Sunday, November 26, 2006

Nancy's House

What is a blog if we never talk about politics?

Let me be clear. Whether the government is run by Democrats or Republicans does not change much when I am deciding to buy Berkshire Hathaway (NYSE: BRKB) shares for my son’s college savings account. Neither will the actions of the soon to be Speaker of the House, Ms. Nancy Pelosi. But it sure will be fun to watch what she will do next when it comes to US policy towards China.

Source: The Wall Street Journal

An article in the Wall Street Journal about her stance towards China caught my recently. She has protested in Tiananmen Square, she has held protests outside of White House on China matters and she is expected to allow tough China legislation to come to full vote in the House. Don’t get me wrong, I am all for protection of human rights and religious freedom. To be sure, labor conditions at many factories supplying American multinationals still need to be improved. However, taking a tough stance towards China won’t be the most constructive way to deal with things.

She should be reminded that the US economy is more than ever linked to the global economy and is a direct beneficiary of the ascendance of these two countries. After all if foreigners weren’t lending the US so much money, Americans would not be able to consume as much as they do today. In fact they would not be able to buy the fancy wine she makes at her vineyard in California (Ms. Pelosi is quite well off indeed - she is worth up to $55 million with a $25 million stake in a couple of Californian vineyards and a $10 million stake in a golf course).

Suggestion for Ms. Pelosi – have a nice dinner with Treasury Secretary Henry Paulson to learn about what it takes to have a cordial and constructive relationship with the Chinese. Whether Ms. Pelosi likes it or not, China (and India for that matter) will influence the world more than she may realize for the rest of this century. I will never forget when David Conklin, a professor at Ivey School of Business, reminded me and my classmates how lucky we are to be able to witness India and China change the world. Meanwhile, my brother and I are happy participating in the growth of these markets through investments such as ICICI Bank Limited (NYSE: IBN) in India and US multinationals which will undoubtedly benefit from the rise of the consumer class in China.

Thursday, November 23, 2006


"We remain agnostic about the market. We light a candle and hope it goes down. Only during periods of stress can you find good companies at reasonable prices."

Bruce Berkowitz, Fairholme Fund – Barron’s August 14 2006

The Dow continues to break records. Google (Nasdaq: GOOG) continues to defy and hit a high of $513 today - not far from where I thought the stock would be in 5 years when I first wrote about it last November (the rapid rise is partly the risen I sold Google in our Model Portfolio). Incidentally, I find it interesting that an air of skepticism remains in the air. People don’t seem to want to believe the market rally has taken place and that it may indeed continue. Many continue to hold onto to their cash. Perhaps a good contrarian sign that the bull may still have some legs. But I digress. Amid the market’s recent torrid advance and the private-equity orgy, one sector remains unloved and untouched: homebuilders.

Don’t hold your breath though. Recent articles are beginning to mention the beaten down homebuilder stocks as possible targets for private-equity folks. We shall see. Regardless, my position on this sector has not changed. So I won’t rehash what I have said before except that I see opportunity in this sector. In the ten years since I started investing, I don’t recall any other industry getting so much negative news day after day, week after week. Company earnings are coming in below estimates, existing home sales are declining, potential new home owners are canceling contracts, inventories of new homes are piling up and homebuilders themselves are the most pessimistic they have been in years. Yikes. Amid all this the shares are holding up well, a possible signal that we are at or near a bottom.

So if you knew all this and someone gave you a few million dollars tomorrow to buy a business and make a living running it, what would you do? Where would you look? I bet homebuilding would be one sector you would shy away from, let alone a business which provides homebuilding materials to builders, unless, you are Warren Buffett. This brings me to USG Corporation (NYSE: USG) which recently emerged from bankruptcy. Mr. Buffett has managed to snap up shares and increase his holding in the company to nearly 20%, most of it recently at around $46. You may not know USG but I bet you know what SHEETROCK® is. Indeed, that is a USG brand. Apart from being cheap (the stock is trading at 4 times trailing EBITDA), what is unique about USG is that the management sought bankruptcy protection not because the business was performing badly, but because they wanted to shelter shareholders from asbestos litigation related to products sold decades earlier. The company emerged from bankruptcy with its equity intact - a rare occurrence.

If Buffett’s foray into a housing related stock doesn’t give you comfort, here is another data point to consider. Bill & Melinda Gates Foundation’s recent SEC filing shows the addition of seven homebuilders to its stock portfolio. The Foundation’s endowment is managed by an under the radar fellow named Michael Larson. However, I wouldn’t be surprised if Mr. Gates is getting a few ideas from his good pal in Omaha. Mr. Gates is a Buffett apprentice and they are extremely good friends – they do play online bridge on weekends after all.

Who knows, perhaps it is premature to jump in. But calling a bottom is never easy, if not impossible. But at these levels, the shares of the various companies in this sector offer a decent Margin of Safety and an above average upside potential for the long-term investor. One more thing to consider – during a couple of recent speeches, the brain of them all, Alan Greenspan, has been quoted as saying, “the worst may well be over,” and that he is seeing “early signs of stabilization” in the housing market.

Timmy and Wendy Part Ways

Late Septmeber was the big date. Wendy’s (NYSE: WEN) finally let go of Tim Hortons (NYSE: THI). The call earlier this year to buy Wendy’s shares before the spin-off was completed has turned out well with a return of about 30%. Tim Hortons shares languished after the partial spin-off and launch of its IPO but are trading near an all-time high now that the spin-ff has been completed. The stock may not be cheap but you are holding on to a valuable brand and a franchise which should be able to provide shareholders with sustainable growth for some time.

Meanwhile, it didn’t take Mr. Market too long to realize that it was valuing Wendy’s portion of the business too pessimistically pre spin-off. Wendy’s shares began inching up almost immediately after the split. The script is playing out almost to perfection. The Baja chain has been jettisoned and Wendy’s has announced a $1 billion share buyback program including a recently completed Durtch auction to vacuum up 19% of outstanding shares. Thank you very much. If management can execute its turnaround strategy from here, shares should have another 30% upside from here.

Sears Capital LP

OK, so that entity doesn’t really exist. At least I don’t think it does. But Sears Holdings (Nasdaq: SHLD) does. I first wrote about Sears and Eddie Lampert in October 2005. The stock is up about 50% since then and may not be the bargain it was back then. But it’s too early to bail.

Mr. Lampert has kept his word and emphasized profitability over top-line growth (sales are declining) while adding to his cash pile. As predicted, Mr. Lampert is also beginning to take advantage of the freedom he has been given by the Board to use the cash for acquisitions and investments as he sees fit. Last week’s earnings announcement showed a handsome profit from Mr. Lampert’s investment activities using fancy, albeit risky, derivates known as total-return swaps. It is still early in the game and I would venture to bet that Mr. Lampert is looking to make a more substantial move. I am not sure if I believe rumors that he has been sniffing for an acquisition with potential targets being companies like Anheuser-Busch (NYSE: BUD) and Home Depot (NYSE: HD). No matter. Over the past 18 years he has proven to be a worthy investor, perhaps, dare I say, as good as Mr. Buffett. This ride may be bumpy but I think patience will be richly rewarded in the long-term.

