Margin of Safety

Ballast

2012-02-15T12:42:00.022-05:00

"It is expensive to sit on cash."

"I gave you my money to invest in the markets, not to sit on it and do nothing with it."

Yes, investors dish out plenty of advice to 'professional' money managers. If the 'professional' does not oblige, the investor takes her money back and gives it to a 'professional' who will oblige and invest every last cent in stocks right away. If this is the case, we would advise the investor to keep her money and just buy an index fund, saving herself the fees and expenses associated with 'active' and 'professional' money management. This is because being fully invested makes sense only when Mr. Market is throwing fat pitches at us - we define a fat pitch as a company which is trading at a significant discount to its intrinsic value. This is when you want to go all out and swing confidently. Otherwise, you need to keep cash on hand to take advantage of the fat pitches when they are thrown sometime in the future. If you were planning to buy and own a private business, would you buy it when sellers are demanding a premium for their businesses or would you wait until you find a distressed seller who must sell his business at a price you perceive to be attractive?

If an investor trusts her risk capital to an asset manager, then presumably she has assessed the opportunity cost of parting with this capital for a reasonable period of time. There is no sense in coercing the manager into taking undue risk because you don't want the manager to 'just sit on cash'. The manager's task is to provide the investor with reasonable absolute returns over an entire business cycle. If the investor does not have the patience for this and has better uses for her cash, then by all means she should have never parted with it to begin with.

In the end, the asset manager's job is to own high quality businesses which will prosper over time, resulting in higher stock prices which will therefore increase the purchasing power of our hypothetical investor. The magic is to buy these businesses at attractive valuations and with plenty of margin of safety. This is possible only if the manager has had the foresight to hold onto cash, waiting for opportunities when volatile markets cause the valuation of securities to decline below their long-term intrinsic value. No cash, no possibility of taking advantage of Mr. Market's gyrations.

We recently watched an interview with Matthew McLennan, the portfolio manager of First Eagle Funds (of Jean-Marie Eveillard fame), who eloquently articulated the need to maintain cash on hand when constructing a portfolio of stocks. Mr. McLennan notes that markets are like stormy waters and investing is analogous to sailing a ship through the choppy waters without getting thrown overboard. It is the cash on hand which provides the ballast the ship needs to avoid disaster as Mr. Market's mood fluctuates from giddy to fearful. Without that ballast, the investor would never have the chance to take advantage of the fat pitches.

Do not be afraid to hold onto cash in your portfolio. But also do not be afraid to be greedy when others are fearful. These days investing in the bluest of blue chip global companies will enrich you with highly attractive dividend yields (much better than locking your capital in 10 Yr Treasuries for a meager 2%) while providing you with the opportunity to participate in the future growth of these wonderful enterprises. Intel (NASDAQ: INTC), General Electric (NYSE: GE) and Coca Cola (NYSE: KO) are a few names that come to mind. Happy sailing.

DISCLOSURE: I OWN SHARES OF INTEL, GE AND COCA COLA.

Nucs Proliferate

2012-01-19T12:38:00.005-05:00

Gilead's acquisition of Pharmasset (NASDAQ: VRUS) has been completed and PSI-7977 is now safely tucked into Gilead's pipeline drawer. As we discussed earlier this year, this was a relatively attractive merger arbitrage opportunity if you could stomach some downside risk.

Sure enough, the love affair with pre-approved HCV products and the companies developing them continues to proliferate. On January 8th, Bristol-Myers (NYSE: BMY) announced it will acquire Inhibitex (NASDAQ: INHX) for $26 or $2.5B. Inhibitex shares were trading at around $10 before the announcement. Inhibitex's crown jewel is INX-189, a nucleotide polymerase inhibitor or "Nuke" for short. For obvious reasons I prefer the acronym "Nuc". If you want to know what a Nuc looks like, here is a nice picture:

Inhibitex shares are trading at $24.61 today. By buying the shares and waiting for the acquisition to be completed, the return on investment would be 5.65%. The acquisition is expected to be closed by February 10th and would result in a spectacular annualized return.

It is important to note that this investment opportunity is somewhat riskier than the Gilead/Pharmasset merger arbitrage trade. INX-189 has not cleared the all important 12 week hurdle in its Phase II trials and therefore it is possible that an adverse event such as liver toxicity signals in patients enrolled in the trials will occur prior to close, scuttling the acquisition.

The bidding for Inhibitex was a competitive process as Bristol-Myers had to raise its offer several times to fend off other companies which rumors suggest included Johnson & Johnson and Merck. I highly recommend that you read the Tender Offer filing by Bristol-Myers, which lays out the bidding process in detail, prior to making an investment in Inhibitex shares. You will note that Bristol-Myers was able to review non-public material information prior to making its bid. Somewhat comforting.

DISCLOSURE: I OWN SHARES OF INHIBITEX.

Housekeeping

2012-01-05T10:18:00.006-05:00

It has been a while since I made any changes to the Model Portfolio. That may be an understatement since the last trade in the portfolio was completed in October of 2009. Cadbury Schweppes did get gobbled up by Kraft (NYSE: KFT) which itself is spinning in to two companies. Two companies we have discussed in the past and held for some time in the portfolio.

I have decided to stop maintaining this portfolio going forward as I simply do not have the time to manage it. Having said that, I will continue to track the performance of the portfolio as is (including the cash position). It will be an interesting 'buy-and-hold' experiment to look back on years from now.

Since inception on September 1, 2006 the Model Portfolio's NAV increased by 16% versus the S&P 500's total return of 8.09% through the end of 2011. This does not include any dividends received since September 2010. Below is a snapshot of the portfolio as at the end of December 2011.

Start 2012 with a VRUS

2012-01-02T09:18:00.007-05:00

It's been over year since I last posted on Margin of Safety. Let's just say life has been super busy. But for 2012 the plan is to post once a month at a minimum. Let's see how that resolution plays out.

A lot has happened since my post on October 2010 and I won't rehash the events of 2011 here in too much detail. Needless to say it was one of the most volatile years for the markets in recent memory. Retail investors abandoned equities in droves and prominent hedge fund managers were clobbered as high correlations apparently offset their superior stock picking skills. Meanwhile in Europe the situation went from bad to worse as leaders struggled to come up with a solution to appease the bond vigilantes. And then there is our favorite Mr. Buffett who was going about his business as usual and was putting his cash to work even as investors were fearing a total world collapse instigated by the affairs in Europe. In 2011 Mr. Buffett became a 5.5% shareholder of IBM (NYSE: IBM) at an average price of $170. IBM ended the year at $183.88. Yup, it seems stock picking does work after all and Mr. Buffett doesn't charge 2/20 to do the picking for you.

So here we are the day before the markets re-open for 2012 and many of the overhangs present in 2011 remain. Certainly the situation in Europe will continue to be on everyone's radar as will the U.S. Presidential race and D.C. politics in general. There are also worries about a Chinese hard landing and a double-dip recession in the U.S. 'Macro' will be the topic of discussion yet again. Investors remain cautious and are sitting on a substantial amount of cash - or they are taking their money out of equities and piling into fixed income securities and specifically U.S. Treasuries. Nevermind that some of the largest blue chip companies in the world will pay you a higher dividend yield than the U.S. 10 Yr. Intel (NASDAQ: INTC), Johnson & Johnson (NYSE: JNJ) and Coca-Cola (NYSE: KO) come to mind.

But there are plenty of other opportunities to take advanatge of which will somewhat insulate your portfolio from Mr. Market's volatility. The key is to focus on investments which are uncorrelated to the markets. Consider a risk arbitrage investment opportunity in shares of Pharmasset (NASDAQ: VRUS) which I profiled on Canada's Business New Network (BNN) on December 19th.

Pharmasset is being acquired by Gilead (NASDAQ: GILD) for $11B or $137 per share. When the announcement was made in late November, Pharmasset shares soared from around $72 to $134. Then the shares began to drift lower and traded as low as $123 before rebounding last Friday to close at $128.20. The deadline to tender shares is midnight January 12, 2012 with the acquisition expected to close shortly after.

The potential reasons for the decline are numerous. What is apparently spooking merger arbitrageurs is the potentially large downside (see below) and the fact that the purchase and sale agreement provides Gilead with a broad Material Adverse Clause (MAC) provision allowing the company to walk away from the deal if there is a Material Adverse Event associated with Pharmasset's Hepatitis C Virus (HCV) drug under development. There are also other conditions which could trigger the MAC but this is the main one. The drug under development is a paradigm changing oral product for treatment of HCV code-named PSI-7977. This is what Gilead is after.

By investing in Pharmasset shares at $128.20 you woud lock in a 6.86% return on your investment. Assuming he deal closes by the end of Q1 (I think it will close in January), the anualized return (a metric used by merger arbitrageurs) would be about 27.44% which is incredibly high. If you really want to juice up your returns, you can also consider selling one January 21, 2012 $125 put option for about $7 for each 100 shares of Pharmasset you purchase. This of course doubles your exposure and magnifies your losses if Gilead walks away from the transaction. But if the transaction goes through, your return on investment including the option premium you collect would be 12.32%.

Of course no investment is without risk hence the term 'risk arbitrage'. Usually such situations offer a lower upside as the target stock trades closer to the acquisition price. At the same time the downside is usually on the order of 20%-30% if the deal is scrapped. This is what merger arbitrageurs are used to. In Pharmasset's case, if something does happen to PSI-7977 between now and closing of the deal, the stock would be decimated by 50%-80%. So you get more juice on the upside but you also have to stomach a potentially very large downside.

In my opinion what the folks in the merger arbitrage camp are missing is that Gilead is an expert in the anti-viral therapeutic space and they would not be putting $11B on the line for a product which is not yet approved by the FDA. The acquisition will almost certainly close before any additional clinical trial results will be announced and most certainly before PSI-7977 is approved. The key is that PSI-7977 has passed some key hurdles which almost guarantee its success including 12 weeks of treatment without any adverse liver signals being detected. By contrast, on December 16th, Pharmasset announced the discontinuation of another pipeline drug PSI-938 due to abnormalities detected in liver function during a Phase IIb trial. This news by the way further spooked the markets and was the reason for the decline in the shares to the $123 level. Nevermind that this news had no bearing on Gilead's offer to acquire Pharmasset. We have talked about Efficient Market Theory before, right?!

Before you invest in Pharmasset I highly urge you to do your own research as well as read the SC-14D9 filing by Pharmasset on sec.gov for details of the transaction and the negotiations between Gilead and Pharmasset. It's a good read.

All the best for 2012.

DISCLOSURE: I OWN SHARES OF PHARMASSET.

Bond in Drag

2010-10-12T21:37:00.011-04:00

I am not a strategist or an oracle. But I know something smells funny when Johnson & Johnson’s (NYSE: JNJ) stock yields more than the bonds it recently issued to yield hungry investors. With U.S. Treasury yields in a free fall, investors looking to earn some sort of a return on their cash are willing to accept what appear to be insanely low coupons on corporate debt. The spread over risk-free rates may seem appropriate but the absolute yield is not enough to persuade us to forgo JNJ’s stock for its bonds.

Granted, the bond market may be signaling a faltering recovery with deflationary forces setting in and the stock market may get caught wrong footed. It is unlikely they can be both right. But we would rather collect a handsome dividend with potential for upside than earn a paltry return in bonds while locking up our capital for a lengthy period of time Even if the market does falter and JNJ’s stock declines, it is highly unlikely the company would cut its dividend. Plus, we would gladly hold the stock for the long run and buy more of it.

