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A new European Value Report was released today. The report features the top two monthly investment ideas, as selected by The Manual of Ideas equity research team in Europe.
In the just-released monthly issue of Downside Protection Report, The Manual of Ideas highlights the research team's top two monthly investment ideas. Each stock is judged to have strong downside protection and above-average upside potential. Here is an excerpt from the editorial commentary:
Last month we wrote that “May could prove to be a good month to ‘go away.’” Indeed. Investors were rattled out of complacency — one might say unexpectedly, but such things are never expected. The S&P 500 Index ended the month down 8%, bringing the benchmark’s YTD performance to an unimpressive -2%.
Where we go from here is impossible to know. Significant problems remain in our world, but this is hardly anything new. Prior generations have dealt with even bigger problems, and the stock market has done just fine over the long term. As a result, we believe investors need to keep their perspective and their “cool.” Timing the market is almost always an exercise in futility.
The only market timing to which we subscribe is the one based on bottom-up idea availability. If ideas with strong downside protection and good upside potential are hard to find, it’s perfectly fine to hold a large cash position. However, when decent businesses are available at a discount to their liquidation values, the time may be right to be fully invested without worrying whether the market will have another leg down. Time has shown that Ben Graham-style investing works. A reason it has continued to work for many decades is that it is hard to do. Humans are not wired to invest in “troubled” companies, even if the troubles are temporary.
Take the massive oil spill in the U.S. Gulf of Mexico and the moratorium that has been put in place as a result. Does anyone really believe that the Gulf of Mexico will suddenly become off limits to oil and gas exploration? Will regulation really become that much more costly and burdensome, despite the best efforts of the energy industry lobby and the fact that once the news cycle moves on, legislators and regulators tend to move on, too? While we’re at it, does anyone really believe that the much-touted shale plays will usher in an era of unlimited supply of natural gas at prices that make it barely economical for companies to explore for gas?
The two companies featured in this issue may present interesting opportunities for investors willing to look beyond the headlines and toward a world that remains starved for energy. Emerging economies continue to demand increasing amounts of oil and gas, while true alternatives remain in their infancy. And with commodities in general looking more attractive vis-à-vis easily printed fiat currency, history may yet play out in way that puts this month's two featured companies among the beneficiaries rather than the victims. Did we mention the two companies are cheap?
By Ravi Nagarajan
This is the second in a series of articles covering “unpopular” larger companies. Benjamin Graham believed that such companies may present opportunities for enterprising investors. We discussed the Graham approach in more detail in a recent article.
Recent events in the Gulf of Mexico have increased awareness of the risks facing oil exploration companies operating in very deep waters. Drilling for oil beneath five thousand feet of water entails challenges that test the abilities of exploration companies under the best of circumstances. We are now witnessing the impotence of industry or government to deal with a well that has been gushing out of control for over a month. The current moratorium on deepwater drilling in the United States could be adopted by other countries as well and we cannot predict the duration of the moratorium. In this environment, is any investment in oil exploration or ancillary products and services worthy of consideration?
National Oilwell Varco (NOV) was formed on March 11, 2005 by the merger of Varco International and National-Oilwell. The company is the fifth largest oil and gas products and services company by revenues. The company is a supplier of rig technology, petroleum services and supplies, and distribution services. Customers include oil majors as well as drilling contractors. National Oilwell Varco has not been mentioned as one of the involved parties in the Deepwater Horizon disaster.
Overview of Business
One of the daunting aspects of investing the oil and gas exploration industry involves the amount of industry jargon that an investor must understand in order to intelligently read financial reports. The National Oilwell Varco 2009 10-K report includes a glossary of terms (pages 23 to 27) that the reader is encouraged to review. The business overview section also provides a good understanding of the interaction between firms such as NOV and drilling contractors and exploration firms. We will not attempt to provide an introduction to the industry and terminology to keep this article to a reasonable length.
NOV operates in three segments:
Due to the importance of the number of drilling rigs as well as the influence of oil and gas prices on drilling activity, we present the exhibit below to illustrate industry trends in recent years (along with data on the oil/gas ratio, unrelated to this article, but a subject we have covered from time to time in the past).
As we can see, exploration companies respond to incentives. As the price of natural gas and oil increased from 2004 to 2008, rig counts increased. The collapse in prices in 2009 resulted in a decrease to worldwide rig counts.
Historical Performance and Valuation
The following exhibit shows the past five years of performance and valuation data as reported by Value Line. When looking at the historical record, please be aware that NOV acquired Grant Prideco on December 16, 2007 in a $7.2 billion cash and stock transaction.
We can see that overall sales per share track the active rig count statistic on a directional basis. In addition, we can see that overall profitability has been enhanced in recent years as high commodity prices created a rush to drill more active wells giving NOV and other firms in the industry the ability to expand margins.
The following exhibit shows NOV’s revenues, operating profit, and operating margins broken down by reporting segment:
It is apparent that Rig Technology is the most consistent segment in terms of delivering high operating margins and is also the largest segment by revenues and operating profits. Petroleum services and supplies delivers consistent profitability although operating margins were depressed in 2009. Distribution services predictably offers the lowest margins.
First quarter 2010 results (click here for 10-Q) show that this pattern is basically intact with operating margins for Rig Technology, Petroleum Service & Supplies, and Distribution services at 30.8%, 12.2%, and 3.3% respectively. Overall first quarter revenues were $3,032 million in 2010 which is a decline of 12.9 percent compared to the first quarter of 2009. Operating profits for Q1 2010 came in at $637 million, down 11.5 percent from Q1 2009.
Geographic Distribution
The following exhibit shows the distribution of sales by geographic location for the past five years. The United States only accounts for 27 percent of worldwide sales for 2009. As recently as 2006, sales in the United States were in excess of fifty percent of revenues.
The chart below shows sales by geography broken down for 2009.
Impact of Regulatory Changes
The degree of geographical diversification at NOV provides some comfort against the risk that any one country’s regulatory changes will have an outsize influence on overall results. However, obviously the United States is a large market and other countries, particularly developed countries, may adopt risk averse policies going forward toward deepwater exploration.
From a regulatory perspective, the clear risk is that new policies will slow or stop deepwater exploration by NOV’s customer base which will have a corresponding effect on demand for the company’s products. A lesser regulatory risk may involve mandated changes to parts (blowout prevents are an obvious example) that companies such as NOV will have to implement. While it is likely that any increase in cost will be passed on to the customer, the dynamics of unknown regulatory changes to NOV’s products and the impact on margins cannot be determined.
Backlog Characteristics
As noted previously, NOV’s Rig Technology segment has a significant backlog of orders based on the long planning cycle for new oil exploration. The company’s backlog grew from $0.9 billion at March 31, 2005 to $11.8 billion at September 30, 2008, but has fallen to $5.4 billion on March 31, 2010. Most notably, the land rig backlog comprises 13 percent while the offshore backlog comprises 87 percent of total orders as of March 31, 2010. In general, customers cannot cancel projects for “convenience” and provide substantial down payments. Only 3.6 percent of the starting backlog balance on September 30, 2008 has been cancelled to date. Nevertheless, it is obvious that any extended moratorium on deepwater drilling will have a negative impact on NOV’s backlog.
One important point to note regarding the backlog is that 91 percent of the total backlog is related to equipment destined for international markets. Thus, even though 87 percent of NOV’s backlog is related to offshore projects, the vast majority are for projects outside the jurisdiction of the United States. As noted previously, other countries may very well adopt a moratorium on deepwater activity as well, so the heavy international bias of the backlog may not offer as much protection as envisioned.
