The Ideas Report For Serious Investors

By Greenbackd

In A Crisis In Quant Confidence*, Abnormal Returns has a superb post on Scott Patterson’s recounting in his book The Quants of the reactions of several quantitative fund managers to the massive reversal in 2007:

In 2007 everything seemed to go wrong for these quants, who up until this point in time, had been coining profits.

This inevitably led to some introspection on the part of these investors as they saw their funds take massive performance hits.  Nearly all were forced to reduce their positions and risks in light of this massive drawdown.  In short, these investors were looking at their models seeing where they went wrong.  Patterson writes:

Throttled quants everywhere were suddenly engaged in a prolonged bout of soul-searching, questioning whether all their brilliant strategies were an illusion, pure luck that happened to work during a period of dramatic growth, economic prosperity, and excessive leverage that lifted everyone’s boat.

Here Patterson puts his finger on the question that vexes anyone who has ever invested, made money for a time and then given some back: Does my strategy actually work or have I been lucky? It’s what I like to call The Fear, and there’s really no simple salve for it.

The complicating factor in the application of any investing strategy, and the basis for The Fear, is that even exceptionally well-performed strategies will both underperform the market and have negative periods that can extend for three, five or, on rare occasions, more years. Take, for example, the following back-test of a simple value strategy over the period 2002 to the present. The portfolio consisted of thirty stocks drawn from the Russell 3000 rebalanced daily and allowing 0.5% for slippage:

(Click to enlarge)

The simple value strategy returns a comically huge 2,450% over the 8 1/4 years, leaving the Russell 3000 Index in its wake (the Russell 3000 is up 9% for the entire period). 2,450% over the 8 1/4 years is an average annual compound return of 47%. That annual compound return figure is, however, misleading. It’s not a smooth upward ride at a 47% rate from 100 to 2,550. There are periods of huge returns, and, as the next chart shows, periods of substantial losses:

(Click to enlarge)

From January 2007 to December 2008, the simple value strategy lost 20% of its value, and was down 40% at its nadir. Taken from 2006, the strategy is square. That’s three years with no returns to show for it. It’s hard to believe that the two charts show the same strategy. If your investment experience starts in a down period like this, I’d suggest that you’re unlikely to use that strategy ever again. If you’re a professional investor and your fund launches into one of these periods, you’re driving trucks. Conversely, if you started in 2002 or 2009, your returns were excellent, and you’re genius. Neither conclusion is a fair one.

Abnormal Returns says of the correct conclusion to draw from performance:

An unexpectedly large drawdown may mark the failure of the model or may simply be the result of bad luck. The fact is that the decision will only be validated in hindsight. In either case it represents a chink in the armor of the human-free investment process. Ultimately every portfolio is run by a (fallible) human, whether they choose to admit it or not.

In this respect quantitative investing is not unlike discretionary investing. At some point every investor will face the choice of continuing to use their method despite losses or choosing to modify or replace the current methodology. So while quantitative investing may automate much of the investment process it still requires human input. In the end every quant model has a human with their hand on the power plug ready to pull it if things go badly wrong.

At an abstract, intellectual level, an adherence to a philosophy like value – with its focus on logic, discipline and character - alleviates some of the pain. Value answers the first part of the question above, “Does my strategy actually work?” Yes, I believe value works. The various academic studies that I’m so fond of quoting (for example, Value vs Glamour: A Global Phenomenon and Contrarian Investment, Extrapolation and Risk) confirm for me that value is a real phenomenon. I acknowledge, however, that that view is grounded in faith. We can call it logic and back-test it to an atomic level over an eon, but, ultimately, we have to accept that we’re value investors for reasons peculiar to our personalities, and not because we’re men and women of reason and rationality. It’s some comfort to know that greater minds have used the philosophy and profited. In my experience, however, abstract intellectualism doesn’t keep The Fear at bay at 3.00am. Neither does it answer the second part of the question, “Am I a value investor, or have I just been lucky?”

As an aside, whenever I see back-test results like the ones above (or like those in the Net current asset value and net net working capital back-test refined posts) I am reminded of Marcus Brutus’s oft-quoted line to Cassius in Shakespeare’s Julius Caesar:

There is a tide in the affairs of men,

Which, taken at the flood, leads on to fortune;

Omitted, all the voyage of their life

Is bound in shallows and in miseries.

As the first chart above shows, in 2002 or 2009, the simple value strategy was in flood, and lead on to fortune. Without those two periods, however, the strategy seems “bound in shallows and in miseries.” Brutus’s line seems apt, and it is, but not for the obvious reason. In the scene in Julius Caesar from which Brutus’s line is drawn, Brutus tries to persuade Cassius that they must act because the tide is at the flood (“On such a full sea are we now afloat; And we must take the current when it serves, Or lose our ventures.”). What goes unsaid, and what Brutus and Cassius discover soon enough, is that a sin of commission is deadlier than a sin of omission. The failure to take the tide at the flood leads to a life “bound in shallows and in miseries,” but taking the tide at the flood sometimes leads to death on a battlefield. It’s a stirring call to arms, and that’s why it’s quoted so often, but it’s worth remembering that Brutus and Cassius don’t see the play out.

* Yes, the link is to classic.abnormalreturns. I like my Abnormal Returns like I like my Coke.

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

Kraft Foods Inc. released its annual proxy statement yesterday which serves as timely illustration of the faulty logic that compensation committees regularly use when setting executive pay levels.  As we discussed last month, compensation policies can encourage executives to pursue value destroying mergers.  Kraft CEO Irene Rosenfeld earned $26.3 million in total compensation for 2009 with significant components granted due to “exceptional leadership” that resulted in closing the Cadbury acquisition in February.  This is the same “exceptional leadership” that resulted in Warren Buffett taking a rare public stand against the actions of a manager in which Berkshire Hathaway holds minority positions.  Berkshire Hathaway is Kraft’s largest shareholder.

“Exceptional Leadership” Rewarded

The following excerpt from the proxy pertains to Ms. Rosenfeld’s actions related to the Cadbury acquisition that justified payment of the annual incentive bonus at 130 percent of target:

Led the combination of Kraft Foods and Cadbury, which transformed the portfolio into faster growing categories and geographies.  The Committee assessed Ms. Rosenfeld’s leadership in executing on the formal bid for Cadbury in November 2009 and closing this complex deal in early 2010 as exceptional; and The Committee specifically noted her commitment to financial discipline as evidenced by maintaining our investment grade rating, accretion to cash earnings in the second full year, and our current dividend.

Led the divestitures of businesses that continue to transform the portfolio.  Divested the North American frozen pizza business in the first quarter of 2010 for $3.7 billion; and Divested several slow growth small businesses during 2009 that generated approximately $0.04 of incremental EPS.

As for Ms. Rosenfeld’s base pay, the company notes that her salary is “below the size-adjusted median of the Compensation Survey Group”.  Presumably, Kraft’s larger size in 2010 following the Cadbury acquisition will result in the company being placed into a larger peer group that will lead to higher base salary recommendations in the future which would illustrate the incentives managers have to grow the size of a business regardless of returns on incremental capital.

Pizza Business Divestiture

The bonus justification associated with the divestiture of the pizza business is particularly disingenuous because the claim that the sale raised $3.7 billion completely ignores the tax inefficiencies that Warren Buffett discussed in a CNBC Interview in January:

I feel poorer. (Laughs.) Kraft, in my judgment, well just in the past two weeks there’s been two things that caused me to feel poorer. They sold a very fine pizza business and they said they got 3.7 billion for it. But, because it had practically no tax basis, they really got about 2.5 billion. They sold a business for 2.5 billion that Nestle is willing to pay 3.7 billion. Now can Nestle run it that much better than Kraft? I doubt it. But that business that was sold for 2.5 billion earned 280 million pre-tax last year. But they sold that at less, right around nine times pre-tax earnings in terms of their own figure.

Now they mentioned paying 13 times EBITDA for Cadbury, but they’re paying more than that. For one thing, EBITDA is not the same as earnings. Depreciation is a very real expense. But on top of that, they’ve got a billion-three they’re going to spend of various rearrangements of Cadbury. They’ve got 390 million dollars of deal expenses. They are using their own stock, 260 million shares or something like that, that their own directors say is significantly undervalued. And when they calculate that 13, they’re calculating Kraft at market price, not at what their own directors think the stock is worth. So, the actual multiple, if you look at the value of the Kraft stock, is more like 16 or 17 and they sold earnings at nine times. So, it’s hard to get rich doing that.

It appears that Kraft’s Board of Directors is content to embed misleading information regarding divestitures in the proxy statement in an attempt to justify a very rich pay package for a CEO who presided over significant value destruction leading the company’s largest shareholder to “feel poorer” as a result.  However, one can hardly blame Ms. Rosenfeld for her actions.  She knew that the executive compensation policies would reward this type of action and was only acting according to the incentives that the Board provided.

If shareholders of Kraft are looking for those to blame for the value destruction, they should note the members of the compensation committee at Kraft and vote their proxies accordingly:

The compensation committee members during 2009 were Ajaypal S. Banga, Myra M. Hart, Lois D. Juliber, Mark D. Ketchum, and Deborah C. Wright.

Alternatively, shareholder can vote with their feet by selling their shares.  If the company’s largest shareholder cannot prompt common sense corporate governance, it is doubtful that smaller shareholders could achieve better results.

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 which owns approximately 8 percent of Kraft common stock.

Posted by manualofideas at 10:43 PM | Permalink | Comments (0)

A new European Value Report was released this morning. The report features the top two monthly investment ideas, as selected by The Manual of Ideas equity research team in Europe.

The first company owns the largest coal-fired power plant in the U.K., which is responsible for meeting 7% of the U.K.’s electricity needs. With a strong balance sheet and cash generative operations, the company has staying power. The report estimates fair value at £7 per share (midpoint of valuation range), compared to a recent market price of £3.81 per share.

The second featured company is a German printing equipment and services provider with a resilient, high-margin services business. While the downside is protected by tangible book support and cash generation from the services business, a recovery in printing press demand could provide strong upside.

Posted by manualofideas at 09:36 AM | Permalink | Comments (0)

Charlie Munger’s annual letter to shareholders of Wesco Financial Corporation was published last week.  Wesco Financial is a publicly traded company that is 80 percent owned by Berkshire Hathaway.  Charlie Munger is Berkshire Hathaway’s longtime Vice Chairman and also serves as Chairman and President of Wesco Financial.  Mr. Munger’s annual letter does not attract nearly as much attention as Warren Buffett’s letter to Berkshire shareholders (discussed last month) but nonetheless provides notable insights worthy of extended discussion.

Overview

Mr. Munger makes reference to Wesco’s 10-K report which was released in early March and should be reviewed in conjunction with the financial information provided in the letter.  Wesco reported operating income of $54.1 million for 2009 which is down from $77.6 million in the prior year.  While insurance underwriting produced a $7.2 million profit for 2009 compared to a $2.9 million loss in the prior year, investment income dropped to $55.8 million compared to $64.3 million in 2008.

In Wesco’s non-insurance operations, CORT’s business has been “melting away” faster than management can fix it as demonstrated by a $1.4 million loss in 2009 compared to a $15.7 million profit in 2008.  Precision Steel produced a $648,000 loss in 2009 compared to a $842,000 profit in 2008 as its business was “pounded by the Great Recession”.  Another factor leading to lower reported results for 2009 was a $6.2 million after-tax write down of the carrying value of a condominium development that was completed on land adjacent to Wesco’s headquarters in Pasadena.

Insurance

Wesco engages in the reinsurance business through its Wes-FIC subsidiary and provides various types of insurance coverage to the banking industry through its Kansas Bankers subsidiary.

Since the beginning of 2008, Wes-FIC’s business has been dominated by Wesco’s participation in Berkshire Hathaway’s reinsurance contract with Swiss Re.  Wes-FIC has assumed 10 percent of Berkshire’s 20 percent quota-share reinsurance of Swiss Re which means that Wes-FIC has assumed 2 percent of essentially all of Swiss Re’s property-casualty risks incepting over the five year period starting on January 1, 2008.  This business accounted for the vast majority of earned premiums in 2009 and generated $10.4 million in underwriting profits.  In addition to Wes-FIC’s participation in the Swiss Re contract, the business is exposed to various risks associated with the aviation industry.

Kansas Bankers Surety Company is engaged in providing various types of insurance coverage to the banking industry.  As we discussed last year, Kansas Bankers made a decision to exit the deposit guarantee bond business and this process continued in 2009.  As a result of shrinking the deposit guarantee bond business, Kansas Bankers experienced a significant decline in earned premiums and posted a $3.2 million underwriting loss for the year.  Mr. Munger reports that the aggregate face value of outstanding deposit guarantee bonds has declined to $33 million insuring ten institutions which is down sharply from $9.7 billion insuring 1,671 institutions when the exit from this line of business commenced in 2008.

We continue to note that management’s actions have demonstrated an unusual level of underwriting discipline by rejecting risks that are perceived as inadequately priced even at the expense of a painful reduction in premium volume and near term underwriting losses as overhead expenses failed to shrink in line with earned premiums.  This is the type of underwriting discipline that we discuss extensively in our 2010 Berkshire Hathaway Briefing Book and has led to sustained levels of underwriting profitability at National Indemnity and other Berkshire insurance operations over very long periods of time.  There are few businesses that are willing to voluntarily shrink in the short run in order to preserve capital required for opportunities in the future which is one reason many insurers fail to achieve underwriting profits in the long run.

CORT Gets “Hammered”

Mr. Munger pulls no punches when discussing the poor performance at CORT which posted a $1.4 million loss in 2009 compared to a $15.7 million profit in 2008.  While CORT’s revenues only declined to $380 million in 2009 compared to $410 million in 2008, the revenue decline was much more severe when one excludes the impact of acquisitions.  On a “core revenues” basis, CORT experienced nearly a 20 percent decline in 2009.  Mr. Munger expects “disappointing profits” for 2009:

Under Wesco’s ownership, CORT has continuously undertaken to improve its competitive position. With several websites, principally, www.cort.com and www.apartmentsearch. com, professionals in more than 80 domestic metropolitan markets, affiliates servicing more than 50 countries, almost twenty-one thousand apartment communities referring their tenants to CORT, many ancillary services, and its entrée to the business community as a Berkshire Hathaway company, CORT is better positioned than previously to benefit from an economic turnaround if it occurs in due course. Near term, we expect more of the difficult business conditions of the recent past, but we do not expect another operating loss at CORT in 2010. Instead, we expect disappointing profits.