This is not meant to be a recommendation to buy JNJ’s stock but merely an illustration of the vagaries of Mr. Market. Investors of all types appear to be dumping equities in favor of the ‘safety’ of bonds and gold. What about all the money that is being printed by central banks all around the world? Could inflation be on its way sooner than people think one that money finds its way into the hands of borrowers? Higher rates would follow thereby decimating bondholders in its wake. Gold appears to be in agreement with this outcome as its price zooms ever higher if you agree with the characterization that it is a classic inflation hedge. The bond bulls on the other hand contend that the world is on the brink of collapse and we are in a deflationary spiral which will only lead to lower Treasury yields. Even if this is so, the bulk of the gains have probably already materialized and in any case the risk/reward profile just doesn’t seem to be there when compared with equities.

In any case, shouldn’t one be investing in equities when all others are reluctant to do so?! Apparently not if you ask David Rosenberg who is the high profile Economist and Strategist at the wealth management firm Gluskin Sheff in Toronto. In a recent note he thought it more prudent to lock one's capital up for 10 years in U.S. Treasuries collecting a paltry 2.4% yield (Mr. Rosenberg argues that bonds will mature at par reducing the risk of owning them. But what good is a bond which pays us 2.4% and locks up our capital with no optionality for 10 years!), described Pfizer (NYSE: PFE) as a “bond in drag” (Question for Mr. Rosenberg – wouldn’t your clients have benefited if you had actually bought shares of Pfizer when they were trading below $15? Why only point out the decline from $19 to $14 since the beginning of the year?), conjured up memories of Nortel (I am not kidding) when alluding to risk of owning equities and, finally, disagreed with Warren Buffett’s recent assessment of equity valuations:

“They’re making a mistake, the ones that are buying the bonds ... It’s quite clear that stocks are cheaper than bonds. I can’t imagine anybody having bonds in their portfolio when they can own equities, a diversified group of equities. But people do because they lack confidence. But that’s what makes for the attractive prices. If they had their confidence back, they wouldn’t be selling at these prices. And believe me, it will come back over time.”

The last time Mr. Buffett made such a proclamation was back in November 2008 when he wrote an Op-Ed piece for the New York Times and was ridiculed for his views. Well, we all know how the markets have performed since then.

Mr. Rosenberg and the bond/gold bulls could be right. We may end up with a double-dip recession and/or a decade of no growth à al Japan which would severely dent current equity valuations. To be fair, Mr. Rosenberg concedes that gold prices may have gone too far too fast. Still he conveniently touts the virtues of holding bonds in a deflationary world while at the same time advocating gold for its ability to preserve value as currencies get debased. But couldn't higher gold prices possibly be a prelude to dangerous inflationary forces eventually rearing their ugly head and destroying bond prices? Something doesn't add up here. To be sure highly successful investors such as John Paulson have also made huge bets on gold viewing it as a means of preserving their wealth (a currency substitute). But at least they don't deny the possibility of higher inflation/rates down the road.

As massive inflows into bond funds continue (Mr. Rosenberg rationalizes this by describing it as sensible asset allocation by oh so rational investors), the allure of owning rock solid businesses at today’s prices which offer attractive dividend yields is too much to pass on. At least we know Charlie Munger would rather own JNJ or Coca Cola (NYSE: KO) or Kraft (NYSE: KFT) rather than gold. Here is a classic quote from a recent speech by Charlie:

“I don't have the slightest interest in gold. I like understanding what works and what doesn't in human systems. To me that's not optional; that's a moral obligation. If you're capable of understanding the world, you have a moral obligation to become rational. And I don't see how you become rational hoarding gold. Even if it works, you're a jerk.”

The Old Abnormal

2009-10-14T21:01:00.008-04:00

Earlier this decade we were graced with the catchphrase the ‘new economy’ to explain why price to earnings ratios of 100 made sense. Today’s catchphrase, the ‘new normal’, has been coined by the folks at PIMCO to explain why we should get used to much lower growth rates for a while. Mohamed El-Erian and his boss Bill Gross have been on a bit of a mission touting the virtue of weighing security portfolios in favor of bonds and reducing allocation to equities. The logic is that the Great Recession has embarked us on a new era of slow growth characterized by high employment, capital starvation, more regulation and the rising power of China and other emerging markets at the expense of the United States. According to PIMCO equity exposure should now be in the 30% to 54% range as opposed to 60% with no more than half in U.S. equities. Needless to say this advice will benefit PIMCO as one of the biggest bond shops in the world with over $800 billion under management, $120 billion of that coming in since the beginning of 2008.

Perhaps not surprisingly the masses are blindly following the advice of the 'experts' and succumbing to Mr. Market’s mood swings. There is a lot of talk about slow growth, the importance of asset allocation and the nasty repercussions of a depreciating U.S. Dollar. I recently posed a question to Stephen Yacktman of Yacktman Funds during a Q&A facilitated by the Wall Street Journal’s Journal Community and here is what he had to say about the new normal:

So one can try to figure out how to play the asset allocation game or one can concentrate on buying good businesses at reasonable prices. As I have discussed before, many of the largest U.S. corporations offer a natural hedge against a declining U.S. Dollar not to mention the fact that by virtue of being multinationals they will also let you participate in the growth of non-U.S. economies. This is the time to invest in equities for the long run not when growth resumes and the ‘new normal’ morphs into the ‘old abnormal’. To be sure Mr. Market has been on a bit of a tear since April and equities are more fairly valued than cheap. But companies such as Johnson & Johnson (NYSE: JNJ), Coca Cola (NYSE: KO), Procter and Gamble (NYSE: PG), Pfizer (NYSE: PFE), Microsoft (NYSE: MSFT), Intel (Nasdaq: INTC) and Ebay (Nasdaq: EBAY) are worth considering despite the recent rally.

The Golden Wall

2009-08-19T22:57:00.003-04:00

The Black Box algorithms and catchy names served their purpose while the good times rolled along through the early part of 2007. Fees and market beating returns for the likes of Pequot Capital and Atticus Capital were all too easy to come by. But the recent turmoil in the markets is turning out to be a tad too much for these folks. Pequot is all but shut down and Atticus announced a few weeks ago that it is returning 95 percent of its investors' money by October. It turns out, according to one source close to Atticus' Mr. Barakett, that “there is no fundamental analysis in the market today” and that the "golden era of equity investment is over”. I am not making this up. This was printed loud and clear on the front section of Financial Times' Market section. Yup, Mr. Barakett even attributed a portion of his performance over the past ten years to luck. So much for the secret Black Box algorithms and hanging in there for your loyal investors when the times get tough. Unfortunately he has no incentive to do so. Why work hard to make up for losses when he won't get paid for his efforts (hedge funds can't collect a performance fee until they get back over the previously set high water mark)? This pervasive psychology along with the rise of the Black Swan theory and Dr. Doom and headlines such as “There will be Blood” in our own Globe and Mail newspaper are what typify market bottoms. We may not be out of the woods yet but this is exactly when you want to be putting your money to work. The golden age may have ended for the fancy hedge fund folks, but Mr. Market will happily continue climbing that shiny Golden Wall of Worry for a long time to come.

Certifiably Crazy

2008-11-25T14:53:00.007-05:00

The recent sell-off in Berkshire Hathaway's (NYSE: BRKB) stock has been nothing short of astonishing. But it is perhaps another sign of fear creeping into investors' psychology. Hand in hand with that decline has been a dramatic rise in the value of the company's credit default swaps implying the AAA-rated conglomerate's credit should be considered junk. Whitney Tilson's article published by Seeking Alpha is a great read on this subject. He calls the stock's dramatic decline "certifiably crazy".

Mr. Buffett himself warned of the derivative time-bomb in his 2002 letter to shareholders. Who in their right mind would think that one of the best investors of our lifetime would ignore his own words of wisdom and enter into such perilous contracts? The equity index put options written against 4 indexes appear to be causing the most angst for Mr. Market. Never mind that the contracts do not require him to post barely ANY collateral even in the event these indexes decline dramatically and that any losses recorded on the books are merely paper losses and nothing more. Never mind that the first contract won't expire until 2019 and that they have an average life of 13.5 years. Never mind that according to a just released email from Mr. Buffett, the value of the indexes would have to decline to ZERO for Berkshire to incur a loss equal to its maximum exposure of $35.5 billion. And never mind that he has gotten paid $4.85 billion in premiums for those contracts which he may invest as he wishes.

Mr. Buffett has indicated that he will provide much greater detail about these contracts in his 2008 shareholder letter and that he will provide "all aspects of valuation" and "deficiencies in formula" for pricing the derivatives. He goes on to say that he uses the formula despite the deficiencies. Classic Buffett to point out the shortcomings of the formula. This should make for some fascinating reading.

In a sign of the times we live in, Berkshire's stock has already rallied 28% from the lows they hit last week. They closed today at just over $3,200. Something is not right when you witness this kind of volatility in Berkshire. But it is precisely in the midst of this confusion that you should be taking advantage of the buying opportunities being presented by Mr. Market. Mr. Tilson has. He has doubled his holding in Berkshire by committing 20% of his fund to the stock.

Burnt Hedges

2008-11-15T10:14:00.016-05:00

Fancy suits, designer glasses and a personality that perhaps stood out a bit from the crowd. Back in 2007 as the Dow was marching its way to a record 14,000, these were apparently some of the prerequisites for launching a fund according to some folks. Oh yes, there was one more prerequisite: a secret sauce or ‘black box’ strategy to go along with the fanciness. The Hedgies could do no wrong with returns exceeding 25% a year over the past 5 years or so, justifying their exorbitant fees. Bland looking, boring value investors were out of style.

Well, a Black Swan has swooped in and ripped the Armani suits and the black boxes to pieces. Hedge funds are closing up shop at a rapid pace and more carnage probably lies ahead as redemptions pour in at a furious pace and losses mount. Our own Globe and Mail newspaper has had recent articles about ‘high-profile’ Lawrence Asset Management and Salida Capital which have suffered heavy losses.

To be sure there are those who will come out of this stronger and bigger than before. Steven Cohen’s SAC Capital has managed to raise capital in this environment, a testament to his staying power and superior performance relative to peers. John Paulson’s Paulson & Co. has posted impressive gains amid the turmoil. But the ranks of the Hedgies will be thinner come 2009. Here is a sampling of Canadian hedge funds’ performance as reported by the Globe and Mail in October 2008.

Time to Buy

2008-11-13T20:52:00.022-05:00

It has been a while but life can get busy sometimes. I last posted on Margin of Safety in January 2008 and discussed the possibility of a recession and outright Armageddon. Well, both of those are upon us with a vengeance. I have been investing for a little over ten years and the tech bubble and ensuing recession pale in comparison to what is happening right now.

Meanwhile, I have been behind on updating you on the Model Portfolio but have been posting trades I would have executed during that time. I have just posted an update of the portfolio’s performance for the twelve months ending September 2008. Please visit that section of the blog for more color on the portfolio’s performance. Of course the carnage began in October and the Model Portfolio has not been spared. But I plan to add new positions and add to existing holdings as the market experiences these wild convulsions.

These are scary times for investors. I feel especially bad for those who have been saving to go to college or those who may have been contemplating a retirement. The joke is that 401(k)s are now 201(k)s. Predictions range from a short recession to a long and hard economic slowdown that may last through 2011. One article I read used the expression “contained depression” to describe the environment we will face over the next few years. Others are calling this a bottom while others think we may see Dow 7,000. Regardless, we have given up a decade of gains in the stock market. How this will end and when the markets will begin a turn around are anyone’s guess.