A final point regarding the backlog is that a significant number of jackup rigs (those operating in shallow water) are very old. According to NOV’s latest 10-Q, 71 percent of the installed base of jackup rigs are more than 25 years old. Since the moratorium has no impact on jackup rigs operating in shallow waters, this source of business should be unaffected by a deepwater drilling moratorium.
Conclusion
National Oilwell Varco closed on Friday, May 28 at 38.13. The shares have fallen in sympathy with the overall sector over the past five weeks and traded above $46 as recently as April 26. The shares are currently trading at under ten times likely earnings for 2010. The company clearly has enjoyed healthy profit margins over the past five years and while margins and profitability were down due to lower commodity prices in 2009, overall results held up quite well.
The international diversification of NOV’s business and the other factors discussed above seem to indicate that risks specifically related to the Deepwater Horizon disaster should have a muted effect on the company’s future progress. However, NOV is still exposed to overall commodity prices and industry risks. If oil and natural gas prices crash to the lows of early 2009, exploration activity is sure to decline significantly and this will be reflected in active rig counts. This will have a corresponding negative impact on NOV’s results. The most likely scenario for a commodity price crash would be another worldwide recession, perhaps brought about by the current debt crisis in Europe.
In summary, it is not “obvious” that NOV is undervalued at current levels, but it seems reasonable to regard the company’s future fate as more tied to overall global demand for oil and natural gas and the prices of these commodities rather than to the regulatory risks associated with Deepwater Horizon. Therefore, future panic associated with Deepwater Horizon may present an opportunity to establish a position in NOV if the shares fall in sympathy with players that are more directly exposed to the disaster.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. Disclosure: No position in National Oilwell Varco. Please note that the author is not an expert in the oil supplies and services industry having started research in the field only in the weeks since the Deepwater Horizon incident. The author owns shares of Contango Oil & Gas, an exploration firm with the majority of operations in shallow Gulf of Mexico waters.
By Plan Maestro
In trying to understand the state of the sector, the sharp recovery of the financial industry profits has been the most surprising event. Here are is graph from a Moody’s presentation based on national accounts data:
The main reason for this recovery despite the heavy losses of several banks between 2007 and 2009 was the big bailout that we discussed in the first installment of the series. This low interest rate environment combined with lesss competition has been a boom for the survivors. And even those on the edge are recapitalizing and may have a second chance.
The big implication is that since the USA still has an economy heavily dependent on the financial industry, as can be seen from this chart from a recent column by Paul Krugman , its ability to profit its way to health is good news.
By Ravi Nagarajan
This is the first in a series of articles covering “unpopular” larger companies. Benjamin Graham believed that such companies may present opportunities for enterprising investors. We discussed the Graham approach in more detail in a recent article.
Few large companies have built up as much brand equity and consumer goodwill as Johnson & Johnson. The company routinely appears near the top of lists of the most respected American companies and makes products that consumers rely on. The company’s prompt response to the Tylenol recalls in 1982 made it the subject of numerous case studies on how to properly handle such situations.
Given Johnson & Johnson’s history, allegations of improper behavior related to recent recalls has surprised many investors. The FDA is considering criminal charges against the company for pursuing a “stealth recall” of Motrin before being pressured into a formal recall in July 2009.
In addition to the recall related trouble, Johnson & Johnson is also exposed to the new health care law’s 2.3 percent revenue tax on medical devices which will go into effect in 2013. The medical device tax in particular, and health care reform in general, has weighed on the stock price of many companies involved in the industry. In this article, we will take a brief look at Johnson & Johnson’s history to determine whether there are any rays of sunlight that may break through the stormy clouds currently over the company.
Ten Year History and Current Valuation
A brief look at Johnson & Johnson’s ten year history reveals a company that has consistently delivered growth in earnings per share, dividends, and sales while posting steadily improving margins. The following table displays selected data found in Value Line’s latest report on Johnson & Johnson (Value Line makes all Dow 30 stocks available free of charge). Click on the image for a larger view.
What is interesting about Johnson & Johnson is that the market has steadily cut the price to earnings multiple for the stock over the past decade. This is not unlike the experience of Wal-Mart or Microsoft shareholders over the past decade. The business has done very well and key metrics keep improving while the stock gets less and less popular over time.
Johnson & Johnson closed at $58.30 on Friday, May 28 which represents a trailing P/E ratio of 12.6. The forward P/E ratio is slightly under 12 assuming modest earnings growth this year. With a current dividend of $2.16 per share, Johnson & Johnson provides a 3.7 percent yield. Over the past decade, dividends have increased at a 13.3 percent annualized rate while the payout ratio has only increased modestly. With a market capitalization of nearly $161 billion, one would expect growth to slow at some point, and perhaps the market believes that the decline in revenues in 2009 and very modest earnings per share growth means that the slowdown is imminent.
Medical Device Segment
Since we believe that one of the factors depressing the stock price is related to the health care law’s 2.3 percent medical device tax on gross revenues, it is important to dig a bit deeper and look at Johnson & Johnson’s segment information which is reported in annual 10-K reports filed with the SEC. The tables below show Johnson & Johnson’s revenues, operating profits, and operating margins broken down by segment (click on the image for a larger view):
We can see that medical devices accounts for a significant percentage of Johnson & Johnson’s total revenues (38 percent in 2009) and a greater percentage of operating profits (46 percent in 2009). In addition, we can see that operating margins are relatively high for medical devices and have been growing higher over time. In 2009, medical device operating margins were 32.6 percent, the highest of any segment. Certainly medical devices seem to be an important part of Johnson & Johnson’s business. The charts that appear below present segment data for 2009 for revenues and operating profits.
Impact of Medical Device Tax
Is it accurate to take the 2.3 percent revenue tax on medical devices and simply multiply it by segment revenues in order to measure the potential impact? This would not be accurate because the tax only applies to medical devices shipped within the United States. In addition, the final version of the health care law made the tax deductible for income tax purposes (some versions prior to the final reconciliation process were non-deductible).
The following table shows Johnson & Johnson’s medical device segment revenues broken down by region for the past ten years (click on the chart for a larger view):
We can see international sales have become more important for the medical device segment in recent years and now exceeds the sales volume of domestic shipments. Less than half of the medical device revenues at Johnson & Johnson would be subject to the tax based on 2009 revenues:
The tax does not take effect immediately, but let us assume that Johnson & Johnson has to pay the 2.3 percent gross revenues tax on the $11,011 million in medical device revenues in 2009. The tax would amount to approximately $253 million, but we must remember that this figure is deductible for income tax purposes. Therefore, assuming a 35 percent tax rate, the net tax impact would be approximately $164 million. With total net profits of $12.9 billion in 2009, the impact of the medical device tax would amount to a reduction of only 1.3 percent of net income.
Assessing the Risks
Let us revisit the two risks to Johnson & Johnson discussed in this article (there are other business risks that an investor may want to consider as well — specifically the risk profile of the pharmaceutical segment which we have not discussed):
The bottom line is that Johnson & Johnson is now a very unpopular large company from Mr. Market’s perspective. At a PE ratio of approximately 12 and a dividend yield of 3.7 percent, the stock appears to be cheap given the company’s history of growth as well as the current levels of profitability that clearly demonstrate the presence of a powerful moat in all three business segments. The company’s market capitalization is now at the point where one can reasonably expect growth to slow in the future, but investors are not paying a price that demands much future growth.
