The Ideas Report For Serious Investors

 

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By Ravi Nagarajan

Despite a snowstorm that caused the absence of several speakers, the Columbia Investment Management Conference in New York today included many interesting presentations and panel discussions.  The highlight of the day was the conversation between Columbia Professor Bruce Greenwald and Martin Whitman, Founder and Portfolio Manager of Third Avenue Management.

Mr. Whitman has a sixty year history in the investment management field and represents a distinguished voice of experience we can all learn from.  This article includes several topics that were included in the discussion between Prof. Greenwald and Mr. Whitman but it is not a complete transcript and, unless otherwise noted, is based on the authors notes and recollection of the conversation rather than a presentation of direct quotes.

The Evolution of a Value Investor

Most investors who have arrived at a “value oriented” strategy moved toward the approach over a period of time.  Many of us know the story of Warren Buffett reading every book on investing in the Omaha library but not reaching the conclusion that value investing represents the best strategy until reading Ben Graham’s The Intelligent Investor in 1950.  A similar “evolution” was the case for Mr. Whitman who entered the business as a security analyst at Shearson, Hammil in 1950.  For the first four years, Mr. Whitman focused on many of the traditional benchmarks that security analysts today still concentrate on such as earnings per share growth and predicting near term price movements.

In 1955, Mr. Whitman read Between the Sheets by William J. Hudson which is a book (currently out of print) regarding the importance of paying particular attention to the balance sheet.  This book combined with several real life examples at the time convinced Mr. Whitman that emphasizing balance sheet quality should be more heavily considered in the field of security analysis.  Mr. Whitman also gained a great deal of experience working as a portfolio analyst for William Rosenwald starting in 1956. Experience in stockholder litigation and bankruptcy, fields that were shunned at the time, also provided important lessons regarding analyzing the capital structure of distressed firms.

“Cheap is Not Sufficient”

At several points in the discussion with Prof. Greenwald, Mr. Whitman came back to a central theme:  It is not sufficient for a security to be “cheap”.  It must also possess a margin of safety as demonstrated by a strong balance sheet and overall credit worthiness.   In other words, there are many securities that may appear cheap statistically based on a number of common criteria investors use to judge “cheapness”.  This might include current year earnings compared to the stock price, current year cash flow, and many others.  However, if the business does not have a durable balance sheet, adverse situations that are either of the company’s own making or due to macroeconomic factors can determine the ultimate fate of the company.  A durable balance sheet demonstrates the credit worthiness a business needs to manage through periodic adversity.

A New Take on Graham’s “Net-Nets”

Mr. Whitman believes that it is a “myth” that there are no “net-net” opportunities available in the market today.  We discussed Graham’s concept of net-nets in a prior article and came up with some examples of such opportunities over the past year (for example, see the articles on Hurco and George Risk Industries).  However, such opportunities are very rare and often exist only in the most thinly traded stocks and therefore are rarely actionable.

Rather than adhering to Ben Graham’s original concept of “net-nets”, Mr. Whitman has made a few modifications.  Instead of using current assets as the store of value, he looks at “readily ascertainable asset value” and tries to buy at a large discount to that value.  Assets that can be readily convertible to cash may include high quality real estate, for example.  In certain situations, assets such as real estate may be more valuable in a liquidation than inventories which are part of current assets but often highly impaired in distressed situations.

One other point that Mr. Whitman made while discussing corporate governance also applies to many net-net situations.  The true value of a company may never come out if there is no threat of a change in control.  This obviously makes intuitive sense because the presence of a very cheap company alone will not result in realization of value unless management is willing to act in the interests of shareholders either by liquidating a business that has no future prospects but a very liquid balance sheet or taking steps to improve the business.

When asked if the management of a typical public company is overpaid, Mr. Whitman said “you’d better believe it” due partly to the fact that most Boards of Directors are “a bunch of wimps, including me.”  This serves as a reminder that there is one other characteristic that many value investors share:  Humility and a willingness to admit 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.  

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It appears that the Volcker Rule is meeting a quick demise in the United States Senate only one month after it was initially proposed.  The Volcker Rule is designed to limit the proprietary trading activities of commercial banks.  A common complaint by opponents of the rule is that Paul Volcker made great contributions to the country during his tenure as Federal Reserve Chairman but is now too “out of touch” with modern finance and lacks credibility when it comes to reform proposals.  Rather than debating the merits of the proposal, many opponents of the rule are simply implying that Mr. Volcker is too old to have valid ideas.

“Out of Touch” or “Voice of Experience”?

Mr. Volcker did not seem “out of touch” in his recent lengthy interview with the Financial Times, but it seems like pundits are playing right into the scenario outlined in Charlie Munger’s latest parable (however, Mr. Munger is old as well and using the same line of “reasoning” he may also be “out of touch” with modern finance.)

Looking at the substance of the proposal rather than dwelling on Mr. Volcker’s age, it appears that he is advocating a simple rule based policy that seeks to prohibit entities with a commercial banking license from engaging in proprietary trading activities that could later require resolution by the FDIC or, in the case of “too big to fail” institutions, large cash infusions from the government:

“Don’t expect the support you would get from being a bank within the club of insured deposits and access to the Federal Reserve and all the loving attention you get as a bank organization” — Paul Volcker in Financial Times interview.

While it is true that there are cases where it may be unclear whether a financial institution is engaging in proprietary trading for its own account or acting on behalf of clients, a rule based principle such as the Volcker rule still has value in terms of setting the rules for the game and allowing the majority of financial institutions to adjust their business models accordingly.

Alternative Proposals are Unsatisfactory

The alternative proposals in the Senate are unsatisfactory because they do not offer a simple rule based regulation and instead direct regulators to micromanage banks in a manner that is likely to be ineffective and cumbersome.  According to an article in The Wall Street Journal, Chris Dodd (D., Conn.) and Bob Corker (R., Tenn.) are negotiating the framework of a structure that will continue to allow proprietary trading but would give regulators more discretion to limit or ban “risky trading” at banks particularly when systemic risks are evident.  Banks would be examined on a case-by-case basis and regulators would have the power to “limit or halt certain activities they felt were a systemic risk.”

After the events of the past two years, it is unclear why there are any grounds to believe that regulators will be able to understand the nature of proprietary trading books let alone selectively decide which positions pose a risk either to the financial institution in question or to the broader economy.  The riskiness of a proprietary position may not be evident without examining a series of hedges and offsetting positions that even top bank executives have had trouble monitoring in the past.

Is Regulatory Micromanagement Feasible or Desirable?

Even putting aside the question of whether such regulation is feasible, one must consider whether it is desirable from the perspective of economic efficiency and preservation of a capitalist model.  A  simple rule based regulation such as the Volcker Rule spells out the prohibited activity in clear terms and regulators are charged with enforcing this “blocking” regulation.  The alternative proposals have no simple rules but instead provide significant discretion to the regulators.  The regulators will then have to micromanage the activities of banks and guide them through the inevitable “gray areas”.  There will be ample opportunity for regulatory capture in such an environment.

The Volcker Rule is a modest attempt to reduce the overall level of risk in commercial banking and does not even approach the level of restrictions that were previously imposed under the Glass-Steagall Act.  The entire post WWII economic boom in the United States was achieved under a system in which Glass-Steagall was in place.  It is therefore unconvincing for opponents of the far more limited Volcker Rule to suggest that this modest regulation would harm the United States economy.

Those who support capitalism should support limited regulations that preserve the system or we may soon resemble the later years of “Basicland” in Charlie Munger’s parable.

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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Edward Lampert, Founder of ESL Investments and Chairman of Sears Holdings Corporation, has released his annual letter to shareholders.  Mr. Lampert’s investment style has often been compared to Warren Buffett’s approach particularly when it comes to capital allocation.  While many companies fail to adhere to disciplined capital allocation practices, Sears has taken a more intelligent approach.

Maintenance vs. Expansion Capital Expenditures

Mr. Lampert has been criticized for failing to make the necessary investments to keep Sears and K-Mart stores competitive.  Personal experience and anecdotal evidence does suggest that Sears Holdings retail properties are not necessarily the most modern facilities in many locations.  However, this fact alone does not automatically justify blindly committing funds to expansion or improvements beyond “maintenance” levels of capital expenditures:

I have written previously about what I believed was the reckless expansion of retail space leading to lower profitability for many retailers and to low or negative returns on the investment required to expand space. In other industries, consolidation rather than expansion has led to a more sensible competitive environment and better returns for shareholders. If you examine the level of capital expenditures over the past decade at many large retailers and compare that expenditure to value created, it would not paint a pretty picture.

Additionally, the dramatic declines in capital expenditures over the past couple of years at most large retailers are strong evidence that the level of maintenance capital expenditures for a big box retailer is materially below what many analysts and experts previously believed. Most of the capital spent over the past decade has been largely for store expansion, with some lesser amount required for maintaining existing stores.

The cost of updating or expanding properties must be weighed against the best possible alternative uses for the funds such as improving Sears’ strongest brands like Kenmore and Craftsman or authorizing share repurchases:

While we continued to repurchase shares during the economic crisis because the value was attractive and because we had significantly lower leverage than others in our industry, many of our competitors suspended their repurchase programs to appease credit rating agencies only to resume them again after their share prices recovered significantly.

Mr. Lampert also criticizes ratings agencies for simplistic analyses that automatically favor capital investment to share repurchases ignoring the fact that capital investment at negative rates of return can end up harming bondholders as well as stockholders.

Owner Orientation

While many executives only pay lip service to “shareholder value” and “management alignment with shareholder interests”, Mr. Lampert’s record and ownership interest in Sears Holdings serves to back up his claims.

We do some things differently than others, and we have certain beliefs that differ from theirs. Our culture is owner-oriented, because we have owners who serve on the board that governs the company. We believe that ownership makes a difference, especially when owners have significant financial interests in the company and a long-term perspective. Instead of this raising concern, rating agencies should welcome and value owners with a demonstrated track record of long-term value creation and conservative capital policies, even when some of the capital allocation preferences differ from those that others believe lead to higher long-term credit performance.

This is the type of owner orientation that makes it preferable to repurchase shares rather than plowing funds into capital expenditures at negative rates of return even though doing the latter is more popular within any organization in the short run and also will win the praises of local community leaders at ribbon cutting events.  The problem with companies that pursue popularity rather than intelligent capital allocation is that eventually the day of reckoning will arrive and the music will stop.

Regulation and Politics

Wading into more controversial topics, Mr. Lampert is critical of policies that may over-regulate the economy by placing government bureaucrats in place of private sector capital allocators when it comes to sustaining an economic recovery.  In terms of financial regulation, Mr. Lampert advocates the removal of the implicit “too big to fail” guarantee which would level the playing field.  However, it is unclear how the government can remove the “too big to fail” perception without some form of regulation to constrain financial institutions from reaching the size and interconnectedness that makes government bailouts inevitable.

Capital can quickly reorganize and provide financing for businesses and projects that create value for our society, without the heavy hand of government planning and policy. I disagree with most people calling for a gigantic overhaul of our financial system led by new and “improved” regulations. Instead, begin the process of allowing more competition in financial services and begin the removal of implicit and explicit government guarantees that provide the perception that some are “too big to fail.” While there are those that claim that their institutions are not too big to fail, they surely recognize the significant competitive advantages that come from this perception. Of course they will accept regulations as long as these regulations do not permit additional competition from entities and institutions that do not take insured deposits, do not have access to Federal Reserve funding, and do not have government guarantees associated with their debt offerings. Regulatory capture comes when there is little competition allowed outside regulated entities and a “freezing” of competitors and innovation in an industry.

Mr. Lampert also protest the special treatment given to Amazon.com and other online retailers that are not required to collect sales and use tax in locations where they do not have a physical presence.  It is difficult to argue with the logic behind treating traditional retailers and online retailers in a uniform manner and the observation that current practices will prove unsustainable as more commerce shifts online.

The real story here is that it is not the payment of taxes or the charging of taxes that is at issue. It is the collection of taxes on behalf of local governments from purchasers of goods and services from stores in a locality or for use in such locality. It is the latter fact that is often ignored. A person who buys products from Amazon.com is required by law to pay sales or use tax to their local jurisdiction. In practice, almost nobody does so. The cost and unpopularity of enforcing such laws has allowed customers to avoid paying sales or use taxes, even though they are required in many states and localities. If you buy a work of art or piece of jewelry in NYC, for example, and have it shipped to New Jersey or California, the seller does not collect sales tax on that purchase but the buyer would be required to pay sales or use tax on the purchase where they receive the merchandise and use the merchandise. So, a piece of jewelry shipped to California would require the buyer to pay California sales or use tax.