There is no question we have some hard times ahead of us. The number of people losing their jobs is mounting every day. The world’s consumption appears to be screeching to a halt. Oil has lost more than half its value and other commodities have been battered as well. Wall Street has been reshaped forever. Bear Stearns, Lehman Brothers and Merrill Lynch are gone. Goldman Sachs (NYSE: GS) is trading at levels not seen since its IPO in 1999 and is now a bank holding company. Even the most revered investors have not been spared. Buffett, Icahn, Kerkorian, Eddie Lampert and Bill Miller have all lost billions. Many prominent mutual funds that have been closed to investors for years are reopening heir doors. Meanwhile, many hedge funds are reeling from Mr. Market’s wrath and succumbing to the high volume of redemptions forcing them to sell assets at any cost. There is no doubt the recent volatility and severe decline in the valuation of various companies are in part due to investors demanding their capital forcing funds to liquidate in anticipation of upcoming redemptions.

Franchises such as Goldman Sachs and General Electric have been left for dead by Mr. Market. I have been buying both in recent weeks. For all I can tell Mr. Market is assuming that companies such as Intel (Nasdaq: INTC), Cisco (Nasdaq: CSCO), Ebay (Nasdaq: EBAY) and Starbucks (Nasdaq: SBUX) will never grow again. It seems our beloved analysts are overshooting on the downside just as they did on the upside. The bearish mentality is pervasive and even the venerable Warren Buffett is being questioned for his recent moves.

Mr. Buffett has been putting a lot of Berkshire Hathaway’s (NYSE: BRKB) cash to work in recent months. He has financed the acquisition of Wrigley’s by Mars as well as Dow Chemical’s (NYSE: DOW) acquisition of Rohm and Haas for a total of more than $7 billion. He has purchased preferred shares in Goldman and GE to the tune of $8 billion as well as warrants to buy common stock within a 5 year period at $115 and $22.5 respectively. Many pundits are questioning his timing for these transactions. A recent Op-Ed piece in the New York Time also drew fire from critics. In that article Buffett declared: “Buy American. I am.”, and concluded with this paragraph:

"I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities."

As we were going through the tech bubble, the experts declared: this time is different, companies with no earnings are worth infinity. As the Dow worked its way toward 14,000 in recent years they declared: this time is different, China and India will grow indefinitely. Now the Dow is hovering near 8,000 and they have declared: this time is different, Buffett is wrong and he is making his bets too early. Early he may be but wrong he is not. Calling a bottom is a futile exercise but buying companies at attractive valuations is a game winning strategy. Buffett is still the richest man in the world and I am betting he is still the one and only expert to listen to.

a’R’mageddon

2008-01-21T17:02:00.000-05:00

In 2005, while an MBA candidate at Ivey, I was enthralled by David Conklin’s Global Environment of Business class. David is a fantastic professor and was kind enough to warn us on numerous occasions to sell any and all of our US dollars because it had nowhere to go but down. I did not heed his warning.

Fast forward to 2007. I spoke with David in December asking him about his availability to give a presentation on the credit markets to our team at DRI Capital. I confessed to David that I had not taken his advice on the USD. He gave me a second chance. He said Armageddon is upon us and to brace myself. Here we are in January and 2008 has begun with a bang. The Dow has swooned more than 15% from its high (earlier today stock markets around the world were pummeled and the Dow Futures don’t look pretty for tomorrow).

The R word is being thrown around like there is no tomorrow and financial stocks are in a free fall. Even strong results from IBM (NYSE: IBM) and Intel (Nasdaq: INTC) were not enough to calm the jittery crowd. Meanwhile, Bank of America (NYSE: BAC) seemingly took advantage of the turmoil and snatched Countrywide Financial (NYSE: CFC) for pennies on the dollar. At least 30 BofA analysts spent 4 weeks on their due diligence. Time will tell how real the diligence was and if this move was brilliance or stupidity. Countrywide shareholders will get 0.1822 BofA shares for every share they own. Countrywide shares are trading at least 20% below that exchange value creating what could turn out to be a fantastic arbitrage opportunity. The market believes BofA could still walk away or reprice the deal.

Meanwhile, Mr. Buffett is bouncing up and down with joy snapping up more Burlington Northern Santa Fe (NYSE: BNI) on a daily basis. He also figured he may as well start a bond insurance business while he is at it. Look no further than Ambac (NYSE: ABK) and MBIA (NYSE: MBI) to see why he smells blood. I hope you weren’t one of those unloading your Berkshire Hathaway (NYSE: BRKB) stock because according to many Mr. Buffett is apparently past his prime. Well not quite. The shares have all but ignored the downdraft and have rocketed to all time highs as Mr. Buffett works his magic and puts his cash hoard to work. There are also the Sovereign Funds of Kuwait and Singapore and the famous Prince Al-Waleed. All are salivating at the chance to own a piece of America’s behemoth financial titans.

One positive out of all this is that stellar businesses such as Moody’s (NYSE: MCO) are trading at half their peak valuations. And one of our favorites, Mr. Lampert’s Sears Holdings (Nasdaq: SHLD) has been cut in half. Ok, so retail is in the dog house especially since a recession is all but inevitable, if the US isn’t only experiencing one. But I believe Mr. Lampert will squeeze value out of Sears. The real estate and the Sears brands should provide ample downside protection. In the meanwhile, both Mr. Lampert and I thank Mr. Market for giving us the opportunity to buy more stock. Starbucks (Nasdaq: SBUX), the purveyor of my daily morning coffee has also been the subject of numerous analyst downgrades and doomsday scenario press coverage by the media. That is one to keep an eye on. And how about Intel? Robust results and the crushing below we predicted they would deliver to Advance Micro Devices (NYSE: AMD) have not prevented a 30% decline from 2007 peak valuations.

The magnitude of write-offs at the Citigroups (NYSE: C) and Merrills (NYSE: MER) of the world has been staggering. That may just be the tip of the iceberg. But don’t fret Mr. Market’s moodiness. To paraphrase Warren Buffett, be greedy when others are fearful. Yes, life will go on beyond Armageddon and will almost certainly be better than before.

Syntax Destruction

2007-09-18T21:33:00.000-04:00

This past weekend Alan Greenspan was interviewed byLesley Stahl on 60 minutes. During the interview, what was known as "fedspeak" during his tenure as Fed Chairman was coined Syntax Destruction by the man himself. Here is what he told Lesley: "I would engage in some form of syntax destruction which sounded as though I were answering the question, but in fact, had not."

Lesley then went on to play a clip (you may be able to take a peak at it here on YouTube) of one of Mr. Greenspan's testimonies in Congress. I almost fell off my chair laughing. Here is what he said during that testimony:

"Modest preemptive action can obviate the need of more drastic actions at a later date and that could destabilize the economy."

Mr. Greenspan's reaction after he watched the clip, "Very profound." You could sense the sarcasm in his voice a mile away. Not that the Fed's actions matter much to us in the long run. But at least Mr. Greenspan's Fed provided us with some entertainment.

Alpha's Delta

2007-09-18T21:13:00.002-04:00

S&P's total return for August: 1.5%

Goldman Sachs Group's (NYSE: GS) flagship Global Alpha fund performance for August: -22.7%

The Model Portfolio outperforming both: PRICELESS

Moody Brothers

2007-09-12T21:15:00.000-04:00

Some of the most high profile value investors have been hit hard by the recent turmoil in the credit markets. Bill Miller and Wally Weitz have seen their holdings in homebuilders and mortgage originator Countrywide Financial (NYSE: CFC) suffer massive losses.

It doesn’t stop there. Great franchises suspected of being remotely exposed to the subprime fiasco in one way or another have seen their shares pummeled over the past few months. Citigroup (NYSE: C), Lehman Brothers (NYSE: LEH) and Moody’s (NYSE: MCO) are a few that come to mind.

What if Mr. Bernanke doesn’t cut rates? What if home prices plummet? What if the U.S. consumer is tapped out? People asking these questions are also throwing around the R word - you know, a Recession.

Against this backdrop, the Millers of the world are sticking to their guns. In a recent letter to shareholders, Miller contends that he would be a buyer of homebuilders and Countrywide if they were not already in his portfolio. To form, as two large shareholders in Countrywide were unloading shares in August, Legg Mason increased its position in the firm. Then there was Bank of America’s (NYSE: BAC) $2 billion injection into Countrywide which it can turn into an equity stake convertible at $18. And yes, amid this mayhem, our friend Mr. Buffett took a new position in Bank of America and continued to increase his exposure to banks. Mr. Lampert also jumped in and bought a stake in Citi.

A bear trap? Hardly. Is there more turmoil ahead? No doubt. But it is precisely this kind of uncertainty which creates long term opportunity. There is no question that Moody's business will be affected as appetite for fancy loan structures has all but disappeared. But the company's long term prospects will not diminish because of recent scrutiny of its role in the creation of CDOs - that would be a collaterlaized debt obligation. Meanwhile its stock has declined more than 35% from peak. Some of the financials I have mentioned above are trading at extremely attractive multiples and provide Treasury like yields close to 5% to boot. Lehman, as profiled in Barron's recently, could be a Goldman Sachs (NYSE: GS) in the making and trades at only 1.5 times book value. Even Countrywide is worth a look. The company has survived through down cycles before and has managed to diversify its business to include banking. Smaller rivals are exiting the mortgage business altogether. The company should emerge as a stronger player once the market stabilizes. It has ample resources at its disposal to navigate through the credit crunch and is trading below book value.

Moody’s is now predicting that housing’s woes will not subside anytime before 2009. That may seem light years away but if your time horizon is more like 5 to 10 years, this is the time to take advantage of Mr. Market’s generosity and start building a position in some fantastic businesses such as Moody’s and Lehman.

Candy Shop

2007-08-16T23:32:00.000-04:00

"Be fearful when others are greedy and greedy when others are fearful." Warren Buffett

It was only about a month ago that the Dow had surpassed the 14,000 mark. Today, the Dow crashed down close to the 12,500 level. Yours truly felt like I was in a candy shop. The are too many opportunities to list but I hope you were sitting on some cash to be able to take advantage of Mr. Market's generous overreaction. As is often the case, we have gone from one extreme to another. The word 'liquidity' has now been replaced with the words 'credit crunch'. Financial stocks are getting punished and the stocks of numerous companies which were the target of private equity buy-out offers have been dragged lower. We will see how all this plays out. Certainly it is too early to call today's late market recovery an end to the volatility. Problems could still spread to other parts of the U.S. economy and with global implications.

But opportunities to profit from this turmoil in the long-run abound. I have continued to add to my positions in companies such as Citigroup (NYSE: C), USG (NYSE: USG) and Cadbury Schweppes (NYSE: CSG). I have initiated new positions in battered companies such as Lehman Brothers (NYSE: LEH) and Moody's (NYSE: MCO) (the latter 3 stocks are also newcomers to the Model Portfolio). Lehman will get through all this just fine and I will gladly add to my position should shares decline further from here. Moody's has ONLY been around since 1900 and basically forms a duopoly with Standard and Poors as the two dominant rating agencies. This time around the company may have its hands full with regulators because of its role in accelerating the adoption of fancy financial derivatives tied to subprime mortgages which are now wreaking havoc on the financial markets. But the company will make it through this downturn just as it has in the past. For good measure, the company has just doubled its borrowing capacity so it can buy back even more of its stock (Moody's already spends most of the oodles of cash it generates each year on buybacks). The news on housing and subprime probably won't get better anytime soon. But this is exactly what you want. Mr. Market's candy shop is open for business. Be greedy when you walk into the candy shop.