What would Benjamin Graham think about Johnson & Johnson’s valuation today? We obviously cannot be so presumptuous as to make any definitive statement, but the company’s record over the past ten years combined with a very secure and growing dividend that yields in excess of the ten year Treasury note would probably at least spark his interest in the stock as a potential “relatively unpopular large company” worthy of serious consideration.
The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. Disclosure: No position in Johnson & Johnson currently but seriously considering a purchase.
Apple has overtaken Microsoft to claim the number two spot in the ranking of American companies as measured by market capitalization. At $222 billion, Apple only trails Exxon Mobil which has a $279 billion market cap. Microsoft’s market capitalization fell today to $219 billion. What does this mean and are there any lessons that investors can learn from Apple’s amazing rise over the past decade?
Apple’s Business Success Drove Result
There can be no doubt that Apple’s business success has driven investor enthusiasm and led the market to value the company at a very high level. When one looks back at Apple’s condition in the late 1990s, few investors at the time would have bet much on the company even existing in 2010 let alone being the second most valuable company by market cap. The leadership of Steve Jobs in general and the introduction of the iPod and iPhone not only drove Apple’s bottom line results but radically disrupted the hardware, software, music, and telecommunications industries.
Apple’s earnings growth, as we will see in a table later in the article, has been extremely rapid particularly over the past few years as the iPhone gained momentum. Sales have increased at a rapid clip while net profit margins have expanded. It is no surprise that investors are excited about future prospects and willing to pay over twenty times 2010 earnings estimates to own the shares (Value Line estimates 2010 earnings at $11.55/share).
Whether a buyer of Apple stock today will be successful in the long run is beyond the scope of this article, and indeed far beyond the abilities of this author to analyze. Obviously, based on projecting the past five years of results into the future, nearly any price can be justified today. However, at some point (which we cannot pretend to know with any certainty), Apple’s growth will slow and investors will suddenly refuse to pay rich multiples of earnings.
Microsoft: Solid Business Results, Dismal Stock Performance
Microsoft’s story over the past ten years under CEO Steve Ballmer has been one of solid progress in business results and absolutely dismal performance from a stock price perspective. This can be traced to the fact that investors in the late 1990s and early 2000s were willing to pay very rich multiples of earnings based on Microsoft’s track record up to that point. Microsoft often traded at multiples of 50 or more during the height of investor euphoria.
Looking at Microsoft’s Value Line data (available free of charge as a Dow 30 member), we can see the rapid earnings growth in the mid to late 1990s that fueled investor enthusiasm and we can also see solid, but slowing growth over the past ten years. Indeed, the company failed to increase year over year earnings only twice over the past decade. In addition, a dividend was introduced. Profit margins declined over the past decade as the company’s business matured and pricing came under pressure (operating system sales for net books are a good example of the pricing headwinds faced in recent years). Still, at a 24.9 percent net profit margin in 2009, Microsoft clearly remains a great business.
The stock price decline over the past decade is attributed to the fact that investors were willing to pay far less for each dollar of earnings than in the past. At an average PE ratio of 13.4 in 2009, investors were treating Microsoft as an average company, at best, and possibly as a company that may be in decline going forward.
A table showing key data (all from Value Line) for Apple and Microsoft appears below.
What can we learn from the history of Apple and Microsoft over the past decade?
First, while Apple’s success story is indisputable, it is very difficult to see how a value investor could have justified a purchase of the company’s common stock in the early part of the last decade while insisting on any margin of safety. The wonderful success Apple has experienced was courtesy of products that hardly anyone could foresee at the time. Would it have made sense to purchase shares in 2005 or 2006 after the iPod was firmly established and when speculation raged over the iPhone? Possibly for an investor who firmly believed that the industry was within his circle of competence, but most value investors probably still would have passed.
Second, we can see from Microsoft’s history the dangers of paying a fancy price for a wonderful company based upon expectations that past trends can continue indefinitely. Despite turning in solid performance over the past ten years from a business perspective, any buyer of Microsoft stock from that era is sitting on losses of fifty percent or more. It is clear that a value investor would not have purchased Microsoft stock in 1999 or 2000 simply based upon the valuation at the time. There was no margin of safety.
While this article is not intended to make any statement regarding Apple’s valuation, it would seem prudent for any prospective Apple shareholder to consider Microsoft’s experience over the past ten years and the importance of a margin of safety when making long term investment commitments.
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. Disclosures: No position in Apple or Microsoft.
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It is said that those who fail to study history are doomed to repeat it. The benefits of a careful study of general history is self evident and the same applies to investors who wish to learn from past events as well as the mistakes of others. There is no reason to learn painful lessons firsthand when we can learn vicariously through our predecessors. At the same time, it is important to guard against the tendency to judge those making decisions in the past solely based on events that occur subsequently. However, it is reasonable to expect that an individual making a decision in the past should have acted logically based on knowledge available at the time.
With this in mind, it is interesting to review Michael Burry’s letter to his investors written in November 2006. ‘A Primer on Scion Capital’s Subprime Mortgage Short’ is Dr. Burry’s attempt to explain his decision to take a bearish position in credit default swap contracts. Based on accounts in The Big Short, which we reviewed last week, Dr. Burry’s investors were highly skeptical of his short position and many were threatening to withdraw funds.
Viewed from our perspective in May 2010, Dr. Burry’s investment thesis was obviously correct and the letter makes perfect logical sense. We have the benefit of hindsight and are fully aware of the wreckage in the mortgage market that took place after mid 2007. However, the real question is whether the argument was persuasive from the vantage point of late 2006. It certainly appears persuasive even if one does not base that judgment on what we know today. Dr. Burry clearly outlines the structure of the securitizations in question, documents the very thin nature of the lower tranches, and shows how a modest level of default could easily hit the higher “investment grade” tranches.
The following excerpt is from the conclusion of Dr. Burry’s letter and nicely illustrates the risk/reward characteristics of the trade. If the thesis was proven to be incorrect, the annual cost of carrying the position would amount to about six percent of fund assets each year. The benefits of the thesis being proven correct was massively larger than the actual risk assumed:
The Funds currently carry credit default swaps on subprime mortgage-backed securities amounting to $1.687 billion in notional value. As I selected these, I was not looking to set up a diversified portfolio of shorts. Our shorts will have common characteristics that I deemed to be predictive of foreclosure, and therefore they should be highly correlated with each other in terms of both the timing and the degree of ultimate performance. Again, ultimate performance matters much more than the valuation marks accorded us by our counterparties in the interim. In the worst case, I expect our mortgage short will fully amortize to nil value over the next three years, corresponding to an average annual cost of carry over that time of roughly six percent of current assets under management. Calibrating the more positive outcomes will become easier as 2007 progresses.
It is always risky to retroactively pass judgment on decisions that were made in the past with imperfect information. It is true that the consensus viewpoint at the time was that nationwide home prices “never” decline, and if this is accepted at face value, the annual six percent cost of carry could seem like a simple speculation. Dr. Burry’s investors included sophisticated and well respected value investors who today would probably concede that his short thesis was accurate but disagreed strongly at the time. Alan Greenspan still thinks that those who predicted the housing bubble were merely lucky “statistical illusions”.