Wednesday, November 01, 2006

3 and 30

Mr. Buffett: "Why do you charge 2 and 20?"
Hedge fund manager: "Because I can't get 3 and 30."

Warren Buffett, recounting a conversation with a hedge fund manager

The Dow surpassed 12,000 a few weeks back without the fanfare one may have expected. The hoopla surrounding Dow 10,000 was curiously absent this time around. The recent advance seems orderly and justified.

Still, some are partying hard, maybe too hard, on Wall Street these days. The $1.2 trillion hedge fund industry and the $1 trillion private equity folks are going bananas. The Hedgies are making fancy trades and the Barbarians are accepting lower returns while loading on the debt. Where this will all end is anybody’s guess.

To be sure there are signs that the system is beginning to cleanse itself. The recent implosion of various high profile hedge funds may be the beginning. Amaranth went down in flames playing around with natural gas and others are closing shop, taking a break or getting hammered by placing wrong bets on bonds and direction of interest rates. How people expect to consistently return 20% or 30% or 50% to their investors in beyond me when some of the best investors of our time have been happy beating the market by a handful of percentage points over time. It amazes me when people tell me such and such hedge fund is up 50% year to date. At that rate, the fund manager should displace Mr. Gates on the Forbes richest people in the world in no time. Brace yourselves.

I recently finished reading Adam Smith’s (George J.W. Goodman) Supermoney. I wish I had read this book before the .com bubble burst. The environment of the late 60s was eerily similar to the late 90s. Companies with negligible or nonexistent earnings were going public and trading at crazy multiples. Money managers were promising outsized returns. The accumulation of supercurrency – stocks and options – was the name of the Game. It all ended badly with the 1973 – 1974 bear market. In a July 1999 Book Review article in the New York Times Mr. Smith wrote:

Within living memory, a billion dollars was real money. We can see why - if not when - our own trillion-dollar bubble will pop: even though the Internet itself will grow as a mighty force, if the market will give a billion-dollar value to a two-year-old company losing money, then the efforts of a diligent populace will be put to creating such companies, until the supply of those companies overwhelms the demand for them. The seasons turn and all the rivers flow into the sea. We read these histories and we know the ending. Yet such is the intensity and excitement of manias that they never lack for participants.

Good call indeed. Incidentally, Supermoney has the distinction of being the first book to introduce Mr. Buffett to the world. At the time, Benjamin Graham had approached Mr. Smith to work on a new edition of The Intelligent Investor which led Mr. Smith to visit a so-called Warren Buffett in Omaha, Nebraska. Isolated from the frenzy of Wall Street, we get a first glimpse into Mr. Buffett’s disposition. Smith writes:

A leading investment manager of a billion dollar fund had delivered himself of a statement that money management was a full-time job, not only week by week and day by day; “Securities must be studied on a minute by minute program.”

“Wow!” Warren wrote. “This sort of stuff makes me feel guilty when I go out for a Pepsi.”

It gets better. Perhaps not surprisingly, the teachings of Benjamin Graham were in question by the hotshot money managers of the time. Mr. Buffett’s response in a letter to Smith:

“Graham’s teachings,” he wrote, “have made a number of people rich, and it is difficult to find any cases where those teachings have made anyone poor. There are not many men you can say that about.”

We all know who has had the last laugh some 25 years later!

All of which brings us back to the Hedgies and the Barbarians. I don’t know how all this will end. To be sure, the markets seem to be absorbing the shocks quite well. The Amaranth news barely put a dent in the market and other hedge funds are undeterred. And word is that the private equity players really know what they are doing this time around. But it all makes me uneasy. The Game we play in pursuit of supercurrency is taking place in a continuously evolving arena and is all about accumulation of wealth. To play the Game right, you must take advantage of the follies of Mr. Market and you must have a long-term contrarian perspective on things without getting caught up in the emotional roller coaster of the moment. In the meantime, in the words of Adam Smith, “If you are still for the Game, why, may you prosper; I wish you the joys of it.”

Tuesday, October 24, 2006

The Record

No explanation needed.

Wednesday, October 11, 2006

Harrah's Arbitrage

“[O]ur insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long term investments. (Charlie’s sign off after we’ve talked about an arbitrage commitment is usually: “Okay, at least it will keep you out of bars.”)”
Warren Buffett, 1988 Chairman’s Letter

In his 1988 Chairman’s Letter, Buffett allocated one section to arbitrage. He considers risk arbitrage a short-term substitute for cash, assuming of course that the transaction will provide a probability adjusted return in excess of the risk-free rate. At least back then, Berkshire invested a sizable sum in only a few opportunities a year. Perhaps most importantly, he invested only in already publicly announced transactions. Forget rumors or which companies may be potential targets.

This brings us to the recent buy-out offer for Harrah’s Entertainment (NYSE: HET) by a private-equity group which may offer an intriguing arbitrage opportunity. On October 2nd, news broke out that Harrah’s had received an offer for $81. The shares leapt from a previous close of $66.43 to a high of $80.01 before closing at $75.68. The seemingly wide gap between the stock’s closing price and the offer price is attributable to the uncertainties about the deal closing (financing, management’s refusal to sell, etc.) and the time it may take to close the deal. The casino licensing requirements alone could take up to a year and prove a challenge, although certain waivers could apply to institutional investors thus reducing some of the uncertainty. You are probably thinking a 7% potential return is not much of an arbitrage opportunity. But you know I am not a proponent of Efficient Market Theory. Just because the market says 7% is the best you can do, it doesn’t mean it’s so. Here is why.

I expect the initial $81 offer to be just a starting point (in fact the offer was raised to $83.5 today but the stock settled back near $76 after opening above $77). If you read the Wall Street Journal article on October 3rd, you will note that as early as September 15th, the buyers were exploring the casino licensing requirements in Missouri and potentially other states. Their lawyer had already obtained a waiver from Harrah’s to work with the private-equity outfits. I believe Harrah’s management expected an offer to be on its way.

The fact that they granted a waiver weeks before an offer was submitted also demonstrates that an offer was not unwelcome. Indeed, given Harrah’s was one of the cheapest casino stocks among peers, perhaps management got tired of Mr. Market’s treatment and decided to go about its business as a private entity instead. The trick will be to make existing shareholders happy by putting up a ‘fight’ and demanding a higher price from the buyers. Perhaps this smells of conspiracy theory to you but I don’t find it too farfetched.

