The Ideas Report For Serious Investors

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.

Posted by manualofideas at 04:51 AM | Permalink | Comments (0)

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.

Posted by manualofideas at 04:49 AM | Permalink | Comments (0)

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.

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U.S. News & World Report recently profiled ten mutual funds it considers worthy of investor consideration. While we may not agree with all the selections, we were pleased to see Tilson Dividend Fund (TILDX) on the list. The fund is managed by value investor Zeke Ashton who has remained somewhat of a secret in the mutual fund world, despite performance in the top 1% of his peer group.

Read the U.S. News & World Report article.

We interviewed Zeke Ashton late last year - read more here.

Posted by manualofideas at 09:49 PM | Permalink | Comments (0)

H. Kevin Byun, managing partner of Denali Investors, provides some enlightening commentary in his just-released Q1 letter to investors. Byun argues that the equity market is behaving as irrationally on the upside today as it did on the downside in late 2008 and early 2009. He attributes some of the recently exuberant action to so-called "Mr. Magoo pretenders" who suffered big losses in 2008 and may still be chasing their high watermarks. In a quest to recoup losses and get paid, Messieurs Magoo appear content to gamble with their investors' capital, risking disaster yet again. Byun also discusses his concerns surrounding the recent rise of protectionism.

Download Byun's Q1 letter or keep reading his market commentary here:

The first quarter of 2010 has been marked by a continued upward creep in the markets, in stark contrast to recent fear and dislocation. From the lows reached far back in March, when the S&P broke to 667, we have seen a rally of over 75%.

2010, as it turns out, is a make-or-break year for many funds. The severe drawdown in 2008 and massive run-up in 2009 showed once again that it is better to fail conventionally than to succeed unconventionally. With many funds still below high water marks, their urgency for near-term performance in 2010 is greatly magnified. How can these fund managers properly invest with a long-term view when a short-term sword of Damocles hangs precariously above? Can these Mr. Magoo pretenders make it another year? And so career risk, business risk, and behavioral finance, rather than the best interests of their investors, comes to the fore.

With 2010 shaping up to be another interesting year, my view remains that the potential big-picture range and probability of outcomes have widened considerably, although the expected value or average represented through the market may appear narrow. With all the dislocations, machinations, and interventions, the potential energy in the markets is building once again. Exactly how and when the kinetic shifts occur remain an unknown, but the set up to dramatic changes appears to be in place. Expect the water to be choppy.

One related area that has become a topic of increasing attention, just to pick one out of the hat, is that of exchange rates, namely the call coming from some corners for China to let their currency float. From my perspective, it is not analytically prudent to draw a line in the sand on the issue due to the tricky and ever present law of unintended consequences. There are many interpretations even for concepts far simpler than floating and fixed rate frameworks, but let’s venture through. Regarding these unintended consequences, I would like to humbly present the following words as food for thought.

I often see politicians on the news putting the issue in binary terms, as right versus wrong, as good versus bad, as us versus them. This may prove to be a great disservice. Indeed, our country has outsourced many jobs, and low level ones at that. But this means we have also outsourced our unemployment and social unrest. Can you imagine what our unemployment number would look like if the capital base and employee base that supplies our goods just from China were simply put inside the US? Would it surprise you that this would approach Great Depression numbers? The migrant workers and unemployed masses of the Great Depression actually do exist today. But it simply goes unnoticed here because that too has been outsourced!

Conversely, what I have never seen a politician ever mention in the exchange rate debate is the likely resulting inflation. Why not? The average person is already stretched and living paycheck to paycheck. The group that will be impacted the most, which is that same group to which politicians pander, will find costs for basic items moving further out of range. Does it make sense that twenty pairs of tube socks from China are available for $8 retail? For every dollar prices for these tube socks move up to reflect true domestic and rate adjusted costs, a dollar less is available for other necessities. Such limited financial resources create an increasingly desperate zero sum game. Do I buy food or do I buy school supplies for the kids? If exchange rates do float and there is inflation, what will be the call to action then? Who will be the scapegoat? This may result in further finger pointing and a resurgence of social unrest, trade tariffs, trade barriers, and protectionism. This will be part of a negative reflexive process that may have much more severe and unfortunate consequences. But no one is talking about that.

If you are intellectually honest, you have to admit this is not a simple scenario to figure out for which this discussion barely scratches the surface and does not do justice.

As such, I present the following parable not as an answer, but as a surprisingly liberating approach for the analytical mind. It is a story my father told me a long time ago.

“Seh-Ong Ji Ma”
(Seh-Ong’s Wise Horse)

There was a farmer named Seh-Ong that had a beautiful and strong horse. The neighbors complimented, “You are so lucky to have such a beautiful and strong horse.” The farmer replied, “We’ll see.”