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 conventional wisdom today is that few individuals had the foresight to truly understand the subprime lending bubble while it was inflating. However, it did not take an MBA from an elite institution to understand intuitively that median home prices could not rise endlessly while median family incomes remained stagnant or that temporarily low teaser rates on zero down mortgages would end in tears unless home prices continued to rise. In fact, many ordinary Americans without any financial background could intuitively understand that a bubble was forming. However, while many understood the nature of the bubble, very few were able to profitably bet on the eventual crash.
If you are already cynical about the motives and practices of professional investors in the major Wall Street banks, chances are that you are not even half as cynical as Michael Lewis. In The Big Short, Mr. Lewis spins a tale that places very unlikely characters at the center of the subprime bubble. All of the individuals were either completely unknown or relatively small players, but they shared in common an insight into the bubble that resulted in spectacular profits. This book reads almost like a novel, at least for those who have a basic understanding of credit default swaps, collateralized debt obligations, and related terminology and concepts.
The Cast of Characters
The cast of characters in the book includes Michael Burry of Scion Capital, Steve Eisman of FrontPoint Partners, and Charlie Ledley and Jamie Mai of Cornwall Capital. Like many others, these men understood the nature of the bubble that was quickly forming, but they had the foresight to come up with ways in which they could place bets that would pay off in the event of a collapse in the worst CDOs. By purchasing credit default swaps (CDS) on CDOs comprised of the worst subprime mortgage bonds, all of these investors were able to realize huge payoffs when the collapse finally came. However, this required the ability to not only see the impending crash but to be willing to go against conventional wisdom for several years.
Did Michael Burry Make a Macro Call?
Michael Burry’s story is the most compelling when it comes to the price that must be paid for bucking conventional wisdom when managing other people’s money. Trained as a medical doctor, Dr. Burry had built a strong reputation for bottom up stock picking and attracted the interest of prominent value investors who realized excellent returns during the early part of the last decade. However, when Dr. Burry revealed his bet against the subprime mortgage market, nearly all of his investors strongly objected and many demanded their money back. It took nearly two years of gut wrenching conflict and short term underperformance before the strategy finally paid off.
One gets the sense that Dr. Burry was not the easiest person to deal with given his interpersonal issues related to Asperger Syndrome. And in some ways, the reluctance of the investors to accept what seemed like a major “macro call” from someone they thought was a bottoms up stock picker seems understandable. What the investors missed is the fact that Dr. Burry was not really making a macro call at all. He had studied the prospectuses for countless CDOs and identified the worst of the worst to bet against. He then convinced major investment banks to create CDS that would pay off in the event of default. Furthermore, he knew that the bonds in question were comprised of subprime mortgages with teaser rates that would expire in 2007 and the data made it obvious that defaults would rise at that time. From this perspective, the “macro call” looks less like a speculation and much more like a value investment, although Dr. Burry was never able to successfully convince his investors.
The Main Villains: Credit Rating Agencies
There is no shortage of villains in the book and the reader is repeatedly exposed to insane and distasteful behavior by many of the characters in the investment banks. However, the true villains and the “enablers” of the crisis are clearly the credit rating agencies that either naively or purposely rated subprime CDOs as AAA securities thereby giving cover to investors who abdicated their role as analysts and blindly paid up for seemingly “bullet proof” paper. Here is a quote from the book by Steve Eisman:
“They’re underpaid,” said Eisman. “The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for. There should be no greater thing you can do as an analyst than to be the Moody’s analyst. It should be, ‘I can’t go higher as an analyst.’ Instead it’s the bottom! No one gives a fuck if Goldman likes General Electric paper. If Moody’s downgrades GE paper, it is a big deal. So why does the guy at Moody’s want to work for Goldman Sachs? The guy who is the bank analyst at Goldman Sachs should want to go to Moody’s . It should be that elite.” (Page 156)
It becomes obvious that the ratings agencies had no real insight into the CDOs they were rating as AAA, nor did they really appear to care about improving their models. Given the fact that the banks creating the CDOs were paying the credit rating agencies, there was an inherent conflict of interest because if one agency refused to “play ball”, then another one would be willing to do so. Eventually, the agencies announced a change in the models used for subprime CDOs but inexplicably refused to make it retroactive by re-rating existing bonds.
Demise of the Partnership Model
While Mr. Lewis clearly believes that the ratings agencies were incompetent, he also places a great deal of blame on the demise of the partnership model of the investment banks. He believes that public share ownership of the banks allowed management to pursue risky strategies that would never have been tolerated in a partnership model. Those who have read The Partnership: The Making of Goldman Sachs can obtain a better understanding of how the partnership model worked and it may be a better approach. However, it must be noted that many of the investment bank CEOs did in fact lose the vast majority of their net worth in the crash.
If the partnership model has merit, it is more likely due to the culture of ownership that pervades the firm rather than simply exposure to loss. Public ownership comes with quarterly guidance, earnings estimates, analyst meetings, investor conference calls, short term thinking, and other dysfunction that would not exist in a partnership model. Still, it is not obvious that a partnership model is a panacea or that the subprime crisis would have been averted had the investment banks not opted for public ownership over the past two decades.
Entertaining and Worthwhile Read
Mr. Lewis, who first became famous for writing Liar’s Poker, is nothing if not a talented storyteller who can keep his audience enthralled by the drama (at least those with an interest in the subject). However, The Big Short cannot be considered a definitive history of the subprime crisis and does not come anywhere near the level of depth that Andrew Ross Sorkin delivered in Too Big to Fail, which we reviewed in January.
It may not be entirely fair to compare the two books. Mr. Sorkin gained access to some of the most important players in the major investment banks and in government to paint a broad picture of the financial crisis. Mr. Lewis, in contrast, took the stories of relatively unknown investors who were spectacularly successful in profiting from the crash. In reality, the books serve different purposes and are both worth reading. Those who are more interested in a behind the scenes account of the crisis from the perspective of “major players” should select Too Big to Fail while those who are looking for more insight into the minds of several very brilliant and contrarian investors should opt for The Big Short.
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.
By Plan Maestro
Most of you have seen a similar version of this chart with a mountain of commercial real estate problems for banks:
But the fact is that for closed banks the percentage of CRE loans non accruing is much lower than C&D
So it looks like CRE issues have been much exaggerated compared to C&D’s. Part of its better performance up to now is because
But there are also some particular characteristics of CRE loans that make them a better risk
Some people call this “extend and pretend” and would agree when the cash flow is not present or the collateral is weak. But refinancing was and is an essential part of banking and this was not a CRE construction bubble like the end of the 80s. And for investors this “extend and pretend” has the advantage that progress is more gradual and the underwriting can be evaluated without sudden NPA collapses like could happen with C&D loans.
Concluding, for investors a large percentage of CRE loans is a risk but this risk is much easier to bound than C&D’s. Look for:
With all the talk over the last year and a half about commercial real estate (CRE) being the next shoe to drop while not dropping, this post is about reminding us of what was really the issue. This can give perspective of the relative order of magnitude of future problems and their consequences.
The real bank killer has been construction and development loans (C&D) with the next possible culprit not even close. This is a chart detailing the type of collateral for real estate loans of closed banks.
SFR: Single Family Residential
Source: http://marketwi.se/2010/04/are-banks-failing-because-of-cre/
Careful with those construction and development loans:
So the problem with C&D loans is part the probability of default but even more consequential its severity. Other types of loan problems can be mitigated by refinancing but it is much more difficult with C&D in the middle of a recession.
For most of the banks that I have stumbled upon with recent non performing assets surprises their issue was still related to C&D (ie: CBNK a couple of days ago). And most of their C&D loans were residential since the size of the commercial C&D market is dwarfed by the residential market.