Precision Steel Gets “Pounded”

Precision Steel experienced a significant decline in revenues with $38.4 million for 2009 compared to $60.9 million for 2008.  In terms of pounds sold, Precision Steel is only shipping half the annual volume compared to the number of pounds shipped thirty years ago when the company was acquired by Wesco.  The main factor responsible for this downturn is that Precision Steel’s traditional customers have been moving production outside the United States and management has been unable to compensate for these competitive losses as well as for the impact of the recession:

Apart from the recessionary-caused weakness, the general and ongoing decline in Precision Steel’s physical volume is a serious reverse, not likely to disappear in some “bounce back” effect once the economy recovers.

Straight Talk

Although Mr. Munger’s letter cannot be characterized as upbeat, it is notably more positive than last year’s letter when he referred to the economy as being in the midst of “the worst economic disaster since the Great Depression.”  But at a more general level, it is hard to not appreciate Mr. Munger’s willingness to deliver bad news to shareholders in a direct and candid way.  For every CEO who is willing to do this, there are dozens who prefer to invent reasons and explanations that strain credulity and attempt to shift blame to others.  For another example of a straight forward document that delivers the required information in a candid manner, please read Wesco Financial’s 2010 Proxy Statement which was also released late last week.

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 directly own shares of Wesco Financial.  The author owns shares of Berkshire Hathaway, 80 percent owner of Wesco, and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Posted by manualofideas at 11:40 AM | Permalink | Comments (0)

By Matt Darrah

My recommendation to buy Tetragon does not follow my typical tenet of buying good companies with management teams who are wise capital allocators at a cheap price, but due to the attractiveness of the Company’s valuation, I believe it represents an attractive investment opportunity.

• Extremely Attractive Valuation: (1) stock price implies a 51% discount to the Company’s fair value based on reasonable assumptions; (2) trades at 3.3x FCF or a 31% FCF yield
• Relatively Strong Portfolio Performance in a Horrible Market for Lenders: (1) loan default rate of 6.5% compared to 9.6% for the overall market; (2) 32% of CLOs failing Junior Par Coverage Tests compared to 38% for the overall market; (3) 12.0% of loans rated CCC+ or below compared to 16.5% for the overall market
• Market Seems to Be Punishing the Stock for an Out of Market Fee Arrangement the Company made with its Investment Manager at the Time of its IPO: (1) while I also don’t like the fee arrangement, Management clearly disclosed the arrangement to shareholders, and I believe I can adequately predict its impact on cash flows; (2) future shareholders unlikely to be harmed from fee structure

Tetragon Stock Price Since IPO (April 2007)

Source: BigCharts.com.

Company Overview

Tetragon Financial Group Limited (“Tetragon”, “Company”, or “TFG”) is an investment company that was publicly listed on the Amsterdam Stock Exchange in 2007 (Euronext Amsterdam: TFG) (OTC: TGONF). The management team formed TFG to invest in the equity tranches of collateralized loan obligations (“CLOs”).

CLOs borrow money and raise equity, and then use those funds to purchase bank loans. The CLO then uses the interest it earns on those bank loans to pay the interest its own debt, and whatever cash flow is left is sent to the equity holders. Basically, CLOs mimic banks, but instead of using
depositors’ capital to buy and originate loans, CLOs borrow money from investors. Typically, a CLO will borrow in multiple “tranches” of debt. The CLO is required to pay back the senior debt tranches first, and these tranches have more rights that protect them from losing money, which come at the expense of more junior tranches and the equity holders. Investors who want to avoid losses and are willing to accept lower rates of return buy the senior most debt tranches. Junior tranches and the equity holders take on more risk, but enjoy higher returns. A sample CLO structure is shown below.

Sample Collateralized Loan Obligation (CLO) Structure

Source: Matt Darrah's investment newsletter, March 25, 2010.

When the loans that the CLO holds perform according to plan, the assets generate enough cash flow to pay the required interest on the CLO’s debt (senior, mezzanine, and subordinated notes) with the remaining cash flow being distributed to the equity holders.

As I said before, investors buying the senior tranches of debt first and foremost want their principal to be safe, and require that various tests are met to protect their cash flows when the loans do not generate the amount of cash flow planned. Two basic tests protect investors in these senior tranches: the overcollateralization test (O/C) and the interest proceeds (I/C) test. The O/C test measures the par value of leveraged loans to liabilities, but deducts certain assets from being used for the purposes of the test. Types of excluded assets primarily include loans that are rated below a certain level by S&P and/or Moody’s. The I/C test evaluates available interest received from the CLO’s assets to make interest payments on the debt issued by the CLO. CLOs are typically designed to first violate the O/C test during times of distress.

When a CLO violates one of these tests, it begins to “trap cash”. Trapping cash means that the CLO stops distributing any cash to the equity and/or other junior debt tranches and begins to pay down senior notes on an accelerated basis. Paying down debt helps bring the CLO back into compliance, as lower debt levels mean that both ratios will improve as the qualified assets in the CLO will have to cover less debt, and there will be less interest burden on the CLO.

During the recent credit crisis, many CLOs violated these tests and thus began trapping cash. Investors who held the equity tranches of these CLOs stopped receiving payments as a result. In response, many of these investors began to trying to fire sell the CLO equity tranches, resulting in lower market prices for such assets.

TFG only invests in the equity tranches of CLOs, and thus has been severely impacted by the credit crisis.

However, TFG has performed better than many of its peers in terms of several key metrics including: (i) Loan Default Rates (% of loans that are not in compliance with their loan agreements), (ii) CLOs tripping an O/C or I/C test, and (ii) % of loans rated at CCC+ or lower by the rating agencies. This strong performance results from management’s selection of seasoned CLO managers who were able to better weather the financial crisis.

Tetragon Portfolio Outperformance vs. Market on Key Metrics

Source: Matt Darrah's investment newsletter, March 25, 2010.

Valuation

Asset-Based Valuation

As of February 28th 2010, TFG held 68 CLO investments that management valued at $707MM. Additionally, the Company held $163MM of cash. Adding the CLOs and the cash together and subtracting out TFG’s $13MM of liabilities results in a total value of $857MM or $6.91 per share.

Four major assumptions determine the value of a CLO: (i) default rate, (ii) recovery rate (% of par that the CLO will receive in final satisfaction of the claims on a defaulted loan), (iii) prepayment rate (% of loans repaid each year), (iv) reinvestment price (% of par the CLO is able to invest money it receives from prepayments), and (v) the discount rate used to value the cash flows resulting from assumptions (i) – (iv).

In my opinion, TFG uses appropriate assumptions to value the portfolio. Below is a summary of these assumptions.

Portfolio Valuation Assumptions Used by Tetragon

Source: Matt Darrah's investment newsletter, March 25, 2010.

The 6.4% default rate approximates the Company’s current default rate, and assumes that will continue for two years. I believe this is unlikely unless there is a severe double dip recession. The default rate averages 2.4% for levered loans, so 2.1% appears to be an adequate assumption after 2011 given the draconian 6.4% assumption in 2011.

In 2009, recovery rates averaged ~40%, compared to the Company’s 55% assumption for 2010 and 2011. I would expect recovery rates to increase more towards their 75% historical levels as the economy improves, and thus I think assuming 55% for 2010 may be too aggressive, but is offset by the fact that recovery rates will likely be higher in 2011. The 71% recovery rate in 2012 and beyond seems reasonable given the historical 75% recovery rate.

Prepayment rates currently average 14.3%, compared to the assumed 7.5%. A higher prepayment rate results in a higher valuation, as TFG is able to buy loans at today’s attractive prices. Prepayments averaged 40% from 1997 – 2009 versus 20% assumed in TFG’s model after 2011. I expect that the 20% prepayment rate can be achieved, as the high yield markets were not available to issuers during part of 2009, and thus the 2009 prepayment rates are understated. Note that many companies issued high yield bonds to repay their bank loans during 2009.

TFG’s assumed reinvestment rate of 87% in ’10 & ’11 seems a little aggressive, but based on conversations with management, I believe that the lower value resulting from reinvesting at current market prices is offset by the higher current prepayment rates discussed above.

Further, the management team is essentially discounting these cash flows at 30% with a special balance sheet reserve called an Accelerated Loss Reserve (“ALR”). I believe a 30% discount rate represents an appropriate required return on risky CLO equity tranches. However, note the market values the Company’s holding at 51% of the value determined by this model, which means the market is implying a much larger discount rate than 30%. Such a large discount rate gives me comfort that even if the assumptions described above are not met, my investment will not be impaired.

Note that while management chooses the assumptions to place in the valuation models, they must use standardized models produced by Wall Street Analytics to value each CLO investment owned, so management cannot manipulate the model beyond the assumptions they place in the model. KPMG audits the valuation and State Street, the fund’s administrator, reviews the valuations too.

Cash Flow Based Valuation

Despite the fact that 42% of TFG’s CLO investments trapped cash at the worst points of 2009, the Company’s investments still generated $109MM of cash net investment income in 2009. This level of cash flow implies that TFG trades at 3.3x 2009 cash flow.

Summary of Cash Flow-Based Valuation Analysis

Source: Matt Darrah's investment newsletter, March 25, 2010.

Bear in mind that the Company has experienced a number of the CLOs that were trapping cash earlier in 2009 start to distribute cash to equity holders again. I believe that this trend will continue as the CLOs repay senior debt tranches to bring themselves back in compliance, and thus the normalized cash flow of this business is likely much higher than 2009 levels.

Positive Trend among Cash-Trapping CLOs

Source: Matt Darrah's investment newsletter, March 25, 2010.

Further, TFG will redeploy repaid loans at much higher interest rates given the current favorable market environment for investing in loans. Note that CLOs get to keep their historically low interest rates on debt tranches that were negotiated in 2007, which is very attractive to the equity holders.

Key Risks

A couple key risks could undermine my investment thesis. I believe they are primarily mitigated by the low valuation outlined above, but I will list other mitigating factors too.

Mark to Model Valuation

TFG uses a model based valuation technique that I cannot independently verify. However, I gain comfort that I am buying these assets at 51% of purported fair market value and 3.3x cash flow (note that the level of cash flow gives me some comfort that the assets are fairly valued).

Management Incentives Not Aligned with Long-Term Shareholders

A third-party asset management company, Polygon Credit, makes investing decisions for TFG, and receives a 1.5% base management fee on assets under management, and 25% of the fair value increase above a nominal hurdle rate each quarter. Unfortunately, the management agreement does not contain a “high water mark” clause. The lack of this clause means that despite the fact that TFG’s assets have been tremendously written down, the Polygon Credit will still able to collect a performance fee when fair market value goes up in a single quarter. To give you an example of how this could be used to harm shareholders, Polygon could write down the assets to $1 by using very draconian assumptions about default, recovery, prepayment, and reinvestment rates, and then collect 25% of any valued it received above $1. Moreover, Polygon could simply continue this revaluation every other quarter to continual pick the shareholders’ pocket.

While I believe that the fee arrangement is outrageous, I don’t believe management is performing such tricks, nor do I believe that they will due to the oversight from their auditors and the lack of a historical tendency to do so. When few buyers existed for CLO equity in Q1 2009, TFG could have easily written the portfolio down to $150MM - $300MM based on the few comparable transactions completed in the market. Instead, the Company recorded the assets at $615MM, which seems much more realistic based on trailing cash flows received by the portfolio.

Further, this conflict does reduce the likelihood that management is inflating its mark to model valuations.

Potential Catalysts

Share buybacks and Dividends

TFG has been buying back shares below asset value at a rate of ~500k shares per month. Since TFG buys the shares below asset value, the purchases enhance the stock’s value. The Company recently declared a $0.03 per share dividend for Q1 2010, which implies an annualized dividend
yield of ~3%.

Recent Acquisitions

TFG recently purchased CLO equity assets with a $39MM cost basis and a strong manager of $2.5Bn of CLO assets for only $3MM. Acquiring assets at these attractive prices appears very accretive, but perhaps more importantly, the acquisition adds a CLO manager to TFG’s cash flow stream. Asset managers are much more stable generators of cash flow, as they collect fees on assets under management instead of being exposed to the volatility of asset values. Given that the Company
owns the majority of the equity in many of its CLO investments, I wouldn’t be surprised if TFG begins replacing underperforming CLO managers with its newly acquired one (who according to management is one of its top CLO managers in terms of performance through the credit crisis), which could provide a new, robust stream of steady cash flows.

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 06:19 PM | Permalink | Comments (0)

We are pleased to announce a content partnership with Plan Maestro of the value-oriented investment blog Variant Perceptions. The latter regularly features high-quality content and analysis for those looking to improve their investment skill and identify potential opportunities. As part of the content partnership, we will republish selected Variant Perceptions content we find particularly valuable to our readers and members.

To kick off the partnership, we are publishing in several posts (see below) a series entitled "Charting Banking," a great resource for those considering investments in the battered banking sector.

"Charting Banking" Series:

• Introduction
• Part I: Interest Spread
  
• Part II: Net Interest Margin
  
• Part III: Funding
  

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By Plan Maestro

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By Plan Maestro

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By Plan Maestro

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Middleburg Financial Corporation is a small bank holding company with primary operations in the western suburbs of Washington D.C.  The bank’s headquarters are in Middleburg, Virginia. Over the past two years, David Sokol has accumulated nearly twenty percent of the bank’s outstanding shares in his personal accounts.  Mr. Sokol is Chairman of MidAmerican Energy Holdings and Chairman and CEO of NetJets, both of which are subsidiaries of Berkshire Hathaway.  Since Mr. Sokol is often mentioned as a potential future CEO of Berkshire Hathaway and would be responsible for allocation of capital, we found it interesting to learn of his significant personal investment in Middleburg Financial and decided to take a closer look.

Middleburg:  The Heart of Virginia Hunt Country

Middleburg is located at the southern edge of Loudoun County, one of the most affluent counties in the United States in terms of median household incomes.  Middleburg Bank’s main market is on the outer periphery of the Washington metropolitan area in the heart of Virginia’s Hunt Country.  Based on personal observations, this is a region characterized by idyllic rural settings mixed with the advance of suburban sprawl during the housing boom.  The region has not been spared the impact of the housing crash but recent trends indicate overall stabilization.  The area has the advantage of being within commuting distance of the Washington job market which has benefited from the growth of the Federal government.

Brief Profile

Middleburg Bank has offered banking products and services to the surrounding area since it was founded in 1924.  The bank operates seven full service financial centers and two limited service facilities.  The bank serves Loudoun, Fairfax, and Fauquier counties and has plans to add a full service financial center in neighboring Prince William County later this year.  Middleburg Bank owns a 57 percent interest in Southern Trust Mortgage, a regional mortgage lender headquartered in Virginia Beach.  Starting in 2008, Middleburg Bank consolidated the operations of Southern Trust in the bank’s financial statements.

