The Ideas Report For Serious Investors

 

Posted by manualofideas at 10:15 PM | Permalink | Comments (0)

While reviewing the Bureau of Economic Analysis (BEA) “advance estimate” of Q4 2009 GDP, it seems instructive to revisit the Q3 2009 “advance estimate” which was discussed here exactly three months ago.  A quick review suggests that there is little point in treating preliminary reports too seriously due to significant inaccuracies which often result in subsequent revisions.  While investors and politicians always fixate on the advance number, few outside the economics profession seem to pay much attention to subsequent revisions.

Q3 2009:  3.5% Estimate vs. 2.2% Reality

The advance GDP estimate for Q3 was 3.5% while the current estimate is 2.2%.  This is obviously a very significant change.  The BEA does not pretend that advance estimates are accurate.  In each quarterly GDP release, the BEA publishes a table showing “vintage comparisons” between the advance estimates and subsequent revisions.  From the advance estimate to the final figures, the average revision in Real GDP, without regard to sign, was 1.3% for estimates made between 1983 and 2006.  This happens to be the difference between the advance estimate and latest revision for the Q3 GDP data.

Q4 Advance Estimate:  5.7% Growth

Since we know that subsequent revisions are likely, the advance estimate should be treated with some skepticism.  Nevertheless, a quick review is still interesting.  In addition to the data in the main release, the BEA has an interactive tool that can be used to generate tables such as the report shown below which breaks down the contributions to the percentage change in real GDP (click on the image for a larger view of the data):

From the table, one can quickly see that inventories accounted for the bulk of the growth in GDP for the quarter with a 3.39 percent contribution.  Private business decreased inventories by $33.5 billion in the fourth quarter compared to a decrease of $139.2 billion in the third quarter.  Real GDP measures production, not final sales, so changes in inventories can often have a major influence on reported GDP numbers.  In this case, the decrease in the rate of inventory liquidation accounts for a major boost to GDP.

The report shows signs of weakness in other areas including anemic growth in personal consumption.  Notably, final sales of domestic product (GDP less changes in private inventories) only increased 2.2 percent in the fourth quarter.  Although this is a slight improvement over the 1.5 percent increase in final sales in the third quarter, growth is still quite slow.  It appears that GDP growth in the first quarter may depend on whether companies decide to begin building inventories rather than only reducing the rate of inventory liquidation.

Pay More Attention to Revisions

While it is understandable for markets to react to the advance estimate, it is less obvious why revisions to the initial estimate attract little attention in comparison.  To the extent that investors consider macro factors at all, which is itself a debatable practice, more attention should be given to the second and final revisions to GDP and less to the advance estimate which is only an “educated guess” based on incomplete data.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 06:30 PM | Permalink | Comments (0)

"The International Monetary Fund is forecasting positive growth in 2010; yet, it warns the pace of growth will be too sluggish to prevent further increases in unemployment across the global economy. What is the outlook for the global economy in 2010?"

Speakers: Josef Ackermann, Montek S. Ahluwalia, Dominique Strauss-Kahn, Lawrence H. Summers, Zhu Min, Martin Wolf, Yoshito Sengoku

Watch the discussion.

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"No industry is immune to the global, cyclical and structural changes reshaping the world economy. Chairs of the World Economic Forum Governors Meetings each share their industry's evaluation of the most important challenges and opportunities in 2010."

Speakers: Josef Ackermann, Hans-Paul Burkner, Colin Dyer, Eric Mindich, Jeff Zucker, Kevin Steinberg

Watch the event.

Posted by manualofideas at 07:47 PM | Permalink | Comments (0)

Charlie Rose spoke to Larry Summers about the U.S. economy today.

Watch the conversation.

Posted by manualofideas at 07:15 PM | Permalink | Comments (0)

Bill and Melinda Gates today announced a $10 billion initiative to develop vaccines that could save eight million lives in the developing world. This calculates to an investment of roughly $1,250 per life saved. What a remarkably low number. The U.S. government spent some $100 billion bailing out AIG -- the monetary equivalent of 80 million lives saved (assuming that Gates's calculations are correct and extrapolating to a bigger population).

Another stunning and counterintuitive finding is that extending the life expectancy of people in the developing world does not lead to a population explosion. On the contrary, a longer life expectancy has led to smaller family sizes in most developing countries that have experienced increases in life expectancy. The net result has been a significant decrease in the rate of population growth.

So, not only does Gates's investment -- relatively modest on a global scale -- promise to save the lives of children but also address the problem of population growth. Why does it take a private foundation to get this done when governments have far greater resources?

Posted by manualofideas at 06:07 PM | Permalink | Comments (0)

Procter & Gamble CFO Jon Moeller discusses the company's quarterly results and outlook with CNBC's Becky Quick.

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Eli Lilly CEO John Lechleiter discusses the company's earnings and outlook with CNBC's Mike Huckman.

Posted by manualofideas at 11:12 PM | Permalink | Comments (0)

As long as consumer confidence is not there, thrift will continue, Indra Nooyi, CEO of Pepsico, told CNBC.

Posted by manualofideas at 11:10 PM | Permalink | Comments (0)

"We will all be losers if governments clamp down on markets too zealously, according to Deutsche Bank CEO Josef Ackermann." (source: CNBC)

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Carlos Ghosn, Nissan-Renault president/CEO weighs in on Toyota's recall, with CNBC's Maria Bartiromo.

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ECB chief Jean-Claude Trichet discusses the banking sector with CNBC's Maria Bartiromo.

Posted by manualofideas at 11:03 PM | Permalink | Comments (0)

"The global slowdown has caused a radical change in the way people buy and use products, but fast-moving consumer goods like Coca-Cola are less impacted by the change, Muhtar Kent, CEO of the Coca-Cola Company, told CNBC Thursday." (source: CNBC)

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Morgan Stanley CEO John Mack discusses his firm's new pay structure and more with CNBC's Becky Quick.

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"The EU budget deficit was only 2% in 2008, but it is now expected to balloon to nearly 7% of gross domestic product for member economies as a whole in 2010. How can Europe repair its damaged public finances and still maintain its course for economic recovery?" (source: World Economic Forum)

Speakers: Lech Kaczynski, Yves Leterme, George A. Papandreou, Jose Luis Rodriguez Zapatero, Jean-Claude Trichet, Valdis Zatlers, Robin Niblett

Watch the webcast, entitled "Rethinking the Euro Zone".

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"Switzerland has been criticized lately: On the one hand, Switzerland's direct democracy is a showpiece; on the other hand, it unleashes worldwide consternation. International pressures on bank secrecy lead to concessions in the exchange of fiscal information. The accusation of cherry-picking comes up regularly. Does Switzerland have to fear for its reputation and economy?" (source: World Economic Forum)

Speakers: Andre Schneider, Thomas Wipf, Pascale Bruderer-Wyss, Niall Ferguson, Peter Maurer, Haig Dr Simonian, Ulrich Thielemann, Stephan Klapproth

Watch the webcast, entitled "Switzerland: Misfit or Model?"

Posted by manualofideas at 10:45 PM | Permalink | Comments (0)

"Multilateral trade, climate change, Millennium Development Goals and nuclear non-proliferation are just some of the items on the global agenda in which the ld expects India to play an active and constructive role. What does the world expect from India and what does India expect from the international community?" (source: World Economic Forum)

Speakers: Robert D. Hormats, Anand G Mahindra, Zakir Mahmood, Anand Sharma, Vikram Chandra

Watch the webcast, entitled "Will India Meet Global Expectations?"

Posted by manualofideas at 10:41 PM | Permalink | Comments (0)

"The financial crisis has caused an economic crisis around the world. Drastic state measures have prevented the collapse of the economic system: governments have established rescue funds for failing banks or nationalized banks for relaunching economic growth. At the same time, central banks have intervened with important injections of liquidity and have lowered interest rates." (source: World Economic Forum)

Speakers: Ziya Akkurt, Christine Lagarde, Patrick Odier, Nikolaus Schneider, Joseph E. Stiglitz, Stephan Klapproth, Juan Somavia

Watch the webcast, entitled "After the Financial Crisis: Consequences and Lessons Learned".

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The latest issue of European Value Report, published on January 28th, highlights Vodafone (VOD) as a top monthly investment idea. Key excerpts are included below, but first let's look at David Einhorn's thesis on Vodafone, as laid out in Greenlight Capiital's Q4 2009 letter to investors:

"VOD is a U.K. based wireless operator with over 300 million subscribers worldwide and a market capitalization of £73 billion. The Partnerships established their position in VOD at an average cost of £1.38 per share. VOD's core consolidated operations in Europe, Asia, the Middle East, and Africa already generate in excess of an 8% equity free cash flow yield and support a near 6% dividend yield for shareholders. This does not count any value of VOD's most significant asset, a 45% ownership in Verizon Wireless, the #1 US cellular operator. Vodafone does not consolidate Verizon Wireless and, as a result, sell-side analysts seem to ignore its significant value. VOD currently does not receive a dividend from Verizon Wireless which we believe has led to the market implicitly ignoring its value, despite significant growth in revenue, EBITDA, and cash flow. We believe that Verizon Communications (VZ), which owns the other 55%, will need continued access to the cash flow from Verizon Wireless, and will therefore restore the dividend to VOD or work on an extraordinary transaction. Currently Verizon Wireless's cash flow is being used to repay inter-company debt to VZ. However, this debt will be fully repaid by mid-2010, at which point we expect VZ will need to act. We believe that any changes that reveal the value of VOD's Verizon Wireless stake will force the market to re-rate VOD shares. In the meantime, we collect a nice dividend. Ascribing a reasonable valuation to Verizon Wireless and VOD's other unconsolidated assets, we estimate that VOD trades at less than 3x estimated 2010 EBITDA, versus in excess of 5x for the peer group average in Europe."

The following is an overview of Vodafone, excerpted from European Value Report:

Vodafone provides wireless communications services worldwide. The company had 303 million consolidated subscribers and 323 million proportionate subscribers at September 30, 2009. Non-consolidated operations include a 45% stake in Verizon Wireless, and stakes in China Mobile, Bharti Airtel and SFR. Minority interests are mainly attributable to Vodafone Essar and Vodacom.

Selected Operating Data

We start our approach to valuing Vodafone by recognizing the significant value inherent in its Verizon Wireless stake. The first table below shows estimated values of Vodafone’s 45% equity stake in Verizon Wireless based on a range of EBITDA multiples applied to Verizon Wireless’ calendar 2009 EBITDA.

Our next step is to value the rest of Vodafone’s operations. We are guided by a simple observation: the current Vodafone dividend yield of 5.8% is supported by a 6%+ FCF yield based on cash flows excluding Verizon Wireless (to be conservative, we include purchases of network licenses in the calculation of free cash flow and do not reduce cash taxes paid by Vodafone for amounts attributable to Verizon Wireless pass-through tax payments). As these cash flows are diversified geographically and likely to grow over time (>60% of consolidated subscribers are in emerging markets), an investor can make a fair return from these “non-Verizon Wireless” cash flows when buying Vodafone shares at the current price.

In summary we add the estimated value of Vodafone's 45% stake in Verizon Wireless and the estimated equity value of the rest of Vodafone, i.e. the current stock price, to arrive at a fair value for all of Vodafone operations of £1.85 to £2.11.

Summary Valuation Analysis

Disclosure: No positions.

Learn more about European Value Report.

Posted by manualofideas at 11:56 AM | Permalink | Comments (0)

By Greenbackd

In “Black box” blues I argued that automated trading was a potentially dangerous element to include in a quantitative investment strategy, citing the “program trading / portfolio insurance” crash of 1987. When the market started falling in 1987 the computer programs caused the writers of derivatives to sell on every down-tick, which some suggest exacerbated the crash. Here’s New York University’s Richard Sylla discussing the causes (care of Wikipedia).

The internal reasons included innovations with index futures and portfolio insurance. I’ve seen accounts that maybe roughly half the trading on that day was a small number of institutions with portfolio insurance. Big guys were dumping their stock. Also, the futures market in Chicago was even lower than the stock market, and people tried to arbitrage that. The proper strategy was to buy futures in Chicago and sell in the New York cash market. It made it hard — the portfolio insurance people were also trying to sell their stock at the same time.

The Economist’s Buttonwood column has an article, Model behaviour: The drawbacks of automated trading, which argues along the same lines that automated trading is potentially problematic where too many managers follow the same approach:

[If] you feed the same data into computers in search of anomalies, they are likely to come up with similar answers. This can lead to some violent market lurches.

Buttonwood divides the quantitative approaches to investing into at three different types and their potential for providing a stabilizing influence on the market or throwing fuel on the fire in a crash:

1. Trend-following, the basis of which is that markets have “momentum”:

The model can range across markets and go short (bet on falling prices) as well as long, so the theory is that there will always be some kind of trend to exploit. A paper by AQR, a hedge-fund group, found that a simple trend-following system produced a 17.8% annual return over the period from 1985 to 2009. But such systems are vulnerable to turning-points in the markets, in which prices suddenly stop rising and start to fall (or vice versa). In late 2009 the problem for AHL seemed to be that bond markets and currencies, notably the dollar, seemed to change direction.

2. Value, which seeks securities that are  cheap according to “a specific set of criteria such as dividend yields, asset values and so on:”

The value effect works on a much longer time horizon than momentum, so that investors using those models may be buying what the momentum models are selling. The effect should be to stabilise markets.

3.  Arbitrage, which exploits price differentials between securities where no such price differential should exist:

This ceaseless activity, however, has led to a kind of arms race in which trades are conducted faster and faster. Computers now try to take advantage of arbitrage opportunities that last milliseconds, rather than hours. Servers are sited as close as possible to stock exchanges to minimise the time taken for orders to travel down the wires.

In arguing that automated trading can be problematic where too many managers pursue the same strategy, Buttonwood gives the example of the August 2007 crash, which sounds eerily similar to Sylla’s explanation for the 1987 crash above:

A previous example occurred in August 2007 when a lot of them got into trouble at the same time. Back then the problem was that too many managers were following a similar approach. As the credit crunch forced them to cut their positions, they tried to sell the same shares at once. Prices fell sharply and portfolios that were assumed to be well-diversified turned out to be highly correlated.

It is interesting that over-crowding is the same problem identified by GSAM in Goldman Claims Momentum And Value Quant Strategies Now Overcrowded, Future Returns Negligible. In that presentation, Robert Litterman, Goldman Sachs’ Head of Quantitative Resources, said:

Computer-driven hedge funds must hunt for new areas to exploit as some areas of making money have become so overcrowded they may no longer be profitable, according to Goldman Sachs Asset Management. Robert Litterman, managing director and head of quantitative resources, said strategies such as those which focus on price rises in cheaply-valued stocks, which latch onto market momentum or which trade currencies, had become very crowded.