Let’s assume the deal will take a year to close. The probability of a deal closing is quite high. Even if the deal falls through, the cat is out of the bag. Shareholders would demand that management maintain and boost the current stock price through a special dividend or buybacks. For example, this could be financed by borrowing against the company’s vast real estate holdings – apparently a strategy contemplated by the buyers to fund their buy-out. Furthermore, there is a high likelihood that other suitors will emerge boosting the offer price further. I think the private equity players can pay up to $86 and still enjoy a nice free cash flow yield given that Harrah’s is a cash machine. Finally, Harrah’s pays close to a 2% dividend. Add all that up and the shares look like a nice place to park some of your cash at $76 a share until you find a juicy long-term opportunity.

Saturday, September 30, 2006

Model Portfolio

My Ivey's Super Investors colleagues have abandoned me. So starting this month we will start keeping track of a Model Portfolio that I have put together based on recommendations I have made since last September on the two blogs. I have dropped some winners from the portfolio. They include Canadian Western Bank (TSX. CWB.TO), ING Canada (TSX: IIC.TO) and Goldcorp (TSX: G.TO). I have also dropped an underperformer in Pier 1 (NYSE: PIR) which has been hammered since I first mentioned it but has recently rebounded amid rumors of a buyout.

We will have monthly updates on the portfolio and I will let you know if I make any changes before each monthly update. Approximately $180,000 has been invested so far and we will add cash to the portfolio until total invested capital equals $200,000. On a pre-tax basis and including commissions, this portfolio would have handily beat the S&P 500 since last September. I have assumed each position was added to the portfolio in two transactions. We will hopefully continue this streak going forward. Please remember that the Model Portfolio and the AA Value Fund are separate. The latter is a super concentrated portfolio which I will occasionally update you on as I have in the past.

Tuesday, September 12, 2006

Seth Klarman

Value Investing - A risk-averse investment approach designed to buy securities at a discount from underlying value

Margin of Safety - Investing at considerable discounts to underlying value, an individual provides himself or herself room for imprecision, bad luck, or analytical error (i.e. “margin of safety”) while avoiding sizable losses

Seth Klarman, Margin of Safety, Glossary, 1991

Seth Klarman’s Margin of Safety has been getting some press lately. The book was highlighted in an article in the August 7th issue of BusinessWeek. The Globe and Mail featured an article on the book on August 12th.

I had found out about Klarman and his book years ago while I was researching investment books to buy to add to my library. However, the book has been out of print since 1991. You can buy a used one at Amazon these days for about USD $1,000. No thank you.

So you can imagine why I was in disbelief when one day in early August I found myself walking down Bay Street, on my way to the office, with a copy of the book in hand. Just the night before, I had received a text message from my brother, who didn’t know about my meeting earlier that morning, alerting me to the BusinessWeek article. Talk about coincidence. The book belongs to Carl, the head of US equities research and portfolio manager of US equity funds at a prominent Canadian investment management firm. A few days before my brother’s text message, Carl had emailed me after having discovered my blog and we had agreed to meet for a chat.

Carl’s books were stacked on top of each other in the corner of his office. I took a quick glance and recognized a bunch of them. But I hadn’t noticed Klarman’s book. When Klarman later came up in conversation, Carl offered to lend me the book. Thanks Carl.

The book is a quick read and it is a classic. Klarman is a true Graham disciple. There is a fantastic chapter on investing in distressed and bankrupt securities. He emphasizes the importance of holding cash and being patient, the need to evaluate one’s portfolio against emerging investment opportunities which may be better bargains, and why it is crucial to ignore Wall Street’s latest financial innovations and gimmickries. There is also a section on a very important principle which many investors fail to grasp: “the first 80% of the available information is found in the first 20% of time spent.” Digging in too much can mean lost opportunity. As long as you leave yourself a decent Margin of Safety, you will be fine.

Klarman does an excellent job making the case for value investing and how one may profit by adhering to the discipline. However, he reminds us that not everyone is wired to succeed at it. Being a contrarian can be a lonely and psychologically challenging endeavor at times. Here is the conclusion of the chapter on value investing and the importance of Margin of Safety: “Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.”

Monday, August 28, 2006

Miller Time

“The call is much harder from here, with only scattered Stone Age tribes in the Amazon, the comatose, or newly arrived aliens from Alpha Centauri, unaware that energy stocks are a one way ticket to outperformancedue to demand from China and India, the location of reserves in unstable areas, thelack of investment in new refining capacity, the rate of depletion, the dwindling ability to locate giant new fields, and so on.”
Bill Miller on Value Trust’s lack of exposure to energy stocks, July 2006

Bill Miller is well known for his outstanding record of beating the S&P 500 for 15 years in a row. He manages the Legg Mason Value Trust and is considered a value investor, although you may not agree with that designation given 20% of his portfolio is invested in internet companies including Yahoo (Nasdaq: YHOO), eBay (Nasdaq: EBAY), Amazon (Nasdaq: AMZN) and Google (Nasdaq: GOOG). He thinks the first three are trading at 50% of fair value – my brother and I agree and have added to our eBay position and considering adding to our Amazon holdings.

The press is having a ball these days speculating if the run is finally coming to an end as Miller’s portfolio has been decimated so far this year. Miller has admitted as much and in July wrote a letter to his investors reminding them to think long-term and that his portfolio looks different from the index, and may therefore underperform significantly at times, for a good reason: to beat the index you have to look different from the index. In his letter he admitted he was too early to get into homebuilder stocks such as Centex (NYSE: CTX) and Pulte (NYSE: PHM) and that he missed out on energy stocks. Another possible reason to speculate an end to his spectacular run may be that his fund has gotten too big. After all, Buffett has said that “a fat wallet is the enemy of superior investment results.”

In any case, it seems Miller is not alone. Other value managers are singing the same tune. In late June, Bill Nygren of the Oakmark Fund gave a speech at a Morningstar Conference in which he laments the short-term focus of financial media, echoed by Miller in his letter noting the “market’s myopic, obsessive focus on what is going on for the next three to six months.” Oakmark’s recent absolute returns have been nothing to balk at, but Nygren has been underperforming the market. One culprit has been his lack of exposure to energy stocks. The other is his decision to begin buying what he classifies as superior businesses at reasonable prices beginning in 2003.

He provided some interesting data in his slides and focused on 10 stocks Oakmark finds interesting. Stocks we have talked about and included on the list are Wal-Mart (NYSE: WMT), Citigroup (NYSE: C), Home Depot (NYSE: HD), and Tyco (NYSE: TYC). Consider this. These ten stocks have declined 42% vs. S&P 500’s 19% decline from its peak in 2000. Meanwhile, S&P earnings have increased 67% since 1999 vs. 161% for the ten companies. Moreover, on a P/E basis, they are trading at about par with the market. In other words, they are priced as if they are average businesses. If the market is right, well, then they are priced accordingly and Nygren views this as his margin of safety. Otherwise, higher earnings growth and a P/E expansion should reward him (and us) handsomely.