Mr. Lampert recommends Thomas Sowell’s latest book Intellectuals and Society.  Although I have not kept up with Mr. Sowell’s work in recent years, I consider one of his previous books, The Vision of the Anointed, to be one of the best essays on the mentality that often drives the decisions of those in high positions of power.

Click on this link to read Edward Lampert’s full letter to Shareholders.

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:  The author does not own shares of Sears Holdings.

Posted by manualofideas at 01:58 PM | Permalink | Comments (0)

Those who have followed the career of Berkshire Hathaway Vice Chairman Charlie Munger know that he has a long history of using parables to educate the public regarding business, economic, and political issues.  By far, the best compilation of Mr. Munger’s thoughts on business and life can be found in Poor Charlie’s Almanack, which is a must read book for anyone seriously interested in Berkshire Hathaway.  The latest Munger parable can be found on Slate.com and the story lacks a happy ending.

Basically, It’s Over:  A parable about how one nation came to financial ruin is obviously a warning regarding the current state of politics and economics in the United States.  The reader learns how a fictional nation named “Basicland” grew over a period of two hundred years through a system that mirrored the early United States with encouragement of trade, strong property rights, and a simple banking system.  Over time, a casino mentality took hold leading to speculative activity, high levels of debt, and a convoluted tax system perverted by the actions of special interests.

Does this sound familiar yet?

An elder statesman, the “Good Father” known as  “Benfranklin Leekwanyou Vokker”, attempted to talk some sense into Basicland’s leaders, but to no avail.  Eventually, Basicland came to be known as Sorrowland as the economic and political system collapsed.

As I read this obviously pessimistic warning to America, it slowly occurred to me that perhaps there is a contradiction between the latest parable and the optimism Mr. Munger expressed at last year’s Berkshire Hathaway annual meeting:

“As I move close to the edge of death, I find myself getting more cheerful about the economic future,” Munger, aged 85, said.  Munger sees “a final breakthrough that solves the main technical problem of man,” he continued. By harnessing the power of the sun, electrical power will become more available around the world. That will help humans turn sea water into fresh water and eliminate environmental problems, Munger explained.

Putting aside the “edge of death” quip, this indeed was an optimistic comment showing great faith in the future prospects of mankind.

Upon further reflection, it dawned on me that there may not be any contradiction at all.  Mr. Munger could very well be cheerful about the economic future for mankind while simultaneously holding negative views regarding the economic future of the United States.  After all, one of the companies in Berkshire Hathaway’s portfolio that is directly engaged in many of the “final breakthroughs” that Mr. Munger talked about is BYD, a Chinese company.

Perhaps if the political leaders in Washington are unwilling to listen to “Benfranklin Leekwanyou Vokker”, they will pay attention to Mr. Munger instead.  Better yet, someone may want to nominate Mr. Munger for the commission looking into solving the country’s fiscal problems.  Of course, this will never happen because common sense is  not a highly regarded virtue in Washington 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.

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During the hurricane season, the news media often reports forecasted losses even before a storm makes landfall.  The same was not true during the epic blizzards that impacted the Mid-Atlantic states earlier this month.  While there were a number of reports regarding damage to individual structures, few estimates were made regarding aggregate damages.

Official loss estimates for the storms will not be available until next week, but preliminary estimates reported by P&C National Underwriter Magazine peg the total at a minimum of $2 Billion. Each storm is being categorized as a separate catastrophe since each storm is likely to result in at least $25 million in insured losses.

Most of the losses are expected to come from roof damage, broken pipes, and ice dams forming in rain gutters which often result in flooding of structures.  Many structures in the Mid-Atlantic and South are not constructed with enough strength to withstand the types of snow loads experienced in recent weeks.  Warmer temperatures have returned to the region in recent days which has helped with snow melt.

Business interruption insurance is likely to generate significant losses.  Many areas of the Mid-Atlantic were crippled for days which prevented workers from commuting.  Many retail businesses had empty shelves for close to a week due to resupply problems caused by snowbound roads.

Winter storms typically cause $1 Billion in damages each year and are the third largest cause of catastrophe losses behind hurricanes and tornadoes.

Please click on this link to read P&C National Underwriter’s article.

Posted by manualofideas at 11:58 AM | Permalink | Comments (0)

The Birmingham Business Journal has reported that Burlington Northern Santa Fe has purchased a 32 acre facility in Birmingham for $3 million.  The company is in the process of evaluating the facility for future expansion.  The site is a former pet food manufacturing facility and is located next to Burlington Northern’s existing intermodal facility.  The railroad has received requests from area businesses that are interested in expanded rail service.

Burlington Northern was acquired by Berkshire Hathaway in a deal that was finalized on February 12.  The purchase of the railroad was characterized by Berkshire Hathaway Chairman and CEO Warren Buffett as an “all-in wager on the economic future of the United States”.  The purchase price was not without controversy because it appeared to be a full price.  We recently made the case that the purchase may have been motivated by an intention to increase capital expenditures with Berkshire’s backing in order to pursue more rapid expansion.

While a $3 million purchase by Burlington Northern is hardly a large move and was probably planned prior to Berkshire’s offer for the company, the location of the expansion is notable because Birmingham is at the outer periphery of Burlington Northern’s route network.  In addition to Burlington Northern, Norfolk Southern and CSX Transportation have a significant presence in the city.  As one can see from Burlington Northern’s route network pictured below, expansion in Birmingham may lead to other interesting possible expansion activity in the deep South.

Click on the map or on this link for a more detailed set of BNSF Route Maps.

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 11:56 AM | Permalink | Comments (0)

Swiss Re announced annual results for 2009 yesterday and declared that the measures taken in 2009 to rebuild the company’s capital base have been very effective.  In a letter to shareholders, Swiss Re Chairman Walter B. Kielholz and CEO Stefan Lippe made the following comments regarding the company’s capital position and intention to redeem the CHF 3 billion investment made by Berkshire Hathaway last year:

The measures we have taken to rebuild our capital base have proven to be very effective. In 2009, our capital position improved steadily quarter by quarter. At year end, estimated excess capital at AA level was more than CHF 9 billion. This means we are on schedule to meet our goal of redeeming the CHF 3 billion convertible perpetual capital instrument (CPCI) issued to Berkshire Hathaway.

We originally discussed the terms of Berkshire’s investment in March shortly after the terms of funding were announced, and revisited the status of the investment in January when J.P. Morgan analysts released a report stating that Swiss Re was on track to redeem the investment by June 2010.

Redemption Comes at a Stiff Price

The terms of the convertible perpetual capital instrument reflect the distress facing Swiss Re at the time the funding was provided.  With a 12% interest rate and the right to convert into common shares at CHF 25 (nearly 50 percent below today’s quotation) after the third anniversary of the investment, Berkshire secured highly favorable terms.

Swiss Re has the right to redeem the instrument, but at a stiff price.  Swiss Re must pay 140% of face value if the company elects to redeem the instrument prior to March 23, 2011 and at 120% of face value thereafter.  Barring a collapse in the price of Swiss Re common stock, is nearly certain that Swiss Re management would want to redeem prior to March 23, 2012 when Berkshire will have the right to convert into common shares.

From the shareholder letter referenced above, it appears that the J.P. Morgan analysts  were correct in forecasting a near term redemption of the instrument although Swiss Re management does not explicitly state the timing of redemption.

Other Business Ties

Berkshire Hathaway and Swiss Re have other business ties beyond the convertible instrument discussed in this article.  Berkshire entered into an agreement with Swiss Re in 2009 for a retroactive reinsurance policy for CHF 2 billion covering substantially all of Swiss Re’s non-life insurance losses for loss events occurring prior to January 1, 2009.  In addition, Berkshire has a 20% quota-share contract with Swiss Re covering substantially all of Swiss Re’s property/casualty risks incepting from January 1, 2008 and running through December 31, 2012.  Berkshire also owned 11,262,000 shares of Swiss Re common stock as of December 31, 2008.

Update:  February 19, 2010 @ 3pm

The Street.com and Reuters are reporting that Swiss Re CFO George Quinn indicated that the company will redeem the preferred convertible security in 2011.  Presumably, Swiss Re would want to wait until at least March 23, 2011 to pay 120% of face value rather than the 140% that would be required for redemption at an earlier date.

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:  The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 11:54 AM | Permalink | Comments (0)

By Greenbackd

Jae Jun at Old School Value has updated his great post back-testing the performance of net current asset value (NCAV) against “net net working capital” (NNWC) by refining the back-test (see NCAV NNWC Backtest Refined). His new back-test increases the rebalancing period to 6 months from 4 weeks, excludes companies with daily volume below 30,000 shares, and introduces the 66% margin of safety to the NCAV stocks (I wasn’t aware that this was missing from yesterday’s back-test, and would explain why the performance of the NCAV stocks was so poor).

Jae Jun’s original back-test compared the performance of NCAV and NNWC stocks over the last three years. He calculated NNWC by discounting the current asset value of stocks in line with Graham’s liquidation value discounts, but excludes the “Fixed and miscellaneous assets” included by Graham. Here’s Jae Jun’s NNWC formula:

NNWC = Cash + (0.75 x Accounts receivables) + (0.5 x  Inventory)

Here’s Graham’s suggested discounts (extracted from Chapter XLIII of Security Analysis: The Classic 1934 Edition “Significance of the Current Asset Value”):

As I noted yesterday, excluding the “Fixed and miscellaneous assets” from the liquidating value calculation makes for an exceptionally austere valuation.

Jae Jun has refined his screening criteria as follows:

Volume is greater than 30k

NCAV margin of safety included

Slippage increased to 1%

Rebalance frequency changed to 6 months

Test period remains at 3 years

Here are Jae Jun’s back-test results with the new criteria:

For the period 2001 to 2004

For the period 2004 to 2007

For the period 2007 to 2010

It’s an impressive analysis by Jae Jun. Dividing the return into three periods is very helpful. While the returns overall are excellent, there were some serious smash-ups along the way, particularly the February 2007 to March 2009 period. As Klarman and Taleb have both discussed, it demonstrates that your starting date as an investor makes a big difference to your impression of the markets or whatever theory you use to invest. Compare, for example, the experiences of two different NCAV investors, one starting in February 2003 and the second starting in February 2007. The 2003 investor was up 500% in the first year, and had a good claim to possessing some investment genius. The 2007 investor was feeling very ill in March 2009, down around 75% and considering a career in truck driving. Both were following the same strategy, and so really had no basis for either conclusion. I doubt that thought consoles the trucker.

Jae Jun’s Old School Value NNWC NCAV Screen is available here (it’s free).

Posted by manualofideas at 11:50 AM | Permalink | Comments (0)

Kansas City Federal Reserve President Thomas M. Hoenig has been a voice in the wilderness for some time.  Mr. Hoenig was the only dissenter of the policy action at the January meeting of the Federal Open Market Committee because he believes that economic and financial conditions no longer warrant the Federal Reserve’s commitment to keep the federal funds rate at “exceptionally low” levels for an extended period of time.  Last year, Mr. Hoenig gave a speech outlining alternatives to the “too big to fail” doctrine that has become conventional wisdom in Washington.

In a speech in Washington yesterday, Mr. Hoenig argues that there are only three options for dealing with the unsustainable fiscal situation:  Have the Federal Reserve print money to monetize the national debt;  do nothing as long as markets are willing to fund borrowing at inevitably higher interest rates; or act now to implement programs that restore balance to fiscal policy.  A few excerpts from the speech are provided below.

Fiscal Irresponsibility Threatens Fed Independence

The question of what combination of spending and revenue actions the country might choose is the purview of Congress and the executive branch. As a central banker, it is my responsibility to anticipate and avoid the consequences that an unchecked expansion of the debt may have on monetary policy. It is a fact that the current outlook for fiscal policy poses a threat to the Federal Reserve’s ability to achieve its dual objectives of price stability and maximum sustainable long-term growth, and therefore is a threat to its independence as well.

The founders of the Federal Reserve understood this conflict. They understood that placing the printing press with the power to spend was a formula for fiscal and financial disaster. Aware of this danger, they designed our central bank to be responsible for stable prices and long term growth, and they gave it a degree of independence so that it could carry out this mandate.

Unprecedented Mountain of Debt

The immediate concern is the size of the deficit. The CBO projects the deficit was almost 12 percent of GDP in fiscal year 2009 and will be almost 8 percent in the current fiscal year—extraordinarily high levels by historical standards. In the entire history of the United 6 States, the government has run deficits over 10 percent of GDP in only a few instances, and usually only during or immediately following a major war.