Litterman argued that only special situations and event-driven strategies that focus on mergers or restructuring provide opportunities for profit (perhaps because these strategies require human judgement and interaction):

What we’re going to have to do to be successful is to be more dynamic and more opportunistic and focus especially on more proprietary forecasting signals … and exploit shorter-term opportunistic and event-driven types of phenomenon.

As we’ve seen before, human judgement is often flawed. Buttonwood says:

Computers may not have the human frailties (like an aversion to taking losses) that traditional fund managers display. But turning the markets over to the machines will not necessarily make them any less volatile.

And we’ve come full circle: Human’s are flawed, computers are the answer. Computers are flawed, humans are the answer. How to break the deadlock? I think it’s time for Taleb’s skeptical empiricist to emerge. More to come.

Posted by manualofideas at 10:48 AM | Permalink | Comments (0)

"I'm pretty confident that Greece will do whatever is necessary to meet the conditions that the ECB sets," George Soros, chairman of Soros Fund Management, told CNBC in Davos Wednesday. "Germany is not in the mood to be the deep pocket," he added. (Source: CNBC)

Posted by manualofideas at 12:10 AM | Permalink | Comments (0)

Go to minute 12 of the following video -- the Paulson testimony on the Fed's apparent money printing to bail out AIG is truly stunning.

Watch Paulson's entire Congressional testimony.

Posted by manualofideas at 09:04 PM | Permalink | Comments (0)

"The result of extensive input throughout the previous year by experts from business, academia, and the public sector, Global Risks 2010 highlights a number of slow-moving risks exacerbated by the financial crisis and global economic downturn, and stresses the continued need to further enhance global resilience to risks. Global governance gaps, an issue already to the fore in Global Risks 2009, continues to be at the nexus of global risks and the need for coordinated global action is increasingly urgent."

Download the report here.

Also, check out this risk connection map.

Finally, watch a discussion on The Next Global Crisis, moderated by Maria Bartiromo.

Posted by manualofideas at 05:39 PM | Permalink | Comments (0)

In the late 1990s, pension funds decided that it would be a good idea to purchase stocks near the peak of the technology bubble.  Strike one.  In the mid 2000s, the idea was to join the private equity and hedge fund wave sweeping over Wall Street just in time for the 2008 financial crisis.  Strike two.  Now, The Wall Street Journal reports that public pension funds have decided to employ leverage in order to boost the low returns offered by bonds.

All of these moves have been made because the rate of return assumptions set by pension funds determines the perceived solvency of a system.  Since defined benefit pension plans have fixed liabilities, the rate of return expected on plan assets can mean the difference between a fully funded plan and one that is insolvent and in need of major capital infusions.  In the case of public pension funds where benefits are fixed by law, the problem is even more severe particularly given the current fiscal situation facing nearly all states due to falling tax receipts caused by the recession.

When In a Hole, First Stop Digging …

The Wall Street Journal article describes the motivation for employing leverage:

Wilshire Consulting, which advises pension funds on investments, says leverage helps the funds meet their long-term return targets without relying too heavily on volatile stocks, or tying up their money for long stretches in private investments. Low interest rates make it impossible to meet those targets with simple bond investments. Wilshire managing director Steven Foresti says he has been in discussions with about a half-dozen funds that are interested in the leverage strategy.

So having given up on investing in “volatile stocks” or in private investments, funds are now returning to the bedrock investment of choice for pension funds in the past:  boring bonds.  Yet, with interest rates at multi-decade lows, how are pension funds supposed to meet the return assumptions that make their systems seem marginally solvent?

Most big public pensions have expected annual rates of return between 7.5% and 8%. Wisconsin, for example, assumes 7.8%. Many analysts consider those return rates unrealistic. Yet pension funds are loath to change them because that would require local governments to get more money from taxpayers to compensate for lower projected returns. Even at an 8% return, the average public fund will have about 55% more in liabilities than in assets 15 years from now, due to recent losses and challenges in raising contribution rates, according to PricewaterhouseCoopers.

So we are at the point where the average pension fund is severely underfunded even with an 8% rate of return assumption.  If pension funds wish to invest primarily in high quality bonds, they will need to trim this return assumption even further which would make the solvency of the typical pension system even more dismal than it already is.  New Jersey’s dysfunctional system is a good case study of what awaits public pension systems across the country.

Reality Check Needed

It is very likely that the move to employ leverage is going to be “strike three” against the public pension plans.  While there is a great deal of debate regarding prospects for inflation going forward, Warren Buffett’s views on the subject seem to make the most sense.  Mr. Buffett believes that inflation is likely to pick up significantly in the future, even going as far as to discuss his concern over an “onslaught of inflation”.

If the bond market begins to price in the risk of higher inflation in the future, bond prices will decline significantly.  The leverage employed by pension funds will then have the opposite effect of what plan managers are hoping for and bond losses will be magnified.

Maintaining the illusion of higher than achievable returns will do nothing to improve the pension funding situation and could cause great harm in two ways.  First, leverage could magnify the losses experienced by the funds if inflation picks up in the coming years.  Second, politicians will be emboldened to ignore the pension problem or even make it worse if actuarial projections show a rosier picture than can be justified  by a sober attention to the facts and a prudent investment policy.

Roger Lowenstein has attempted to warn policymakers regarding this mistake in his book While America Aged which was reviewed here nearly a year ago.  Unfortunately, Mr. Lowenstein’s warnings seem to have fallen on deaf ears.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

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By Greenbackd

The New Yorker has John Cassidy’s interview with Richard Thaler, Chicago School economist and co-author (along with Werner F.M. DeBondt) of Further Evidence on Investor Overreaction and Stock Market Seasonality, a paper I like to cite in relation to low P/B quintiles and earnings mean reversion. Thaler is also the “Thaler” in Fuller & Thaler Asset Management, which James Montier identifies in his 2006 research report Painting By Numbers: An Ode To Quant as being a “fairly normal” quantitative fund (as opposed to being “rocket scientist uber-geeks”) with an “admirable track [record] in terms of outperformance.” I diverge from Thaler on a number of issues, but on these two I think he’s right:

On the remnants of efficient markets hypothesis:

Well, I always stress that there are two components to the theory. One, the market price is always right. Two, there is no free lunch: you can’t beat the market without taking on more risk. The no-free-lunch component is still sturdy, and it was in no way shaken by recent events: in fact, it may have been strengthened. Some people thought that they could make a lot of money without taking more risk, and actually they couldn’t. So either you can’t beat the market, or beating the market is very difficult—everybody agrees with that. My own view is that you can [beat the market] but it is difficult.

The question of whether asset prices get things right is where there is a lot of dispute. Gene [Fama] doesn’t like to talk about that much, but it’s crucial from a policy point of view. We had two enormous bubbles in the last decade, with massive consequences for the allocation of resources.

On stock market bubbles:

[Cassidy] When I spoke to Fama, he said he didn’t know what a bubble is—he doesn’t even like the term.

[Thaler] I think we know what a bubble is. It’s not that we can predict bubbles—if we could we would be rich. But we can certainly have a bubble warning system. You can look at things like price-to-earnings ratios, and price-to-rent ratios. These were telling stories, and the story they seemed to be telling was true.

And I love this line in relation to the impact of the recent crisis on behavioral economics:

I think it is seen as a watershed, but we have had a lot of watersheds. October 1987 was a watershed. The Internet stock bubble was a watershed. Now we have had another one. What is the old line—that science progresses funeral by funeral? Nobody changes their mind.

Science progresses funeral by funeral. Nobody changes their mind. It seems to me it’s not the only discipline that proceeds by funeral.

Posted by manualofideas at 02:55 PM | Permalink | Comments (0)

By Nadav Manham

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It’s war on the television screen.  On one side you have GEICO’s Gecko and the famously maligned Caveman.  On the other side is Flo, the hyper enthusiastic Progressive sales clerk.  It’s hard to escape these characters during sporting events or prime time as they try to win market share through a combination of amusing brand building characters and claims of lower prices.

Which company is gaining the upper hand?

GEICO is a subsidiary of Berkshire Hathaway and investors can monitor the company’s progress through Berkshire’s quarterly financial statements.  Progressive is a publicly traded company where one can gain greater insights into financial results through monthly financial releases.

Last year, we presented a ten year comparison between GEICO and Progressive to see if any trends could be identified regarding underwriting results or market share.  (Note:  Since underwriting results and investment results should be evaluated separately, we focused only on underwriting results.)

From this study, we could see that over the ten year period GEICO generally had a slightly higher growth rate in premiums earned, a higher loss ratio, and a significantly lower expense ratio.  This led to the observation that GEICO has been able to gain market share in recent years by offering lower premiums (leading to higher loss ratios) while maintaining higher underwriting profitability over the past few years due to tight controls on expenses, as reflected in the lower expense ratio.

2009 Results

GEICO

Since Berkshire Hathaway’s annual report has not been released yet, we only have GEICO’s results through the first nine months of the year based on Berkshire’s Q3 report. GEICO had $10,103 million in net premiums earned, which is up 9% from the first nine months of 2008.  The loss ratio was 77.2 and the expense ratio was 18.3 which results in a combined ratio of 95.5.  Pre-tax underwriting profits for the first nine months of 2009 came in at $459 million.

Progressive

Progressive recently published financial results for December which also includes figures for the full year.  The company reported $14,012.8 million in net premiums earned, which is up almost 3% from 2008.  The loss ratio for the year was 70.7 and the expense ratio was 20.9 for a combined ratio of 91.6.  Pre-tax underwriting profits came in at $1,175.6 million for the year.

For comparative purposes, for the first nine months of the year we can examine Progressive’s results for September.  The company reported $10,293.4 million in net premiums earned, a loss ratio of 70.5, an expense ratio of 21.1, and a combined ratio of 91.6 for the first nine months of 2009.  Pre-tax underwriting profits for the first nine months of 2009 came in at $859.6 million.

GEICO Aims for Market Share

From looking at the data presented above, it would appear that GEICO has made a decision to take a more aggressive stance on pricing which has resulted in increasing market share but at the expense of a higher loss ratio.  For the first three quarters of 2009, GEICO nearly matched Progressive in terms of premiums earned and was growing premiums at a much faster rate than Progressive.

The higher loss ratio would suggest that GEICO is competing on price.  In addition, GEICO’s expense ratio for the first nine months of 2009 was 18.3 compared to 17.9 for 2008 which could indicate a more aggressive advertising strategy.

While we will not know for certain until Berkshire Hathaway publishes the 2009 annual report next month, it looks likely that GEICO may surpass Progressive in terms of net premiums earned for 2009 if the trends established during the first nine months of the year persisted into the fourth quarter.

The price of gaining this market share is a lower level of profitability compared to Progressive, at least in the short run.  However, since insurance is a product that has high switching costs given the hassle involved in changing insurance companies, GEICO may be able to retain the gains in market share even if they become slightly less aggressive on pricing going forward.  Generally, consumers are not going to be motivated to change auto insurance companies unless the savings is more than trivial.

Most Effective Ad Campaign?

So who is more effective:  Flo or the Gecko?  Take our poll and register your opinion.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway. No position in Progressive.

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The December issue of Portfolio Manager's Review, entitled "2009 Losers, 2010 Winners?," listed 100 noteworthy losers in 2009, profiled and analyzed 18 companies, and highlighted five companies as the Top 5 ideas among 2009 losers. Included in the Top 5 was hotel owner and operator Lodgian (LGN), which today agreed to be acquired by Lone Star Funds at a 67% premium to an average of recent closing prices.

While we are certainly pleased that our subscribers had an opportunity to profit from this unique idea in a very short period of time, we are also interested in taking a closer look at how this profit opportunity came about. We came across micro cap company Lodgian as a result of one of our value-oriented screens and were quickly intrigued by the non-recourse nature of the company's hotel mortgage debt. Here is what we wrote about Lodgian in the Editor's Commentary of the December issue of Portfolio Manager's Review:

Lodgian (LGN) owns and operates hotel real estate, representing one of the cheapest ways of buying into a portfolio of hotel properties financed by non-recourse debt. The market valuation of Lodgian implies imminent bankruptcy. However, based on the non-recourse nature of the hotel mortgage debt, Lodgian can escape bankruptcy by offloading unprofitable hotels on the lenders—if the latter are unable or unwilling to modify terms to Lodgian’s satisfaction. This creates an opportunity for investors, as enterprise value is low relative to normalized earnings and asset value. A prerequisite to future value creation, however, is successful extension of debt maturities, mainly related to Goldman Sachs and IXIS. We note a potentially active shareholder base including Oaktree and Blackstone. Overall, for investors who do not require much trading liquidity and can wait for real estate and hospitality markets to recover, Lodgian could deliver strong long-term returns.

Notice our focus on "long-term" returns -- while we considered Lodgian too cheap and too attractively financed to ignore, there was simply no catalyst in sight to near-term value realization. Many investment managers, even value-oriented investors, often shy away from companies that do not have a visible catalyst. Unfortunately, at least in the case of Lodgian, this can prove to be a mistake. If a company is dramatically undervalued and has properly incentivized management or a shareholder base that can exert the right kind of influence over management, a value-unlocking event may occur much faster than investors assume.

Another argument that might have been made against investing in Lodgian would have had to do with the state of the real estate market and the hospitality industry. An investor might have said, "I understand Lodgian is dramatically undervalued based on the assets it owns, but it will take a long time for its markets to recover." This is another mistake often made by investors: Simply because certain fundamentals may take a while to recover, it doesn't mean the stock price will take just as long to recover. After all, today's stock prices are meant to reflect all future net cash flows, discounted at an appropriate rate. So, if Lodgian was dirt cheap even after assuming that cash flows won't recover for a while, and even after applying a conservative discount rate, then why wait? Someone -- in this case Lone Star Funds -- may have the guts to buy the asset today, knowing that it is likely to deliver a strong return over a multi-year period. By not acting on a clearly undervalued asset, investors leave themselves open to being "usurped" by someone who arrives to the party late but is more decisive in claiming the obvious bargain on the table.

Click here to read our profile of Lodgian, as presented in the December issue of Portfolio Manager's Review. Read today's Lodgian acquisition announcement.

Download a sample issue of Portfolio Manager's Review. Subscribe and gain immediate access to the latest monthly report, entitled "Top 10 Ideas For 2010."

Posted by manualofideas at 11:46 AM | Permalink | Comments (0)

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(Thanks to Value Investing World for the link.)

Posted by manualofideas at 06:51 PM | Permalink | Comments (0)

By Greenbackd

Continuing the quantitative value investment theme I’ve been trying to develop over the last week or so, I present my definition of a simple quantitative value strategy: net nets. James Montier, author of the essay Painting By Numbers: An Ode To Quant, which I use as the justification for simple quantitative investing, authored an article in September 2008 specifically dealing with net nets as a global investment strategy: Graham’s net-nets: outdated or outstanding? (.pdf). Quelle surprise, Montier found that buying net-nets is a viable and profitable strategy:

Testing such a deep value approach reveals that it would have been a highly profitable strategy. Over the period 1985-2007, buying a global basket of net-nets would have generated a return of over 35% p.a. versus an equally weighted universe return of 17% p.a.