Concluding, as an investor you have to be really sure of a bank underwriting standards (LTV in particular) when they have 20%+ of their portfolio in C&D loans even with good capital ratios. And reading 10Ks will probably not be sufficient so I personally much rather avoid those banks.
Warren Buffett was highly critical of Kraft’s acquisition of Cadbury throughout the takeover process. It is therefore not entirely surprising to learn that Berkshire Hathaway cut its stake in Kraft by nearly 23 percent during the first quarter. It is not common for Mr. Buffett to openly criticize managers so it was all the more notable to hear him say that the deal made him feel poorer, particularly due to the “dumb transaction” involving the sale of Kraft’s pizza business to fund part of the acquisition.
In a 13F Filing with the Securities and Exchange Commission this afternoon, Berkshire reported holding 106.7 million shares of Kraft as of March 31, 2010 compared to nearly 138.3 million shares on December 31, 2009. In addition to the sale of Kraft shares, Berkshire liquidated shares in several other companies and added to positions in three companies. No new positions were initiated during the quarter. Let’s take a brief look at the Kraft sale and other transactions revealed in today’s report.
Why Sell if Kraft is Still Undervalued?
The reason we stated that the sale of Kraft shares was not “entirely surprising” is due to Warren Buffett’s longstanding preference for dealing only with managers who can be trusted to exercise good business judgment. With wholly owned subsidiaries, Mr. Buffett is looking for good operational managers who can run their businesses well but he handles all capital allocation personally. This is not the case with minority stakes in public companies. Mr. Buffett quite clearly believes that Kraft CEO Irene Rosenfeld is incompetent in capital allocation, although he has said that she is a capable operational manager.
What makes the size of the reduction somewhat surprising is that Mr. Buffett still believes that Kraft is undervalued on a component part basis. According to several accounts of notes taken at the Berkshire Hathaway annual meeting (for example, click on this link for The Inoculated Investor’s notes), Mr. Buffett quite clearly stated that Kraft is undervalued. The implications of a large sale is that the degree of undervaluation may not represent enough of a margin of safety to protect against future incompetence in capital allocation. Of course, Berkshire continues to own a large stake in Kraft even after the sales during the first quarter.
Other First Quarter Portfolio Changes
During the first quarter, Berkshire eliminated positions in Wellpoint, United Health Group, Travelers, and SunTrust Bank. Both individually and in aggregate, these were relatively small positions for Berkshire and from the prior 13F report, it appears that the Wellpoint and United Health stakes were most likely positions controlled by GEICO’s Lou Simpson.
In addition to Kraft, positions that were reduced but not entirely eliminated include CarMax (3.4% reduction), Costco (17.5% reduction), Gannett (21% reduction), Johnson & Johnson (11.9% reduction), M&T Bank (17.2% reduction), Moody’s (3.2% reduction), Conoco Philips (9.4% reduction), and Proctor & Gamble (9.6% reduction).
Berkshire added to its position in three companies: Republic Services (30.6% addition), Iron Mountain (11.4% addition), and Becton Dickinson (16.3% addition).
In addition to the changes noted above, the latest report shows the effect of Berkshire’s acquisition of Burlington Northern Santa Fe. The 76.8 million shares that were held as of December 31, 2009 no longer appear on the report due to the completion of the acquisition on February 12.
Due to the widespread availability of free high quality resources for viewing Berkshire’s portfolio in real time, we are no longer providing the spreadsheet that was previously posted following the 13F release. Instead, we suggest using Dataroma’s Berkshire portfolio tracker for basic information or GuruFocus.com for more in depth coverage.
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.
By Greenbackd
The incredible Zero Hedge has an article on Seth Klarman’s address to the CFA Institute:
Seth Klarman was speaking at the CFA Institute earlier, and in typical fashion cut to the chase: in summarizing the current market, the Baupost founder said he “sees few bargains in the current environment and predicted on Tuesday that the stock market could suffer another lost decade without any gains.” And the punchline: his description of market conditions which he compared to “a Hostess Twinkie snack cake because everything is being manipulated by the government and appears artificial.” Such facility with words, there is a reason the man runs a $22 billion fund and his book “Margin of Safety” has been out of print for years, and sells for a $1000 on ebay.
Sayeth Seth (via Reuters):
“Given the recent run-up, I’d be worried that we’ll have another 10 years of zero returns,” Klarman, who rarely speaks in public, said at the CFA Institute’s annual conference in Boston.
“I’m more worried about the world broadly than I’ve ever been in my whole career,” Klarman said.
Inflation is a risk that Klarman said he is particularly concerned with given the government’s high rate of borrowing to bail out the financial system. Baupost has purchased far out-of-the-money puts on bonds to hedge the risk, he said.
The puts, which Klarman said he viewed as “cheap insurance,” will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.
Typically, Baupost focuses on out-of-favor stocks and bonds. Klarman cleaned up in 2007 and 2008 buying distressed debt and mortgage securities that later recovered.
One area Klarman said he is currently scouring for potential investments is private commercial real estate below the top quality. Publicly traded real estate investment trusts, however, have “rallied enormously” and are “quite unattractive,” he said.
…
“We’d rather underperform a huge bull market than get clobbered in a bear market,” he said.
For those of you who don’t want to shell out $1,000 on eBay for Seth’s out-of-print Margin of Safety and have only recently become aware that the Internet is available on computers, the Zero Hedge article includes a link to a scanned copy of the book, available at a price even an anarcho-capitalist could embrace.
By Plan Maestro
Mrs PlanMaestro knows her consumer goods and it was the first person I talked with after the recent appearance of Dean Foods in the 52 week lows lists. While I have not made a decision on this opportunity, I thought that the intricacies of the milk industry were fascinating and managed to convince her to write about them. We have the pleasure to publish her first contribution to this blog … and if you like it please say so to have more
The recent share drop has put Dean Foods (DF) on the spot so I would like to comment on the US dairy industry and provide some perspective on the attractiveness of DF’s business.
In short, the US milk industry is going nowhere. USA per capita milk consumption is among the highest in the world reaching around 70 liters per person. In recent years per capita consumption has remained stagnant in the face of more innovative categories (e.g. functional drinks) which have been gaining share of throat.
While there has been some growth coming from yogurt or soy drinks, none of the dairy industry innovations have been successful increasing the range of consumption occasions or cannibalizing other categories. Unless a radical innovation widens the range of consumption occasions and consumer profile (most probably coming from the large beverages companies, rather than the traditional dairy companies), we can only expect milk industry volume to grow at the same pace as the population growth.
What is really striking in this industry is that private label (PL) penetration has reached 70%. This is a very high number compared to any other beverage category. For obvious reasons, penetration is higher in categories with a larger share of volume sold through supermarkets (which is the case for milk). However, the gap in milk is quite astonishing. PL penetration in water is around 30%, in juices around 20%, and in carbonated drinks under 10%.
Even compared to other groceries, milk remains the category with the largest PL penetration (Cereal ~30%, Mayonnaise ~20), even though volume sold in supermarkets is quite similar for all them (above 80% of volume).
While private label penetration is usually driven by heavy discounts, until very recently milk PL prices were almost in parity to branded products. Most of the PL products are now associated with high quality and as supermarkets extend their reach nationally, they are making such brands available cross nation. On the other side, branded milk has remained mostly regional and unable to differentiate significantly from the PL offer (no single brand holds more that 2% of the industry market share). DF, after a series of acquisitions, has managed to consolidate around 18% of the industry’s market share (47% branded and 53% private label production).
