Ken Kam's Best Ideas Blog

I'm pretty happy with the trades I made two weeks ago. They were designed to recognize a tax loss and free up capital to put in the stocks I was confident would benefit more from a market rebound. The trades have worked well, with the stock I sold, InfoSonics (nasdaq: IFON), continuing to drop while the stocks I bought are trading higher.

Today I want to discuss U.S. Global Investors (nasdaq: GROW), up nearly 15% on news that the special dividend and stock split approved by shareholders in a difficult proxy vote would be paid on March 29 to shareholders of record on March 19 - today.

Since I recommended that shareholders vote in favor of the proxy, I've received a lot of e-mail from readers questioning whether U.S. Global Investors' proposal to convert its Class C stock, which is not publicly tradable, to Class A stock, which is, benefits all shareholders or just the CEO, who happens to own almost all of the Class C stock. The proxy statement seems to indicate the value of the Class C stock is about 50 cents while the value of the Class A stock is currently about $40, so I can understand how it might appear that the main purpose of the proxy was to enable Frank Holmes to convert his non-marketable stock worth 50 cents to publicly tradable stock worth $40. But that is simply not the case.

Rules, rules, rules

The Class C stock was created because mutual fund regulations say that if there is a change in control of a mutual fund's investment adviser, the management contract needs to be re-approved by the mutual fund's shareholders. If all of the company's stock were publicly tradable, then every few days the normal volume of trading would change the ownership of the company by enough to trigger the change-in-control rule. To enable the company to go public, the Class C shares were created and given enough rights so that Class A shares could trade without triggering the change-in-control rule.

The last sale price of 50 cents for the Class C shares probably took place more than 14 years ago, just before the company went public. A lot has changed since then. The Class A shares are worth a lot more now, and the Class C shares should be, too.

Since the Class C shares control the management contracts with the mutual funds, they are arguably worth more than the Class A. When Holmes converts a Class C share to a Class A share, he gets more-liquid shares with fewer rights. He cannot exchange all of his Class C stock into Class A without triggering the change-in-control rules. But after the tremendous job he's done, I think its not only fair but in the Class A shareholders' interests to allow him to exchange what he can so he can get a return on his 14-year investment.

Time to mind the store

Now that the vote is over, management can get back to the business of running the mutual funds. Assets under management have been flat since they more than doubled in the first quarter of 2006. The investors in U.S. Global Investors' funds who caused last year's growth spurt have had a volatile, but ultimately rewarding year. As these shareholders consider where to invest this year's 401(k) and IRA contributions, their investment in U.S. Global Investors' funds will stand out as one of the better decisions they made last year.

Conventional wisdom in the mutual fund industry is that 80% of each year's inflows to all mutual funds go to the funds ranked 4- or 5-star by Morningstar. With four out of the five top-performing funds over the past five years in their family, U.S. Global Investors' funds could well see their assets double again this year.

Growth in the mutual fund industry is never smooth. Growth spurts occur when there is a combination of good performance and favorable market sentiment. Market sentiment toward emerging markets and natural resources may be negative right now, but the underlying factors that have made these areas such great investments for the past five years have not changed.

If you don't have any emerging markets or natural resources in your portfolio, pick up some U.S. Global Investors while market sentiment is negative. Market sentiment might change quickly but U.S. Global Investors' impressive five-year track record will not.

Posted by Mark Taguchi at 12:00 AM | Permalink

U.S. Global Investors (nasdaq: GROW)

Subscriber's have written me asking whether GROW's proposal to convert Class C stock (which is not publicly tradable) to Class A stock benefits all shareholders or just the CEO, Frank Holmes (who happens to own almost all of the Class C stock). From the proxy statement the value of the Class C stock seems to be about $0.50 while the value of the Class A stock is currently about $40. I can understand how it could appear that the main purpose of the proxy was to enable Frank Holmes to convert his non-marketable stock worth $0.50 to publicly tradable stock worth $40. But that is not the case.

The Class C stock was created because mutual fund regulations say that if there is a change in control of a mutual fund's investment advisor, the management contract needs to be re-approved by the mutual fund's shareholders. If all of the company's stock were publicly tradable, then every few days the normal volume of trading would change the ownership of the company enough to trigger the change-in-control rule and require an expensive proxy voting process. When GROW went public Class C shares were created and given enough rights so that the Class A shares could trade without triggering the change-in-control rule.

