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Whistle!…. substitution. Exelis (XLS) is out!

March 8, 2013

I know I just wrote that investing requires patience, but I just couldn’t help myself. After all, I did come into the new year with a resolution: to focus my holdings in areas where I have an edge. That means fewer large cap companies and more small caps, among other things.

So I’ve decided to act on this resolution and I’m selling off Exelis (XLS) and substituting it with….? Well, cash for the moment. Why sell off XLS? Yes, it is a large cap, but selling only for 6x earnings (and CF) plus its paying a dividend of 4%. Still, I think the equity markets are a bit frothy and want to reduce my exposure. This sale is being made with the full understanding that I haven’t held XLS as long as I should have; generally spinoffs outperform in the SECOND year after being spun out, not the first year. There are a couple of things, however, which are knawing at me. First is the pension obligation at XLS. I knew about it when I first did my analysis, but in the past year I’ve been contemplating what this could mean to the company in the long run given the low interest rate environment we have now and extending out for the foreseeable future, and it’s not pretty. Most large pension plans are on a collision course with reality; a high assumed earnings rate coupled with today’s low interest rate environment are a potent combination and a receipe for disaster. A ticking time bomb as they say. Unless we get some significant inflation in short order, 10 years from now these companies will be having to contribute significant amounts to their pension plan. Bye bye free cash flow! The other looming problem is the budget deficit in the US and resulting spending cuts. Clearly this latter is being factored into the current market valuation of the company; XLS is selling for a PE that is less than 50% of the general market PE. But could the deficit problem and potential defense spending cuts be much larger than the market is currently discounting? I think so.

Sorry to do an abrupt about face. But there it is.

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From → Positions Closed

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