Berkshire Ruminations

Wednesday, December 27, 2006

Sears Holdings - Part 2

As soon as Eddie Lampert and his fund, ESL Investments, put together the surprise takeover of Sears Roebuck to create Sears Holdings, changes in the temperament of the company began to surface. Lampert, in his role as Chairman of the new company, immediately began insisting on undertaking only value-creating projects. Quit selling products at a loss just to compete with Wal-Mart. Quit carrying excess inventory. Quite simply, get more efficient. The most interesting change, though, is much more subtle. Within months, Lampert had decided to abandoned the ingrained Wall Street convention of hosting quarterly conference calls, writing quarterly letters to shareholders and providing earnings guidance in anticipation of the conference calls and earnings announcements.

Humorously, once Lampert ceased issuing earnings guidance, analysts quit following the stock! As if the analysts agreed in unison, “Well if the company won’t tell me how to rate the stock, then I wont bother trying.” We can infer what we wish about what this says of the stock analyst’s role in the market, but to put things in context, SHLD currently has seven analysts following the stock. Companies of similar size such as Best Buy, Starbucks and Charles Schwab generally have fifteen to twenty ratings.

Lampert’s dismissal of this standard Wall Street practice can be interpreted in one of several ways. On one hand, it may indicate his arrogance or contempt for the individual investor. This is plausible, as Lampert’s hedge fund owns 40% of the company – the individual makes up a comparatively small chunk of the ownership picture. On the other hand, perhaps Lampert and management simply want to avoid the burden of constantly having to answer to the market about matters of which it is not concerned. This is one explanation given by the company for its decision.

On yet another hand, perhaps it is indicative of his focus on the long-term prospects of the company. A couple of years ago, I was fortunate to meet and hear Professor Michael Jensen speak to our college. The famed Harvard scholar has, more or less, written the book on the incentives of corporate managers and appropriate ways to compensate them. On this particular day, his message was remarkably simple and clear: “We must stop the earnings guidance ‘game.’” His contention, later formalized in a paper called “Just Say No to Wall Street,” was that focus on the short-term expectations is responsible for many of the corporate governance issues in our recent history, particularly when executive compensation is directly tied to these short-term expectations. Further, he claims that an “overvalued stock can be as damaging to the long-run health of a company as an undervalued stock.”

This struck a chord with me as an admirer of Berkshire Hathaway, which provides no earnings guidance, and of Warren Buffett, who has insisted for years that he would rather Berkshire stock trade at a fair value than a high value. Since the overwhelming majority of companies today provide earnings guidance to analysts and host quarterly conference calls, we can not expect to invest only in companies that do not. However, when we observe a company abstaining from these practices, such as Sears Holdings, I feel we can be somewhat more confident that the managers are indeed managing in the long-term investor’s best interests.

One more reason why SHLD may be an interesting ride.

FD: I own shares of SHLD

Wednesday, December 20, 2006

The Best Investment I've Ever Made and Lessons Learned

I came of age financially in the era of irrational exuberance. It was the mid-1990s, and losing stocks were relatively rare. Everything, it seemed, was a winning pick and unfortunately it was also around then that I began picking stocks myself. Netscape. Sun Microsystems. AOL. This was too easy, I started to think. Fortunately, I was somewhat grounded by a levelheaded stock broker who, although not often pushing the types of stocks I would choose today, kept the little money I had safe. I know this because many of the picks I made without his advice proved to be disasters. (The 900% gain I once had on Sun evaporated and I eventually sold at a 50% loss.)

One stock my broker convinced me to buy was in a company called Green Mountain Coffee Roasters (GMCR). It was 1997 and, adjusted for splits, my purchase price was around $5.00. The stock is now around $50, for an annualized return of about 27%. For ten years. The ride has not been a roller coaster, but it has been consistent. For me, it has been fun watching this company grow and my holdings grow along with it, all while the telecoms and dot-coms on which everyone else was so fixated soared, crashed and then disappeared.

In retrospect, the Green Mountain purchase seems somewhat prescient. It is exactly the type of company I look for today, but that I bought long before I knew the first thing about Warren Buffett. I am quite fortunate to have stumbled upon it, not only for its returns but for a lesson in how good business leads to success.

CEO Bob Stiller is an entrepreneur. He founded the company, has led the company throughout its history and still owns 32% of it personally. He is truly the patriarch of the company, and it is his value system that seems to guide the company. This value system is rooted in the following principle, as described on the company’s website:

“Green Mountain Coffee is dedicated to conducting business in a manner that balances economic goals with environmental and social impacts on the local and global communities.”

The hardened capitalist might object to this do-gooder business model, but that doesn’t bother the company. It is the socially responsible business practices, in fact, that attract customers to Green Mountain products anyhow. The drinkers of gourmet coffees, of course, are stereotypically young and liberal, and generally not too keen on "big corporations” like GMCR. As evidence of Green Mountain’s surmounting of this problem, observe the wild success of the company’s fair-trade coffees and Paul Newman’s “Newman’s Own” product line.

When I first learned about Green Mountain’s humanitarianism, I was skeptical. It just seems too easy for a firm to claim it is doing good, all while padding its own pockets. In ten years of watching the company and its philanthropy, I am convinced that I have not simply been getting lip service. Moreover, it is reassuring to know that folks with enough integrity to put charitable giving on the same level as profits are running my money. I trust the leaders of this company as much as I can trust any stranger.

While sitting across the table from Warren Buffett at lunch last fall, I asked him about a problem of mine that has impeded my investing ever since I first tried to emulate his style. “You say to invest in companies run by managers that you trust, but how can I, as an individual without direct access to them, determine if those managers are trustworthy?” His response? “Look at how they are compensated.”