As troubling as these deficits appear, even more disconcerting is the longer-term outlook for the federal debt caused by the accumulation of these deficits over time. The CBO’s long term debt projections clearly show that current fiscal policies are unsustainable. In one scenario, the liftoff point for federal debt—that is, the time when debt starts rising without any sign of stabilizing—occurs shortly after 2020. By 2035, federal debt held by the public reaches 80 percent of GDP—a level only exceeded during and just after World War II. In another, more pessimistic scenario, the liftoff in debt has already begun, with federal debt held by the public reaching 181 percent of GDP in 2035, easily exceeding the peak debt to GDP ratio of 113 percent that occurred at the end of World War II.

Importance of Maintaining Fed Independence

In the United States, the Federal Reserve’s policies in the early 1980s provide a vivid example of the benefits that arise from the exercise of central bank independence. During this time, high interest rate policies designed to lower inflation were deeply unpopular both among elected leaders and the broad public. But the Federal Reserve was able to exercise its independence and pursue long-term goals which systematically reduced inflation and changed the psychology of the nation regarding its expectation about inflation’s path. As a result, the United States has had nearly three decades of low inflation.

Will Corrective Action Occur Before or After a Profound Crisis?

Unfortunately, nations often must experience a profound crisis to focus the government’s attention on taking corrective action. Usually it is at this point that governments reestablish fiscal discipline and renew their commitment to an independent central bank. Ironically, however, these generally are precisely the reforms that would have prevented a crisis in the first place. The only difference between countries that experience a fiscal crisis and those that don’t is the foresight to take corrective action before circumstance and markets harshly impose it upon them. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door.

For the full text of Thomas Hoenig’s speech, please click on this link.

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By Ravi Nagarajan

Note to Readers:  The following essay is part of an introductory section of an upcoming analysis of Berkshire Hathaway to be published by The Rational Walk shortly after the 2009 Berkshire Hathaway Annual Report is released at the end of February.  The full analysis will be available for purchase as premium content with certain excerpts to be provided on The Rational Walk blog free of charge.

For a formatted PDF File of the following essay, please click on this link.

From Cigar Butts to Business Supermodels

There are numerous books and publications that provide detailed accounts of the history of Berkshire Hathaway as well as Warren Buffett’s life and career.  It is also impossible to fully understand Berkshire without studying the life and career of Vice Chairman Charles T. Munger.  A list of resources for those interested in a comprehensive history of the company and its leaders is provided as an appendix to this document (available in the forthcoming full analysis).  This section merely attempts to provide some context regarding the remarkable history of Berkshire Hathaway and Warren Buffett’s investment approach.

Warren Buffett’s Early Investment Philosophy

Warren Buffett’s early investment philosophy was largely based on the principles developed by Benjamin Graham.  Mr. Buffett has stated on many occasions[1] that his view of investing changed dramatically when he first read Mr. Graham’s book, The Intelligent Investor, in early 1950.  Up to that point, Mr. Buffett had read every book on investing available at the Omaha public library but none were as compelling as Mr. Graham’s straight forward approach summarized in the phrase: “Margin of Safety”.

Benjamin Graham’s approach is more fully documented in Security Analysis which, in contrast to The Intelligent Investor, is more targeted toward professional investors.  Mr. Graham’s approach involved examining securities from a quantitative perspective and making purchases only when downside risks are minimized.  This approach rarely involved speaking to management since doing so could adversely influence the analyst’s impartial view of the data.  In particular, Mr. Graham was a proponent of purchasing stocks selling well under “net-net current asset value” arrived at by taking a company’s current assets and subtracting all liabilities.  In such cases, the buyer was paying nothing for the business as a going concern and had some downside protection due to liquid assets far in excess of all liabilities.

Mr. Buffett was able to leverage the “deep value” approach advocated by Benjamin Graham throughout the 1950s.  In the five year period ending in 1961, the Buffett Partnerships trounced the Dow Jones Industrial average with a cumulative return of 251 percent compared to 74.3 percent for the Dow[2].  While Mr. Buffett employed multiple strategies, one approach involved finding companies that fit the “cigar butt” mold, meaning that they had “one puff left” and could be purchased at a deep bargain price.  This approach led Mr. Buffett to begin acquiring shares of Berkshire Hathaway, a struggling New England textile manufacturer, in late 1962. While Berkshire Hathaway was trading well under book value at the time, Mr. Buffett would later say that book value “considerably overstated” intrinsic value[3].

From Cigar Butts to Insurance

Berkshire Hathaway, as it existed in 1963 when the Buffett Partnership became the company’s largest shareholder, was a cheap company from a quantitative perspective but it was not a good company in terms of offering a business that had durable competitive advantages.  In fact, over the next two decades, Berkshire Hathaway continued to invest in the textile mills but would never gain sufficient traction to complete with overseas competitors with lower cost structures.  Textiles are a commodity business and the low price producer has the advantage.  In retrospect, Mr. Buffett’s purchase of Berkshire Hathaway was a mistake[4].

While Berkshire’s textile mills were doomed to eventual failure, a period of profitability[5] appeared in the mid to late 1960s that presented Mr. Buffett with a choice:  He could either reinvest the profits in the textile business or redeploy the funds elsewhere.  Above all else, Mr. Buffett is a master capital allocator.  He could see the troubles brewing in textiles and, despite attempts by Berkshire’s textile managers to obtain capital for new investments, Mr. Buffett chose to deploy the funds elsewhere.

Berkshire’s entry into the insurance business with the purchase of National Indemnity in 1967[6] was a transformational event for the company.  The textile business, despite a temporary period of profitability, required significant capital investments to continue to remain competitive.  In contrast, insurance operations that are well run generate significant cash in the form of “float”.  Float represents funds that are held by an insurance business between the time when policyholders submit payment and when funds are eventually paid out to settle claims.  As long as underwriting practices are sound, float represents a low cost means of funding investments.  By purchasing National Indemnity, Berkshire was on its way to transforming from a textile manufacturer consuming large amounts of capital at low to negative rates of return into an insurance powerhouse generating large amounts of float for investment in other businesses offering better prospects of high returns.

See’s Candies:  The Turning Point

Few Californians can recall a holiday season where See’s Candies were not a prominent part of the festivities.  The brand is so powerful in California and other western states that many consumers would never think of buying a competing product.  See’s Candies is a textbook example of a company with a formidable “moat”.  Such companies have built up brand identity that cannot be replicated by new entrants even with significant capital investments[7].

Berkshire Hathaway Vice Chairman Charles Munger has been widely credited with convincing Warren Buffett that there are certain situations where deviating from Benjamin Graham’s “deep value” approach can be justified.  Mr. Munger has rebutted[8] the notion that his influence was a deciding factor in Mr. Buffett’s overall record, but many accounts[9] of the events surrounding the See’s Candies purchase supports the conclusion that Charlie Munger deserves much credit for shifting Berkshire’s bias from cigar butts selling at a “bargain price” to excellent businesses selling at a “fair price”.

See’s Candies is the perfect example of a business that produces an excellent return on equity year after year but requires very little capital investment in order to sustain the “moat” that makes such returns possible.  When Berkshire purchased See’s Candies for $25 million in 1972, the company only had $8 million of net tangible assets.  However, See’s was earning approximately $2 million after tax at the time[10].   $17 million of the $25 million purchase price could not be accounted for by assets on See’s balance sheet but represented the value represented by intangible “brand equity”.

Over the first twenty years of Berkshire’s ownership of See’s Candies, sales increased from $29 million to $196 million while pre-tax profits grew from $4.2 million to $42.4 million.  However, that is not even the most amazing part of the story.  What is more remarkable is that Berkshire Hathaway only had to reinvest $18 million of retained earnings over that twenty year period while $410 million of cumulative pre-tax earnings were sent back to Berkshire for redeployment in other investments[11].

There have been many other key turning points in the history of Berkshire Hathaway but the decision to pay a “premium price” for See Candies in 1972 may best symbolize the transformation of Mr. Buffett’s approach toward investing.  This is perfectly summarized in Mr. Buffett’s 1992 Letter to Shareholders:

In my early days as a manager I, too, dated a few toads.  They were cheap dates – I’ve never been much of a sport – but my results matched those of acquirers who courted higher-priced toads.  I kissed and they croaked.

After several failures of this type, I finally remembered some useful advice I once got from a golf pro (who, like all pros who have had anything to do with my game, wishes to remain anonymous).  Said the pro:  “Practice doesn’t make perfect; practice makes permanent.”  And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.

Berkshire Hathaway is the company it is today because Mr. Buffett stopped kissing toads like the original Berkshire textile business and started aggressively pursuing supermodels like See’s Candies instead even if they were more “expensive dates”.  As we shall see, Berkshire has no shortage of supermodels today.

[1] For example, see Mr. Buffett’s preface to any recent edition of The Intelligent Investor.
[2] The Buffett Partnership track record is available in many publications.  See, for example, Roger Lowenstein’s Buffett: The Making of an American Capitalist, 1995 Hardcover Edition, Page 69.
[3] See comment in Berkshire Hathaway Owner’s Manual, Page 5.
[4] Mr. Buffett directly stated that buying Berkshire was a mistake in his 1989 letter to shareholders.
[5] See Lowenstein, Page 133.
[6] For a good history of the National Indemnity purchase, see Lowenstein, pages 133 to 135.
[7] For an excellent brief history of See’s Candies, see Max Olson’s paper entitled Quality without Compromise.
[8] See Mr. Munger’s statement in Poor Charlie’s Almanack, Third Edition, “Rebuttal:  Munger on Buffett”
[9] For example, see Alice Schroeder’s account of the See’s Candies purchase in Snowball:  Warren Buffett and the Business of Life, Chapter 34.
[10] See the appendix to Warren Buffett’s 1983 Letter to Shareholders.
[11] See Warren Buffett’s 1991 Letter to Shareholders.

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: The author owns shares of Berkshire Hathaway.

Posted by manualofideas at 11:18 AM | Permalink | Comments (0)

It might be fair to say that certain credit ratings were a bit off the mark...

Read the related Economist article.

Posted by manualofideas at 10:14 PM | Permalink | Comments (0)

Toyota’s recalls in recent weeks have attracted a predictable amount of attention given the number of impacted vehicles on the road.  Rarely a day goes by when Toyota’s latest woes are not reported on the front page of The Wall Street Journal and on television news reports.  For a company that has built its reputation on safety and dependability, the recalls are particularly damaging.

Building a Brand

It often takes decades for a company to build brand awareness and this is certainly the case for Toyota vehicles in the United States.  While the company has been in business since 1937, it was not associated with high quality until the 1980s.  In fact, the company’s cars were widely ridiculed during the 1960s and 1970s particularly by Detroit auto executives who considered the United States market to be “owned” by the Big Three.

In recent years, the Toyota Camry has often been the best selling passenger car in the United States.  Consumers who selected the Camry were not buying it for driving excitement but due to Toyota’s reputation for reliability and economy.  I purchased a 2003 Toyota Camry as a commuter car.  The vehicle had all the excitement of a common household appliance such as a toaster but it never let me down. (It should be noted that the 2003 Camry is not part of the recall.  I have since sold the Camry and purchased a Ford Mustang offering more “driving excitement”).

Decades to Build, Days to Destroy

Unfortunately, what can take decades to build up can be destroyed very quickly.  This is particularly true if problems are revealed that destroy the salient qualities of the brand.  In the case of Toyota, a recall related to safety and reliability harm the foundation of the brand.  This is not a peripheral quality issue such as a radio that breaks.  The problems, while very rare, are potentially life threatening.

From this perspective, the problems are not unlike the famous case study involving the Tylenol cyanide poisonings in 1983.  Johnson & Johnson’s response to the incident has been widely praised as the model for crisis management.  Indeed, the company’s prompt actions to prevent tampering in the future may have even strengthened the brand.

Of course, the main difference between the current Toyota recall and the Tylenol incident is that the car recall is likely due to a flaw in either Toyota’s engineering or the engineering of a sub-contractor rather than the result of criminal tampering.  This makes it even more critical for Toyota to take particularly forceful action to deal with the recall.

Toyota needs to rebuild the trust consumers used to have in its products.  Conducting a recall is the bare minimum required to rebuild that trust.  The company should consider taking additional steps to encourage consumers to stick with the brand.  This might include giving away free services to consumers to encourage people to bring in affected vehicles for timely recall repairs.  An extension of the factory warranty would also represent a forceful action.

Brands and Reputation are Fragile

Barron’s published an annual ranking of the world’s most respected companies this weekend.  Toyota ranked #6 on the list but the survey was completed prior to the recent recall announcements.  If the survey was taken again today, there is little doubt that Toyota’s ranking would fall.  However, the extent of that fall is something that management should be able to influence with prompt action.

From an investment perspective, Toyota’s troubles illustrate the importance of selecting management that will protect the value of a brand.  If one is paying for a significant amount of intangible assets when purchasing a business, it is critical to know that managers of the business are committed to protecting those assets.  The power of great brands is indisputable and it is often worth paying for intangible assets that  provide a business with a moat, but only if management can be trusted  to protect the asset.