The last sale price of $0.50 for the Class C shares probably took place more than 14 years ago just before the company went public. A lot has changed since then. The Class A shares are worth a lot more now, and so should the Class C shares.

Since the Class C shares control the management contracts with the mutual funds, they are arguably worth more than the Class A. When Frank Holmes converts a Class C share to a Class A share, he gets more liquid shares with fewer rights. He cannot exchange all of his Class C stock into Class A without triggering the change-in-control rules. But after the tremendous job he's done, I think its not only fair, but in the Class A shareholders interests, to allow him to exchange what he can so he can get a return on his 14 year investment.

Now that the vote is over, management can get back to the business of running their mutual funds. Assets under management have been flat since they more than doubled in the first quarter of 2006. The fund investors that caused last year's growth spurt have had a volatile, but ultimately rewarding year. As these shareholders consider where to invest this year's 401k and IRA contributions, their investment in GROW's funds will stand out as one of the better decisions they made last year.

Conventional wisdom in the mutual fund industry is that each year, 80% of the new money going to mutual funds, go to the fund's ranked 4 or 5-star by Morningstar. At the end of 2006, GROW had 4 out of the top 5 best 5-year performing funds out of 13,078 funds. Their Eastern European Fund is a 5-star and returned 32.79% in 2006. Their Global Resources Fund returned 22.19% in 2006 and is a 4-star. The other two funds that ranked in the top 5 were up over 50% in 2006. Even though GROW's funds are down YTD'07, most of their current fund investors have made a lot of money and GROW could well see their assets double again.

Growth in the mutual fund industry is never smooth. Growth spurts occur when there is a combination of good performance and favorable market sentiment. Market sentiment towards emerging markets and natural resources may be negative right now, but the underlying factors that have made these areas such great investments for the past 5 years have not changed. If you don't have any emerging markets or natural resources in your portfolio, pick up some GROW while market sentiment is negative. Market sentiment might change quickly, but GROWs impressive 5-year track records will not.

Posted by Mark Taguchi at 03:35 PM | Permalink

I don't believe, as many academics do, that the stock market pretty much always prices stocks correctly. This might be true of the stocks in the Standard & Poor's 500 Index ($INX), but of the more than 10,000 tradable stocks, there are many that simply do not have enough of a following for pricing mistakes to be quickly corrected.

If an S&P 500 stock dropped 20% on no news, it's a pretty good bet that bad news is coming. But for most of the other 9,500 tradable stocks, 20% drops can and do occur for reasons that have nothing to do with the underlying value of the company. When these situations occur, they can be great buying opportunities, but you have to be willing to do some homework to make sure that there is in fact no bad news on the horizon.

Elan (ELN) and U.S. Global Investors (GROW), two of my favorite stocks, have suffered large drops in the past two weeks. I have resisted the urge to post immediately after each bad day because I wanted to finish my homework first. Here's what I've found:

Elan

The company presented at the JPMorgan Healthcare conference two weeks ago and left the overall impression that Tysabri sales were ramping nicely and that an Alzheimer's drug (AAB-001), currently in Phase 2 trials, was progressing well. Almost immediately after the conference, the stock started its descent, falling nearly every day.

I think Wall Street was disappointed over the news about the Alzheimer's drug. Apparently, Wyeth's (WYE) CEO -- Wyeth is Elan's partner for AAB-001 -- had previously stated that the companies would "peek" at the data in December 2006, and if the results were "spectacular," they would go immediately into Phase 3 trials. When Elan did not announce they were going into Phase 3 trials, Wall Street inferred that the results must not have been spectacular.

There was even some speculation that Wyeth was going to pull out of the trial.

I had invested in Elan primarily because of Tysabri. I think the Alzheimer's drug could be worth a lot, but it's too early to tell. I regard it more as a bonus rather than the main reason to invest. I was pleased to hear that Tysabri sales were ramping nicely, and speaking separately at the same conference, the CEO of Biogen Idec (BIIB), Elan's partner on Tysabri, seemed to agree.