Nygren for one was vindicated after the bubble burst in 2000 as investors who had bailed on him to buy tech-havy funds wished they had stuck with him. Perhaps most importantly, both Miller and Nygren have skin in the game and are invested in their funds. During his speech, Nygren reminds us that it is practically impossible to avoid mistakes when investing. The secret to success is to consistently apply your investment philosophy and discipline over the long run and to stay patient.

Lou Simpson

“You live by the sword, you die by the sword. If you are right, you are going to add value. If you are going to add value, you are going to have to look different than the market. That means either being concentrated, or, if you are not concentrated in a number of issues, you are concentrated in types of businesses or industries.”
Lou Simpson, GEICO Insurance

In The Warren Buffett CEO, Robert P. Miles introduces Lou Simpson as Berkshire Hathaway’s (NYSE: BRKB) back-up capital allocator. Simpson operates very much under the radar and is in charge of equity investments at GEICO, one of Berkshire’s insurance businesses. He has an impeccable record. Indeed, it is all but a forgone conclusion that in Buffett’s absence, Simpson will be responsible for capital allocation at Berkshire.

It took a while to get through this book. There is a lot of repetition with praise for each of the CEO’s of the various subsidiaries and their admiration for their boss. But in my opinion, the real message to take away from this book is that Berkshire is an assembly of many wonderful businesses run by dedicated manager owners who love their job and their businesses. Of course there are some subsidiaries which may be in for tough times such as the various shoe manufacturers. But GEICO, Gen Re, Flight Safety, Executive Jet Aviation (NetJets), Washington Post (NYSE: WPO) and See’s Candies along with a few furniture retailers are top notch businesses. The book also gives you a good feel for the kinds of people and businesses Buffett looks for as well as a culture which he has created to last even once he is no longer at the helm. That is the power of Berkshire.

The chapter on Lou Simpson alone makes this a worthwhile read. His business tenets are listed by Miles as follows:

  1. Read company reports and financial press voraciously. He reads 5 to 8 hours a day. His favorites are the Wall Street Journal, BusinessWeek, Fortune, Forbes and Barron’s. All must reads.
  2. Research any company extensively before making an investment.
  3. Don’t overpay.
  4. Think independently.
  5. Invest for the long-term.
  6. Hold only a few stocks. He thinks individual investors should hold no more than 10 to 20 stocks. We have talked about this before.

Remember our discussion about value vs. growth last October? It seems Mr. Simpson agrees with us: “When you ask if someone is a value or growth investor – they are really joined at the hip. A value investor can be a growth investor because you are buying something that has above-average growth prospects and you are buying it at a discount to the economic value of the business.”

Since we are talking about equity investments at Berkshire, here is a quick update. During Q2, its positions in Gap, Lexmark and Outback Steakhouse appear to have been completely eliminated. The company also disclosed that during Q1, it accumulated a $117 million position in Johnson & Johnson (NYSE: JNJ) – a wonderful company which was trading at a reasonable price.

Sunday, August 06, 2006


"In the short run, the market is a voting machine but in the long run, it is a weighing machine".
Benjamin Graham, The intelligent Investor

A recent study by the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics recommended companies stop giving quarterly guidance to encourage long-term thinking among managers, analysts to stop demanding short-term results and for asset managers to have their own wealth tied up in funds they manage.

It’s about time people start to pay attention. Indeed, a few companies are starting to back away from providing guidance. All this mumbo jumbo about missing analyst consensus by a penny or not meeting the whisper number is ludicrous. Meanwhile, ‘investors’ have punished shares of 3M (NYSE: MMM) and United Parcel Service (NYSE: UPS) in recent weeks even though the long-term prospects for those businesses are more than just average.

For long-tem investors, this behavior simply creates opportunity. The key is to be patient and have the discipline to believe in your investment thesis and not be swayed by short-term fluctuations in prices. Speaking of fluctuations, the market has provided a fun ride since March. After reaching its highest level in years in May, the S&P 500 fell by more than 7% at some point in June before recovering some of the lost ground and has been practically flat on a monthly basis from May to July. Our ‘value fund’ was also whipsawed during this period but recovered sharply in June thanks to a spectacular run in the shares of the NYSE Group (NYSE: NYX) which seem to have been battered for no apparent reason.

We are weighted heavily in these shares and still believe the shares are undervalued at these prices. Meanwhile, Atticus Capital LP, disclosed on Friday that it has almost doubled its holding in the NYSE Group and now owns just over 7% of the company with options to buy more shares. The firm also has stakes in Deutsche Boerse and Euronext, which has agreed to a $10 billion merger with NYSE. The deal is not done by any means as Deutsche Boerse remains a dark horse and could still derail the agreement. Stay tuned.

Charlie and Warren

I am a bit late with this one. But for you die hard value investors and Buffet fans, you have to check Charlie Rose’s three part series on Buffett. The Man, the Company and The Gift are well worth watching, especially the first two. You can find them on Google Video. I have ordered the DVD’s and will add them to the curriculum my son will surely have to complete before he makes his first ever investment. For now, as a 10 month old, he will have to trust his father. Tomorrow, he will be the proud owner of one share of Berkshire Hathaway (NYSE: BRKB) Class B share in his newly opened college savings account.

Sunday, July 16, 2006

α + β

No, we are not about to embark on a lesson in quantum mechanics. Alpha/Beta talk is the latest rage on Wall Street. Let's start with Beta which is basically supposed to symbolize risk - systematic risk to be exact. Beta is used to measure a stock's volatility relative to the overall market. So, for example, a stock with a Beta of 1 moves up and down with the market and therefore encompasses the same amount of systematic risk. Of course, modern financial theory, albeit incorrectly, equates volatility with risk. So the higher the Beta for a stock the riskier it is supposed to be. There isn't much you can do about this kind of risk. The simplest way out is to buy an index fund and do away with the risk altogether.

There is also a non-systematic component to risk which is specific to the business you are investing in. Outperforming the market will depend on how well you mitigate this kind of risk. You certainly can't diversify it away by holding 150 stocks in your portfolio as many mutual fund mangers on Wall Street tend to do. As we have discussed before, the way to go is to build a concentrated portfolio which contains businesses you really understand and bought after a lot of thought and due diligence.

Apparently, there is another way to accomplish this and it involves Alpha. Wall Street firms' ability to conjure up portfolio "strategies" which puts more fees in their pockets is once again on display here. A recent Wall Street Journal article explained how "Portable Alpha" works. The most recent issue of Institutional Investor also had an insert which devoted a section to "Alpha Beta Separation" strategies. What is all the hoopla about? Here is how it's supposed to work. Clients are advised to get exposure to their benchmark index (Beta) through the use of derivatives, freeing up cash to allocate to Portable Alpha - money managers using hedge fund type strategies to boost returns above and beyond the Beta portion of the equation. You got it. The whole pie in the sky pitch assumes that these money managers will consistently beat the market. Well, that just doesn't happen (see Dreman's book for more details). Oh, and I forgot to mention that proponents of Portable Alpha charge hedge fund type fees to boot. It doesn't get any better than that. The Journal noted that "critics say portable alpha is nothing but Wall Street hocus-pocus that lets money managers rack up higher fees." They took the words right out of mouth.