Middleburg Investment Group is a non-bank holding company subsidiary which primarily operates in the Richmond, Virginia area under its Middleburg Trust subsidiary.  Middleburg Trust offers investment and wealth management services as well as fee based investment management services for clients.

Financial History

The ten year financial history of Middleburg Financial shows a steady record characterized by attractive returns on equity and assets until 2006.  Starting in 2007, the company ran into trouble and key metrics deteriorated significantly.  The company had to take a $5 million goodwill impairment on its investment in Southern Trust Mortgage during 2007.  During 2008 and 2009, provisions for loan losses increased compared to prior years.  While the bank remained profitable, return on equity declined to the 3 to 4 percent range from low teen levels that prevailed from 2004 to 2006.  A summary of key statistics for the past ten years appears below (click on the image for a larger view):

In January 2009, the company agreed to accept $22 million in TARP funds through an issue of preferred stock.  In December 2009, the company redeemed the preferred stock although the Federal government still holds warrants to purchase 104,101 common shares at a price of $15.85 per share.  So far, the story regarding TARP is probably similar to many other  small banks in the United States.  However, the manner in which the company raised funds to repay the TARP money is where the story gets interesting.

Sokol’s Investments in Middleburg Financial

From our review of S.E.C. filings, David Sokol first reported a position in Middleburg Financial on November 20, 2008 when he reported ownership of 227,000 shares.  On March 31, 2009, Mr. Sokol entered into an agreement with the company to invest $5 million to acquire 454,545 shares at a price of $11 per share.  Between March 31 and June 2, Mr. Sokol increased his ownership again.  This was followed by market purchases in July and early August.  On February 24, 2010, Mr. Sokol purchased an additional 400,000 shares at $12.75 per share.  He now owns 1,375,792 shares, or approximately 19.9 percent of the common stock.

The table below shows a listing of Mr. Sokol’s activities in Middleburg Financial in recent months:

Mr. Sokol is the largest shareholder by far and owns a stake worth approximately $19.3 million based on today’s closing stock price.  In addition to the $5 million raised from Mr. Sokol in March 2009, the bank also issued additional shares in August 2009 resulting in net proceeds of $19.3 million.  These funds were used to repay the TARP funds in December 2009.

What Drove Sokol’s Decision?

There appear to be no records of any public comment by Mr. Sokol regarding his ownership of the company so some element of speculation is required to determine why he became interested in the company.  From a review of the financial statements and through compiling a ten year history, it seems clear that Middleburg Financial enjoyed a strong franchise during the early part of the last decade in which traditional metrics used to value a bank (such as return on assets and return on equity) were very favorable.  The bank was able to grow deposits at a satisfactory rate and maintained solid net interest margins.  For parts of this timeframe, the bank’s common stock traded well in excess of two times book value.

Community banks like Middleburg did not take many of the risks that ended up sinking larger banks.  We can see that the bank has experienced higher loss provisions but has maintained profitability and, after the equity raises, has capital ratios that are far in excess of regulatory standards.  The cost has been significant dilution particularly over the past year.

There does not appear to be any near term catalyst to return the bank to peak profitability.  In the latest 10-K report for the year ending December 31, 2009, management indicates that net interest margins will likely contract in 2010 and it appears that expansion will prevent net non-interest expense from declining.  One positive factor will be the retirement of the preferred stock which depressed net income available to common shareholders during 2009.

In the long run, if the bank can return to a 10% return on equity, it could earn $10 million, or $1.45 per share.  This could result in a stock price of $15 to $20 depending on the multiple that is used.  However, scenarios in which earnings per share approach this level appear to be at least a couple of years away.  On a more favorable note, at a recent price near $14, Middleburg Financial trades only slightly above tangible book value and far below the typical multiples of book value that prevailed during the last decade.

What led to Mr. Sokol’s decision to personally invest such a substantial sum in this bank?  Obviously, we cannot know for sure but a few observations are quite interesting:

1. At the time of his $5 million investment on March 31, 2009, stock markets were at very depressed levels and it would have been possible to purchase any number of other securities at low prices.  For example, an investor could have purchased Wells Fargo at around $14.
2. Berkshire Hathaway was trading around $87,000.  Presumably investing in Berkshire was an alternative.
3. The S&P 500 traded around 800.
4. It is doubtful that an investment of this magnitude in a small illiquid bank would be intended either for a short term investment or in anticipation of a small gain.  The nature of the investment and the level of risk assumed would indicate that high expectations for long term returns existed.

All of these factors lead us to believe that there are forces at work within Middleburg Financial that could result in significant long term value creation that will eventually be reflected in the common stock price.  Watching this situation play out over the next few years will be interesting in terms of trying to gain insight into the capital allocation decisions of a potential future CEO at Berkshire Hathaway.

For a spreadsheet with data on Middleburg Financial along with links to S.E.C. filings, please click on this link.

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

Disclosure:  The author does not own shares of Middleburg Financial.

Posted by manualofideas at 04:21 PM | Permalink | Comments (2)

Tariq Ali's Street Capitalist blog has an excellent analysis of Michael Burry's posts on a value investing thread he started in 1996.

Read it here.

Posted by manualofideas at 09:16 AM | Permalink | Comments (0)

A new issue of Portfolio Manager's Review, the flagship monthly publication of The Manual of Ideas has just been published. The 116-page report, entitled "The Brand Value Issue," features 100 public companies with substantial brand value. The acclaimed research team of The Manual of Ideas profiles and analyzes 20 companies, while five companies are highlighted as potential timely investment opportunities.

Among the Top 5 is a company whose brand value alone may exceed the recent enterprise value of the entire company. Also included in the Top 5 is a company that may have suffered near-term brand impairment due to highly publicized quality issues but whose long-term value The Manual of Ideas research team judges to be compelling.

View the 100 companies mentioned in "The Brand Value Issue."

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

By Greenbackd

Dr. Michael Burry has been a very popular topic on Greenbackd recently as a result of Michael Lewis’s The Big Short and the Vanity Fair article Betting on the Blind Side. I have posted a link to Burry’s techstocks.com “Value Investing” thread (now Silicon Investor) and another to Burry’s Scion Capital investor letters, but the thirst for all things Burry remains undiminished. The New York Times now has an article, The Origins of Michael Burry, Online, discussing some of Burry’s early postings on his techstocks.com thread. Here Burry discusses his strategy for shorting:

I mentioned that I pick stocks to short based on valuation, not ratios (I ask you to find the correct free cash flow — I bet most people don’t kow they’re working with negative net working capital, either). But I ENTER based on technical analysis. KO could go up or down. The odds are down, technically, but that’s what buy stops are for. This isn’t a long term short by any means. Research on shorts show that profitable shorts make money with small gains, not by waiting for businesses to bankrupt. The small gains are usually there for the picking. Another indicator – if it’s mentioned in Barron’s as a buy three different times <g> — set me onto Wells Fargo.

What’s there to understand about Coke? The business is a KISS model. This gets to my value/short strategy. When people start claiming a business deserves a special valuation above all reasonable fundamental analysis (because of the “franchise”, because there’s so little institutional ownership for a big cap growth stock, because Buffett’s in it, because global expansion will provide endless opportunity, because ROE is so damned high, because it’s nearly a monopoly, because Buffett’s in it…), that’s a short, IMO.

I just read a bunch of Graham, and he doesn’t deal with shorts (I assume it would be “speculation”), but EMT isn’t all that its panned to be either, IMO.

Just trying to think independently,

Mike

The NYT has also unearthed a Forbes magazine article from 2000:

VALUESTOCKS.NET www.valuestocks.net Supposedly for value investors, though Warren Buffett might not agree with this definition of value. Run by a 28-year-old neurology resident, Dr. Michael Burry, Valuestocks.net showcases Burry’s own $50,000 portfolio, which includes some surprising choices including Pixar, the maker of Toy Story. Has good information on how to identify net-net stocks (trading for less than assets minus all conceivable liabilities). Accompanying all this are Burry’s incisive reports, as good as anything from Wall Street. One of the site’s best features is a list of essential finance texts, including thumbnail reviews and links to Amazon.com (Burry’s only source of revenue, since he doesn’t accept banner ads). BEST: Original analysis, links to great finance sites, and a must-read book list for value investors. WORST: Limited content is sometimes dated.

It seems Greenbackd is rapidly, if unintentionally, becoming Mike Burry’s Of Permanent Value, which is Andrew Kilpatrick’s encyclopedic collection of stories about Warren Buffett. Incidentally, my copy of Of Permanent Value is around ten years old, which means it’s one-third the size of the 2010 edition (I’m not even joking. Mine came in a single volume, and it now seems to be a three-volume extravaganza. Buffett has been busy over the last 10 years).

Posted by manualofideas at 10:04 PM | Permalink | Comments (0)

By Greenbackd

The New York Times has a fantastic profile on Carl Icahn called Does Icahn Still Make Them Tremble?

He is one of Wall Street’s most colorful, controversial and complicated characters.

Wearing slightly rumpled khakis and waving his eyeglasses to punctuate key points, Mr. Icahn is constantly jumping from one topic to another in an endless stream of dialogue. In that respect, he more closely resembles an absent-minded professor than a master of the universe.

Corporate executives visiting his offices walk through hallways adorned with paintings of battle scenes and sculptures of cowboys on bucking broncos. One large painting in the conference room features a lion gazing at the bones of an animal in a desert.

Yet he bristles at being labeled a “raider,” despite the fact that he is widely viewed as a founding member of the clan that roamed Wall Street in the 1980s, occasionally pursuing hostile takeovers with ruthless abandon.

He prefers to paint his role in those years with the same “activist investor” brush he holds today, arguing that he has created tens of billions of dollars of value for shareholders in companies in which he invested. (In conversations, he declares that he has created $30 billion, $40 billion and even $50 billion worth of value for shareholders. What is a few billion among friends?)

This is Icahn’s thesis for his investments in the biotechnology sector:

“The biotechs have been his big winners recently,” particularly investments in ImClone Systems and MedImmune, said Mr. Young at Institutional Shareholder Services. “His thesis, which is no secret, is that biotech firms should be purchased by Big Pharma, which is always in need of new products. In his mind, that’s a match made in heaven.”

I love this story:

Mr. Icahn does not seem to let anything, including a very close friendship, get in the way of protecting his and his investors’ profits. Late in 2008, through his hedge fund, he sued Realogy, a real estate company controlled by Leon Black, the head of the private equity firm Apollo Management. Mr. Black was trying to reduce Realogy’s hefty debt load by offering to exchange some of the debt with bondholders.

Mr. Icahn, a bondholder who has known and been friends with Mr. Black for decades — the two have been longtime tennis partners — objected to some terms of the exchange and sued.

“Carl and I have been good friends for over 25 years,” Mr. Black said in an e-mail message. “Occasionally we skirmish as couples are wont to do, but I believe we both feel that when the chips are down that the friendship is paramount.”

How, exactly, does one sue and still be good friends with someone on Wall Street? Mr. Icahn smiles sagely over his cup of coffee: “The two of us have a saying that we always use whenever there is friction in our business dealings. We always say, ‘there’s only one Maltese Falcon.’ ”

At one point in that classic 1941 film, a character chasing a valuable figurine says to a close associate, “You’ve been like a son to me,” Mr. Icahn explains, paraphrasing from the movie.

Then, lowering his voice with mock intensity, Mr. Icahn adds that the character says that if you lose a son, it’s possible to get another — “but there’s only one Maltese Falcon.’ ”

Click here to see the rest of the article.

Posted by manualofideas at 04:23 PM | Permalink | Comments (0)

Every Friday in recent months, the Federal Deposit Insurance Corporation (FDIC) has announced a list of bank failures along with plans for resolution of the failure.  The shareholders and management of these banks may look with envy at the elite group of banks in the United States that are considered “too big to fail” and enjoy protections that are unavailable to smaller financial institutions.  Appalachian Community Bank, which failed last Friday, was simply closed by regulators who arranged to have customer deposits assumed by another bank.  In other cases, such as the failure of Advanta Bank, the FDIC is unable to find another financial institution to take over deposits.  In most cases, managers lose their jobs, shareholders are wiped out, and uninsured creditors lose some or all of their investment.

The privileged bankers who run institutions that are considered to be “too big to fail” do not suffer the same fate as their smaller counterparts as Simon Johnson and James Kwak describe in their forthcoming book 13 Bankers:  The Wall Street Takeover and the Next Financial Meltdown. Although the book is not a comprehensive account of the financial crisis or a “behind the scenes” epic story like Andrew Ross Sorkin’s Too Big To Fail, the authors present a compelling case in favor of not allowing financial institutions to reach the point where they pose systemic risks.

Historical Context

The authors begin with a brief review of the history of America’s financial system dating back to the debate between Thomas Jefferson and Alexander Hamilton.  Jefferson’s idealistic vision of America as a decentralized agrarian society and Hamilton’s preference for a strong central government that actively supports economic development were at odds from the earliest days of the republic.  Hamilton and his allies eventually won the debate despite Jefferson’s belief that the Bank of the United States violated the Tenth Amendment which specifies that the Federal government may only engage in activities specifically enumerated by the Constitution. President Washington eventually came to the conclusion that the bank was permitted under the Constitution’s commerce clause.

If this debate sounds familiar, that is because the same arguments are often made today regarding the proper role of the Federal government in society.  An excellent example is the constitutional question brought up by opponents of an “individual mandate” to purchase health insurance.  This is not an enumerated power in the Constitution but may be justified by a broader interpretation of the commerce clause if we accept the argument of supporters.

The broader point that the authors bring up is that Jefferson was one of the first of many to oppose the existence of large institutions in society that could generate overwhelming economic and political power.  The authors proceed to take us through a brief history of the 19th century culminating in the concentrations of power at the turn of the 20th century which led to broad anti-trust action against oil and railway interests.  The Panic of 1907 forced a policy debate that led to the establishment of the Federal Reserve in 1913.  The authors then provide a brief overview of the Great Depression laws such as Glass-Steagall that shaped much of America’s postwar financial landscape.

The End of “Boring Banking”

The authors trace the problems facing the system today to the deregulation that began in the 1970s and culminated in the late 1990s with the repeal of Glass-Steagall which removed the last barriers between commercial and investment banking.  Along the way, the reader also has the benefit of a brief review of the savings and loan crisis of the late 1980s and early 1990s and the growing political power of the banking industry as bankers and politicians increasingly “cross pollinated” between the Washington – New York corridor.  Regulatory capture is the obvious problem that can occur when an industry is regulated by individuals who used to work in the industry or hope to do so again in the future.