The Muellers

2007-07-22T23:24:00.000-04:00

I wrote about Mueller Water Products (NYSE: MWA MWA-B) last July. At the time only the Class A shares were publicly traded. Later on, Walter Industries (NYSE: WLT) completed the spin-off of Mueller by distributing its Class B shares to its shareholders. The Mueller stake in the Model Portfolio is of the B kind and resulted from owning Walter shares to begin with. But for the AA Value Fund which I update you on from time to time, I purchased Mueller A shares before the B shares began trading.

Back in June I began noticing that the A shares are more volatile but also outperforming the B shares. This was baffling because apart from a smaller float and different voting rights, the A shares represented the same economic interest in the business as the B shares. In fact, if anything, the B shares should have been trading higher than the A shares. The company’s management team was just as surprised about this and didn’t have a good answer for it during a presentation on June 12 at the JPMorgan 2^nd Annual Basic and Industrials Conference (which is still available on Mueller’s web site if you care to listen to it).

The gap between the A and B shares on June 27^th was mind boggling. I sold the A shares at $16.9 and bought a larger amount of B shares at $14.9. Today, that gap has narrowed and the B shares trade at ONLY a 7% discount to the A shares. This situation was also mentioned by Barron’s The Trader column on July 16^th. So far the switch has worked out well with the B shares declining less than the A shares since the end of June. Plus, we own more of the company now and have 8 votes per share as opposed to 1 vote per share. Ah, so much for the efficient market theory – AGAIN.

Below is an update on the AA Value Fund which I last updated you on in January. For the first 6 months of 2007, the Fund was up 21.5% vs. S&P 500’s 6% increase. No capital contributions have been made to the Fund since the beginning of 2003.

Savings Galore

2007-07-05T22:21:00.000-04:00

I last alluded to the skewed perception of U.S.'s savings rate earlier this year. Barron's appears to agree as was apparent in a cover story in May.

Visiting Greenwald

2007-06-28T23:29:00.000-04:00

There are those who make the pilgrimage to Omaha once a year to soak in the wisdom of Warren and Charlie. Then there are those who make the yearly pilgrimage to Columbia University’s Business School for the Value Investing Seminar taught by Bruce Greenwald. I registered for the course a year ago and finally got to attend the seminar last week. It was well worth the wait.

There were 85 students from all over the world and Greenwald did not disappoint. I have written about Greenwald before when I reviewed his book. It turns out he is working on a revised edition due out some time next year. The new version will delve deeper into valuing growth as a value investor. It will no doubt be a must read.

Greenwald overloaded us with information over the course of two days and not all of it has sunk in yet. The valuation cases on Liz Claiborne (NYSE: LIZ), Apple (Nasdaq: AAPL), Amazon (Nasdaq: AMZN), American Express (NYSE: AXP) and Wal-Mart (NYSE: WMT) were outstanding. Plus, it was great to be in the company of other hard core individual and professional investors who are just as passionate about investing as you are.

Greenwald’s valuation methodology is powerful. It combines the search for unglamorous stocks with a valuation methodology based on asset values and current earnings while being patient and disciplined. The seminar underscored the fact that there is no easy way out of thorough analysis and a complete understanding of what you are investing in. Once you have calculated an intrinsic value and determined that a company has a moat, the heavy lifting begins. Are your valuation assumptions sound? Is that moat defensible? Does the company have a sustainable competitive advantage? How much should you pay for growth?

An important concept is that if nothing is popping up as an opportunity, you better have a default strategy. Cash is fine but probably not optimal. At least buy the index against which you are being measured until you find investments worth pursuing.

By the way, in case you are wondering, he doesn’t recommend Amazon at current prices. AmEx on the other hand is a buy.

Lampert and The Prince

2007-06-13T21:33:00.000-04:00

We first profiled Eddie Lampert late in 2005. Since then, Sears Holdings (NYSE: SHLD) has returned approximately 35%. Our thesis on this company and Mr. Lampert has not changed. Meanwhile, others are jumping on the bandwagon. Most recently on June 1st, Morningstar (Nasdaq: MORN), which by the way is a holding in the Model Portfolio, raised its fair value estimate from $150 to $240. Not as exciting was an increase in price target from $195 to $200 by Goldman Sachs earlier today - we can thank strong cash flow generation and valuation updates for that generosity. We highly encourage you to read Mr. Lampert's Chairman Messages to get a sense of his approach to operating a business and to making investments. You are in good hands. Here is what he did with some of the cash Sears generaed in 2006:

$816 million used for share repurchases (we repurchased over 6 million shares in the year at an average price of about $133 per share);
$474 million used for capital expenditure reinvestments in our businesses;
$318 million contributed to fund our legacy pension obligations;
$282 million used to purchase an additional interest in Sears Canada. Our ownership level is now 70%, up from 54% last year; and
$250 million used for net debt reductions as our domestic debt balance declined to $3.0 billion (or $2.3 billion excluding capital lease obligations).

Mr. Lampert generated some other headlines worth mentioning. In May, SEC filings revealed that his hedge fund vehicle, ESL Investments, had amassed an $800 million stake in Chuck Prince's Citigroup (NYSE: C). It appears he built his stake through last September and bought more during the first three months of 2007. Overall, we estimate his average cost at close to $50. We have spoken positively about Citi in the past. My brother and I have been longtime shareholders. With Lampert on-board and a 4% yield, we are happy to continue to hold.

Tracking Buffett 3

2007-04-09T14:19:00.001-04:00

It's that time again. It's been almost a year since we took a peak at Berkshire Hathaway's equity portfolio, although we may have discussed his new holdings in the passing such as his significant holding in USG Corporation (NYSE: USG), the maker of SHEETROCK.

Since last May, Mr. Buffett has disclosed a substantial holding in Johnson & Johnson (NYSE: JNJ) as well stakes in Sanofi-Aventis (NYSE: SNY) and Unitedhealth Group (NYSE: UNH). These new positions are a play on demographics and the healthcare needs of ageing baby boomers. As a bonus, both JNJ and Sanofi are significant players overseas and provide a natural hedge against a potentially vulnerable US Dollar. Furthermore, they provide exposure to burgeoning emerging markets and their inevitable need for healthcare products and services. My brother and I have been a longtime JNJ shareholder and recently added Unitedhealth at around $53.

Berkshire has also added to its arsenal of construction and housing related holdings, including USG and ACME Brick, by taking a small position in Ingersoll-Rand (NYSE: IR), a manufacturer of climate control and HVAC systems among other things.

Meanwhile, Buffett has eliminated or reduced various positions in the portfolio. Lexmark (NYSE: LXK) and Gap (NYSE: GAP) are both gone. Lexmark's stock has made a nice comeback. Berkshire had doubled down on Lexmark after a monumental decline and probably broke even on that trade. In Q4 of 2006, Berkshire reduced its Comcast (Nasdaq: CMCSA) holding after a nice run up in 2006. We have been doing the same with our Comcast holding in the Model Portfolio.

Today, Mr. Buffett revealed 10.9% stake, at prices up to $81.8, in railroad operator Burlington Northern Santa Fe Corp. (NYSE: BNI). It appears he has taken smaller stakes in two other railroad operators as well. Indeed, in his recent annual report, he had mentioned two undisclosed positions worth a combined $1.9 billion. Railroads' fortunes have turned around significantly in recent years accompanied by improved operating efficiencies and pricing power. The railroads should continue to prosper as globalization leads to increased trade (import and export) and as energy demand (coal and natural gas) continues to rise. It is interesting to note that his good friend Bill Gates has a significant holding in Burlington's competitor Canadian National Railway (NYSE: CNI). Our exposure to the globalization and trade theme comes through Expeditors International of Washington (Nasdaq: EXPD) which we own both personally and in the Model Portfolio.

So as markets continue to fret over the possibility of a recession and a slumping housing market, Mr. Buffett is deploying his cash and finding value where others see trouble.

Cigs, Candy and Pop

2007-04-02T21:33:00.000-04:00

If you are a value investor, chances are you are well aware of the buzz surrounding Altria's (NYSE: MO) spin-off of Kraft (NYSE: KFT). In short, today Altria completed the spin-off of its 89% stake in Kraft by distributing those shares to Altria shareholders. We have discussed spin-offs here in the past. And we have participated in them in the Model Portfolio. In a March 22nd email to my brother I described a strategy to play the Altria spin-off:

"The one stock we should probably own is MO. I like the stub strategy. Basically, you buy MO and short KFT. When you receive the KFT spin-off shares, you cover the short position. This way you have created a 'stub' for the MO piece that will be left over afterwards. It's a common strategy to play spin-offs."

If you want to learn more or refresh your memory about the wonderful world of spin-offs, refer back to or order yourself a copy of Greenblatt's book. In this case, on March 22nd, Altria was trading at around $86. Kraft was trading at around $32. So you could have created the 'MO Stub' at about $57.5. Meanwhile, Altria When-Issued shares (which excluded the Kraft portion) were indicated in the mid $60s. At least based on that information, you would be looking at a neat 13% return. Indeed, Altria ended today above $68 as a standalone. Kraft ended below $32. Ignoring the slight gain on our short position, this trade would have resulted in an annualized gain in excess of 270%. Not bad. There goes the Efficient Market Theory again.

In any case, apologies for not writing about this earlier. It would have made for a nice arbitrage opportunity. Here are a few more you may want to consider. One is the upcoming and confirmed split of Cadbury Schweppes (NYSE: CSG). Our friend Nelson Peltz is at it again just as he did with Heinz (NYSE: HNZ), a former Model Portfolio holding. He has amassed a 3% stake. Cadbury will be split its candy and beverage businesses. Who hasn't heard of Trident gum and 7 Up or Dr. Pepper? The confectionary business would be a shoe in for a merger and private equity players must be salivating at the prospects of owning the beverage business. Upon news of Peltz's move, the stock rocketed 10% or so and has inched up since. But dig around a little and you may be surprised to find that a hefty 10%-25% return has been left on the table, based on a sum of the parts analysis, even after the recent run up in the shares.

The other opportunity has nothing to do with cigarettes, candy or pop but has everything to do with the business of security. Brinks Co. (NYSE: BCO) has been the recent recipient of much attention from the hedge fund activists including Pirate Capital and MMI Investments which have taken sizable positions in the company. Pirate's founder eventually got his way and was given a seat on the Board. Since then this one seems to be flying under the radar a bit. Meanwhile, the folks at MMI have been kind enough to share their diligence with us. A bit of sleuthing on the SEC web site and you will come across a set of slides filed by MMI laying out various scenarios under which Brinks management would be able to increase shareholder value. Let me know if you would like me to send the file to you. Needless to say you could be staring at a 10% - 25% return on your investment if you buy the shares at a current $63 with manageable downside risk. So as we did with Harrah's (NYSE: HET), if you are sitting on some cash, you may want to park some with the folks at Brinks.

氣質

2007-03-17T17:44:00.001-04:00

It's been a fun few weeks. Volatility has returned to the markets and with volatility comes opportunity. It was a perfect storm of sorts. A significant decline in the Chinese stock market, Alan Greenspan chiming in about the possibility, not probability, of a recession later this year and soft durable good orders. Not to mention troubles brewing in the subprime mortgage sector. Add it all up and before you knew it the Dow Jones Industrials had declined 416 points.

But look deeper and you may find that this was just a healthy correction after many consecutive months of gains. Maybe more declines are in store. That would be just fine with us too. Let's take a look at the various elements which instigated the downdraft.

The collapse of the Chinese stock market that was all but driven by retail investors has literally no impact on the growth of the Chinese economy. For now manufacturing, income growth and creation of jobs are all that matter. The priority for the authorities is to prevent the economy from overheating. In fact, the attempt to drain liquidity from the economy was one cause of the sell-off.

