In defense of investing in companies, not mutual funds

Many of you who have followed me for years know I’m not a big fan of mutual funds for many reasons.

I prefer to invest in public companies for my clients, where they hold the securities in their name and I watch the company fundamentals and buy and sell based on the financial statements.

Recently, Roger Edelen, a finance professor at the University of California, Davis, released a study that points out a couple of new things that I should share with you. Please Google the study if you would like more details.

Mr. Edelen points out that when a fund buys or sells a substantial amount of a company’s stock, it can move the market, causing the share price to rise if they are buying the stock, or fall if selling the stock, thereby putting it in the position of continuing to buy while the price is rising or selling as the price is falling.

Let me give you an example on the sell side — Fidelity Equity Income Fund. I’m not saying this is a good or bad fund; I'm just using it as an example.

The fund is listed as having $8.69 billion in assets, which makes it a pretty good size fund. An investor can get the holdings of the stocks from many sources. I got mine from Yahoo Finance, which shows that Paychex Inc. accounts for 1.94 percent of the $8.69 billion portfolio. If I do the math, it shows me that 1.94 percent of $8.69 billion is about $169 million, and with the stock trading at around $34, Fidelity holds just about 5 million shares. Over the last three months the average trading volume for Paychex is 3,130,490, so I think you can see Mr. Edelen's point on how, if Fidelity wanted to get out of a company like Paychex, it could take days if not weeks, and the stock could be falling from all the sell volume.

The professor also points out that small cap funds incurred higher trading costs. The average for a small cap value fund was 2.29 percent. If you like those small cap growth funds, be prepared for annual fees of 3.17 percent.

So now you have a couple more reasons why I prefer to hold the individual companies in my client’s portfolio, sometimes it is not possible like in a 401K. In that case a mutual fund is still your best choice, and hopefully your employer has picked good funds for you to choose from.

I received a request from Walter, who owns 100 shares of Owens-Illinois (NYSE: OI). He bought it last September at $18.95 and it now trades around $26 per share. Should he keep it or sell it?

Walt, this is an interesting company. It was founded back in 1903 and makes and sells glass container products to the food and beverage industry. It’s one of those products that we use every day, but never stop to think about who makes that product.

I was also surprised to learn that the company has a market cap of $4.3 billion, which means it's not a large company but not that small either. The stock has traded as low as $16.82 and as high as $26.78 over the last year.

The company has a PE of 23.1 which is on the high side, but the industry has a PE of 316, so 23 doesn’t look too bad. Price to sales looks good at 0.60 for the company, just under the industry average of 0.69. Price to tangible book value is a problem for both the company and the industry both showing zero.

I looked at the company’s balance sheet and noticed that it has $2.1 billion in goodwill and only $891 million in equity. In other words, take away half of the goodwill and there is no value, since the liabilities exceed the assets.

Sales did decline for OI at nearly 5 percent year over year, while the industry experienced a 7 percent increase. Earnings per share favor the company growing 136 percent while the industry saw a 94 percent drop in the EPS. Very strange numbers on both sides. I looked at the income statement and in the last quarter of 2011, the company did have an unusual expense of $877 million. I glanced at the balance sheet and it looks like the company wrote off some goodwill to the tune of about $700 million, which also saw a 50 percent haircut in the equity. With that big write-off, it makes earnings look really good year over year, but now you know it didn’t have some big growth spurt — it was based on a low number last year due to a big write-off.

Oh my gosh — debt to equity is 428 percent compared with the industry average of 234 percent. Total debt on the balance sheet is nearly $3.8 billion and the equity is only $881 million thanks to more than $2 billion in goodwill. Ouch!

Walt, I’m not going to go any further. This is not a company I would ever hold in my portfolio. It’s done well for you and the stock may continue to rise to $30, maybe $40 per share, but the risk of the company is very high. If there is a slowdown in the industry or some competition comes in and cut prices, this company could be in bankruptcy so fast it would make an investor's head spin.

I can’t tell you when this is going to happen or if it will happen. All I can tell you is the risk is high and with such a weak balance sheet it could happen at any time. It took me almost two years to be right on GM going into to bankruptcy.

So be careful. It’s a shame, too, because I really liked the product, but it’s not for me.

Have a question or a company you'd like me to take a look at? Email me at brent@wilseyassetmanagement.com.

Wilsey is president of Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.