Tysabri seems to be on track to be a big success this year. Because Tysabri is main reason I invested in the company, I am not going to sell because Wall Street thinks the Alzheimer's results were not spectacular.

About that Alzheimer's trial

Elan and Wyeth are testing four doses of AAB-001. Each group started about four to five months apart. The investigators can "peek" at each group's results at 12 months, and a full evaluation is done at 18 months. In December, I believe, 18-month data from the first group and 12-month data from the second group was available.

In order to justify moving immediately to Phase 3 in December, the results from the two lower doses would have had to be so strong that there would be no hope that results from either of the two higher doses could be even better. By the end of this year, they'll have all the data they need to make the right decision.

I'm glad they decided to wait until they have more data rather than moving ahead prematurely. Only Wall Street and other very short-term investors can be disappointed with this decision.

U.S. Global Investors

It looks like I was too quick to buy back into U.S. Global Investors. I waited until I thought the bulk of the tax-motivated selling was over, but the stock has continued to fall, indicating that there may be something else going on as well.

The reason I invested in U.S. Global Investors is that it runs four of the five top-performing mutual funds of the past five years. In 1999, when the fund I co-managed was the top-performing mutual fund for the previous five years, I saw assets under management increase nearly eight times. I also know that as assets ramped, expenses did not rise as quickly, so profits grew even faster than our assets.

I was disappointed that U.S. Global's assets only doubled in 2006. But I think it brought in a lot of new shareholders and performed well for them last year. Between now and April 15, when their funds' shareholders decide where to invest this year's IRA and 401(k) contributions, I think U.S. Global's assets under management are going to get another bump up. In doing my homework, I've not come across anything that changes this opinion.

Although the business is fine, the way it has handled their latest proxy has become somewhat of a self-inflicted wound. In November, the company announced a 2-for-1 stock split and a special dividend of 50 cents per share (25 cents per share post-split). Frankly, it does not matter to me whether they split the stock. Just as splitting a slice of pizza doesn't get you any more pizza, splitting a stock does not increase the value of the company.

The problem is that once you tell Wall Street that you're going to split your stock and pay a dividend, you'd better do it. That's where this became a self-inflicted wound.

Most public companies incorporate in Delaware so they know they will be treated the consistently with other public firms. Under Delaware law, a simple majority is enough to carry the vote. U.S. Global Investors, however, is incorporated in Texas, and Texas law requires a two-thirds majority vote to approve U.S. Global's proposals.

More than 50% of the company's shares have voted in favor of the proposals, but when it did not get the required two-thirds vote, the company adjourned the shareholders meeting. This gives it more time to get out the vote, but it also increased the risk in Wall Street's view that the split and dividend might not happen. The number of shares of U.S. Global that have been shorted has ballooned and now represents about 25% of all shares outstanding.

A proxy worth your attention

Usually, it's not worth an individual investor's time to vote on a proxy because the management team generally has enough votes lined up to pass its proposals before the proxies are even mailed out. But this time it's different. Your vote could matter.

The record date for the proxy vote was Nov. 20. Anyone who owned stock on that date is entitled to vote. Shareholders can go directly to U.S. Global's Web site or call 1-800-USFUNDS. The voting deadline is Jan. 31 -- Wednesday.

The sooner this is settled, the sooner the company can get back to growing four of the five best-performing mutual funds of the past five years. If you own the stock, I recommend that you vote in favor of the proposals so we can put this episode behind us. That way, we can get management's attention back to growing the business -- and get the stock price back to where it was before this all started.

Posted by Mark Taguchi at 05:00 PM | Permalink

One my best performing stocks this year is U.S. Global Investors (GROW). In the last three months this stock has more than doubled putting many recent GROW shareholders in a dilemma. They would like to sell some of their shares, but they don't want to have to pay taxes on their gain by April 15, 2007. By waiting until January to sell, they can move their gains into their 2007 tax year thereby potentially deferring their tax liability until April of 2008! I believe that one reaso why GROW has performed so well recently is that a lot of people who would ordinarily be sellers are waiting until January.