Days later, the horse ran away from the farm and could not be found. The neighbors wailed, “You are so unlucky to have lost such a beautiful and strong horse.” The farmer replied, “We’ll see.”

Days later, the farmer’s horse returned, but had brought back seven other wild horses that were equally beautiful and strong. The neighbors complimented, “You are so lucky to have so many beautiful and strong horses.” The farmer replied, “We’ll see.”

Days later, the farmer’s son was attempting to train one of the wild horses, fell off the horse, and broke his leg. The neighbors wailed, “You are so unlucky to have your son break his leg.” The farmer replied, “We’ll see.”

Days later, the king’s army came through to take all the able-bodied young men for war. The neighbors complimented, “You are so lucky to have your son spared from the war.”

The farmer replied, “We’ll see.”

For me, this is one of the most powerful, simple, and elegant lessons of life and, therefore, investing.

Read Kevin Byun's Q1 2010 Denali Investors letter.

Download Kevin's 2009 presentation at Columbia Business School.

Read an excerpt of our exclusive interview with Kevin.

Posted by manualofideas at 09:20 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.

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

Maintenance vs. Expansion Capital Expenditures

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

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

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

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

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

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

Owner Orientation

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

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

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

Regulation and Politics

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

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

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

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

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

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

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

Disclosure:  The author does not own shares of Sears Holdings.

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

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

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

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

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

When In a Hole, First Stop Digging …

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

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

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

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

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

Reality Check Needed

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

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

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

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

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

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

Part One of Bill Ackman Interview:

Part Two of Bill Ackman Interview:

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

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

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

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

CNBC Interview: Part One

CNBC Interview:  Part Two

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

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

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

Here are excerpts from the interview:

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

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

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

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

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

In their 2008 letter to shareholders of Leucadia National (NYSE: LUK), released on April 15th, chairman Ian Cumming and president Joe Steinberg describe 2008 as a year in which "everything came tumbling down." Leucadia reported a staggering loss of $2.5 billion on tax asset writeoffs ($1.7 billion), markdowns of investment securities ($700 million) and interest expense and other items.

Cumming and Steinberg explain the idiosyncratic nature of the tax asset writeoff by providing some color on how tax assets are accumulated in the first place and how they are monetized (hint: you need profits to derive any value from such intangible assets). The Leucadia co-heads state that in the past the company "bought assets and companies that were in extremis and as a result of shepherding them through Chapter 11 we acquired not only a good business, but also a tax loss carryforward or other tax benefit. One such company was WilTel Communications."

The letter discusses in some detail Leucadia's major investments, most of which suffered a disastrous year in 2008. Two of the more prominent investments are investment banking firm Jefferies (NYSE: JEF) and subprime auto lender AmeriCredit (NYSE: ACF).

While reflecting on the past and suggesting they might have quit after paying out a special dividend some ten years ago, Cumming and Steinberg remind shareholders about the continuity of Leucadia's business model over the past three decades:

"We tend to be buyers of assets and companies that are troubled or out of favor and as a result are selling substantially below the values, which we believe, are there. From time to time, we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long-term track record. We are not income statement driven and do not run your company with an undue emphasis on either quarterly or annual earnings. We believe we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated."

In addition to maintaining a value discipline, "a theme of [Leucadia's] investing [over the past several years] has been to make some investments in those things which are likely to increase in value as the underdeveloped world acquires the means to increase their standard of living." This has included investments in commodity producers, including mining companies Fortescue, an iron ore miner in Australia, and Cobre Las Cruces, a Spanish copper mine. With sharp recent declines in commodity prices, Cumming and Steinberg warn that "patience will be required" to see these investments reach their full potential.

While generally sticking to their guns, the Leucadia co-heads readily admit that it will take an economic recovery for Leucadia to grow shareholder value. Cash flows from the company's manifold operating businesses do not currently cover corporate interest payments, making cash management and cost reductions a top priority. This dynamic also constrains Leucadia on the investment front at a time when true value investors like Cumming and Steinberg have got to be as excited as ever about the opportunities available to them.

While Leucadia is undoubtedly less well positioned to take advantage of the current downturn than company management would like, we have little doubt the company will survive -- and eventually thrive. Leucadia has always tried to make investments in assets that are worth substantially more than the purchase price, and they appear to have succeeded at doing so. Unfortunately, sometimes it takes years for Ben Graham's proverbial Mr. Market to come around to agreeing with those who are right. Indeed, "patience will be required."

Disclosure: No position.

Posted by manualofideas at 10:34 AM | Permalink | Comments (0)

Matthew McLennan, manager of the First Eagle Global Fund, comments on his fund's approach and his favorite stock investments. 

First Eagle funds have benefited from a solid long-term investment approach, which has been ingrained into the funds' culture thanks to the leadership of founder and famed value investor Jean-Marie Eveillard.