It is uncertain to me how the milk industry in the US commoditized much faster than other categories. My guess it was the compounding result of several factors:
To sum up, this is a mature industry with an unclear growth perspective with a very high level of commoditization (estimated category operating margin of 5%). For Dean Foods to compete successfully in it, requires being able to differentiate its product offer versus Private Label while being able to widen its operating margin. A deeper look into Dean’s strategy will be developed in a following post.
In recent weeks, there has been some speculation that Li Lu may be a potential candidate for Chief Investment Officer at Berkshire Hathaway once Warren Buffett retires. Berkshire Hathaway’s succession plans call for Warren Buffett’s job to be split into two roles. The new CEO will have ultimate responsibility for Berkshire Hathaway and one or more investment officers will have oversight responsibility for investment operations and will report to the CEO.
Who is Li Lu? According to his Wikipedia entry, Li Lu was an organizer of the student protest movement in China and took part in the Tiananmen Square protests of 1989. After the post-Tiananmen crackdown, Mr. Lu had to flee mainland China and moved to the United States where he became one of the first students in the history of Columbia University to complete three degrees simultaneously: a B.A. in Economics, a J.D. from Columbia Law School, and a M.B.A. from Columbia Business School. Mr. Lu founded Himalaya Capital in 1997 and ran the fund until 2004. In 2004, he founded a long only investment vehicle named LL Investment Partners.
During the Berkshire Hathaway annual meeting, Charlie Munger made a vague reference to a candidate for the CIO position who returned 200 percent in 2009. At the Wesco meeting the following week, Mr. Munger mentioned Li Lu in the context of the BYD investment. While no specific reference has been made to Li Lu, it is obvious why there is some speculation regarding the possibilities.
In the following video, Li Lu speaks to Bruce Greenwald’s value investment class at Columbia University. Please click on this link for the video. Note that registration is not required to view the video. Simply click on the play button in the center of the display. Do not select a video quality. The site will open up an unrelated window but should begin streaming the main presentation. The actual lecture starts at about the three minute mark.
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.
The Value Investing Congress took place in Pasadena, California last week. The Congress is a major event in the value investing community and featured many well known speakers including Paul Sonkin, Bruce Berkowitz, Mohnish Pabrai, Tom Russo, Whitney Tilson, and many others. Fund managers discuss macro viewpoints as well as specific actionable investment ideas.
The Inoculated Investor has provided a terrific set of notes from the Congress covering two days of sessions. In addition, detailed notes on Wesco Financial Corporation’s annual meeting are provided. Charlie Munger’s comments are always worthy of careful attention and this year was no exception. The entire value investing community owes Ben of The Inoculated Investor a debt of gratitude for providing this level of detail free of charge.
Click on this link for Value Investing Congress Meeting Notes
Click on this link for Wesco Annual Meeting Notes
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: Long Berkshire Hathaway. Wesco is a 80 percent owned subsidiary of Berkshire Hathaway.
Over the past three decades, videogame distribution and target markets have changed dramatically. In the 1980s, videogame arcades were extremely popular among teenagers and young adults but over time the popularity of home videogame consoles ruined the economics of arcades and broadened the target market significantly. Newer videogame consoles have made the arcade games of the 1980s seem antiquated in comparison. Now home console videogames may be facing the same future as arcades as online based games gain popularity.
A sustained shift to online gaming would have serious implications for manufacturers of consoles and computer based games. According to The Wall Street Journal, videogame software sales fell 11 percent to $10.5 billion in 2009 and continued to decline in the first quarter of 2010. At the same time, online social games such as Zynga’s very popular FarmVille game, have been rising rapidly. FarmVille has attracted 78 million active monthly users who play the game on Facebook. The game is surprisingly low tech in appearance and functionality, yet has captured the imagination of millions of users.
Zynga recently announced the private placement of preferred shares that imply a market valuation of $4 billion. The company was founded in 2007 and claims to be profitable. FarmVille is a free game but “virtual products” are sold online. Users earn virtual currency from farming activities but can accelerate the development of their farms using “cash” purchased from Zynga. This provides Zynga with a revenue stream. According to The Wall Street Journal, industry-wide sales of such virtual goods is expected to rise to $2.1 billion in 2012 from an estimated $336 million in 2009.
Virtual Goods: A Crazy Idea?
While the idea of purchasing “virtual goods” may seem absurd, it is not that different from purchasing other forms of cheap entertainment such as a movie ticket. Furthermore, the fact that the price of entry is free and the game has social aspects can lead to competition among players that can induce players to part with real cash in exchange for virtual currency.
The Wall Street Journal article cited previously highlights the problem for traditional videogame makers. While a social videogame like FarmVille may cost a firm like Zynga $500,000 to $1 million to develop, firms like Activision may spend more than $20 million to develop traditional console games that sell for $60 through retailers like GameStop.
Just like arcades did not disappear overnight when early consoles made home based play possible, online social games like FarmVille will not displace console games entirely and a transition will not occur overnight. However, the addictive and competitive nature of cheap social videogames combined with increasing affordability of high bandwidth internet connections make the economics compelling and add a level of risk to the traditional gaming industry. In Asia, online videogames are already extremely popular with games such as Ragnarok Online developed and run by South Korean developer Gravity.
FarmVille as a Lesson in Economics
The game actually represents an interesting lesson in economics. Players must purchase seeds, trees, and other assets which generate FarmVille “income” after a waiting period of a few hours to a few days. Such income can then be reinvested in additional income producing assets, buildings, and other improvements.
Most videogames are probably corrosive to the minds of younger people but FarmVille might actually help provide some education on economics. For example, a simple economics problem involves optimization of crop selection based on seed cost, fuel cost, expected yield, and the time value of money. The game can also be played in just a few minutes per day, although hours can be spent on it if you get overly enthusiastic or if you have friends who interact with you regularly.
Total “startup capital” invested for the author’s farm was $20 — not too bad at approximately the cost of two movie tickets. The farm is now self sustaining. The illustration below is a depiction of the author’s FarmVille farm (click to enlarge).
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.
By Nadav Manham
The Washington Post Company has announced it will sell Newsweek. CEO Donald Graham, who did not go to auctioneer school, said "we don't see a sustained path to profitability for Newsweek." The destruction of Newsweek's profitability, notes the article, is part of a larger trend: TV Guide, Businessweek, and Reader's Digest all met a similar fate.
Meanwhile, the article implies, The Economist and The Week, the latter founded by Felix Dennis (if I remember correctly, it was the only title he kept when he sold off his publishing empire), are profitable, as are popular titles like US Weekly and People. Obvious question: why?
The article gives the standard qualitative answers for the decline of publications like Newsweek: the fragmentation of audiences, the rise of cable and internet news and the speeding up of the news cycle, increasing political polarization, loss of advertising rate base, etc.
My project for myself, however, is to try to answer these questions more quantitatively, the way our BMMT Dream Team would do it. I would construct historical income statements for each of the magazines mentioned, both the failures and the successes, and figure out why specific line items went south and how. The name of the game in evaluating magazines is predicting operating margins (leverage and asset turnover don't mean that much), which means predicting the return on investment of a given investment in expenses. In other words, don't think of income statement expenses as expenses; think of them as capital expenditures, as investments undertaken to produce a return, in the form of revenues. The higher the gap between operating expenses and the revenues they produce, the higher your return on investment.