We intentionally selected June 30 as the tax year-end for our mutual fund so it doesn't matter from a tax perspective whether I trade on December 31, 2006 or January 1, 2007. Consequently, I can take advantage of the opportunity to sell some GROW now while tax considerations are keeping many sellers on the sidelines. If, as I suspect, the sellers all come out at the same time in the first few trading days of 2007, I'll be buying these shares back -- hopefully at a lower price.

My opinion on GROWs prospects has not changed -- I still like the stock. I don't often make tax motivated trades, but GROW has done so well recently that I'm willing to do this trade with about 1/2 of my position.

Posted by Ken Kam at 05:12 PM | Permalink

One my best ideas stocks, U.S. Global Investors (nasdaq: GROW) was hit hard after a report in a leading business journal stopped just short of accusing the company of using lightly traded securities called warrants to manipulate the performance of one of its mutual funds -- the Gold Shares Fund (USERX) up over 29% so far this year.

The article reported that the fund held 1.1 million warrants issued by Goldcorp (GG) which doubled in value between June 12 and August 30 when Goldcorp's stock rose just 21%. However, between August 31 and September 29 (the date of the article), Goldcorp's stock dropped 21% but the warrants fell only 11%.

The reporter does not state it, but seems to assume that the price of the warrants should always move in tandem with the price of the underlying stock. Therefore, if a 21% gain in the underlying stock results in a 100% gain in the warrant, a 21% loss in the stock should have caused the warrant to fall by much more than 11%.

The reporter leads readers to conclude that the reason the warrants fell only 11% is that GROW owns 75% of the entire issue and somehow prevented the price from falling. The reporter never states this conclusion. But, by failing to provide an alternative explanation, he gives readers the impression that it is the only possible explanation. It isn't.

When a warrant is "in-the-money" (meaning that the price of the underlying stock is above the warrant's exercise price) its price will change the way the reporter assumed. However, the relationship is different when a warrant is "out-of-the-money" (the warrant's exercise price is above the underlying stock's price). Here's why.

A warrant's value can be broken down into two parts -- its time value, and its intrinsic value. Its instrinsic value is the difference between the underlying stock's price and the warrant's exercise price. If the stock is selling for $20 and the warrant gives you the right to buy the stock at $15, the warrant is "in-the-money" and has an intrinsic value of $5. A warrant's intrinsic value does move in tandem with the price of the underlying stock -- just as the reporter assumes.

But what happens when a warrant is out-of-the-money? To continue this example, if the stock traded down to $10, a warrant with an exercise price of $15 would have $0 intrinsic value. It would not, however, be worthless because at some point during the warrant's life, it could trade at more than $15. This is the warrant's time value and it depends on how much time is left before the warrant expires.

If tomorrow the underlying stock drops from $10 to $8 the warrant's intrinsic value which was $0 before would still be $0. The warrant's time value would decline a little because the passage of time will have reduced its remaining life. But, if the warrants had a 5 year life (as the warrants in question did), then the passage of 1 day would not have a great impact on the warrants time value. In this case, it is perfectly reasonable to expect the price of the warrants to fall less than the price of the stock. Nothing unsavory or illegal is required.

The whiff of scandal was enough to cause GROW to drop from the low $30s just a few weeks ago to around $22. I don’t think the drop was warranted by the facts reported in the article. Unless the newspaper has some actual evidence, this episode will soon blow over. I'm not selling.

Posted by Ken Kam at 06:54 PM | Permalink

We first brought GROW to your attention in April when it was one of our Watchlist Focus Stocks. The more I look into this company, the more I like the stock. The company manages mutual funds that specialize in natural resources, Eastern Europe, and China -- areas of the market that have all done well over the past 1, 3 and 5 years. But, instead of investing in these mutual funds, I think it's better to invest in the company that manages the funds.

GROW is in an industry I know well. In 1997, when I was CEO at Firsthand Funds, one of the funds I co-managed was ranked the #1 mutual fund in the country for the previous 3-year period. Assets under management (AUM) grew from $50 million to $250 million within months of that announcement. In 1999, the same fund was ranked the #1 fund for the previous 5 year period and assets swelled from $800 million to peak at $8 billion.

GROW is going through a similar growth spurt. AUM grew 56% in 2005 from $1.4 Billion to $2.1 Billion. Just 4 months later, on April 20, 2006, the company announced that AUM topped $5 Billion.