An annual return of 35% over 23 years would put you in elite company indeed, so Montier’s methodology is worthy of closer inspection. Unfortunately he doesn’t discuss his methodology in any detail, other than to say as follows:

I decided to test the performance of buying net-nets on a global basis. I used a sample of developed markets over the period 1985 onwards, all returns were in dollar terms.

It may have been a strategy similar to the annual rebalancing methodology discussed in Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update. That paper demonstrates a purely mechanical annual rebalancing of stocks meeting Graham’s net current asset value criterion generated a mean return between 1970 and 1983  of “29.4% per year versus 11.5% per year for the NYSE-AMEX Index.” It doesn’t really matter exactly how Montier generated his return. Whether he bought each net net as it became a net net or simply purchased a basket on a regular basis (monthly, quarterly, annually, whatever), it’s sufficient to know that he was testing the holding of a basket of net nets throughout the period 1985 to 2007.

Montier’s findings are as follows:

• The net-nets portfolio contains a median universe of 65 stocks per year.
• There is a small cap bias to the portfolio. The median market cap of a net-net is US$21m.
• At the time of writing (September 2008), Montier found around 175 net-nets globally. Over half were in Japan.
• If we define total business failure as stocks that drop more than 90% in a year, then the net-nets portfolio sees about 5% of its constituents witnessing such an event. In the broad market only around 2% of stocks suffer such an outcome.
• The overall portfolio suffered only three down years in our sample, compared to six for the overall market.

Several of Montier’s findings are particularly interesting to me. At an individual company level, a net net is more likely to suffer a permanent loss of capital than the average stock:

If we define a permanent loss of capital as a decline of 90% or more in a single year, then we see 5% of the net-nets selections suffering such a fate, compared with 2% in the broader market.

Here’s the chart:

This is interesting given that NCAV is often used as a proxy for liquidation value.

Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.

Montier believes this may provide a clue as to why the net net strategy continues to work:

This relatively poor performance may hint at an explanation as to why investors shy away from net-nets. If investors look at the performance of the individual stocks in their portfolio rather than the portfolio itself (known as ‘narrow-framing’), then they will see big losses more often than if they follow a broad market strategy. We know that people are generally loss averse, so they tend to feel losses far more than gains. This asymmetric response coupled with narrow framing means that investors in the net-nets strategy need to overcome several behavioural biases.

Paradoxically, it seems that what is true at the individual company level is not true at an aggregate level. The net net strategy has fewer down years than the market:

If one were to frame more broadly and look at the portfolio performance overall, the picture is much brighter. The net-net strategy only generated losses in three years in the entire sample we backtested. In contrast, the overall market witnessed some six years of negative returns.

Here’s the chart:

And it seems that the net net strategy is a reasonable contrary indicator. When the market is up, fewer can be found, and when the market is down, they seem to be available in abundance:

The main drawback to the net net strategy is its limited application. Stocks tend to be small and illiquid, which puts a limit on the amount of capital that can be safely run using it. That aside, it seems like a good way to get started in a small fund or with a individual account. Montier concludes:

…In various ways practically all these bargain issues turned out to be profitable and the average annual return proved much more remunerative than most other investments.

Good old Benjamin Graham. What a guy.

Posted by manualofideas at 05:26 PM | Permalink | Comments (0)

General Re, a Berkshire Hathaway subsidiary, has reached a $92 million settlement with the federal government which will allow the firm to avoid prosecution for its role in an accounting fraud involving AIG.  The Wall Street Journal reports that the settlement also includes corporate governance changes that will require Berkshire Hathaway’s Chief Financial Officer to attend meetings of General Re’s audit committee and mandates that General Re appoint an independent director.

The terms of the settlement call for General Re to pay $60.5 million toward restitution for investors who suffered losses in the AIG fraud, $12.2 million to settle the charges with the Securities and Exchange Commission, and $19.5 million to the U.S. Postal Inspection service.

Troubled History

Berkshire Hathaway’s acquisition of General Re in 1998 ran into difficulties almost immediately when underwriting standards proved to be inadequate and large losses ensued.  The September 11, 2001 terrorist attacks demonstrated continued underwriting weakness at the company which Warren Buffett discussed in his 2001 annual letter to shareholders.  Berkshire also inherited General Re’s problematic derivatives book which took years to wind down at a significant loss, as described in Mr. Buffett’s 2002 annual letter to shareholders where he famously referred to derivatives as “financial weapons of mass destruction.”  It should be noted that underwriting issues at General Re appear to be fixed based on results in recent years and the company does provide a large amount of float for Mr. Buffett to invest.

Beyond the financial troubles at General Re, the most troubling aspect has been the serious risks to Berkshire’s reputation based on the alleged impropriety surrounding AIG.  A number of General Re executives were implicated in the case and there were some convictions as well.  All companies depend on their reputation to varying degrees, but none as much as Berkshire Hathaway.  Berkshire’s sterling reputation has enriched shareholders over the years by making it possible to acquire companies whose founders weigh such matters very highly.  Now that the AIG matter is settled, Berkshire and General Re can move past this unfortunate chapter.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 05:20 PM | Permalink | Comments (0)

Bill Ackman of Pershing Square went on the air right before Warren Buffett this morning. Quite interesting that Ackman appears to have misread Buffett's views on the Kraft deal for Cadbury. Watch Ackman's comments first and then scroll down to the Buffett interview in our next article. The juxtaposition is fascinating.

Part One of Bill Ackman Interview:

Part Two of Bill Ackman Interview:

Posted by manualofideas at 03:36 PM | Permalink | Comments (0)

If Kraft CEO Irene Rosenfeld was hoping for a public vote of confidence from Warren Buffett, she is surely disappointed this morning.  Perhaps not surprisingly based on his unusual public criticism of Kraft on January 5, Mr. Buffett says that he “feels poorer” in light of Kraft’s richer bid for Cadbury and he disagrees with the decision to shed a highly profitable frozen pizza business to provide funding for the deal.

The statement today in a CNBC interview prior the special meeting of Berkshire Hathaway shareholders clearly refutes yesterday’s Wall Street Journal article which cited an unnamed source within Kraft who indicated that Mr. Buffett was “totally supportive” of the new terms.

Mr. Buffett also comments on a number of topics including the Obama Administration’s proposed bank tax, stating that he does not believe that banks are making “obscene profits” and companies that have already repaid TARP funds should not be forced to effectively pay for bailouts at Fannie Mae and Freddie Mac.

Other topics covered include the Berkshire Hathaway Class B stock split, Wells Fargo’s results, executive compensation, and Ben Bernanke’s prospects for a second term as Federal Reserve Chairman.  In addition, Mr. Buffett is not planning to increase Berkshire’s stake in Posco at this time and indicated that reports yesterday to the contrary may have been due to a misunderstanding with Posco’s CEO due to language translation.

CNBC Interview: Part One

CNBC Interview:  Part Two

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 02:08 PM | Permalink | Comments (0)

Longtime shareholders of Berkshire Hathaway know that Warren Buffett hardly ever comments directly on his assessment of the company’s intrinsic value.  In an interview with Bloomberg at today’s special meeting of shareholders, Mr. Buffett made an exception to his usual silence on the matter when he was asked about issuing shares of Berkshire to pay for part of the Burlington Northern transaction.

The question of whether the bid for Burlington sends any signals regarding Mr. Buffett’s views on Berkshire’s intrinsic value has been discussed here shortly after the transaction announcement in November and again after the proxy statement was released in December.

Here are excerpts from the interview:

You have no problem issuing shares if your stock is fully valued.  I think our stock actually, measured against book value which many people do and is not a crazy way to measure it, it’s at the low end … so I hate issuing shares.  And if I’m paying $100 a share to Burlington shareholders, it’s costing our shareholders more than $100 which I will explain to them in the annual report, because we’re using shares I don’t want to use.

Now, this deal still makes sense in our view.  I mean, we talk about this extensively at the Board.  But we value Berkshire [shares] that we’re giving out at what we think Berkshire is worth.  Unfortunately the Burlington shareholder is going to value it at the market, so we have to give them $100 worth.  Weighing all of that, we like the deal.  But we don’t salivate over it.  I mean, it was close.  We wouldn’t have issued any more shares than we’re doing.

To view the interview, click on the image displayed below or on this link.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 01:23 PM | Permalink | Comments (0)

Watch an excellent presentation by James Montier of Societe Generale.

(Thanks to David Lau for the link.)

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The 124-page report, published on January 20th, is entitled "Best Ideas For 2010." The report contains a snapshot of 100 potential investments, of which 30 are profiled and analyzed by The Manual of Ideas research team. Finally, ten companies are selected as the top ideas for 2010.

Read the report now | Subscribe

Posted by manualofideas at 01:37 AM | Permalink | Comments (0)

According to a Bloomberg article, Warren Buffett may be interested in increasing Berkshire Hathaway’s stake in Posco, a South Korean steelmaker. Posco cited Mr. Buffett as saying that he “should have bought more Posco shares when the stock price dropped during the economic crisis.”  According to Bloomberg, Mr. Buffett met with Posco CEO Chung Joon Yang in Omaha yesterday.  Mr. Buffett has not commented on the meeting.

Here is a brief except from the article regarding prospects for Posco this year:

World steel demand will rise 10 percent this year, Posco said last week when it announced a 77 percent jump in fourth- quarter profit and plans to push ahead with $30 billion of overseas expansion. Buffett, 79, may have a paper profit of more than $1.3 billion in his Posco holding, first disclosed in 2007.

“From the point of view of Buffett, there may be few steel stocks to buy in Asia,” said Chang In Whan, president of KTB Asset Management Co. in Seoul, which manages the equivalent of $8.9 billion in assets. “I’m sure Posco will acquire companies this year, which will help it secure growth in size as well as in efficiency.”

Berkshire held 3,947,554 shares of Posco on December 31, 2008 which represented a 5.2% stake in the company.  Berkshire did not report updates on positions in securities traded on foreign exchanges in quarterly 10-Q reports or in 13-F filings during 2009.

The price of Posco stock has increased from 380,000 Won on 12/31/2008 to 604,000 today while the U.S. Dollar has weakened from 1262 Won/USD on 12/31/2008 to 1124.61 Won/USD as of yesterday.  This would indicate that the value of Berkshire’s holdings in Posco has appreciated from $1.191 billion on 12/31/08 to approximately $2.12 billion today.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 06:58 PM | Permalink | Comments (0)

By Greenbackd

Recently I’ve been laying the groundwork for a quantitative approach to value investment. The rational is as follows: simple quantitative or statistical models outperform experts in a variety of disciplines, so why not investing in general, and why not value investing in specific? Well, it seems that they do. A new research paper argues that quantitative funds outperform their qualitative brethren. In A Comparison of Quantitative and Qualitative Hedge Funds (via CXO Advisory Group blog) Ludwig Chincarini has compared the performance characteristics of quantitative and qualitative hedge funds. Chincarini finds that “both quantitative and qualitative hedge funds have positive risk-adjusted returns,” but, ”overall, quantitative hedge funds as a group have higher [alpha] than qualitative hedge funds.”

Definition of quantitative and qualitative

Chincarini distinguished between quantitative and qualitative equity-focussed funds thus:

Our main method used to classify was to look for the term quantitative or a description of a similar nature to place a fund in the quantative category. We also looked for words like discretionary to classify qualitative funds and systematic to classify quantitative funds. Of the four main hedge fund categories, we only found two of them reliable enough to classify. Thus, in the Equity Hedge category, we classified Equity Market Neutral and Quantitative Directional as quantitative hedge funds and Fundamental Growth and Fundamental Value as qualitative categories.

…

We did not classify any of the Event Driven funds since these funds vary too substantially within the category and it was not clear from the descriptions how to separate quantitative and qualitative funds. We also did not classify any of the Relative Value funds, even though many of these funds use quantitative techniques, because the broader descriptions left us no clear cut way to divide them.

…

We classified a fund as quantitative if the following words appeared in the fund description: quantitative, mathematical, model, algorithm, econometric, statistic, or automate. Also, the fund description could not contain the word qualitative. We classified a fund as qualitative if it contained the word qualitative in its description or had none of the words mentioned for the quantitative category.

Performance

Using return data from 6,354 hedge funds from January 1970 through June 2009, Cincarini concludes, based on the raw performance data:

Generally, quantitative funds have a higher average return and a lower average standard deviation than qual funds. Amongst the quant funds, the highest average return comes from the Quantitative Directional strategy. The correlations of the fund categories with the S&P 500 are quite low at 0.17 and 0.38 for quant and qual respectively. The risk-adjusted return measures provide mixed evidence, but overall seems in favor of quant funds.

…

The qual funds perform significantly better than quant funds in up markets (25% and 15% respectively). However, the quant funds do significantly better in down markets (-2% versus -16%). This is mainly driven by the presence of Equity Market Neutral funds. In the 1990s, the average qual fund return was higher than the average quant fund return. They were roughly the same from 2000 – 2009. During the financial crisis (which we measure from January 2007 - March 2009), quant funds did better than qual funds (3.29% versus -4.77%).

Table 9 below shows performance summary statistics for the various funds:

Advantages and disadvantages of quantitative vs qualitative

Chincarini identifies several advantages quant funds hold over qualitative funds:

…the breadth of selections, the elimination of behavioral errors (which might be particularly important during the financial crisis of 2008 – 2009), and the potential lower administration costs (after hedge fund fees).

And several disadvantages:

The disadvantages for quantitative hedge funds include the reduced use of qualitative types of data, the reliance on historical data, the ability to quickly react to new economic paradigms. These three might have been especially crippling during the financial crisis of 2007 and 2009.

Finally, there is the potential of data mining, which will lead to strategies that aren’t as effective once implemented. In this paper, we will only focus on the return differences rather than attempting to detail which of the advantages or disadvantages in central in the return differences.

Hat tip Abnormal Returns.

Posted by manualofideas at 06:05 PM | Permalink | Comments (0)

In a recent interview with The Columbus Dispatch, NetJets Chairman and CEO David Sokol predicts that the company will be profitable this year and no further staffing reductions will be required “barring any major shifts in the global economy.”  In November, Mr. Sokol made positive comments about prospects for NetJets in 2010 and stated that a break-even year would be likely. Since taking over at NetJets last August, Mr. Sokol has made a number of management changes and has imposed budget discipline designed to trim costs.  NetJets is a subsidiary of Berkshire Hathaway.