As for Mr. Greenspan, he was quick to qualify his comments by saying that while a recession was possible, it was not probable. Thank you very much.

The troubles in subprime mortgages may have more damaging effects and could spill over to other parts of the economy. The already fragile housing markets may be broadly affected. Or investors' appetite for risk may diminish, spelling doom for the private equity powerhouses relying on the junk bond market to make the math work. Perhaps, but in my opinion unlikely.

If the private equity players, hedge funds and activist investors were giddy before the market's decline, they must be salivating at their prospects now. Surely, the discount to intrinsic value of companies such as Brinks Co. (NYSE: BCO) and Cadbury Schweppes PLC (NYSE: CSG), being pursued by hedge funds and activist investors, has not disappeared over night.

Then there is Carl Icahn's recent bid for WCI Communities Inc. (NYSE: WCI). Who in their right mind would want to buy a homebuilder now? Let's just say Mr. Icahn has done just fine buying up assets when all others have shunned them. If you are not satisfied with Mr. Icahn's track record, you may be interested in what the folks at Goldman Sachs (NYSE: GS) had to say during their recent quarterly conference call. Goldman did not seem worried and proclaimed that "while market conditions will regularly shift, we are confident that our client-driven strategy will continue to produce the strongest results for the firm." Oh by the way, Goldman is ramping up its subprime operations and is on hunt to snap up distressed subprime lenders on the cheap.

If Mr. Icahn and Goldman are not good enough, let me fall back on our most reliable mentor Warren Buffett. In an interview with Liz Claman of CNBC last week, Mr. Buffett rewarded us with his usual wisdom. It's worth a listen. Here are a few excerpts:

"Long term you will do just fine owning American equities. I have no idea what the market will do next week or next month or next year. Zero. I don't think about it and if I thought about it, it would do no good. The main thing an investor needs is the proper temperament. He doesn't need a 150 I.Q. He doesn't need to be an expert in accounting. But he does have to keep his balance when untoward things happen in the market. The reason investors do poorly in the market is they beat themselves. The Dow went from 66 to 11400 over the past century. You would think it would be hard not to do well over that period ... You have to have emotional stability. And if you have emotional stability and stick with American businesses you will do fine."

"I don't think about the economy. It doesn't make any difference to me because I am going to buy a business and be with it forever. I have never in my life not bought something because I thought the economy is going to get poor and I have never bought something I didn't like because I thought the economy was going to be great for a while. We are going to play the game as long as I am alive. There will be mostly good years, there will be a few sensational years and there will be a few terrible years. I can't dance in and out and skip the terrible years."

"[Berkshire's] own businesses right now are pretty good but the residential construction businesses - the carpet business and the bricks business - have headed down in a significant way. But it doesn't make any difference. We are going to be in the carpet and bricks business forever."

Icahn, Goldman and Buffett. All sucessful investors with the proper temperament. In case the bottom falls from under the Chinese markets again, remember the Chinese word for temperament - 氣質.

GaveKal

2007-02-27T14:19:00.000-05:00

GaveKal is an international boutique economic research firm based in Hong Kong. According to GaveKal, the U.S economy is not on the verge of collapse as many bears proclaim by citing such gloom and doom factors as the bursting housing bubble, the debt-burdened consumer and the yawning US. current account deficit.

GaveKal’s thesis rests on the prospects of the “platform company” or “Sizzle Inc.”, as Barron’s characterized it, which has outsourced the volatile portions of its operations such as manufacturing to become leaner, more productive and, indeed, more profitable than ever. As discussed in a recent Wall Street Journal article, the resulting reduction in economic cycle volatility has been dubbed the “great moderation” by economists. GaveKal provides an in-depth analsyis of why what is happening really is 'different this time' in a must read book titled Our Brave New World co-authored by the firm’s founders.

Instead of building that next plant, corporations are spending more than ever on research and development, which by the way is considered an expnse and not an investment, to be on the leading edge of innovation. Then there is the supposed negative American household savings rate which conveniently fails to take into account spending on healthcare and education, not to mention the rising value of retirement and brokerage accounts. Indeed, contrary to the official figures reported in the press, the U.S. national wealth continues to grow. So is the world's for that matter. Notwithstanding the possibility, or perhaps the inevitability, of a slowdown (earlier today the Chinese stock market declined by 9% while the Dow, Nasdaq and the S&P were all taking a beating to the tune of more than 3% each), the U.S. will always offer the political and economic stability that has been so attractive to the inflow of foreign capital which so many are afraid will one day dry up, ceasing to support the U.S Dollar from a monumental crash.

I am not one to argue with the venerable Alan Greenspan who yesterday warned of a possible recession towards the end of 2007. But instead of trying to time Mr. Market, for those us with a long-term view, it may suffice to enjoy an afternoon coffee, reading GaveKal’s tome and contemplating how best to allocate our investments among GaveKal’s four recommended asset classes: 1. Cash or gold, 2. Emerging markets or commodities, 3. Platform companies and, 4. High quality government bonds. Hint: you should be overweight in platform companies. Wal-Mart (NYSE: WMT) anyone?

Slick Reality

2007-01-31T23:08:00.000-05:00

Oil markets have been on a wild ride in recent weeks. After hitting a high of $77 last summer, oil prices have continued to fall and briefly dipped below $50 a barrel in intraday trading during the week of January 15^th. Today oil zoomed past $58.

Numerous articles have been written about reduced oil demand due to high prices, pegging last summer as the tipping point. Others have tried to figure who will be hurt and who will benefit from the decline in prices. It is somewhat ironic that in the middle of all this volatility, the viability of alternative sources of fuel such as ethanol has come under scrutiny. Lower oil prices in conjunction with rising corn prices make ethanol’s economics much less attractive. But ethanol is another topic for another day.

Analysts and experts appear to be ignoring a multitude of signals and data points which should allay any fears of a dooms day scenario. Of course, this means Mr. Market may be providing us with a few attractive opportunities in the energy sector.

First, there is the share price performance of various publicly traded companies since the slide in oil prices began last summer. They have held up quite well and have even increased in some instances. For example, Exxon Mobil (NYSE: XOM) has appreciated about 20% in that time span. Indeed, even at these lower levels (see graphic from the Wall Street Journal to the left), Big Oil companies remain highly profitable cash machines. In fact these companies’ internal forecasts and capital budgets are predicated on much lower oil price assumptions than we are faced with today.

Second, there is the minor issue of supply and demand. Many opine that based on supply and demand economics alone, ignoring geopolitical factors, oil prices should be at $40. That may be accurate but good luck eliminating those risks altogether. If it was a forgone conclusion, President Bush would not have felt compelled to ask for a doubling of the U.S. Strategic Petroleum Reserves. Apart from this risk premium, the supply/demand imbalance is far from over. A recent guide provided by The Wall Street Journal titled “Unreliable Spigots, Mighty Thirsts” highlighted the precariousness of the world’s oil supply and the insatiable appetite for oil. The U.S. will remain the world’s largest consumer of oil and developing countries’ demand for oil will surpass that of industrialized nations in about two decades. Notwithstanding Peak Oil Theory, this oil will have to come from somewhere, putting a floor on prices.

Third, there is the flow of smart money into energy assets. General Electric (NYSE: GE) recently purchased oil services company Vetco Gray for $1.9 billion. Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) are teaming up to buy the oil and gas assets of Dominion Resources Inc. (NYSE:D) for $15 billion. And yes, there is Mr. Buffett’s $1 billion bet on ConocoPhillips (NYSE: COP). These investors should realize above average returns on their investments without requiring sky high oil prices. Indeed, current oil price levels would suffice. The U.S. Department of Energy’s forecast is for oil prices to dip to $47 a barrel in 2014, rising to $57 in 2030. Keep in mind these prices are well below oil’s 1980’s peak price on an inflation-adjusted basis.

Those three reasons have convinced my brother and I to build a position in ConocoPhillips over the last several months at an average price of $64. The stock trades at just 7 times 2007 earnings estimates. The knock against the stock is its heavy debt load compared to peers, its willingness to pay up for acquisitions and its exposure to such risky locales as Venezuela and Russia (ConocoPhillips has a 20% stake in Lukoil). Still, in the U.S., ConocoPhillips is the third largest oil company, the second largest refiner and the largest natural gas producer. Not bad and you get diversification to boot. We also recently took a position in Diamond Offshore (NYSE: DO) at just below $81. Diamond trades at around 9 times 2007 earnings estimates. The stock has declined as Mr. Market seems to be pricing in an inevitable decline in oil prices which would diminish demand for Diamond’s rigs. But the need to replenish reserves won’t go away anytime soon and Diamond has plenty of rigs to oblige. Diamond sweetened the pot today by announcing a $4 special dividend on top of its regular dividend for shareholders of record on February 14^th. At today’s stock price, if you hold the stock for a year, you can lock in about a 5% yield on your investment and the rest, as they say, is gravy.

The Librarians

2007-01-22T21:36:00.000-05:00

“Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
Warren Buffett, Berkshire Hathaway, 1994 Chairman’s Letter.

There is no shortage of investment disciplines, philosophies and methodologies out there. There are those who look at companies’ fundamentals, there are those who read charts and then there are the quants. The quants gather gobs of data, form hypotheses which are tested against historical data and tweak their computer models to forecast future returns. We all know how reliable past performance can be as a predictor of future returns. In his 1990 Chairman’s Letter, Warren Buffett wrote, “Beware of past-performance ‘proofs’ in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.”

To be sure, venerable quantitative shops such as Renaissance Technologies Corp. and D.E. Shaw have amassed enviable track records and kept their investors happy. One has to wonder though if the market has not ironed out the inefficiencies which have been exploited by these whizzes over the past two decades.

It is interesting that D.E. Shaw’s web site has a section on Qualitative Strategies noting that a large share of the firm’s attention is now spent on identifying “profit opportunities by human experts” and that such strategies “have accounted for much of the firm's growth over the years, and now represent an equally important element of its strategic focus.” Renaissance’s site is too exclusive to post any such information.

Then there was the recent Businessweek article, “Outsmarting the Market”, profiling Barclays Global Investors (BGI), the subsidiary and quant group of parent Barclays PLC. Impressive indeed. $19.9 billion of above market returns or “alpha” over the past five years. 2800 pension funds and institutional investor clients. Billions under management - $370 billion to be exact. Alas, all the fancy research, hypotheses and models for a mere 1.64% above market return on average. This is done by spreading bets across a wide numbers of investments. The idea of a concentrated portfolio is taboo to say the least since that would entail too much price volatility, which as we have discussed before, is wrongly equated with risk.

The quants don’t care much about the companies they are ‘investing’ in. Businessweek writes that the “whole sprawling human drama of business is of no interest to Barclays’ researchers, who never venture out to call on a company or tour a store or a factory.” I wonder if it was the same lack of analysis that lead to Barclay’s acquisition of BGI for $443 million in 1995.

AA Value Fund Update

2007-01-02T20:54:00.000-05:00

I last updated you on the AA Value Fund in early August. Just a reminder that the AA Value Fund is separate from our Model Portfolio. The Fund is a super concentrated portfolio which I will update you on periodically.

The S&P 500 was flat from June to July and began its climb in August. The Fund actually ended August below its July level before mounting a comeback. As I had noted in my last update, the Fund was heavily weighted in the NYSE Group at the time(NYSE: NYX). While we made out OK with that position, we made the mistake of selling it too soon. Had we held on through the end of the year, the Fund's performance would have been stellar. Since August we also took positions in Mueller Water Products (NYSE: MWA) which is also a holding in our Model Portfolio and Harrah's (NYSE: HET) which I wrote about earlier. Mueller at below $14 was too good to pass on and the Harrah's story played as we anticipated with a winning bid of $90 being accepted by the company's Board.