Posted by manualofideas at 11:00 AM | Permalink | Comments (0)

Bridgewater Associates Annual Letter to Clients

Posted by manualofideas at 10:21 AM | Permalink | Comments (0)

Pershing Square IV Letter to Investors

Posted by manualofideas at 10:18 AM | Permalink | Comments (0)

Perry Capital's Year-End Letter to Investors

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

Owls Creek's Fourth Quarter Letter to Investors

Posted by manualofideas at 10:09 AM | Permalink | Comments (0)

Viking Onshore - 4Q 2008 Letter

Posted by manualofideas at 10:06 AM | Permalink | Comments (0)

J.C. de Swaan of Princeton University recently wrote a cover story on hedge funds for Caijing, the Chinese business/financial magazine.  We are grateful to J.C. de Swaan for his permission to republish the article in English for the benefit of our readers.  Excerpt:

What a difference a year makes. Between 1989 and the end of 2007, hedge funds returned an annual average of 14%, with some hiccups, but none worse than one down year in 2002 with a negative average return of 1.5% when global markets were down 21%. Even in 1998, when Long-Term Capital Management (LTCM) famously collapsed, hedge funds generated positive returns on average.

2008 proved cataclysmic. Hedge funds returned an average negative 18%, according to Hedge Fund Research. The poor performance was pervasive across strategies, except for Global Macro strategies, up an average 5%, and those that had a short bias, up an average 29%. Almost every other strategy ended the year in the red, with Convertible Arbitrage posting the worst performance, down an average of 35%. Emerging markets performed worse than the developed world, with Asia ex-Japan focused funds down an average of 34% and Russia/Eastern Europe focused funds down an average of 58%. Weak performance also carried across hedge fund sizes, humbling many of the most storied managers.

Performance of selected hedge fund strategies (Percent annual returns)

Source: Hedge Fund Research

Read the full article.

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

The following are links to annual reports of the Yale Investments Office since fiscal year 2000 (ended June 30th). Heading the Investments Office throughout this period has been highly respected investment manager David Swensen.

• Yale Endowment Update FY 2000
• Yale Endowment Update FY 2001
  
• Yale Endowment Update FY 2002
• Yale Endowment Update FY 2003
• Yale Endowment Update FY 2004
• Yale Endowment Update FY 2005
• Yale Endowment Update FY 2006
• Yale Endowment Update FY 2007
• Yale Endowment Update FY 2008

Posted by manualofideas at 10:09 PM | Permalink | Comments (0)

In another installment of "We Lost Most of Your Money, You Can't Have the Remainder Back, Now Give Us More Money," Michael Zimmerman "plans to start a hedge fund focused on retail and consumer stocks after his main fund halted redemptions and lost as much as 88 percent last year," according to Bloomberg.

At least in the movie business, they try to sell you a sequel after having done reasonably well with the original.

Posted by manualofideas at 12:52 PM | Permalink | Comments (0)

Steel Partners put out an interesting press release on Wednesday. Excerpt:

WebFinancial L.P. will become a diversified holding company with interests in a variety of businesses, including industrial products, energy, aerospace and defense, banking, insurance and food & beverage. The company will be managed by Steel Partners LLC and intends to seek a listing on a national stock exchange.

Posted by manualofideas at 09:25 AM | Permalink | Comments (0)

Posted by manualofideas at 01:25 PM | Permalink | Comments (0)

Watch Steve Markel and Tom Gayner of Markel Corporation talk about their approach to business and to investing (from Darden Value Investing Conference, November 6, 2008):

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

Yale President Richard Levin said in a budget letter that Yale estimates its far-flung endowment portfolio to have lost a quarter of its value since June 30th:

It is not our custom to announce the mid-year status of our endowment portfolio, but these unusual circumstances call for a departure from custom. Thanks to the outstanding work of David Swensen and his colleagues in the Investments Office, our endowment has declined significantly less than market indices. Taking into account only the value of marketable securities, our investment return from July 1 through October 31 was a negative 13.4%. But this does not tell the whole story. Our endowment is invested in both marketable securities (chiefly stocks and bonds) and “illiquid” assets, such as real estate and private equity investments that are not traded on a daily basis and are difficult to value with precision. The value of our marketable securities has declined further since October 31, and, even earlier, we began to establish reserves in anticipation of substantial decreases (“write-downs”) in the value of our private equity and real estate investments. As a consequence, our best estimate of the endowment’s value today is $17 billion, a decline of 25% since June 30, 2008, and this is the value we are using for purposes of budget planning. We are also assuming that the endowment will remain flat during the 2009-10 academic year and resume growth after June 30, 2010, at the rate that we have historically used in our budget modeling.

Read the full statement.