2009 Loss:  $720 million

The Columbus Dispatch article states that NetJets posted a $720 million loss for 2009 with the majority of the loss resulting from aircraft write-downs.  Through the end of the third quarter, NetJets had reported a $531 million pre-tax loss of which $436 million was attributed to asset writedowns and downsizing costs.  NetJets was profitable on an operating basis for the last two months of 2009 according to Mr. Sokol.

Potential Acquisitions

The article also states that Mr. Sokol has been approached by a number of smaller competitors that may be interested in selling their businesses to NetJets.  However, only one potential deal is in the pipeline at this time.  The company is not interested in taking on additional debt for large acquisitions and instead is planning to reduce debt by $300 million in 2010.

The Political Factor

One clear headwind for NetJets going forward involves a growing populist sentiment against private aviation.  No intelligent executive in today’s political climate would dream of taking a private plane to Washington D.C. if called to testify before a Congressional committee.  However, the problem extends beyond symbolism.

Populist sentiment is increasing in general and the fractional aviation industry must do a better job of communicating the tangible economic benefits associated with their product.  It is likely that populist sentiment will recede once the benefits of the current economic recovery are more widely spread through the country.  Until then, this is an additional negative factor for the industry in general.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 12:01 AM | Permalink | Comments (0)

Value investor Amit Chokshi of Kinnaras Capital Management levels criticism at Bill Miller in a recent blog post, arguing that Miller has been overpaid given his lackluster long-term track record. Writes Chokshi:

It appears that Legg Mason is rolling out its public relations machine and finding amicable partners in the media to help bolster its reputation along with that of its most recognized fund manager Bill Miller.  This Bloomberg article attempts to repair Miller's deservedly tattered reputation but the authors missed a few key points that potential Value Trust investors should consider.

The Bloomberg article points out that Miller's Value Trust fund rose 43% through December 23rd, beating 93% of its peers.  This performance has led to some self-congratulatory comments with Miller stating "Even when things were really bad last fall, it was pretty clear that there would be a cyclical bullish phase to the market" and “It is too early to pat ourselves on the back...we’re just one year off of a very bad period, so we can’t get complacent."

This mentality of feeling like "you're back" after one good year despite prior years of destroying your investors capital through incompetent stock selection compounded by high fees is sickening, particularly to younger investment managers like myself.  Rather than even consider complacency, Miller should feel shame in his long-term performance and disregard for any risk management.  Miller should also show some level of concern for his investors as those that placed capital in Value Trust as far back as 1997 are underwater.  Even worse, Miller and his team were highly compensated for this incompetence.

LEGG MASON VALUE TRUST ("LMVTX") HISTORICAL PERFORMANCE

Read the full article by Amit Chokshi.

Posted by manualofideas at 06:25 PM | Permalink | Comments (0)

We are pleased to announce a partnership with Greenbackd, whereby we will occasionally republish Greenbackd content for the benefit of our members. Greenbackd is a widely respected online source of information for value-oriented investors, and we are pleased to make their analysis available right here. The following is a recent article by Greenbackd:

One of the most fascinating examples of the phenomenon of mean reversion was identified by Werner F.M. DeBondt and Richard H. Thaler in Further Evidence on Investor Overreaction and Stock Market Seasonality. DeBondt and Thaler examined the relative performance of quintiles of stocks on the NYSE and AMEX ranked according to book value. As an adjunct to the main study, one of the variables they analyzed was the relative earnings performance of stocks in the lowest and highest price-to-book quintiles.

DeBondt and Thaler’s findings are as interesting as they are counter-intuitive. Stocks in the lowest price-to-book quintile (the cheapest stocks) grew their earnings faster than the stocks in the highest price-to-book quintile (the most expensive stocks). Tweedy Browne set out DeBondt and Thaler’s findings in Table 3 below, which describes the average earnings per share for companies in the lowest and highest quintile of price-to-book value in the three years prior to selection and the four years subsequent to selection:

In the four years after the date of selection, the earnings of the companies in the lowest price-to-book value quintile (average price-to-book value of 0.36) increase 24.4%, more than the companies in the highest price-to-book value quintile (average price-to-book value of 3.42), whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to mean reversion, which Tweedy Browne described as the observation that “significant declines in earnings are followed by significant earnings increases, and that significant earnings increases are followed by slower rates of increase or declines.”

The implication here is that not only does the price of stocks that are cheap relative to other stocks regress to the mean, but the underlying performance does too. That’s an amazing finding. There’s really no good reason why low price-to-book should be such a good predictor for short and mid-term earnings growth. I’ve spent some time thinking about why this might be so, and the only possible explanation I can come up with is magic. Nothing else fits.

Posted by manualofideas at 07:37 PM | Permalink | Comments (0)

The author of this opinion piece is hedge fund manager Nick Gogerty.

Business values are tied to 2 things, a competitive dynamic and perceived value by the purchaser.

Put these 2 pieces together and you end up with price.  Please note this is a little more subtle than supply and demand and the framework varies with each market.

The competitive dynamic means substitute offerings.  If a business model or offering is truly unique or has a defensible market position via geography like railroads or mental perceived value like impulse purchases of fast moving consumer product brands a firm may be able to extract higher margins. 

Many competitive environments are relatively stable with the top 3-5 players holding 50-60% of market share and dictating price via competition between them. 

It is like a horse race with most of the horses being about equal and extracting a median profit margin in the respective industry with some slight  point of differentiation.  If a horse nudges ahead with an innovation or advantage they may extract higher profits for awhile.  The duration and scope of that advantage is their competitive moat.  The moats success is measured by sustainable extra market profit margin.

Gum by gum

People paying an Extra $0.05 for a pack of $0.50 gum might just double the profits for a company in a 10% net margin business.  If you don't believe you are brand conscious ask yourself, when was the last time you bought a generic piece of gum at the counter.

This competitive dynamic of limited shelf space at the check-out counter and a relatively non-innovative space means high margins for those 4-5 firms who can dominate the 3 foot battle field by the check out counter. 

The latest innovative blister pack packaging was probably treated with serious anger when the first innovator put it in place. It meant everyone else would have to offer something competitive, spending capital and a dipping into margins until the costs were spread to the consumer at a new but accepted average price point for gum.  The first mover had an edge for awhile with the new perceived value via the packaging borrowed from the pharma industry.  Old wine into new bottles doesn't revolutionize the wine industry for long but means competitors have to keep up.

The real innovators dilemma: staying ahead

Innovators in a space have 2 challenges, they must create something new of value and be able to extract higher margins for the risks of failure.  At the same time, depending on the innovation, innovators know that in many instances they are tipping their hand to their competitors who will replicate the innovation.

These horse races produce many winners over time, mostly consumers who see each unique horse, try out innovations of product, supply chain, brand, pricing etc.  Each successful innovation leading to higher initial margins via happy paying customers gets extracted away by competitive replicators. This usually means most of the benefits end up with the consumer.  That is how capitalism typically works assuming no collusion is in place.  Positive externalities in the form of valued innovations are company led, but consumer driven.

The goal for a firm is to either have an innovation process for continuous advantage or an innovation that is so unique or protected it can't easily be replicated.  Southwest airlines has a unique corporate culture that puts out a different vibe than one would anticipate from a price led competitor.  Otherwise airlines are a horrible business with few sustained +10-15 year profitable margin firms.  No moat equals business margin misery.  Network hubs, airmiles etc.  all proved to be false profits as they were replicable.

Some businesses have geographic moats, such as the short haul rail roads. They mostly compete with trucking instead of each other.  This is an example of an asymmetric moat.  Find the key component such as fuel, unions etc. that drive the relationship and you can understand the business and potential moat better.  Most of it boils down to 2-3 key metrics. 

As an investor, I am not interested in figuring out what is "hot" for earnings next quarter, but rather what might the next 3-9 years look like. This does limit the industries one can assess and it often means skipping the sexy sectors.  High sustained margins may not always correlate with lots of media coverage.

 The fun part of investing is figuring out what the moat is for each industry and competitor.  The best businesses have multiple moats that all contribute to margin and are harder for others to replicate.  Moats come in different shapes and forms. 

A good value investor is really a good collector of mental moat models and the competitive positioning for each participant in a market.  There are really only probably 20-25 key datapoints needed to understand a marketplace and all of its participants.  Of course one needs the framework to put around the needle in the haystack. 

Most Wall Street and popular analysis is about selling more haystack.  Great ideas aren't sold by the pound.  This fact means many miss the the effective and elegant thesis for the sake of the data heap.  The nice thing about value is that often it moves slowly or the investor can choose an industry where it moves slowly.

Find the moat.  Measure the Moat for its length (time) and depth (extra margin) and then you are one step closer to understanding value in the horse race of capitalism.  Anybody can tell you price, few spend the time to understand value.

Posted by manualofideas at 07:32 PM | Permalink | Comments (0)

The Financial Times reports that Hershey is getting closer to finalizing the terms of a counter-bid to Kraft’s hostile £10.4 billion bid for Cadbury.  The war of words between Kraft and Cadbury has escalated in recent days as Cadbury’s management ratchets up the rhetoric regarding Kraft’s “conglomerate” model being an unattractive fit for Cadbury.  Warren Buffett’s recent comments regarding Kraft seeking a “blank check” for the purchase only dimmed prospects for the acquisition even further.

The problem for Hershey has been the possibility that an acquisition of Cadbury would require taking on significant debt and could impact the company’s investment grade credit rating.  In order to reduce the amount of debt required, Hershey has authorized Byron Trott to seek private equity investors to participate in the deal.

Mr. Trott is a former Goldman Sachs banker who now runs his own firm.  He is also known as Warren Buffett’s favorite banker.  Berkshire Hathaway reportedly made an investment in Mr. Trott’s new firm when he set it up last year.

It seems highly unlikely that Berkshire Hathaway would participate in the planned equity raise for a Cadbury bid given the company’s investment in Kraft and Mr. Buffett’s high profile comments regarding the transaction.  Nevertheless, for those who enjoy following corporate board room dramas, it looks like we are in for at least a few more chapters before the story on Cadbury’s future is complete.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 12:08 AM | Permalink | Comments (0)

Posted by manualofideas at 12:07 AM | Permalink | Comments (0)

By Nadav Manham

The media business is very seductive and glamorous, and people and companies get involved in it for all kinds of non-economic reasons.  One of the lessons the Dream Team teaches is that if you're focused strictly on economics, you have to un-seduce yourself and deglamourize where you allocate your time and capital. 

Case in point: scientific publishing.  Not seductive, not glamorous, but in the first six months of 2009 Elsevier, which is the medical and scientific publishing division of Reed Elsevier, earned operating profits of 32%.  And many of the journals Elsevier publishes are very expensive (they may have gotten too expensive, but that's another story). If you can convince people to pay a lot of money for your product, and you get to keep 32% of what they pay you, then you have a good business.

This article by Michael Clarke of the Scholarly Kitchen explains why scientific publishing is such a good business, so good that it has not suffered the upheavals that other forms of publishing have.

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

Posted by manualofideas at 12:04 AM | Permalink | Comments (0)

By Nadav Manham

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

Posted by manualofideas at 12:02 AM | Permalink | Comments (0)

By Nadav Manham

More on the AOL Time Warner merger, which this book described as "the con of the century."  Ouch.  Hindsight is 20/20, and it's easy to forget that much conventional wisdom celebrated the merger when it was announced.  But if you examine the facts on the ground at the time in the context of certain unbreakable laws of business economics, as they were known to the participants at the time, it's difficult to escape the conclusion that the AOL Time Warner merger was . . . the con of the century.  Specifically, Time Warner's decision to  give half of itself away in exchange for half of AOL was unjustifiable even in those heady days.

Only two things could have possibly justified Time Warner's decision.  The first is that there were enough merger-related synergies, either marginal revenues that only a merger could bring about and/or marginal cost cuts that only a merger could enable.  The AOL Time Warner crew trumpeted total potential EBITDA synergies of $1 billion, which no one should have believed.  AOL's total EBITDA at the time was $1.8 billion; it was more than a stretch to believe that number could nearly double just by joining the Time Warner family.  If you want to read more, check out "The Curse of the Mogul." 

The second thing is that AOL was actually worth what Time Warner gave up for it.  What was the ex ante probability that that was true? 

    a) Time Warner was technically acquired at a 71% premium to its market price--if you invert the math you can also say that Time Warner bought AOL at a 42% discount to its market price. 

    b) AOL's stock closed at $73.75 on the eve of the merger announcement.  With about 2.61 billion diluted shares outstanding, that means it had a merger-day market cap of $192.5 billion.

   c)  AOL's EBITDA for the FY ended 6/30/2000 was about $1.8 billion.  Give the company the benefit of the doubt and assume that EBITDA is a useful proxy for the cash generating ability of the business--it works out to 26% margins on FY 2000 revenue of $6.886 billion.  That's a good business. 

   d)  $192.5 billion divided by $1.8 billion equals 107.  AOL was trading for 107 times that year's cash flow when it merged.  Time Warner paid a 42% discount, so it paid a multiple of 62 times that years' cash flow for AOL. 

Under what circumstances is it justified to pay 62 times cash flows for a business?  Only when the future cash flows of that business are so high as to justify it.  Did Time Warner have reason to believe this when it decided to give half of itself away?  Consider the following:

   i)  Just on general capitalist principle, it's extremely rare that a large public company ever grows into a cash flow multiple of 62 times.  There is a chart on page 107 of my edition of "Stocks for the Long Run" that shows the "warranted P/E ratio" of each of the legendary Nifty Fifty stocks of 1972, those companies widely considered the best companies in the world.  "Warranted P/E ratio" is defined as: that P/E ratio that would have produced a total return from 1972-1997 equal to the 1972-1999 returns of the S&P as a whole.  In other words, "warranted P/E ratio" answers the question "How much should an investor have paid, as a multiple of that year's earnings, for a stock, given its subsequent earnings growth?"  Of the entire Nifty 50, only three had a warranted P/E ratio above 62 times.  One sold water flavored with sugar, caffeine, and some other stuff listed in a bank vault in Atlanta.  One sold little sticks of tobacco that happened to be addictive.  And the third sold pharmaceutical drugs.  Everyone else came up short.  It's extremely rare for a public company to grow into a cash flow multiple of 62 times.

  ii)  Just on general human nature principle, it's extremely rare that when someone comes to you and offers to sell his company to you for the "bargain price" of 62 times cash flow, that you are in fact getting a bargain.  "Why come to me?  What have I done to deserve such generosity?" is the better response.

 iii)  The only way to be one of the extremely rare companies that can grow into a 62x multiple is to have a really really good moat in a growing industry, and the former is more important than the latter.  That AOL was in a fast-growing industry was true.  That it had a really really good moat was less true.

Let's examine the state of AOL's moat as of January 2000.  Think back to the supply chain that allowed a layperson like me to access this new thing called the internet:

1)  First I turn on my computer.  More than likely this computer was a PC running Microsoft Windows.