Wednesday, July 12, 2006

The Weather Channel

A recent Wall Street Journal article highlighted the fact that demand for catastrophic reinsurance products is outstripping supply. Meanwhile, hedge funds and private-equity firms are filling the gap by providing coverage in certain cases. But don’t forget the king of reinsurance, Warren Buffett. Indeed, Berkshire Hathaway is making a big bet on mega-cat reinsurance even as others flee. And here is yet another classic quote from Mr. Buffett on the subject: "If you like to watch football, you probably enjoy the game a little more if you have a bet on it. I like to watch the Weather Channel." Gotta love it!

Saturday, July 08, 2006

Blue Gold

Over the past couple of years, sporadic articles have appeared in BusinessWeek and the Wall Street Journal about water. The sector certainly seems to be under the radar and yet water related indices such as the Bloomberg World Water Index of 11 utilities has returned 35% annually since 2003, far outpacing the S&P 500 and even various oil and gas indices.

A little bit of digging unearths a plethora of information about gloomy forecasts of a water shortage over the next couple of decades as well as neglected water infrastructure in various countries. From the United Nations to the OECD to the Environmental Protection Agency, there is no shortage of opinion on global water issues.

Big money is certainly getting onboard and has been gearing up to take advantage of the opportunities. The Gabelli Fund recently organized its first Water Infrastructure Conference and is one of the largest shareholders of Watts Water Technologies (NYSE: WTS). Then there is General Electric (NYSE: GE) which has water purification and treatment businesses and expects the opportunity to grow significantly going forward.

We have had the water sector on our radar for some time. Various stocks have pulled back from recent highs and appear to be trading at reasonable valuations. ITT Industries (NYSE: ITT) and Pentair (NYSE: PNR) are a couple of examples. There is also the PowerShares Water Resources ETF (AMEX: PHO) if you don’t want to pick and choose.

We finally pulled the trigger on a mini-conglomerate which recently decided to spin off it water infrastructure business through an IPO. Walter Industries (NYSE: WLT) which has also been the target of various activist hedge funds has been on a wild ride recently.

We first took a position at around $65 and then again at $44 during the recent market decline. The remaining shares of Mueller Water Products (NYSE: MWA) should be distributed to Walter shareholders in short order. Walter currently owns about 75% of the Mueller. A bunch of Wall Street firms initiated coverage of Mueller couple of days ago. Let’s take $20 as a price target. At that price, Walter’s stake in Mueller accounts for $38 of its stock price which is trading at about $55. In other words, you are getting Walter’s natural resources (coal and gas), homebuilding and financing businesses for about $17 a share. Let’s say the homebuilding and financing businesses are worth about a couple of dollars. This leaves $15 for the natural resource business. Assuming a coal segment comparable P/E of 14, this part of the business would only have to earn $0.93 to justify this price. This is way too conservative even if coal and gas prices decline significantly. Plus, the company has locked in the price for its coal through next year at above $100 per metric ton. And I expect demand for Walter’s high quality metallurgical coal used by the steel industry to be sustained for some time.

I think Walter Industries is worth at least $75. So get in on the Blue Gold rush by buying Walter shares and waiting for the full spin-off of Mueller.

Saturday, June 10, 2006

The Sell-Off

“Face up to two unpleasant facts: the future is never clear and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.”
Warren Buffet, Forbes, August 1979

It has been a fun ride over the past 4 or 5 weeks. The Dow, Nasdaq and S&P 500 have corrected by about 7%, 10% and 6% respectively. Ouch. The volatility stems from the market’s uncertainty over the Fed’s interest rate policy and whether or not Mr. Bernanke will follow through with the Fed’s 17th consecutive rate hike in late June. Inflation appears to have pierced Mr. Bernanke’s 1%-2% comfort zone, albeit fractionally, and that has made investors jittery. Add to that the carnage in emerging markets in recent weeks and you have yourself a real doozy of a situation.

What to do? Does it make sense to sell, sell, sell a la Jim Cramer or should you instead be taking advantage of the sell-off to add to your positions. By now you should know what my answer will be. To be fair, my brother and I have trimmed or eliminated some positions in recent weeks. In particular we liquidated our Goldcorp (TSX: G.TO) position, took some money off the table on Chaparral (Nasdaq: CHAP), and reduced our position in Vimpelcom (NYSE: VIP) by 50%. Otherwise, we have used the decline to add to some of our core holdings. We have added to Ebay (Nasdaq: EBAY), Intel (Nasdaq: INTC) and Microsoft (Nasdaq: MSFT). We also nibbled a bit more at Centex (NYSE: CTX) and may do the same with Pulte (NYSE: PHM).

The homebuilders have been beaten up badly as they continue to reduce their earnings forecasts and worries about further interest rate hikes weighs on their shares. But my thesis remains intact. Scarcity of land and demographics are still positive long-term trends that should benefit the larger players. Further pain in the sector will also provide them with the opportunity to drive consolidation through the sector by gobbling up weaker players. Meanwhile, Bill Miller continued to build his positions in these companies through Q1. When we initiated our position in the homebuilders, I told my brother there could be a 20% downside in the shares. That scenario sure has materialized. To add fuel to the fire, a slightly worrisome article in a recent issue of Barron’s questioned the nature of off-balance sheet JV’s set up by various homebuilders to boost ROA and ROIC. The article also questioned whether the companies can truly walk away from the options they have purchased to buy land. Various CEO’s have claimed the use of these options will reduce their financial exposure during a downturn. In any event, I continue to believe in the soft landing scenario for housing. These companies have been around for decades and they are certain to provide us with a reasonable rate of return in the long run.

2p - 1 = x

“We try to think like Fermat and Pascal would if they’d never head of modern financial theory.”
Charlie Munger

In his book The Warren Buffett Portfolio, Robert Hagstrom does an excellent job outlining his thoughts on the focus investment strategy and the psychology of investing. But two chapters in his book in particular caught my attention.

The sixth chapter is titled The Mathematics of Investing. Hagstrom discusses probability theory and the important role it plays in Buffett’s and Munger's decision process. In one example, Buffett takes us through his thinking when he purchased a significant stake in Well Fargo in 1990 just as the West Coast was in the midst of a recession and banks with exposure to residential and commercial mortgages were thought most vulnerable. Wells Fargo’s stock had declined from $86 to $57. An approximately 50% decline.