View past Yale Endowment Annual Reports. We highly recommend these reports, as they include excellent descriptions of a variety of important investment and portfolio management concepts, including an explanation of Monte Carlo simulations.

Posted by manualofideas at 05:13 PM | Permalink | Comments (0)

One of the most fascinating aspects of the Madoff fraud is the fact that investors in Madoff funds apparently turned a blind eye to Madoff's use of a no-name accounting firm:

Bernard L. Madoff Investment Securities LLC used Friehling & Horowitz, an auditor operating out of a 13-by-18 foot location in an office park in New York City’s northern suburbs.

We wonder what excuse Madoff gave clients who inquired about the peculiarity of such a prominent investment manager using such an inadequate audit firm. Did Madoff say, "Well, we know everything is kosher, so we don't really care about paying extra for a big audit firm." Or did Madoff say, "If you're going to invest with Madoff, there needs to be an element of trust. The way you show that you trust us is by not letting the choice of our audit firm prevent you from investing."

Whatever Madoff's brushoff was, it worked. Many investors are blinded by greed -- and who would not be greedy for steady positive monthly returns even in times of market turmoil?

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

The New York Times reports that Citadel has halted redemptions after major losses in its funds. With an increasing number of hedge funds halting redemptions, investors are finding out that getting back their capital isn't what they tought is was -- a right. Instead, withdrawals are increasingly becoming a privilege, one that may be granted when times are good but that becomes unavailable precisely at the moment most investors want their money back.

Posted by manualofideas at 08:39 AM | Permalink | Comments (0)

The Manual of Ideas has made available for free the inaugural issue of its monthly subscription-based Downside Protection Report. DPR seeks out stocks with an exceptionally large margin of safety. Featured companies are judged to have low risk of permanent impairment, below-average price volatility and above-average capital appreciation potential.

Summary Investment Thesis (excerpted from full report):

An investment in Greenlight Re should outperform the market in times both good and bad, due to David Einhorn’s superior investment skill and Greenlight’s strategy of selling stocks short in addition to buying them. We estimate fair value at $18-24 per share, based on the analysis presented in this report.

39-year-old David Einhorn has had phenomenal success managing Greenlight Capital (not the same legal entity as Greenlight Capital Re), a value-oriented hedge fund that has grown into a billion dollar firm from humble beginnings, with only $1 million in assets in 1996. While returns have suffered this year, we estimate that Greenlight has delievered an annualized return since inception, net of all fees and expenses, of more than 20%. This is an impressive feat considering that the fund navigated through both the bursting of the Internet bubble in 2001-02 and the ongoing U.S. credit contraction and recession. Also impressive is the fact that Einhorn achieved such returns while maintaining relatively low net exposure to equity markets, due to a strategy of buying undervalued stocks and selling short overvalued, mismanaged or downright fraudulent companies.

Greenlight Re went public in May 2007 as a publicly traded version of Einhorn’s hedge fund, with several enhancements:

- Tax-advantaged structure by virtue of Cayman Islands domicile, making Greenlight Re a pass-through vehicle for U.S. investors.

- Reinsurance underwriting should add value, an aspect that is unique to Greenlight Re as compared to Einhorn’s hedge fund. Underwriting is conservative, with significant unutilized capacity and most premiums related to frequency rather than severity business.

- Investors may sell their shares in the open market at any time, a liquidity benefit not available to hedge fund investors.

- Repurchases should accelerate growth of per-share value, as Greenlight Re may buy back stock at a discount in times of market distress. The Board authorized a two million-share buyback in August.

- Investors should benefit from price-to-book multiple expansion over time, as the market comes to appreciate Einhorn’s investment skill. This may allow investors buying at current prices and selling in the future to get paid for the discounted value of Einhorn’s “alpha.”

Einhorn is incentivized to grow shareholder value, as he owns 17% of Greenlight Re. He also has a track record of fair treatment of investors.

We judge Greenlight Re shares to have superior downside protection due to (1) their discount to book value, (2) Einhorn’s proven ability to generate investment outperformance, (3) a conservative underwriting posture, (4) an ability to repurchase shares below fair value, thereby limiting the downside and increasing future upside, and (5) an ability to go long as well as short in the stock market, enabling Greenlight to seize opportunities regardless of overall market direction.

Access the full report on Greenlight Capital Re here.

Disclaimer: Copyright 2008 by BeyondProxy LLC, the publisher of The Manual of Ideas. BeyondProxy and its affiliates may have positions in and may make purchases or sales of the securities discussed in this report. It is the policy of all Related Persons to allow a full trading day to elapse after the publication of this report before purchases or sales of any securities discussed herein are made. No Related Person held a position in GLRE as of the date of publication of this report. Use of this report and its content is governed by the Terms of Use described in detail here.

Posted by manualofideas at 07:39 AM | Permalink | Comments (0)