Policy Prescriptions

The authors advocate an end to the “too big to fail” problem by prohibiting financial institutions from growing beyond a certain size and breaking up existing ones that are already beyond size limits.  In addition, broad consumer protection legislation is called for in an attempt to curb some of the abuses of the mortgage meltdown of the past several years.

Many opponents of this point of view argue that very large institutions are required for America to compete in a modern economy and we cannot “turn back the clock” on the system.  The authors propose a hard cap on size where no institution can have more than 4 percent of GDP in assets, which would amount to approximately $570 billion today.  Furthermore, due to the riskier profile of investment banks, the authors call for size limits of 2 percent of GDP, or approximately $285 billion.

“A 4 percent cap would only roll back the clock to the mid-1990s.  At that time, the largest commercial banks — Bank of America, Chase Manhattan, Citibank, NationsBank — each had assets roughly equivalent to 3-4 percent of U.S. GDP.  On the investment banking side, Goldman Sachs and Morgan Stanley only passed the 2 percent threshold in 1997 and 1996 respectively;  at the time, they were the two premier investment banks in the world, and no one thought they were unable to meet their clients’ needs.”  pg 216, pre-publication galley.

Six banks would be affected by this proposal:  Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley.

Of course, it is impossible to ignore the fact that regulators have been moving in exactly the opposite direction in recent years.  The “solution” to the meltdown in the fall of 2008 was to encourage or force financial institutions to combine with each other leading to ever-larger banks that are even further into the “too big to fail” category.

Regulation in a Free Market

The authors of the book lean to the political left, particularly in their recommendations for consumer protection laws that are designed more to protect individuals from themselves rather than to safeguard the financial stability of the system as a whole.  From a free market perspective, full disclosure of consumer products and bans on deceptive or fraudulent lending practices are perfectly appropriate but outright bans on financial products should draw scrutiny.  Protecting informed individuals from their own poor decisions is a questionable use of regulatory power.

On the other hand, regulations intended to prevent a meltdown of the financial system as a whole are firmly within the appropriate powers of government because the alternative is to continue engaging in taxpayer funded bailouts.  Blocking regulations such as prohibiting the merger of two institutions that would lead to a group that is too big to fail, or even the breakup of existing institutions, can be justified as a means of preventing greater harm to society.  Furthermore, such blocking regulations reduce the need for “regulation by micromanagement” that would otherwise be needed to prevent the failure of large institutions.

Free market advocates (which firmly includes the author of this article) need to realize that our current system is not a true “free market” because institutions that are too big to fail enjoy upside benefits while downside risks are socialized through taxpayer bailouts.  A free market must include the consequences of failure and advocates of free markets should support regulatory efforts that move in this direction.  It is not clear whether the authors of 13 Bankers have come up with the best policy solution but they have made an important contribution to the debate.

Note to Readers:  This book was reviewed based on a pre-publication galley provided by the publisher in February 2010.  The publisher notes that the galleys are subject to revision and all quotations or attributions should be checked against the final bound copy of the book.  The book is scheduled for publication on March 30.

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 which holds investments in Bank of America, Wells Fargo and Goldman Sachs.

Posted by manualofideas at 08:46 AM | Permalink | Comments (0)

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Posted by manualofideas at 01:02 PM | Permalink | Comments (0)

It has become relatively common to read annual reports of companies that previously engaged in regular share buybacks yet mysteriously decided to halt the practice during 2009 even as share prices hit multi-year lows.  As The Economist has noted, share buybacks are making a comeback in 2010 just as markets are approaching levels last seen prior to September/October 2008. Why is this happening now and how should shareholders evaluate management decisions on buybacks?

A Rare Skill Set

Shareholders employ a Chief Executive Officer with an expectation that he or she will intelligently run the business in a manner that is likely to maximize profitability over long periods of time.  Over time and depending on the nature of the specific business, a good manager should be able to generate cash flow above and beyond maintenance capital expenditure requirements.

Operational excellence should ideally result in a growing pile of cash on a company’s balance sheet.  However, simply because a manager is good at running a business and generating free cash flow does not mean that the manager will intelligently deploy the free cash flow for benefit of the company’s owners.  Great operational managers are rare and so are great capital allocators.  It is exceedingly rare to find a manager who is excellent in both areas.

Reinvest or Return Cash to Owners?

When a manager finds that cash is building up on the balance sheet, a choice must be made:  Either the funds will be reinvested within the business or returned to shareholders.  Reinvestment can be accomplished through internal growth or through acquisitions of other companies while returning cash to shareholders can take the form of dividends or share buybacks.

There are a number of factors that naturally predispose  most operational managers to retain cash for reinvestment purposes:

First, excellent operational managers are normally optimists who have a history of seizing opportunities and finding success in areas where others may have failed.  Accordingly, such individuals often have a healthy opinion of their own capabilities and feel that cash in their hands may be used in intelligent ways within their current business.

Second, it is natural for most managers to want to build up the size of the company they oversee in terms of annual sales, number of locations, number of employees, etc.  When a manager says “I run a $10 billion company”, he is normally referring to annual sales volume rather than profitability. Just from an “ego” perspective, there is perceived value in running a larger enterprise.

Finally, and possibly most importantly, financial incentives often reward managers for growing the size of a business even if incremental returns on invested capital are substandard.  If you start with a business earning high returns on capital, incremental investments at inferior returns will only show up slowly in overall results and only be apparent to alert shareholders who are paying careful attention.

Share Buybacks or Dividends?

In cases where the CEO (or the Board of Directors) has decided that there are no legitimate opportunities for internal investment, there are primarily two ways in which excess cash can be returned to shareholders:  Share buybacks and dividends.  Many managers prefer buybacks for a few reasons:

First, a buyback reduces the number of shares outstanding and can mask the effect of option grants to executives and others in the organization.  In the absence of a buyback program, the share count of companies providing options to employees will creep up over time and make it more difficult for managers to achieve growth in reported earnings per share.

Second, managers who hold stock options have a clear incentive to favor buybacks over dividends.  Paying dividends reduces the intrinsic value of options since cash is flowing out of the business to shareholders while the option strike price remains unchanged.  In contrast, a share buyback effectively invests the cash on behalf of remaining shareholders in stock of the company itself which has a positive impact on option holders.

When Buybacks Make Sense

If a company has reached the point where free cash flow cannot be invested internally or via acquisition at acceptable rates of return, the cash should be returned to shareholders either through buybacks or dividends.  Buybacks are only appropriate when management believes that shares are trading at levels under a conservative estimate of intrinsic value.  When such buybacks occur, all remaining shareholders are better off because the intrinsic value of each share will increase and eventually be reflected in market prices.  In contrast, shares purchased indiscriminately at any price can destroy value when managers buy shares at inflated prices.

This leads to the question of whether managers who were repurchasing shares in 2007 and 2008 at high prices but failed to repurchase shares in 2009 were acting in the best interests of shareholders.  There are no blanket answers since each situation is different.  Many companies that had positive free cash flow in 2007 and 2008 were burning cash in 2009 due to the economic downturn.  Continuing a repurchase program even at lower prices could be ill advised if doing so depletes working capital that could cause financial distress or collapse.

Red Flags

When red flags should appear are cases where a company remained profitable and generated free cash flow throughout the economic downturn but mysteriously halted buybacks as the share price declined.  Such managements should answer for why they considered it appropriate to buy back shares at higher prices in 2007 and 2008 but  not at bargain prices in 2009.  There could be valid reasons such as a desire to keep dry powder available for acquisitions made possible by distressed conditions or ensuring that the company builds up even more cash reserves in case of a longer recession or depression.  However, the burden should be on management to explain this decision to shareholders in a coherent manner.  Building up cash far in excess of any conceivable need to protect the business could simply indicate that managers were hoarding cash to sleep well at night at the expense of owners of the business.

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 01:41 PM | Permalink | Comments (0)

From The Wall Street Journal's Deal Journal:

Michael Burry and John Paulson both made a killing betting against the housing market.

As a result, the fortunes of Burry, Scion Capital’s founder, and Paulson, of Paulson & Co., have earned them spots as the subjects of books: Burry, as the subject of Michael Lewis’s “The Big Short: Inside the Doomsday Machine,” and Paulson, as the subject of Wall Street Journal reporter Gregory Zuckerman’s “The Greatest Trade Ever.” Zuckerman also touches on Burry in his book.

But looking at the portraits from the two books, these two investors have more in common than their money. Here are some quirks Burry and Paulson share:

They were viewed as different, even socially awkward. Burry believed you had to be unusual to succeed. And he was. “He found it maddeningly difficult to read people’s nonverbal signals, and their verbal signals he often took more literally than they meant them. When trying his best, he was often at his worst,” Lewis writes.

Paulson, similarly, seemed different than his peers. They dressed casually; he wore ties and dark suits. They were making money; he wasn’t. “When he met with clients, they sometimes were surprised by his limp handshake and restrained manner, both unusual in an industry full of bluster,” Zuckerman writes.

Obsessive. Both lived inside their heads for hours at a time, reading hundred-plus-page mortgage-bond prospectuses and studying the housing market to plan their strategies.

“His mind had no temperate zone: he was either possessed by a subject or not interested in it at all,” Lewis writes of Burry.

Paulson’s growing fixation on housing even sparked doubts about his business, writes Zuckerman. “One long-time client, big Swiss bank Union Bancaire Privée, received an urgent warning from a contact that Mr. Paulson was “straying” from his longtime focus, and that the bank should pull its money from Paulson & Co., fast.”

But this obsessiveness likely helped the men in their search for investors supporting the risky bets against the housing market. By mid- 2005, “Burry’s fund was up 242%, and he was turning away investors.” And Paulson made $15 billion for his firm in 2007 alone. (Read an interview with Gregory Zuckerman in Newsweek.)

They did it their way. Neither Burry nor Paulson were experts in derivatives, mortgages or real estate. Burry, a former medical resident, was a self-taught investor, and Paulson focused specialized in corporate mergers.

“Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied [Warren] Buffett, the less he thought Buffett could be copied.” Lewis writes. “Indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual.”

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

In a guest post yesterday on the excellent Greenbackd blog, S. Raj Rajagopal made a case for shorting Berkshire Hathaway and followed up later with more details regarding valuation.  Mr. Rajagopal is an MBA student at Cornell and has work experience in the investment field.  It takes a great deal of courage to make a public case for shorting Berkshire given the company’s long history and loyal shareholder base.  We often discuss  psychological tendencies that harm investors and one such tendency is to dismiss opposing points of view without critical examination.  Mr. Rajagopal’s case deserves such examination before rendering a judgment.

“Adoration is not an investment strategy”

Mr. Rajagopal bases much of his initial post not on quantitative evidence but on the premise that adoration for Warren Buffett is not an investment strategy.  On this point he is clearly correct.  It makes no sense to simply purchase Berkshire Hathaway because of Warren Buffett’s track record.  Obviously some buyers of Berkshire stock make their decision purely based on Mr. Buffett’s track record.  However, any sophisticated investor understands that you do not purchase a security simply based on folksiness or admiration for a grandfatherly character. If Mr. Rajagopal intended his short case to be read by professionals, he begins with an obvious straw man argument.

Bailout Obsession

Having presented this initial warning against backward looking thinking, it is ironic that much of the rest of Mr. Rajagopal’s thesis simply looks at the past in an attempt to forecast the future without providing any substantial quantitative evidence.  For example, several slides in the initial presentation are devoted to Mr. Buffett’s investments in companies that were in financial distress in 2008.  Much is made of Mr. Buffett’s letter to Treasury Secretary Hank Paulson offering to help construct an investment fund partly using $100 million of Mr. Buffett’s own personal fortune outside Berkshire Hathaway.  Of course, Mr. Buffett’s offer was never acted upon by Treasury.

Mr. Rajagopal goes on to lambast Berkshire as a “bailout baby” simply because Berkshire took large positions in companies that were in financial distress and then allegedly manipulated the political process to stack the deck in favor of Berkshire.  Mr. Buffett received numerous phone calls throughout the financial crisis with offers to invest in distressed firms at very attractive prices.  Should he have ignored such opportunities?  How is Mr. Buffett a “welfare queen” (why not a “bailout king”?) based on investments in which Berkshire’s capital was clearly at risk of loss and actually helped provide the votes of confidence that stabilized the system?  None of this is clear from the presentation.

Incorrect Reading of Buffett’s Statement on Berkshire Valuation

Mr. Rajagopal completely fails to interpret Mr. Buffett’s recent statements on Berkshire’s valuation and claims that the “Oracle of Omaha says Berkshire is overvalued now”.  This is obviously not the case.  As we pointed out in January, Mr. Buffett actually stated that Berkshire was undervalued at the time based on its historical relationship to book value and in his latest letter to shareholders, Mr. Buffett explains his rationale regarding using stock for the Burlington acquisition in great detail.  Berkshire’s stock price has advanced since the conclusion of the Burlington acquisition but Mr. Buffett has made no further comments to support Mr. Rajagopal’s claim that he believes the stock to be “overvalued now”.

Derivatives:  Ticking Time Bombs?

Mr. Rajagopal directly calls Mr. Buffett a “hypocrite” for warning about derivatives in 2002 and then investing in derivatives for Berkshire’s account.  It does not appear that Mr. Rajagopal has any grasp of the nature of Berkshire’s derivatives exposure and he offers no substantiation whatsoever for referring to the derivatives as ticking time bombs.  We discussed the misunderstandings related to Berkshire’s derivatives over a year ago and suggest that Mr. Rajagopal review the article or numerous others which explain the nature of these instruments in detail.

Filling Buffett and Munger’s Shoes

Mr. Rajagopal notes that male life expectancy in the United States is 74 years but does not point out that this is life expectancy at birth.  Mr. Buffett is 79 years old and has an actuarial life expectancy of over eight years.  Mr. Munger is 86 years old and has an actuarial life expectancy of over five years.

At the top of his slide he has a subtitle reading:  “David ‘who’ Sokol” in an apparent reference to Mr. Sokol being one of the more frequently cited candidates for CEO at Berkshire.  It is unfortunate that Mr. Rajagopal has decided that Mr. Sokol is unworthy and we would suggest a review of Pleased But Not Satisfied as a good starting point for Mr. Rajagopal to educate himself on one of Mr. Buffett’s potential successors.

Mr. Rajagopal seems to also have issues with the Burlington acquisition which we have discussed here frequently over the past three months.  However, he provides no valuation information and simply comes up with an “inevitable conclusion” that Mr. Buffett is seeking to “protect his franchise with a mammoth acquisition” prior to handing over the reins.  We are also told that “volatility” will increase due to S&P 500 inclusion and the stock split which will cause Berkshire to become a “volatile middle aged and mature stock”.