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 does not own shares of Toyota.

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

Andrew Frye of Bloomberg writes,

Matthew Rose, chief executive officer of railroad Burlington Northern Santa Fe Corp., welcomed Warren Buffett as his company’s new owner while showing analysts and hedge-fund managers the door.

Buffett’s Berkshire Hathaway Inc. completed the buyout yesterday after winning the approval of Burlington Northern investors. The deal, valued at $100 a share, allows Rose to hand out returns of nearly 300 percent, plus dividends, to investors who bought stock the day he was named CEO in 2000. The problem, he said, is that shareholders with that length of commitment are dwindling in number and influence.

"When I started as CEO 10 years ago, the typical investor had a time frame of three to five to seven years," Rose said in an interview. "Year-by-year, that’s gotten shorter."

The increased focus on short-term results, fueled by real- time media and quarterly analyst calls, can be a distraction for a railroad executive who needs to buy locomotives that run for 20 years and put down tracks that last for 40, Rose said.

Read the full Bloomberg article.

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

The Manual of Ideas: Are there any books on value investing, particularly globally oriented investing, that you have found valuable but investors may not be broadly familiar with?

Ori Eyal: Reading voraciously is a characteristic that all great investors share in common. There is simply no better way to gain wisdom and learn about the world than to read great books.

For international investing, Jim Rogers’s earlier books, Investment Biker, Adventure Capitalist, and Hot Commodities are good. The Economist is a great weekly magazine to read and learn about the world. I also think Mohnish Pabrai’s The Dhandho Investor and Joel Greenblatt’s You Can Be a Stock Market Genius are great investing books.

Economics is a key investing skill so I think everyone should read Milton Friedman, especially his books Capitalism and Freedom and Free to Choose.

Trying to forecast what the future will look like is an important investing skill. To this end I recommend books by Ray Kurzweil, Fantastic Voyage and The Singularity Is Near. Bill Gates has called Ray Kurzweil “the best person I know at predicting the future of artificial intelligence.”

To broaden your latticework of mental models, I highly recommend books by Richard Dawkins, Jared Diamond, Richard Feynman, Michael Pollan and John Brockman. I also think Buzzmarketing by Mark Hughes and Influence by Robert Cialdini are must read books.

Finally, I highly recommend the fantastic publications by The Manual of Ideas: Downside Protection Report, Portfolio Manager’s Review, etc. I also think that Value Investor Insight is great.

Read a sample issue of Downside Protection Report.

Read a sample issue of Portfolio Manager's Review.

Posted by manualofideas at 03:45 PM | Permalink | Comments (0)

Posted by manualofideas at 03:31 PM | Permalink | Comments (0)

By Greenbackd

Regular readers of Greenbackd know that I’m no fan of “the narrative,” which is the story an investor concocts to explain the various pieces of data the investor gathers about a potential investment. It’s something I’ve been thinking about a great deal recently as I grapple with the merits of an investment in Japanese net current asset value stocks. The two arguments for and against investing in such opportunities are as follows:

Fer it: Net current asset value stocks have performed remarkably well throughout the investing world and over time. In support of this argument I cite generally Graham’s experience, Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update paper, Testing Ben Graham’s Net Current Asset Value Strategy in London, a paper from the business school of the University of Salford in the UK, and, more specifically, Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values, James Montier’s Graham’’s net-nets: outdated or outstanding?, and Dylan Grice’s Are Japanese equities worth more dead than alive.

Agin it: Japan is a special case because it has weak shareholder rights and a culture that regards corporations as “social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.” In support of this argument I cite the recent experiences of activist investors in Japan, and Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values (yes, it supports both sides of the argument). Further, the prospects for Japan’s economy are poor due to its large government debt and ageing population.

How to break the deadlock? Montier provides a roadmap in his excellent Behavioural Investing:

We appear to use stories to help us reach decisions. In the ‘rational’ view of the world we observe the evidence, we then weigh the evidence, and finally we come to our decision. Of course, in the rational view we all collect the evidence in a well-behaved unbiased fashion. … Usually we are prone to only look for the information that happens to agree with us (confirmatory bias), etc.

However, the real world of behaviour is a long way from the rational viewpoint, and not just in the realm of information gathering. The second stage of the rational decision is weighing the evidence. However, as the diagram below shows, a more commonly encountered approach is to construct a narrative to explain the evidence that has been gathered (the story model of thinking).

Hastie and Pennington (2000) are the leading advocates of the story view (also known as explanation-based decision-making). The central hypothesis of the explanation-based view is that the decision maker constructs a summary story of the evidence and then uses this story, rather than the original raw evidence, to make their final decision.

…

All too often investors are sucked into plausible sounding story. Indeed, underlying some of the most noted bubbles in history are kernels of truth.

As to the last point, arguably, the converse is also true. Investors have missed some great returns because the ugly stories about companies or markets were so compelling.

There are several points that are not contentious about an investment in Japan. The data suggests to me and to everyone else that there are a large number of net current asset value bargains available there. The contention is whether these net current asset value stocks will perform as they have in other countries, or whether they are destined to remain net current asset value bargains, the classic “value traps.” My own penchant for value investing, and quantitative value investing in particular, makes this a reasonably simple matter to resolve. I am going to invest in Japanese net current asset value stocks. Here are the bases for my reasoning:

• I believe that value investing works. I believe that this is the case because it appeals to me as a matter of logic. I also believe that the data supports this position (see Ben Graham’s Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk). Where a stock trades at a significant discount to its value, I am going to take a position.
• I believe that Graham’s net current asset value works. In support of this proposition I cite the papers listed in the “Fer it” argument above.
• I believe that simple quantitative models consistently outperform expert judgements. In support of this proposition generally I cite James Montier’s Painting By Numbers: An Ode To Quant. Where the data looks favorable to me, I am going to take a position, and I’m going to ignore the qualitative factors.
• I believe that value is a good predictor of returns at a market level. In support I cite the Dimson, Marsh and Staunton research. I am not dissuaded from investing in a country simply because its growth prospects are low. Value is the signal predictor of returns.

The arguments militating against investing in Japan sound to me like the arguments militating against any investment in a NCAV stock, which is to say that they are arguments rooted in the narrative. I’ve never taken a position in a NCAV stock that had a good story attached to it. They have always looked ugly from an earnings or narrative perspective (otherwise, they’d be trading at a higher price). As far as I can tell, this situation is no different, other than the fact that it is in a different country and the country has economic problems (which I would ignore in the usual case anyway). While the research specific to NCAV stocks in Japan is not as compelling as I would like it to be, I always bear in mind the lessons of Taleb’s “naive empiricist,” which is to say that the data are useful only up to a point.

This is not to say that I have any great conviction about Japan or Japanese net current asset value stocks. Far from it. I fully expect, as I always do when taking a position in any stock, to be wrong and have the situation follow the narrative. Fortunately, the decision is out of my hands. I’m going to follow my simple quantitative model – the Graham net current asset value strategy – and take some positions in Japanese net nets. The rest is for the goddess Fortuna.

Posted by manualofideas at 12:26 PM | Permalink | Comments (2)

The Financial Times has published a five part video interview with Paul Volcker who is the head of President Obama’s Economic Recovery Advisory Board.  Mr. Volcker discusses his proposed “Volcker Rule” which would limit the proprietary trading activities of commercial banks.  For institutions such as Goldman Sachs that may wish to avoid the ban on proprietary trading, Mr. Volcker suggests that they will have to do so without the benefits of a commercial banking license:

“Don’t expect the support you would get from being a bank within the club of insured deposits and access to the Federal Reserve and all the loving attention you get as a bank organization.”

In addition, he characterizes the resolution process for non-banks as “euthanasia rather than life support” implying that regulators will have the authority to quickly take over and close down a non-bank in an orderly manner.  While it is not clear whether the Volcker Rule will pass in its proposed form, Mr. Volcker’s views are now clearly influencing the President’s policy choices.  This was not the case for much of 2009.

Click on the image below or on this link to view the first part of the interview.  Additional segments of the interview are available on the Financial Times website.

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 10:53 AM | Permalink | Comments (0)

Want to know which countries are the major coffee growers? Or who imports the most potash? The interactive agriculture and fertilizer markets map courtesy of Potash Corp. (POT) provides global crop and fertilizer data in a visual and user-friendly way. Launch World Agriculture and Fertilizer Map.

During our research on leading agriculture-related companies including Potash Corp. and Monsanto (MON), we have come across many interesting facts about global agriculture. For example, did you know that the average yield per acre of planted corn is 157 bushels in the U.S. versus 35 in India? But even the developed countries of the European Union are at "just" 105 bushels per corn acre. There are certainly many factors that explain these differences in crop yield including: seed quality, fertilizer application, use of chemicals for weed and insect control, level of mechanization, and, of course, inherent land quality and other natural factors. So how do companies like Potash Corp. and Monsanto fit into all of this? Are they potentially good investments given the anticipated growth of the agriculture industry to meet rising food demand worldwide? We provide investment cases for Potash Corp. and Monsanto in the forthcoming monthly issue of Portfolio Manager's Review.

To get in-depth analysis on Potash Corp. and Monsanto (as well as 20+ additional, non-agriculture stocks), subscribe to Portfolio Manager's Review today.

Disclosure: No positions.

Posted by manualofideas4 at 09:30 AM | Permalink | Comments (0)

Last month, we posted Matt Darrah's investment case for Corporate Executive Board (EXBD). This month, Matt is back with a well-researched and thoughtful piece on farm products company Bunge (BG). Matt argues that the risks of owning Bunge outweigh any potential upside and that investors should be cautious about investing in the company.

Please note that The Manual of Ideas does not advocate short selling, as it is a risky strategy that can backfire and cause significant losses for investors, even if their thesis is proven correct in the long term. As such, we present Darrah's research piece in order to show you the investment risks that can sometimes be uncovered as a result of in-depth fundamental research. The Manual of Ideas has not verified the data and quotations presented in the following write-up and can therefore not vouch for their accuracy.

Executive Summary

• Low Return on Invested Capital: Total invested capital does not produce meaningful amounts of cash flow. BG operates in a highly competitive industry, where it cannot materially differentiate itself.
• Unattractive Valuation: Recent stock price implies less than 4% normalized free cash flow yield. The market seems to be ignoring Bunge’s lack of historical free cash flow generation.
• Numerous Potential Catalysts Could Drive Stock Price Lower: Multiple sources confirm Bunge has large and speculative derivative (future and options) holdings that could result in material losses. Accounting results do not reflect the economic realities of the business, and Wall Street will eventually figure this out. BG recently sold a key division to avoid a liquidity crisis.

Bunge Company Overview

Bunge Limited (“Bunge” or “BG”) engages in the agribusiness, fertilizer, and food business.

Bunge Business Segments (% of 2009 revenue)

Source: Matt Darrah's investment newsletter, January 2010.

Bunge’s Agribusiness segment (73% of 2009 revenue) purchases, stores, transports, processes, and sells agricultural commodities and commodity products. Bunge principally handles and/or processes oilseeds and grains. It primarily deals in soybeans, rapeseed (canola), sunflower seed, wheat, and corn. The division processes those oilseeds and grains into vegetable oils and protein meals, principally for the food and animal feed industries. This segment also processes sugar and corn into bio-fuels. The Agribusiness division’s main competitors are Archer Daniels Midland Co. (ADM), Cargill Incorporated, and Louis Dreyfus Group.

Bunge’s Edible Oil segment (15% of 2009 revenue) uses the soybean, sunflower, and rapeseed (canola) oil produced in its Agribusiness segment for packaged and bulk oils, shortenings, margarines, mayonnaise, and other products derived from the vegetable oil refining process. Bunge owns and/or operates edible oil refining and packaging facilities in North America, South America, Europe, and Asia. It sells retail edible oil products in Brazil under a number of brands, including Soya, which is the leading packaged vegetable oil brand. Bunge possesses the highest market share in the Brazilian margarine market with its brands Delicia and Primor. One brand, Bunge Pro, has become the top foodservice shortening brand in Brazil.

In Europe, Bunge leads the market in consumer packaged vegetable oils, which are sold in various geographies under brand names including Venusz, Floriol, Kujawski, Olek, Unisol, Ideal, and Oleina.

In Asia, Bunge’s primary edible oil product brands include Dalda and Chambal in India, and the Douweijia brand soybean oil in China. In several regions, Bunge also sells packaged edible oil products to grocery store chains for sale under those stores’ private labels. The Edible Oil Segment’s customers include baked goods companies, snack food producers, restaurant chains, foodservice distributors, and other food manufacturers who use vegetable oils and shortenings as inputs in their operations, as well as retail consumers. This division primarily competes with ADM, Cargill, Associated British Foods plc, Stratas Foods (a joint venture between ADM and Associated British Foods plc), Unilever, and Ventura Foods, LLC.

