Syntax Destruction

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

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

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

"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

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

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

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

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

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

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

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

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

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

“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

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

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

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

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

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

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

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

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

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

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

Timmy and Wendy Part Ways

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

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

Sears Capital LP

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

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

3 and 30

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

Warren Buffett, recounting a conversation with a hedge fund manager

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

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

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

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

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

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

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

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

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

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

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

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

The Record

No explanation needed.

Harrah's Arbitrage

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

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

This brings us to the recent buy-out offer for Harrah’s Entertainment (NYSE: HET) by a private-equity group which may offer an intriguing arbitrage opportunity. On October 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

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

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.”