For 2006, the Fund was up 59.7% vs. S&P 500's 13.6% increase. This brings the Fund's CAGR since the beginning of 2003 to 49.3% vs. S&P 500's 13.5% return. I have not made any additional capital contributions to the Fund since 2003.

Our current holdings include Intel (Nasdaq: INTC), Expeditors International of Washington (Nasdaq: EXPD), Leucadia National (NYSE: LUK) and Western Union (NYSE: WU).

The Dressing, The Dog and The Herd

2007-01-02T20:35:00.000-05:00

The end of year provided for some very entertaining reading and tube watching. There were articles galore about end of year portfolio strategies – from tax loss selling to window dressing of portfolios by professional money managers. Among the stocks potentially being dumped, according to a December 26^th Wall Street Journal article would be Corning (NYSE: GLW) which we have talked about before and is a holding in our Model Portfolio.

Then there was the Wall Street Journal article on December 2^nd talking about the oh-so invincible hedge funds who felt they should catch up by unwinding bearish positions and joining the rally. Who says the markets are efficient?!

On another day in December, CNBC had a special on the Dogs of the Dow strategy. That’s the strategy which dictates you buy the 10 worst performing Dow stocks for the upcoming year. Unfortunately for the Dog people, as laid out in another December 26^th WSJ article, real losers may be hard to find. Only 4 of the bottom ten actually finished below their 2005 levels. Intel (Nasdaq: INTC), one of our favorite picks and a Model Portfolio holding to which we added to recently, got the honor as THE worst performer of the Dow with a 19.55% decline.

Amid all of this, I wonder what Mr. Jon Brorson has been up to lately? Mr. Brorson was profiled in a rather amusing article in the WSJ on September 29^th as the Dow was mounting a fierce rally from a July low of about 10,700 to 11,700. He has $2.3 billion under management and apparently has a knack for timing market turns. Oh boy. That’s a recipe for stress if I have ever seen one. The article notes Mr. Brorson’s day begins at 4:50 am and ends by going to bed by 9 pm – “I am wiped out when I get home each day,” proclaims Mr. Brorson. No wonder. Checking the leading sectors every hour and eyeing stock charts by drawing horizontal lines across the peaks and valleys can do that to you. Hopefully he didn’t cut back too much on that Phelps Dodge (NYSE: PD) position which ended the year 40% higher from its September levels after becoming a taekover target. Unfortunately, Mr. Brorson appears too worried about the herd and “knows that if the market keeps defying his expectations, he will at some point be forced to start buying the winners, or risk falling behind.”

I say hold the dressing, love THE dog and ignore the herd.

All the best for 07.

Nancy's House

2006-11-26T22:21:00.000-05:00

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.

SHEETROCK

2006-11-23T00:36:00.000-05:00

"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

2006-11-23T00:14:00.000-05:00

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

2006-11-23T00:12:00.000-05:00

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.

3 and 30

2006-11-01T22:38:00.000-05:00

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.”

The Record

2006-10-24T00:07:00.000-04:00

No explanation needed.

Harrah's Arbitrage

2006-10-11T23:58:00.000-04:00

“[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 2^nd, 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 3^rd, you will note that as early as September 15^th, 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.

Model Portfolio

2006-09-30T19:01:00.000-04:00

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.

Seth Klarman

2006-09-12T23:26:00.000-04:00

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 7^th issue of BusinessWeek. The Globe and Mail featured an article on the book on August 12^th.

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.”

Miller Time

2006-08-28T20:57:00.000-04:00

“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

2006-08-28T20:23:00.000-04:00

“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:

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.
Research any company extensively before making an investment.
Don’t overpay.
Think independently.
Invest for the long-term.
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.

Short-Termism

2006-08-06T22:33:00.000-04:00

"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

2006-08-06T22:29:00.000-04:00

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.

α + β

2006-07-16T17:42:00.001-04:00

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.

The Weather Channel

2006-07-12T22:09:00.000-04:00

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!

Blue Gold

2006-07-08T14:30:00.000-04:00

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.

The Sell-Off

2006-06-10T19:09:00.000-04:00

“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 17^th 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

2006-06-10T18:36:00.000-04:00

“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

2006-06-10T18:26:00.000-04:00

“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%.

Tracking Buffett 2

2006-05-31T20:20:00.000-04:00

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.

Capitalists’ Woodstock

2006-05-25T21:34:00.000-04:00

On May 6^th 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.

Home Sweet Home

2006-04-21T22:52:00.000-04:00

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

2006-04-21T18:48:00.000-04:00

"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.

Intel

2006-04-06T23:20:00.000-04:00

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!”

Timmy's IPO

2006-03-25T10:55:00.000-05:00

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.

AA Value Fund

2006-03-17T22:55:00.000-05:00

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.

Intrinsic Value

2006-02-12T11:16:00.000-05:00

“Many shall be restored that are now fallen and many shall fall that are now in honor.”
Horace, the Latin lyric poet and satirist, Ars Poetica

That is a quote Benjamin Graham used in the first edition of Security Analysis in 1934. Any value investor should know it by heart. It is very difficult to make investment decisions which defy herd mentality on Wall Street especially when those decisions mean ignoring the hot stocks de jour.

The discipline of value investing is a powerful and time-tested approach which has rewarded its disciples through bear markets, bull markets and recessions. Bruce Greenwald’s Value Investing – From Graham to Buffett and Beyond does a superb job laying out the fundamentals as they have evolved since Graham pioneered this school of thought. The book uses case studies to reinforce the concepts including a detailed look at Intel in the late ‘80s and early ‘90s. The second half of the book consists of 8 chapters devoted to the investment approach of some of the most celebrated value investors of all time including Buffett, Greenberg, Klarman and the Schlosses.

This book will become an invaluable investment resource and you will end up referring back to it over and over again. Here is a quick primer on how you estimate the intrinsic value of a security:

Calculate the Net Asset Value of the company. You do this by calculating the Reproduction Cost of the assets. In other words, if a competitor were to enter the market, how much would it need to spend to get in the game. The NAV is calculated by making adjustments to the Book Value which include R&D and Marketing and Advertising expenditures a competitor would need to spend in order to become a genuine challenger. You can use the adjusted book value to calculate a Market Value to NAV ratio as an initial gauge of how expensive a stock may be.

Calculate the Earnings Power Value of the company. To calculate EPV, you start with operating income (EBIT) and make adjustments which include adding back depreciation and amortization and subtracting capital expenditures. This is the same as the distributable cash flow to shareholders assuming no growth. A hard core value investor never assumes any growth when calculating the intrinsic value of a company. We will get to this later. This number is then divided by the cost of capital to calculate EPV. Note that a value investor does not have to contend with the practically impossible task of estimating what a company’s growth prospects may be five or ten years down the road. This eliminates a lot of uncertainly. Incidentally, the difference between the EPV and the NAV, when positive, is called the franchise value. In other words, the company’s moat. The EPV must then be adjusted so you can compare it with the current market cap of the company. To do this, you subtract interest bearing debt and add back all cash in excess of 1% of sales (1% of sales in cash is about how much is needed to operate a company). For a value investor, this is the intrinsic value of the company. Ideally you want to buy the stock when it is trading below the EPV to provide yourself with a Margin of Safety.

So what about growth? What value can we ascribe to growth when we are calculating the intrinsic value of a company such as Intel? The answer is simple. You have to assess whether the company can grow without destroying shareholder value. I won’t get into the details, but basically if the company is going to reinvest excess cash into its operations, it must earn in excess of the cost of capital to create value for existing shareholders. Greenwald calls this growth within the franchise. To calculate what I will call the Growth Factor which is the ratio of the Present Value of Future Cash Flows (PV) to EPV, you need to estimate a growth rate and calculate two ratios: Return on Equity/Cost of Capital and Growth Rate/Cost of Capital. Don’t worry about the math, but with those two ratios in hand you can calculate a Growth Factor. This is how it works. A ratio of 2.0 means the company’s intrinsic value could be twice the calculated EPV. Conversely, if you decide to buy the stock at EPV, the company’s growth should provide you with a 50% Margin of Safety.

A lot has changed since Greenberg wrote the 2001 edition of his book. But keeping his assumptions constant for a quick back of the envelope calculation justifies a $27 intrinsic value for Intel (Nasdaq: INTC). At today’s price this provides only a 25% Margin of Safety. Not enough for a value investor.

Timmy and Wendy

2006-02-06T23:15:00.000-05:00

Canadians love their Tim Horton’s coffee. Canada’s version of Starbucks Coffee (NASDAQ: SBUX), affectionately referred to as Timmy’s, has been an enormous success since its first store opened in 1964. In 1995, Wendy’s International Inc (NYSE: WEN). merged with Tim Horton’s and facilitated its entry into the US market. Over the past 5 years, Timmy’s has carried Wendy’s on its back and has masked the dismal results at the Wendy’s franchise.

Last July, a hedge fund run by Bill Ackman, Pershing Square Capital, demanded that Wendy’s management raise dividends, initiate a more substantial share repurchase program and implement a partial spin-off of Timmy’s. The shares jumped on the news from around $45 to just above $50 and then retrenched before resuming their upward trend. Ackman has been successful in his recent bid to shake things up at MacDonald’s.

In December of 2005, another well-known hedge fund manager, Nelson Peltz, entered into the picture and made more demands. Most significantly, Peltz asked management to implement a complete spin-off of Timmy’s, sell ancillary businesses improve Wendy’s abysmal operating margins by bringing then on par with industry peers. Previously, he successfully turned around Arby’s and Snapple.

In their regulatory filings, Peltz and his Trian partnership disclosed a 5.5% stake in Wendy’s shares at prices ranging from $48 to $51. After that filing, Wendy’s shares jumped to $55. Trian’s filings lay out the recipe for unlocking value for Wendy’s shareholders. The 13D filing is available on SEC’s web site and makes for educational reading. Trian pegs Timmy’s worth at $32 to $36 a share. These numbers were floating around in a few articles on the internet earlier in the year. Trian’s main thesis is that operating margin at Wendy’s franchise can be almost doubled implying a share value of at least $45 for a total valuation of $77 or higher.

I did not catch wind of all this until middle of January. At $45, Wendy’s shares were a huge bargain. If you believed the rumors that Timmy’s would float at $36, Wendy’s franchise was available at $9 a share! While Wendy’s restaurants’ results have not been spectacular, there is no reason to believe that a competent management team could not turn things around. In any case, perhaps hindsight is 20/20. The question we should ask now is if the shares are worth a look at current prices, hovering around $57?

Rumors are that Timmy’s shares will be in high demand. The IPO share price may be as high as $38. The recent success of MacDonald’s (NYSE: MCD) Chipotle Mexcan Grill (NYSE: CMG) spin-off highlights the market’s appetite for this sector right now. Plus, without getting into much detail (I will let you read Timmy’s S1 on your own spare time), Tim Horton’s is a solid growth story. If the shares float at $38, Wendy’s implied valuation per share is about $19. This means there is plenty of value left in the shares if you believe Trian’s pitch and management’s ability to institute a turnaround. Moreover, by buying Wendy’s shares today, you will “lock in” any potential appreciation in Timmy’s shares after the IPO.