But this was a bank that was earning $1B pretax at the time. Even if its entire loan portfolio – not just the real estate loans – were hit severely, the bank would still break even. Buffett reasoned that " a year like that ... would not distress us". Other risks existed but Buffett assigned a low probability to those as well. In the end, Buffett figured the odds of making money on the shares were on the order of 2:1 providing him with his Margin of Safety. The shares continued their decline after he bought them and were up only 5% the next year. But in 1992 and 1993 the shares appreciated 34% and 73% respectively, followed by more gains in subsequent years. Not bad.

Another interesting tool introduced by Hagstrom is the Kelly Optimization Model, 2p – 1 = x. It suggests that if you know the probability of success (p), you bet the percentage of your capital (x) that will maximize return. So if you think the probably of buying Coca Cola (NYSE: KO) has only a 55% chance of giving you above average returns over the next decade, you should invest 10% of your portfolio in the stock. It is not clear if Buffett uses this formula in his thinking, but he certainly makes a big bet when he likes his chances. Consider that in 1988 – when he began building a position in Coca Cola – Capital Cities/ABC, GEICO, Coca Cola and the Washington Post comprised 36%, 28%, 21% and 12% of his portfolio respectively.

The eight chapter introduces the concept of the market as a complex adaptive systems. The market has many agents (people) who have their own partial views and biases. They interact with other agents, none of them in control of the market, accumulate experiences and adapt to the constantly changing environment. Such a system is impossible to predict and forecast, especially in the short-term. Buffett says, “We have long felt that the only value of stock forecasters is to make fortune tellers look good.” In other words, don’t worry about price fluctuations, just focus on the economics of the business you are investing in and be assured that in the long-run, the market will reward companies that create shareholder wealth. Of course, all of this assumes you have done your homework and you are buying stock at a reasonable Margin of Safety.

Absolute Focus

“Imagine the cost to us, if we had let a fear of unknowns cause us to defer or alter the deployment of capital.”
Warren Buffett, Berkshire Hathaway Annual Report 1994

Being a successful investor is all about patience, discipline, focus and conviction. How you measure your success is also very important. Most money managers and mutual funds have locked themselves into a relative measurement game. They better deliver returns relative to their chosen benchmark or else! The benchmark can be the S&P 500 index or the Russell 2000 index. This is exactly why these funds end up owning a large number of equities in their portfolios, sometimes in the 100s. You have to own the market to keep up with the market. This is also one reason why 90% of them end up underperforming the market. So if you want average returns, this is the path you should follow.

If you want above average returns, you must become a focus investor measured on absolute performance. Forget about the day to day and short term gyrations of the market and concentrate on the economic value of the businesses you invest in. As we have discussed in the past, holding a large number of stocks in your portfolio doesn’t reduce the risk, it just spreads the risk. You are better off building a focused portfolio which enables you to become intimately familiar with each business you own. Don’t forget, you are part owner of a business when you buy stock, even if it’s just a 100 shares.

How many holdings should a focused portfolio have? Well, Warren Buffett has said he would not consider making an investment unless he is convinced he would want to commit at least 10% of his net worth. This implies a portfolio of 10 holdings. His partner, Charlie Munger, who had started his own partnership in the 1960’s had concluded that owning as few as 3 stocks would provide him with above average returns. And he was right. From 1962 to 1975, his partnership returned an average of 24.3% annually vs. the market's 6.4% return. The one caveat was that he achieved this by enduring increased volatility. The portfolio significantly underperformed the market in some years.

Indeed, a focused portfolio is not for the faint of heart. You must have the temperament and psychological wherewithal to stand the peaks and valleys. You must be patient, avoid the temptation to buy and sell and ignore market forecasts. After all, wars and market crashes and oil shocks did nothing to deter Warren Buffett from staying the course. You may underperform the market from time to time, but in the long run you should handily meet or exceed an absolute measure of performance such as inflation plus 10%.

Wednesday, May 31, 2006

Tracking Buffett 2

It's that time again. It's been more than six months since we reviwed Buffett's stock holdings. A lot has been going as Mr. Buffett has been busy putting his cash to work. He has reduced or eliminatd some positions while taking significant new positions along the way.

Berkshire significantly reduced its stake in Pier 1 (NYSE: PIR) as the furniture retailer has continued to struggle. He continues to hold a small position. Apart from a few full divestments, Buffett has pared back his positions in H&R Block (NYSE: HRB) by around 40%, Gap (NYSE: GPS) by 35%, Sealed Air (NYSE: SEE) by almost 38%, and Iron Mountain (NYSE: IRM) by 30%. I was a bit surprised by the 16% reduction in Home Depot (NYSE: HD), but this does not seem to be a significant sale at this stage since he had increased his position by 429% in Q3 of 2005. In fact I would use a bit more weakness in the shares to add to my position.

Meanwhile, the additions to the portfolio are worth paying attention to. Lots of attention. I have already talked about Anheuser-Busch and Wal-Mart in a previous post and continue to hold both stocks. Buffett increased his Wells Fargo (NYSE: WFC) holding by 50% and Lexmark (NYSE: LXK) by 200%. Lexmark had plunged more than 30% in Q4, when Buffett added to his position, and has almost fully recovered. Also since last September, Berkshire has doubled its Tyco (NYSE: TYC) stake. We have also used recent weakness in the shares to add to our position.

During the latest quarter, Berkshire took new positions in General Electric (NYSE: GE), United Parcel Service (NYSE: UPS), and ConocoPhillips (NYSE: COP). Foreign stock additions to the portfolio include Diageo PLC and Tesco PLC. What all these companies have in common is international revenue exposure. As I noted in a recent post, Mr. Buffett is using this strategy to hedge against further deterioration in the US Dollar. He is probably just getting started. I have been a GE shareholder for almost a decade and would use any weakness in the shares to add to my position in the low $30s. As for ConocoPhillips, it trades at a discount to peers primarily because of the company's aggressive exploration expenditures. Regardless, the new position is an endorsement by Mr. Buffett that high energy prices are here to stay. In energy, I have been a shareholder of Canadian income trusts with exposure to the Oil Sands as well as Encana (NYSE: ECA) and Petro Canada (NYSE: PCZ).

Stay tuned as Mr. Buffett continues to deploy his cash.

Thursday, May 25, 2006

Capitalists’ Woodstock

On May 6th 24,000 people made their pilgrimage to Omaha, Nebraska to take part in the festivities planned around Berkshire Hathaway’s (NYSE: BRKB) annual meeting. Warren Buffett and his partner in crime, Charlie Munger, did not disappoint their disciples. By all accounts, the weekend was as informative and entertaining as would be expected. The highlight for me was the exchange between Buffett and Munger about hedge funds and private equity funds.

“We have so many deal flippers in the game they're going to get in each other's way. How will private equity firms continue to make money by just flipping and flipping and flipping and flipping?” asked Munger.

“They'll make it on fees, fees, fees," quipped Buffett, adding that when he gets a call from a private equity group, he puts the phone down "even faster than Charlie".