Seriously Flawed Valuation Model

After facing a barrage of criticism regarding his initial case for shorting Berkshire, Mr. Rajagopal produced a follow up post with his valuation model.  Unfortunately, the valuation only reinforces the impression that Mr. Rajagopal does not understand Berkshire Hathaway.  The following problems were noted in the model:

1. Earnings per share are used in the valuation model even though reported earnings per share for Berkshire are inadequate for judging progress in intrinsic value on a year to year basis because of the volatility to earnings caused by the timing of capital gains and losses as well as the mark to market requirements for the derivatives book.  In addition, many of Berkshire’s publicly traded holdings have earnings far in excess of paid dividends and Berkshire’s share of such earnings are not reported in Berkshire’s earnings figures.
2. Projections for earnings per share going forward are based on an average of the past five years in reported earnings growth which is purely backward looking and fails to take into account any of the drivers of reported earnings that have changed in recent years (purchase of high yielding securities such as the Goldman Sachs and GE Preferreds, acquisition of BNSF, etc).
3. Book Value progress each year is apparently calculated by adding starting year book value to earnings for the year which fails to account for any changes in book value associated with unrealized gains in Berkshire’s portfolio of publicly traded securities.
4. The model uses a 9% discount rate even though the “notes” section states that an 8% rate will be used.  This has a material long term impact on the valuation.  Neither the 8% or 9% rate is ever justified.
5. Target ROE is set at 10% “since BRK is so big” which is an inadequate explanation of a key variable used in the valuation.
6. The model produces prices at a discount to book value but no explanation is provided regarding what element of goodwill is impaired or why Berkshire would trade at a discount to book value which would be unprecedented.
7. The model mysteriously produces declining valuations for Berkshire after 2016 even though book value continues to grow.  At 2021, we have an absurd calculation of an $84 valuation along with an estimate of $209 of book value leading us to believe that Mr. Rajagopal believes that Berkshire’s price to book value will shrink to 0.40 over the next ten years.

It is difficult to know what to make of Mr. Rajagopal’s short thesis in light of the obvious flaws in both the original presentation and the follow up valuation model.  It took some courage for Mr. Rajagopal to offer a short case for Berkshire but unfortunately he completely failed to justify his thesis.

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 and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Posted by manualofideas at 12:13 PM | Permalink | Comments (0)

Another snippet:

Posted by manualofideas at 11:35 AM | Permalink | Comments (0)

Bain & Company has released an interesting report for those with an interest in private equity.

(Thanks to Yaser Anwar for the link.)

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

A Conversation with George Soros at HKU from JMSC HKU on Vimeo.

Posted by manualofideas at 06:55 PM | Permalink | Comments (0)

Roundtable w/ Soros et al: Make Markets Be Markets from Roosevelt Institute on Vimeo.

Q&A:

Q&A from Make Markets Be Markets from Roosevelt Institute on Vimeo.

Posted by manualofideas at 05:56 PM | Permalink | Comments (0)

In a pattern that would be amusing if it was not so disturbing, we are again witnessing the spectacle of lawyers for a disgraced CEO who claim that their client was “unaware” of key risks that led to the downfall of their firm.  The Lehman Brothers bankruptcy examiners report has been widely covered in the business media over the past few days and, at a minimum, paints a picture of shocking incompetence and an intent to mislead among Lehman’s senior management team.  It is the type of scenario in which a former CEO’s only defense appears to rest on claims that he was incompetent rather than criminally negligent.

Repo 105 Transactions

The Wall Street Journal reports that Lehman management routinely engaged in “Repo 105″ transactions in an attempt to dress up the balance sheet prior to the end of financial reporting periods.  In a normal repurchase agreement, a borrower uses a financial security as collateral for a cash loan.  The agreement generally involves the sale of the collateral combined with a commitment to repurchase the same security at a point in the future at a higher price.  In a “Repo 105″ transaction, Lehman was able to book the transaction as if it was an outright sale rather than an ordinary repo transaction because the assets the firm moved were worth 105% or more of the cash it received in return.

Through this accounting maneuver, Lehman was able to appear less leveraged than it really was.  According to the Wall Street Journal, no United States based law firm would sanction this accounting treatment so Lehman secured an opinion letter from a London law firm named Linklaters.  If a U.S. based Lehman entity needed to engage in a Repo 105 transaction, it would have to move the security to a European division to execute the transaction.

Lehman executives are on record acknowledging the necessity of such transactions as the following quote from a Wall Street Journal article clearly demonstrates:

Four days prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman’s fixed-income division, was searching for a way to meet his balance-sheet target, according to the report. He wrote in an email: “Can you imagine what this would be like without 105?”

A day before the close of Lehman’s first quarter in 2008, other employees scrambled to make balance-sheet reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: “We have a desperate situation, and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it.”

Grossly Negligent, Criminally Responsible, or Merely Incompetent?

Lehman’s CEO Dick Fuld is cited in the bankruptcy examiner’s report as being “at least grossly negligent” regarding the Repo 105 transactions:

The examiner wrote there was “sufficient evidence” to support a legal claim that Mr. Fuld was “at least grossly negligent for failing to ensure” Lehman filed proper financial statements about its accounting for the transactions, and that a key former executive of the firm, the chief operating officer, personally briefed him on the matter.

Of course, Mr. Fuld’s attorneys have decided to pursue the “incompetent” defense as opposed to taking any responsibility for the situation:

Mr. Fuld’s lawyer said on Thursday that Mr. Fuld “did not know what those transactions were” and wasn’t “aware of their accounting treatment.”

It is unclear what is more shocking:  The prospect of a CEO of a major financial institution willfully pursuing financial transactions designed specifically to mislead investors and counterparties into thinking that the firm was less leveraged than it really was or the idea that the CEO really had no idea that these maneuvers were taking place at all.

Buffett’s Decision on a Lehman Investment

The bankruptcy report also contains some interesting information regarding Lehman’s attempts to have Warren Buffett invest $2 billion in the company as a “stamp of approval”.  Of course, Mr. Buffett decided against doing so when he found problems in Lehman’s 10-K as well as negative signals from Lehman executives who were unwilling to invest in the firm on the same terms he was offered.

As is often the case, we can also look at Mr. Buffett’s statements regarding corporate governance to understand what went wrong at Lehman:

“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.”

– Warren Buffett’s 2009 Letter to Shareholders.

If Lehman’s story can be distilled down to its core problem, it seems to be that the company’s CEO did not regard himself as the Chief Risk Officer.  Based on Mr. Fuld’s own admission (if we are to believe him), he was not aware of critical accounting policies that misled investors and counterparties who were using Lehman’s financial statements to judge the health of the business.  Of course, the Repo 105 maneuver was only necessary because of other failures to control risk at the firm.

It would be a refreshing change if at least one CEO involved in the demise of a major financial institution would step up and admit that the responsibility was his rather than hiding behind the “incompetence” defense.

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 04:11 PM | Permalink | Comments (0)

Last month, we posted Matt Darrah's cautionary thesis on Bunge (BG) and the month before we published his long case for Corporate Executive Board (EXBD). This month, Matt looks at KHD Humboldt Wedag, which recently announced an intention to split into two companies in order to highlight the value of its key assets. You can read the original announcement, dated January 6th, here, and an update, dated March 4th, here. Upon completing his primary research on KHD, Matt decided to take no action on KHD. In the following write-up, Matt explains why he passed on KHD:

Introduction

This month’s recommendation is an example of a company I considered as a potential stock purchase, but ultimately decided not to buy. This stock may represent a compelling investment opportunity for some, but it doesn’t fit with my investment philosophy, so I decided to pass. Note that I do not believe investors should short sell the stock, as it may appreciate in price.

Company Overview

KHD is an industrial plant engineering and equipment supply company for the cement, coal, and minerals processing industries. Their products and services include plant design, equipment design and development, engineering services, and automation services. KHD operates in India, China, Russia, Germany, the Middle East, Australia, South Africa, and the United States.

Valuation

Most investors who like this stock point to its seemingly attractive valuation. KHD is valued at $419MM based on Wednesday’s stock price of $13.93, but the firm had $402MM of net cash as of September 30, 2009 (latest financial statements). Typically, an investor could look at this information, and say that he or she was purchasing KHD for $17MM ($419MM market capitalization less $402MM of cash). However, in this instance that analysis is incorrect.

When buying a stock, an investor should act as if he or she is buying the whole company. KHD has received ~$149MM of customer prepayments for future work. If an investor were buying the whole company, he or she would insist on keeping the cash necessary to complete requested work and not give the cash to the old owners. This business has historically generated ~6% profit margins (94% cost), so it will need almost all of the $149MM to service the business customers have prepaid. Adding that $149MM to the $419MM market capitalization while subtracting the $402MM of cash results in an investor buying the business for $166MM. I believe normalized cash flow is ~$34MM per year, and thus the Company is trading at a 20% FCF yield. Below I will explain why I do not find this free cash flow yield appealing enough to invest in KHD.

Increased Competitive Pressures

KDH faces increased competitive pressures from companies with capabilities that it does not currently possess. Companies such as Bechtel or Fluor can manage the entire construction of a cement plant, including the design and equipment supply. Increasingly, cement manufacturers use these companies to act as the primary contractors, relegating companies like KHD to a subcontractor role. Based on my calls to those familiar with the industry, companies like KHD are selected directly by clients only in order to reduce cost. Additionally, as a subcontractor, KHD faces price pressures from the primary contractor, as it does not have the direct client relationship. Despite the seemingly compelling free cash flow yield, this concern over competitive pressures leads me to doubt the long term sustainability of the KHD’s cash flow generating ability.

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 02:48 PM | Permalink | Comments (0)

Bloomberg has put together an interesting interactive presentation on the layers of costs often assumed by stock market investors. Writes Bloomberg:

Beware the costs of financial middlemen. You may think you're only paying 0.5% to 2% to have other people manage your money, but the multiple layers of financial intermediation that is so prevalent in today's investing world – with one money manager subcontracting to another – can lead to as much as 6% in non-performance-related fees being assessed along the way. What's worse is that this proliferation of the middlemen has been accompanied by rising CEO pay but often lukewarm returns for shareholders -- the ultimate owners of the companies.

View the interactive presentation.

Posted by manualofideas at 06:54 PM | Permalink | Comments (0)

Berkshire Hathaway’s 2010 Proxy Statement was released yesterday and much attention has been devoted to the low compensation provided to Warren Buffett and Charlie Munger.  Mr. Buffett’s total compensation remained at $175,000 which included $100,000 of salary and $75,000 in director’s fees from the Washington Post.  In addition, the company paid $344,490 for Mr. Buffett’s personal security during 2009.  Mr. Munger’s salary remained at $100,000.  Marc Hamburg, Berkshire’s Chief Financial Officer, received $874,750 in total compensation. The $100,000 salary for Mr. Buffett and Mr. Munger has remained constant for 29 years, during which time inflation has eroded over 60 percent of the purchasing power of a dollar.

Appropriate Alignment of Incentives Today …

According to Berkshire Hathaway’s Owner’s Manual, Mr. Buffett has over 98 percent of his net worth in Berkshire while Mr. Munger’s family has over 80 percent invested in the company.  Both men wish to set an example by ensuring that their fortunes move in lockstep with the results for investors:

Charlie and I cannot promise you results. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner. We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when our partners do and in exactly the same proportion. Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours.

As a result of this unique management philosophy and heavy ownership interest, it is hard to see how large salaries would do anything to enhance the alignment of incentives between Berkshire management and shareholders.  Mr. Buffett has stated on many occasions that he would happily pay Berkshire in exchange for running the company.  Berkshire shareholders are the big winners in this arrangement.  Mr. Buffett’s salary in 2009 amounted to approximately 11 cents per Class A share.

However, Berkshire’s Policy May Be Flawed …

When a company establishes a policy on executive compensation, the arrangement needs to codify principles that will apply regardless of who holds the top management position.  Policies should not be set up such that they work when applied to unique situations but fail to work in a broader context. Unfortunately, Berkshire’s overall policy on executive compensation may fall into this category.  Here is the policy statement from the proxy:

The Committee has established a policy that: (i) neither the profitability of Berkshire nor the market value of its stock are to be considered in the compensation of any executive officer; and (ii) all compensation paid to executive officers of Berkshire be deductible under Internal Revenue Code Section 162(m). Under the Committee’s compensation policy, Berkshire does not grant stock options to executive officers. The Committee has delegated to Mr. Buffett the responsibility for setting the compensation of Mr. Hamburg, Berkshire’s Senior Vice President/Chief Financial Officer.

Based on the wording of this policy, it seems like it is intended to apply over the long run, which means it will apply to Mr. Buffett’s successor as Chief Executive Officer.  The policy is indicating that the executive officers cannot be paid in a manner that is based on profitability of Berkshire or the market value of the stock.  Accordingly, stock options are not granted to executive officers.

The obvious question is how the Board intends to align the incentives of the next CEO with the interests of shareholders if they will not take into account company profitability or even the long term share price.  What will the overall compensation philosophy look like and what performance metrics will be used to set salary and bonus compensation?  These are legitimate questions that are not adequately answered in the current policy on executive compensation and require clarification.

The next CEO at Berkshire is very likely going to be someone who is motivated by a desire to follow in Mr. Buffett’s footsteps and to continue his legacy.  Money may not be a driving factor since the successor is almost certain to be independently wealthy already.  However, the next CEO is not going to have nearly as much of an ownership interest in Berkshire compared to Mr. Buffett and therefore it is necessary to formalize a compensation system that provides monetary incentives that are aligned with shareholder interests. Furthermore, this should be done while Mr. Buffett is running the company and can provide his “stamp of approval” since any successor who seeks a change is likely to encounter substantial criticism when proposing any changes to policies that applied under Mr. Buffett.

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 and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Posted by manualofideas at 04:25 PM | Permalink | Comments (0)

By Greenbackd

Yesterday I highlighted an investment strategy I first read about in a Spring 1999 research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy. The premise, simply stated, is to identify undervalued small capitalization stocks where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’m going to explore it in some depth over the next few weeks.

The idea is reminiscent of “Super” Mario J. Gabelli’s Private Market Value with a Catalyst methodology, the premise of which is the value of a company “if it is acquired by an informed wealthy family, or by another private or public corporation, as opposed to the price it is trading at in the stock markets. Simply put, it is the intrinsic value of a company plus the control premium:”

To calculate PMV, Gabelli first takes into account the free cash flow (after allowing for depreciation), deducts debt and net options (stock options) and adds back the cash. To this, he then applies an ‘appropriate’ multiple to arrive at the PMV. It sounds simple enough, but where you can go completely wrong is the multiple. Gabelli says he either looks at recent valuations of similar acquisitions or applies an appropriate historical industry acquisition multiple to arrive at the PMV.