Bunge recently announced that it is selling the bulk of its fertilizer business for $3.5Bn of net proceeds, so I won’t be discussing this division in detail although I will discuss the implications of selling this division later in this report.

Also, given that the milling division only constitutes 3% of Bunge’s sales, I will not be discussing that division in detail.

Low Return on Invested Capital Business

While Bunge has consistently reported net income based on GAAP accounting principles, it has consistently burned cash. Bunge has reported combined net income for the past 3, 5, and 10 years of $2.1Bn, $3.1Bn, and $4.4Bn, respectively. However, free cash flow over those same time periods equaled negative $(708)MM, negative $(1.6)Bn, and negative $(2.5)Bn respectively. Note FCF has only been positive in two of the past ten years. Typically, over long periods of time, GAAP reported earnings should approximate free cash flow. Temporary differences can arise during periods when a company is growing rapidly and spending money on new property, plant, and equipment, or investing in working capital.

These temporary variances should tend to reverse over five and ten year periods. Prolonged differences between free cash flow and net income typically indicate that free cash flow is a more accurate indication of the true earnings power of the firm, which would indicate that Bunge earns less than a 3% return on invested capital. Even assuming that 70% of capital expenditures are growth related (based on management’s guidance), Bunge still generates below a 8% ROIC (see adj. FCF column below).

Bunge's Historical Return on Invested Capital (click to enlarge)

Source: Matt Darrah's investment newsletter, January 2010. 

Further, Bunge operates primarily in businesses with very small to no moats protecting its returns, as the processing of agricultural products does not require any proprietary knowledge, equipment, or processes, nor are any of its brands likely meaningful to consumers, as evidenced by their historically EBIT margins around 5%.

Unattractive Valuation

Based on GAAP earnings, Bunge doesn’t appear to be overvalued. As discussed above, given the large disparities between free cash flow and net income, its valuation should be based on historical free cash flow. Given the past three years of adjusted free cash flow (adjusted for estimated growth CapEx per the methodology described above), Bunge trades at 23x free cash flow. Basing valuation on unadjusted free cash flow (basically assuming management’s guidance on growth CapEx is unreliable), the last three years’ cumulative cash flow is negative.

It is important to note that the valuations metrics do not take into account the sale of the Fertilizer business, as the cash flow generated by the sale of those assets is still undisclosed. However, as I will discuss below, I believe that the sale of the fertilizer business will only serve to reduce Bunge’s free cash flow generating ability.

Valuation Based on Adjusted Net Income and Free Cash Flow (click to enlarge)

Source: Matt Darrah's investment newsletter, January 2010.  

Catalysts

Derivatives

Bunge has indicated that it only uses derivatives to hedge exposure to commodities cost, implying that they will not be impacted by fluctuations in the underlying cost of the commodity. For instance, Bunge may loan a farmer fertilizer and then receive payment of a fixed amount of soybeans once the farmer has harvested his crop. In order to protect itself from price declines prior to the harvest, Bunge would sell short the volume management expects to receive from the farmer. By doing so, if the price of soybeans declines, while Bunge waits for the harvest, the value Bunge receives from the farmer is less, but the Company has gained enough money to offset that loss with its short position.

However, based on interviews with traders familiar with Bunge’s trading operation, a former executive-level Bunge employee, and a knowledgeable former CFO of a competitor, Bunge operates a speculative trading operation. As the (not-disgruntled, in fact very supportive) former employee stated, "there is no way Bunge could make the margins it makes without some speculation." I also spoke with traders (again supportive) who are knowledgeable about Bunge’s trading operations who stated that Bunge is actively trading in futures contracts that do not necessarily conform to a hedging strategy (the traders could tell because the trades didn’t coincide with harvest seasons). Further, the former CFO of a competitor discussed the difficulties of managing such a hedging operation from an internal controls standpoint. Based on his knowledge of Bunge’s CFO’s background, he did not feel Bunge’s CFO adequately understood the potential loss exposure that could be incurred as a result of its derivative operations.

Unrepresentative Accounting

As previously stated, Bunge’s free cash doesn’t approximate their net income over long periods of time.

These types of discrepancies normally indicate that GAAP accounting does not accurately reflect the economics of the underlying business, and it may suggest fraudulent accounting. A former CFO of a competitor said that after pouring through Bunge’s financial statements, he could only come to the conclusion that "the books were cooked."

Additionally, Bunge’s financial disclosures reveal that management consistently does not reserve enough allowance for doubtful accounts on loans that Bunge makes to farmers. Loan contracts are difficult to enforce on farmers in Brazil, and according to interviews I conducted, most CFOs would reserve at least the full amount of any contract in litigation, as the likelihood of recovery is negligible. Further, a typical CFO would reserve above that amount to anticipate future defaults. However, while Bunge as of September 30th, 2009 is litigating ~$235MM of loans, it had only reserved $196MM at that time. Bear in mind that litigation usually is pursued as a last resort in most defaults, so defaults are likely much higher than $235MM.

Further, Bunge experienced two material breaches of internal controls that were disclosed in 2007. One resulted in a $7Bn revenue restatement, while the other resulted in a theft by several employees from its Peruvian division that resulted in a $34MM loss.

Sale of Fertilizer Business

Bunge recently sold its Brazilian fertilizer operations to Vale for $3.5Bn of net proceeds. While management and sell-side analysts have espoused numerous strategic rationales for why this division was sold, I believe the sale occurred because Bunge needed the cash, and this division was the most readily saleable asset. As shown below, Bunge needed to finance its money losing operations and redeem its preferred stock, which matures during 2010, and therefore had to sell assets. Interestingly, many analysts have noted that the division was sold below the replacement value of the assets, which implies Bunge was in a weak negotiating position, possibly the result of the cash need illustrated below.

Liquidity Bridge (click to enlarge)

Source: Matt Darrah's investment newsletter, January 2010.

Interestingly, Bunge had historically thought the fertilizer division was a growth business and spent large amounts of growth CapEx to improve it. The sale "really surprised" a former executive, as "that business generated a lot of cash…and was a nice grower." Note that the business was likely bleeding cash this year given lower fertilizer prices, but Bunge’s largest free cash flow generating year (2008) coincided with a large increase in fertilizer profits.

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."

Posted by manualofideas at 02:53 PM | Permalink | Comments (0)

By Greenbackd

In his Are Japanese equities worth more dead than alive?, SocGen’s Dylan Grice conducted some research into the performance of sub-liquidation value stocks in Japan since the mid 1990s. Grice’s findings are compelling:

My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

In the same article, Grice identifies five Graham net net stocks in Japan with market capitalizations bigger than $1B:

He argues that such stocks may offer value beyond the net current asset value:

The following chart shows the debt to shareholders equity ratios for each of the stocks highlighted as a liquidation candidate above, rebased so that the last year’s number equals 100. It’s clear that these companies have been aggressively delivering in the last decade.

Despite the “Japan has weak shareholder rights” cover story, management seems to be doing the right thing:

But as it happens, most of these companies have also been buying back stock too. So per share book values have been rising steadily throughout the appalling macro climate these companies have found themselves in. Contrary to what I expected to find, these companies that are currently priced at levels making liquidation seem the most profitable option have in fact been steadily creating shareholder wealth.

This is really extraordinary. The currency is a risk that I can’t quantify, but it warrants further investigation.

Posted by manualofideas at 12:22 PM | Permalink | Comments (0)

In a wide ranging discussion this afternoon, Berkshire Hathaway Chairman and CEO Warren Buffett interviewed former Treasury Secretary Hank Paulson at the Greater Omaha Chamber of Commerce annual meeting in Omaha.  The topics discussed ranged from insights in Mr. Paulson’s recently published book, On The Brink, as well as broader questions regarding the 2008 credit crisis, relations with China, and prospects for the United States economy going forward.  While the tone of the interview was friendly, a number of important topics were covered in a candid manner.  The video of the interview appears below.

If the above video fails to load, watch the interview here.

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 10:44 AM | Permalink | Comments (0)

BUSINESS OVERVIEW
Syms operates retail stores offering discounted merchandise from designer labels for men, women and children. Syms opened the first store in 1959 and currently operates 53 stores, including 23 Filene’s stores acquired in 2009.

COMPANY-OWNED REAL ESTATE

^{Source: Company filings, The Manual of Ideas analysis.}

INVESTMENT HIGHLIGHTS

• Owns real estate associated with 21 of 30 Syms-branded retail stores, with retail space of 1.2 million sq. ft, warehouse/office space of 350k sq. ft (including 19 acres of land) and other space of 391k sq. ft. The PP&E is carried at $96 million but is likely worth substantially more. One owned store is located in NYC, while the others are generally near highways in places with at least one million people.
• Won bankruptcy auction for Filene’s in 2009, adding 23 leased stores and $315 million revenue (based on November 2009 quarter-end annualized revenue). Syms paid $39 million in cash, and also acquired $21 million of inventory, $30 million of store fixtures, and the Filene’s brand. Syms recorded a related $10 million bargain gain.
• Retail concept: Sell brand-name apparel for less. Brands carried by Syms include Burberry, Ralph Lauren, Calvin Klein, and Tommy Hilfiger. Filene’s stores also offer “off-price” branded apparel and are located in similar markets (mostly in Eastern U.S.).
• Received $30 million of insurance proceeds in December related to death of chairman Sy Syms. CEO Marcy Syms (57) has become chairman.
• Pro-forma net cash of $8 million as of November 28, 2009 (includes $30 million insurance windfall).
• Shares trade at 0.6x tangible book value and 0.2x enterprise value to pro forma trailing revenue.

INVESTMENT RISKS & CONCERNS

• Syms-branded same store sales fell 10% in June-November of 2009. Despite revenue pressure, "clean" EBIT was $1+ million in FQ3 on revenue of $135 million, including full Filene’s contribution.
• Controlled by the founding Syms family, which owns 56% of the company. While the passing of Sy Syms may lead to changes down the road, CEO Marcy Syms, who draws a $600,000+ base salary, appears firmly in charge and set to continue.
• Competes against discount stores, specialty apparel stores, department stores and factory outlet stores, with few sources of competitive advantage.
• Low returns on capital. Although the purchase of Filene’s leased stores lowers incremental capital intensity, capital remains tied up in owned property.

MAJOR HOLDERS
Syms family 56 % | Other insiders <1% | Franklin 10% | DFA 8% | Kahn Brothers 3% | Barington 2% | MFP 1%

Disclosure: No positions.

Syms has been featured in recent issues of Downside Protection Report and Portfolio Manager's Review. Subscribers, please log into the members-only website to review additional information and analysis on Syms.

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

Respected value investor Aaron Edelheit of Sabre Value recently discussed his investment approach and current investment opportunities in an exclusive interview with Portfolio Manager's Review. The full interview will be published in the forthcoming monthly issue of the Review. Here is a quick excerpt for those looking to pick up a good book:

The Manual of Ideas: Are there any “off-the-beaten path” books that have made you a better investor?

Aaron Edelheit: I just read a fantastic book called “The First Tycoon,” by T.J. Stiles, about Cornelius Vanderbilt. There were many lessons and ideas I drew from the book about what made him so successful, and I think there is a lot to learn about history as well.

Read the full interview with Edelheit as soon as it is published -- subscribe to Portfolio Manager's Review today.

Posted by manualofideas at 04:26 PM | Permalink | Comments (0)

By Greenbackd

Since last week’s Japanese liquidation value: 1932 US redux post, I’ve been attempting to determine whether the historical performance of Japanese sub-liquidation value stocks matches the experience in the US, which has been outstanding since the strategy was first identified by Benjamin Graham in 1932. The risk to the Japanese net net experience is the perception (rightly or not) that the weakness of shareholder rights in Japan means that net current asset value stocks there are destined to continue to trade at a discount to net current asset value. As I mentioned yesterday, I’m a little chary of the “Japan has weak shareholder rights” narrative. I’d rather look at the data, but the data are a little wanting.

As we all know, the US net net experience has been very good. Research undertaken by Professor Henry Oppenheimer on Graham’s liquidation value strategy between 1970 and 1983, published in the paper Ben Graham’s Net Current Asset Values: A Performance Update, indicates that “[the] mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index. One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983.” That’s an outstanding return.