Peltz may not get all his wishes. Today, Wendy’s management announced that Timmy’s shares will be fully distributed in 9 to 18 months after the IPO citing tax efficiency reasons. Peltz had hoped for a speedier distribution. On the other hand, Wendy’s management laid out numerous other initiatives to improve efficiencies, sales and margins. While they did not acknowledge Peltz, it seems to me they are on the right track and have effectively endorsed Peltz’s recipe for a turnaround. It will be interesting to see how Peltz reacts to these initiatives.

In my opinion, Wendy’s shares offer a compelling valuation at these levels. While some of the margin of safety may have been eroded over the past 6 months, I believe the prospect of a well received Tim Horton’s IPO warrants taking a position in Wendy’s shares today. Wendy’s franchise will not be fixed overnight, but there is no reason why the operational efficiencies cannot be brought inline with industry peers over the next two to three years. We have taken a position just above $57. May Tim Horton, the National Hockey League legend, work his magic once again.

Diversification

2005-12-30T20:18:00.000-05:00

I have mentioned diversification before. You may not believe me if I told you that Berkshire has 90% of its equity holdings in its top 10 positions. Sequoia has 80% in its top 10. Other examples of concentrated funds include the Fairholme Fund. These and other outstanding investors have achieved stellar results by eschewing diversification as defined by many financial advisors trying to sell index funds to the unsuspecting investor. Instead, they maintain that the best way to minimize risk is to THINK. Invest in those companies you understand best and be selective. I recently finished reading a highly recommended book by Joel Greenblattt, You Can Be A Stock Market Genius. With regards to diversification he cites statistics which he summarizes as follows:

After purchasing 6 or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and
Overall market risk will not be eliminated merely by adding stocks to your portfolio

Limit the number of your holdings to 25 or 30 holdings and you should be just fine.

By the way, Greenblattt’s book is a must read. Remember my recent blog about spin-offs? Well, he has a whole chapter on spin-offs and why they represent great investment opportunities. For a recent spin-off opportunity, you may want to check out Chaparral Steel Company (Nasdaq: CHAP). Talk about a company with an amazing culture. Greenbalt’s case studies are simple to follow and very educational. You will also learn all about risk arbitrage (he doesn’t like this strategy), merger securities, bankruptcies and LEAPS. Perhaps then you can replicate Greenblatt’s Gotham Capital’s 50% annual return . Not bad.

Gooooogle

2005-11-30T23:02:00.000-05:00

There has been lots of talk about Google recently (NASDAQ: GOOG). My brother commented the company is the “darling of the moment on Wall Street”. Is that a fair characterization or is Google for real? Perhaps the more important question is whether the stock is overvalued or undervalued?

This weekend I came across commentary in the Wall Street Journal’s Breakingviews about the merits of breaking up Microsoft (NASDAQ: MSFT). I don’t agree with that proposition but that’s a topic of discussion for another time. The article also talked about Google and compared its valuation to that of Microsoft’s at the same point in the companies’ lifecycles. Indeed, Google’s shares are pricier than Microsoft’s were in their early days. The conclusion was that an investor buying into Google shares would not see the same upside as an investor that had bought into Microsoft shortly after its IPO.

It is hard to argue against that. At about 50 times next year’s earnings, the stock is not cheap. Morningstar has pegged Google’s intrinsic value at $254. Indeed, the upside would appear limited. For example, even if we assume the company can continue to grow earnings at a 30% for the next 5 years, it is conceivable the stock could reach $560 assuming a P/E of 15 at that time. It is trading at around $400 these days after reaching an all-time high of $430.

However, in my opinion, those are conservative assumptions. Google has only begun to scratch the surface of its vast potential. As an example, think about the possibilities as broadband proliferates and video becomes a killer app on the net. Google will be a key player as our living rooms are digitized and we become perpetually connected through our wireless gizmos. It’s not just search and advertising. The company has proven its unbelievable potential by creating Google Earth and Google Desktop and other so-called ‘web services’ offerings are sure to follow.

I recently finished reading Phil Fisher’s classic book, Common Stocks and Uncommon Profits. I finally know what scuttlebutt means! It is no secret that Fisher’s investment approach has influenced Warren Buffett. They both agree that it is futile to try and predict where the market is heading or when the current business cycle may shift up or down. They both advocate holding onto winners and not following the crowd. And Buffett agrees with Fisher that diversification is NOT the recipe for reducing risk.

What does Fisher have to do with Google? He had a fantastic track record of identifying growth stocks. One piece of advice he gives is that an investor should never assume that because a stock is trading at a high P/E multiple, that all the future growth is already discounted by the lofty valuation. In other words, do not underestimate the earnings power of what could be the next ultimate growth stock. This is what I see in Google and by now the stock has already appreciated more than four-fold since the IPO. The road may be bumpy and competition is heating up, but my back of the envelope calculations tell me the stock will appreciate by another 50% over the next five years. Any major decline in the stock should be used as an opportunity to snap up shares.

Valuable Spin-offs

2005-11-24T22:41:00.000-05:00

I have been following public offerings of corporate spin-offs for three years now. You may ask what does this have anything to do with value investing? Well, the rationale behind most, if not all, of these spin-offs is that the entities are not being fully valued by the market as long as they are wholly owned by the parent company. The idea is therefore to unlock value by floating the companies as independent entities. I have only tracked a handful of these spin-offs since 2002. They have all performed spectacularly. Undoubtedly there are cases when the plan goes awry.

It is important to understand the true motif behind a spin-off. Is the parent off-loading debt onto the balance sheet of the new entity? Will the spin-off be allowed to truly compete and behave independently from the parent? Has the spin-off been given a competitive edge by its former parent through a transfer of intellectual property portfolio, for example?

I got interested in spin-offs after I read a BusinessWeek article in early 2002 about FMC Technologies (NYSE: FTI). At the time the stock was trading below $20. Over the past three years I have added Genworth (NYSE: GNW), Hospira (NYSE: HSP) and the recent American Express spin-off Ameriprise (NYSE: AMP) to my watch list. I held FTI for a while but sold it way too early. I have never owned the others. Too bad.

It will be interesting to see what Mr. Buffett will do with his newly found shares of Ameriprise (He owns 12% of American Express (NYSE: AXP). If he keeps them, then perhaps that is a signal that indeed the shares offer the value investor a decent Margin of Safety. It is interesting to note that in an article about Ameriprise published by the Wall Street Journal on September 28th, Mr. Nadel of Fox-Pitt Kelton said: ""If the stock falls below $34, then investors should want to own it because the downside in the stock is limited and the upside could be very attractive if management could execute on improving the company's return on equity." at the time of the article the shares were trading on the "when-issued" market at $37.25. When trading officially began in early October, the shares where at $35 and traded to a low of $32. Today they trade at $44. Yes, spin-offs can be lucrative.

Berkshire's Surprise

2005-11-24T21:36:00.000-05:00

It’s official. This week Berkshire Hathaway submitted filings to the SEC disclosing its position in Anheuser-Busch (NYSE: BUD). Mr. Buffett has been accumulating shares since Q4 of 2004. He initiated a position with 9 million shares and has accumulated just over 44 million shares through Q3 of this year. By the end of Q2, Berkshire had 40 million shares of BUD.

The biggest surprise was the disclosure of a stake in Wal-Mart (NYSE: WMT) to the tune of $870 million! The majority of that position was built through Q2 with 15 million shares. An additional 5 million shares were added in Q3. In recent months, there have been numerous articles, including one from Barron’s in early October, discussing Wal-Mart as potentially undervalued by a wide margin. Barron’s noted that Mr. Buffett has on numerous occasions mentioned his failure to take a full position in Wal-Mart in the late 90’s as one of the biggest mistakes of his investment career. At the time, Wal-Mart was trading at much higher multiples than today. The bottom-line is that Wal-Mart has one of the widest moats of them all. And when a company of this quality is trading at the same multiple as the S&P 500, you don’t hesitate. Just load up!

As I have noted in my previous posts, I have taken positions in both of these companies in recent months. I have to say it feels good to know the best investor of our lifetime, perhaps ever, is on my side.

What Price Growth

2005-11-17T21:03:00.000-05:00

It goes without saying that the next Starbucks (Nasdaq: SBUX), Intel (Nasdaq: INTC), Microsoft (Nasdaq: MSFT) or Cisco (Nasdaq: CSCO) is staring us in the face today and we just don’t know it. These companies, among others, turned out to be the penultimate growth stocks of the past two decades. Should a value investor invest in growth stocks? Or is it senseless to apply the Margin of Safety principal to these companies? A true Grahamite might cringe at the thought, but as Berkshire’s Buffett and Legg Mason’s Miller have shown, Growth at a Reasonable Price is value investing at its best.

This week, Morningstar (Nasdaq: MORN) published an update on a study of 50 stocks, examining what would have been a reasonable price to pay for Cisco, for example, back in 1995. Their methodology is simple and yet extremely creative. In this case, Morningstar chose the S&P 500’s performance over the past 10 years as the benchmark. They then calculated what the maximum price an investor could have paid for the stock back in 1995 in order to just match the index’s performance. This means if the stock was trading below this theoretical maximum, the stock effectively had a built in Margin of Safety and would have outperformed the index. In Cisco’s case, the stock was trading at $1.95 with a P/E of 27. Even if an investor had paid $6, implying a P/E of about 80, he would have matched the S&P 500 toe to toe. Also on the list are Amazon (Nasdaq: AMZN), Ebay (Nasdaq: EBAY), Yahoo (Nasdaq: YHOO) and XM Satellite (Nasdaq: XMSR). No doubt we will one day look back at these and others as the next generation of growth stocks.

Morningstar’s conclusion is that assuming you have identified a true high quality growth story, you should not be afraid of paying up for that growth as long as you have determined a Margin of Safety exists. The P/E may be high, but in the end, what matters is the company’s ability to generate free cash flow and to invest that cash to earn superior returns above its cost of capital.

Morningstar's recipe to find the next set of growth stocks is to look for companies with these characteristics:

An emerging economic moat (a term used by Buffett and Munger meaning sustainable competitive advantage).
Ability to thrive in good and bad times, fulfilling unmet needs or providing superior products.
A motivated and growth-oriented management team with personal skin in the game.

Some stocks that may fit the bill are Google (Nasdaq: GOOG) (yes, even at these prices), Teva (Nasdaq: TEVA) (the undisputed generic biopharmaceutical champion) and Morningstar (the well respected financial information and independent research firm which I believe is on its way to becoming an asset management powerhouse). Too bad the folks at Morningstar don’t rate their own stock – a wide moat and a five star rating anyone?

Value v. Growth

2005-10-14T16:20:00.000-04:00

Over the past several months I have come across a number of articles discussing the increasing popularity of the forgotten growth stocks, especially amongst professional money managers. I suppose historically, value investors have in general favored sectors such as financial and industrial stocks while shunning typical growth sectors such as healthcare, consumer staples and technology.

I find all this talk about value versus growth somewhat confusing. Sure, when value investors are loading up on their favorite value stocks, growth stocks are most probably trading at multiples outside their comfort zone. Inevitably though, value stocks begin to outperform while growth stocks go through a rough patch, period of underperformance or a correction. Value investors then change their tune and begin considering purchase of traditional growth sectors. You get the picture. I think Bill Nygren of the Oakmark Fund put it very eloquently at a recent conference when he said that Wall Street is now "an upside down world" and that "buying above-average businesses at average prices is just as much value investing as is buying average business at below-average prices."

This is in effect what Buffett has been doing ever since he took a position in Coca Cola - Growth at a Reasonable Price. In his book titled Money Masters of Our Time, John Train notes that Buffett dismisses the distinction between Grahamian value investing and buying prime growth stocks, "saying that both techniques involve analyzing the present value of the future cash flows you expect to receive."