“Some of the factors that we look at while deciding multiples to apply are: what the business is going to be worth in five years from now, what kind of return on equity can we get over time, how much further debt can be put on the company, the tax rate and what the company would be worth if there was no growth or at some particular rate (4 or 8 per cent for instance),” he explains. Of course, the multiple – and the PMV – changes over time, as it is a function of interest rates, the capitalisation structure and taxes, all of which have an indirect impact on the value of the franchise.

Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recall were each called “Endangered Species Update” and discussed the returns from the strategy. It seems that those follow-up reports are now lost to the sands of time. All that seems to remain is the press release of the final report:

For the last few years, Piper Jaffray has been reporting on the difficulties that small public companies face in today’s equity markets. Since the late 1990s many well run, profitable companies with a market capitalization of less than $250 million have watched their share prices underperform the rest of the stock market. With limited analyst coverage and low trading liquidity, many high-quality small companies are “lost in the shuffle” and trade at significantly lower valuation multiples than larger firms. Since our 1999 report “Wall Street’s Endangered Species,” we have held the position that:

This is a secular, not cyclical, trend and the undervaluation will continue. The best strategic move to increase shareholder value is to pursue a change-of-control transaction. Company management and the Board should either sell their company to a large strategic acquirer with the hope of gaining the buyer’s higher trading multiple, or take the company private.

In the last few of years, many small public companies identified this trend and agreed with the implications. Executives responded accordingly, and the number of strategic mergers and going-private transactions for small companies reached all-time highs. Shareholders of these companies were handsomely rewarded. The remaining companies, however, have watched their share prices stagnate.

Since the onset of the recent economic slowdown and the technology market correction, there has been much talk about a return to “value investing.” Many of our clients and industry contacts have even suggested that as investors search for more stable investments, they will uncover previously ignored small cap companies and these shareholders will finally be rewarded. We disagree and the data supports us:

Any recent increase in small-cap indices is misleading. Most of the smallest companies are still experiencing share price weakness and valuations continue to be well below their larger peers. We strongly believe that when the overall market rebounds, small-cap shareholders will experience significant underperformance unless their boards effect a change-of-control transaction.

In this report we review and refresh some of our original analyses from our previous publications. We also follow the actions and performance of companies that we identified over the past two years as some of the most attractive yet undervalued small-cap companies. Our findings confirm that companies that pursued a sale rewarded their shareholders with above-average returns, while the remaining companies continue to be largely ignored by the market. Finally, we conclude with our third annual list of the most attractive small-cap companies: Darwin’s Darlings Class of 2001.

Piper Jaffray did follow up the reports in a 2006 article called Is There a Renewed Prospect of Going-Private Transactions? Their conclusion:

Small-Cap Stocks Outperform

Small-cap stocks have experienced a dramatic resurgence over the past five years. With weak performances from large-cap stocks, small-caps have become more favorable investments with better returns and stronger trading multiples. Here is what we have seen:

• Over the last one-, three- and five-year periods, companies in the Russell 2000 have offered average returns of 21%, 227% and 240%, respectively, compared to S&P 500 companies with average returns of 16%, 89% and 57%, respectively.
• The valuation gap that we saw five years ago between the bottom two deciles of companies in the Russell 2000 and the S&P 500 no longer exists, with the last two deciles in the Russell trading at only a 3% discount to the median EBIT multiple of S&P 500 companies and a 9% premium over the median P/E multiple.

(Click to embiggen)

Despite the rebound in valuations, small-cap stocks continue to face the same capital market challenges:

• For companies with market caps between the $50 million and $250 million range, there are approximately 1.3 analysts covering each stock versus 7.7 analysts for companies with market caps of more than $250 million.
• Trading volumes are slightly higher, with the last three deciles trading an average 202,276, 176,092 and 223,599 shares, respectively, per day, but still significantly below the volume of S&P 500 companies, which trade an average of 4.0 million shares per day.

More to come.

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

The bankruptcy examiner assigned to the Lehman Brothers bankruptcy case published a 2,000+ page report yesterday, which reads like the modern-day equivalent of a Greek tragedy. Many things went wrong on Lehman's road to collapse, a collapse that appears to have been preventable had Lehman executives owned up to the company's dire situation. Lehman chief Richard Fuld let slip away several opportunities to shore up Lehman's capital base, most notably an opportunity to cut a deal with Warren Buffett of Berkshire Hathaway. Such a deal would have put an important "stamp of approval" on Lehman, likely giving it much-needed time and credibility.

The Role of Warren Buffett and David Sokol

Here are some passages that mention Warren Buffett's contacts with Lehman as it was trying to raise capital:

pp. 613-614: After the near collapse of Bear Stearns, Lehman moved to raise additional capital. Lehman initiated work on an equity offering and restarted efforts to locate candidates willing to make a strategic investment in Lehman. In late March [2008], Lehman undertook discussions with Warren E. Buffett, CEO of Berkshire Hathaway. However, those discussions did not result in any investment by Buffett, Berkshire Hathaway, or any of its affiliates. Instead, at the beginning of April 2008, Lehman completed a $4.0 billion convertible preferred stock offering. Other offerings to bolster Lehman’s capital followed in May and June.

pp. 640-642: The SpinCo idea was a variation on a good bank/bad bank structure. Among
Lehman’s strategic options, SpinCo had a longer time horizon than other options, because substantial advance work would be needed. By early August 2008, Lehman anticipated completing the spin‐off in the first quarter of 2009. Lehman intended SpinCo to accomplish four interrelated purposes. The first and primary purpose of SpinCo was to relieve Lehman’s balance sheet of its “outsized” commercial real estate exposure that had become a source of increasing market concern and pressure. Second, by moving those assets to a separate entity, Lehman hoped to avoid the necessity of having to continue marking down those assets as the market continued to deteriorate. That process had exposed Lehman to criticism in the press and by analysts in what Hugh “Skip” E. McGee, III, the head of Lehman’s Investment Banking Division, referred to as the “are we marked correctly game.” Third, by spinning off those assets, Lehman would avoid a “fire sale for the vultures” that would have locked in its paper losses. Instead, SpinCo would allow Lehman to manage those assets on a value‐maximizing basis for the benefit of Lehman’s shareholders, either by selling the SpinCo assets or holding them to maturity. Fourth, once Lehman had purged its balance sheet of “toxic” commercial real estate assets, it hoped that the post‐spin “clean” or “core” Lehman (a.k.a. “CleanCo”) could achieve returns on equity in the low teens, twelve times net leverage, and maintain an A rating. However, SpinCo faced substantial structural and execution issues that led some observers to question its feasibility. Paulson told the Examiner that he expressed great skepticism about SpinCo to Fuld and advised him to abandon the plan. James L. “Jamie” Dimon, JPMorgan’s CEO, told the Examiner that he did not believe that SpinCo would work, thinking that the proposal was too leveraged, too complex, and involved too much real estate. When the concept was described to Buffett, he dismissed it. Ultimately, Lehman was not able to carry out the SpinCo plan prior to its bankruptcy.

p. 651: In March 2008, Lehman had approached Buffett concerning a private investment. In mid‐July 2008, Lehman again considered approaching Buffett about investing in SpinCo debt. In late August or early September 2008, McGee called MidAmerican Energy Holdings’ President David L. Sokol, hoping to entice Sokol either to have MidAmerican Energy Holdings invest in the SpinCo plan or to advocate the plan to Buffett. McDade and McGee showed Sokol Lehman’s “Gameplan”
presentation, explaining that Lehman was ready to execute the plan if Lehman had an investor. Sokol was not interested in investing, but relayed the basic premise of the SpinCo plan to Buffett. During that discussion, Buffett dismissed the idea as unrealistic.

p. 664-667: In late March 2008, McGee suggested that Lehman reach out to Buffett. McGee had a pre‐existing banking relationship with Sokol of MidAmerican Energy, which is majority‐owned by Buffett’s Berkshire Hathaway. Either McGee or Joseph G. Sauvage, LBI Vice‐Chairman, called Sokol to ask if Buffett would take Fuld’s call. Jerry A. Grundhofer, who was about to join Lehman’s Board, also asked Buffett if he would take Fuld’s call. Buffett agreed. Before calling Buffett, Fuld called Sokol on March 27, 2008. That same day, Lehman prepared a draft of a letter, to be sent by Fuld to Lehman employees, outlining a $3.5 billion investment from Buffett in Lehman’s preferred stock at a $54 per share conversion price. Fuld told the Examiner that he did not know how that letter came to be prepared, and it does not appear that Fuld saw the draft. Fuld also did not recall Buffett indicating a willingness to invest $3.5 billion. Buffett was surprised that Lehman had prepared a draft letter announcing the deal, because he never got close to a deal with Lehman. Fuld and Buffett spoke on Friday, March 28, 2008. They discussed Buffett investing at least $2 billion in Lehman. Two items immediately concerned Buffett during his conversation with Fuld. First, Buffett wanted Lehman executives to buy under the same terms as Buffett. Fuld explained to the Examiner that he was reluctant to require a significant buy‐in from Lehman executives, because they already received much of their compensation in stock. However, Buffett took it as a negative that Fuld suggested that Lehman executives were not willing to participate in a significant way. Second, Buffett did not like that Fuld complained about short sellers. Buffett thought that blaming short sellers was indicative of a failure to admit one’s own problems. Following his conversation with Buffett, Fuld asked Paulson to call Buffett, which Paulson reluctantly did. Buffett told the Examiner that during that call, Paulson signaled that he would like Buffett to invest in Lehman, but Paulson “did not load the dice.” Buffett spent the rest of Friday, March 28, 2008, reviewing Lehman’s 10‐K and noting problems with some of Lehman’s assets. Buffett’s concerns centered around Lehman’s real estate and high yield investments, lending‐related commitments, derivatives and their related credit‐market risk, Level III assets and Lehman’s securitization activity. On Saturday, March 29, 2008, Buffett learned of a $100 million problem in Japan that Fuld had not mentioned during their discussions, and Buffett was concerned that Fuld had not been forthcoming about the issue. The problems Buffett saw in the 10‐K along with Fuld’s failure to alert Buffett to the issue in Japan cemented Buffett’s decision not to invest in Lehman. At some point in their conversations, Fuld and Buffett also discovered that there had been a miscommunication about the conversion price. Buffett was interested only in convertible preferred shares. Buffett told Fuld that he was willing to agree to a $40 conversion price per share, while Fuld thought Buffett was offering to buy in at “up‐40,” or 40% above the current market price, which would have been about $56 per share. On Friday, March 28, 2008, Lehman’s stock closed at $37.87. Fuld spoke to Lehman’s Executive Committee and several Board members about his conversations with Buffett. Lehman recognized that an investment by Buffett would provide a “stamp of approval.” However, Lehman already had better offers for its April capital raise, and Lehman did not think it could give a better deal to Buffett at the same time it gave a less attractive deal to others. On Monday, March 31, 2008, before Buffett could tell Fuld that he was not interested, Fuld called Buffett to say that Lehman could not accept his terms.

p. 667-668: McGee contacted Sokol again in late August or early September 2008 and outlined Lehman’s “Gameplan” for survival, specifically SpinCo. During a subsequent telephone call with Sokol, McGee explained the “good bank/bad bank” scenario and stated that Lehman would need an investor. Sokol believed the e‐mail and call were intended to induce Sokol to pass that information on to Buffett, so Sokol briefed Buffett on SpinCo. Buffett thought the idea would not solve Lehman’s problems. Sometime during the week prior to Lehman’s bankruptcy, McGee again reached out to Sokol with what both Sokol and McGee described to the Examiner as a “Hail Mary” pass. McGee asked, “Do you have any ideas to save us?” Sokol, who was bear hunting in Alaska at the time, told McGee that he did not.

p. 708: On Saturday, September 13, 2008, Barclays reached out to Buffett to ask whether Buffett would guarantee Lehman’s operations until a Lehman‐Barclays deal closed. Barclays and Buffett discussed a scenario in which Buffett would provide $5 billion of protection. Buffett expressed interest in that possibility, but Barclays did not pursue it.

p. 709: Lehman’s management had scheduled a Board meeting for noon on Sunday, September 14, 2008, but delayed the meeting until 5:00 p.m. in order to try to come to some resolution at the FRBNY meetings. At some point on Sunday, Fuld was told that the FSA would not waive the requirement that a guaranty of Lehman’s obligations required the approval of Barclays’ shareholders, and therefore the FSA would not approve the Barclays deal. Fuld asked Paulson to call Prime Minister Gordon Brown, but Paulson said he could not do that. Fuld asked Paulson to ask President Bush to call Brown, but Paulson said he was working on other ideas. From that, Fuld inferred that Paulson was going to call Buffett, although Paulson never mentioned Buffett’s name. Fuld brainstormed about other means to contact and convince the FSA to permit the deal, including having Jeb Bush, a Lehman advisor, ask President Bush to call the Prime Minister.