2)  I click on the "dial in to AOL" button, which triggers my modem to dial a telephone number and make that noise we all remember.

3)  On my screen appears "Welcome to AOL" and "You've Got Mail!" and off I go.  There are many many web pages owned by AOL, and I spend my entire session on them, looking at AOL-sold advertisements in the process.

Who did I pay along the way?  I paid something to Microsoft when I bought my PC, for access to its operating system.  I paid something every month for the use of the phone line that my modem used.  Then I paid AOL a monthly subscription for its very user-friendly way of accessing the internet, and for its very fun and informative and user-friendly web pages it directed me to.  As a bonus, a bunch of advertisers paid AOL to show their ads on its virtual real estate that I viewed.  These advertisers paid a lot of money to AOL because the internet was new and exciting, and because AOL had all these customers seemingly locked in.  It was a "walled garden," and in fact the AOL Time Warner merger even drew scrutiny from antitrust authorities and experts like Lawrence Lessig because they thought that with the addition of all the Time Warner online content the new company would be even more of a walled garden, favoring its own sites over non-AOL and non-Time Warner sites.

That was how I and many others accessed the new thing called the Internet circa January 2000.  AOL had two moats: it was a toll bridge that charged consumers about $20/month for its user-friendly way of getting on the internet.  And it was a toll bridge that charged advertisers for the privilege of selling stuff to its 23 million subscribers.

Now I have a confession to make.  I've been fibbing a little.  That was not how I accessed this new thing called the internet circa 2000, which, it's important to note, wasn't so new by then.  It was how my mother accessed the internet circa 2000.  I, on the other hand, was a senior in college by then.  Here is how I accessed the internet.  See if it sounds familiar:

1)  First I turned on my computer.  This computer was a PC running Windows, an operating system I paid Microsoft for up front when I bought my computer.   I also paid Microsoft up front for the operating system when I bought a new computer in 2007.  And I'll probably pay them a little when I buy my next computer.  Something tells me you will too.  As this guy might say:  "That's not a moat . . . THAT's a moat."

2)  I didn't need AOL at all to help me access the internet, nor did I need a phone line.  My college had wired my dorm with ethernet, so I just plugged my computer into the ethernet jack.  I didn't click an AOL button either because by that time my Windows operating system had a button that allowed me to open a browser called Internet Explorer.  The browser allowed me to get right on the internet with no problem and no AOL.  And it was free to use--actually it was bundled into the upfront cost of my operating system, but I didn't pay much attention to that at the time.  Microsoft fought something called a "Browser War" for the right to bundle its browser with its operating system.  It won that war: by the time of the AOL Time Warner merger it had a browser market share of 80% and growing, up from approximately zero in 1996. 

3)  When I finally reached the internet, I had very little interest in AOL's websites or email.  I had my own email address by then, and by then there were maybe a billion web sites that were not owned by AOL or Time Warner.  I cared about investing, so I spent a lot of time on Yahoo! Finance.  I cared about my college, so I spent a lot of time on my college's web site.  I cared about fitness, so I spent a lot of time on the web sites of a few gurus who knew how to build web sites from their basements using something called HTML.  I cared a lot about sex, so . . . never mind.  The point is, by the year 2000 you could spend the entire day surfing the internet without ever encountering one AOL web site.  And the growth of non-AOL web sites was expotential.  So exponential, in fact, that a bunch of people were already trying to figure out how to help organize it all.  One team, two Stanford graduate students named Larry and Sergei, had just six months before managed to attract $25 million of venture capital.  And advertisers were paying attention.  With every passing month AOL's advertising real estate diminished as a percentage of the total advertising real estate available.  As far as I was concerned, AOL's moat was non-existent.

Again, hindsight is always 20/20, but Time Warner really had no excuse for assuming AOL's moat would continue:

1)  As a general rule, technology that's easy for college students to use eventually becomes easy for their mothers to use.

2) Time Warner could have and should have known that non-AOL and non-Time Warner advertising real estate was growing exponentially, which would inevitably diminish the value of its own real estate.

3)  Most importantly, and most inexcusably, the seeds of AOL's eventual moat destruction were being sown . . . within Time Warner itself!  Time Warner Cable was hard at work upgrading its systems to allow always-on broadband connectivity to the internet.  It had a new service called Road Runner that was dedicated to providing faster and more reliable online access, a superior product to telephone modems. 

Then as now, a very bad deal.

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

Posted by manualofideas at 12:00 AM | Permalink | Comments (0)

By Nadav Manham

I'm starting a new category, which I'm going to call "BMMT Capital Partners: the Economics of New Media Investing." 

1)  My New Year's resolution is to spend more time thinking about great investments than great investors.  I feel like I'm running out of things to say about what makes a great investor in terms of psychology and how he sets up his fund and the incentives he faces, etc.  I'm now at the point where I simply think "a great investor is someone who makes great investments."  Therefore I think my job is really to find and study great investments and then work backwards to the people who make them.

2)  Part of knowing what makes a great investment is knowing what the market tends to misprice.  It's not enough simply to understand what makes a great business, because often what makes a great business great is well-known to the market and therefore not mispriced.  To get from a great business to a great investment you have to figure out what about it is mispriced.

3)  I believe what the market tends to misprice is the long-term earnings power of a company two to five years out from the time of investment, especially for younger companies, companies in changing industries, and/or companies entering new business lines.  The market was pretty good at pricing Coca-Cola's Q3 2009 earnings back June 2009.  It was less good at pricing its 1991-2000 earnings back in 1988, when Buffett made his big bet (see future post) after correctly forecasting a fundamental change in the economics of Coke's business.

4)  Those investors (whether they are stockpickers, PE investors, venture capital investors, or operating within businesses) who develop an edge in this area can make a lot of money.  You could have made a little money correctly predicting Coke's Q3 09 earnings a few months in advance, but you would have made a lot of money correctly predicting Coke's 1991-2000 earnings power back in the fall of 1988.

5)  What most determines the long-term earnings power of a company two to five years out AND is undervalued by the market is the quality and durability of its moat.  When Buffett bought Coke in 1988 he did not have any unique insights about the general growth of the soft drink industry in the coming two decades--his estimate was probably as good as the market's.  Where he did have an insight was in forecasting correctly the percentage of the future growth of the soft drink industry that would be captured by Coke rather than its competitors, which was a function of its moat.  He also had an insight in correctly forecasting the percentage of that future growth that would be captured by Coke's shareholders rather than its employees, suppliers, construction contractors, distribution partners, etc.  That too was a function of its moat.

6)  Those investors who can correctly forecast the quality and durability of a company's moat two to five years ahead of time can make a lot of money. 

So I want to study moats and how to forecast them.  I've decided to focus my efforts on moats in the media industry, for several reasons:

a) It's a fun industry.

b) It's undergoing a lot of change.

c) Many investors have made a lot of money investing in media in the past few decades.  Many investors have lost a lot of money investing in media in the past few years.  So you'll get a lot of mileage out of studying media if your goal is to judge investors.

What does the name "BMMT Capital Partners" mean?  I imagine assembling a Dream Team of the greatest media investors of the modern era, those who've made money in the last decades and who have managed to keep it or even grow it in the upheavals of the past few years, and asking them to form an investment partnership to invest in new media companies in the next decade.  They can make investments in existing companies, private equity, venture capital, whatever.  The goal is to forecast the future of moats, which is where the real money is.  My Dream Team is:

Buffett, Warren

Malone, John

Murdoch, Rupert

Thomson Family.

So please stay tuned.  In this category I plan to look at the media industry and its moats, and underlying everything will be the question "What would the Dream Team do?"

First up: check out this article about the rise of Fox News.  Forget about the politics and focus on the fact that the channel went from nothing in 1996 to current run-rate operating profit of $700 million, which if you capitalize at 10x comprises about a fifth of the equity value of its parent company News Corporation, and which is more than the combined earnings of CNN, MSNBC, and the evening newscasts of NBC, ABC, and CBS.  Rupert Murdoch's allocation of corporate capital to start Fox News has to rank among the best media investments of the past two decades, especially considering how poor the competition is.  Compare it to, say, the New York Times Company's decision to buy the Boston Globe, or to buy back its shares in the early years of the decade, and you'll see what I mean.  Now the New York Times can only write slightly snarky articles about media companies that make money, rather than being one itself. 

What was Dream Team Member Murdoch thinking when he made that bet back in the mid-1990s?  How to reverse engineer that great investment?  Here are my thoughts on what he did right:

1)  Murdoch is famous for ranting about how liberal the news media is.  I don't care about politics but in economics terms he happens to be right: In deciding to start a news operation with a conservative slant Murdoch was entering a field with almost no competition from traditional media conglomerates.  About half the company votes republican and in aggregate they spend the same money on cars, clothes, detergent, etc. as democrats do.  Advertisers don't care about politics either, they care about eyeballs and wallets.  So the decision to create a channel to connect advertisers to an underserved population of eyeballs and wallets was a great contrarian move.

2) Murdoch correctly forecast that cable channels would have the most durable and lucrative economics of all the various platforms for delivering news.  He did not start a newspaper with a conservative slant, or a magazine.  He did not start a broadcasting network with a conservative slant.  He did not start a website with a conservative slant.  He started a cable channel.  Another great move.  Interestingly, around this same time fellow Dream Team Member John Malone was reallocating his fortune away from cable systems and towards cable channels.

3)  Murdoch did the right thing by putting Roger Ailes in charge.  Ailes was the perfect person to execute Murdoch's strategy.

4)  Murdoch was patient.  Fox News did not make much money until 2003, but Murdoch had the ability and the willingness to continue to invest in it until it hit the tipping point of size and popularity that cable channels need to extract high carrying fees from cable systems.

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere. 

Posted by manualofideas at 04:59 PM | Permalink | Comments (0)

By Nadav Manham

One of the themes of this blog [The Investor's Consigliere] is that the value investing mindset, the ability to buy at the largest discount between present price and future intrinsic value, can be found and studied inside of businesses too, not just in people who buy stocks for a living.  

Lots of professional investors lay out money to buy a stock they hope to sell within about two years at a big profit.  This article from the NYT style section demonstrates that professional diamond dealers do the same thing, and at the highest end they do it Buffett/Munger-style, by making big concentrated bets. 

In December 2008 Laurence Graff paid $24.3 million for the legendary (to him, not to me) Wittelsbach diamond.  That $24.3 million became inventory, part of working capital.  It's called working "capital" for a reason, and like any other kind of capital it's supposed to earn a return, in cash.  I used to know this only in the abstract; it was only when I got involved in a small private equity venture that I came to understand it in my bones: working capital sucks. 

Working capital, namely inventory and/or accounts receivable, is a kind of Purgatory for cash, a painful but necessary intermediate state between cash lying around doing nothing and making cash money from a business.  No one wants to enter Purgatory unless there is something better on the other side, and for working capital that "something better" is a acceptable return on the pre-Purgatory cash you started with.  Laurence Graff is a billionaire who owns a private company; there was no shortage of opportunities for him to do something else with that $24.3mm.  That he chose to invest it in one blue rock means 1) he loves the game and 2) he thinks he can earn a better return from investing in diamond working capital than from anything else. 

The article goes into some of the reasons why, which convince me he has a good shot at earning a good return on his investment.  It comes down to know-how and lack of competition.  Thousands of people and institutions can invest $24.3mm in a stock, but I can count on my hands the number of people who know how much to bid for a diamond like the Wittelsbach, and then know how to maximize its value two years out (an eternity in working capital-years!), first by cutting and polishing it properly, then by creating just the right kind of buzz via a Smithsonian exhibition, then by knowing the names and diamond-buying habits of every single potential buyer in the world, then by setting it just right in a necklace, then by selling it at the best price, and finally, last but not least, by collecting the money in cash (that last part is harder than it seems).

Laurence Graff dropped out of school at 14.  If he took an MBA investing class I suspect he would fail.  If he read this blog post I suspect he would have no idea what I'm talking about.  But whether he knows it or not, in his little corner he's the world's greatest value investor.  And furthermore, if you shake the family tree of the world's other greatest value investors, you'll almost always find a grocer, or a dry-goods merchant, or maybe even a diamond dealer--someone who knew all about value investing in working capital.

The author of this post is president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.

Posted by manualofideas at 12:14 AM | Permalink | Comments (0)

In a recently published letter to shareholders, the managers of Oak Value Fund explain their investment strategy, results for 2009, as well as the investment case for several current holdings.  In addition, the managers comment on Berkshire Hathaway’s proposed acquisition of Burlington Northern Santa Fe.  Oak Value has a solid long term track record despite a relatively high expense ratio demonstrating the benefits of a rigorous value-oriented approach.  Two brief excerpts from the letter appear below.

Investment Philosophy

In our work we are neither interested in the value nor the price of “everything.” We focus our efforts on understanding a collection of growing, advantaged businesses and having an informed opinion of what we believe they are worth. For this group of companies, we are very interested in price, but only in relation to our estimate of their value. Determining price requires a buyer and a seller. Assessing value requires knowledge, insight and judgment. Price is a reaction to the present. Value is a function of the future – growth, predictability and quality. As another great investor once said, “price is what you pay, value is what you get.”

Berkshire Hathaway and Burlington Northern

Berkshire Hathaway made headlines during the quarter with the announcement that it would acquire the remaining 77% of the Burlington Northern Santa Fe railroad company. This is a large acquisition, even for Berkshire, but we believe it is consistent with Mr. Buffett’s longstanding position that it is better to pay a fair price for a good business than a good price for a fair business. The long-term economics of the railroad industry should remain quite attractive, and Burlington’s geographic footprint in the West, where long-term growth prospects appear to be above average, could make it especially compelling. The Burlington network is positioned to benefit from increased volume of imports from China, increased intra-country transport of coal out of the Rockies, and increased movement of grain out of America’s heartland. After a quarter century of consolidation and reorganization, the railroad industry today operates much more efficiently and rationally. As one of the industry’s largest players, Burlington should benefit from structural and competitive advantages for years, if not decades.

Meanwhile, shares of Berkshire Hathaway remained little changed during the quarter as the investment community seemed preoccupied with the task of interpreting some “hidden message” in the timing and/or structure of the Burlington transaction. In our opinion, the most important message for observers to glean from this transaction is the sheer economic power of the Berkshire Hathaway business model to accomplish such a transaction at this point in time.

Click on this link to read Oak Value Fund’s Letter to Shareholders (pdf)

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Disclosure: No position in Oak Value Fund. Long Berkshire Hathaway.