In The performance of Japanese common stocks in relation to their net current asset values, a 1993 paper by Bildersee, Cheh and Zutshi, the authors undertook research similar to Oppenheimer’s in Japan over the period 1975 and 1988. Their findings, described in another paper, indicate that the Japanese net net investor’s experience has not been as outstanding as the US investor’s:

In the first study outside of the USA, Bildersee, Cheh and Zutshi (1993)’s paper focuses on the Japanese market from 1975 to 1988. In order to maintain a sample large enough for cross-sectional analysis, Graham’s criterion was relaxed so that firms are required to merely have an NCAV/MV ratio greater than zero. They found the mean market-adjusted return of the aggregate portfolio is around 1 percent per month (13 percent per year).

As an astute reader noted last week ”…the test period for [the Bildersee] study is not the best. It includes Japan’s best analog to America’s Roaring Twenties. The Nikkei peaked on 12/29/89, and never recovered:”

Many of the “assets” on public companies’ books at that time were real estate bubble-related. At the peak in 1989, the aggregate market price for all private real estate in the city of Tokyo was purportedly greater than that of the entire state of California. You can see how the sudden runup in real estate during the bubble could cause asset-heavy companies to outperform the market.

So a better crucible for Japanese NCAVs might be the deflationary period, say beginning 1/1/90, which is more analogous to the US in 1932.

To see how the strategy has performed more recently, I’ve taken the Japanese net net stocks identified in James Montier’s Graham’’s net-nets: outdated or outstanding? article from September 2008 and tracked their performance from the data of the article to today. Before I plow into the results, I’d like to discuss my methodology and the various problems with it:

1. It was not possible to track all of the stocks identified by Montier. Where I couldn’t find a closing price for a stock, I’ve excluded it from the results and marked the stock as “N/A”. I’ve had to exclude 18 of 84 stocks, which is a meaningful proportion. It’s possible that these stocks were either taken over or went bust, and so would have had an effect on the results not reflected in my results.
2. The opening prices were not always available. In some instances I had to use the price on another date close to the opening date (i.e +/1 month).

Without further ado, here are the results of Montier’s Graham’’s net-nets: outdated or outstanding? picks:

The 68 stocks tracked gained on average 0.5% between September 2008 and February 2010, which is a disappointing outcome. The results relative to the  Japanese index are a little better. By way of comparison, the Nikkei 225 (roughly equivalent to the DJIA) fell from 12,834 to close yesterday at 10,057, a drop of 21.6%. Encouragingly, the net nets outperformed the N225 by a little over 21%.

The paucity of the data is a real problem for this study. I’ll update this post as I find more complete data or a more recent study.

Posted by manualofideas at 09:44 AM | Permalink | Comments (0)

Those of our readers who have followed the evolution of Steak n Shake (SNS) over the past couple of years know that the company has made huge strides in terms of stabilizing operations and creating value for shareholders. Whereas the previous management team almost ran Steak n Shake into the ground, new chairman Sardar Biglari quickly restored the company's fiscal health, ensuring that Steak n Shake will be around for a long time to come. Not least, Steak n Shake's stock price has enjoyed a renaissance of sorts after languishing for years under the old management.

Despite all the positives that Sardar Biglari's involvement has brought to Steak n Shake, the Indianapolis Business Journal (IBJ) has published an article that can hardly be described as anything other than a hatchet job. In the article, Cory Schouten writes:

"Biglari in June persuaded the board to transform Steak n Shake into a holding company for a diverse range of investments and give Biglari sole discretion over asset allocation. The board’s vote essentially allowed the hedge-fund owner to use the publicly traded company as a personal investment vehicle."

"The unanimous vote came after Biglari, the board chairman, managed to push out every board member unwilling to give him dictatorial authority over Steak n Shake despite his relatively modest ownership stake."

"Personal investment vehicle"? "Dictatorial authority"? This language might be more appropriately used to describe the state of Steak n Shake under previous management. Biglari's words -- and, more importantly, actions -- have made it clear that his paramount goal is maximizing long-term value for all Steak n Shake shareholders. Biglari's authority could be described as "dictatorial," but so could every CEO's authority. The question is whether such authority is used for the benefit or detriment of shareholders. In Biglari's case, the business results and stock price of Steak n Shake speak volumes.

The IBJ article also stokes fears about Steak n Shake relocating to Biglari's hometown of San Antonio, Texas, implying that jobs and capital investment might be lost in Indianapolis. We have no problem with a hometown paper looking out for its town, but in this case the IBJ is far off-base. Steak n Shake "The Restaurant Company" will continue to be based in Indianapolis. Meanwhile, Steak n Shake "The Holding Company" will operate out of San Antonio, Texas, likely with a very lean holding company staff.

The inability of organizations such as the IBJ to distinguish between Steak n Shake "The Restaurant Company" and Steak n Shake "The Holding Company" is precisely why Steak n Shake "The Holding Company" will be renamed Biglari Holdings. Listen up, confused IBJ readers: The restaurant business will continue to be called Steak n Shake.

The reader comments posted on the IBJ website show just how destructive it can be in the fast-paced online age when misleading or outright wrong information is spread by a supposedly authoritative voice. Writes IBJ reader Mike,

"This is an unexpected turn of events. I frequent Steak n Shake for many reasons, but mostly b/c of the local headquarters. I for one will not go as often (or ever) if most of the local corporate jobs are moved."

Adds IBJ reader Joe,

"when did we...decide to let sleazeball Iranian refugees (from the Shah's regime no less)purchase/own good 'ol 'Merkan companies and run 'em into the ground...my guess is his family has millions in Swiss bank accounts they've been living off of for years (used to work with one of these Iranian ex-pats years ago and had he was the sleaziest 'businessman' I ever met!)"

Another IBJ reader who calls himself Indy Observer takes a more lighthearted approach to spreading baseless rumors:

"Any truth to the rumor that the Steakburger is being renamed the Big Lari Burger?"

On second thought, that last one could actually catch on. Give it a few decades, by which time Biglari Holdings may well be another stock with a six-figure price tag and tens of thousands of happy shareholders attending each annual meeting. At that time, "Big Lari Burger" just may become a no-brainer name for a burger that will be enjoyed by droves of happy shareholders.

Disclosure: No position.

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

By Nadav Manham

I just blogged that Pepsi isn't running a Super Bowl ad.  But guess who just did?  Here's what the CEO had to say (here too).

Why would this internet company decide to advertise on T.V.?  The opportunity cost relative to advertising on the internet is not high, as the company already gets a lot of free advertising there.  Plus the Super Bowl audience likely allows the company to reach more internet naifs/future users at lower cost than any other way of spending ad money.

It's also interesting that the product being advertised is in many ways the product that least needs it:  plain old search, which is a monopoly enjoys high market share. 

I really liked the ad; it was minimalist, easy to understand, and moving in a kind of mystical way--"look at the power of search technology to expand your knowledge and change your life."  Does anyone associate Yahoo search or Bing with any of that?  That's one component of the moat.

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 11:41 AM | Permalink | Comments (0)

The following are links to hedge fund manager interviews posted on the website Hedgefundnews.com. The interviews were conducted between 1995 and 2004.

• John B. Kleinheinz, Kleinheinz Capital Partners - January 2004
  
• John Paulson, Paulson & Co. - July 2003
  
• Russell Abrams, Titan Capital Group - April 2003
  
• John Muresianu, Lyceum Capital - January 2003
  
• Robert P. Rotella, Rotella Capital Management - June 2002
  
• Alexander J. Roepers, Atlantic Investment Management - April 2002
  
• Ernst von Olnhausen, Robert Vicas, Double V - October 2001
  
• Raj Gupta, Epoch Funds - July 2001
  
• Michael Rome, Lazard Frères - April 2001
  
• Brian Stark, Michael Roth, Staro Asset Management - January 2001
  
• Thomas M. O'Neill, Navigator Asset Management - October 2000
  
• Gregg D. Groechel, American Express - July 2000
  
• Marc J. Gabelli, Gabelli Asset Management - April 2000
  
• Fabien Pictet, Fabien Pictet & Partners Ltd. - January 2000
  
• Errol M. Rudman, Rudman Partners, L.P.-October 1999
  
• Morris Mark, Mark Asset Management-July 1999
  
• Stephen Edwards, Magus Capital Management Ltd.-April 1999
  
• Sanford Grossman, Quantitative Financial Strategies-Jan. 1999
  
• George Hall, Clinton Group-July 1998
  
• Charles Schaffran, Alliance-April 1998
  
• Wayne Cooperman, Ricky Sandler, Fusion Partners-January 1998
  
• Stacy Ruchlamer, The Consumer Fund, L.P.- October 1997
  
• Geoffrey L Symonds, Trace Global Opportunities Fund-July 1997
  
• Raj Rajaratnam, The Galleon Group-April 1997
  
• Charles Davidson, Joseph Jacobs and Shaiy Pilpel, Wexford Management LLC-January 1997
  
• John Armitage and William Bollinger, Egerton Capital Limited-November 1995
  
• Gerald R. Jordan, Jr., Hellman, Jordan Management-July 1995
  
• Michael Sofaer, Sofaer Capital Inc. -May 1995
  

Posted by manualofideas at 08:15 PM | Permalink | Comments (0)

Canadian value investor Vito Maida, founder of Patient Capital Management and former Prem Watsa protege, discusses his strategy and market outlook in this interview with the Financial Post.

If video fails to load, click here to watch.

If video fails to load, click here to watch.

Here is how Patient Capital describes the firm's investment philosophy:

PCM's investment philosophy is based on long-term absolute value. The objective of the investment philosophy is to focus on the preservation of capital while earning superior rates of return. PCM attempts to meet these objectives by purchasing only those securities that meet very strict criteria for value and quality. PCM's mandates allow for substantial cash balances to accumulate if securities cannot be found that meet its very high standards. Investments are only considered in companies that have a long history of operation and are in stable businesses that PCM can analyze and understand with a high degree of certainty.

PCM’s portfolios are constructed entirely on a bottom up basis. Each investment is analyzed through a very independent and rigorous analytical approach. Reliance on external research is minimal. Historical annual reports are analyzed to determine balance sheet strength, sustainability of cash flows and profitability. A very important component of the analytical process is an assessment of the company’s accounting policies. In depth interviews are often conducted with company management in order to assess future strategy and competitive position. In addition, a considerable amount of time is spent attempting to estimate “intrinsic value” through the use of discounted cash flow models and traditional valuation measures such as price/earnings ratios and price/book ratios.

New investments are only purchased if PCM’s criteria for high quality fundamental characteristics such as superior returns on capital, substantial free cash flow and low debt are present as well as a security price that is trading at a substantial discount to PCM’s estimated intrinsic value.

Although PCM’s investment horizon is five to ten years we will exit an investment for any one or more of the following reasons:

• The security price reaches our targeted sale price;
• Significant management changes occur;
• A dramatic change in strategic direction is undertaken;
• Increased debt levels are incurred;
• Adverse changes in accounting policies are implemented.

We believe that our investment philosophy is very different from virtually every other Canadian value manager. Because our clients do not require us to be fully invested we do not have to compromise our standards for quality and price in order to meet a fully invested mandate. Other value mangers that must remain fully invested must by definition practice “relative value investing.” In addition, PCM portfolios are concentrated and will hold a maximum of twenty securities.

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

Posted by manualofideas at 03:47 PM | Permalink | Comments (0)

On January 12, 2010, Google announced that the company would re-evaluate its approach to doing business in China after the discovery of cyber attacks that appeared to target human rights activists.  While Google did not directly accuse the Chinese government of complicity in the attack, the company clearly stated that it is no longer willing to censor search results.  At a time when nearly every major company in the United States is trying to expand opportunities in China, Google has decided to buck the trend with a very controversial move that could result in a major setback for the business.  What could Google’s executives have been thinking when they made a decision that was sure to cause a political uproar?

Richard L. Brandt’s latest book, Inside Larry & Sergey’s Brain, presents a portrait of Larry Page and Sergey Brin that helps the reader understand what may have motivated the company to initially enter China by accepting some level of censorship.  Although the book was published prior to Google’s recent announcement, we can draw some important insights regarding the way Google’s founders think about the issue of doing business in China.  Perhaps more importantly, the book also allows the reader to glimpse into the psyche of the founders and draw some conclusions regarding entrepreneurship in general.  For anyone investing in early stage companies, the insights are invaluable.

Mr. Brandt’s book is not as well known as  Googled:  The End of the World as We Know It which we reviewed in November.  However, one can argue that Mr. Brandt succeeds in providing a more vivid background of both founders and he also makes a better effort to draw links between their core values and a number of decisions that were made which may appear “crazy” at first but actually led to Google’s stunning success.  It is easy to see in retrospect how conventional thinking could have destroyed Google’s ambitions at several points during the  early years.  The fact that Mr. Brin and Mr. Page stuck to their core values made all the difference.

Can Idealism Coexist with Good Business Sense?