The Role of David Einhorn

Greenlight Capital's David Einhorn is also mentioned in the report. Here are the excerpts:

p. 205-206: ...David Einhorn of Greenlight Capital, who at the time held short positions in Lehman, stated in an April 8, 2008 speech: "There is good reason to question Lehman’s fair value calculations. . . . Lehman could have taken many billions more in write‐downs than it did. Lehman had large exposure to commercial real estate. . . . Lehman does not provide enough transparency for us to even hazard a guess as to how they have accounted for these items. . . . I suspect that greater transparency on these valuations would not inspire market confidence." Einhorn’s skepticism was also reflected in the financial press. On March 20, 2008, Portfolio.com published an article titled “The Debt Shuffle,” which asked: “What actually happened to Lehman’s balance sheet in the first quarter? Assets rose. Leverage rose. Write‐downs were suspiciously miniscule. And the company fiddled with the way it defines a key measure of the firm’s net worth.” Lehman’s Head of U.S. Global Credit Products, Eric Felder, forwarded this article to Ian Lowitt, Lehman’s Co‐Chief
Administrative Officer, with the note, “bunch of people looking at this article,” to which Lowitt replied, “[d]oesn’t help.” Firms such as Lehman required the confidence of the market to assure its sources of short term financing that they would be repaid; and the market’s confidence in Lehman was publicly questioned.

p. 661: SpinCo was seen by some as validation of their suspicion that Lehman’s assets were not properly valued. David Einhorn, President of Greenlight Capital, told the Examiner that the creation of SpinCo supported his contention that Lehman had not been marking down its commercial assets. Einhorn believes that Lehman’s efforts to spin out its commercial real estate into a company where the assets did not have to be marked to fair value revealed that Lehman had not been marking those assets to fair value. 

p. 713: After Bear Stearns nearly collapsed, short sellers began to focus on Lehman and other banks. On March 20, 2008, Russo contacted Linda Thomsen, the SEC’s Head of Enforcement, regarding rumors of hedge funds “taking another run at Lehman.” On April 1, 2008, at Lehman’s prompting, Erik R. Sirri, head of the SEC’s CSE program, made a statement at an annual conference regarding the SEC’s view of the seriousness of rumors and stock manipulation in the context of short sales. At the April 15, 2008 Board meeting, Lehman’s management discussed Lehman’s concerns regarding short selling. On May 21, 2008, at the Ira Sohn Conference, one day after the comment period for the SEC’s proposed rule concluded, Einhorn gave a presentation on Lehman, analyzing Lehman’s Form 10‐Q, filed April 9, 2008.2767 Einhorn announced that he was shorting Lehman’s stock based on his belief that the stock was over‐valued. Before that presentation, Einhorn had corresponded with Callan in mid‐May 2008, as part of what he described as fact‐checking in advance of his presentation at the Ira Sohn Conference. Einhorn focused on four major issues in his correspondence with Callan and in his May 21, 2008 speech: (1) Lehman’s disclosures regarding CDO exposure and related write‐downs; (2) the difference between the amount of Level III assets disclosed in the Form 10‐Q filed in February 2008 and during Lehman’s first quarter 2008 earnings call; (3) Lehman’s disclosure and valuation of its stake in KSK Energy; and (4) Lehman’s write downs of its CMBS assets. On the day of Einhorn’s speech, Lehman’s stock closed down $2.44, with its highest volume of the entire month of May 2008. Einhorn’s criticism of Lehman and Callan is commonly cited as the reason for Callan’s replacement less than three weeks later. Following the near collapse of Bear Stearns, Einhorn published a book, Fooling Some of the People All of the Time, which focused on Allied Capital. Thomas C. Baxter, Jr., General Counsel to the FRBNY, said that reading Einhorn’s book made him think that the FRBNY should pay more attention to short sellers’ concerns. However, Baxter did not reach that conclusion for the reason that Lehman would have wanted, namely to persuade the Government to regulate short sellers, but rather because it appeared to Baxter that Einhorn may have been shorting Lehman for good cause. Baxter was unable to say, however, whether anyone at the Federal Reserve followed up on Einhorn’s criticism of Lehman in his speech.

The following are links to the Report of the Examiner in the Chapter 11 proceedings of Lehman Brothers:

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

Here is an interesting view of the finances of the U.S. government from 1789 to 1870. In the early years, the government was funded entirely by customs revenue, and debt levels were extremely low. All this changed with the onset of the Civil War of 1861-1865. Revenue exploded as the government started taxing citizens in earnest. At the same time, debt levels also exploded, as military spending went through the roof. As we know too well, internal revenue and deficit spending have not gone away.

(click to enlarge)

Click here for more charts from the U.S. Census of 1870.

Posted by manualofideas at 05:07 PM | Permalink | Comments (0)

By Greenbackd

Back in the spring of 1999, when the world was enamored of dot coms and not much else, three guys at Piper Jaffray, Daniel J. Donoghue, Michael R. Murphy and Mark Buckley*, produced a superb research report called Wall Street’s Endangered Species. The thesis of the paper was that there were a large number of undervalued companies with strong fundamentals and solid growth prospects in the small cap sector (defined as stocks with a market capitalization between $50M and $250M) lacking a competitive auction for their shares. Donoghue, Murphy and Buckley argued that the phenomenon was secular, and only mergers or buy-outs would ”close their value gap:”

Management buy-outs can provide shareholders with the attractive control premiums currently experienced in the private M&A market. Alternatively, strategic mergers can immediately deliver large cap multiples to the small cap shareholder.

I believe that this phenomenon led to the emergence of activist investors in the small cap sector over the last decade. More on this in a moment.

Endangered species report

The document is drafted from the perspective of a M&A team selling corporate advisory services. Here’s the pitch:

Many well-run and profitable public companies in the $50-250 million market capitalization range are now trading at a significant discount to the rest of the stock market. Is this a temporary, cyclical weakness in small stocks that is likely to reverse soon? No, these stocks have been permanently impaired by a shift in the economics of small cap investing. This persistent under-valuation is sure to be followed by a rise in M&A activity in the sector. We have already seen an uptick in the number of “going private” transactions and strategic mergers involving these companies. Management teams that identify this trend, and respond to it, will thrive. The inactive face extinction.

Donoghue, Murphy and Buckley’s thesis was based on the then relative underperformance of the Russell 2000 to the S&P 500:

The accompanying graph, labeled Exhibit I, illustrates just how miserably the Russell 2000 lagged the S&P 500 not only last year but in 1996 and 1997 as well. Granted, small cap returns have tended to run in cycles. Since the Depression, there have been five periods during which small cap stocks have outperformed the S&P 500 (1932-37, 1940-45, 1963-68, 1975-83, and 1991-94). It is reasonable to believe that small caps, in general, will once again have their day in the sun.

They argued that the foregoing graph was a little misleading because the entirety of the Russell 2000 universe wasn’t underperforming, just the smallest members of the index:

However, a closer look at the smallest companies within the Russell 2000 reveals a secular decline in valuations that is not likely to be reversed. The table in Exhibit II divides the Russell 2000 into deciles according to market capitalization. Immediately noticeable is the disparity between the top decile, with a median market capitalization of $1.5 billion, and the tenth decile at less than $125 million. Even more striking is the comparison of compounded annual returns for the past ten years. The data clearly demonstrates that it is not the commonly tracked small cap universe as a whole that is plagued by poor stock performance but rather the smallest of the small: companies less than about $250 million in value.

Stocks trading at a discount to private company valuations

The underperformance led to these sub-$250M market cap companies trading at a discount to private company valuations:

Obscurity in the stock market translates into sub-par valuations. As shown in Exhibit IV, the smaller of the Russell 2000 companies significantly lag the S&P 500 in earnings and EBIT multiples. It is startling to find that with an average EBIT multiple of 9.0 times, many of these firms are valued below the acquisition prices of private companies.

And the punchline:

Reviving shareholder value requires a fundamental change in ownership structure. Equity must be transferred out of the hands of an unadoring public, and into those of either: 1) management backed by private capital, or 2) larger companies that can capture strategic benefits. Either remedy breathes new life into these companies by providing cheaper sources of capital, and by shifting the focus away from quarterly EPS to long-term growth.

Increasing M&A activity

The market had not entirely missed the value proposition. M&A in the small cap sector was increasing in terms of price and number of transactions:

Darwin’s Darlings

Donoghue, Murphy and Buckley argued that the value proposition presented by these good-but-orphaned companies, which they called “Darwin’s darlings,” presented an attractive opportunity, described as follows:

Despite the acceleration of orphaned public company acquisitions in 1997 and 1998, there remains a very large universe of attractive public small cap firms. We sifted through the public markets, focusing on the $50-250 million market capitalization range, to construct a list of the most appealing companies. We narrowed our search by eliminating certain non-industrial sectors and ended up with over 1500 companies.

We analyzed their valuations relative to the S&P 500. The disparity is so wide that the typical S&P 500 company could pay a 50% premium to acquire the average small cap in this group without incurring earnings dilution. Those dynamics appear to be exactly what is driving small cap takeover values. The median EBIT multiple paid for small caps in 1998 was roughly equal to where the typical S&P 500 trades.

We honed in on those companies with multiples that are positive, but even more deeply discounted at less than 50% of the S&P 500. Finally, we selected only those with compounded annual EBIT growth of over 10% for the past five years. As shown in Exhibit VII, these 110 companies,“Darwin’s Darlings,” have a median valuation of only 5.8 times EBIT despite a compounded annual growth rate in EBIT of over 30% for the past five years.

The emergence of activists

Donoghue, Murphy and Buckley identified the holders of many of these so-called “Darwin’s darlings” as “small cap investment funds focused on likely take-over targets:”

As detailed in the description of our “Darwin’s Darlings” in Exhibit VIII, management ownership varies widely among these companies. For recent IPOs of family-held businesses, management stakes are generally high. For those that were corporate spin-offs, management ownership tends to be low. We frequently find large blocks of these stocks held by small cap investment funds focused on likely take-over targets, leading to a surprisingly high percentage of total insider ownership (management plus holders of more than 5%).

Regardless of ownership structure, these companies typically have the customary defensive mechanisms in place. They are also protected by the fact that they are so thinly traded. In most cases it takes more than six months to accumulate a 5% position in the stock without moving the market. Hence, we expect virtually all acquisitions in this sector to be friendly. There is no question that some very attractive targets cannot be acquired on a friendly basis. However, coercing these companies into a change of control means being prepared to launch a full proxy fight and tender offer.

In When Wall Street Scorns Good Companies, a Fortune magazine article from October 2000, writer Geoffrey Colvin asked of Darwin’s darlings, “So why are all these firms still independent?”

The answer may lie in another fact about them: On average, insiders own half their shares. When the proportion is that high, the insiders are most likely founders; they have enough stock to fend off any hostile approach, and they haven’t sold because they aren’t ready to give up control. Not many outside investors want to go along for that ride. Thus, low prices.

But there’s still a logical problem. Since the companies are so cheap, why don’t managers buy the shares they don’t already own– take the company private at today’s crummy multiple, then sell the whole shebang at an almost guaranteed higher price? Going private has in fact become more popular than ever, but what seems most striking is how rare it remains. Of Piper Jaffray’s 1999 Darwin’s Darlings– 110 companies–only three went private in the following 12 months. That makes perfect sense if you figure that many of the outfits are run by owner-managers whose top priority is keeping control. Announce a going-private transaction and you put the company in play, and even a chummy board may feel obliged to honor its fiduciary duty if a higher bid comes along.

Thus we reach the somewhat ugly truth about Wall Street’s orphaned stars: Many of them (not all) like things the way they are–that is, they like staying in control. The outsider owners are typically a diffuse bunch in no position to put heat on the controlling insiders. The stock price may be lousy, but when the owner-managers decide to sell–that is, to get out of the way–it will almost certainly rise handsomely, as it did for the 19 of last year’s Darwin’s Darlings that have since sold.

So shed no tears for these scorned companies, and don’t buy their shares without a deep understanding of what the majority owners have in mind. In theory the spreading corporate governance movement ought to protect you; in practice the shareholder activists have bigger fish to fry. Such circumstances may keep share prices down, but that’s the owner-managers’ problem. At least, in this case, the market isn’t so mysterious after all.

I believe that the third paragraph above best describes the reason for the emergence of the activists in the small cap sector. Observing that stock prices rose dramatically when owner-managers of “Wall Street’s orphaned stars” decided to sell, and outside investors were “typically a diffuse bunch in no position to put heat on the controlling insiders,” activist investors saw the obvious value proposition and path to a catalyst and entered the fray. This led to a golden decade for activist investing in the small cap sector, one that I think is unlikely to be repeated in the next decade. Regardless, it’s an interesting strategy, and an obvious extension for an investor focussed on small capitalization stocks and activist targets.

*Donoghue, Murphy and Buckley in 2002 founded Discovery Group, a fund manager and M&A advisory that takes significant ownership stakes (up to 20%) in companies trading at a discount to “fundamental economic value.”

Posted by manualofideas at 02:39 PM | Permalink | Comments (0)

Respected value investor Aaron Edelheit writes a very interesting piece on his excellent blog:

A very, very strange thing happened to a company I follow called Contango Oil & Gas (AMEX: MCF). This is an extremely well-run company that generates tons of cash from natural gas in the Gulf of Mexico. You couldn’t ask for a more efficient and well run company. Consider that Contango has raised $60.5 million in its life and yet has already bought back $65 million, thus having a negative capital situation due to negative dilution. Quite an astonishing task for a commodity company. Further the company’s costs are the lowest around with their find, develop and acquire costs at a measly $1.36 per mcf (thousand cubic feet).

Mr. Ken Peak, the CEO, is a straight shooter, no-nonsense kind of CEO. In fact, I wish most CEOs were more like him. In their last press release for earnings, Mr. Peak said, “Concerning natural gas prices, the weather is cooperating on the demand side, but natural gas supply continues to hold steady. I wouldn’t be surprised by either $3.00 or $6.00 natural gas over the next year or so, but we have good prospects and are aggressively moving forward to drill.” Now how many CEOs would have the guts to say that $3 mcf natural gas prices could happen? Compare him to Chesapeake Energy’s rather repugnant CEO, Aubrey McClendon, who is a perma-bull who enriches himself at shareholder’s expense and has created no value for shareholders.

For disclosure purposes, I have invested in Contango in the past and wrote a research report on it at $38.30, exclaiming how cheap it was. I have since taken my profits with its move to over $50 per share and reallocated my money elsewhere. I still follow Contango, in case it sells off again, and to see what Mr. Peak is doing.

So imagine my surprise when I see Monday’s press release, which has been getting absolutely zero press or news. Contango, which has been strictly an oil & gas company, announced that they were making an investment of up to $3 million in looking in Alaska for gold!

Here is what Mr. Peak said:

“This investment does not signal, foreshadow or represent a change in our natural gas and oil exploration business model. We recognize that the risks and challenges inherent in gold exploration are quite different from our natural gas and oil exploration business and were attracted to invest in this project solely by what we perceive to be its reward/risk ratio, where a relatively small amount of initial exploration risk capital ($3 to $5 million is envisioned) could potentially lead to a more extensive gold exploration/development project. Our 2009 exploration program found relatively few samples of commercial grade gold ore – generally considered to be 0.5 grams per tonne or more – but we believe our results merit an expanded exploration program for the summer of 2010.”

Mr. Peak continued, “Our planned 2010 exploration program will be directed toward additional rock sampling, trenching and drilling core holes. Shareholders are reminded that at this early exploration stage our investment should be considered as nothing more than an ‘interesting speculation’ and that the odds of our ultimately being successful in finding gold in a volume sufficient to support a commercial gold mining operation are quite low. To put it in oil and gas parlance, this ‘play’ is the rankest of ‘wildcats’ that is currently only at the ‘idea’ stage and we are hoping, based on our 2010 work program, to learn if we can mature it to the ‘prospect’ stage in order to justify committing additional risk exploration capital. After we have taken our core, rock and pan samples, they will be assayed in an independent lab and then evaluated for prospectivity and commercial development potential. This process will likely take until December 2010.” Here is the link to the release: Contango Gold Investment

I think this is a big warning sign. Neither Contango, nor Mr. Peak, as far as I know have any experience looking for gold, and the company has made all of its money on natural gas. This investment raises a host of questions. What also does it say about the natural gas market, or Mr. Peak’s view of it, that he would be willing to spend $3 million on gold instead of drilling for natural gas? What does it say about the value of Contango’s stock, that Mr. Peak would rather search for gold and not buy his own stock back?