Also of note was Berkshire’s announcement of a $4 billion transaction to acquire 80% of Israeli machine tools company, Iscar Metalworking. What is significant about this is that the deal signifies the first major ex-US acquisition for Berkshire. It most definitely will not be the last. Buffett reduced his bet against the US dollar significantly in Q1, but by buying foreign assets he is in essence accomplishing the same thing. More deals will surely follow. He also alluded to a $15 billion transaction in the works but gave it a low probability of closing.

Slowly but surely Buffett is putting his cash to use. While he continues to take significant minority stakes in companies such as Wal-Mart (NYSE: WMT) and Anheuser Busch (NYSE: BUD), his preference is clearly to buy operating companies that fit his investment criteria. Since last year’s acquisition of PacifiCorp, he has put more than $10 billion to work. He also implied that in three years Berkshire will have significantly less cash than today. Indeed, he has suggested Berkshire would like spend more than $15 billion in the energy sector alone. His target seems to be a cash position of $10 billion compared to nearly $40 billion today.

Skeptics continue to question Berkshire’s prospects. They contend Buffett has lost his touch as evident by the cash hoard he carries on the Balance Sheet. Incidentally, Berkshire’s businesses generate $100 to $200 million of cash a week. Not bad. In any case, these skeptics are missing the point. This is value investing at its best. No rush. Patience and discipline are the governing rules. Nobody does it better than Buffett. The whole idea is to be invested in Berkshire before he has deployed the cash. Meanwhile you are safekeeping your cash with the greatest investor of all time. Not to mention the fact that Berkshire is one of a handful of AAA rated companies around (it's also the only AAA rated reinsurer) and a rock solid investment, period. More importantly, the shares remain at least 25% undervalued as book value and earnings power continue to rise. The recent dip in the shares represented a great opportunity to add to holdings.

Friday, April 21, 2006

Home Sweet Home

People will always need a place to call home. Indeed, housing has been a hot topic of discussion lately. The consensus goes something like this: The Fed is raising rates which will render mortgages expensive for consumers. Cracks are beginning to show in the foundation as orders for new homes are on the decline and new home sales are hitting their lowest levels in recent years. Of course, this is supposed to spell doom for homebuilders such as Pulte Homes (NYSE: PHM) and Centex (NYSE: CTX).

Wall Street's reaction has been swift and punishing. Homebuilders stocks have retreated from their highs and are trading at extremely low P/E ratios by historical standards. In fact, the hombuilders have the lowest P/E of any major industry sector on the stock market (Dreman anyone?!). On a forward P/E basis, the leading companies are trading at a 2 to 3 times discount to the S&P 500. But people forget that these companies have been around for decades and have been through many cycles. That experience has served them well as they have transformed their businesses into conservatively capitalized enterprises, managing cash while focusing on shareholder returns. Just look at the return on equity they are delivering. They don't own excess land and are dominant enough to drive a wave of consolidation through the sector should things go awry and the smaller rivals begin to falter.

Don't forget that the Fed should be close to ending its string of rate hikes. That should lessen the severity of the gloom and doom scenario predicted by naysayers who believe higher rates will destroy the consumers' appetite for homes. Meanwhile, the economy seems resilient and wages are on the rise giving the consumer enhanced buying power. Sure, the housing market in some markets is frothy to say the least and homebuilders themselves admit as much. But a softening market or a gradual leveling out is the more likely scenario than a severe crash.

It is practically impossible to call a bottom on a stock. Pulte and Centex are the two largest homebuilders by revenue and are both repurchasing shares. Their book value (which is a conservative estimate of the liquidation value for these companies) puts a nice support under the shares. I think the downside is manageable while there could be a 25% to 35% upside in the shares.

The Contrarian

"Nobody beats the market, they say. Except for those of us who do."
David Dreman January 21, 1998

You would not be a value investor without having a contrarian edge and a thorough understanding of investor psychology. The contrarian of them all is David Dreman. He has been a Forbes columnist for many years and is considered the father of contrarian investing.

In Contrarian Investment Strategies: The Next Generation, Dreman reminds us that the opinion of a Wall Street analyst is not gospel. He will also remind you that markets are far from efficient and that investors overreact in predictable irrational ways which you can profit from. He presents compelling data and statistics which show low P/E, low P/Book and low P/Dividend stocks have outperformed the market over time. He recommends sticking with high quality companies and staying away from bonds which have seriously underperformed stocks when adjusted for inflation and tax.

His 41 Contrarian Investment Rules are valuable reminders of how hard it can be to avoid the herd mentality. Here are a few:

Rule 1 - Do not use market-timing or technical analysis. These techniques can only cost you money.

Rule 2 - Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in-depth profits. (AA note: for more on the powers of rapid cognition without the need for exhaustive deliberation, you should read Malcom Gladwell's Blink)

Rule 6 - Analysts' forecasts are usually optimistic. Make the appropriate downward adjustment to your earnings estimates.

Rule 10 - Take advantage of the high rate of analyst forecast error by simply investing in out-of-favor stocks.

Rule 11 - Positive and negative surprises affect "best" and "worst" stocks in diametrically opposite manner.

Rule 14 - Buy solid companies currently out of market favor, as measured by their low P/E, P/Cash Flow or P/Book ratios, or by their high yields.

Rule 20 - Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.

Rule 25 - Don't be seduced by recent rates of return for individual stocks or the market when they deviate sharply from the past. Long term returns of stocks are far more likely to be established again.

Rule 29 - Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don't sell.

Rule 30 - In a crisis, carefully analyze the reason put forward to support lower stock prices - more often than not they will disintegrate under scrutiny.

Rule 32 - Volatility is not risk. Avoid investment advice based on volatility.

Rule 41 - A given in markets is that perceptions change rapidly.

Mentally, these rules can be hard to adhere to especially when the value stocks you own do not participate in hot-stocks-du-jour rallies. A disciplined and patient value investor with a contrarian psyche is a rare breed. But I believe such an investor has the best shot at mastering the stock market. It's a good thing markets are not efficient after all.

Thursday, April 06, 2006


A few days ago a friend asked me about my opinion about Intel (Nasdaq: INTC). I have been an Intel shareholder for many years and I have continued to add to my position even as the shares have continued their rather dramatic decline recently. At current levels, Intel is not your pure value play, but it's getting there. I believe the shares provide a reasonable Margin of Safety and would expect any further declines to be relatively moderate from these levels. The company is buying its shares back aggressively and I expect will continue to increase dividends. Here is an excerpt of the email I sent back in reply earlier today.