Google’s idealism is hardly a well kept secret.  In fact, the idealism of the founders has often been mocked as disingenuous by outside observers.  However, Mr. Brandt clearly shows how Mr. Brin and Mr. Page kept Google on course with an idealistic view of the world that ultimately provided the differentiation required to succeed.

Perhaps the most important example was Google’s insistence to not permit advertisers to purchase ranking in search results and to keep all advertisements clearly distinct from search results.  Google could have easily maximized short term profitability in the early years by taking a less idealistic approach (as all their competitors did).  It must have been incredibly tempting to do so.  The founders did not come from wealthy families and were facing pressure to produce profits.  However, ultimately the decision to consider the needs of the search user first trumped short term profitability but led to the trust required for the company to gain traction in numerous other initiatives.

Pros and Cons of Entering China

Google’s founders struggled with the question of censorship for several years before deciding to accept restrictions in exchange for being permitted to enter China.  Mr. Brandt’s chapter on China asserts that the founders never lost sight of their determination to contribute to positive change within Chinese society.  The question was whether engagement, even with restrictions, could improve the free exchange of information within the country.  Google was the first search engine to insist on at least notifying users if the results of a query were censored.  This fact alone helped to expose the actions of government to restrict the information citizens are permitted to see.

It is difficult to maintain cynicism regarding Google’s intentions for China after the company announced a willingness to exit the country if the government continues to require censorship.  While some subsequent statements made by Google’s CEO Eric Schmidt appeared to soften Google’s stance to some extent, the company seems committed to follow through on the statements made on January 12.  At this point in time, the decision seems likely to cost Google some profits but so did the earlier decision to refuse to allow advertisers to influence search ranking.  Google may be making a long term profit maximizing move if the new policy builds trust in China and the government eventually is forced to back down.

Genius, Hard Work, and Entrepreneurship

Sergey Brin and Larry Page have IQs that are obviously off the charts.  They were also willing to work extremely hard and found a way to start Google with very little capital.  They started out of a garage and used second hand and improvised furniture.  They were able to secure venture capital funding and attracted other talented people to join the company.

But while IQ, hard work, and guts are required elements associated with any successful startup, these attributes alone are not sufficient to ensure success.  Silicon Valley’s history is full of startups that failed despite all of the wonderful qualities that Mr. Brin and Mr. Page brought to Google.  What made Google such a stunning success is what may have been initially viewed by outsiders as insanity on the part of the founders.  However, the unconventional thinking that failed to maximize profitability in the short run directly led to Google’s stunning rise.

Controversy Will Continue

Google will continue to be controversial in the future.  We recently asked whether Google’s recent re-pricing of employee stock options meant that the company’s “Don’t Be Evil” pledge does not apply to stockholders.  Apple CEO Steve Jobs recently declared that Google’s “Don’t Be Evil” mantra is “bullshit”.  Google is often accused of expanding well beyond search particularly with its emphasis on offering applications for cloud computing.  Will the company use dominance over search to gain unfair advantage in new ventures?

Mr. Brandt provides an important service to those who are interested in moving past simplistic sound bites and gaining a better understanding of what makes Sergey Brin and Larry Page tick.  One gets the distinct sense that these men will be rocking the boat in the technology world for decades to come.

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:  The author of this book review does not have a position in Google. Richard L. Brandt provided The Rational Walk with a copy of his book.

Posted by manualofideas at 12:09 PM | Permalink | Comments (0)

Here are some recent letters that you may find worthwhile:

• Chuck Akre: Akre Capital Management Q4 letter
• Christopher Begg, Ben Favazza: East Coast Q4 letter 
• Bruce Berkowitz: Fairholme annual letter
  
• Sardar Biglari: 2009 Steak n Shake chairman's letter
  
• John Burbank: Writeup on gold investment thesis 
• Kevin Byun: Denali Investors Q4 letter
• Carr, Coates and Phillips: Oak Value Fund Q4 letter
• McLane Cover: Mistral Capital Partners December letter
  
• David Einhorn: Greenlight Capital Q4 letter 
• Ori Eyal: Emerging Value Capital Management letter
  
• Bill Gates:2010 Bill & Melinda Gates Foundation 2010 letter
• Jeremy Grantham: GMO Q4 letter
• Bill Gross: February commentary, "The Ring of Fire" 
• Robert Hagstrom: "Who's afraid of a sideways market?"
• John Hussman: Latest weekly comment
• Tomas Jelf: Prologue Capital December 2009 letter
  
• Jonathan Lourie: Cheyne Capital 2010 newsletter
  
• Howard Marks: Latest memo, "Tell Me I'm Wrong"
• Angus Murray: 2010 market outlook for precious metals
• Richard Perry: 2009 annual letter 
• Jay Petschek: Corsair Capital Q4 letter 
• Eric Sprott: December letter, "Is it all just a ponzi scheme?"
  
• Whitney Tilson: T2 Partners annual letter
• Pruitt, Miller and Koster: Chanticleer Advisors annual letter
  

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

The blog My Investing Notebook has posted Bill Ackman's presentation on Kraft (KFT), dated February 3rd. The slides provide a good overview of the businesses of Kraft and Cadbury. Ackman also shares a valuation analysis of the combined company, not surprisingly suggesting that the stock should earn a strong return over the next couple of years.

While we like the presentation, we would take some of the assertions with a grain of salt, particularly Ackman's claims regarding merger synergies, potential margin expansion, and a "good" price paid for Cadbury.

Somehow investors always seem to believe there is room for margin expansion. Needless to say, margins don't always expand.

The following classic Buffett quotation may ultimately prove prescient with regard to Kraft/Cadbury: "In some mergers there truly are synergies - though often times the acquirer pays too much for them - but at other times the cost and revenue benefits that are projected prove illusory. Of one thing, however, be certain: if a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked."

Posted by manualofideas at 05:49 PM | Permalink | Comments (0)

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

In the following interview, Bruce Berkowitz of The Fairholme Fund discusses his recent sale of Pfizer, which had been Fairholme's largest holding through most of 2009.

Berkowitz also opines on the issue of tax rates in the pharmaceutical industry and says that effective tax rates have been too low for too long. The implication is that this could change, potentially depressing earnings -- or at least slowing earnings growth -- across the industry.

Finally, Berkowitz suggests that Fairholme is moving away from a defensive posture toward a more offensive stance in terms of picking investments. Underlying the more aggressive posture is Berkowitz's view that the financial crisis is essentially over and that we are now in recovery mode.

Posted by manualofideas at 05:54 PM | Permalink | Comments (0)

Posted by manualofideas at 05:52 PM | Permalink | Comments (0)

Bruce Berkowitz's Fairholme Fund (FAIRX) disclosed a new position in Citigroup in the annual report of The Fairholme Fund for the fiscal year ended November 30, 2009.

Bruce Berkowitz is one of more than 20 superinvestors regularly covered in Portfolio Manager's Review.

Posted by manualofideas at 05:52 PM | Permalink | Comments (0)

Posted by manualofideas at 05:51 PM | Permalink | Comments (0)

By Nadav Manham

I'm not sure this news got much notice, but one day we may look back on it as a turning point:

For the first time in 23 years, there will not be an advertisement for Pepsi during Super Bowl next weekend. Instead, PepsiCo, the soft drinks maker, which in previous years has wowed audiences with dazzling spots featuring Cindy Crawford and Britney Spears, is going online.

With a major digital campaign that features its own website and a heavy presence on Facebook, PepsiCo is betting that a more interactive approach will resonate with consumers in the always-on age of social networking sites.

I often fall into the trap of analyzing media companies from the point of view of a consumer of media.  I consume a lot of media, so that's how I naturally think.  But it is a trap: the truth is I'm not really a consumer of media.  The true "consumers" of media, the ones that pay most of the bills, are the advertisers.

At the end of the day, advertisers are investors.  They have scarce resources to spend on advertising and they want to maximize the return on what they spend.  If spending $20 million on carnival barkers promises the best return, that's what Pepsi will spend it on.  If spending $20 million on Super Bowl ads promises the best return, that's what Pepsi will spend it on.

In this case, Pepsi has decided, for the first time, that $20 million spent online promises the best returns, in terms of the number of people reached, their demographic attractiveness, and the likelihood of converting them into Pepsi drinkers.  It's potentially a very big deal: Super Bowl ads have historically enjoyed tremendous pricing power, and now at least one company thinks it can do better elsewhere.

So the thing to keep my eye on is advertisers, the true consumers of media.  The expected return on investment to an advertiser, relative to the alternatives available, is what will  ultimately determine the revenue of most media companies.  And then, if the cost structure required to deliver that advertising is low enough--an independent question--you have a good business.

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 05:49 PM | Permalink | Comments (0)

Those of us who completed our education prior to the mid 1990s often feel like students today have it easy in comparison.  Many of us still remember going to the library, finding books using a card catalog, and carrying stacks of books home.  High technology involved looking through old newspapers and magazines using microfiche.  Wikipedia, every student’s favorite reference source, did not exist.  It is easy to imagine how much time could have been saved and how much more could have been accomplished with access to today’s internet!

In the brief video clip shown below, Google CEO Eric Schmidt talks about how technology impacts the lives of younger people and whether the overall quality of education will be improved or hurt by instant access to information.  Mr. Schmidt points out that many aspects of modern technology have raised the bar and improved the quality of the young people hired at Google.  However, he is also concerned that long form reading may be on the decline since media is often consumed in much smaller portions.  This raises the important question of whether the internet may be creating a generation with knowledge that is a mile wide but only an inch deep.

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 05:42 PM | Permalink | Comments (0)

By Greenbackd

Zero Hedge has an article Uncovering Liquidation Value… In Japan? discussing SocGen’s Dylan Grice’s Are Japanese equities worth more dead than alive. The title is a nod to Benjamin Graham’s landmark 1932 Forbes article, Inflated Treasuries and Deflated Stockholders, where he discussed the large number of companies in the US then trading at a discount to liquidation value:

…a great number of American businesses are quoted in the market for much less than their liquidating value; that in the best judgment of Wall Street, these businesses are worth more dead than alive. For most industrial companies should bring, in orderly liquidation, at least as much as their quick assets alone.

Grice writes:

In the space of a generation, Japan has gone from the world economy’s thrusting up-and-coming superpower to its slowing silver-haired retiree. Accordingly, the Japanese market attracts a low valuation. The chart [below] shows FTSE Japan’s equity price to book ratio and enterprise price to book ratio, since equity P/B ratios alone can be distorted by leverage. Both metrics show Japan to be trading at a low premium to book compared to its recent history. So it’s certainly cheap. But does it offer value? The answer can be seen in the chart above, which shows corporate Japan’s RoEs and RoAs over recent decades to have averaged a mere 6.8% and 3.8% respectively. This is hardly the sort of earnings power which should command any premium over book value at all. Indeed, to my mind the question is one of how big a discount the market should trade at relative to book.

The fundamental problem in 1932 America, according to Graham, was that investors weren’t paying attention to the assets owned by the company, instead focussing exclusively on “earning power” and therefore “reported earnings – which might only be temporary or even deceptive – and in a complete eclipse of what had always been regarded as a vital factor in security values, namely the company’s working capital position.” Graham proposed that investors should become not only “balance sheet conscious,” but “ownership conscious:”

If they realized their rights as business owners, we would not have before us the insane spectacle of treasuries bloated with cash and their proprietors in a wild scramble to give away their interest on any terms they can get. Perhaps the corporation itself buys back the shares they throw on the market, and by a final touch of irony, we see the stockholders’ pitifully inadequate payment made to themwith their own cash.

In his article, Grice makes a parallel argument about valuations based on earnings in Japan now:

Regular readers will know I favour a Residual Income approach to valuation. It’s not perfect, and it’s still a work in process, but anchoring estimates of intrinsic value on the earnings power of company assets (relative to a required rate of return, which I set at an exacting 10%) helps avoid value traps. Things don?t necessarily come up as offering value just because they’re on low multiples. The left chart below shows Japan’s ratio of Intrinsic Value to Price (IVP ratio, where a higher number indicates higher value) to be only 0.6, suggesting that in an absolute sense, Japan is intrinsically worth only about 60% of its current market value.

Grice arrives at the same conclusion about Japan as Graham did in 1932 about the US:

But here the tension between “going concern” valuation and “liquidation” valuation becomes important. Let’s just imagine the unimaginable for a second, and that my IVP ratios are correct. Japan currently trades on a P/B ratio of 1.5x, but if it is only worth 60% of that, its “fair value” P/B ratio (assuming we value it as a going concern) would be around 0.9x. Of course, that would only be true on average. Nearly all stocks would trade either above or below that level. And of those trading below, some would trade slightly below, others significantly below. And of those which traded significantly below, some might be expected to flirt with liquidation values which called into question whether or not the “going concern” valuation was appropriate. Indeed, this is exactly what is beginning to happen.