But then I pause my this line of questioning and remember that Mr. Peak has been an excellent allocator of capital and has an excellent eye for value. So, I turn the question around and ask, what does it say about Mr. Peak and Contango’s thoughts on gold and the future of gold?

I think this news deserves a lot more attention and analysis. I know Contango is much smaller, but could you imagine if Exxon announced they were looking for gold? Ken Peak and Contango have an excellent reputation and are held in high regard, their decision should be viewed no less important than if a major such as Exxon had announced it.

Posted by manualofideas at 04:14 PM | Permalink | Comments (0)

Berkshire Hathaway’s investment in BYD made its first appearance in Warren Buffett’s annual letter which provides a table listing common stock investments with a market value of more than $1 billion.  As of December 31, 2009, Berkshire held 225 million shares of BYD with a market value of nearly $2 billion.  Berkshire’s cost basis is $232 million.  While the investment has appreciated significantly, it is unusual for Warren Buffett to purchase shares of what is essentially a technology company in a very unsettled industry environment.

“I am betting on the man.”

Columbia Business School students produce an excellent quarterly newsletter named Graham and Doddsville which is offered free of charge.  The Winter 2010 issue was recently released and contains details of a meeting between Warren Buffett and Columbia students where questions related to the BYD investment were discussed.  Mr. Buffett had high praise for BYD’s Founder Wang Chuan-Fu:

“BYD is a remarkable company run by a remarkable guy who started with $300,000 in 1995 and is now the second largest cell phone battery maker in the world. BYD also has the best-selling car in China on a monthly basis. [Mid- American Energy CEO] Sokol has never seen a better manufacturing operation than BYD. BYD makes everything except the tires and glass to maintain quality control.”

Not only does Mr. Buffett see Wang Chuan-Fu as a remarkable businessman, but also a man of integrity. “It took eleven months for the transaction to be approved. BYD could have backed out of the deal terms – the price had run up to HKD 40 from HKD 8 – but Wang Chuan-Fu did not. I don’t understand the product, so I am betting on the man.”

Mr. Buffett is not the only one at Berkshire who admires Wang Chuan-Fu’s track record.  Berkshire Hathaway Vice Chairman Charlie Munger performed most of the due diligence on BYD along with MidAmerican Energy Chairman David Sokol.  Mr. Munger is not known to offer praise casually, and had this to say about Wang Chuan-Fu in a 2009 Fortune Magazine article:

“This guy,” Munger tells Fortune, “is a combination of Thomas Edison and Jack Welch – something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.”

Wang Chuan-Fu is a man who believes in his product to the point where he is willing to drink BYD’s battery fluid to prove a point regarding environmental safety.

Big Challenges Ahead for BYD

There are some big challenges ahead for BYD as the company moves toward offering its all electric e6 vehicle in Western markets.  We have covered BYD extensively on The Rational Walk over the past year and have noted that the company seems to be hedging a bit more than previously regarding the timing of entry into the United States.  One potential side effect of the Toyota recall situation is that consumers may grow skeptical regarding product quality in general.  This could be particularly troubling for a new entrant from China since there is a perception that Chinese products can have quality problems.

BYD and Daimler recently announced a partnership to develop electric cars for the Chinese market.  The rationale for the alliance is that Daimler’s knowledge of electric vehicle architecture and BYD’s battery technology will be combined to provide a competitive advantage.  However, one other possible advantage is that the Daimler nameplate will bring additional credibility to a new class of all electric vehicles.  While there is no indication that any plans are underway to broaden the BYD/Daimler alliance, the fact that the two companies are working together is an interesting development.

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 and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Posted by manualofideas at 04:07 PM | Permalink | Comments (0)

Posted by manualofideas at 04:03 PM | Permalink | Comments (0)

AIG’s former CEO Maurice “Hank” Greenberg has indicated that he is ready to testify regarding AIG’s transaction with Berkshire Hathaway’s General Re group in 2000.  The transaction in question was orchestrated by General Re in a manner that allowed AIG to inflate its loss reserves by $500 million.  Mr. Greenberg was never charged with a crime but prosecutors identified him as an unindicted co-conspirator and he refused to testify citing his fifth amendment right against self incrimination.  Now that the statute of limitations has apparently expired, Mr. Greenberg is willing to provide testimony in the case.

The AIG situation has been a headache for General Re and Berkshire Hathaway over the past decade.  On January 20, General Re finally reached a settlement with the federal government which will allow the firm to avoid prosecution for its role in the accounting fraud. General Re paid $92 million in total fines as part of the settlement.  Several General Re executives were implicated in the sham transaction and the entire episode threatened to tarnish Berkshire Hathaway’s reputation.  (The AIG matter is not the only trouble Berkshire ran into after the 1998 General Re acquisition.  We provide extensive detail regarding Berkshire’s troubled history with General Re in the Berkshire Hathaway 2010 Briefing Book.)

Warren Buffett was never accused of any wrongdoing in the case and willingly spoke to prosecutors regarding his knowledge of the situation.  When the $92 million settlement was announced, Mr. Buffett made the following statement regarding the matter:

“We did something wrong and we paid the price,” Buffett said during an interview on the Fox Business Network. “It shouldn’t have been done, and there’s nothing inappropriate about the fine we paid, so I have no problem with it.”

So on one hand we have Mr. Buffett who willingly cooperated with prosecutors and has taken responsibility for the actions of one of his companies and on the other hand we have Mr. Greenberg who refused to testify years ago and is only coming forward now that the statute of limitations has expired.

Mr. Greenberg had every right to exercise his fifth amendment protection against self incrimination, but Mr. Buffett has clearly set the better example in this case.

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 and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

Posted by manualofideas at 11:42 AM | Permalink | Comments (0)

By Greenbackd

Seth Klarman’s teachings, which I’ve covered on this site on several occasions (see, for example, Klarman on calculating liquidation value, on identifying catalysts, and on investing in liquidations), are always worth reading. In his most recent investor letter Klarman has provided a list of twenty investment lessons of 2008 (via the always superb Zero Hedge):

Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.

Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

When a government official says a problem has been “contained,” pay no attention.

The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.

Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

See also Klarman’s False Lessons of 2009.

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Warren Buffett includes an “Owner’s Manual” for Berkshire Hathaway shareholders in each annual report which is also available separately on the company’s web site.  The Owner’s Manual does not change very often which is appropriate since it is supposed to communicate basic business principles that are not likely to change each year.  For this reason, it was easy to miss a change that has significant implications for Berkshire Hathaway’s earnings retention policy going forward.

Original Retained Earnings Test

The following statement has been documented as business principle #9 ever since Mr. Buffett published the Owner’s Manual in 1983:

We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.

The basic meaning of this business principle is that earnings retention must, in the long run, deliver at least $1 in market value to shareholders for each $1 that management retains.  It had the virtue of simplicity and was also very easy to measure.  Anyone can calculate Berkshire’s retained earnings for a five year rolling period and then examine whether the retained earnings resulted in a corresponding rise in market value.

Limitations With Original Principle

While the principle is simple and measurable, there are clearly problems with the way it is formulated.  It is obvious that over the past decade, valuation extremes were common for companies both on the upside and downside.  As Mr. Buffett noted in his latest shareholder letter, Microsoft CEO Steve Ballmer and General Electric CEO Jeff Immelt both had the misfortune of taking over as CEO near the peak of a bubble in their company’s stock valuation.  Just as it is difficult to evaluate the performance of these CEOs over the past decade based on share price performance alone, it is difficult to evaluate the wisdom of earnings retention using the same standard.

Berkshire’s Modified Earnings Retention Test

The updated version of Berkshire Hathaway’s earnings test reads as follows:

I should have written the “five-year rolling basis” sentence differently, an error I didn’t realize until I received a question about this subject at the 2009 annual meeting.  When the stock market has declined sharply over a five-year stretch, our market-price premium to book value has sometimes shrunk. And when that happens, we fail the test as I improperly formulated it. In fact, we fell far short as early as 1971-75, well before I wrote this principle in 1983.

The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.

It must be noted that any modification of a long standing test that recently failed should be treated with a healthy dose of skepticism.  Is management changing the test due to a legitimate problem in the formulation of the original wording or is the goal line simply being moved?  The fact that the CEO is Warren Buffett does not mean that this question should not be asked.

Mr. Buffett’s argument is that the original test was improperly formulated because markets can remain extreme for a long period of time, which is certainly true.  During such times, Berkshire’s price to book value often falls.  This is certainly the case as we noted in The Rational Walk’s Berkshire Hathaway Briefing Book. As Mr. Buffett notes, this also happened during the early 1970s far before he formulated the Owner’s Manual principles.

Allowing Mr. Market to dictate earnings retention policy even over a five year period can cause unintended consequences.  For example, Berkshire Hathaway failed to meet the test at the market lows in 2009.  A strict interpretation of the original rule would have forced a dividend in February or March 2009 and would have limited the capital available to Mr. Buffett to take advantage of opportunities caused by the market crash.  This would not have served shareholder interests.

Does the New Rule Make Sense?

The new retention principle says that the litmus test should be whether Berkshire’s book value gain exceeded the performance of the S&P 500 and whether the stock consistently sells at a premium to book – meaning a price to book ratio of at least 1.  Based on this formulation, Berkshire would have passed the earnings retention test even at the 2009 lows.

One obvious problem with the new rule is that book value is only a rough proxy of changes in Berkshire’s intrinsic value, as Mr. Buffett himself tells us in his shareholder letters.  In addition, Mr. Buffett has told us that intrinsic value far exceeds book value.  From a directional standpoint, changes in book value are likely to signal changes in intrinsic value, but a price to book ratio of 1.0 or 1.1 is almost sure to signal an undervaluation of Berkshire shares.

Under the new rule, future managements at Berkshire could argue that earnings should be retained under the new test even if the price to book value is only slightly above 1.0 provided that the change in book value over a five year period at least exceeds the S&P 500 change.

One other objection is that looking at Berkshire’s overall price to book value ratio does not measure the wisdom of retention of incremental capital.  It is perfectly possible to have value destroying earnings retention coincide with maintenance of a price to book value ratio well in excess of 1.0 because of the cumulative effect of decades of good decisions that have created the bulk of the intrinsic value.  At the margin, earnings retention could still destroy value while the price to book ratio remains above 1.0, although below what it otherwise might have been without earnings retention.

No Substitute for Management Judgment

The bottom line is that few shareholders would have wanted Mr. Buffett to declare a dividend in March 2009.  Shareholders trust his judgment based on his cumulative history at Berkshire and are willing to grant a huge amount of latitude based simply on the track record.

The problem with attempting to define this type of rule is that some element of management judgment is always going to be required when deciding on earnings retention policy.  Only after a period of time passes will shareholders be able to evaluate whether the retained earnings created value or not.  Future CEOs at Berkshire Hathaway will find it impossible to alter any of the business principles in any way whatsoever because they will be accused of trying to modify the company culture.  Therefore, Berkshire shareholders must be comfortable with these principles as they apply to the next CEO, not just Mr. Buffett.

The fact that Berkshire Hathaway has an Owner’s Manual with clear principles is a great example for other companies to follow but the recent revision to the earnings retention test demonstrates the inherent limitations associated with static principles that meet the irrational behavior of Mr. Market.

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 and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

If you receive Portfolio Manager's Review in the mail each month, you are eligible to receive Ravi Nagarajan's newly published 70-page Berkshire Hathaway 2010 Briefing Book and Excel model for FREE. Click here to buy the briefing book, then email your purchase confirmation to support at manualofideas dot com. We will promptly refund the $19.96 purchase price to you via PayPal.

Posted by manualofideas at 11:52 AM | Permalink | Comments (0)

Toyota (TM) is currently engaged in a recall of certain car models totaling in excess of eight million vehicles worldwide. The recall campaigns address problems related to the accelerator pedal. To put the size of the recall into perspective, Toyota sold 6.7 million vehicles worldwide in the trailing twelve months. While direct recall costs could be in the billions of dollars, lost sales due to brand damage may “cost” far more.

As the majority of recalls have been in the U.S., American media and politicians have weighed in heavily on the company. Amid a lot of noise, we offer three observations:

1) Massive recalls not uncommon in auto industry: At one point or another, nearly every major brand has had to deal with product recalls. Ford, for example, recently completed a series of recalls affecting 10+ million vehicles. General Motors just this week announced it will conduct a safety recall of 1.3 million cars. While this is no consolation to the people directly affected, as investors we are well-advised to consider the big picture. Recalls are a part of the automotive industry. The irony is that the current focus on Toyota likely makes their new cars the safest around.

2) The political factor: It is hard not to consider politics as a major factor shaping the Toyota debate in the U.S. Toyota has nearly doubled U.S. market share from 9% in 2000 to 17% in 2009. This has been largely at the expense of General Motors, Chrysler and Ford (F). With the U.S. government a significant owner of the former two companies, the objectivity of congressional investigations into Toyota may be compromised. Media hype does not help. Neither does the fact that the industry remains in one of its most severe downturns, with GM and Chrysler briefly undergoing bankruptcy procedures last year. The issue, however, is compounded by the fact that Toyota is also a big employer in the U.S. As all politics is ultimately local, it will be interesting to observe congressmen opinions relative to the presence of "domestic" companies versus Toyota in their respective congressional district or state. Although politics always introduces an element of uncertainty, end-customers are likely to be the ultimate arbiters of the future presence of Toyota on the U.S. market.

3) The price of growth: "Quite frankly, I fear the pace at which we have grown may have been too quick." These are the words of Akio Toyoda, Toyota's President and grandson of the company founder, as part of his testimony to House Committee on Oversight and Government Reform. The testimony is an interesting read, as it highlights the response to a major problem by a world-class organization such as Toyota. In the wider context, it is instructive to pause and contemplate the implications for other fast-growing companies. Investors often are willing to pay high multiples for nominal growth without considering the costs of growth. Be it genetically-modified food or asset management, growth at the expense of human health/returns most likely won't generate value in the long-term.

The Manual of Ideas will profile Toyota in addition to 20+ other companies in the forthcoming monthly issue of Portfolio Manager's Review. Subscribe to Portfolio Manager's Review today.

Disclosure: No position.

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