The Ideas Report For Serious Investors

From The Wall Street Journal's Deal Journal:

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

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

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

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

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

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

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

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

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

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

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

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

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

“Adoration is not an investment strategy”

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

Bailout Obsession

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

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

Incorrect Reading of Buffett’s Statement on Berkshire Valuation

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

Derivatives:  Ticking Time Bombs?

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

Filling Buffett and Munger’s Shoes

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

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

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

Seriously Flawed Valuation Model

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

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

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

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

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

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

Another snippet:

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

(Thanks to Yaser Anwar for the link.)

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

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

Q&A:

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

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

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

Repo 105 Transactions

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

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

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

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

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

Grossly Negligent, Criminally Responsible, or Merely Incompetent?

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

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

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

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

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

Buffett’s Decision on a Lehman Investment

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

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

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

– Warren Buffett’s 2009 Letter to Shareholders.

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

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

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

Posted by manualofideas at 04:11 PM | Permalink | Comments (0)

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

Introduction

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

Company Overview

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

Valuation

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

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

Increased Competitive Pressures

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

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

Posted by manualofideas at 02:48 PM | Permalink | Comments (0)

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

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

View the interactive presentation.

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

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

Appropriate Alignment of Incentives Today …

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

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

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

However, Berkshire’s Policy May Be Flawed …

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

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

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

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

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

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

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

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