Posted by manualofideas at 08:11 PM | Permalink | Comments (0)

In a new quarterly letter, up-and-coming special situation investor Kevin Byun describes his fund's success in 2009 and the fund's investment framework. Byun writes on the latter:

Based on the recent and continuing upheaval in the markets, it becomes worthwhile to revisit the fundamentals of our investment framework and to reevaluate the manner in which they hold us in good stead through current and future turbulent times. Although our partners already adhere to our investment mindset and believe in the validity of the tenets (which we consider sensible and logical), we know that most managed capital does not align with our framework.

Our basic structure (the allocation groupings and the incentive structure) is based on the Buffett partnerships from the 1950’s. Today, most people associate Buffett with a buy-and-hold-forever philosophy. However, most people do not know how he first created wealth for his investors and himself. What the popular view discounts is that Buffett began his career managing a hedge fund that was value-based and heavily involved in special situations. Basically falling into two categories, his “Generals” were undervalued stocks (still studied by many today) and his “Workouts” were special situations investments (unstudied by almost all).

Generals & Workouts: The Generals tend to produce returns that are more greatly affected by the overall market performance, as with rising or falling tides. The Workouts tend to provide market agnostic returns and tend to have more attractive risk-reward profiles in downturns. Much of Buffett’s consistency in outperformance even during years in which the markets declined is attributable to his special situation investments. Critically, the combination of the two is much more powerful than either one alone in producing absolute returns over an extended time frame.

The validity of this portfolio structure strikes me as powerful, simple, and elegant. In my view, those that focus only on one category at the exclusion of the other are at a fundamental disadvantage. The inherent balance in the combined structure is why Buffett himself said he expected, although could not guarantee, to outperform in bear markets and underperform in bull markets. By having a balanced tool kit, a portfolio remains flexible in allocating to the most promising opportunity set that presents itself.

Flexible mandate: We have a flexible mandate that allows us to look at any opportunities that may be attractive. Certain funds that are designed to fit into a ‘style box’ remain captive to a certain sector, geography or asset class. The problem for such fund managers is that capital can flood out as easily as it floods in (i.e. technology sector funds in 1999 versus 2000 or energy specific funds in 2008 versus 2009). Also, they become captive to a slice of the market when it is no longer attractive and are simultaneously prevented from areas that are attractive. Whether bargains are available or not is immaterial. The order of the day is to sell. As a generalist, our flexible mandate allows us to look at opportunities across the spectrum.

Concentration: Another advantage is our concentration of investments into our best five to ten investment ideas. Our opportunistic style of investing allows us to wait for investments with highly favorable risk-reward profiles and requisite margins of safety. Allocating more capital to really good ideas, which do not come around too often, simply makes sense. This builds a portfolio one idea at a time, such that performance over time correlates to the outcome of those ideas rather than to the market. On the flip side, the typical mutual fund holds about 80 positions, which practically guarantees below average performance and explains why 80% of them underperform the market simply due to frictional costs.

Cash: Another advantage is the ability to maintain net cash in the absence of other opportunities. Many funds must be fully invested according to the fund’s mandate. A fund manager must then perhaps buy at a time that may not be prudent or sell at a time that is even less prudent. Our ability to hold cash is a great advantage, especially as the current market dislocation unfolds. The use of leverage can be extremely dangerous. As has become apparent, investments that were mediocre at best were made to look superior in cooperative markets through the use of easy borrowing.

Alignment of Interests: We eat our own cooking. I have the lion’s share of my net worth in the fund and I will continue to keep my assets in the fund. The idea is if we do well, we all do well together. I can assure you that my focus is on judiciously growing partners’ capital. The fund manager, whose responsibility is to protect and shepherd capital, should not be exempt from the downside risk. One should cast a very skeptical eye at managers who consistently pull their fees out of the funds they
manage.

Read Kevin Byun's Q4 2009 letter to investors.

View Kevin Byun's recent presentation on special situation investing.

Posted by manualofideas at 04:58 PM | Permalink | Comments (1)

Robert Huebscher of Advisor Perspectives has published an engaging interview with Bruce Berkowitz, manager of the $11 billion Fairholme Fund and one of the most successful value investors of the past decade. Here is an interesting exchange from the interview:

My last question is an unusual one: Since you are obviously in a very competitive business, why do you do interviews with people like me?

We have no marketing. Our shareholders are wired for wealth creation. They are well-informed by using channels such as yours. Whatever I say here becomes public. It’s a great way to communicate with existing shareholders.

I can make points to you that I would be uncomfortable making to shareholders, because what you do is in the public domain. We don’t talk to that many people. You are an extremely efficient channel for our existing shareholders. It’s not cheap to reach 80,000 readers.

It’s also important for Fairholme to attract the right shareholders. For example, if someone called me up for the five-minute timing digest, we are not going to have a chat. The same would be true with the technical analysis channel.

If I can communicate with our shareholders and with other great potential shareholders, then it is very effective, because there is a natural ebb and flow. People leave us during difficult times. We want to keep in touch with our shareholders and keep a high-quality shareholder base.

This is why we charge a flat 1% fee with no loads and have never used a 12(b)1 fee and actually abolished the ability for us to use such a fee.

Last year, there were outstanding managers who had significant amounts of capital withdrawn, who were unable to execute their strategies. Fairholme did not have significant net outflows. It’s hard for me to remember if we had even a month of net outflows. That is a huge weapon and a big advantage – having the right shareholders who will stick with us while others are running for shelter. Without that we couldn’t execute.

I have to find ways to talk to smart people who can present our concepts to the kinds of people we would like to have as shareholders. That’s why we do it. I’m not giving anything away. I would never talk to you about what I am going to do today, what we plan for the future or what is not in our public reports.

The real service is for our shareholders, to let them know who we are, how we behave, how we maintain our level of integrity, how we perform during difficult times and whether we eat our own cooking. That is what’s important.Now that we’ve finished our tenth year, it’s good that people can look back and see what we had to say every six months and how we behaved during very difficult periods. They can stress test us.

At the end of the day, however, I know talk is cheap. You’ll know in three to five years whether I had anything interesting to say today.

Read the full interview with Bruce Berkowitz.

Posted by manualofideas at 10:57 AM | Permalink | Comments (0)

Posted by manualofideas at 07:51 PM | Permalink | Comments (0)

Here is a video interview with HBS alumnus Seth Klarman "regarding his experience at HBS and his views on leadership and success and the priority of giving back to one's community."

(Thanks to Corner of Berkshire and Fairfax for the link.)

Posted by manualofideas at 07:31 PM | Permalink | Comments (0)

David Lau shares investing lessons from former Merrill Lynch analysts Richard Bernstein, David Rosenberg, and Jeff Saut. Here are some highlights:

Richard Bernstein’s lessons

1. Income is as important as capital gains. Because most investors ignore income opportunities, income may be more important than capital gains.

2. Most stock market indicators have never actually been tested. Most don’t work.

3. Most investors’ time horizons are much too short. Statistics indicate that day trading is largely based on luck.

4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.

5. Diversification doesn’t depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio.

David Rosenberg’s lessons

1. In order for an economic forecast to be relevant, it must be combined with a market call.

2. Never be a slave to the data - they are no substitutes for astute observation of the big picture.

3. The consensus rarely gets it right and almost always errs on the side of optimism - except at the bottom.

4. Fall in love with your partner, not your forecast.

5. No two cycles are ever the same.

Bob Farrell’s lessons

1. Markets tend to return to the mean over time.

2. Excesses in one direction will lead to an excess in the other direction.

3. There are no new eras - excesses are never permanent.

4. Exponential rising and falling markets usually go further than you think.

5. The public buys the most at the top and the least at the bottom.

Read more investing lessons here.

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Subscribe to the bi-weekly 10x45 Bargain Hunter for $99/year.

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It's a shame that former New York Governor Eliot Spitzer ruined his career the way he did, because he is one of the smartest guys we've had in government in a long time. Having someone like him sit on the sidelines while Tim Geithner leads Treasury is not good for the country.

Thanks to The Big Picture for the link.

Posted by manualofideas at 04:32 PM | Permalink | Comments (0)

Here is a fascinating talk by marketing guru Seth Godin on the emergence of new, Internet-enabled global tribes. He challenges us to lead a "tribe," as this is the modern way to effect change.

Thanks to The Big Picture for the link.

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The Associated Press reported on January 10th:

Already the biggest auto market and steel maker, China edged past Germany in 2009 to become the top exporter, yet another sign of its rapid rise and the spread of economic power from West to East.

Total 2009 exports were more than $1.2 trillion, China's customs agency said Sunday. That was ahead of the 816 billion euros ($1.17 trillion) forecast for Germany by its foreign trade organization, BGA.

Perhaps the biggest surprise of this news to those who don't closely follow the rankings of the world's exporters may be the fact that China had not overtaken Germany much earlier. China's might as an export superpower has been writ large in the media for years, so much so that a relatively small nation such as Germany should have been left in the dust long ago. Yet, Germany's export strength has been known for decades, and the latest news simply serves as a reminder that there are export nations other than China that are also crucial to world trade. Japan, of course, is one such nation, as are some of the emerging Asian countries, such as Taiwan and Korea.

Posted by manualofideas at 01:41 PM | Permalink | Comments (0)

With Exxon’s planned acquisition of XTO Energy, investor interest in natural gas has increased and many observers are also excited about the possibilities for substituting gas for crude oil based fuels to save money as well as reduce greenhouse gas emissions.  Exxon’s move into natural gas is also a big bet on the economic viability of exploiting shale deposits which can be more expensive to extract compared to traditional wells.

For an entertaining commentary on natural gas economics, we recommend viewing a presentation made on January 7 by Contango Oil & Gas Company Chairman and CEO Kenneth Peak.  Although the presentation is not a comprehensive introduction to natural gas economics, Mr. Peak provides his thoughts on the industry and talks about his company’s activities in the field.

Click on the image below or on this link to view the 23 minute presentation (registration required).

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

The author owns shares of Contango Oil & Gas Company.

Posted by manualofideas at 12:08 AM | Permalink | Comments (0)

We are pleased to announce a partnership with value investor Matt Darrah of MD Capital Management, whereby The Ideas Report For Serious Investors will occasionally publish Matt's thesis on his best investment ideas. Matt writes a FREE investment newsletter we highly recommend -- email Matt to subscribe.

The following is Matt's recent write-up on Corporate Executive Board (EXBD).

Executive Summary

• Negative Invested Capital Business: (1) The Company operates a subscription business model where customers pay for a full year of a program at the beginning of the year, but the Company is able to pay its suppliers over time. (2) The Company’s extensive historically database of information acts as a barrier to new entrants, and will help the Company maintain its current level of pre-tax cash flow over a long periods of time.
• Management Team Focused on Delivering Value to Shareholders: Management consistently distributes nearly all free cash flow to shareholders through share buybacks and dividends.
• Attractive Valuation: (1) Recent stock price implies a 15% normalized free cash flow yield. (2) The Company’s expected earnings decline in 2010 concerns the Market.
  

Is Corporate Executive Board a Good Company?

Corporate Executive Board Co. (“EXBD” or the “Company”) provides benchmarking data regarding corporate best practices to business executives and professionals worldwide. Approximately 70% of sales are generated in the United States. The Company distributes its information through various case study profiles, executive forums where executives meet to discuss their issues, and benchmarking datasets. For instance, the CFO of a Coca-Cola might subscribe to the CFO Executive Board and/or the Finance Leadership Board. If the CFO wanted to determine the optimal organizational structure for his accounts receivable department, he could review (i) a case study profile of another company that has a top performing AR department, (ii) review EXBD’s organizational structure database, or (iii) discuss with other executives in the network. Customers provide information about their company’s best practices in exchange for receiving the benchmarking data and best practices from other EXBD customers. EXBD was founded in 1979, and is headquartered in Arlington, VA.

Historically, the Company’s customers bought increasing amounts of benchmarking data by subscribing to more programs in order to ensure that their firms were at the forefront of their industries. However, the recent recession forced many executives to reduce expenditures, and thus the Company is expected to experience a 23% revenue decline in 2009. The fact that 25% of the Company’s revenues are generated from customers in the financial services industry exacerbated this decline. Since the Company’s customers pay in advance, EXBD can fairly accurately forecast revenue growth and declines. The primary predictor of future revenue is “Contract Value”, which represents the annualized revenue that results from the current subscriptions in place. As an example, let’s say one of EXBD’s programs has 100 subscribers priced at $40,000 per subscription. The Contract Value would equal $4MM for that particular program. Contract Value has continued to decline throughout 2009, as customers continue to cut cost, but the rate of decline is slowing. This decline in contract value means that 2010 revenues will likely decline again. However, based on the slowing rate of decline and customer calls, I believe that revenue growth will return in 2011, allowing the Company to generate a more typical amount of free cash flow.

The Company obtains the information it publishes from its customers. The fact that EXBD operates the largest network of companies providing benchmarking data to each other provides another barrier to new entrants, as a new competitor would need to replicate the Company’s expansive network, which includes 80% of the Fortune 500 (largest 500 companies in the U.S.). As of December 31, 2008, the Company employed approximately ~2,430 people, none of which belong to unions. The Company spends capital expenditures on replacing/modernizing information technology (few growth related capital expenditures necessary).

The Company has consistently operated with negative capital requirements, as the Company operates a subscription business model where customers pay in advance for a year long service, but pays vendors over longer, commercially standard terms. Further, the Company requires little infrastructure to provide its service, except for information technology.

Below I will discuss the factors that will allow the Company to continue earning at least its current level of free cash flow over long periods of time. Note that the economic slowdown has materially impacted free cash flows, but prior to the recession, free cash flow did not fluctuated much historically.

The corporate best practices benchmarking industry that distributes information like EXBD is characterized by limited price competition and two major firms, Corporate Executive Board and Advisory Board Company. Consulting firms also provide similar benchmarking data, but only when being used for a project. Thus, EXBD’s data is typically used when a consulting project is unnecessary or prior to engaging a consultant to obtain benchmarking data in a more cost effective manner. The market possesses high barriers to entry with no new companies entering the market since the 1979 due to the difficulty of replicating the historical results of surveys conducted to obtain benchmarking data and the extensive networks developed by incumbent industry participants. The Company owns data regarding best practices dating back to 1979 (its inception), which no new entrant can replicate. The Company has developed over 300,000 corporate best practices, 1,500 benchmarking datasets, and 11,500 analytical tools. The Company’s only major competitor focuses on the healthcare segment, so direct competition on price is limited. Historically, the Company has grown by successfully cross selling other EXBD products into an existing customer’s organization. For instance, a customer’s finance department may subscribe to the Finance Leadership Board, and after having success encouraged the marketing department to
subscribe to the Marketing Leadership Council. The Company incurs little additional cost when selling a program to one more incremental customer, because the cost of developing a program is fixed. Thus, every new subscription the Company sells is very profitable. While the Company counts approximately 80% of the Fortune 500 as customers, a very large untapped addressable market of smaller, mid-sized business exists. Thus, not only does the Company possess a moat with regard to its existing customers, but also has strong growth opportunities.

