” carrying a coupon of 4% and distributes them pro rata to shareholders (so shareholder would get a nominal of around 30 USD pref on top of the existing shares).

When he then compares the result with the initial market cap, he makes the following assumptions:

1. the 4% pref share trades at par
2. the Microsoft Share trades at the initial “after cash P/E mupliple” of 8.6 based on the reduced earnings (1.66 USD after ref share dividend) plus the unchanged cash position

The sum of that than is 65% higher than current market cap and this is “value unlocked”.

So let’s stop here and summarize what Einhorn is proposing:

If you divide existing cashflows of a company into two seperate securities, the “sum of parts” will be significantly higher than the previous security. This is of coure a punch in the face of all “efficient market” fans who would argue (apart from tax effects) that in theory the total value (Enterprise value) of a company does not change due to capital structure.

So let’s quickly look at the main assumptions of Einhorn which support his case:

1. Equity multiple

His argument is: The stock will trade at the same multiple before and after the “spin off” of the preferred. I would argue that this is at least “optimistic”.

Somwhere in the presentation he mentions that the preferred dividend should be cumulative, meaning that non paid dividend will accumulate and have to be paid at a later date. This is important !!!

If we go back to the Microsoft example, we have the following EPS before and after Go Ups:

2.84 USD per share before Go Up, 1.66 USD after Go Up (1.18 are Go Up interest).

So what happens, if the profit of Microsoft for some reasons falls by -20% ? Without go ups, of course profit per share drops by 20% to ~2.27 USD per share.

With Go Ups, however, we have to distribute the 2.27 USD between the fixed interest of Go Ups (1.18) and shares which results in a 1.09 EPS including Go Ups. Not surprisingly, the change in EPS of (1.66-1.09) = -0.47 is percentage wise much higher with (0.47/1.66) =-27%.

So his first assumption implies that shareholders are indifferent about a higher leveraged EPS which I think is unrealistic.

2. Valuation of Pref share

Einhorn assumes,that the Go Us will trade at par after issuance. How realsitic is that ?

A 4% Microsoft pref share will have a duration of around 26 years. This is even longer than a 30 year treasury bond. 30 Years treasury yield at the moment is around 3%. So Einhorn assumes a 30 year (deeply) subordinated spread for Microsoft is only 1% p.a.

I don’t know how realistic this is, but a deeply subordinated security is of course much more risky than a corporate bond. For instance if Microsfot starts to issue more senior bonds, the subordinated bonds get less and less liuidation value.

It is also important to mention, that such a Go up will react quite sensitive to any changes in interest rates or credit quality of the underlying. If for instance 5% would be th correct yield, with a constant duration of 26, the Go Up will drop 26% in value.

So to summarize this:

Einhorn’s underlying assumptions are very very “optimistic” if not to say (totally) unrealistic. So why is he doing this ? He is for sure one of the smartest investors alive and knows all this stuff much better than I do ?

I think his startegy could work quite well in the short term:

Under his proposal, “normal investors” of course would feel richer. Imagine, you own a Microsoft stock at USD 30 and you suddenly get a 30 USD bond “for free”. The bond (Go up) will be very difficult to value. This leaves a nice “window of opportunity” for the smart guys to profit from mis pricings as the stock price might not dirctly reflect the “true discount” and the Go Ups might trade above “intrinsic value” for some time.

So Einhorn basically tries to create a what I call “special situation” where normal share holders most likely do not know what to do or value the secrities correctly. I am pretty sure, in the long run this will not increase the total Enterprise Value of the sample companies. But in the short run, it could create a nice arbitrage opportunity for hedge funds like Einhorn’s Greenlight and give the stocks a “quick pop”.

As Einhorn owns most of those stocks, one could summarize Einhorn’s proposal as “talking his own book”. Perfectly fair but one should be aware of this. I nevertheless highly doubt that this is changing the theory of Corporate Finance…..

AIRE KGaA – Increase of Tender offer to 18,25 EUR per share, Q1 report and Uncle Sam

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What a day again for the AIRE KGaA stock.

As reader AS has commented already, AIG has increased the tender offer again up to 18.25 EUR per share.

To make the situation even more interesting, the Swiss fund Alpine Select filed that they have increased their share holding to close to 17%.

In parallel, AIRE published today the Q1 report 2012 which did not contain any news. Money is still coming back. Interestingly they showed on page 8 that 55% of the portfolio is residential real estate, I assume most of this in the US. Current NAV is around 20 EUR.

One funny aspect of the current situation:

I was quite confused that the US Treasury Department was disclosing a stake in AIRE KGaA, ut the i read this sentence:

These voting rights are to be attributed pursuant to sec. 22 para. 1 sentence 1 no. 1 WpHG via American International Group, Inc., United States of America.

As the US Treasury is still holding the majority in AIG, effectively one can sell now the AIRE shares to Uncle Sam.

I think I will soon start selling the shares as the upside seems to be now relatively limited. at the current price it will e the first real “Double”.

Quick news: WMF, Walmart, Praktiker

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WMF

According to a Boersenzeitung article, for some reason WMF is considering exchanging the Pref shares into ordinary shares (full article can be found in the W:O Thread)

I do not really understand how Capvis could profit from an exchange, unless they already have bought a lot of Pref shares. Then it would be a good deal for them.

Interestingly, the Pref shares now more or less are back to the level of the regular shares.

Maybe time to sell on good news ? Q1 numbers seem to have been really good. For the time being: no action.

Walmart

Walmart issued unexpected positive Q1 numbers today. Here I will definitely ue the momentum and sell the shares at today’s VWAP.

For some reason I do not believe in the US recovery story, at least not for “physical” retailers. Even if Warren is still buying…..It was never a “high conviction” play anyway, although it made good money.

Praktiker

Praktiker seems to have found an U Hedgefund for its “secured” loan, US Hedgefund Acnhorage. Although it is too early to assess, the downside scenario for the bonds would now be of course more severe, however the proabality of a deafult is lower. No action yet.

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