How true. Rare is the crooked executive that doesn’t first find a way to pay himself handsomely. Key Lay, for example, is said to have taken nearly a quarter of a billion dollars from Enron before its fall. Bernie Ebbers was paid over $10 million in salary alone in 2000.

According to Green Mountain's latest proxy statement, Bob Stiller was paid no more than $400,000 in 2005. The company’s use of executive stock options has also been somewhat limited - Stiller also currently has options valued around $2,000,000. The next highest paid executives top out around $200,000 and far fewer options. These aren’t Buffett-esque compensation numbers, but they also aren’t outrageous, particularly for an individual who currently owns about $115 million worth of company stock.

I have neglected the fundamentals of the company in my analysis as that is not the focus, but can assure you they are terrific. Earnings have grown at a 21% clip to keep up with the rising stock price and ROE has averaged 17%, all while operating with very little debt, although recently the company did obtain a large revolving credit facility as part of its acquisition of single-cup-brewing-system maker Keurig, Inc. Keurig, it should be pointed out, is a fantastic competitive advantage to the company.

It is easy to overlook the honor of management when a company is performing well, but one should be careful not to do so. If the recent past has taught us anything, it is that a company is much more than a ticker symbol and a price, or even a balance sheet and an income statement. Trusting management is crucial to an investment decision, not only as a means to avoid disaster, but because trustworthy companies are just better businesses.

FD: As indicated in this article, I own shares of GMCR.

Friday, December 01, 2006

USG, asbestos and Berkshire

USG shares shot up yesterday on an upgrade, so I guess it is time I got around to writing about this company.

US Gypsum, or USG as the parent company is now called, manufactures home building products such as wallboard, floor tiles, ceiling panels and the like. It is a manufacturing company that is just about as simple and understandable as they come. Unfortunately, in addition to making these products, years ago the company also manufactured, well, asbestos.

As I indicated earlier in my general discussion of bankruptcy, firms emerging from Chapter 11 can make great investments for value investors. The stock in the new company, although the old shareholders may no longer own it, is less burdened by the heavy liabilities that led the company to file in the first place. Meanwhile investor sentiment is often highly negative and can result in undervaluation – who wants to own stock in a bankrupt company anyhow?

But the USG case is in a special subset of bankruptcies. Its bankruptcy is the direct result of asbestos litigation, a trigger that has caused a superfluity of Chapter 11 cases in recent years. Other companies in similar situations to USG (and that may warrant blog postings all their own) include Owens Corning, Armstrong and Federal-Mogul.

In the early seventies, when the dangers of asbestos became widely recognized, a key ruling by a federal Appeals Court declared that victims of asbestos can sue on a product liability basis, rather than a workers compensation basis. This meant that cases could be heard by a jury which could award plaintiffs virtually unlimited damages. And so the lawsuits began. The decision was appealed to the U.S. Supreme Court and upheld, making it applicable to courts throughout the nation.

Over the years legislators tried unsuccessfully to pass various versions of what would have been the Fairness in Asbestos Litigation Injury (FAIR) Act. Such an act would create a national fund from which all future asbestos claims could be paid and which would be funded by those companies subject to asbestos litigation as well as their insurers. Additionally, the act would all but prevent any individual from filing subsequent lawsuits. For one reason or another this bill has never been passed, although a newer version still sits before the Senate.

Instead, the Bankruptcy Code was amended in 1994 to provide for alternative protection for firms. The provision is Section 524(g) and allows Chapter 11 firms to create their own private trust funds from which future liability will be paid. Thus, a firm that has emerged from bankruptcy and created such a fund will not be exposed to any additional, unforeseen asbestos liability. This has encouraged as many as sixty firms to file bankruptcy primarily for the 524(g) benefits. USG is among them.

Warren Buffett began buying USG back in 2001, shortly after the company had filed Chapter 11. He is very familiar with the economics of asbestos-litigation-plagued firms, both through his experience writing insurance policies and with companies Berkshire owns such as Shaw Industries and Johns Manville. In typical fashion, he has stuck with the stock throughout its bankruptcy, obviously aware of the prospects for the firm’s stock. He saw it rise over $100 and then fall back to the mid-$40s. Importantly, the stock survived and creditors will be repaid in full. In fact, the only real consequence of the entire five year bankruptcy is the creation of a large 524(g) fund and the relief from future asbestos liability. Clearly not a prototypical bankruptcy case.

The 524(g) trust is large, though. The company made a $900 million payment in June as it emerged from bankruptcy protection and will contribute $1.8 billion more over the next two years. This was disastrous to the company’s earnings, of course, as USG was forced to take a huge charge. At the same time, the housing industry was in a substantial downturn and makers of building materials were dragged down with it.

So the stock looked cheap back in June as the company emerged from bankruptcy protection, which is likely why Berkshire, already a large shareholder, agreed to help finance the reorganization plan by “backstopping” a stockholder rights offering. This means that, in order to raise the cash to fund the trust, shares were offered for sale to existing shareholders at $40/share and if those shareholders didn't contribute the $1.8 billion needed, Berkshire would buy the difference itself. As a result Berkshire has amassed an 18% stake in the company. Since the rights offering, the stock has risen to $54.

It will remain interesting to watch events unfold, particularly the performance of the company which by all metrics looks very good. But also how other companies with asbestos burdens fare. Perhaps we will even see the passage of a FAIR act sometime soon. Stay tuned, this should be an fun ride.

FD: I own shares of USG and of course Berkshire, but none of the other companies mentioned in this posting.