“Intel is definitely a disliked stock right now, which is why it’s on my radar screen. The company has had some missteps lately. AMD (NYSE: AMD) is hot on its tails and has been taking share especially in server market. And there are rumors DELL (Nasdaq: DELL) might soon start using AMD chips and stop being exclusive to Intel. All these are negative overhangs on the stock. Plus you have the likes of Texas Instruments (NYSE: TXN) and Marvel (Nasdaq: MRVL)) which seem to have products which are better targeted at today’s most popular consumer electronic gadgets. But Intel is not sitting still either. They continue to spend on R&D and have managed to stay ahead of AMD in cranking out chips more efficiently, leveraging the company’s economies of scale. AMD has made up some ground though. Intel is also diversifying into other areas as evident by their recent partnership with Micron. Not to mention the fact that Microsoft’s Vista will be rolling out next year (hopefully!) and it should bring with it a whole new round of upgrades. Finally, there are the emerging markets, where Intel and AMD are trying to gain a foothold, and which will eventually present the companies with growth opportunities. Worst case scenario, by the way, is that Intel will use a price war to crush AMD. A strategy it has used in the past.

Intel remains the powerhouse of the industry. The company has solid Return on Equity and profit margins (although some think the margins have peaked for the company). The stock pays a 2% dividend at these levels. Not bad and I think they will continue to raise the dividend. On a forward P/E basis, the stock is trading at around 18.5 times 2006 projections and about 15.2 2007 projections. That is compared to the S&P 500 which is trading at 16.1 times 2006 estimates and 15.5 times 2007 estimates. So the question is, does Intel deserve a premium multiple to the market. My position is that the answer is yes. So you could buy the stock just on this basis if you are a long-term investor.

Here is another way to look at things.

Is the stock a value play? In my opinion, it’s not a true value play but if you believe Intel can continue to grow and earn above its cost of capital for every additional dollar of investment, then there might be a reasonable margin of safety provided by that growth assumption. Based on my calculations, Intel is currently trading at about 1.8 times adjusted book value. Not the cheapest it has been historically. Also, I have calculated the company’s Earnings Power Value to be about $80 billion dollars. EPV assumes no growth. Intel would be a beautiful value play if the market cap was closer to this number, because then you would be getting the growth for free. That was the case for Intel in the early ‘90s, for example.

So on this basis, we would not buy Intel today as a pure value play. But we should consider the possibility that growth may provide us with a Margin of Safety above and beyond the EPV we have calculated. I have made the following assumptions (which you could challenge of course), but I think they are reasonable:

Return on Equity: 23%
WACC: 12%
Growth rate: 8%

With those assumptions, I get a Present Value/EPV ratio of about 2. This means Intel’s PV = 2 * EPV = $160 billion or about $26.3 providing us with a margin of safety of 36% over the current price of $19.3.

The closer the market cap gets to my EPV figure, the more comfortable I will be. But for the market cap to be equal to EPV, the stock would have to drop to $14. Possible? Sure. I think it is unlikely, unless the entire market crashes of course (but that is just systematic risk we can’t do anything about). Could the stock hit $17 or $18 in the near term? Sure. But that is why I think you can take a half position now and the rest after the earnings announcement.

One more thing to think about. This company is a cash machine with a squeaky clean balance sheet. They can take on more debt if they want to and they might end up paying a special dividend a la Microsoft (Nasdaq: MSFT) if they can’t figure out what to do with that cash. The stock traded at these levels back in 1996!”

Saturday, March 25, 2006

Timmy's IPO

Friday was the big day. Tim Horton’s (NYSE: THI) IPO was priced at USD $23 and opened at nearly $30. This values the company at almost $6 billion! Meanwhile, Wendy’s shares (NYSE: WEN), retreated to $63 and held steady after briefly hitting an all-time high of $66.35. Based on my last post, this would have resulted in roughly a 13% return on investment in little over a month, not including dividends. Not bad.

What now? The main thesis of my rational behind buying WEN in the first place remains intact. On Friday, THI closed at $28. Remember WEN still owns 85% of Timmy’s. So at that price, the 85% stake represents approximately $38.5 of WEN’s share value. The remainder, or $24.5, is the value the market is attributing to the Wendy’s franchise. That translates to an enterprise value of roughly $3 billion which is still only 8.5 times EBITDA. This is an improvement since Peltz filed his 13D but the multiple is still below the 9 to 11 times for Wendy’s peer group.

There is more work to be done. The Baja Fresh brand still needs to be divested. Some underperforming restaurants will be sold once store-level margins have been improved. Meanwhile management has committed to continue to cut costs to improve EBITDA. Finally, cash from sales of any ancillary businesses and the $5 per share proceeds from the THI IPO will have to be put to work. Once Timmy’s has been 100% spun off (before the end of the year), management will put this cash to use to buy back shares or pay a special dividend or a combination of both.

There are risks. There is no guarantee THI will hold at these levels. Furthermore, there is no guarantee Wendy’s management team will be able to hit Peltz’s targets. But if you are a believer, you will collect around 1.4 shares of THI for every WEN shares you are holding and based on my calculations, you will benefit from another 20% to 25% appreciation as the Wendy’s franchise mounts a comeback.

I continue to like WEN as a value play. Even if the THI IPO frenzy fizzles away, the downside seems minimal. In fact, if the THI does retreat to the IPO price or below, I will snap up shares in a heartbeat. Meanwhile, holding WEN gives you the opportunity to participate in any further, albeit unlikely, gains in THI in the short-term.

Let’s let the story unfold.

Friday, March 17, 2006

AA Value Fund

I opened my first brokerage account at Charles Schwab while I was attending MIT in 1995. I will never forget walking into a Schwab branch and seeing two young kids, supposedly there to greet potential customers, glued to their monitors trading options on tech stocks. It was the beginning of a euphoric period that did not end well. I have to confess that I was caught in the ‘irrational exuberance’ of the moment also. An investment club I co-founded in 1996 had a return of 6 times invested capital before giving up all the gains and more once the technology bubble burst. Needless to say times have changed. So have my investment discipline and philosophy.

From time to time I will update you on my performance as I continue to hone my skills as a value investor. Since the beginning of 2003 and through the end of 2005, my ‘value fund’ has returned a CAGR (Compound Annual Growth Rate) of approximately 46% vs. S&P 500's 13%. This performance does not include any additional capital contributions to the account. I prefer not to turn Margin of Safety into a stock picking showcase, so I am not going to get into the rationale behind each holding and how the individual investments performed. As you may have noticed, I prefer to talk about general themes with a few sprinklings of ideas you may find interesting. If you are interested in learning more about my individual picks, you can visit Ivey's Super Investors.

To give you an idea of typical past and current holdings in my value fund since inception, here is a list in no particular order: American Real Estate Partners (NYSE: ACP), Sears Holdings (Nasdaq: SHLD), Petrobras (NYSE: PBR), Smith International (NYSE: SII), Morningstar (Nasdaq: MORN), NYSE Group (NYSE: NYX), Pier 1 (NYSE: PIR), Intel (Nasdaq: INTC), Cisco (Nasdaq: CSCO) and Amazon (Nasdaq: AMZN). Here is what the journey has been like so far.