Risks to Cash Flows

The largest risk I am concerned about regarding owning EXBD is that the decline in revenue during 2009 was a not a as a result of the recession, but a secular decline in demand for the Company’s products. Based on calls I made to customers, EXBD’s clients still find the Company’s products valuable, but like most companies during the recession had to make cost cuts, and information resources like EXBD’s products were cut as opposed to additional headcount reductions. As the economy recovers and corporate purse strings loosen, I believe the Company will be able to return to its historical level of free cash flow. However, that will likely take place during 2011.

Does Corporate Executive Board have a Good Management Team?

The EXBD management team is lead by Thomas Monahan. He was promoted to Chief Executive Officer in 2005. Prior to becoming CEO, he was general manager of EXBD. Prior to EXBD, Thomas was a senior consultant at Deloitte and Touche. Thomas has returned substantially all free cash flow to shareholders through dividends and share buybacks during his tenure, as the Company does not require large amounts of capital to grow. Thomas owns $1.2MM worth of EXBD common stock or ~2x his base salary, ensuring that he will continue to keep a shareholder mindset.

Can EXBD be Bought at a Cheap Price?

After examining the past several years’ free cash flow, I believe that normalized pre-tax equity free cash flow is ~$105MM. At Thursday’s closing price of $22.82, EXBD’s market capitalization less net cash and marketable securities is ~$718MM, which means the stock has a 15% pre-tax equity free cash flow yield. If EXBD trades at a 7% pre-tax equity free cash flow yield, which would be appropriate for this high quality business with compelling growth prospects, the stock will rise to ~$46, making the stock a compelling buy at $22.82. Further, the Company has a 1.9% dividend yield at $22.82 per share.

The author of this article is Matt Darrah, Chief Investment Officer of MD Capital Management and contributor to The Manual of Ideas. Matt describes his background as follows: "I have been investing since 1998 (age 16) when I saved nearly all my money from working on my winter break from high school, and invested it according to the value investing principles I had read about in Warren Buffett’s shareholder letters and books about value investing. After high school, I attended Southern Methodist University (SMU) in Dallas, Texas, where I graduated summa cum laude with a degree in finance. Post graduation, I worked in investment banking for two years (helping companies raise financing, buy other businesses or sell their businesses) before joining a private equity and debt investment firm, where I have worked for three years. My investing philosophy has been developed through my (i) insatiable reading of books written by and about prominent value investors and their investment philosophy, (ii) 11 years of public market investment experience and (iii) three years of private equity experience, where I have invested and/or manage over $625MM of investments in 6 companies."

The author of this article may own the securities discussed herein. This article is not a solicitation to buy or sell securities. This article may have been lightly edited for publication on The Ideas Report For Serious Investors. For full terms of use of this website, visit http://manualofideas.com/terms.html

Posted by manualofideas at 05:02 PM | Permalink | Comments (0)

Contrarian investor James Chanos of Kynikos Associates gained fame by predicting corporate failures such as Enron and Tyco. Now, Mr. Chanos believes China could be headed for demise. As quoted in a recent New York Times article, Mr. Chanos says that China looks like "Dubai times 1,000 - or worse." Accordingly, the hyperstimulated economy, including unsustainable growth in the real estate market, is headed for a crash.

Mr. Chanos' views on China differ not only from accepted conventional wisdom, but also run against the opinion of such informed and successful investors as Jim Rogers. For more on this debate, please read the recent New York Times story.

Michael Auslin of the American Enterprise Institute also had insightful recent remarks on China, echoing the views expressed by Mr. Chanos. Please click here for further reading.

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Via Bloomberg. Excerpt:

Shares of banks such as Citigroup Inc. and Bank of America Corp. were collapsing [in early 2009] on rumors they would be nationalized. On Feb. 25, the U.S. Treasury put out a white paper and a term sheet on its Web site for the government’s Capital Assistance Program. They said the preferred stock the government was buying in the banks would be convertible to common shares at prices far above where they were trading -- 37 percent higher in the case of Citigroup and 21 percent for Bank of America, Bloomberg Markets reported in its February 2010 issue.

For Tepper, 52, that meant it was time to buy. “If the federal government was putting out this paper, they weren’t going to nationalize the banks,” he says.

Second, the conversion price of the preferred shares meant the bank stocks were seriously underpriced.

“It was crazy,” says Tepper, a Pittsburgh native. “In February and early March, people were in a panic.” 

(Thanks to Nadav Manham for the article link.)

Posted by manualofideas at 09:59 PM | Permalink | Comments (0)

No one enjoys dwelling on past errors whether we are talking about investments, career choices, or poor decisions in personal relationships.  It is far more pleasant to think about what has worked well in the past and to relegate unpleasant memories to what George Orwell referred to in 1984 as the “memory hole”.  In Orwell’s story, the “memory hole” is a chute through which all evidence of unfavorable events are sent to an incinerator by order of a totalitarian government. The attempt to erase bad memories by a government is tyranny;  doing the same in business and investments can lead to repeating the same errors again and again.

While it is never productive to endlessly dwell on mistakes, it is healthy to examine key errors to see whether any lessons can be learned.

“Pie on Face Award” for 2009 …

The Rational Walk is not an investment newsletter and does not provide investment advice.  Nevertheless, at times, we discuss specific securities and views regarding the business prospects for companies.  One such example last June involved a decision to favor shares of Wal-Mart Stores over shares of Sears Holdings.

Let’s be clear:  The mere fact that a stock was sold that has since appreciated by nearly fifty percent does not, by itself, justify the “pie on face” award.  During any six month period, virtually anything can happen in the stock market and price movements cannot be used to evaluate the success or failure of an investment decision.  The reason this decision was a mistake was based on faulty reasoning at the time rather than subsequent short term stock price movement.  Let’s take a look at the two main factors behind the decision.

Error #1:  Excessive Fixation on Macroeconomic Factors

As described in the article, the decision to purchase Sears Holding shares was based on a belief that the underlying real estate assets far exceeded the overall market capitalization of the company.  While the book value of the real estate holdings are carried at historical cost, evidence existed to justify much higher valuations.  In fact, Bruce Berkowitz of the Fairholme Fund assigned his team to a methodical examination of property tax assessments and concluded that the real estate alone could be worth $80 to $90/share.

Throughout the spring of 2009, like most investors, I spent significant time following macroeconomic trends and thinking about the implications of the severe recession on my investments.  Since the tax assessments the Fairholme team examined were from 2008, I became concerned that the values of the real estate may have become impaired since the analysis took place, particularly due to the impact of the recession on commercial real estate such as malls.

Error #2:  Changing Investment Rationale After Initial Investment

The second error involved changing my investment rationale after the initial investment was made.  In the case of Sears Holdings, my initial investment rationale was a play on a severe undervaluation of the company’s real estate holdings rather than an investment in the retail operations of the company.  In my view, if Sears Chairman Edward Lampert could engineer a turnaround at the retail operations, that could add even more value but was not essential to the investment thesis.  In other words, the investment came with a free option on the recovery of the retail operations.

In addition to allowing my macroeconomic concerns impact my views on the value of the company’s real estate holdings, I also became worried that customers would abandon the retail stores given the weakness of Sears and Kmart relative to stronger competitors.  But it made no sense to allow this to impact the investment decision since the retail operations were not part of the original investment thesis.

Lessons Learned

Perhaps the most important lesson to learn is that paying excessive attention to the macroeconomy is generally unhelpful when making specific investment decisions.  This is why Warren Buffett always says that his investment decisions are not made with regard to macro conditions.  It was easy to justify making “exceptions” to this rule in a year like 2009 when talk of depression was widespread.  But it was an error.

The second lesson is to always remember why a security was purchased to begin with.  If the investment thesis centered on real estate value, then only a true erosion of the original thesis should justify a decision to liquidate below appraised intrinsic value.

As of today, Sears Holdings has reached my original high estimate of the intrinsic value of the real estate holdings at nearly $90 per share.  A buyer of the shares today might have to justify the purchase based on the retail operations; a buyer at $50 did not need to consider the retail operations to justify a purchase.  Based on the original investment thesis, Sears shares would be sold at current levels.  However, due to the faulty thinking discussed in this article, they were sold prematurely at $61 thereby giving up an additional 50% of upside.

It so happens that even at $61, the shares were sold at a significant profit.  The performance even exceeded the S&P 500 return over the holding period.  But that is hardly the point.

Examining this type of mistake is never pleasant but it is necessary to avoid repeat performances.  All investors should take the time to do the same to avoid the risk that the “memory hole” will extinguish such experiences and lead to future errors.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 09:52 PM | Permalink | Comments (0)

TheAtlantic.com has a worrisome article on the state of state in America's southern neighbor, Mexico. Writes Philip Cavuto by way of introduction:

In the almost three years since President Felipe Calderón launched a war on drug cartels, border towns in Mexico have turned into halls of mirrors where no one knows who is on which side or what chance remark could get you murdered. Some 14,000 people have been killed in that time—the worst carnage since the Mexican Revolution—and part of the country is effectively under martial law. Is this evidence of a creeping coup by the military? A war between drug cartels? Between the president and his opposition? Or just collateral damage from the (U.S.-supported) war on drugs? Nobody knows: Mexico is where facts, like people, simply disappear. The stakes for the U.S. are high, especially as the prospect of a failed state on our southern border begins to seem all too real.

Read the full article 'The Fall of Mexico'.

(Thanks to Adam Heinrich for the link.)

Posted by manualofideas at 06:39 PM | Permalink | Comments (0)

Interesting article in a recent issue of The Economist:

AT THE start of the 1960s London’s status as a financial centre was in gentle decline, reflecting Britain’s waning importance in the global economy. Then the American government helpfully imposed Regulation Q and the Interest Equalisation Tax, two measures that encouraged investors to hold a lot of their dollars offshore. London became the centre of the so-called Euromarket, attracting more international banks than New York.

Despite its terrible weather and creaking transport infrastructure, London has continued to punch above Britain’s economic weight as a financial centre. The city built up critical mass in legal, accounting and fund-management expertise, and big American investment banks such as Goldman Sachs steadily increased their presence. London is not just Europe’s dominant financial hub (see chart). Before the credit crunch, talk that London would replace New York as the world’s financial centre was commonplace.

That claim sounds rather hollow now, thanks to a change in the political and regulatory climate. “London’s position as a financial centre is now threatened,” says Robin Bowie of Dexion Capital, which runs a listed fund-of-hedge-funds group. A special levy on bankers’ bonuses announced earlier this month has come on top of a forthcoming 50% tax rate on high earners, a charge on the worldwide earnings of expats living in Britain (also known as “non-doms”), pension rules that create marginal tax rates of over 100% and some unfriendly words from Adair Turner, the head of Britain’s financial regulator.

A poll of Bloomberg subscribers in October found that Britain had dropped behind Singapore into third place as the city most likely to be the best financial hub two years from now. A survey of executives this month by Eversheds, a law firm, found that Shanghai could overtake London within the next ten years.

Read the full article at Economist.com.

Posted by manualofideas at 06:34 PM | Permalink | Comments (0)

Miguel Barbosa of the multi-disciplinary Simoleon Sense blog recently interviewed fellow blogger and value investor Tariq Ali, founder of Street Capitalist. Ali sheds light on his investment approach and talks about some of his best and worst investments. Says Ali,

My worst investment was a small position in Mosaic, I definitely took a top down approach with that one, something I will never do again.

Ticketmaster was an investment I really liked. I entered into the position around $3.99 and sold out in the mid $11-range. It was a spinoff that I had watched since the summer when it began trading at $27. I had actually been excited about the business ever since the deal was announced, just because Ticketmaster is such a monopolistic business.

Fairfax financial was purchased at $210 in 2007 and now trades around around $400. Here was a business that has an amazing jockey, Prem Watsa, was bought at about 1/2 book value and had a great portfolio of credit default swaps to hedge against the financial crisis.

Read the full interview with Tariq Ali.

Posted by manualofideas at 05:33 PM | Permalink | Comments (0)

According to a report published this morning, J.P. Morgan analysts believe that Swiss Re will be in a position to pay back its CHF 3.6 billion loan from Berkshire Hathaway as soon as June 2010.  We originally discussed the terms of Berkshire’s investment in Swiss Re last March shortly after the transaction was finalized.

To briefly summarize, the terms of the funding included a 12% fixed interest rate and gave Swiss Re the right to defer interest payments for an additional fee of 15% per annum on the deferred interest.  Berkshire has the right to convert the loan into Swiss Re common shares starting three years after the issue date at CHF 25 per share which is far below the current quotation.

In exchange for repaying the security early and eliminating Berkshire’s right to convert into common shares, Swiss Re must pay a 40% premium over face value if the repurchase occurs prior to the second anniversary of the transaction.

Berkshire’s latest quarterly report contains the following summary:

On March 23, 2009, Berkshire acquired a 12% convertible perpetual capital instrument issued by Swiss Re at a cost of 3 billion Swiss Francs (“CHF”), which is also the face amount of the instrument. The instrument has no maturity or mandatory redemption date but can be redeemed under certain conditions at the option of Swiss Re at 140% of the face amount until March 23, 2011 and thereafter at 120% of the face amount. The instrument possesses no voting rights and is subordinated to senior securities of Swiss Re as defined in the agreement. Beginning March 23, 2012, the instrument can be converted at Berkshire’s option into 120,000,000 common shares of Swiss Re (a rate of 25 CHF per share of Swiss Re common stock).

Based on these terms, Swiss Re will have to pay a CHF 1.2 billion premium if the company elects to repay the loan in June 2010.  The Swiss Re investment appears to represent another case where Warren Buffett skillfully deployed capital at a time when few players were willing or able to make investments.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 03:30 PM | Permalink | Comments (0)

Max Olson of Max Capital Corporation and FutureBlind.com recently published an excellent article on the story of Steak n Shake and Sardar Biglari, the early-30s investor whom some are already calling the next Warren Buffett. We certainly agree that Biglari is someone to watch very closely as he sets out to transform Steak n Shake into a Berkshire Hathaway-like investment vehicle.

Read Max Olson's article.

Read Sardar Biglari's letter to Steak n Shake shareholders.

Posted by manualofideas at 09:31 PM | Permalink | Comments (0)

In September, we speculated that Warren Buffett might be less than thrilled with the terms of Kraft’s bid for Cadbury.  In particular, his comments at the time indicated that he was hesitant to use Kraft’s “undervalued” stock as currency for the transaction.  It appears that Mr. Buffett is growing increasingly concerned about the judgment of Kraft’s management as the “animal spirits” so often associated with expensive acquisitions intensify ahead of the January 19 deadline for Kraft to finalize the terms of the Cadbury bid.