As always, figuring our the right metrics would be key. My gut feeling is that, for all the talk about dead trees and trucks, printing and distribution costs do not play a huge role in determining which magazines succeed and which ones fail. In fact, I would speculate that the general interest publications--the ones that are failing--pay less per unit to print and distribute because of economies of scale. My sense is that the main cost differentiator is the labor involved in putting the thing together in the first place.
Therefore, my sense is that the relevant metrics for these publications is:
a) circulation revenue per journalist/editor man-hour, and
b) advertising revenue per journalist/editor man-hour.
Figuring out which magazines do well on those two metrics and why is the key to evaluating magazines. Remember, Newsweek is not failing because of lack of revenue: $165.5 million is a lot of money. It's failing because its cost structure is too high for its revenue.
In this framework, a magazine can succeed either by keeping the numerator high or the denominator low. Some educated guesses:
The Week does not gross anywhere near Newsweek's $165.5 million; its subscription price is not high and its advertising pages don't command a premium. But it is so inexpensive to produce that its revenue per man-hour is high enough to produce profitability.
The Economist probably pays its editors and journalists a premium (not a huge one though; remember they are not allowed to have bylines, so they never acquire brand value of their own. They can't influence policy at their organizations the way, say, Thomas Friedman and Maureen Dowd did when they complained about their op-eds being put behind a paywall), but because of its enviable demographics and its niche audience of business subscribers, those journalists and editors are extremely productive: they combine to produce more revenue per man-hour than any other magazine.
People Magazine and US Weekly are like The Week: they are just extremely cheap to produce relative to the revenue they earn. The labor involved in putting them together is just very productive.
Newsweek is failing because it's stuck in the middle: its subscription price is comparable to that of US Weekly or People, its advertising rates are comparable--but it just costs way more to produce than US Weekly and People. It probably costs about as much per unit to produce as The Economist, but cannot command the same per-unit subscription and advertising revenues as The Economist. Stuck in the middle.
All of this begs two questions:
1) Before the general interest weeklies got stuck in the middle, they were extremely profitable. Why was that? Maybe a topic for another post.
2) Taking Richard Stengel at his word, why has Time Magazine managed to remain profitable even as it's subject to the same forces affecting Newsweek. Maybe there is only enough circulation and ad revenue to go around for one general interest weekly magazine to prosper, and Time is slowly draining it away from Newsweek.
The only problem with my little project is that it's extremely difficult to create an income statement for an individual magazine. The information is very hard to come by. If anyone has any insight into getting this information, please let me know.
The author of this post is Nadav Manham, president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.
As investors, we are accustomed to reading rather formal announcements by companies. That's why we wanted to share a refreshingly different read from Oracle's (ORCL) latest earnings release. In it, CEO Larry Ellison states:
"Every quarter we grab huge chunks of market share from SAP (SAP). SAP’s most recent quarter was the best quarter of their year, only down 15%, while Oracle’s application sales were up 21%. But SAP is well ahead of us in the number of CEOs for this year, announcing their third and fourth, while we only had one."
This is Ellison's light-hearted take on the latest SAP executive reshuffle, which resulted in CEO Leo Apotheker being pushed aside in favor of a co-CEO structure between Bill McDermott and Jim Hagemann Snabe. Perhaps more than anything else, Ellison's comments reveal just how personal the rivalries between top global companies can be. Ellison is the founder and largest shareholder of Oracle with 23% of the company, while SAP co-founder and chairman Hasso Plattner is the largest shareholder of SAP. Both men are in their mid-60s and can look back at hugely successful careers as entrepreneurs. At the same time, they remain motivated to this day to have active leadership roles in their companies. What's more, Ellison won the America's Cup in February, besting his sailing rival (and fellow billionare) Ernesto Bertarelli. Just a month earlier, Ellison closed the $7 billion acquisition of Sun Microsystems, a potentially transformative deal for Oracle. It is nothing short of remarkable at which speed some people move in this world. Ellison is one example. Steve Jobs of Apple (AAPL) is certainly another. From an investors' perspective, however, such larger-than-life leaders may be a mixed blessing. Given the risk that they can abruptly leave for one reason or another, we are left wondering what the impact would be on the company and its future prospects.
Oracle is one of the many companies we will profile in the forthcoming monthly issue of Portfolio Manager's Review. To subscribe to Portfolio Manager's Review, please click here.
Disclosure: No positions.
Wesco Financial Corporation held its 2010 annual meeting in Pasadena, California on May 5. Wesco Financial is a 80.1 percent owned subsidiary of Berkshire Hathaway. While the Berkshire Hathaway annual meeting attracted approximately 37,000 attendees on May 1, the Wesco meeting is a much lower key event. The main attraction is the opportunity to listen to Charlie Munger’s views on business, the economy, and a variety of other topics.
Will Wesco Become a Wholly Owned Berkshire Subsidiary?
According to a 8-K SEC report filed today, Mr. Munger had the following to say about the possibility of Berkshire eventually acquiring the remaining 19.9 percent interest in Wesco:
At the Company’s Annual Meeting of Shareholders, the Company’s Chairman and Chief Executive Officer, Charles T. Munger, who is also vice-chairman of Berkshire Hathaway Inc. (“Berkshire”), which owns 80.1% of the Company’s outstanding stock, said that it would be logical for the Company to ultimately become wholly owned by Berkshire. Mr. Munger cautioned, however, that such a combination transaction, to the extent it would involve stock consideration, would only make sense if there was an appropriate relationship between the relative values and prices of Berkshire’s stock and the Company’s stock, and that such a relationship does not currently exist. Mr. Munger did not state any particular time frame for such a transaction. No combination transaction of any kind has been proposed or presented to the Company. The Company’s Board of Directors has not discussed or considered any such transaction and neither has Berkshire’s Board of Directors.
This statement is interesting primarily because it contains a reference to the relative valuation between the common stock prices of Wesco and Berkshire and suggests that the companies are currently trading at different levels relative to intrinsic value.
Valuation of Berkshire vs. Wesco
Reflecting on Mr. Munger’s statement, the desire to have both Berkshire and Wesco trade at similar levels relative to their respective intrinsic values makes perfect sense given the desire of management to treat all parties to the transaction fairly. To the extent that Berkshire stock is used to compensate Wesco shareholders, each side should receive as much intrinsic value as they are giving up.
Does Mr. Munger’s statement tell us anything regarding his view of whether Berkshire or Wesco currently represents the better bargain at current prices? Examining the price to book value ratio of each company is admittedly a simplistic and crude approach but nonetheless is interesting to consider.
Both Berkshire and Wesco are expected to file first quarter results tomorrow (May 7), but for now, let us consider December 31, 2009 reported book value. Berkshire had a book value of $84,487 per Class A share while Wesco had a book value of $358 per share. On May 5, Berkshire closed at $114,950 and Wesco closed at $369.25. This gave Berkshire a price/book ratio of 1.36 while Wesco’s price/book ratio was lower at 1.03.
Does this mean that Mr. Munger is saying that Berkshire’s share price is overvalued compared to Wesco? The answer hinges on the following statement that appeared in Mr. Munger’s 2009 letter to Wesco shareholders (a similar statement has appeared in his past letters as well):
We repeat our standard warning. Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality disparity in book value’s intrinsic merits has, in recent years, continued to widen in favor of Berkshire Hathaway.