It seems that there are quite a few stocks trading at a discount to net current asset value in Japan:

Grice likes the net current asset value strategy in Japan (sort of):

Not only are these assets cheap but, unlike the overall market, they probably offer value as well. My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

…

So should we be filling our boots with companies trading below liquidation value? Not necessarily. But I would say the burden of proof has shifted. Why wouldn’t you want to own assets that have been generating shareholder wealth yet which trade at below their liquidation values?

It is interesting that this article echoes another SocGen article, this one a September 2008 report by James Montier called Graham’’s net-nets: outdated or outstanding? in which Montier looked at Graham sub-liquidation stocks globally. Of the 175 stocks identified around the world, Montier found that over half were in Japan.

Now all we have to do is figure out how to invest in Japan.

Posted by manualofideas at 05:29 PM | Permalink | Comments (0)

From the perspective of an outside observer, the debate over financial regulatory reform can seem like nothing more than the typical Beltway chatter full of shrill voices and political posturing.  While the current debate is not free of the usual nonsense, it is important to note that the discussion has at least refocused on the “too big to fail” problem rather than fixating on consumer protection issues that consumed a great deal of time last year.  There is nothing wrong with inquiries into whether credit card and overdraft fee regulations should be changed, but action in such areas will do nothing to prevent the next financial meltdown.

Bail Outs or Bail Ins?

One interesting proposal was recently presented by Paul Calello and Wilson Ervin in a guest article for The Economist.  Mr. Calello is the head of Credit Suisse’s investment bank and Mr. Ervin is the former chief risk officer of Credit Suisse.  The authors argue that regulators should not have to choose between massive taxpayer bailouts and the potential for a catastrophic systemic collapse.  Instead, they argue that a rapid modification of a troubled firm’s capital structure  can result in a “bail in” that reduces systemic risks and mitigates the need for taxpayer funded infusions.  Such a bail in would require regulators to have sufficient power to wipe out common equity holders and recapitalize the financial institution by converting preferred shares and debt into equity.

A Rapid Form of Pre-Packaged Bankruptcy

The authors are actually proposing a very rapid form of pre-packaged bankruptcy since such restructurings are not uncommon in other industries.  The problem with most negotiated recapitalizations is that the process can take a significant amount of time before all stakeholders agree to the terms.  With a major financial institution, such time is simply not available since confidence in the franchise would be harmed beyond repair in a matter of days.

In order to make this approach work, regulators will need to have the power to dictate terms of the recapitalization over a very short period of time – most likely over a “marathon” weekend working around the clock.  As a result, the process and terms of such a recapitalization would need to be known by all parties well ahead of time.  Looking at it from this perspective, the approach is not much different from the “living wills” that some have suggested all financial institutions must set up ahead of any crisis.

A Treatment, Not a Cure

The idea of a regulator having the power to make massive changes to a financial institutions capital structure over a 48 hour period is enough to make free market advocates cringe.  But if the alternative is to permit a massive systemic collapse of the financial system or to expose taxpayers to the costs of bailing out the banks, something like the “bail in” plan may be the best of several undesirable options.

From a free market perspective, the better approach is to examine ways to reduce the number of financial institutions that are too big to fail without creating systemic risks.  While it is true that regulations would need to be imposed that limit the size and/or scope of activities the banks are permitted to engage in, these regulations would be of the “blocking” variety rather than the “micromanagement” variety.  In other words, regulators would block banks from becoming systemically important but would otherwise leave management alone to run the business.  Then managers and owners of the business can be left to determine the appropriate level of risk to accept without putting the taxpayer on the hook for cleaning up after a failure.

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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The life-size bronze sculpture by Alberto Giacometti sold for £65 million at auction today in London. It took just eight minutes before an anonymous phone bidder placed the winning bid after the sculpture opened for bidding at £12m at Sotheby's (BID) auction house in London.

The sculpture now ranks as one of the most expensive works of art ever sold. For Sotheby's, today's Impressionist and Modern Art auction was a huge success, yielding a total of £147 million versus its pre-sale estimate of £69-102 million (before buyer's premium). Perhaps more than anything else, the auction proves that despite the economic crisis individual wealth is well and alive, if only limited to the few. It also proves the attractiveness of Sotheby's business model, which benefits from a duopolistic industry structure.

Portfolio Manager’s Review picked Sotheby's as one of the top three ideas in the July 2009 issue, which was entitled “Businesses with Pricing Power and Low Capital Intensity.”  Read our Sotheby's investment case.

Learn more about Portfolio Manager’s Review.

Posted by manualofideas4 at 05:32 PM | Permalink | Comments (0)

Over the past few years, many obituaries of the newspaper business have been written.  The growing tsunami of instant information combined with increasing accessibility to this information has shaken the comfortable “moat-like” business model of newspapers to the core.  Few other case studies better define Joseph Schumpeter’s concept of “creative destruction”.

Steve Jobs has been a leading technology visionary for the past three decades and has already transformed the music industry.  Ten years ago, free music downloads threatened the very core of the music business.  Consumers began to view pirated music downloads as “normal” and traditional sales of CDs plummeted.  The iPod and the iTunes music store did not fully make up for the music industry’s lost revenues but a new economic model was born.  The latest issue of The Economist considers whether Steve Jobs may represent salvation for newspapers and magazines.  The iPad device has many attributes that could induce consumers to read newspapers electronically with a form factor that may be superior to traditional print.

The internet provides a great deal of free content from traditional newspapers as well as “new media” such as blogs and wikis.  While much of this free content is useful, the need for authoritative sources has not diminished.  This is particularly true for financial journalism which is why The Wall Street Journal and Financial Times have already succeeded in charging for online content.  The business model is clearly broken for most other newspapers not offering much differentiated content.

From initial reviews of the iPad, it looks like readers may get a superior experience through the mix of written content, embedded videos, and an attractive “newspaper-like” form factor.  If Mr. Jobs can deliver a solution for newspapers similar to what he accomplished with music, the cover of this week’s Economist may end up being justified.

The video shown below provides some additional perspectives on the iPad device in a “Tea with the Economist” interview of Jay Rosen, a Professor of Journalism at NYU and prominent authority on recent trends in “new media”.

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 11:58 AM | Permalink | Comments (0)

We recently had the pleasure of interviewing Mary Buffett, author of Buffettology, The New Buffettology and the newly published Warren Buffett Management Secrets: Proven Tools for Personal and Business Success. We will be bringing you various portions of the wide-ranging exclusive interview in the next few days.

We start this series of posts with Mary Buffett's description of Warren Buffett's approach to "winning an argument," which is also discussed in Chapter 17 of Warren Buffett Management Secrets: Proven Tools for Personal and Business Success.

Click here to listen to or download the MP3 audio.

Posted by manualofideas at 12:32 AM | Permalink | Comments (0)

Read the opinion piece Volcker references in the above video.

Posted by manualofideas at 06:38 PM | Permalink | Comments (0)

Former Fed Chairman Paul Volcker's "rule" for reigning in banks is already facing stiff opposition from financial institutions. The latter, of course, were one of the primary victims of loose financial regulation. Nonetheless, financial institutions are the ones most opposed to regulation. The underlying problem might be that financial institutions are not really acting in their long-term best interest. Rather, the senior executives of such institutions are working to maximize their personal upside in the next economic up-cycle, no matter the long-term consequences for shareholders of those companies.

Posted by manualofideas at 01:30 PM | Permalink | Comments (0)

Wilbur Ross, chairman and CEO of WL Ross & Co., discusses his interest in New York's Stuyvesant Town:

Posted by manualofideas at 11:49 AM | Permalink | Comments (0)

Corporate governance is a subject attracting much rhetoric and little change. With governance failures responsible in large part for corporate disasters, new and old, we find Robert Monks' commentary on the subject, and his efforts to change the status quo, a beacon of hope. Shareholder activist and corporate governance advisor Robert Monks recently gave a speech at Harvard Law School about the state of corporate governance. The entire speech was recorded (including the Q&A with students). Please click here to view the video.

We found the following passages from Mr. Monks' speech especially illuminating:

• Three quarters of registered shareholders are fiduciary institutions.
• We can no longer blindly accept the received wisdom as to the roles and responsibilities of owners, directors and CEOs. Categories simply do not perform as advertised.
• It is naïve to think and act as if the current arrangement of power is not satisfactory to many who hold it. Our efforts will be a struggle for reallocation of that power.
• The core problem has been the disappearance of any practical or legal respect for the fiduciary standards that ensure a beneficiary of the loyal competence of the person responsible for managing his property. We have tolerated conflicts of interest throughout the commercial system with the result of enriching service providers and impoverishing beneficiaries. Worse, this regulatory neglect has placed the conscientious fiduciary at a competitive disadvantage.
• Is there genuine commitment to an ownership based governance system? [It must be said that no such commitment exists at present.] This commitment will need be made by government. If so:
  
• There must be effective enforcement of existing law so as to require fiduciaries to take appropriate action to protect and enhance the value of portfolio securities, and
• There must be arrangement for financing “activism” either as an appropriate corporate expense or as a designated portion of the investment management fees.
  
• Peter Drucker has long raised the question as to whether the current standard of board functioning is so unsatisfactory as to require structural change. - “Whenever an institution malfunctions as consistently as boards of directors have in nearly every major fiasco of the last forty or fifty years it is futile to blame men.  It is the institution that malfunctions.”  In the years subsequent to Drucker’s characterization, the inability of any portion of the governance structure to deal effectively with holding top management to account - the “smoking gun” being executive compensation - compels the conclusion of continuing systemic board failure. If the shareholder cannot hold the CEO accountable for his compensation, he has no right to assume that he exercises effective accountability in any other area. 

Posted by manualofideas4 at 07:13 AM | Permalink | Comments (0)

In recent weeks, Kraft’s proposed acquisition of Cadbury has generated a great deal of interest.  When an investor with Warren Buffett’s reputation characterizes the deal as making him “feel poorer”, observers might wonder what could possibly motivate a CEO such as Kraft’s Irene Rosenfeld to pursue such a transaction.

While we cannot pretend to know Ms. Rosenfeld’s motives, there are some general observations investors can make regarding the incentive systems and motivations that make value destroying mergers and acquisitions very common.  Understanding these motives can help investors avoid situations where managements seem prone to destroying value.

Compensation Systems

In most public companies, CEO compensation is set by the Board’s compensation committee.  Usually, the base pay recommendation is made by compensation consultants who evaluate the CEO pay of companies in a “peer group”.  The peer group is inevitably made up of companies with similar revenues since this is considered to be a good proxy for the complexity of the business.

The trouble with setting base compensation by looking only at revenues is that CEOs are then given the incentive to retain earnings and pursue growth for the sake of revenue growth alone.  This can be done either through unwise internal growth or through acquisitions.

The situation gets even worse when stock options are issued to the CEO without adjusting the strike price over time for retention of earnings.  Since most options have a fixed strike price that is usually set at the market value of the stock on the date of the grant along with a ten year term, a CEO can simply retain earnings in order to boost the value of the option.  In contrast, paying dividends would reduce the value of the option.  Such option plans provide every incentive for CEOs to retain earnings even if there are no profitable opportunities for expansion of the business.

Thrill of the Deal

The day to day routine in any job can become boring eventually even in dynamic industries.  It is natural for people to seek some level of “excitement” in their jobs.  When the individual in question is the CEO, it may be more exciting to get on the corporate jet and meet other executives who may wish to “do a deal” than to attend to the routine matters of running the business.

Once a deal is underway, investment bankers and other advisors with strong incentives to see the transaction occur are brought in and create a sense of “deal momentum” that can be hard to break.  Most CEOs have risen to power by being aggressive and not taking “no” for an answer.  This is usually a healthy attribute but can lead to economically harmful deals when other psychological factors are at work and legions of advisors are pushing for the deal to occur.

Ego and Legacy

Most executives who reach the top have a healthy ego and would like to be remembered as great business leaders long after they retire.  This can be a healthy attribute and can lead to excellent performance if the energy is directed in a productive way.  However, the desire to be famous and well respected can lead to value destroying deals.  The temptation offered by doing deals that result in photos on the front page of the Wall Street Journal can be hard to resist.

Start Modifying Incentives with Compensation Reform

Of the factors discussed in this article, compensation systems are likely the easiest to modify in a way that discourages value destroying mergers and acquisitions.  By tying base compensation and bonus to per-share intrinsic value creation rather than simply looking at revenue growth, management incentives can be aligned with shareholder interests.  Stock option plans with a strike price that adjusts for retention of earnings would also be a vast improvement.  Unfortunately, there are few signs that such reforms will gain traction anytime soon.

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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