In a press release issued by Berkshire Hathaway this morning, Kraft management is criticized for seeking a “blank check” which will allow the company to issue up to 370 million shares in order to facilitate an offer for Cadbury.  The press release refers to Kraft’s proxy statement for a special meeting set for February 1 seeking approval for issuance of up to 370 million shares.

It is unusual for Warren Buffett to publicly criticize the management of companies in which Berkshire holds minority positions.  Let’s look at a couple of excerpts from the press release:

The share-issuance proposal, if enacted, will give Kraft a blank check allowing it to change its offer to Cadbury – in any way it wishes – from the transaction presented to shareholders in the proxy statement. And we worry very much that, indeed, there will be an additional change from the revision announced this morning. To state the matter simply, a shareholder voting “yes” today is authorizing a huge transaction without knowing its cost or the means of payment.

The tone of the statement is revealing in that is reveals a lack of confidence in management to protect shareholder interests and profound dissatisfaction with the slightly sweetened terms of Kraft’s offer for Cadbury which were announced this morning (click on this link for coverage in the Wall Street Journal).

The press release goes on to criticize Kraft management for being so willing to issue shares at $27 (or lower) when the company repurchased shares at a higher price in 2007:

What we know with certainty, however, is that Kraft stock, at its current price of $27, is a very expensive “currency” to be used in an acquisition. In 2007, in fact, Kraft spent $3.6 billion to repurchase shares at about $33 per share, presumably because the directors and management thought the shares to be worth more.

Does the board now believe those purchases were a mistake and that Kraft’s true value is only the current price of $27 per share – and that it is therefore fine to structure a major acquisition based upon that price? Would the directors use stock as merger currency if the price were, say, $20 per share? Surely the true business value of what is given is as important as the true business value of what is received when an acquisition is being evaluated. We hope all shareholders will use this yardstick in deciding how to vote.

Here we see the familiar standard that Mr. Buffett has long used to measure whether using stock in an acquisition makes sense for the acquirer:  As much business value must be received as the company is giving up in the share issue.  This does not mean that Kraft cannot use “undervalued” shares to purchase another company, but the target company must be at least as “undervalued” as Kraft if stock is employed in the transaction.

While the press release keeps open the possibility that Berkshire may change its vote to “yes” if the terms of Kraft’s final offer for Cadbury (due by January 19) are acceptable, today’s press release clearly is intended to send a message to Kraft’s management and board.  Perhaps the most amazing aspect of today’s drama is that Kraft CEO Irene Rosenfeld either did not consult with her biggest shareholder in advance or knew of Mr. Buffett’s opposition and went ahead regardless.  In either case, Mr. Buffett’s reason to criticize management in a very public way seems very justified.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 09:01 PM | Permalink | Comments (0)

Most outside observers had difficulty keeping up with the momentous events of the weekend of September 14-15, 2008 with all of the twists and turns that finally led to Lehman Brothers’ historic bankruptcy filing, Bank of America’s purchase of Merrill Lynch, and AIG’s bailout only a few days later. Ever since that tumultuous period, there has been a need for a comprehensive book covering the behind the scenes events.  Andrew Ross Sorkin’s Too Big To Fail has succeeded in delivering exactly what is needed to gain a better understanding of these historic events.

If newspapers are the “first draft of history”, Andrew Ross Sorkin played a major role with his New York Times coverage of the financial crisis in 2008.  Although Mr. Sorkin is only 32 years old, he has obviously been able to build up a massive network of contacts on Wall Street and in Washington. Mr. Sorkin’s coverage spans the timeframe from the failure of Bear Stearns up to the passage of the TARP legislation, but the narrative really shines when it comes to the events of a September weekend when the financial system came much closer to total collapse than anyone on the outside could have realized at the time.

Mr. Sorkin’s book has received a great deal of media attention and book reviews, but there is also a need to step back and think about the lessons that must be learned if future crises are to be avoided.  The inability of Washington to come to any agreements on financial system reform was a significant failure in 2009, but one that received little attention outside the financial press.  With each passing week of relative “calm”, chances grow greater than another crisis may be required to prompt reforms.

Greed and Fear

The old adage that a balance between greed and fear creates equilibrium on Wall Street seems hopelessly out of date in light of the revelations in this book.  In the “text book world”, investors and other players in a market system need to be driven by the profit motive (“greed”) but decisions are tempered by a desire for safety (“fear”).  For many decades on Wall Street, the partnership model in investment banking seemed to keep the level of risk aversion high enough to prevent overreaching (for a great book on the old  model at Goldman Sachs, for example, see Charles D. Ellis’ The Partnership).

One can argue that many leading Wall Street players lost huge sums of money in the 2008 crash, so the absence of more “fear” in the system cannot be explained merely by a change in the ownership models of the investment banks. Indeed, an absence of adequate levels of risk aversion extended to Main Street and Washington as well.  Rep. Barney Frank’s famous declaration in favor of “rolling the dice” with softer underwriting standards for mortgage lending as well as the reckless disregard of financial prudence by many subprime borrowers cannot be ignored.

False Illusions and Egos

From the outside looking in, Wall Street and Washington are populated by highly confident, assertive, and competent individuals who seem equipped to carry out their responsibilities in a capable manner.  While there are many individuals who fit this description well, some of whom appear in Mr. Sorkin’s book, many others appear to suffer from the human defects that affect everyone else.  At several points in the book, we can see cases where ego prevented otherwise intelligent actions from being taken.

For example, why did Lehman Brothers’ CEO Dick Fuld, shocking even his own team, attempt to abruptly change the terms of a nearly sealed deal with Korea Development Bank in early August that would have valued Lehman at a premium and likely saved the firm?  Was it a matter of seeking better terms for his shareholders, a question of ego, or confidence that a government bailout would be a backstop if all else failed?

There are countless other situations in the book where the reader, with the benefit of hindsight, asks:  Why?

Government Saviors?

Government players hardly come out of the story looking like heroes either, with the possible exception of Treasury Secretary Hank Paulson who had the unenviable task of coming up with solutions for the crisis without appearing to favor a bailout of his former colleagues at Goldman Sachs.  Throughout Mr. Sorkin’s account of the events, it becomes quite apparent that helping Goldman was probably the last thing on Mr. Paulson’s mind.

Timothy Geithner, the current Treasury Secretary, was President of the Federal Reserve Bank of New York during the crisis.  Mr. Geithner comes across as the main deal maker for the Fed while Chairman Ben Bernanke takes a much lower profile role.  While there is no doubt that Mr. Geithner played a critical role, he often comes across as authoritarian in terms of his tactics.  For example, at several points, he makes threats or orders bank CEOs to take action during meetings and simply leaves the room asking to be notified when a solution is in place.  Whether this was necessary or not during these remarkable times is an open question, but this is not how we should want government officials to behave in normal times.

President Bush hardly appears in the narrative and seems quite detached in the few occasions where he is being briefed on the crisis.  For all practical purposes, Secretary Paulson was calling the shots for the Executive branch of the Federal Government throughout this process.  Sen. Barack Obama made a few appearances in the book (as well as on Secretary Paulson’s calendar) but Sen. John McCain hardly appears at all which is surprising given that he famously suspended his campaign in order to return to Washington and work on a solution for the crisis.

Financial Regulatory Reform

One of the interesting aspects of the book is the degree to which government officials pushed to “marry” commercial banks and investment banks during the height of the crisis in September.  It seems like every possible permutation was considered, to the point where Mr. Geithner was referred to mockingly as “E Harmony” in a reference to the online dating site.  At the same time, many in government blame the 1999 repeal of the Glass-Steagall Act, which prohibited the union of commercial and investment banks, for precipitating the crisis.

While the idea of giving investment banks access to stable deposits through commercial banks had a great deal of merit during the crisis, such mergers also created ever larger institutions, many of which are considered “too big to fail”.  It seems that society must decide which is the lesser of two evils:  Government regulations that seek to keep financial institutions small such that none can become “too big to fail” or heavy handed regulations that properly govern mammoth institutions that are obviously “too big to fail”.

Wall Street:  Pick Your Regulatory “Poison”

Wall Street cannot have it both ways:  If regulations are repealed that then allow financial institutions to grow so large that a failure would have systemic impacts, then regulations governing the conduct of these institutions is essential to avoid future crises from developing.  On the other hand, if we accept regulations that prohibit mergers that will result in massive institutions, Wall Street firms should have more flexibility to conduct their ongoing affairs without as much regulatory scrutiny since the failure of any one institution will not be systemically important.

It seems preferable to have “blocking” regulations such as Glass-Steagall rather than “operational” regulations required to govern massive financial institutions that are of systemic importance.  A “blocking” regulation is not as intrusive into the day to day operation of firms and is less likely to throw sand in the gears of capitalism.  In contrast, the regulatory regime required to monitor massive systemically important institutions will, of necessity, be intrusive and bureaucratic.

“Too Big To Fail:  The Sequel”?

There are many potential solutions that should lead to a more stable financial system going forward, but each passing week makes it less likely that reforms will be made.  As the economy recovers and “business as usual” returns to Wall Street, the seeds are now being planted for the next crisis.  While no doubt capable of the task, we should hope that Mr. Sorkin does not have the opportunity to write a sequel to Too Big To Fail.  The consequences could be even more severe.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Posted by manualofideas at 08:58 PM | Permalink | Comments (0)

Whitney Tilson and Glenn Tongue summarize the inflation theses of several prominent investors in a new Washington Post article. We agree that investors should have some sense of urgency about thinking through appropriate inflation hedges even if not implementing such hedges immediately. Here is an interesting excerpt from the article:

The debate over gold, considered an excellent inflation hedge by some, is equally lively. Top investors, such as Paulson & Co.'s John Paulson and Greenlight Capital's David Einhorn, placed big bets on gold in 2009. Einhorn explained his rationale at the recent Value Investing Congress: "Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely."

At the same conference, Bill Ackman of Pershing Square Capital Management said he avoids gold because it is "a greater-fool investment." In other words, making money on the yellow metal is less a function of a rise in its fundamental value and more a function of finding someone who is willing to pay you more for it. Tiger's Robertson describes his aversion to gold similarly: "It's less a supply-demand situation and more a psychological one -- better a psychiatrist to invest in gold than me."

Read the full article.

Posted by manualofideas at 04:44 PM | Permalink | Comments (0)

Posted by manualofideas at 10:37 PM | Permalink | Comments (0)

Economics Nobel Laureate Joseph Stiglitz opines in China Daily:

The best that can be said for 2009 is that it could have been worse, that we pulled back from the precipice on which we seemed to be perched in late 2008, and that 2010 will almost surely be better for most countries around the world. The world has also learned some valuable lessons, though at great cost both to current and future prosperity - costs that were unnecessarily high given that we should already have learned them.

The first lesson is that markets are not self-correcting. Indeed, without adequate regulation, they are prone to excess. In 2009, we again saw why Adam Smith's invisible hand often appeared invisible: it is not there. The bankers' pursuit of self-interest (greed) did not lead to the well-being of society; it did not even serve their shareholders and bondholders well. It certainly did not serve homeowners who are losing their homes, workers who have lost their jobs, retirees who have seen their retirement funds vanish, or taxpayers who paid hundreds of billions of dollars to bail out the banks.

Under the threat of a collapse of the entire system, the safety net - intended to help unfortunate individuals meet the exigencies of life - was generously extended to commercial banks, then to investment banks, insurance firms, auto companies, even car-loan companies. Never has so much money been transferred from so many to so few.

We are accustomed to thinking of government transferring money from the well off to the poor. Here it was the poor and average transferring money to the rich. Already heavily burdened taxpayers saw their money - intended to help banks lend so that the economy could be revived - go to pay outsized bonuses and dividends. Dividends are supposed to be a share of profits; here it was simply a share of government largesse.

The justification was that bailing out the banks, however messily, would enable a resumption of lending. That has not happened. All that happened was that average taxpayers gave money to the very institutions that had been gouging them for years - through predatory lending, usurious credit-card interest rates, and non-transparent fees.

The bailout exposed deep hypocrisy all around. Those who had preached fiscal restraint when it came to small welfare programs for the poor now clamored for the world's largest welfare program. Those who had argued for free market's virtue of "transparency" ended up creating financial systems so opaque that banks could not make sense of their own balance sheets. And then the government, too, was induced to engage in decreasingly transparent forms of bailout to cover up its largesse to the banks. Those who had argued for "accountability" and "responsibility" now sought debt forgiveness for the financial sector.

The second important lesson involves understanding why markets often do not work the way they are meant to. There are many reasons for market failures. In this case, too-big-to-fail financial institutions had perverse incentives: if they gambled and succeeded, they walked off with the profits; if they lost, the taxpayer would pay. Moreover, when information is imperfect, markets often do not work well - and information imperfections are central in finance. Externalities are pervasive: the failure of one bank imposed costs on others, and failures in the financial system imposed costs on taxpayers and workers all over the world.

The third lesson is that Keynesian policies do work. Countries, like Australia, that implemented large, well-designed stimulus programs early emerged from the crisis faster. Other countries succumbed to the old orthodoxy pushed by the financial wizards who got us into this mess in the first place.

Whenever an economy goes into recession, deficits appear, as tax revenues fall faster than expenditures. The old orthodoxy held that one had to cut the deficit - raise taxes or cut expenditures - to "restore confidence." But those policies almost always reduced aggregate demand, pushed the economy into a deeper slump, and further undermined confidence - most recently when the International Monetary Fund insisted on them in East Asia in the 1990's.

The fourth lesson is that there is more to monetary policy than just fighting inflation. Excessive focus on inflation meant that some central banks ignored what was happening to their financial markets. The costs of mild inflation are miniscule compared to the costs imposed on economies when central banks allow asset bubbles to grow unchecked.

The fifth lesson is that not all innovation leads to a more efficient and productive economy - let alone a better society. Private incentives matter, and if they are not well aligned with social returns, the result can be excessive risk taking, excessively shortsighted behavior, and distorted innovation. For example, while the benefits of many of the financial-engineering innovations of recent years are hard to prove, let alone quantify, the costs associated with them - both economic and social - are apparent and enormous.

Indeed, financial engineering did not create products that would help ordinary citizens manage the simple risk of home ownership - with the consequence that millions have lost their homes, and millions more are likely to do so. Instead, innovation was directed at perfecting the exploitation of those who are less educated, and at circumventing the regulations and accounting standards that were designed to make markets more efficient and stable. As a result, financial markets, which are supposed to manage risk and allocate capital efficiently, created risk and misallocated wildly.

We will soon find out whether we have learned the lessons of this crisis any better than we should have learned the same lessons from previous crises.

Regrettably, unless the United States and other advanced industrial countries make much greater progress on financial-sector reforms in 2010 we may find ourselves faced with another opportunity to learn them.

Read the opinion piece on the China Daily website.

Posted by manualofideas at 10:59 PM | Permalink | Comments (0)