In Mr. Munger’s opinion, each dollar of book value at Berkshire is worth far more than each dollar of book value at Wesco. How much more? He does not give us a specific figure. However, we do know that the current difference in valuation is not acceptable to consider a stock based transaction in which Wesco would become a wholly owned Berkshire subsidiary.
This brings up the question of whether the price/book value gap would have to widen or narrow in order to make Mr. Munger feel that the appropriate relative value exists. It is highly doubtful that he believes that the price/book value gap would have to narrow given the strong wording that clearly states that Wesco is much less valuable compared to book value relative to Berkshire. This would lead one to believe that Mr. Munger thinks that Berkshire is undervalued relative to Wesco, even with Wesco trading not far above book value.
Can We Draw Conclusions Regarding Berkshire’s Valuation?
Taking this a step further, can we draw any conclusions regarding Mr. Munger’s thoughts on Berkshire’s intrinsic value relative to its current quotation? It would seem that Mr. Munger has to consider Wesco to have an intrinsic value of at least book value or he would be compelled to write down the goodwill component of Wesco’s book value accordingly. If we are correct in concluding that he believes that Berkshire is undervalued relative to Wesco and that he does not believe Wesco is worth less than book value, it then follows that Berkshire must be undervalued at today’s quotation.
Granted, this intellectual exercise makes a number of assumptions and Mr. Munger did not directly say what his views are regarding either Wesco or Berkshire’s current valuation. However, it is rare enough to read any comments from Mr. Buffett or Mr. Munger that even peripherally address valuation so some attempt to parse the statement’s meaning seems warranted.
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. No direct ownership of Wesco shares.
The Inoculated Investor has posted notes from the Berkshire Hathaway and Markel annual meetings.
Direct links to the notes: Berkshire Hathaway; Markel.
Roger Lowenstein is the author of five books covering financial markets. His latest book, The End of Wall Street, was published in April. Mr. Lowenstein is also the author of an excellent biography on Warren Buffett written in 1995 which we reviewed previously. In an article for the Washington Post today, Mr. Lowenstein makes the case for more timely intervention by the Federal Reserve when financial market bubbles are forming. Here is a brief excerpt:
Critics of the Fed have long urged it to intervene in bubbles — an argument that seems even stronger now. Had the Fed raised interest rates more aggressively in the early part of the decade, it is possible that banks would not have made so many questionable loans. We can’t know for sure, of course. But we do know what did happen: From 2001 to 2003, the Fed lowered short-term interest rates 13 times, reaching a rock-bottom level of 1 percent. They stayed there another year, and thereafter rose at a painstaking pace. With credit so cheap, people and institutions borrowed as if there were no tomorrow. And when the bust came, it spawned the worst recession in 75 years.
Defenders of Alan Greenspan often claim that the current version of history is being written by Monday morning quarterbacks who failed to predict the bubbles at a time when action could have been taken. Mr. Greenspan himself has gone so far as to say that individuals who predicted the crash were merely “statistical illusions”. In other words, at any given time, there are people predicting any conceivable outcome and some will be correct purely by chance.
Vanguard Founder John Bogle and many others have pointed the disingenuous nature of Mr. Greenspan’s attempts to rewrite history. While it is certainly true that the Federal Reserve’s “dual mandate” to manage monetary policy both for “full employment” and for a stable currency leads to challenges, cutting interest rates to rock bottom levels from 2001 to 2003 clearly inflated the housing bubble particularly by making it possible for adjustable rate mortgages with impossibly low teaser rates to lure buyers into housing that they had no chance of affording in the long run.
Manipulation of the housing market had real long term costs both for the irresponsible buyers who made unaffordable purchases and later lost their homes and for responsible individuals who refused to purchase over priced housing for years and ended up with a lower standard of living in rental housing. These responsible individuals may now have opportunities to purchase homes at more acceptable prices but are also bailing out irresponsible homeowners as the Federal Government continues various housing support schemes.
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.
By Nadav Manham
In his annual letter to Moore Capital investors, Louis Bacon wrote about his fund's new marketing strategy:
Bacon also said it's looking to attract longer-term investors after its performance was restrained by redemptions during the financial crisis.
Moore Capital has a new marketing team, which "has had very good success in attracting what we hope is sticky capital from more institutional investors," he wrote in the letter.
Bacon is a rock star among hedge fund rock stars. His fund has returned over 20% for over two decades. My understanding is that he charges above-market fees and has a long lock-up. If even he needs stickier capital, imagine how difficult it is for everyone else. And how important.
My working hypothesis about attracting sticky capital is that it is a two-part process. The first part involves, as Bacon notes, attracting more institutional investors with a long-term capital base. This is not easy, but it is simple: everyone knows who these investors are. You might think of this as "structural stickiness": that portion of an LP's propensity to redeem capital from your fund that can be explained by the type of investor it is (pension, endowment, fund of funds, high net worth, etc). The way to increase the aggregate structural stickiness of your capital base is to attract LPs in the right categories. Simple but not easy.
The second part of the process is more amorphous and intangible. It is the effort to increase an LP's "non-structural stickiness," which can be defined as that portion of an LP's propensity to redeem capital that cannot be explained by its category. High non-structural stickiness can overcome low structural stickiness. That is, an investor in a category known for being flighty can sometimes be your most loyal investor. Consider Warren Buffett's father-in-law:
"Doc Thompson was the kind of guy, he gave me every penny he had, basically. I was his boy."
That was in 1956, and it worked out well. Non-structural stickiness is a function of persuasion, positioning, and underwriting.
I've created a new category called "The Search for Sticky Capital" in which I plan to explore these issues further, the search for both structural and non-structural sticky capital. I will explain what I mean by "persuasion, positioning, and underwriting." The presence of sticky capital is a significant source of competitive advantage for a hedge fund, so the ability to attract it and create it is crucial.
I confess I am a novice in this area, so I welcome any thoughts you may have.
P.S. On the flip-side, from the perspective of a prospective investor in a hedge fund, sticky capital is also very important. You want to spend time learning about how a fund goes about increasing the stickiness of its capital, both structural and non-structural.
The author of this post is Nadav Manham, president of Elera Advisors LLC, an investment advisory company focused on value-oriented manager selection. Mr. Manham is a Manual of Ideas contributor and editor of The Investor's Consigliere.
By Greenbackd
Portfolio construction and position sizing are key elements in investing. For every investor, there exists a tension between the desire to maximize the rate of growth of the portfolio while simultaneously minimizing the chance of blowing up. The Kelly Criterion is the method to determine the optimal portion of the portfolio to be invested in any given opportunity. Buffett, Munger, Whitman and Pabrai are all proponents of the theory.
John L. Kelly, Jr, the developer of the Kelly Criterion, seems to have been a remarkable character. According to his entry in Wikipedia, he was a physicist, “recreational gunslinger”, daredevil pilot, developed the vocoder, the first demonstration of which was the inspiration for the HAL 9000 computer in the film 2001: A Space Odyssey, and was a keen blackjack and roulette player, which is a little odd, because his criterion recommends against a bet on the roulette wheel. He died of a brain hemorrhage on a Manhattan sidewalk at age 41, never having used his formula to make money.
The Kelly Criterion output varies depending on two things: the investor’s certainty about the outcome of the investment (the “edge”) and the expected return (the “odds”). I have found it difficult to apply in practice. Hunter at Distressed Debt Investing has a great post on Peter Lupoff’s application of Kelly Theory to event-driven investing in Tiburon Capital Management’s portfolio. Lupoff’s post deals with some of the issues I have had, and is well worth reading.