One of the great things about running a successful mutual fund management company is that your costs are largely fixed. Once you have the investment team in place, and paid for, it doesn't cost much more to be able to serve additional clients. Therefore, once a mutual fund management company reaches a profitable level of AUM, the revenues from additional AUM growth largely fall to the bottom line as profits. GROW was nicely profitable at $2 Billion in AUM. Imagine what profits will be like at $5 Billion.

I have had firsthand experience with the challenges and opportunities that are confronting U.S. Global Investors. As long as natural resources, Eastern Europe and China deliver good returns, assets under management will continue to ramp.

At Firsthand Funds we did well as long as either Tech or Healthcare did well. But the thing that kept me up at night was worrying about how to protect our fund's investors when the time came when neither Tech nor Healthcare was in favor.

It seems inevitable that everything that has performed well in the past 1, 3 or 5 years will someday be out of favor. A mutual fund management company that does not have a plan to protect its customers when the stocks they specialize in are out of favor is eventually going to disappoint all of its customers.

With GROW, we will have to monitor the performance of natural resources, Eastern Europe and China. When these areas fall out of favor, it will be time to exit GROW. But, for now, U.S. Global Investors is in a sweet spot where AUM can double in just a few months with correspondingly large increases in revenue, earnings and most importantly stock price

Posted by Ken Kam at 01:28 PM | Permalink

by Tim Eriksen, m10 member

The asset management industry has been one of the best performing industries over the last few decades. In fact, the best performing stock over the last 25 years is Eaton Vance, which delivered an incredible 32% average annual return.

One of the primary reasons for this outstanding performance is operating leverage. There are minimal costs to service additional accounts in relation to the additional fees the accounts generate. In addition, the industry does not require significant investment in fixed assets. This allows earnings to be used for dividends, debt reduction, share repurchases, or acquisitions.

The typical asset-management firm has historically traded at a PE ratio similar to overall market, currently 16-25 times earnings. The problem is that the larger firms have become so large that their growth rates have slowed dramatically, and as a group appear to be fully valued in the market. What I want is a small firm that is growing assets and could be the next Eaton Vance.

One firm I like is U.S. Global Investors (nasdaq: GROW). The company was founded in 1968, and struggled for years to grow assets due to its emphasis on gold funds and money market funds. Unfortunately for U.S. Global, gold has been a poor performer for much of the last two decades, excluding a few short-lived rallies.

In recent years, the company expanded fund offerings into other natural resources and Eastern Europe. Both areas have been hot of late, and I while I can't comment much on Eastern Europe's prospects, I do think natural resources will continue to outperform. For example, oil stocks are priced as if oil prices will drop in the future, yet the futures market says current prices will not go away. By focusing on natural resources GROW has experienced spectacular growth. In the last three years, AUM has increased by 40%, 20%, and 67%, respectively. At the end of 2005, AUM was $3.0 billion. In the first three months of 2006 AUM has already increased by 33% to $4 billion.

The result is that earnings which typically ran from breakeven to $0.05 per quarter, on after-tax margins of 8%, suddenly surged to $0.15 per share in the September 2005 quarter, on after-tax margins of 16%. The stock took off, going from $5 to $20 before falling back to around $13 after flat December 2005 earnings. It appears that there was a temporary dip in AUM in October which has since been reversed.

Assets are now 70% higher than in the September quarter. If they maintain the same profit margins, earnings should increase to an annualized $1.00 per share. Thus the company is trading at 14 times run-rate earnings, a big discount to the industry average.

The main concern for the company is clearly the lack of diversification in its funds and the heavy reliance on natural resources. There is no doubt that this is a legitimate concern. But since I am bullish on natural resources, I don't mind the reliance. By investing indirectly through an asset manager that focuses on a certain area of the market, I believe it actually allows me to get more upside on the investment than I would get from owning a basket of stocks.

Note: Due in part to his success at Marketocracy, Mr. Eriksen has registered as an Investment Advisor, and started a private investment partnership. Both Mr. Eriksen, and funds he manages, have a position in U.S. Global, as well as other investment advisory firms

Posted by Ken Kam at 05:00 AM | Permalink