Incidentally, I recently finished reading Train's book. It was interesting to learn about the different investment styles of some of the most successful investors including T. Row Price, Philip Fisher, Soros and Lynch. The book is full of valuable insight and advice. I found the chapter on Soros fascinating - talk about a high pressure, high risk investment style. Train does a good job summarizing the philosophies and investment styles of these investors and ends the book with a chapter titled Lessons from the Masters.

It is interesting that whether they are value investors, growth investors, emerging market gurus or currency speculators, they all have common attributes necessary to make any investor successful. Here are a few attributes to note:

Remember you are buying a share of a business. Make sure you understand the business.
Buy stocks when they are unpopular. My brother and I recently added Wal-Mart (NYSE: WMT) to our portfolio. Talk about a stock that has been hammered and a company under scrutiny. Another recent addition to our portfolio is Anheuser-Busch (NYSE: BUD). Let's just say beer is not in with the crowd right now.
Do not be spooked by market fluctuations. Let the story play out. I think in the immediate after-math of a purchase, I have almost always lost money. Always remember why you bought the stock in the first place. My Pier 1 holding recently hit $10 a share. Five years ago I may have sold. But this time, I am waiting for the story to play out.
Buy stocks when they are cheap. Don't buy Intel (Nasdaq: INTC) when it's trading at a historically high multiple and every analyst on Wall Street is upgrading the stock. Speaking of above-average businesses at average prices, I have continuously added to my Intel and Cisco (Nasdaq: CSCO) for more than a year. It was comforting to see Bill Miller at Legg Mason's Value Fund recently added Cisco to his portfolio as well.
Be flexible. The Money Masters have all had the uncanny ability to change with the times. Buffett evolved from a pure Grahamite and slowly incorporated qualitative measures into his approach. Others such as Soros are ready to switch directions on a moment's notice. Train's epigraph to his book is one worth remembering: "Times change and we change in them."

Eddie Lampert

2005-10-02T15:32:00.000-04:00

You may have heard of Eddie Lampert if you shop at Kmart or Sears. Actually, he has been around for a while and is considered one of the most successful value investors around. He founded his private investment fund, ESL Investments Inc., in 1998 with $28 million of seed money from another legendary investor, Richard Rainwater. ESL now has $9 billion under management and Lampert’s net worth is believed to be around $2 billion. Since 1988, ESL has earned 29% a year – compare that to Berkshire’s 25% a year return since 1965.

Lampert has successfully invested in undervalued companies and, unlike Buffett, is not afraid of to consider companies run by sub par management teams. His rational is that those situations offer an even larger potential reward.

Most recently, Lampert was in the news for emerging as one of Kmart’s largest shareholders following that company’s bankruptcy proceedings. Kmart’s stock has rocketed from $15 in 2003 to a high of $160 back in July. It is now sitting at around $120 post-Katrina.

A few important things to note about Lampert’s Kmart foray. Not long after emerging as a controlling shareholder, he made a bid for Sears and merged the two companies into Sears Holdings Corporation (NYSE: SHLD). The company has in excess of $3 billion in cash and is cash flow positive. More importantly, the Board of Directors has given him free rein on the use of cash. This is pretty much what Buffet did with Berkshire. He milked the textile mill for cash and turned Berkshire into an investment vehicle. A la Buffett, Lampert is not giving guidance to the street and instead opting to update matters through his shareholder letters available on Sears’ corporate web site.

For now, Lampert is intent on turning Sears and Kmart around and in August announced that he will be taking a more hands on role in the marketing department. Regardless, his focus is on transforming the culture at Sears, profitability and cash flow generation. He has made it clear that top line growth does not interest him.

Estimates vary as to the Sears’ intrinsic value. I have seen estimates as high as $190 a share just on the basis of the company’s real estate assets. You could also argue that the shares are overvalued and that you are paying a Lampert premium at these levels. The fact is that the shares have come off their peak and have been under more pressure, going as low as $115 recently, as Katrina and Rita have wreaked havoc in the South, hammering many retailers’ operations. I was too slow to pull the trigger when the shares were at $100. This time, my brother and I agreed to get in at $130 before the hurricanes hit.

Let’s call it the Lampert experiment. He has the track record and manages money for a number of well-known wealthy individuals including Michael Dell. It is also comforting to know that successful value investors such as Legg Mason’s Bill Miller and Third Avenue Fund’s legendary value investor Martin Whitman own Sears in their portfolios. In fact, Whitman partnered with Lampert during the Kmart bankruptcy proceedings. Whitman is quoted as saying. “There is no question he will turn Kmart into an investment vehicle like Buffett’s. That is what I am valuing into the stock.”

Tracking Buffett

2005-09-22T20:26:00.000-04:00

I have been tracking Berkshire Hathaway's stock holdings since Q4 of 2003. The company usually files with the SEC about a month and half after the end of the quarter. My thinking was that I might be able to learn a thing or two from Buffett (or Lou Simpson at GEICO for that matter).

When I tallied everything up for that quarter I discovered, for example, that Cadbury Schweppes (NYSE: CSG) had been added to the porfolio. This means Berkshire had bought CSG at prices ranging between $25 and $30. At the time of filing, the stock was trading in the mid $30s. Curiously, CSG was eliminated from Berkshire's filings the following quarter whenBerkshire notified the SEC that it was not obligated to disclose foreign corporation holdings. In any case, the shares traded in the $30-$35 range through October 2004 and then took off to a recent close near $42.

In 2004, Berkshire either eliminated or reduced several of its holdings. It also asked the SEC for confidentiality treatment on its Sun Trust holding in Q4 (In Q2 of 2005, Sun Trust reappeared in the SEC filing but the position had been pared back by 45%). Additions to the portfolio included Pier 1 (NYSE: PIR) in Q2, Comcast Corp (Nasdaq: CMCSA) and Servicemaster Company (NYSE: SVM) in Q3, and Dean Foods (NYSE: DF) in Q4. The Comcast position was doubled in Q4. Incidentally, SVM's business is as simple as providing lawn-care and housekeeping services. Classic Buffett!

So far in 2005, Berkshire has asked for SEC confidentiality on its H&R Block and Torchmark holdings. It has also added Home Depot (NYSE: HD), Lowes Companies (NYSE: LOW), Lexmark International (NYSE: LXK) and TYCO (NYSE: TYC) in Q2. Not disclosed but widely publicized, Berkshire also took a 'significant' position in Anheuser Busch (NYSE: BUD) in Q1.

If you are curious, BUD is trading below the $47-$49 Buffett would have paid (but keep in mind that Berkshire may have gotten warrants or preferred shares for its investment). So is PIR which Berkshire probably bought at prices ranging from $17 to $20. Berkshire added Comcast over two consecutive quarters with prices ranging from high $27s to about $30. The stock is at $29 after hitting a high of $34.5 earlier this year.

To be sure Buffett has had his share of bad calls. But overall, his track record speaks for itself. What I should have done was to buy his B shares (NYSE: BRK-B) at $1,000 when he issued them in 1996. Instead I waited 9 years before I finally added a few shares to my portfolio at $2,800.

I also like the Comcast story: largest cable operator in North America, strong and growing free cash flow, declining capital expenditures and a generous stock buyback program. In the most recent earnings call, Comcast's CEO expressed disappointment with the share performance but noted that this has provided him with opportunity to buy back shares at prices management views as attractive. I have added Comcast to my portfolio at around $32.

Finally, I am intrigued by Pier 1, the largest specialty furniture retailer in North America. The company is in big trouble as competition from Target and Wal-Mart is heating up. Yet, this is a 43 year old company with CEO who has been at the helm for 30 years. He has been through it all. Buffett must like the management team if he invested. I am sure he is also fond of the dividend (which at these prices is north of 3%!) and the share buyback program. Pier 1 has hardly any debt and slowing store expansions to concentrate on improving productivity and operating margins. This fall, the company will mail its first nation-wide direct-mail catalog. I have added Pier 1 at around $12.50. It is comforting to know that Buffett understands the furniture business well. After all, he did purchase 90% of Mrs. B's Nebraska Furniture Mart for $60 million in 1983 with a handshake.

Mr. Market

2005-09-07T20:44:00.000-04:00

The trip to Bandon was a success. My game held up and I even managed to post a few good scores.

I recently finished reading a fantastic book titled “Buffett: The Making of An American Capitalist” by Roger Lowenstein, a WSJ reporter. He did an excellent job chronicling Buffett’s early days and his path to success.

This book is a great read for anyone who wants to learn more about Buffett’s way of thinking and his philosophy about investing. You will also learn about the annual gathering of the Graham Group (founded by Buffett) which has grown in size throughout the years and includes renowned value investors such as Bill Ruane as well as Buffett’s good friend Bill Gates. What is important to note is that Buffett has modified Graham’s highly quantitative approach and introduced a more subjective and qualitative outlook on potential investments, a la Philip Fisher. This is manifested in his decision to buy shares of mega-franchises such as Coca-Cola and American Express. The shares may not have been “cheap” according to Graham’s view of the world, but Buffett’s genius was to understand the future earning power of these companies, to redefine “value” and to buy the shares at a “fair price”.

Buffett’s philosophy is summarized by Lowenstein and I have paraphrased them below. Print this and pin it on the wall next to your computer. It’s simple but powerful. The trick is to control your emotions when you invest. Do your research, make a decision and commit big time. As Ben Graham would say, do not let Mr. Market’s ups and downs trick you into questioning yourself.

Don’t worry about economic forecasts and analyst price targets. Assess the value of the company from a long-term perspective and become part owner of the business by buying shares at a fair price.
Invest in companies in which managers behave as owners and treat investors’ capital with care and responsibility (think return on equity).
Buy stocks in companies and industries which you understand well.
Do your own research.
When you have identified an opportunity, buy the stock and buy a ton of it!

Value Investing

2005-08-16T16:53:00.000-04:00

What better day to get things started than on a day when the markets were in shambles. The Dow was down 120 and the Nasdaq about 30. Worries about inflation and lackluster profits from companies such as Wal-Mart were the culprits this time.

Let me first tell you what this BLOG will be all about. I made my first trade back in 1996 when I opened an account at Charles Schwab while attending MIT in 1995. I remember reading the Wall Street Journal and trying to make quick money by trading biotech stocks which I thought had the potential to make a move once news of various clinical trials were announced. It was a hit and miss strategy at best.

Around the same time, I remember reading an article in the WSJ about a well known investor by the name of Warren Buffet who was contemplating issuing B shares in his company at $1000. The article noted the price of the A shares at around $20,000. I was flabergasted. How could shares of a company trade at such a crazy level? Who was Buffet?

A bit of research about Buffet and his company, Berkshire Hathaway, lead me to Benjamin Graham and a book by the title of Intelligent Investor. I also read a book about Buffet and his life. Graham's investment philosophy was to buy shares of companies that were trading at a discount to their Intrisnsic Value. The idea was to buy shares at a large enough Margin of Safety relative to their Inrinsic Value to ensure superior returns. Buffet adopted this philosophy and supplemented Graham's methodology with his own qualitative measures: Value Invesing at its best. This is what this BLOG is all about - trying to learn from the masterful investors of our time. Which companies are the next American Express or Coca Cola or IBM? Were Graham and Buffet simply at the right place at the right time? Or are companies such as Google the next ultimate value plays staring us in the face? What is Buffet up to these days? Who are some of the other Graham disciples and what can we learn from them?

Time to leave for my annual golf trip to Bandon Dunes. For now, I need to worry about my swing woes. I will need all the help I can get especially if the winds are blowing on the Oregon coast.